Financial management: concepts and applications 9780132936644, 1292077832, 9781292077833, 013293664X

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Financial Management  Concepts and Applications

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Global edition

Global edition

Foerster

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Global edition

Financial Management

Concepts and Applications Stephen Foerster

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Financial Management Concepts and Applications

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The Pearson Series in Finance Bekaert/Hodrick International Financial Management Berk/DeMarzo Corporate Finance*

Foerster Financial Management: Concepts and Applications* Frasca Personal Finance

Berk/DeMarzo Corporate Finance: The Core* Berk/DeMarzo/Harford Fundamentals of Corporate Finance* Brooks Financial Management: Core Concepts* Copeland/Weston/Shastri Financial Theory and Corporate Policy Dorfman/Cather Introduction to Risk Management and ­Insurance Eakins/McNally Corporate Finance Online* Eiteman/Stonehill/Moffett Multinational Business Finance Fabozzi Bond Markets: Analysis and Strategies Fabozzi/Modigliani Capital Markets: Institutions and ­Instruments Fabozzi/Modigliani/Jones Foundations of Financial Markets and ­Institutions Finkler Financial Management for Public, Health, and Not-for-Profit Organizations

Gitman/Zutter Principles of Managerial Finance* Principles of Managerial Finance––Brief ­Edition* Haugen The Inefficient Stock Market: What Pays Off and Why The New Finance: Overreaction, Complexity, and Uniqueness Holden Excel Modeling in Corporate Finance Holden Excel Modeling in Investments Hughes/MacDonald International Banking: Text and Cases Hull Fundamentals of Futures and Options Markets Options, Futures, and Other Derivatives Keown Personal Finance: Turning Money into Wealth* Keown/Martin/Petty Foundations of Finance: The Logic and Practice of Financial Management* Kim/Nofsinger Corporate Governance

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Madura Personal Finance* Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives McDonald Derivatives Markets Fundamentals of Derivatives Markets Mishkin/Eakins Financial Markets and Institutions Moffett/Stonehill/Eiteman Fundamentals of Multinational Finance Nofsinger Psychology of Investing Pennacchi Theory of Asset Pricing Rejda Principles of Risk Management and Insurance Smart/Gitman/Joehnk Fundamentals of Investing* Solnik/McLeavey Global Investments Titman/Keown/Martin Financial Management: Principles and ­Applications* Titman/Martin Valuation: The Art and Science of ­Corporate Investment Decisions Weston/Mitchel/Mulherin Takeovers, Restructuring, and Corporate Governance

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Global Edition

Financial Management Concepts and Applications Stephen Foerster Western University

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Editor in Chief: Donna Battista

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Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text. Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsonglobaleditions.com © Pearson Education Limited 2015 The rights of Stephen Foerster to be identified as the author of this work have been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. Authorized adaptation from the United States edition, entitled Financial Management: Concepts and Applications, 1st edition, ISBN 978-0-13-293664-4, by Stephen Foerster, published by Pearson Education © 2015. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a license permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN 10: 1-292-07783-2 ISBN 13: 978-1-292-07783-3 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 14 13 12 11 Typeset in 9.75/12 Minion by Cenveo® Publisher Services Printed and bound by Courier Kendallville in the United States of America

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To Linda for her love and support, and to Jennifer, Christopher, Thomas, and Melanie for absorbing unsolicited financial advice and tolerating my attempts at humour over the years

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About the Author Stephen Foerster is a Professor of Finance at the Ivey Business School, Western University in Ontario, Canada. He currently teaches corporate finance to Executive MBA students. He received his M.A. and Ph.D. from the University of Pennsylvania (The Wharton School) and also obtained the Chartered Financial Analyst designation. Professor Foerster is a member of the Editorial Board of Financial Analysts Journal. His research interests include capital markets and household finance. Major academic journals such as the Journal of Finance and Journal of Financial Economics have published his research, and he has written over 90 case studies. Professor Foerster has won numerous teaching and research awards. He has been a consultant and executive training course designer and facilitator in corporate finance, portfolio management, finance for nonfinancial executives, value-based management, risk management, and other investment areas. He also serves on a university pension board and a not-for-profit foundation board. Born in Sudbury, Ontario, Professor Foerster is married with four children and enjoys golfing, hiking, and biking.

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Brief Content Part 1: Assessing and Managing Performance  25

1 Overview of Financial Management  25 2 Sizing-Up a Business: A Nonfinancial

Perspective 42 3 Understanding Financial Statements  69 4 Measuring Financial Performance  89 5 Managing Day-to-Day Cash Flow  111 Part 2: Assessing Future Financial Needs  128

6 Projecting Financial Requirements and Managing Growth  128 7 Time Value of Money Basics and Applications 153 8 Making Investment Decisions  175 Part 3: Financing Long-Term Needs  191

9 Overview of Capital Markets: Long-Term

Financing Instruments  191 10 Assessing the Cost of Capital: What Return Investors Require  218

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Brief Content



11

11 Understanding Financing and Payout

Decisions 239 12 Designing an Optimal Capital Structure  259 Part 4: Creating Value  279

13 Measuring and Creating Value  279 14 Comprehensive Case Study: Wal-Mart Stores, Inc. 305

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Contents Part 1: Assessing and Managing Performance  25

1 Overview of Financial Management 

25

1.1 Financial Management and the Cash Flow Cycle  25

Case Study: Advanced Micro Devices Inc.’s Cash Crunch  26



1.2 The Role of Financial Managers  29

In-Depth: Maximizing Shareholder Value: An Ethical Responsibility?  30



1.3 A Nonfinancial Perspective of Financial Management  31

In the News: Walmart’s Financial Challenges  32



1.4 Financial Management’s Relationship with Accounting and Other



1.5 Types of Firms  34



1.6 A Financial Management Framework  36



1.7 Relevance for Managers  40

Disciplines 33

Summary  40 Additional Readings and Information  41 Problems  41

2 Sizing-Up a Business: A Nonfinancial Perspective 42



2.1 Sizing-Up the Overall Economy  44

In-Depth: Gathering Information for a Size-Up  44

2.1.1 GDP Components  45 2.1.2 Sector-Related Fluctuations  47 2.1.3 Inflation and Interest Rates  48 Case Study: Sector Performance and Business Cycles: Duke Energy Corporation and Tiffany & Co.  48

2.1.4 Capital Markets  51 2.1.5 Economic Size-Up Checklist  52



2.2 Sizing-Up the Industry  53

2.2.1 Industry Life Cycles  53 2.2.2 The Competitive Environment  54 2.2.3 Opportunities and Risks  56 2.2.4 Industry Size-Up Checklist  57

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Contents





2.3 Sizing-Up Operations Management and Supply Risk  57



2.4 Sizing-Up Marketing Management and Demand Risk  60



2.5 Sizing-Up Human Resource Management and Strategy  62



2.6 Sizing-Up Home Depot: An Example  64



2.7 Relevance for Managers  66

13

Summary  67 Additional Readings and Information  67 Problems  68

3 Understanding Financial Statements 

69

3.1 Understanding Balance Sheets  69 3.1.1 Understanding Assets  71 3.1.2 Understanding Liabilities  73 3.1.3 Understanding Equity  75 In-Depth: Book Value of Equity versus Market Value of Equity  76

3.2 Understanding Income Statements  77 3.2.1 Understanding Revenues, Costs, Expenses, and Profits  77 In-Depth: EBIT versus EBITDA  79

3.2.2 Connecting a Firm’s Income Statement and Balance Sheet  81

3.3 Understanding Cash Flow Statements  82 3.3.1 Cash Flows Related to Operating Activities  83 3.3.2 Cash Flows from Investing Activities  85 3.3.3 Cash Flows from Financing Activities  85 In-Depth: U.S. versus International Accounting and Financial Statement Presentation 86

3.4 Relevance for Managers  87 Summary  88 Additional Readings and Information  88 Problems  88

4 Measuring Financial Performance 

89

4.1 Performance Measures  89 4.1.1 Return on Equity  90 Case Study: ROE Drivers across Industries: Tiffany and Kroger  93

4.1.2 Profitability Measures  93 4.1.3 Resource Management Measures  96 4.1.4 Liquidity Measures  99 4.1.5 Leverage Measures  100 4.1.6 Application: Home Depot  102

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14

Contents

4.2 Reading Annual Reports  107 4.3 Relevance for Managers  108 Summary  109 Additional Readings and Information  109 Problems  110

5 Managing Day-to-Day Cash Flow 

111

5.1 Cash Flow Cycles  111 5.2 Working Capital Management  116 5.2.1 Managing Inventory  116 In-Depth: Inventory Management Systems  116 5.2.2 Managing Accounts Receivable  117 In-Depth: Aging Schedules and Bad Debt  117

5.2.3 Managing Accounts Payable  118 5.2.4 Application: Home Depot  118 In-Depth: The Cost of Foregoing Discounts on Payables  118 In-Depth: Working Capital Management Ratios across Industries  122

5.3 Short-Term Financing  123 5.3.1 Bank Loans  123 5.3.2 Commercial Paper  124 5.3.3 Banker’s Acceptance  124 Case Study: Commercial Paper and the 2007–2009 Financial Crisis  125

5.4 Relevance for Managers  125 Summary  126 Additional Readings and Information  126 Problems  127

Part 2: Assessing Future Financial Needs  128

6 Projecting Financial Requirements and Managing Growth  128

6.1 Generating Pro Forma Income Statements  129 6.1.1 Establishing Cost of Goods Sold and Gross Profit  130 6.1.2 Establishing Expenses  132 6.1.3 Establishing Earnings  132

6.2 Generating Pro Forma Balance Sheets  134 6.2.1 Establishing Assets  134 6.2.2 Establishing Liabilities and Equity  135

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6.3 Generating Pro Forma Cash Budgets  137 6.3.1 Establishing Cash Inflows  137 6.3.2 Establishing Cash Outflows  137 6.3.3 Establishing Net Cash Flows  138

6.4 Performing Sensitivity Analysis  139 6.4.1 Sales Sensitivity  140 6.4.2 Interest Rate Sensitivity  141 6.4.3 Working Capital Sensitivity  141

6.5 Understanding Sustainable Growth and Managing Growth 142



Case Study: Home Depot’s Pro Forma Statements and Sustainable Growth  145

6.6 Relevance for Managers  147 Summary  148 Additional Readings and Information  148 Problems  149 Appendix: Spreadsheet Analysis  149

7 Time Value of Money Basics and Applications 153

7.1 Exploring Time Value of Money Concepts  153 7.1.1 Future Values  155 7.1.2 Present Values  157 7.1.3 Annuities 159 7.1.4 Perpetuities 160 In-Depth: Spreadsheet and Financial Calculator Tips  161

7.2 Applying Time Value of Money Concepts to Financial Securities 163

7.2.1 Bonds 163 In-Depth: Bond Prices and Yields: Home Depot Inc. Example 167

7.2.2 Preferred Shares  167

In-Depth: Preferred Share Prices and Bond Yields: Kansas City Railroad 169

7.2.3 Common Equity  170 In-Depth: Multistage Dividend Discount Model  172

7.3 Relevance for Managers  172 Summary  173 Additional Readings and Information  173 Problems  173

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Contents

8 Making Investment Decisions 

175

8.1 Understanding the Decision-Making Process  175 8.2 Capital Budgeting Techniques  177 8.2.1 Payback 178 8.2.2 Net Present Value  179 In-Depth: Real Options  181

8.2.3 Internal Rate of Return  182

8.3 Capital Budgeting Extensions  185 8.3.1 Profitability Index  185 8.3.2 Equivalent Annual Cost and Project Lengths  186 8.3.3 Mutually Exclusive Projects and Capital Rationing  187

8.4 Relevance for Managers  188 Summary  189 Additional Readings and Information  189 Problems  190

Part 3: Financing Long-Term Needs  191

9 Overview of Capital Markets: Long-Term Financing Instruments  191

9.1 Bonds 192 9.1.1 Changing Bond Yields  192 9.1.2 Bond Features  193 In the News: The Libor Scandal  194

9.1.3 Bond Ratings  195 In-Depth: What Credit-Rating Agencies Do  196

9.2 Preferred Shares  197 9.3 Common Shares  198 9.3.1 Historical Returns  199

9.4 Capital Markets Overview  201 9.4.1 Private versus Public Markets  201 9.4.2 Venture Capital and Private Equity  202 Case Study: Private Placement Example—Sesac Inc. and the Music of Bob Dylan and Neil Diamond  203

9.4.3 Initial Offerings versus Seasoned Issues  203 In Depth: SOX and the Cost of Being a Public Firm  205 Case Study: Google and Facebook IPOs  206

9.4.4 Organized Exchanges versus Over-the-Counter Markets  209 9.4.5 Role of Intermediaries  209

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9.5 Market Efficiency  210 9.5.1 Weak Form  211 9.5.2 Semistrong Form  211 9.5.3 Strong Form  212 9.5.4 U.S. Stock Market Efficiency  212

9.6 Relevance for Managers  212 Summary  213 Additional Readings and Information  213 Problems  214 Appendix: Understanding Bond and Stock Investment Information 215

Bond Information  215 Stock Information  215

10 Assessing the Cost of Capital: What Return Investors Require  218

10.1 Understanding the Cost of Capital: An Example  219

10.2 Understanding the Implications of the Cost of Capital  221

10.3 Defining Risk  222 10.4 Estimating the Cost of Debt  225 10.5 Estimating the Cost of Preferred Shares  226 10.6 Estimating the Cost of Equity  228 10.6.1 Dividend Model Approach  228 10.6.2 Capital Asset Pricing Model  229 In-Depth: Investing in “the Market”  230

10.7 Estimating Component Weights  232 10.8 Home Depot Application  233 10.9 Hurdle Rates  235 10.10 Relevance for Managers  236 Summary  237 Additional Readings and Information  237 Problems  238

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18

Contents

11 Understanding Financing and Payout Decisions 239

11.1 Capital Structure Overview  240 11.2 Understanding the Modigliani-Miller Argument: Why Capital Structure Does Not Matter  242

11.3 Relaxing the Assumptions: Why Capital Structure Does Matter  245 11.3.1 Understanding the Impact of Corporate Taxes  246 11.3.2 Understanding the Impact of Financial Distress  247 In the News: Largest U.S. Bankruptcy  249

11.3.3 Combining Corporate Taxes and Financial Distress Costs  249 11.3.4 Impact of Asymmetric Information  250

11.4 Understanding Payout Policies  251 11.4.1 Paying Dividends  251 11.4.2 Repurchasing Shares  252 11.4.3 Do Dividend Policies Matter?  253

11.5 Relevance for Managers  254 Summary  255 Additional Readings and Information  255 Problems  256 Appendix: Why Dividend Policy Doesn’t Matter: Example  257

12 Designing an Optimal Capital Structure 259

12.1 Factors Affecting Financing Decisions: The FIRST Approach  259 12.1.1 Maximizing Flexibility  259 Case Study: Ford Motor Company and Financial Flexibility Prior to the Financial Crisis  261

12.1.2 Impact on EPS: Minimizing Cost  261 12.1.3 Minimizing Risk  265 12.1.4 Maintaining Shareholder Control  266 Case Study: Maintaining Control: Google Inc. and Dual Class Shares 267

12.1.5 Optimal Timing  268

12.2 Tradeoff Assessment: Evaluating the FIRST Criteria  268 In-Depth: Optimal Amount of Debt at the Firm Level: Six Flags Inc. Example 269

12.2.1 Example: Optimal Capital Structure and Minimizing the Cost of Capital 271 Case Study: Changing Capital Structure: The Home Depot Example  272 In-Depth: The Cost of Equity, Levered Betas, and the Target Capital Structure 273

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19

12.3 Relevance for Managers  274 Summary  276 Additional Readings and Information  276 Problems  277

Part 4: Creating Value  279

13 Measuring and Creating Value 

279

13.1 An Overview of Measuring and Creating Value  280 13.2 Measuring Value: The Book Value Plus Adjustments Method 282

13.2.1 Pros and Cons of the Book Value of Equity Plus Adjustments Method 283

13.3 Measuring Value: The Discounted Cash Flow Analysis Method  283

13.3.1 Estimating Free Cash Flows  284 In-Depth: Why Do We Add Back Noncash Items?  285

13.3.2 Estimating the Cost of Capital  286 13.3.3 Estimating the Present Value of Free Cash Flows  287 13.3.4 Estimating the Terminal Value  288 In-Depth: The Most Common DCF Estimation Mistakes  289

13.3.5 Estimating the Value of Equity  289 13.3.6 Pros and Cons of the Free Cash Flow to the Firm Approach  291

13.4 Measuring Value: Relative Valuations and Comparable Analysis 291

13.4.1 The Price-Earnings Method  291 13.4.2 Pros and Cons of the Price-Earnings Approach  293 In-Depth: The Price-Earnings Model and the Constant Growth Dividend Discount Model  294

13.4.3 The Enterprise Value-to-EBITDA Method  294 13.4.4 Pros and Cons of the EV/EBITDA Approach  295 In-Depth: Comparing P/B, P/E, and EV/EBITDA across Industries  296

13.5 Creating Value and Value-Based Management  297 13.6 Valuing Mergers and Acquisitions  300 13.6.1 Valuing Comparable M&A Transactions  301

13.7 Relevance for Managers  302 Summary  302 Additional Readings and Information  303 Problems  304

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Contents

14 Comprehensive Case Study: Wal-Mart Stores, Inc. 305

14.1 Sizing-Up Walmart  307 14.1.1 Analyzing the Economy  307 14.1.2 Analyzing the Industry  308 14.1.3 Analyzing Walmart’s Strengths and Weaknesses in Operations, Marketing, Management, and Strategy  310 14.1.4 Analyzing Walmart’s Financial Health  312 In-Depth: Target Corporation: ROIC  318 In-Depth: Target Corporation: ROE  319

14.2 Projecting Walmart’s Future Performance  319 14.2.1 Projecting Walmart’s Income Statement  319 14.2.2 Projecting Walmart’s Balance Sheet  321 14.2.3 Examining Alternate Scenarios  323

14.3 Assessing Walmart’s Long-Term Investing and Financing  324 14.3.1 Assessing Walmart’s Investments  324 14.3.2 Assessing Walmart’s Capital Raising and the Cost of Capital  325 In-Depth: Target Corporation: Cost of Capital  326

14.4 Valuing Walmart  326 14.4.1 Measuring Walmart’s Economic Value Added  326 In-Depth: Target Corporation: EVA  327

14.4.2 Estimating Walmart’s Intrinsic Value: The DCF Approach  328 14.4.3 Estimating Walmart’s Intrinsic Value: Comparable Analysis  328 In-Depth: Target Corporation: EV/EBITDA Analysis  330

14.4.4 Creating Value and an Overall Assessment of Walmart  330

14.5 Relevance for Managers and Final Comments  331 Additional Readings and Information  331 Problems  332

Glossary  Index 

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Preface Welcome to the wonderful world of finance! What is the first thing that comes to your mind when someone mentions corporate finance or financial management? If you’re like many students and nonfinancial managers, your initial response may be “It sounds like something I don’t need to know” or “It sounds complex, and it deals with lots of numbers” or “It doesn’t sound like the most exciting business subject I have studied.” Yet my experience teaching business undergraduates, MBAs, and executives has led me to conclude that virtually everyone can overcome these initial feelings through an educational process that: Shows how finance integrates with other areas of business Shows the practical side of finance, rather than just the theoretical concepts Shows that finance is a dynamic, interesting, and topical area of study Understanding finance is critical to understanding business in general, because finance is a key driver of a firm’s activities. Familiarity with financial concepts also helps you fully understand many of the stories featured every day in the financial press.

Key Features Financial Management: Concepts and Applications is made distinctive by incorporation of the following features: It introduces a unique financial management framework that serves as a unifying theme throughout the book. At the beginning of each chapter, we return to the framework and describe how the concepts in the chapter relate to the unifying theme. The benefit of this approach is that you won’t get lost in the trees but will always have an eye on the greater forest. It emphasizes practical examples and applications of concepts. Throughout the book, we focus on Home Depot, Inc., the world’s largest home improvement retailer. For example, after we discuss the topic of cost of capital, we’ll look at how to estimate Home Depot’s cost of capital. The book also includes examples of other firms and situations relevant to our discussions. Much of this information is conveyed visually via charts, exhibits, and tables. It integrates both the nonfinancial and financial areas of business. A unique feature for a finance textbook is the inclusion of a chapter that presents a nonfinancial perspective of financial management to help students identify opportunities and risks as well as to understand the corresponding financial implications. It highlights the relevance of the concepts for practicing managers. Whether you are a nonfinancial manager or an aspiring financial manager, you always want to know “so what?” Each chapter includes a summary section that describes the relevance of the concepts and ideas and the key take-aways for managers. It concludes with a comprehensive case study that summarizes the major concepts addressed throughout the book and presented in the unifying theme. The last chapter focuses on a well-known retail giant, Wal-Mart Stores, Inc. (Walmart), and

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22 Preface shows how we can apply all of the concepts introduced in the book to assess Walmart’s performance and to identify ways that Walmart can create value for its shareholders. It is relatively short in length for a finance textbook, compared to many traditional finance texts with over 1,200 pages. This text is aimed primarily at nonfinancial executives and managers, as well as current MBA and undergraduate students who are aspiring managers and want to be in a position to better communicate with financial managers, accountants, and controllers. The book is meant to be a practical guide to financial management, for those have never had direct exposure to the field of finance. The emphasis is on the application of tools to better understand a firm’s financial situation. Thus, the three major objectives of the book are as follows: To provide nonfinancial managers with insight into the various activities of a firm that affect cash flows To assist current and future managers in developing the analytical skills necessary for evaluating business problems and opportunities from a financial perspective To help nonfinancial managers better understand key concepts related to some of the major decisions facing financial managers

How This Book Is Organized Financial Management: Concepts and Applications is divided into four parts. Part One, Assessing and Managing Performance, consists of Chapters 1 through 5. Chapter 1 provides an overview of finance and financial management. Chapters 2 through 5 focus on assessing a firm’s current business from both the nonfinancial and financial perspectives. This assessment is critical to understanding the firm’s financial health and managing its performance. To begin, Chapter 2 looks at sizing up a business by examining external factors, such as the economy and the industry in which the firm operates, as well as the firm’s strengths and weaknesses in nonfinancial areas like marketing, operations, and human resources management. Chapters 3 and 4 explore assessing a business from a financial perspective. Chapter 3 presents key financial statements, whereas Chapter 4 examines historical ratios or measures of performance in order to determine the firm’s liquidity, efficiency, capacity to take on more debt, and overall profitability. Finally, Chapter 5 focuses on day-to-day cash flow management, including management of accounts receivable, inventory, and accounts payable. Part Two, Assessing Future Financial Needs, consists of Chapters 6 through 8. Chapter 6 focuses on projecting a firm’s financial requirements through pro forma income statements, balance sheets, and cash budgets. The importance of spreadsheet analysis is also discussed. Chapter 7 summarizes time value of money concepts, which form the basis for bond and equity valuation. The investment decision process is examined in Chapter 8. Part Three, Financing Long-Term Needs, consists of Chapters 9 through 12. First, Chapter 9 provides a bridge from short-term to long-term financing needs by presenting an overview of capital markets, as well as various debt and equity issues. Next, Chapter 10 focuses on assessing a firm’s cost of capital by estimating the costs of debt and equity. The financing and payout decisions that a firm faces are examined in Chapter 11. Chapter 12 then looks at issues related to designing an optimal capital structure, including such trade-offs as cost, risk, and flexibility.

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Preface

23

Part Four, Creating Value, consists of Chapters 13 and 14. Chapter 13 considers the measurement and creation of value. Traditional valuation techniques such as discounted cash flow analysis are presented. The chapter also looks at the concept of economic value added (EVA®), which is part of value-based management. Finally, Chapter 14 integrates all of the previous chapters by providing a comprehensive case study of Walmart. Key terms are defined in the margins of each chapter, and a comprehensive glossary of key terms is presented following the last chapter. Each chapter contains self-study questions that summarize the key concepts covered in the chapter. The solutions to these questions are provided in MyFinanceLab.

Instructor Resources Valuable instructor resources are available for this text and may be found on ­www.pearsonglobaleditions.com. A PowerPoint® presentation created by author Stephen Foerster presents each chapter in a logical, visual progression and includes slides of example problems. A computerized Test Bank, created by Curtis Bacon of Southern Oregon University, is available in TestGen™ for Windows or Macintosh. Instructors can create tests or quizzes of varying lengths and difficulties using the questions included. The Test Bank for this title is also available in MyFinanceLab™. A Solutions Manual by author Stephen Foerster provides instructors with solutions to all end-of-chapter problems.

For Students

MyFinanceLab® is powered by a sophisticated adaptive learning engine that tailors learning material to meet the unique needs of each student. Videos, interactive quizzes, and other learning aids help students of various learning styles work with the material, and autograde functions help instructors focus on teaching. Financial Management: Concepts and Applications will provide valuable insight to interested individuals and nonfinancial executives as part of an executive or university course in applied corporate finance, a case course in financial management, or as a supplement to financial theory courses. This book assumes no prior knowledge of finance, but it provides a tremendous amount of value added—hopefully it is one of the best investments you will ever make!

Stephen Foerster [email protected]

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Acknowledgments I am indebted to my colleagues and to the many students at the Ivey Business School, Western University, who provided comments and suggestions on my earlier writing efforts that helped with the clarity of this undertaking. In particular I wish to recognize colleagues Craig Dunbar, Mary Heisz, Michael King, Claude Lanfranconi, Larry Menor, Gerard Seijts, Colette Southam, Stephen Sapp, Mark Vandenbosch, and Larry Wynant. The Pearson team including Donna Battista, Blair Brown, Jonathan Boylan, Deepa Chungi, Jeff Holcomb, Miguel Leonarte, Erin McDonagh, Susan McNally, Carol Melville, Tessa O’Brien, Lisa Rinaldi, Katie Rowland, Vincent Scelta, Elissa Senra-Sargent, and Roberta Sherman helped enormously to shape, develop, and design the book and accompanying materials. I especially owe a huge debt of gratitude to Laura Town, who meticulously reviewed and helped improve earlier drafts. I also owe a great deal to Jack Repcheck, who introduced me to the book publishing world, and special thanks to Andrew Lo for his early book-writing encouragement and support. In addition, I would like to thank Alan Wolk, the accuracy reviewer, as well as the following people for their helpful comments and suggestions during reviews: Bulent Aybar, Harvard University; Joan Branin, University of California, Riverside; Robert Coackley, University of California, Berkeley Extention; Daniel Gibbons, Webster ­University; Judson Russell, University of North Carolina, Charlotte; Salil Sarkar, ­University of Texas at ­Arlington; Howard Steed, Catholic University; and Eric Wehrly, Seattle University. Pearson would like to thank and acknowledge the following people for their work on the Global Edition: Contributors Monal Abdel-Baki, The American University in Cairo, Egypt Dayana Mastura, Universiti Teknologi PETRONAS, Malaysia Zarehan Binti Selamat, Multimedia University, Malaysia Reviewers Izlin Ismail, University of Malaya, Malaysia Manolis Noikokyris, Kingston University, U.K. Zulnaidi Yaacob, Universiti Sains Malaysia

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1

Overview of Financial Management Welcome to the world of finance. This chapter provides an introduction to financial management, highlighting the important role of cash in a business. The chapter also describes key questions facing financial managers and fundamental concepts related to financial management. The relationship between financial management and accounting is examined, and different types of firm structures are described. Finally, the chapter presents a financial management framework that provides a unifying theme throughout the book. This framework shows that the primary goal of a firm is value creation, and that the creation of value is driven by two key factors: growth and risk.

1.1  Financial Management and the Cash Flow Cycle

You may have heard the expression “Cash is king!” This saying highlights the importance of a noble profession: financial management. At its heart, financial management involves managing cash, the bloodline of any corporation. Cash is important because it is crucial to three activities that every business faces. First, a firm needs to invest in real assets,1 or assets that produce goods or help provide services, in order to function as a business; it also needs to invest in working capital. These real assets may be tangible, such as plants and equipment, or they may be intangible, such as investments in research and patent development, whereas working capital investments represent money tied up in inventory and money owed by customers who buy on credit. Second, a firm must finance or pay for its real assets, meaning it must have cash on hand or be able to obtain cash from some external source, such as a bank or investor. The firm obtains cash from this source in exchange for taking on some obligation, such as agreeing to pay annual interest on a loan and to pay back the loan in a certain number of years. Third, a firm needs to generate cash from its operations. As shown in Figure 1.1, the financial manager is at the center of cashmanagement activities in all three areas. In other words, although the financial manager is not directly involved in the operations of a business—that’s left to

1

Note: All bold terms in blue are defined in the margins and in a glossary at the end of the book.

Learning Objectives Obj 1.1

Explain the major cashrelated activities of a firm and the cash flow cycle. Obj 1.2

Describe the major duties, tasks, and key questions facing financial managers. Obj 1.3

Describe fundamental concepts that nonfinancial managers need to understand. Obj 1.4

Describe the relationship between financial management and accounting, operations, marketing, information technology, and human resources. Obj 1.5

Explain the difference among sole proprietorships, general partnerships, limited liability companies, S corporations, and C corporations. Obj 1.6

Explain the components of the financial management framework. Obj 1.7

Explain why understanding financial management is relevant for managers.

Objective 1.1

Explain the major cashrelated activities of a firm and the cash flow cycle.

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CASE STUDY

Advanced Micro Devices Inc.’s Cash Crunch

In the fall of 2012, Advanced Micro Devices Inc. (AMD) was facing a financial crisis. The company was a semiconductor designer and maker of PC processors, and thus a competitor of the much larger Intel Corp. On October 18, 2012, the firm issued its third-quarter results, which indicated a net loss of $157 million on revenue of $1.27 billion. The ­company’s cash had declined from $1.8 billion to $1.5 billion over the quarter, and it was expected to drop to $600 million or lower in the next 12 months—significantly less than the $1.1 billion in reserves the company said it required. The quarterly operating expenses by AMD were around $450 million, and its debt was over $2 billion. In an attempt to control the crisis, the company announced a restructuring plan aimed at reducing operating expenses and improving its competitive position. How had AMD’s finances come under such stress? The simple reason for AMD’s woes was less cash coming in to the firm and more cash going out, resulting in a cash crunch. On the cash inflow side, sales were being hurt because the global economy was weak and consumer tastes were changing. The company relied on the PC market for 85 percent of its sales, but the PC market was declining. In addition, AMD already faced one major competitor in Intel, and new entrants were threatening to enter the market. On the cash outflow side, AMD needed to spend money developing products for new markets, but analysts were concerned the firm would run out of funds before it was able to transform itself. The firm was trying to negotiate with a chip supplier to reduce purchase commitments and hence expenses. Credit rating agencies were considering downgrading AMD’s debt, which would increase borrowing costs. The firm’s stock and bond prices were falling, limiting access to new capital. As a result of all of these factors, AMD is experiencing a cash crunch, which highlights the importance of cash flow management. It is critical to anticipate cash flow needs and secure financing before a cash crunch occurs. Sources: AMD news release “AMD Reports Third Quarter Results and Announces Restructuring,” October 18, 2013; and Bloomberg Businessweek “AMD Faces Looming Cash Crunch Amid Quest for New Markets,” Ian King, October 25 2012, http://www.businessweek.com/news/2012-10-25/ amd-faces-looming-cash-crunch-amid-quest-for-new-markets-tech#p1 (accessed December 10, 2012).

Fig 1.1 Cash-Related Activities and the Financial Manager

financing

operating

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financial Manager

investing

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operating managers, marketing managers, human resource managers, and o ­ thers—he or she plays an indirect role by ensuring there is enough cash to operate. The financial manager also ensures that any cash generated from operations is ­utilized effectively by investing in more real assets or paying back investors and lenders. Let’s take a closer look at the cash flow cycle—or where cash comes from and where it goes in a business—as depicted in Figure 1.2. In doing so, we’ll work through an ­example that builds on the three main cash-related activities: financing, investing, and operating. We’ll see the close relationship among how a firm is financed, how it invests, and how it operates. We’ll also touch on some important finance terms that will be described in greater detail later in the book. As you read the example, keep two important points in mind. First, if a firm doesn’t have cash, then it can’t operate. Second, a firm’s profits are not the same as its cash flow. Let’s start our example by focusing on financing activities. Say, for instance, that Ace Manufacturing Inc. is a start-up venture that needs to buy a new machine to manufacture electronic components. To facilitate the purchase, Ace identifies a number of individuals who are willing to supply cash now in exchange for something in the future, as defined in a simple contract (albeit a carefully worded and important contract). The contract that Ace provides to these suppliers of cash

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real assets: Assets used to produce goods and services working capital: The difference between current assets and current liabilities on the balance sheet cash flow cycle (cash conversion cycle): The pattern and timing of where cash comes from and where it goes in a firm

Fig 1.2 The Cash Flow Cycle

Equity

financing

Loans

CASH

Accounts Receivable

Accounts Payable

Labor, Other Expenses

operating

Inventory

Credit Sales

Sales

Fixed Assets

investing

Cash Sales

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financial instruments (financial assets): Securities such as bonds and stocks that represent claims on the assets of a firm liabilities: Obligations to pay a specified amount or perform a particular service bond: A financial instrument issued by a firm representing long-term debt common equity (common stock): Securities representing the direct ownership of a firm, or the residual claims on the assets common shareholders: Owners of common shares, or common equity profits (net earnings, net income, net profits): The difference between revenue and all associated expenses over a particular time period. dividends: A share of the profits of the firm distributed to shareholders

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indicates the nature of their expected return, such as interest payments in the case of a loan, or perhaps a specified share of any future earnings Ace generates in the case of issuing equity. Contracts like these are known as financial assets or financial instruments. Now, let’s assume Ace decides to pay for its new machine by obtaining a loan from Solid Bank Ltd. So Ace agrees to a make a series of scheduled interest payments and principal payments to Solid Bank, much like a home mortgage, with the exact payment terms set out in the contract. If Ace is unable to make these payments, the contract specifies that Solid Bank can claim the machine and sell it in order to recoup the money it lent to Ace. This loan is also known as a liability to Ace, or an obligation the firm needs to pay. Liabilities may take forms besides loans, such as bonds (discussed in more detail in Chapters 7 and 9), which are another type of financial instrument that represents a long-term debt. On the other hand, instead of borrowing, Ace might issue common equity (also discussed in more detail in Chapters 7 and 9), which is a stake or share in the ownership of the firm in exchange for a cash investment. The common shareholders, or purchasers of these shares, provide an immediate source of cash to Ace and are known as residual claimants. The shareholders receive a “contract” known as a stock certificate, which indicates they will own a certain portion of whatever profits (or earnings after expenses) are left after other claimants, such as lenders like Solid Bank, have been satisfied. Thus, the shareholders are collectively the ultimate owners of the firm, and they entrust the company’s managers—including its financial managers—to act in their best interest. Now that our sample firm has some cash, let’s turn to investing activities. Recall that Ace needs to buy a new machine to manufacture electronic components. We consider this activity an investment in fixed assets. Ace expects to be able to use this machine to manufacture electronic components for quite a number of years before it needs to be replaced. Thus, Ace will have a large cash outflow initially, but assuming it is successful in making products that are in demand, it will reap the rewards of profits in the future. Notice from Figure 1.2 that Ace has used its investment in fixed assets to create inventory. Next, let’s examine Ace’s operating activities. To create electronic components, Ace needs to order parts from suppliers. We’ll examine the cash flow implications of dealing with suppliers (and customers) in much more detail in Chapter 5; for now, simply note that it’s customary for suppliers to provide supplies immediately, with an expectation of repayment in some specified period, such as 30 days—this is referred to in Figure 1.2 as accounts payable. Ace therefore needs to ensure it is on good terms with its suppliers. Ace also has cash outlays for labor as well as other operating-relating expenses. Later, once Ace has built up an inventory of electronic components, it can generate sales to its customers, who are computer manufacturers. Like most companies, Ace will make its sales on credit, with its customers promising to pay in, say, 30 days—just like Ace’s relationship with its suppliers. So, from a cash flow management perspective, Ace needs to ensure its customers submit payment in a timely manner. We have also included in Figure 1.2 the possibility that some customers may pay in cash. We’ve now come full circle in our cash flow cycle. When Ace receives payment from its customers, it can use the cash to pay interest on its loan or even repay part or the entire loan. It might also pay dividends—making cash payments—to its common shareholders. As the cycle continues, Ace may invest in more assets and buy more supplies to create more inventory to replace the depleted inventory from earlier sales.

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1.2 The Role of Financial Managers Let’s examine the role of the financial manager throughout this cash flow cycle. Financial management represents the bridge between a firm’s real assets and its financial commitments—in other words, between the assets in which the firm has invested (and which are expected to generate cash) and the commitments the firm has made to its suppliers of cash. Accordingly, financial managers have four main duties: assessing the current business, assessing future financing needs, developing long-term financing strategies, and assessing future investments. To elaborate, financial managers are concerned with the following tasks: Understanding the firm’s present business situation and measuring its current performance. Assessing the firm’s future financial needs in the short and medium term (say, over the next one to five years). Determining the best way to obtain cash to pay for real assets (known simply as financing) and assessing other financing decisions, including how best to manage money generated by the operations of the business. For example, financial managers must decide whether earnings available after expenses and taxes should be paid directly to the firm’s shareholders in the form of dividends or reinvested back into the firm in the form of retained earnings. Investing money in the various operations of the business (known simply as capital budgeting or investing) and seeking ways to maximize the value of the firm by growing cash flows while mitigating risk. Financial managers are concerned with both short-term and medium-term/longterm decisions. Short-term decisions focus on day-to-day cash flow and working capital management, which is the relationship between the firm’s short-term assets (what the firm owns) and liabilities (what the firm owes). Medium-term/long-term decisions affect the firm’s overall capital structure, or mix of debt and equity. The ultimate task of the financial manager is to ensure the firm is maximizing value for its key stakeholders: its shareholders. Value is created by increasing cash flows and providing returns commensurate with the risk involved in the growth activities. Of course, a firm has other important stakeholders as well—including lenders, employees, customers, and the communities in which the firm operates—but the common shareholders are the key stakeholders, because they are essentially the owners of the business. Figure 1.3 summarizes several key questions that highlight the ultimate task facing financial managers. Later, we’ll see how these questions relate to the focal point of our financial management framework.

Q: How can my financial decisions help create value for the firm’s shareholders?

Objective 1.2

Describe the major duties, tasks, and key questions facing financial managers.

financing: The process of obtaining funds to pay for real assets retained earnings: The cumulative amount of earnings retained or reinvested in the firm and not paid out as dividends capital budgeting: The process of selecting investment projects investing: The process of committing funds for the purpose of obtaining a return over a particular period of time working capital management: The process of managing short-term decisions pertaining to current assets and current liabilities assets: Tangible or intangible items of value to a firm capital structure: The mix of debt and equity that a firm uses to finance its operations

Fig 1.3 Key Questions Facing Financial Managers

To Create Value:

What amount of financing does the firm require? How should the firm raise the required financing? What investments should the firm make?

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In-Depth

Maximizing Shareholder Value: An Ethical Responsibility?

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Finance professors often get criticized by ethics professors because they tell their students that the goal of the firm is to maximize shareholder value. Financial scandals such as Enron, Tyco and others are regularly blamed on the excessive focus on shareholder value maximisation. Theo Vermaelen, Professor of Finance at INSEAD, says this critique is misplaced and reflects a lack of understanding of what we teach in finance courses. “Shareholder value is defined as the present value of free cash flows from now until infinity, discounted at a rate that reflects the risks of these cash flows. So, maximizing shareholder value is not the same thing as maximizing short-term profits, earnings per share or manipulating stock prices through accounting fraud. The Enron disaster, in which all shareholders lost their money, has nothing to do with excessive focus on shareholder value,” he says. Another misunderstanding is that because anyone who evaluates decisions on the basis of consequences for shareholder value, does not care about other stakeholders. “In a discounted cash flow spreadsheet, shareholder value is calculated by taking revenues and then subtracting labor costs, executive compensation, interest, and taxes. This residual cash flow incorporates the interests of all stakeholders, not simply the shareholder. What we don’t do is ‘balance’ the interest of stakeholders as you can justify any decision by stakeholder maximization theory. For example maximizing stakeholder value could mean that I pay workers above-competitive salaries at the expense of shareholders. The problem is that if you do this in a competitive market, in the long run you will be driven out of business, as recently illustrated by the collapse of General Motors. Of course, in the short run a firm may make abnormal profits, but this will attract competitors, so that in the long run also shareholders will earn a competitive rate of return”. While economists typically justify maximizing shareholder value on the basis of economic efficiency arguments, Vermaelen wants to give an ethical twist to this. He proposes a new definition of ethical behavior in business that is less tied to highly personal values: respect for implicit contracts. Once we embrace this definition, maximizing shareholder value may well be an ethical responsibility. Vermaelen adopts the view that a company should be considered as a nexus of contracts between various stakeholders. All contracts have explicit and implicit characteristics. For example, the debt contract has a large number of explicit terms such as maturity, interest rate, seniority, covenants, and so on. However, shareholders have a largely implicit contract. Apart from voting rights, which are relatively meaningless for small stockholders, shareholders have no explicit rights. Shareholders are not entitled to any dividends or can’t get their money back. As a company needs shareholders, the survival of a corporation with widely dispersed ownership depends on the survival of this implicit contract. “In a capitalist economy it is reasonable to assume that shareholders have an implicit contract that the management will maximize their interests,” Vermaelen says. “So, I believe that respect for such implicit contracts is an ethical responsibility. Hence, policies that are deliberately aimed at destroying shareholder value are unethical. Unless, of course, the company makes it clear in advance that it will pursue a different objective. For example, a company that raises equity and states that it will start a corporate social responsibility policy that distributes five per cent of its profits to the poor behaves ethically because investors can incorporate the lower profits in the issue price of the stock. But implementing such policies when they were not announced in advance is, in my view, unethical.”

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Chapter 1  Overview of Financial Management



Proponents of CSR argue that many of these policies actually do create shareholder value. For example, giving money to the poor may create sympathy for the company, increase revenues and/or lower labor costs and may ultimately be value maximizing. “Obviously if CSR policies are simply PR or marketing exercises than obviously they are not inconsistent with value maximization or unethical,” Vermaelen says. “But it is up to the company to prove that this marketing strategy works.” The fact that managers may not maximize shareholder value is generally described as an agency problem. Traditionally economists try to deal with this by designing compensation schemes that align the interest of stockholders and managers. Or, alternatively, appoint a board of directors that has the fiduciary duty to make sure managers maximize shareholder value. “The problem is that it is difficult, if not impossible to solve the problem this way, as the current credit crisis indicates,” Vermaelen says. “Bonuses based on short-term profits led bankers to take risks that produced short-term profits and short-term stock price increases without creating long-term shareholder value. So besides designing better incentive schemes to align managerial and shareholder interests, there is a need to promote the ethical view that the right thing to do is to maximize shareholder value”

Source: This article is republished courtesy of INSEAD Knowledge (http://knowledge.insead.edu) Copyright INSEAD 2008.

1.3  A Nonfinancial Perspective of Financial Management Perhaps unfortunately, not everyone will be able to enjoy the challenges and rewards that come with a career in financial management. So now let’s consider financial management from a number of nonfinancial managers’ perspectives. In the final chapter of this book, Chapter 14, we’ll examine Wal-Mart Stores Inc. (Walmart) as a comprehensive case study. For now, let’s consider a variety of nonfinancial managers who would be interested in Walmart’s financial performance.

Objective 1.3

Describe fundamental concepts that nonfinancial managers need to understand.

Suppose you worked for Walmart in an operations capacity and wanted to consider how you could have a positive financial impact on Walmart; Suppose you were considering investing in Walmart’s common shares and wanted to understand whether it was a good time to invest; Suppose you were an analyst assigned to recommend stock investments in Walmart; Suppose you worked at a credit rating agency assigned to assess the creditworthiness of Walmart’s bonds; or Suppose you were a major competitor of Walmart and wanted to understand the threats you faced. From each of these perspectives you would need to examine Walmart’s financial health. You would want to gather information, such as Walmart’s financial statements, analyze the information, and assess Walmart’s financial strengths and weaknesses. Keeping in mind these various perspectives, Figure 1.4 summarizes some fundamental concepts that nonfinancial managers need to understand. These concepts will be further developed in later chapters.

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Fig 1.4 Fundamental Concepts Related to Financial Management

Assessment of the Current Business



Business size-up (economic conditions, industry key success factors,   opportunities and risks, strengths and weaknesses)



Performance measurement (financial statement analysis)



Day-to-day cash management

Assessment of Future Financing Requirements



Financial statement projections



Understanding investment decisions

Issues Related to Long-Term Financing Decisions



Understanding capital markets



Determining the cost of capital



Raising long-term capital

Issues Related to Investments



Measuring value



Creating value

In the News

Walmart’s Financial Challenges

In the spring of 2012, Walmart had just released its most recent quarterly results covering the busy 2011 holiday season, through January 31. The economic recovery from recession was slow but Walmart wanted to encourage spending. As such, and wanting to reverse a decline in same-store revenues year-over-year, Walmart had guaranteed holiday shoppers that they would receive the lowest price on merchandise. Walmart refocused on offering low prices throughout the store instead of temporarily slashing prices selectively. While Walmart was able to reverse its declining trend in revenues, its overall gross margin (profits after cost of sales as a percentage of sales) declined. “They’re working extremely hard just to see improving sales,” said Brian Sozzi, chief equities analyst at NBG, an independent research firm. “But it’s coming at the expense of profits on each sale.” Going forward, Walmart officials said the company would keep looking for ways to cut prices. “You can expect us to invest even more in lower prices,” [Mike] Duke, Walmart’s CEO, said. During a recent media call with reporters, Charles Holley, chief financial officer, said that January has the best performance in the quarter [November through January], reflecting the sales momentum the discounter is enjoying. “I do think there’s a new normal with customers. The markets are more volatile. Gas prices are more volatile. Customers are looking for new ways to save money because they don’t know [what is] around the corner.” Source: “Sales Up, Quarterly Profits Down, at Wal-Mart,” by Anne D’Innocenzio, Associated Press reporter, February 21, 2012, http://www.theledger.com/article/20120221/NEWS/ 120229897?p=1&tc=pg (accessed December 11, 2012).

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1.4  Financial Management’s Relationship with Accounting and Other Disciplines

Many newcomers to the area of finance have a mistaken impression that a firm’s finance and accounting functions are essentially the same. (Try not to express this view in the presence of either finance professors or accounting professors!) In reality, these two functions are distinct, although a firm’s finance department relies heavily on data supplied by the firm’s accounting department. Let’s take a closer look at the relationship between financial management and accounting. To make capital budgeting and financing decisions, a financial manager requires key financial data, such as information about the firm’s cash inflows and outflows. The financial manager relies on the firm’s accountant to provide this information in a systematic and organized fashion. In this role, known as financial accounting, the accountant supports the financial manager by identifying relevant data related to the activities of the firm, then presenting the data in an agreed-on and standardized manner, known as generally accepted accounting practices. The accountant communicates this information not only internally to managers but also externally to shareholders, lenders, analysts, and other interested parties. To communicate financial data, accountants provide scorecards that summarize the firm’s relevant economic activity. These scorecards take several forms. For ­example, the balance sheet provides a snapshot of the firm’s assets, as well as the financing of those assets, at a specific moment in time. The income statement provides a measure of the firm’s profitability over a particular period, such as a year. Similarly, the cash flow statement provides a summary of the firm’s cash inflows and outflows over a particular length of time, categorized into cash related to ­operating, investing, and financing— the three main areas that are highlighted in Figure 1.1. Beyond financial accounting, accountants carry out a second important role known as cost accounting. Here, they determine the proper allocation of costs associated with the creation of products and assist in creating budgets useful for financial planning. They also provide information that can help managers evaluate decisions, such as whether to acquire a new asset. For example, accounting information would indicate a firm’s ability to generate a certain level of operating profits relative to the amount of assets employed to generate those profits. This information would assist in cost-benefit analysis of a potential new investment. Therefore, financial and nonfinancial managers alike are highly dependent on the types of information accoun­tants provide. Financial managers also interact with managers from functional areas other than accounting, including operations, marketing, technology, and human resources. Managers in all of these functional areas require funding for their activities, which necessitates their interaction with financial managers. For instance, the operations function allows for development of the products or services a firm will sell. Operations managers require funds for both small capital expenditures (such as equipment purchases) and large capital expenditures (such as plant expansions). In addition, most firms not strictly in service-­related industries need to invest in inventory. Furthermore, how a firm deals with suppliers and what repayment terms it may be able to negotiate has important financial implications. Marketing plays a crucial role in generating revenue for the business. Marketing managers require funds for marketing and selling activities, as well as for entering new markets both domestically and globally. In addition, marketing-related policies such as credit terms provided to customers have important financial implications as they result in investments in accounts receivable.

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Objective 1.4

Describe the relationship between financial management and accounting, operations, marketing, information technology, and human resources.

balance sheet: A financial statement reflecting the value of a firm’s assets, liabilities, and net worth at a particular time income statement: A financial statement indicating a firm’s revenues, expenses, and resulting income over a period of time cash flow statement: A financial statement reflecting a firm’s cash inflows and outflows categorized into cash related to operating, investing, and financing

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Technology often plays a crucial role in the competitiveness of a firm; information technology in particular allows for efficient communication among employees, managers, and customers. Many firms are constantly investing in the newest technology and information systems. The human resource function manages the people that will contribute to the success of the business. Every organization needs to invest in its people not just through competitive salaries and benefits but also through training and providing a desirable workplace that helps retain personnel. Hiring, training, and retaining personnel cost money. Each of these functional areas is, in some way, involved with either the generation or consumption of cash. Understanding and appreciating the implications of cash inflows and outflows will help the managers of these nonfinancial functions better communicate with their firm’s financial managers. Of course, it is important for financial managers to also understand and appreciate the other functional areas and roles within a firm to avoid making what might seem like a smart financial decision but is actually a dumb operational or marketing decision. In Chapter 2, we will more closely investigate the relationship between financial management and each of these areas as we examine the strengths and weaknesses of firms and the financial implications. In Chapter 5, we will examine cash management implications related to suppliers and customers.

1.5 Types of Firms Objective 1.5

Explain the difference among sole proprietorships, general partnerships, limited liability companies, S corporations, and C corporations.

sole proprietorship: A business structure with a sole owner and manager general partnership: A business structure with two or more individuals as joint owners and whereby each partner is liable for any business debts

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Now that we have a better idea of what financial management involves and how financial managers interact with managers from other functional areas, we can step back to examine the overall environment in which all managers operate—what we are referring to as the firm2 or enterprise. Firms can take a variety of structures, depending on the form of ownership. More specifically, on a spectrum from simple to complex, they can be categorized as sole proprietorships, general partnerships, limited liability companies, S corporations, or C corporations. A simplified comparison of the key characteristics of each enterprise type is presented in Figure 1.5, and additional information and definitions are provided in the discussion that follows. Despite their differences, sound financial management is essential to the success of each type of firm. As previously mentioned, the simplest enterprise structure is a sole proprietorship, whereby a single person starts and owns a business. For example, an individual may start her own consulting business, working out of her home. The main advantage of this firm structure is its simplicity, as there are no special tax-filing or recordkeeping requirements. The main disadvantage is that the individual owner is personally liable for everything related to the business. As such, the owner must carefully manage cash inflows and outflows. A slightly more complicated enterprise structure is the general partnership, whereby two or more individuals jointly own a business. For example, several dentists might form a partnership that allows them to share the overhead costs associated with running an office, or two family members might start a lawn-care business. An advantage of general partnerships is their relative simplicity, with no costly state registration

2 Although the focus in this book is on for-profit firms, many of the concepts covered can be applied in a not-for-profit setting, albeit with different interpretations.

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Chapter 1  Overview of Financial Management



Fig 1.5 Comparison of Enterprise Types

Sole Proprietorship (SP)

General Partnership (GP)

Size One person More than one person Existence

Firm exists until sole proprietor dies or dissolves the business

Liability Unlimited

Limited Liability Company (LLC)

S Corporation (S Corp)

C Corporation (C Corp)

One or more persons Up to 100 people (varies from state to state)

No limit on the number of persons

Firm typically exists until a partner dies or withdraws

Firm could exist in perpetuity (varies from state to state)

Perpetual

Perpetual

General partners are usually equally liable

Members are not liable for company debts

Shareholders are not liable for company debts

Shareholders are not liable for company debts

Ownership and Sole proprietor owns General partners Depends on LLC Management and manages the usually have equal agreement firm ownership and management rights

The firm is The firm is managed by a managed by a team of managers; team of managers; shareholders elect shareholders elect a board of directors a board of directors to oversee to oversee management management

Taxation Once Once Once Once

Twice: corporation and shareholders

Examples Individual consultants; Dentists; firms Real estate investment mom and pop stores owned by close properties; restaurants friends or family

Public corporations

Small businesses; family businesses

required and no onerous tax forms. The main disadvantage is that all individual partners are jointly liable and responsible for any debts related to the partnership. Thus, costs must be monitored closely. The limited liability company (LLC) is similar to a hybrid between a general partnership and a corporation. It is like a partnership with one general partner, but the other partners are not involved in active management and only have their invested capital at risk. The owners of an LLC are known as members. This type of entity is common in real estate investments. The main advantage is the limited liability compared to a general partnership. The disadvantage is that this structure is somewhat more complex than a general partnership, and some types of businesses cannot be LLCs, such as banks and insurance firms. An S corporation is a corporation that passes income, losses, and deductions through to its shareholders for federal tax purposes. An S corporation can have no more than 100 shareholders. A main advantage of this business structure is the limited ­liability—meaning the most investors can lose is the amount of capital they have invested in the corporation, similar to an LLC. Another benefit is the single form of taxation whereby only the corporation is taxed rather than double taxation faced by regular corporations in which individual investors also pay taxes on dividends received from the corporation. A disadvantage is that there are fewer tax deductions available compared to a regular corporation and the number of shareholders is restricted. Finally, the most common enterprise structure—and the focus of this book—is that of a regular corporation, also known as a C corporation. C corporations operate under the oversight of a board of directors whose members are elected by the firm’s ­shareholders. In turn, the board of directors appoints a management team to run the day-to-day operations of the business. C corporations offer the benefit of limited liability. This type of

M01_FOER6644_01_SE_C01.indd 35

limited liability company (LLC): A business structure whereby the owners or members are not personally liable for the firm’s debts S corporation: A business structure in the United States whereby income, losses, and deductions pass through to its shareholders for federal tax purposes C corporation (corporation): A business structure in the United States that has a legal and tax structure separate from its owners with a board of directors that appoints management to run the operations

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Part 1  Assessing and Managing Performance

firm also has a legal personality separate from its owners, along with the benefit of a potentially unlimited lifespan. C corporations may be privately owned by their shareholders, or they may be publicly owned, with shares that can be traded (e.g., through a stock exchange such as the New York Stock Exchange). The main disadvantage is that of double taxation. Given C corporations’ additional complexity, strong financial management is central to their success.

1.6  A Financial Management Framework Objective 1.6

As shown in Figure 1.1, the role of financial manager is closely related to the three main cash-related activities of every firm, regardless of type: financing, investing, and operating. Let’s highlight these activities as part of a broader financial management framework we’ll use as an anchor throughout the book. We begin with a simplified version of the framework in Figure 1.6 that ties together a number of recurring themes. Keep the following key messages in mind as you review this model and proceed through the remainder of the book:

Explain the components of the financial management framework.

Fig 1.6 Simplified Financial Management Framework

external environment economy

industry

the enterprise

financing

operating

investing

Growing profits, dividends, cash flow

Managing the risk profile

growth

risk

value creation

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Chapter 1  Overview of Financial Management



37

Fig 1.7 Financial Management Framework

external environment economy

industry

the enterprise

financing

• Expansion/recession • Interest rates • Credit conditions • Financial markets

• Operations/ suppliers • Marketing/ customers • Working capital • People

• Competition • Technology • Regulation • Key success factors

Financial Leverage

operating

• Debt financing • New equity • Dividend policy

Profit Margin

investing Asset Turnover

• Capital expenditures • Long-term projects

Managing the risk profile

Growing profits, dividends, cash flow

growth

risk Cost of capital

Return on equity

value creation

We need to understand the external environment in which an enterprise o ­ perates— in particular, what’s happening in the economy and the industry—before we can understand the firm’s cash-related activities and assess its financial health. We need to understand the overall financial implications of decisions that affect the three cash-related activities of every firm: operating, investing, and financing. We need to understand how a firm attempts to grow profits, dividends, and (most importantly) cash flows while managing its risk profile in order to create value. Next, let’s populate the simplified framework with some additional details to arrive at our overall financial management framework, as shown in Figure 1.7. chapter 2 external environment economy

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industry

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Part 1  Assessing and Managing Performance

Here is how each of the subsequent chapters maps to the various components of our financial management framework. Chapter 2 discusses the external environment in which firms operate. We will e­ xamine the economy from a number of perspectives, considering what drives expansions and recessions; how interest rates tend to change in different stages of the business cycle; how to measure credit conditions; and how financial markets play a key role. We will also look at key industry success factors and highlight the important task of assessing the competitive environment. In addition, we will learn about the importance of technology and regulation. chapterS 3 and 4

the enterprise

financing

operating

investing

In Chapters 3 and 4, we will focus on the firm as a whole and its three main a­ ctivities—operating, investing, and financing—and the resulting financial performance. More specifically, Chapter 3 will present the three key financial statements: income statements, balance sheets, and cash flow statements. We will see how a firm generates profits, what it owns and owes, and where the cash flow comes in (or goes out) related to the three activities. Chapter 4 will examine performance measures, including those highlighted in Figure 1.7: profit margin, asset turnover, and financial leverage. We will also learn how these three particular measures are all related to return on equity, which in turn is related to a firm’s growth. chapterS 5 and 6

operating

Growing profits, dividends, cash flow

growth

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Chapter 1  Overview of Financial Management



39

In Chapters 5 and 6, we will focus on a firm’s operating activities and their impact on growth. More specifically, Chapter 5 examines working capital management—­dealing with credit terms from suppliers and to customers—and Chapter 6 looks at projecting profits and financial requirements from operating activities. chapterS 7 and 8

investing

Managing the risk profile

risk

Chapters 7 and 8 discuss the investment activities of a firm. Chapter 7 presents the foundational building blocks of time value of money that are critical to understanding the impact of cash inflows and outflows associated with investing in projects. After that, Chapter 8 examines techniques that help us assess investment decisions. chapterS 9, 10, 11, and 12

financing

Managing the risk profile

risk

Chapters 9 through 12 will present the financing activities of a firm, which in turn affect the firm’s risk profile. Chapter 9 considers the capital markets in which a firm goes to raise external capital. Chapter 10 examines how we measure the firm’s cost of capital. Chapter 11 helps with an understanding of a firm’s financing and dividend decisions. Chapter 12 focuses on designing an optimal capital structure, or mix of debt and equity.

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Part 1  Assessing and Managing Performance

chapterS 13 and 14

Growing profits, dividends, cash flow

Managing the risk profile

growth

risk

value creation

Finally, in Chapters 13 and 14, we bring together the related topics of growth and risk. Chapter 13 examines how to measure value and how value is created. We will see that higher growth of cash flows has a positive impact on the overall value of a firm, whereas more risk has a negative impact. Chapter 14 integrates all of the concepts covered in the book by examining Walmart and its attempts to create value for its shareholders.

1.7 Relevance for Managers Objective 1.7

Explain why understanding financial management is relevant for managers.

Regardless of the discipline, every manager needs to understand financial management concepts because every business unit is involved in cash inflows, cash outflows, or both. Nonfinancial managers are clearly not involved in key decisions made exclusively by financial managers, such as determining the appropriate mix of debt and equity, but nonfinancial managers live with the consequences of these decisions. An underlying key objective for all managers is creating value for the firm. Value creation involves many financial aspects such as growing the cash flows of a business while attempting to mitigate the riskiness of that cash flow stream.

Summary

1. Cash is a key component to the three main business activities: operating, investing, and financing. 2. The cash flow cycle indicates where cash comes from and where it goes in a business. 3. Profits are not the same as cash flows. 4. Assets are what the firm owns, liabilities are what it owes, and equity is the difference between the two. 5. Financial managers make decisions that attempt to create value for the firm’s shareholders. 6. Nonfinancial managers need to understand fundamental concepts related to financial management such as assessing a business, future financial requirements, long-term financing decisions, and investments.

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7. Financial managers interact with accountants and with managers from other disciplines such as operations, marketing, information technology, and human resources. 8. There are a variety of types of firms, including sole proprietorships, general partnerships, limited liability companies, S corporations, and C corporations. 9. Growth and risk are two key drivers of value creation.

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Chapter 1  Overview of Financial Management



41

Additional Readings and Information

There are numerous in-depth corporate finance books (about 1,000 pages in length or more), some for American audiences and others for global ­audiences, including: Berk, Jonathan, and Peter DeMarzo, Corporate Finance: Global Edition. 3rd ed. Boston: Pearson Education & Professional Group, 2014. Brealey, Richard, Stewart Myers, and Franklin Allen. Principles of Corporate Finance, Global Edition. New York: McGraw-Hill/Irwin, 2010. There are also shorter versions (about 800 pages) of some of these texts, including:  Berk, Jonathan, Peter DeMarzo, and Jarrad Harford. Fundamentals of Corporate Finance. 2nd ed. Boston: Pearson Prentice Hall, 2010. An even more concise examination (less than 500 pages) of corporate finance is:  Higgins, Robert. Financial Analysis for Financial Management. 10th ed. Boston: McGraw-Hill Irwin, 2011. A classic study that describes a theoretical framework for the firm and the role of shareholders and managers is: Jensen, Michael, and William Meckling. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics 3 (1976): 305–360. Information about different business entities and tax implications is available from the Internal Revenue Service website: http://www.irs.gov/Businesses/ Small-Businesses-&-Self-Employed/

Problems

1. What is the role of the financial manager? 2. What is the ultimate task of the financial manager? 3. Explain how the cash flow cycle works. 4. What goals should always motivate the actions of a firm financial manager? 5. What are the advantages and disadvantages of organizing a firm as a corporation?

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6. Suppose three optometrists wished to form a business that was expected to last until the oldest one was about to retire. The three had known each other since college and were close friends who trusted one another. What type of firm might be appropriate? 7. What is the primary goal of an enterprise? 8. What are the two key drivers of value?

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2

Sizing-Up a Business: A Nonfinancial Perspective

Learning Objectives Obj 2.1

Describe the economic size-up process.

So it is said that if you know others and know yourself, you will not be imperiled in a hundred battles. —Sun Tzu, The Art of War

Obj 2.2

Describe the industry size-up process. Obj 2.3

Describe the operations management size-up process. Obj 2.4

Describe the marketing management size-up process. Obj 2.5

Describe the human resource management and strategy size-up process. Obj 2.6

Understand how the size-up process applies to Home Depot. Obj 2.7

Explain why sizing-up a business is relevant for managers.

size-up: A process for assessing external and internal factors and strengths and weaknesses pertaining to a firm SWOT analysis: A process for assessing the strengths, weaknesses, opportunities, and threats pertaining to a firm

Financial management is often associated strictly with number crunching and quantitative analysis related to cash management (not that there is anything wrong with number crunching). As a result, the nonfinancial aspects of financial management are often overlooked. Although it’s true that financial management involves management of cash, cash does not originate from nor end up in the chief financial officer’s (CFO’s) desk drawer. Rather, it is the other parts of the business that are involved in the generation of and need for cash. For this reason, it’s critical that a firm’s financial managers understand what external factors impact the firm’s creation and use of cash, as well as how various functional areas within the firm (operations, marketing, human resource management, and so on) affect cash flows. In other words, if we wish to understand a firm’s current financial position or its anticipated financial needs, we must first size-up the business by understanding overall economic conditions, the industry in which the firm operates, and the strengths and weaknesses of the firm itself. What we broadly refer to as a business size-up is closely related to the process known as SWOT analysis, which involves examining a firm’s strengths, weaknesses, opportunities, and threats. This chapter is the first of four that focus on assessing a firm’s current business. Whereas Chapters 3 and 4 look at analyzing financial statements and assessing a firm’s financial health and Chapter 5 explores day-to-day cash flow management, this chapter concentrates on sizing-up a business from a nonfinancial perspective. We begin the chapter by revisiting our financial management framework that contains many of the key components of our size-up process. We then consider how we can determine various elements critical to a firm’s success by looking at external factors (such as the economy and the industry in which the firm operates), as well as the firm’s strengths and weaknesses in nonfinancial areas (such as marketing, operations, and human resource management). This type of comprehensive nonfinancial size-up is a critical component in analyzing a firm’s opportunities and risks, along with their possible impacts on cash flows. A size-up can help financial managers understand a firm’s historical position and anticipate future financing needs. For this reason, size-up analyses should be revisited on an annual basis. Size-ups are also a useful tool for people outside the firm, such as potential lenders.

42

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Chapter 2  Sizing-Up a Business: A Nonfinancial Perspective



43

Fig 2.1 Financial Management Framework: External Environment and Operating Decisions

external environment economy

industry

the enterprise

• Expansion/recession • Interest rates • Credit conditions • Financial markets

• Operations/ suppliers • Marketing/ customers • Working capital • People

operating

financing

• Competition • Technology • Regulation • Key success factors

investing

Recall that in Chapter 1, we introduced a financial management framework that will serve as our unifying theme throughout the book. We revisit that framework here in order to highlight how our nonfinancial size-up relates to the overall financial management framework. An excerpt of the overall framework is presented in Figure 2.1. This excerpt indicates our main focus in this chapter, which is understanding a firm’s external environment and its impact on the firm’s operating decisions. As you look at Figure 2.1, note that there are two major components to sizing-up a business: (1) analyzing the firm’s external environment and (2) analyzing various factors within the enterprise. As depicted in the figure, the two key external factors that impact a firm’s cash flows are the overall performance of the economy and the structure and nature of the industry in which the firm operates. Understanding the relationship between the economy and a particular industry can help us determine the effects of changing economic variables on overall industry profitability. In turn, understanding an industry’s key success factors (described in Section 2.2.4) gives us a benchmark by which to assess a firm’s strengths and weaknesses in that industry. Figure 2.1 also illustrates that the financial management framework focuses on three major areas of decision making within the firm: operating decisions, investing decisions, and financing decisions. In later chapters, we’ll see that these three areas correspond with the three key components of a firm’s cash flow statement, and we’ll also learn more about investment and financing decisions. In this chapter, however, we’ll focus primarily on elements related to operating decisions, as indicated in the “Operating” circle in Figure 2.1. In particular, we’ll see that there are a number of functional areas that combine to form a particular business, all of which are related to the operating decisions of a firm. Beyond the finance area, some of the most important functional areas involve operations, marketing, and human resource or people management. Understanding each area—including its strengths and weaknesses—can help us assess both the short- and longer-term financing needs of the firm.

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Part 1  Assessing and Managing Performance

In-Depth

Gathering Information for a Size-Up

Our first step in the size-up process is to gather information. For publically traded firms, major sources of information include the firm’s annual report, as well as its Securities and Exchange Commission (SEC) Form 10-K filing (available through the SEC’s Electronic Data Gathering, Analysis, and Retrieval system, or EDGAR). For industry assessments, consulting firms often provide free industry reports that discuss key issues facing a particular industry, challenges and opportunities, and an outlook of the future. Investment banks provide research reports on specific firms that attempt to set target prices for the stock, as well as supply both qualitative and quantitative analysis. These reports are available directly from the investment banks but many are also available through thirdparty data providers such as Thomson One. Basic financial information and links to additional data sources are also available through many financial and information-gathering websites, including reuters.com, bloomberg.com, money.msn.com, and finance.yahoo .com, to name a few. Finally, general economic information is available through such places as the Bureau of Economic Analysis website and the Federal Reserve website.

Remember, our overall goal in sizing-up each of these external and internal factors is to increase the value of the enterprise—and we can do this through astute decision making. Sizing-up a business is all about identifying opportunities and risks, understanding their impact on a firm’s financial health, and using this information to make choices that add value. Also, a good size-up helps us better appreciate and interpret the key financial statements we will examine in the next chapter. We cannot accurately assess a firm’s health unless we have a proper context for these statements. For example, we may look at performance numbers differently if we know we are in a recession or if there has been a major change in the industry.

2.1  Sizing-Up the Overall Economy Objective 2.1

Describe the economic size-up process.

gross domestic product (GDP): The total value of the output of goods and services produced or offered by a country over a period of time

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When asked where the economy is going, economists often talk as if they have more than two hands (“on the one hand . . . on the other hand . . . on the other hand . . . ”). In fairness to economists, predicting economic activity is a challenging task. Yet understanding the relationship between economic activity in general and the revenue and profits of a particular business can provide important insights into the anticipated f­ inancial needs of the firm. Many businesses are critically tied to the overall economy, meaning their p ­ rofitability varies directly with economic performance (although this relationship is more pronounced for some types of firms than for others). Thus, changing economic activity will directly impact revenues. Also, costs tend to change with changing economic activity. Furthermore, depending on a firm’s reliance on borrowing or its need for capital, a changing economic environment will have a direct impact on the firm’s financial performance. For example, if a firm is about to refinance a $100 million loan that has come due and current interest rates are 1 percent higher than the rate on the maturing loan, then the firm’s interest payments will increase by $1 million per year. The economic activity of a country is typically measured in terms of the total amount of goods and services produced over a particular time period, such as a year. This measure is known as the country’s gross domestic product (GDP). Economists

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Chapter 2  Sizing-Up a Business: A Nonfinancial Perspective



Expansion

Capacity trend

Peak

45

Fig 2.2 The Business Cycle

Real GDP

Actual output

Recession

Trough

Time

often track economic activity by focusing on real (inflation-adjusted) changes in GDP, either on a year-by-year or quarter-by-quarter basis. Over the long term, countries tend to have a greater capacity to increase economic activity, either by employing more labor or by building more plants and equipment. However, a country’s actual output of goods and services may not, in the short term, increase at the same rate as the country’s capacity. Consequently, a gap develops between capacity and actual output. Cyclical changes in the size of this gap make up what is commonly referred to as the business cycle. The typical business cycle is presented in Figure 2.2. As depicted in Figure 2.1, peaks in the business cycle tend to occur when the capacity-­ to-output gap is smallest, and troughs tend to occur when the gap is largest. When changes in real GDP are positive, the economy is said to be expanding. Conversely, two consecutive quarterly declines in real GDP are generally said to indicate a recession.1 Over the past 160 years, the average U.S. expansion has lasted around three-and-ahalf years, and the average recession has lasted roughly 16 months. If you consider only the period since World War II, though, the average expansion has grown to almost five years and the average recession has shrunk to less than one year. Of course, there is considerable variation from these averages. Figure 2.3 indicates year-to-year real GDP growth in the United States between 1948 and 2011, as measured each quarter. The areas shaded in light blue represent recessions. As depicted in the figure, prior to the mid1980s, America’s real GDP often grew by over 7 percent from one year to the next, such as in 1950, when it grew by over 13 percent. Since 1985, however, the nation’s real GDP increased by over 5 percent in just one period, in 2000. Figure 2.3 also highlights the severity of the 2007–2009 recession. If we consider all the data in this figure, we find that the average U.S. year-to-year GDP growth from 1948 to 2011 was approximately 3.3 ­percent. Since 1985, though, the yearly average has been a more modest 2.7 percent.

2.1.1 GDP Components There are four components or segments that contribute to a country’s overall gross domestic product. The largest component for many developed countries is typically the consumer segment, which is driven by the consumption patterns of individual

1

Note that the National Bureau of Economic Research’s Business Cycle Dating Committee doesn’t have a fixed definition for recession. Instead, it describes a recession as a period with “a significant decline in economic activity spread across the economy” that can last from a few months to more than a year. See http://www.nber.org/cycles/recessions.html (accessed January 3, 2013).

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business cycle: Changes in countrywide economic activity reflecting expansions, or increases in real (inflation-adjusted) output, versus contractions, or decreases in economic real output recession: A downturn in a country’s economic activity, typically measured as two consecutive quarters of decline in real (or inflation-adjusted) gross domestic product

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2010–Q3

2008–Q1

2005–Q3

2003–Q1

2000–Q3

1998–Q1

1995–Q3

1993–Q1

1990–Q3

1988–Q1

1985–Q3

1983–Q1

1980–Q3

1978–Q1

1975–Q3

1973–Q1

1970–Q3

1968–Q1

1965–Q3

1963–Q1

1960–Q3

1958–Q1

1955–Q3

15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 –1 –2 –3 –4 –5

1953–Q1

Fig 2.3 U.S. Real GDP Annual Change Percentage, 1948–2011

1950–Q3

Part 1  Assessing and Managing Performance

1948–Q1

46

Note: Based on four-quarter moving average; shaded areas are recessionary periods as determined by the National Bureau of Economic Research, http://www.nber.org/cycles.html (accessed March 1, 2012) Source: U.S. Bureau of Economic Analysis, http://www.bea.gov/national/ (accessed March 1, 2012)

consumers. The second component is the business investment component. This segment includes any business investments, such as investments in plants, equipment, and research and development. The segment also includes investments by individuals in housing. The third component is the government sector, which includes any transfer payments to individuals. Finally, the fourth component is the net export segment, which is calculated by subtracting a nation’s total imports from its total exports. If a country exports more than it imports, it is known as a net exporting country, and this portion of its GDP will have a positive value. In contrast, if a country imports more than it exports, it is described as a net importing country, and the net exporting portion of its GDP will have a negative value. Figure 2.4 shows how these four components made up the U.S. GDP in 2011. Note that consumption made up over 70 percent of the nation’s GDP, followed by government Fig 2.4 U.S. GDP (in billions of dollars) by Components, 2011

Government spending 20.1%

Net exports –3.8% –576 3,030

Investment 12.7%

1,914

10,726

Consumption 71.1%

Source: Bureau of Economic Analysis, http://www.bea.gov/national/ (accessed March 1, 2012)

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Chapter 2  Sizing-Up a Business: A Nonfinancial Perspective



47

spending at just over 20 percent and business investments at just under 13 percent. Because the United States was a net importing country in 2011, the net exporting part of the nation’s GDP had a negative value, allowing the other three components to add up to over 100 percent.

2.1.2 Sector-Related Fluctuations At various stages in the business cycle, different sectors or industries may be growing or shrinking at different rates in terms of revenue growth or stock market performance. For example, the basic materials sector (which includes mining and forestry) tends to do well in stock market performance relative to other sectors during early stages of an expansion, whereas the utility and financial sectors tend to do relatively better in the early stages of a recession. Business cycles can be caused by a decline in demand for goods and services by any of these sectors. Figure 2.5 shows an example suggestive of the typical relative stock market performance of various sectors at different business cycle stages. Note that stock market performance tends to anticipate upcoming profitability, which is why the stock price curve leads the business cycle curve. Some sectors can have a dramatic impact on overall GDP. For example, the housing sector is particularly important because if someone buys a new home, she or he will need to furnish the home—and purchasing furnishings will have a positive impact on furniture and appliance sales. There is also a “wealth effect” whereby households feel wealthier if house prices are increasing—even if they are not planning to sell their house—and thus may buy more goods and services. A more direct effect on GDP may be related to households that have home equity loans. As houses are assessed at a higher value, banks may agree to increase homeowners’ lines of credit or borrowing capacity, backed by the value of their house as collateral.

Information technology Consumer discretionary

Materials Telecom services

Energy

Health care Consumer staples

Industrials

Market top

Financials

Utilities

Which sector tends to perform best?

Fig 2.5 Sector Stock Market Performance and Business Cycles

Peak

Recession

Recession Bull market Expansion

Business cycle

Bear market Market bottom

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Trough

Stock market

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Part 1  Assessing and Managing Performance

Case Study

Sector Performance and Business Cycles: Duke Energy Corporation and Tiffany & Co.

Let’s take a look at how two firms in different industries performed around the 2007–2009 recession. Duke Energy is America’s largest multistate regulated gas and electric utility. Tiffany & Co. is an international high-end jewelry retailer—broadly speaking, it’s in the consumer discretionary industry. You would expect Tiffany to be hit harder by the recession than Duke, because we can easily forgo jewelry purchases in a recession but we still need electricity, and that is what we see based on year-over-year revenue changes from 2008 to 2011. We also see this trend reflected in the firms’ stock returns (including dividends) based on an initial $1 investment.

Revenue Change Duke 2007

 

Tiffany  

Stock Return ($1 invested) Duke

Tiffany

1.00

1.00

2008

3.8%

-2.7%

0.78

0.52

2009

3.6%

5.2%

0.96

0.97

2010

12.1%

13.8%

1.05

1.44

2011

1.8%

18.1%

1.36

1.56

The data show that Tiffany’s revenue declined between 2007 and 2008, then again between 2008 and 2009. A $1 investment in Tiffany stock at the end of 2007 would have left the investor with only 52 cents by the end of 2008. By comparison, Duke’s revenue actually increased during 2008 before a small drop in 2009. Duke’s stock performance, although down in 2008, was much better than that of Tiffany. Interestingly, whereas Tiffany had a greater drop in revenue and worse stock performance during the recession, it bounced back much stronger than Duke once the recession ended as discretionary consumption rebounded. Tiffany’s revenue growth was higher than Duke’s in 2010 and 2011, and its overall stock return between the end of 2007 and 2011 was better than Duke’s overall return.

2.1.3 Inflation and Interest Rates

inflation: The rate of increase in prices in a country, typically measure relative to a representative basket of goods and services

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Business cycles are also related to financial variables, such as changing prices for goods and services and fluctuations in interest rates, which can be influenced by central banks. These financial variables reflect overall credit conditions, or the ability of firms to borrow money. The Federal Reserve System (commonly called the Fed) is the central banking system in the United States, and its board of governors is charged with implementing various monetary policy tools, such as setting the rate at which commercial banks can borrow from it. (This key borrowing rate is known as the discount rate.) The Fed’s primary goals are to maintain stable prices or low and steady inflation, maximize employment, and moderate long-term interest rates. Inflation, typically measured as an increase in the price consumers pay for a representative basket of goods and services, tends to occur at a greater rate as the economy expands. There is often a direct link between inflation and the nation’s money supply, which is controlled by the Fed. Some economists claim that too much money “chasing” too few goods tends to cause inflation. In other words, if the Fed makes more money available to banks and banks more readily lend this money to consumers, then consumers will want to make more purchases. If, however, the

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Chapter 2  Sizing-Up a Business: A Nonfinancial Perspective



25

49

Fig 2.6 U.S. Annual Inflation Percentage as Measured by the Consumer Price Index, 1914–2011

20 15 10 5 0 –5

2010

2006

2002

1998

1994

1990

1986

1982

1978

1974

1970

1966

1962

1958

1954

1950

1946

1942

1938

1934

1930

1926

1922

1918

–15

1914

–10

Source: U.S. Department of Labor, Bureau of Labor Statistics, ftp://ftp.bls.gov/pub/special.requests/cpi/ cpiai.txt (accessed March 1, 2012)

supply of goods and services is limited, then the price of these goods and services will rise as demand increases. Figure 2.6 documents annual U.S. inflation from 1914 to 2011. During that period, the average annual inflation rate was 3.3 percent. Notice that during the Great Depression of the 1930s, the United States (along with many other countries) experienced bouts of deflation, whereby average prices actually declined. High or increasing inflation is considered a bad thing, primarily because it creates uncertainty. In other words, consumers may be deterred from buying goods and services if they aren’t sure their wages will increase fast enough to cover the increased costs of those goods and services. Similarly, businesses may be hesitant to invest if they’re unsure whether they can sell their goods and services at prices that exceed their costs. Deflation is also a bad thing because if prices are expected to continue decreasing, then consumers may postpone purchases. Thus, the “sweet spot” for the overall economy is low and steady inflation, or price stability. As inflation increases, so do overall interest rates. Interest rates, or yields on various financial instruments such as bonds, represent the price of money. From the demand side, interest rates represent what an individual borrower would be willing to pay a lender, given the opportunities the borrower is facing. From the supply side, nominal interest rates can be divided into two components: real rates and expected inflation. Real rates represent the “fair” return that a lender would like to receive in the absence of any inflation. This real return includes two parts. The first part is a return to the lender to compensate for forgoing consumption today. The second part is a default premium that depends on the perceived riskiness of the borrower. Expected inflation, however, is often a function of the economy’s current position in the business cycle. During expansions, expected inflation—and hence nominal interest rates—tend to increase. These increases in expected inflation often occur when consumers increase

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deflation: The rate of decrease in prices in a country, typically measure relative to a representative basket of goods and services interest rates: The yields on various financial instruments such as bonds, that effectively represent the price of money: a borrowing or lending rate

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their borrowing needs, because they typically spend more during an expansion. Nominal rates tend to peak shortly after the peak in the overall economy, then decline during a recession. Governments are often the largest borrowers of funds, and their borrowing rates tend to vary depending on the agreed-on borrowing term. A plot of the different rates at which a government can borrow, with differing times to maturity, is known as a yield curve. The shape of a yield curve is important for a number of reasons. First, the shape provides an indication of the anticipated change in interest rates. According to one theory known as unbiased expectations, longer-term interest rates or yields reflect lenders’ (and borrowers’) best guess of anticipated shorter-term rates, say for one year. For example, if the U.S. government can borrow for one year at an annual rate of 4 percent and for two years at an annual rate of 5 percent, then market participants (i.e., borrowers and lenders) are anticipating that the one-year rate in one year will be around 6 percent. If that is the case, then the government should be indifferent between borrowing for two years at 5 percent versus borrowing for one year at 4 percent and then borrowing again for an additional year at around 6 percent (thus averaging to the two-year rate of 5 percent).2 So, according to the unbiased expectations theory, upward-sloping yield curves imply market participants anticipate increasing interest rates. A competing theory known as liquidity preference assumes that lenders require a higher yield on longerterm loans. Thus, even if market participants are not expecting rates to increase, we still might observe a slightly upward-sloping yield curve. The shape of a yield curve is also important because it provides an indication of borrowing costs for corporations. In the United States, we tend to think of government securities as “risk-free” from the perspective of the borrower, given that the government has never defaulted on its obligations and has the ability to pay back debts and interest through increased taxes, reduced spending, or essentially printing money, which has the undesirable side effect of creating inflation. (Not all government debt is risk-free, however. Two classic examples include the Russian government’s default on its debts in 1998 and the Greek government’s default in 2012.) On the other hand, corporations are viewed as riskier borrowers than the government. Therefore, we would expect the cost of corporate borrowing to be greater. To estimate the cost of borrowing for corporations, we start with the cost of government borrowing (for a particular time to maturity), then add a premium that compensates the lender for the risk of possible default. The size of the default or risk premium depends on an assessment of the firm’s default risk, which is one of the goals of our business size-up. A third reason why the shape of the yield curve is important is because it provides clues about the economy’s current position in the business cycle—and this information is critical for our size-up process. Periods of expansion are associated with upward-­ sloping yield curves because inflation and interest rates tend to increase throughout an expansion. At troughs in the business cycle, yield curves tend to be upward sloping as well, but they start from a lower level. In contrast, yield curves tend to be inverted or downward sloping prior to a recession, with short-term rates higher than long-term rates. This inversion often occurs as central banks attempt to tighten monetary policy by increasing short-term rates (i.e., the discount rate) when the economy appears to be overheating and there is danger that inflation will increase. If the central bank is successful, then rates are expected to decline in the longer term. yield curve: A plot at a particular point in time of the different (typically government) borrowing rates, with differing times to maturity

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2

This is only an approximation. To estimate the “break-even” rate in one year, we would employ the following formula: (1 + 5%)2 = (1 + 4%) * (1 + r) and then solve for r, the anticipated one-year rate in one year. In this case, r is actually 6.01%.

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Fig 2.7 U.S. Yield Curves at Various Business Cycle Stages (yield %)

6

5

4

3

2

March 2005 expansion February 2007 pre-peak June 2009 trough

0

3MO 6MO 1YR 2YR 3YR 4YR 5YR 6YR 7YR 8YR 9YR 10YR 11YR 12YR 13YR 14YR 15YR 16YR 17YR 18YR 19YR 20YR 21YR 22YR 23YR 24YR 25YR 26YR 27YR 28YR 29YR 30YR

1

Source: Federal Reserve http://www.federalreserve.gov/econresdata/researchdata.htm and http://www .federalreserve.gov/econresdata/statisticsdata.htm (accessed March 1, 2012)

Figure 2.7 shows three different yield curves at different stages in the business cycle, consistent with our conjectures. Notice that in March 2005, the economy was expanding and the yield curve was upward sloping. In February 2007, just prior to the peak in the economy, the yield curve was inverted. Later, at the business cycle’s trough in June 2009, the yield curve was upward sloping, with extremely low short-term rates.

2.1.4 Capital Markets As part of our economic size-up, it’s also important to understand overall capital market conditions so that we can determine whether it might be a good time for a firm to raise capital (rather than borrow funds). For example, if a firm is considering raising capital by issuing equity, then overall stock market conditions are important. Issuing equity may be easier when stock prices in general are rising. Figure 2.8 shows the level or average of U.S. stock prices, as measured by the wellknown Standard & Poor’s (S&P) Index, from 1871 to 2011. The S&P Index measures the average stock prices of a wide range of large firms and is the most common broad market index used by professional investors. (The Dow Jones Industrial Average is more popular in the media but is a much narrower measure of only 30 stocks.) Note that ­Figure 2.8 uses a logarithmic or log scale, in which a price movement from $1 to $10 looks the same as a price movement from $10 to $100 because in both cases, there is a tenfold increase. Also note that the graph does not include dividends that investors would have received. As we look at Figure 2.8, we see a number of different patterns of stock levels. After stock prices peaked in 1929, the Great Depression occurred. It wasn’t until 1953 that average stock prices returned to their 1929 levels. Notice also that in the 52-year period between 1948 and 2000, stock prices increased almost a hundredfold. More recently, average stock prices in 2011 were at a similar level to those in 1999, with the first decade of the new millennium referred to as a “lost decade” for stocks. Yet despite these

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Fig 2.8 Average U.S. Stock Prices as Measured by the S&P Index (1.0 in 1871), 1871–2011

1000 $100 in 1993 100 $10 in 1957

$280 in 2011

10 $1 in 1871 1

1871 1876 1881 1886 1891 1896 1901 1906 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

0

Source: Robert Shiller website, http://www.econ.yale.edu/~shiller/data.htm (accessed March 1, 2012)

ups and downs, stocks have done well over the long term. Analysis of these stock prices along with dividend and inflation data (collected and made available by Robert Shiller) reveals that over the entire period, stocks provided an average annual return (including dividends) of around 6.5 percent adjusted for inflation, or close to 10 percent on a nominal basis.

2.1.5 Economic Size-Up Checklist Recall the importance of an economic size-up: Understanding the relationship between economic activity in general and the revenue and profits of a particular business can provide important insights into the anticipated financial needs of the firm. Figure 2.9 includes a checklist of key questions to consider when sizing-up overall economic conditions. Fig 2.9 Questions to Ask During an Economic Size-Up

Q: What is the current business cycle stage? Q: What is the relationship between the business cycle and the firm’s revenues? Q: What is the relationship between the business cycle and the firm’s costs? Q: How important are changing interest rates to the financial position of firms

within our industry?

Q: What is the current outlook for the overall economy (i.e., the GDP forecast)? Q: What is the current outlook for interest rates (i.e., next year)? Q: How easy or difficult is it to obtain financing (i.e., issuing debt or equity)? Q: Are there any key economic variables whose changes might affect the financial

performance of firms in this industry?

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2.2  Sizing-Up the Industry To better understand a firm’s financial position, it is critical to consider both current and anticipated industry conditions. An industry analysis can provide insight into a firm’s current financial position, as well as how the company’s financial needs might change as industry conditions change. This analysis can also help identify any key risks and opportunities facing the firm. As we go through our industry discussion, keep in mind that the ultimate outcome of an industry analysis is identification of “key success factors” that articulate what resources or skills are necessary for a firm to successfully compete in the industry. Key success factors provide a checklist by which the internal strengths and weaknesses of a firm can be judged. In turn, this checklist serves as a crucial benchmark that can be utilized as part of the firm’s internal size-up (discussed later in this chapter) because it compares the firm’s capabilities in various areas (such as operations, marketing, and human resource management) with the key industry success factors. We prepare this checklist after completing our industry size-up. Such a list may contain, say, three to five factors that we determine to be crucial for industry participants. We should attempt to prioritize the list starting with what we consider to be the most crucial factor. It’s important to recognize that not all firms will be able to achieve every factor on our list. For example, there may be trade-offs between one success factor of proving goods at low prices and another success factor of providing quick delivery. The ultimate strategy of a particular firm will determine which key success factors it should emphasize and attempt to achieve. The chosen strategy will, in turn, have important financial implications.

Objective 2.2

Describe the industry size-up process.

2.2.1 Industry Life Cycles The starting point for any industry analysis is the definition of a particular industry. Industries can be categorized based on the type of product or service they offer, or instead on the particular market segment their product or service is directed toward. Industry categories may be very broad or very narrow. In addition, new industry categories are emerging all the time and replacing obsolete categories.3 The key to an effective industry analysis is to choose a sector or industry that is not so broad as to be meaningless yet not so narrow that sufficient data aren’t available. Industries, like individuals and products, go through a number of stages in their life cycle. Various benchmarks, such as revenues or profits, exhibit different growth rates at different stages: Stage 1 represents the initial or start-up stage of firms within a particular industry. At this point, the firms tend to have very low demand and hence low revenue but high prospects for revenue growth. Because start-up costs are large, profits are typically negative. In this stage, firms often require a significant amount of cash in order to grow. 3

One commonly used industrial classification system is the Global Industry Classification Standard (GICS), which was developed by Standard & Poor’s. In this system, there are 10 sectors, 24 industry groups, 68 industries, and 154 subindustries. The 10 sectors are energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services, and utilities. As an example of finer GICS categorizations, within the consumer discretionary sector, some of the industry groups include consumer durables and apparel, consumer services, and retailing. Similarly, the retailing industry sector contains industries such as distributors, Internet retail, and specialty retail. Finally, within specialty retail, some of the subindustries include apparel, computers and electronics, and automotive.

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Fig 2.10 Typical Revenue Changes during the Industry Life Cycle

Stage 4: Stabilization/maturity Stage 3: Mature growth

Revenue

Stage 5: Decline

Stage 2: Rapid growth

Stage 1: Start-up Time

During stage 2, revenue tends to grow rapidly and positive profits materialize while competition is relatively muted. This is frequently the point at which private firms “go public,” meaning they issue equity shares through an initial public offering process. Also, this is often the period when firms within the industry consolidate, as well as when firms with poor prospects tend to die out. In stage 3, competition intensifies, revenues continue to grow but at a slower or more mature rate, and firms tend to become more efficient as costs are controlled. However, increased competition may put a downward pressure on profit margins. Stage 4 is a phase of stabilization and maturity. Depending on the industry, this stage may last for decades. Any growth in revenue tends to occur at about the same rate as growth in the overall economy. Competition is significant. Finally, stage 5 represents a period of decline during which substitute products cause overall revenue generation in the industry to drop. Figure 2.10 summarizes typical revenue changes over the five stages of the industry life cycle. During an industry size-up, it’s critical to establish what life stage a particular firm is in. This information will be important when interpreting the firm’s current financial position as well as its projected position. It’s also critical to anticipate when a firm might be transitioning from one stage to the next. Often there is a naïve belief that recent growth in revenue and profits will continue in a linear fashion, which may not actually be the case.

2.2.2 The Competitive Environment With the exception of companies in regulated industries that enjoy a monopoly position, firms face various intensities of competition within their industry. Although there are a number of factors that govern competition within an industry, most fall into one of five categories identified by business scholar Michael Porter. Porter’s so-called Five Forces, as shown in Figure 2.11, are as follows:

initial public offering (IPO): The initial sale of stock of a firm to the public

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The threat of new entrants The threat of substitute products or services The bargaining power of suppliers The bargaining power of customers The intensity of rivalry among the current competitors

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Fig 2.11 Porter’s Five Forces Governing Competition in an Industry

Threat of new entrants

Bargaining power of suppliers

Intensity of rivalries

55

Bargaining power of customers

Threat of substitutes

The extent of these forces determines the overall profitability of the industry. Thus, Porter argues that firms must understand how these forces work in a particular industry, how they affect individual firms in the industry, and how each firm can try to take advantage of these forces. Let’s take a closer look at each of Porter’s Five Forces, beginning with the threat of new entrants. New entrants often increase capacity within an industry. Therefore, the easier it is for firms to enter a particular industry, the lower the profit margins and growth prospects within that industry. Conversely, if there are huge barriers to entry, then an industry is much more attractive to existing firms. Such barriers include the need for large capital expenditures (such as plants and equipment), economies of scale, access to distribution channels, product differentiation, existing patents and proprietary technology, and government regulation. Also, existing competitors might be expected to react strongly to any new potential entrants. Porter’s second factor involves the threat of substitutes. If an industry offers a unique product or service that is very much in demand, then there are opportunities for multiple firms in the industry to enjoy large profit margins. However, if prices are perceived as too high, substitute products may become available, causing profit margins to shrink and revenues to decline. Even in the absence of high prices, new innovations may make an existing product or service become less appealing. Porter’s third and fourth factors—the bargaining power of suppliers and customers—­ can also impact the profitability of an industry. Powerful suppliers are often those who are concentrated and offer a unique product or service, so they can exert pressure by raising prices. In addition, customers who deal in large volumes and may be purchasing a relatively standardized product or service from a variety of sources can cause a squeeze on profit margins by forcing down prices or demanding higher quality. With regard to Porter’s fifth factor, more intense rivalries among existing firms can result in lower profit margins as competitors jockey for position. Competitive tactics might include lowering prices, introducing new products, or increasing marketing efforts in order to gain market share. Competition tends to be more intense when a particular product or service is much like a commodity, with very few distinguishing features. In addition, if the typical firm within an industry tends to have high fixed costs, competition tends to be more intense as firms attempt to utilize as much capacity as possible.

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Fig 2.12 Industry Profitability and Competitive Position

Profitable

Industry Profitability

Value creation

0

Value destruction

Unprofitable Disadvantaged

Advantaged

Competitive Position

Often, there are a number of factors unique to a particular industry that can intensify competition. For instance, revenue generation in one industry may be dependent on the demand for goods and services in another industry. As an example, the sale of newsprint depends in part on the communications industry and the demand for newspapers, which in turn depends on overall economic conditions and the availability of electronic substitutes—both of which affect advertising demand and revenue. All of these factors together impact overall growth opportunities within the industry. The structure of competitive forces establishes the overall profitability of an industry. A competitive advantage occurs only when one competitor’s profitability is higher than others due to a combination of higher revenues or lower costs. Ultimately, as Figure 2.12 indicates, in order to create value for shareholders, a firm must strive to identify its competitive position within an industry and then try to move to an “advantaged” position, ideally within a profitable industry. A long-term sustainable advantage occurs when a firm is either the low-cost producer within the industry or is able to differentiate its product or service, thereby increasing profitability.

2.2.3 Opportunities and Risks By analyzing the so-called PEST factors—political, economic, social, and technological— a manager can gain further insight into the opportunities and risks facing a particular industry. Political factors include legislative changes that might add to or eliminate regulation in a particular industry, thus posing additional costs or providing new opportunities. For example, favorable tax changes or incentives can result in lower price offerings and increased demand in an industry. Economic factors were discussed previously in Section 2.2. As described in that section, some industries’ revenue growth is closely tied to the performance of the ­overall economy. These industries are known as cyclical industries. Other industries, such as utilities, have more stable revenues regardless of the current stage in the business cycle. Social trends can also have a longer-term impact on an industry. For instance, if the consumption of a particular product is determined to have detrimental effects on people’s health, the product’s sales may decline. Finally, technological improvements can lead to major efficiency gains. New equipment, for example, may lower a firm’s cost of sales, resulting in a higher profit margin.

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Q: What industry segment and life cycle stage is this firm in?

Fig 2.13 Questions to Ask during an Industry Size-Up

Q: How profitable is the industry currently? Q: What is the competitive environment? How intense is the competition? Are

there significant barriers to entry? Do suppliers or customers have bargaining power? Is there a threat of the emergence of substitute products?

Q: What are the overall prospects for revenue growth and increased profitability in

the industry?

Q: What are the key opportunities and risks for this industry in relation to the

political, economic, social, and technological environments?

Q: Overall, what are the key success factors for this industry?

Thus, analysis of the four PEST factors can help identify opportunities and risks that may impact a firm’s financial performance and requirements.

2.2.4 Industry Size-Up Checklist We perform an industry size-up in order to consider both current and anticipated industry conditions and thus ultimately better understand a firm’s financial position. A summary of key industry size-up questions is presented in Figure 2.13.

2.3  Sizing-Up Operations Management and Supply Risk After examining current and anticipated economic conditions, completing an industry analysis, and determining key industry success factors, a manager’s size-up analysis should move from an external perspective to an internal one, focusing on the firm’s capabilities in various areas. If you are doing a size-up of your own firm, you should have access to all the data you need. If you’re sizing-up a publicly traded firm, you can rely on annual reports and 10-K filings for information. However, sizing-up a private company may pose a challenge because you’ll need to rely on third-party reports such as trade publications. The first step in internal analysis involves examining the operations of the firm. Here, the key question to address is: Assuming customer demand is strong, to what extent is the firm able to fulfill that demand by providing the service or making the product available to the customer? This part of the analysis focuses on identifying ­supply risk, or the chance that the firm may suffer supply-related losses. For goods, these losses may stem from being unable to acquire materials or produce sufficient inventory to supply the product. In the case of services, these losses may stem from not having adequate provision capacity as demanded by the customer. Managers can assess a number of areas that relate to a firm’s overall operating system, which transforms inputs into outputs and enables the realization of value for customers. In general, all operating systems involve what are known as the Six Ps of Operations: Product quality Process Plant (or facilities)

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Objective 2.3

Describe the operations management size-up process.

supply risk: The chance that the firm may suffer supply-related losses by not being able to meet demand

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Parts (or inventory) People (or labor) Partners (or supply network) Let’s establish some key questions to be addressed in each area and consider each of these elements in greater depth. Product quality: How important is quality to the customer and how does the firm define quality? Product quality management is concerned with the extent to which a firm is able to provide a reasonable amount of product or service quality in light of constraints such as cost. A firm measures quality by determining whether and how well it meets production specifications. However, to consumers, quality often involves the notion of value, or quality relative to the price paid. Poor quality can result in substantial costs for the firm in terms of repairs, higher warranty costs, or damaged reputation and future business. From an assessment perspective, the importance of quality must be determined by understanding what consumers want. The firm’s operations must then be evaluated to determine whether consumer needs are being met. Process: What process does the firm employ and how effective is this process? Process management involves determining the appropriate process for providing a product or service. In manufacturing settings, typical process choices include whether to use job shops or a variety of workstations (producing several different products in small batches), whether to use line flow or a series of sequential operations (producing similar products using specialized equipment), and whether to focus on multiple projects or production of a single item. In service settings, these processes also apply, but they relate to the processing of customer inputs. Regardless of setting, it’s important for a firm to ensure that its choice of process, which has cost and time implications, is meeting customer needs. For example, if a firm needs to switch from line flow to a job shop production model, then it may need to invest in a lot of new equipment. Another dimension of process management is choosing what technology to invest in. Here, the goal is to maximize the firm’s investment, trading off the cost of the new process or technology with potential gains in efficiency. Plant: Next, what is the current capacity of the firm’s plant or facilities? Plant or facilities management involves ensuring that sufficient capacity or maximum output is available and allowing for efficient, effective work flows. Facilities refers to the physical plant and equipment available to produce goods or offer services. There is a trade-off between being able to meet demand and the cost of having facilities and equipment available but idle. Thus, planning and anticipating demand is a crucial part of facilities management. On a day-to-day basis, this longer-term planning translates into scheduling or determining how available capacity will be best utilized. Parts: What type of inventory and inventory management system does the firm have? Parts or inventory management applies primarily to manufacturing businesses and ensures a proper mix of different types of inventory: raw materials, work-in-­ process, and finished goods. Raw materials are inputs for the finished goods, and work-in-process represents inventory that has not been completed. As with other components of operations, managing inventory involves trade-offs. From a supply perspective, having huge amounts of inventory will ensure that any demand for a product can be readily met. On the other hand, there are huge costs associated with holding large amounts of inventory due to the actual costs of raw materials, storage space, and administration. Thus, there is a trade-off between the risks of stock-outs (not having goods available) and the opportunity to meet unexpectedly large demand. In a nonmanufacturing context, there may also be inventory management concerns if

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certain goods are required in order to provide services (as in the food service industry, for example). People: What people skills does the firm require? People or labor management involves the hiring and maintenance of a sufficiently skilled workforce. Here, a firm’s managers must ensure that adequate labor capacity exists, match workers with the right jobs, provide appropriate training, clearly define responsibilities, communicate effectively, provide adequate supervision, and set standards and performance rewards. Management must ensure that the firm is paying an appropriate amount for employees at different skill levels. Management should also work toward a positive labor environment and always be cognizant of the firm’s union status. Partners: Finally, how well is the firm’s supply network configured? Most organizations are to some extent reliant on the efforts of supply network partners in order to produce products and/or deliver services. As such, managers must be concerned about how effectively the supply network is configured. They must also productively manage the coordinated efforts of the firm’s supply network partners for efficient, responsive procurement and distribution that meets customer demands. In addition, managers should ensure that a firm’s incentives and actions are aligned with those of its partners. Figure 2.14 summarizes the Six Ps of operations, along with key questions managers need to ask about each area.

Product Quality Q: How important is quality to the customer?

Fig 2.14 Questions Related to Operations and Supply Risk: The Six Ps of Operations

Q: How does the firm attempt to define, design, deliver, and diagnose quality? Process Q: What process does the firm currently employ? Q: How effectively is that process functioning? Q: How critical are technological innovations and investments? Plant or Inventory Q: What is the current capacity of the firm’s facilities? Q: How close is the firm to full capacity? Parts or Inventory Q: What type of inventory does the firm have? Q: How much inventory is required to meet demands? Where is that inventory? Q: What inventory management system does the firm currently employ? People or Labor Q: What skills does the firm require in its workforce? Q: How skilled is the current workforce relative to the skills required? Q: What is the firm’s current labor environment? Partners or Supply Network Q: How well is the firm’s supply network configured? Q: How reliable, efficient, and responsive is the supply network?

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After each of these components of operations management is examined and compared with key industry success factors, a final assessment of the firm’s supply risk can be determined. Inevitably, this assessment will be somewhat subjective, yet it will also be extremely useful as part of the subsequent financial analysis. For example, a manager might make a final assessment using a 1-to-10 scale, with 1 indicating low supply risk and 10 indicating high supply risk. If the firm is currently producing a high-quality product at a reasonable cost, is employing the latest technology, is not at capacity, has an effective inventory management system in place, has a skilled labor force and a positive labor environment, and has a well-functioning supply network, then its supply risk will be judged as very low. However, if the firm’s current product or service is judged to be poor quality and quality is a key industry success factor, then the firm would be expected to invest to improve quality; otherwise, it will suffer a decline in future revenues. A supply risk assessment can also help highlight critical inputs to projected financial statements, such as expenses or the cost of goods sold. For example, if there is a high supply risk attributable to a possible work stoppage, managers should consider this possibility when assessing a firm’s projected financial needs.

2.4  Sizing-Up Marketing Management and Demand Risk Objective 2.4

Describe the marketing management size-up process.

After assessment of a firm’s operations and supply risk, our internal size-up continues with an examination of marketing management and demand risk, or the possibility that actual demand for a product or service will fall short of anticipated demand. Here, the key question to address is: Assuming the firm is able to readily supply a product or service, to what extent is customer demand available? Assessing demand risk requires examination of a firm’s marketing capabilities—and this requires an understanding of how marketing decisions are made. Generally, the marketing decision-making process begins with analysis, which leads to the choice of what is known in marketing as the value proposition. Once the value proposition is chosen, a marketing strategy is developed to support the value proposition. Finally, implementation of the strategy leads to measurable marketing outcomes with important financial implications.4 Marketing analysis involves many of the elements of strategic analysis described in Sections 2.2.2 and 2.2.3 (such as competitive and PEST analysis), as well as some elements of operations analysis described in Section 2.3 (such as assessing suppliers and partners). Marketing analysis also involves assessment of a firm’s capabilities, which we’ll explore in Section 2.5. Most importantly, much of the marketing analysis process focuses on knowing the customer. Understanding consumers’ buying choice/rejection process is essential. A firm must comprehend the critical aspects of the buying process: who, what, where, when, and how: Who: With regard to the who, there may be a distinction between who buys the product and who actually consumes it. When a firm is aware of this distinction, it can aim its key marketing efforts at the group that is most involved in the purchase decision.

demand risk: The possibility that actual demand for a product or service will fall short of anticipated demand

4

Much of the marketing framework described here was developed by Mark Vandenbosch, Ivey Business School at Western University.

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What: For the what, consumers may be buying a physical item or some sort of intangible, such as service, convenience of purchase, sales advice, or delivery. Where: For the where, location is often an important part of the buying process, and it refers to the channel through which a product or service is delivered. When: With regard to the when, the firm needs to understand how consumers’ timing of purchases can vary by time of day or month of the year. How: Finally, the how encompasses buyers’ prepurchase process, as well as their actual purchase decision. A firm’s market research can help better articulate this buying process. With this information in mind, markets can be segmented on the basis of groups that have distinctive needs or characteristics, or by geographical location. After that, the firm can more easily establish the current size, potential for growth, and profitability of each segment. Once its marketing analysis is complete, the firm can choose a value proposition. The value proposition is a statement that describes why a specific target consumer should choose the firm’s product or use its service. This proposition considers the target market (selected from among the segmented markets identified earlier), how the firm’s product or service is meaningfully different from those offered by competitors, and how the firm wishes to position the product or service. Ideally, the value proposition includes a compelling product or service concept. For example, if Procter & Gamble defines the market for Tide laundry detergent as “laundry obsessives” who really care about clean clothes, then the company’s value proposition might be “Tide provides the best cleaning because it is the most powerful detergent on the market.” Once the value proposition is chosen, the firm can make strategic and tactical choices that build on and support that proposition. These choices lead to the firm’s marketing mix, also known as the Four Ps of Marketing: product, price, promotion (or communications), and place (or distribution channel): Product: The product choice involves determining the actual physical product, as well as its quality level, special features, packaging, warranties, and services. Price: The price choice involves determining not only an absolute price but also a price relative to the competition. Promotion: The promotion choice involves choosing a method of persuading the consumer or decision maker to actually buy the product or service, whether through advertising, point-of-purchase display, or other forms of promotion. Place: Finally, the place choice involves determining the most appropriate distribution channel to reach the target market. Location is often critical to the purchase decision. Figure 2.15 summarizes the key areas of market assessment, including the target market, the Four Ps, and the main questions managers need to ask during a marketing and demand risk assessment. After each of these components of marketing management is examined and compared with key industry success factors, a final assessment of demand risk can be determined. As with supply risk, this assessment may be based on a 1-to-10 scale, with 1 indicating low demand risk and 10 indicating high demand risk. Demand risk may be low for a variety of reasons. For instance, the firm may have a well-defined value proposition based on sound marketing analysis, or it may be targeting an attractive market. Similarly, the firm may have an appropriate marketing mix with a product very much in demand offered at an appropriate price with an effective promotional campaign and appropriate distribution channel.

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Fig 2.15 Questions Related to Marketing and Demand Risk: The Target Market and the Four Ps of Marketing

Target Market Q: What is the particular target market? Q: How important are the who, what, where, when, and how of the purchase

decision?

Product Q: What are the product’s critical physical and intangible attributes? Price Q: Is the product price appropriate relative to the competition? Place Q: Is the distribution channel appropriate? Promotion Q: Is the promotional campaign having a positive impact on potential buyers?

Demand risk assessments are also useful for highlighting critical inputs to projected financial statements. For example, if there is a high demand risk attributable to an illdefined value proposition, a faddish product offering, or a weak sales force, managers should incorporate such a possibility into the firm’s projected financial needs.

2.5  Sizing-Up Human Resource Management and Strategy Objective 2.5

Describe the human resource management and strategy size-up process.

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The focus of human resource management is on the capabilities and character of the management team, including the chief executive officer (CEO), president, senior management, and all other managers. Because it’s often a challenge to examine a firm’s management from inside the company, it may be better to look at the management team from an external perspective. This involves asking questions such as How would prospective lenders or investors view the firm’s management? and Does the current management team offer opportunities or present risks to the firm? After all, a firm’s success or failure depends in large part on its managers because they are the people responsible for making strategic decisions and implementing action plans. There are a number of key management attributes that are required to improve a firm’s chances of business success. For example, managers in functional areas such as operations, marketing, information systems, and finance must be capable and have expertise and technical knowledge in their area. Similarly, a firm’s general managers must be able to supply leadership skills. A firm’s size and current growth stage must also be considered as part of the management analysis because the firm’s leadership will face different challenges during different life cycle stages. For example, there are numerous challenges associated with starting a new business—and many new businesses fail due to a lack of management depth. Problems also often arise when a successful entrepreneur fails to plan for succession, which can lead to the downfall of a promising business. Challenges may occur if a business grows too rapidly or lacks focus, particularly by expanding into new areas

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beyond the firm’s original core capabilities. Finally, firms face extra complications when they go public. For example, there is more transparency required with quarterly disclosure of financial statements. In addition, firms may have much more dispersed ownership, so managers are challenged to satisfy all owners—some of whom may desire more dividends, and some of whom may prefer that earnings be retained in the business. In all types of businesses, but particularly in smaller organizations, the experience, actual track record, and skills of the key senior managers are an overwhelming determinant of a firm’s success. A manager’s technical training and previous experience running other businesses are relatively easy to evaluate. A manager’s commitment to the firm may also be gauged by determining his or her financial stake in the business. Ultimately, all managers need to act in the best interest of shareholders, maximizing the value of their shares while carefully considering the potential effects of their actions on other key stakeholders, including employees, customers, communities, and the broader society in which the firm operates. For the management team in general, technical knowledge and experience in a functional area are vital traits. In addition, managers’ ability to establish relationships among customers, suppliers, distributors, lenders, and shareholders is critical to the success of the firm. Clearly, no single person will have the skills necessary to establish all these relationships, so the various members of the management team must be able to work together well. It’s also critical that the firm knows how to attract new managers and develop leadership talent. Leadership skills are another key success factor. Managers must be able to motivate other employees and effectively delegate authority. Managers must also be able to create enthusiasm and stimulate loyalty. Because a company’s success is often impacted by its organizational structure, performance measurement system, reward system, and overall level of communication between and among managers and employees, the firm’s managers must possess the leadership skills needed to clearly articulate the business’s strategy and focus. At an individual level, each manager can be judged by his or her character. Some of the most important elements of character include a person’s creativity, humility, honesty, integrity, compassion, fairness in dealing with others, courage, and willingness to admit mistakes rather than lay blame on others. In combination with these character traits, managers need to develop their capabilities in four key areas: business intelligence, strategic intelligence, organizational intelligence, and people intelligence.5 Business intelligence refers to understanding the nuts and bolts of a business and the economics of the business model. Strategic intelligence refers to understanding the strategic context in which a business is positioned, along with the opportunities and risks a business faces. Organizational intelligence refers to understanding the dynamics within a business, including the firm’s structure, procedures, and compensation system. Finally, people intelligence refers to the ability to understand and motivate people to achieve extraordinary results. Figure 2.16 summarizes some of the key human resource management and strategy factors that should be considered during an internal size-up.

5

This model of intelligence is presented in Crossan, Mary, Jeffrey Gandz, and Gerard Seijts, 2008, “The Cross-Enterprise Leader,” Ivey Business Journal 9B08TD03.

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Fig 2.16 Questions Related to Human Resource Management and Strategy

Q: What management challenges is the firm currently facing? Q: Are these current challenges being sufficiently addressed? Q: What is the overall strategy and focus of the firm? Q: Who are the key principals in the firm? Q: What technical skills do these individuals possess? Q: What business experience do they have (both inside and outside the firm)? Q: What leadership skills do the firm’s managers possess, and do they believe in

leadership development?

Q: What ownership position do the managers have? Q: Is the current management team a good fit for the firm’s size and current

life-cycle stage?

Q: How would you assess the character and intelligence (business, strategic,

organizational, and people) of the firm’s key managers?

Q: How much management depth does the firm have, and what is the turnover

among management ranks?

Q: What are the overall strengths and weaknesses of the management team?

2.6  Sizing-Up Home Depot: An Example Objective 2.6

Understand how the size-up process applies to Home Depot.

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The following scenario illustrates an abridged version of the business size-up process, its implications, and its related conclusions. Our focus firm throughout the book is Home Depot, Inc., the world’s largest home improvement retailer focusing on the “do-it-­ yourself ” segment, with more than 2,200 stores in the United States, Canada, Mexico, and China. We begin our external analysis of Home Depot with an assessment of the economy as of the spring of 2012. After the severe recession of 2007–2009, U.S. GDP grew by 3.0 percent in 2010 and 1.7 percent in 2011.6 Many economists projected GDP growth of slightly above 2.0 percent for both 2012 and 2013.7 So we feel the economy is in the early expansion stage of the business cycle. We believe the outlook is similar for the home improvement industry since overall economic activity is closely tied to the activity of the general economy because consumer spending is the main driver of economic activity. Let’s examine current monetary policy. The Fed is keeping interest rates low in hopes of stimulating borrowing and consumption because it is still concerned about the fragile nature of the economic recovery. So we expect both short-term and long-term interest rates to remain low over the next year, then to gradually rise as the economy strengthens. Lower interest rates help lower the cost of financing for firms in the home improvement industry, and also have a positive impact on demand, because consumers are more likely to borrow—say, for home renovations—when rates are lower. 6

See http://www.bea.gov/newsreleases/national/gdp/2012/gdp4q11_3rd.htm (accessed January 5, 2013).

7

See http://www.economist.com/blogs/graphicdetail/2012/03/focus-0 (accessed January 5, 2013).

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The next step in our external analysis is to consider the industry of which Home Depot is a part: broadly the retail industry, but more specifically the home improvement industry. The overall growth prospects for this industry are quite good, with 2012 growth forecast at 5.0 percent, compared to 3.8 percent in 2011, according to the Home Improvement Research Institute.8 This forecast is based on an increase in consumer confidence, employment gains, and signs of a housing recovery. Demographic trends have suggested that baby boomers, the largest segment of the U.S. population, might consider downsizing their homes in the long term. Such a trend could possibly have a negative effect on long-term home improvement demand, with lower demand for new houses. However, because the industry is in a mature stage, its profit growth probably won’t be much different than overall economic growth over the long term. Let’s again consider Porter’s Five Forces: Existing competition within the home improvement industry is fairly intense, primarily between Home Depot and Lowe’s Companies, Inc.9 The market is quite fragmented with many smaller competitors such as hardware and plumbing stores, with no threat of major new entrants. There are no threats of substitutes. The two major players have strong bargaining power with suppliers, given their size: Home Depot with revenue of over $70 billion, and Lowe’s with revenue over $50 billion. Because customers are typically small contractors or households, customers have little bargaining power. The implication from our assessment is that Home Depot is well positioned in an attractive industry with few threats, and thus profit margins are expected to remain strong. Key success factors in the industry include the ability to offer quality products at reasonable prices, good customer service, and efficiency of operations. Next, our internal assessment of Home Depot begins with operations management. The firm recently completed an operational review and had started to restructure its supplychain and information technology infrastructure. Its distribution network is at a competitive disadvantage relative to Lowe’s, although Home Depot recently changed to a regional network similar to Lowe’s, copying and implementing that firm’s best practices. This suggests that Home Depot recognizes some of its weaknesses and invested to overcome them. In terms of Home Depot’s marketing management, during the previous five years the firm sold its wholesale division, HD Supply, closed its entire EXPO Design Center chain in order to concentrate on its main ubiquitous “orange box” stores, and has reviewed the products offered in its stores. Given its size and bargaining power with suppliers of products, advertising, and rent, the firm has driven hard deals and lowered its costs. It has attempted to gain customer loyalty by passing along a portion of these savings through lower prices. In terms of human resource management, Home Depot’s chairman and CEO, Frank Blake, is credited with the firm’s aggressive strategy of focusing on the orange box stores and improving corporate governance, in part by reducing previous lavish executive compensation practices. Blake and the firm’s CFO each hold almost 600,000 shares in Home Depot, suggesting a strong alignment of their personal financial stake and the interest of all shareholders. 8See

http://www.marketwire.com/press-release/accelerated-growth-forecast-for-home-improvement -market-1634615.htm (accessed January 5, 2013). 9Information

related to the competitive position and outlook for Home Depot and Lowe’s is based on Morningstar equity research reports released in February 2012.

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Relative to key industry success factors, Home Depot is providing good products at reasonable prices, is focused on continual customer loyalty, and is improving the efficiency of its operations to improve its supply-chain and information technology infrastructure to the level currently enjoyed by Lowe’s. Continued success in these areas is expected to require continued investment. Overall, without looking at exact numbers, Home Depot is in strong shape. The next step in assessing Home Depot’s financial health is to understand the firm’s financial statements—both current and projected. We’ll learn more about financial statements in Chapter 3 and projections in Chapter 4.

2.7 Relevance for Managers Objective 2.7

Explain why sizing-up a business is relevant for managers.

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Performing a business size-up is crucial for managers. In terms of an economic size-up, changing economic activity directly impacts revenues, and costs tend to change throughout a business cycle. In addition, if a firm is dependent on a particular commodity as a raw material input, such as aluminum, then changes in the price of that commodity will have important implications for the pricing of the product. Finally, understanding overall economic performance not only helps explain a firm’s past financial performance, but it also makes it easier for managers to anticipate future economic performance and project a firm’s future financial statements (as we’ll discuss in the next two chapters). Industry analysis helps managers understand customer needs. Ultimately, consumers are searching for either the lowest price or a product or service that offers particular features. So, for a firm to succeed in an industry over the long term, it must be a low-cost producer, or it must find a niche by offering a product or service that is unique. Thus, in a particular industry, the key to success might be improving operations by investing in more efficient technology and offering a product or service at the lowest price; or the key might be in marketing, by packaging the product in an appealing manner or utilizing a better distribution channel. Alternatively, the ability to manage labor relations in a heavily unionized industry might be central to success. Key success factors should be prioritized because firms often lack the resources necessary to make changes in multiple areas. In general, every key success factor will have important financial implications. It’s important to conduct a thorough business size-up before attempting to analyze a firm’s current financial position or future financial needs. This is because each component of the size-up has important implications for financial analysis. For example, the economic size-up should establish the relationship between overall economic performance and industry performance (in terms of revenues and profits), and it should also provide a sense of the outlook for interest rates. The industry size-up should generate a list of key success factors based on opportunities and risks related to the industry’s current life cycle stage, growth prospects, intensity and nature of competition, and any other unique characteristics. This industry analysis will provide a benchmark against which to compare the capabilities of the firm, thereby making it possible to assess the firm’s strengths and weaknesses in relation to key industry success factors. Finally, analysis of the firm’s operations, marketing, and human resource management will help highlight key supply and demand risks and internal capabilities, all of which have financial implications. For example, if a firm heavily relies on variable-rate loans and interest rates are expected to rise, then the firm should incorporate higher borrowing costs into its financial projections. Similarly, if one key industry success factor is providing a product with strict specifications that can be produced only with the latest technology, then the firm must anticipate major technology investments.

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In addition, simply understanding economic and industry characteristics can make it easier to understand a firm’s recent and anticipated performance. For example, if the overall economy has shown little or no growth over the past few years, this lack of growth might have had a negative impact on the revenues of all firms within the industry, and it might also have contributed to slower payments by customers. Without this knowledge, it would be impossible for managers to interpret the firm’s financial performance in a meaningful manner.

Summary

1. A business size-up is a critical precursor to any financial analysis. The analysis includes both an external assessment of the economy and industry as well as an internal assessment of the firm’s capabilities and strengths and weaknesses in the areas of operations, marketing, and human resource management. 2. An economic size-up focuses on identifying the current business cycle stage, the relationship between overall economic activity and the industry’s performance, and the anticipation of interest rate changes. 3. An industry size-up identifies the industry life cycle stage and prospects for growth, the intensity and nature of the competition, the overall risks and opportunities, and the key success factors. 4. An operations size-up identifies the firm’s strengths and weaknesses related to the operations management of product quality, process, plant (facilities), parts (inventory), people (labor), and partners (supply network), and provides for an assessment of the supply risk facing the firm.

5. A marketing size-up identifies the firm’s strengths and weaknesses related to the marketing management areas of the identification of a target market, and the development of an appropriate marketing mix consisting of product, price, place, and promotion, as well as provides for an assessment of the demand risk facing the firm. 6. A human resource management size-up identifies the firm’s strengths and weaknesses related to the human resource management areas of strategy, capabilities, and character. 7. The business size-up will be utilized to better understand the current financial position of the firm, through financial performance measures, and to assist in developing projected financial statements.

Additional Readings and Information

A basic text on economics from a managerial perspective is: Farnham, Paul. ­Economics for Managers, 3rd ed. Boston: Prentice Hall, 2013. Historical U.S. stock index, dividends, earnings, and inflation data back to 1871 are available from Robert Shiller’s website: http://www.econ.yale.edu/~shiller/ data.htm Economic data and research are available from the National Bureau of Economic Research website: http://www.nber.org/ as well as the Bureau of Economic Analysis website: http://www.bea.gov The classic work on competitiveness is: Porter, Michael. Competitive Advantage: Creating and Sustaining Superior Performance New York: The Free Press, 1985.

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SWOT analysis short book chapters are available from Harvard Business School Press: SWOT Analysis I: Looking Outside for Threats and Opportunities, product # 5528BC-PDF-ENG, 2005; and SWOT Analysis II: Looking Inside for Strengths and Weaknesses, product # 5535BC-PDF-ENG, 2005. Examples of industry life cycles are presented in: Klepper, Steven. “Industry Life Cycles.” Industrial and Corporate Change 6 (1997): 145–182.

Problems

1. What information would need to be gathered in order to assess the economy’s current position within the business cycle? 2. Describe the four stages of the business cycle. 3. What differentiates a trough from a recession? 4. What are the four key components of gross domestic product? 5. What are central banks, and what are their main goals? 6. What is the importance of price stability? 7. When should deflation be prevented? 8. Describe the two hypotheses that explain the shape of the yield curve. 9. Describe the three shapes of the yield curve that tend to be associated with different business cycle stages.

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10. Compare the typical profitability of a stage 2 firm versus a stage 3 firm. 11. Describe Porter’s Five Forces that govern the competition within an industry. Compare and contrast the Porter analysis for the utilities industry and for the jewelry industry (part of the consumer discretionary industry). 12. Develop a list of key success factors in the auto manufacturing industry. 13. Develop a list of factors that would result in a firm having high supply risk and high demand risk.

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3

Understanding Financial Statements Learning Objectives Obj 3.1

Explain the various components of the balance sheet. Obj 3.2

This chapter is the second of four that focus on assessing the current business of a firm. In Chapter 2, we focused on sizing up a business from a nonfinancial perspective, in Chapter 4, we will examine financial performance, and in Chapter 5, we’ll learn how to assess a firm’s day-to-day cash management. In Chapter 3, however, we concentrate on understanding the financial aspects of a business by examining its key financial statements. The goal of this chapter is not to turn you into an accountant— but rather to assist you in being an intelligent consumer of financial information. We focus on three fundamental financial statements: balance sheets, income statements, and cash flow statements. Financial statements are the key scorecards of a firm. They allow both internal managers and external analysts and investors to assess the overall financial health of a firm and understand the firm’s cash flow over time. This chapter is related to our unifying theme as depicted in Figure 3.1. All of the three fundamental financial statements relate to the growth of a firm. Comparing income statements over time, we can see how the firm’s profits have grown. Comparing balance sheets, we can see how assets, liabilities, and equity have grown. And finally, comparing cash flow statements, we can see how cash flows have grown. Recall that we identified three key decision-making areas within an enterprise—operating, investing, and financing. We’ll see that these three key areas are the three key elements in a business’s cash flow statement and are important elements in other financial statements. In Chapter 4 we will connect these financial statements with some key performance measures that relate to each of the main decision-making areas.

Explain the various components of the income statement. Obj 3.3

Explain the various components of the cash flow statement. Obj 3.4

Explain why understanding financial statements is relevant for managers.

balance sheet: A financial statement reflecting the value of a firm’s assets, liabilities, and net worth at a particular point in time

3.1  Understanding Balance Sheets Most corporations prepare three types of financial statements: balance sheets, income statements, and cash flow statements. Let’s start by considering the role of the balance sheet. In simple terms, a balance sheet provides a snapshot of a firm’s financial position at any given time. To best understand why balance sheets are so valuable to financial managers, it helps to use a real-life example. Thus, throughout this chapter and the rest of the book, we’ll utilize the Home Depot, Inc. as our primary sample firm. Home Depot is the world’s largest home improvement retailer focusing on the “do-it-yourself ” segment,

Objective 3.1

Explain the various components of the balance sheet.

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Fig 3.1 Financial Management Framework: Focus on Key Decision-Making Areas within an Enterprise

the enterprise

financing Financial Leverage

operating

investing

Profit Margin

Asset Turnover

Growing profits, dividends, cash flow

growth Return on equity

with more than 2,200 stores in the United States, Canada, Mexico, and China. The company’s shares are traded on the New York Stock Exchange, and it is one of only 30 firms that make up the well-known Dow Jones Industrial Average. Figure 3.2 presents the consolidated balance sheets for Home Depot as of January 31, 2010; January 30, 2011; and January 29, 2012. Here, the term consolidated refers to a large firm with numerous subsidiaries, some wholly owned and some partially owned, each with its own balance sheet. The various balance sheets are then consolidated (based on accepted accounting practices) into one all-encompassing balance sheet. As illustrated in Figure 3.2, a balance sheet consists of two parts. The first part represents all the assets of the firm. The second part represents the claims on those assets. This portion of the balance sheet is usually made up of two major categories: liabilities (such as bank loans) and common equity (or shareholders’ equity). One somewhat obvious aspect of all balance sheets is that they balance. In other words, the first part of the sheet must always equal the second part. To put this in mathematical terms: Total assets = total liabilities + total equity Thus, as of January 29, 2012,1 Home Depot had total assets of $40,518—which equals the sum of its total liabilities ($22,620) plus its equity ($17,898). Rearranging this simple equation gives us another useful equation: Total equity = total assets - total liabilities

1

Throughout this chapter, unless stated otherwise, any numerical references to Home Depot refer to amounts as of January 29, 2012, and are expressed in millions.

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Chapter 3  Understanding Financial Statements



Fig 3.2 Home Depot Consolidated Balance Sheets

Home Depot and Subsidiaries Consolidated Balance Sheets (Amounts in millions)

ASSETS

71

January 29, January 30, January 31, 2012 2011 2010

Current Assets Cash and cash equivalents (marketable securities) Accounts receivable Inventories Other current assets Total Current Assets

$1,987

$545

$1,421

1,245

1,085

964

10,325 10,625 10,188 963

1,224

1,327

14,520

13,479

13,900

Property and Equipment (at Cost) Land

8,480 8,497 8,451

Buildings

17,737 17,606 17,391

Furniture, fixtures, and equipment

10,040

9,687

9,091

2,718

2,595

2,412

Other property and equipment

38,975 38,385 37,345

Less accumulated depreciation and amortization

14,527

13,325

11,795

24,448

25,060

25,550

Net property and equipment Goodwill Other assets Total Assets

1,120 1,187 1,171 430

399

256

$40,518

$40,125

$40,877

LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities Accounts payable Current installments of long-term debt Other current liabilities Total Current Liabilities Long-term debt (excluding current installments) Deferred income taxes Other long-term liabilities Total Liabilities STOCKHOLDERS’ EQUITY Total Liabilities and Stockholders’ Equity

$4,856

$4,717

$4,863

30

1,042

1,020

4,490

4,363

4,480

9,376 10,122 10,363 10,758

8,707

8,662

340

272

319

2,146

2,135

2,140

22,620

21,236

21,484

17,898

18,889

19,393

$40,518

$40,125

$40,877

Source: Adapted from The Home Depot, Inc. Annual Reports, 2010 and 2011

This rearrangement highlights the idea that equity holders are residual claimants, meaning they have a claim on any assets after the firm’s debt holders have been satisfied. Consequently, the equity holders are the true owners of the firm.

3.1.1 Understanding Assets Assets are presented on the left-hand side of a firm’s balance sheet (if assets and liabilities/ equity are shown side-by-side; otherwise assets are presented in the upper area and

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book value: The value of an item as recorded on financial statements current assets: Assets such as accounts receivables and inventory that are expected be converted into cash within one year cash equivalents: Short-term, liquid investments (usually maturing in less than 3-months) that can readily be converted to cash, such as treasury bills marketable securities: Short-term investments, usually with maturities of less than one year, that are available for sale accounts receivable (receivables): Money owed by customers inventory: Goods or materials available to be sold or to be used to manufacture products prepaid expenses: Short-term expense expected to yield benefits in the near term other current assets: Current assets not included in other main categories such as cash, accounts receivable, or inventory long-term assets: See fixed assets fixed assets (capital assets, longterm assets): Long-term tangible assets that a firm owns such as land, property, buildings, or plant and equipment depreciation: The periodic decline in the value of a (typically tangible) asset, recognized for accounting or tax purposes amortization: The periodic decline in the value of a (typically intangible) asset, recognized for accounting or tax purposes

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liabilities/equity in the lower area). Assets represent what a firm owns, controls, or derives some future benefit from. By convention, most assets are listed on a balance sheet at their cost at the time of purchase. This cost base is known as the book value of the assets. Most assets are categorized as short term and long term, or fixed. Assets that do not fit cleanly into either category are simply referred to as other assets. Short-term assets are also called current assets and are generally considered assets that can reasonably be expected to be turned into cash within a year. These include cash and cash equivalents like government Treasury bills, which are safe and liquid, as well as marketable securities. Cash is necessary to run the day-to-day operations of a business. Often, any excess cash is invested in marketable securities which are short-term investments generally readily convertible into cash within a year. Beyond cash and marketable securities, additional types of short-term assets include accounts receivable, inventories, prepaid expenses, and other current assets. If a business offers credit terms (as most businesses do), then accounts receivable represent sales that have been generated but not yet paid for by customers. In contrast, inventories represent the amount of goods that a business has available but has not yet sold. Inventory may consist of finished goods ready for sale, work in progress, or raw materials. Prepaid expenses represent intangible assets that will be used in the near future. For example, Home Depot prepays the production costs for its print and broadcast advertising. Finally, other current assets are current assets that do not fit cleanly into any of the other categories. On its balance sheet, Home Depot includes prepaid expenses in the other current assets category, along with sponsorship promotions. Thus, a firm’s total current assets can be calculated using the following equation: Current assets = cash + marketable securities + accounts receivable + inventories + prepaid expenses + other current assets For Home Depot:   Cash and marketable securities (cash equivalents) $1,987 + Accounts receivable 1,245 + Inventories 10,325 + Other current assets (including prepaid expenses)    963 = Current assets $14,520 Let’s now turn our attention to long-term assets. Long-term assets, sometimes referred to as fixed assets or capital assets, typically include any land or property, buildings or plants, and equipment that a firm owns. In most situations, land is assumed to remain useful indefinitely. This is not the case for buildings and equipment, which tend to wear out or become obsolete over time and need to be replaced. The concept of depreciation reflects these assets’ reduction in value over time. Depreciation is actually an allocation of costs over a particular period (such as a year), based on the premise that certain assets (such as a piece of equipment) undergo wear and tear as they are used, which in turn causes their value to decline over time. Amortization is similar to depreciation but applies to intangible assets, such as patents or trademarks. Just as the value of tangible assets (such as buildings) declines over time, so does the value of many intangible assets, since the legal protection offered by a patent or trademark will eventually expire. Together, depreciation and amortization represent the accumulated allocation of cost from the time of an asset’s purchase or acquisition to the current time. Therefore, the net value of a firm’s property, plant, and equipment at any point in time is calculated as: Net value of property and equipment = property and equipment at cost accumulated depreciation and amortization

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To estimate an asset’s annual depreciation or amortization cost, we must first estimate a useful life for the asset—or how long we expect the asset will serve its function before it needs to be replaced. With this information in hand, we can then calculate the asset’s depreciation using several different methods. The simplest method, known as straight-line depreciation, simply divides the asset’s original cost by its useful life. For example, if a piece of equipment costs $50,000 and its useful life is estimated at 10 years, then its annual depreciation would be $5,000. After three years, the total accumulated depreciation would be $15,000, meaning the equipment has a residual or net value of $35,000. Remember, even though depreciation represents a loss in value, it is not an actual cash expense. When totaling their long-term assets, many firms also include a category known as goodwill. Goodwill arises in situations in which a firm acquires another asset (or company) and pays more than the asset’s fair market value. Thus, goodwill is calculated as the difference between the price paid for the asset and the fair market value. The term goodwill comes from the notion that the firm is paying the seller an amount in excess of the current fair market value based on expectations that the asset will be worth more to the new owner. Finally, in addition to current and long-term assets, a company’s balance sheet may also include a category for other assets. This category typically includes intangible assets, such as patents or trademarks. In summary, the total assets of a firm can be calculated using the following equation: Total assets = current assets + long@term assets (i.e., property, plant, and equipment) + goodwill + other assets So, for Home Depot:   Current assets + Net property and equipment assets + Goodwill + Other assets = Total assets

$14,520 24,448 1,120 $430 $40,418

3.1.2 Understanding Liabilities Liabilities and equity are presented on the right-hand side of a firm’s balance sheet (if assets and liabilities/equity are shown side-by-side; otherwise assets are presented in the upper area and liabilities/equity in the lower area). Liabilities are typically categorized as current, long term, deferred income taxes, or other long term. Current liabilities include any debt-related commitments due over the next year. Specific categories of current liabilities include the following: Accounts payable, which represent money owed by the firm to its suppliers for supplies received but not yet paid for Notes payable, which represent short-term obligations, such as written promises to repay short-term bank loans Current portion of long-term debt, which represents any principal repayments due within the next year Other current liabilities, which represent obligations that have been accrued but not yet paid, such as taxes or salaries owed All of these current liabilities are represented in the following equation: Current liabilities = accounts payable + notes payable + current portion of long@term debt + other current liabilities

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goodwill: The value of a business paid by a purchaser above its fair market value accounts payable (payables): Money owed to suppliers and trade creditors notes payable: Short-term obligations, such as a written promise to repay short-term bank loans or promissory notes

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Thus, for Home Depot:   Accounts payable + Notes payable + Current portion of long-term debt + Other current liabilities = Current liabilities

$4,856 0 30 4,490 $9,376

Unlike current liabilities, long-term liabilities represent borrowed money that needs to be repaid in more than one year. (Thus, this category excludes the current portion of long-term debt, because that amount is considered a current liability.) Examples of longterm liabilities include long-term loans from banks, as well as bonds issued by the firm that represent a contractual obligation to repay a number of lenders. A third category of liabilities (often stated separately) is deferred income taxes, also called deferred tax liabilities or future taxes. This category arises because firms are allowed to keep two sets of “books” or financial statements: one for their shareholders, which we refer to as book accounting, and one for the IRS or its equivalent in other countries, which we refer to as tax accounting. (In this case, having two sets of books doesn’t imply that a firm is trying to hide any unsavory business deals!) The set of books for shareholders is meant to reflect the economic value of an asset. Here, income tax provisions are simply based on reported income before tax. In turn, the income before tax is based on such expenses as depreciation. Each year’s depreciation amount is meant to reflect the actual decline in the economic value of the assets. In contrast, federal tax law (enforced by the IRS) often allows for accelerated depreciation methods for federal income tax purposes compared to, say, the straight-line method of depreciation. The reason for allowing this accelerated depreciation is to provide incentives for firms to invest in new plants and equipment (and ultimately to create new jobs!).

bond: A financial instrument issued by a firm representing long-term debt deferred income taxes: A provision for future income taxes arising from timing differences between the recognition of tax liabilities for tax purposes versus a firm’s accounting system

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To better understand what this means, let’s consider an example. Recall that in the previous straight-line depreciation example, the year 1 depreciation for a piece of equipment was $5,000. However, for IRS reporting, federal tax law may allow for a year 1 depreciation of, say, $15,000. For the firm, this means that its year 1 expenses are $10,000 greater for tax accounting purposes than for book accounting purposes. In turn, this implies that the firm’s taxable income will be $10,000 less, because depreciation expenses are subtracted from operating profits before taxes are calculated. So, if the firm has a tax rate of 35 percent, it will pay $3,500 less in taxes (i.e., it will have a tax differential of $3,500) using accelerated depreciation for federal income tax purposes than it would using the straight-line method for book accounting purposes. This difference between actual (and lower) income tax collected by the IRS and (higher) income tax that would otherwise be paid without the federal tax law incentives must be recognized in order to make the balance sheet balance. Each year’s differential must be accumulated over time as well. So, in this example, the year 1 tax differential of $3,500 would be added to a year 2 differential of, say, $3,000, for a total accumulated differential of $6,500 after two years. The result—in this example, $3,500 after the first year and $6,500 after the second year— is the item of deferred income taxes. Deferred income tax can be thought of as a liability, but not in the typical sense, as with debt. For example, if this is the only piece of equipment that the firm buys, eventually in later years the straight-line depreciation (i.e., $5,000 per year) will exceed the depreciation for tax purposes (which at some point must be less than $5,000 since over the lifetime of the piece of equipment the total depreciation will be the same in both cases), and the firm will pay more in taxes in those later years than if straight-line

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depreciation was used. Thus, the firm hasn’t saved any money in terms of taxes paid, but rather has deferred the payment of those taxes for several years. However, during a growth phase if a firm is regularly buying new equipment, it may be able to continue deferring any incremental future taxes for quite a long time. In this case, the deferred income tax line item may continually increase without representing any pressing concern for the firm. The fourth and final category of liabilities, referred to as other long-term liabilities, consists of any liabilities not included in the previous three categories (current, long term, and deferred income taxes). For Home Depot, this category includes items such as a guarantee of debt in a subsidiary firm, some capital leases, and liabilities associated with currency hedging vehicles (which represent payments to purchase types of “insurance”— for example, to protect against changes in the value of the dollar relative to the euro). So, to summarize, a firm’s total liabilities are represented by the following equation: Total liabilities = current liabilities + long@term liabilities + deferred income taxes + other long@term liabilities Thus, for Home Depot:   Current liabilities + Long-term debt + Deferred income tax + Other long-term liabilities = Total liabilities

$9,376 10,758 340 2,146 $22,620

3.1.3 Understanding Equity The final category on the right-hand side (or lower part) of a firm’s balance sheet is the equity section, also known as stockholders’ equity, shareholders’ equity, or net worth. From a practical perspective, there are only two important categories in this section (although more categories often appear on a firm’s accounting statements): (1) preferred shares or preferred equity and (2) all other categories that collectively represent common equity. Although preferred shares (discussed in greater depth in Chapter 6) often appear under the equity section of a financial statement, they are actually a hybrid between debt and equity, having features of each. Instead of interest payments (as with debt), preferred shareholders receive regular dividends. However, from the firm’s perspective, tax laws prohibit dividend payments from being expensed (unlike interest payments). As such, dividend payments are paid out of a firm’s after-tax income. Another distinction between equity and debt is that preferred shareholders do not receive any principal repayment. The term preferred relates to the fact that these shares have preference over common shares in terms of dividend payments—meaning no common share dividends can be paid until preferred dividends are paid. Also, in the event of bankruptcy by the firm, preferred shareholders would stand in line before common shareholders to recover the principal they invested. (Of course, in most bankruptcies, there is no money left for preferred shareholders anyway.) For most firms, equity refers primarily (or exclusively) to the common equity owned by common shareholders. These common shareholders are the actual owners of the firm because they share any remaining profits once other stakeholders—debt holders and preferred shareholders—have been satisfied. A number of subcategories are often included in the common equity section of a firm’s balance sheet, but these distinctions are not really of any practical importance (except to accountants). Typical subcategories include common stock and paid-in capital (representing the nominal value of the equity, either when the firm was initiated or through subsequent common equity issues),

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preferred shares (preferred stock): A class of stock, typically dividend bearing, that has preference over common stock in terms of both dividend payments as well as claim on assets common shareholders: Owners of common shares, or common equity

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In-Depth

Book Value of Equity versus Market Value of Equity

Home Depot’s book value of $17,898 (millions) in common equity on January 29, 2012, is simply an accounting measure that represents the difference between the cost of all of the company’s assets (after depreciation and amortization) minus all of its liabilities. Home Depot has a total of 1,562 (million) common shares, so its per-share book value of equity is $11.46. As opposed to book values, market values represent what investors are actually willing to pay for stock. To calculate the market value of Home Depot’s equity (also known as market capitalization), we simply multiply the current stock price of $44.77 (January 29, 2012) by the number of outstanding shares (1,562 million) to arrive at a value of $69,931. Thus, the market-to-book ratio, which is calculated by dividing the market value of shares ($69,931) by the book value of shares ($17,898), is 3.91. We can also calculate the ­market-to-book ratio by dividing the actual share price ($44.77) by the book value per share ($11.46). Note that this ratio implies that investors believe Home Depot shares are worth more than their book value amount, which could be due to investor expectations that the company has opportunities to grow and invest in profitable projects. Recall also that equity represents the difference between assets and liabilities. Thus, whenever the market value of a firm’s equity exceeds its book value, this implies that investors believe the true economic value of the firm’s net assets (or what the firm owns less what it owes) is worth more than what they are reflected as on the balance sheet. When considering the larger U.S. economy, we generally observe market values well in excess of book values. For example, the overall U.S. market-to-book ratio in 2012 was 9 8 7 6 5 4 3 2

0

Steel Automotive Homebuilding Office equipment/supplies Electronics Entertainment Telecom services Natural gas utility Advertising Total market Newspaper Auto parts Packaging & container Retail/wholesale food Industrial services Apparel Retail store Semiconductor Oil/gas distribution Aerospace/defense Retail building supply Household products Beverage Computer software Trucking E-commerce Internet Toiletries/cosmetics Restaurant Tobacco

1

Source: Aswath Damodaran, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pbvdata.html (accessed March 30, 2012)

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2.00. However, as the accompanying chart indicates, average market-to-book ratios vary by sector. At the end of January 2009, during the heart of the U.S. financial crisis, Home Depot’s market-to-book ratio was a relatively low 2.36. Still, this value was above the industry average at that time. As of May 2012, Home Depot’s market-to-book ratio had risen even further above the average for its industry (retail building supply).

treasury stock (representing stock that a corporation has bought back from shareholders and thus a negative equity amount), retained earnings2 (representing the accumulated amount of profits not paid out in dividends), and in the case of firms with assets and liabilities in foreign currencies, an adjustment for foreign currency translation. When compiling a balance sheet, the simplest approach is to lump all of these together under the label of “common equity,” “shareholders’ equity,” or “stockholders’ equity.” Alternatively, a firm can segregate its retained earnings, which allows for a clear connection between the income statement and balance sheet by focusing on net income and changes in retained earnings, as discussed in Section 3.2. For the remainder of this book, unless otherwise noted, we’ll use the terms equity and shareholders’ equity to refer to common equity. Thus, for many firms, common equity can be represented by the following simplified relationship: Common equity = common stock + retained earnings Home Depot’s equity calculation is a bit more complex, however. To find the firm’s common equity, we begin by adding its common stock and paid-in capital of $7,053, retained earnings of $17,246, and an adjustment for foreign currency translation of $293. After that, we subtract treasury stock of $6,694. The resulting figure of $17,898 represents the book value of Home Depot’s common equity. (Note that Home Depot has not issued any preferred shares.)

3.2  Understanding Income Statements After the balance sheet, the second financial statement that all corporations are required to prepare is the income statement, which is useful for measuring the overall profitability of the firm. A firm’s income statement records its revenues (or sales), costs and expenses, and profit (or earnings or income) over a particular period of time, such as a year. Figure 3.3 presents Home Depot’s consolidated income statements for the fiscal years that ended on January 31, 2010; January 30, 2011; and January 29, 2012.

Objective 3.2

Explain the various components of the income statement.

3.2.1 Understanding Revenues, Costs, Expenses, and Profits Let’s now take a closer look at various elements of a firm’s income statement. The most basic relationship depicted in any income statement can be summarized as follows: Revenues - costs and expenses = profit 2

income statement: A financial statement indicating a firm’s revenues, expenses, and resulting income over a period of time

A common mistake is thinking of retained earnings as “excess cash,” which they are not!

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Fig 3.3 Home Depot Consolidated Statements of Earnings

Home Depot and Subsidiaries Consolidated Statement of Earnings (Amounts in millions, except per share data)



Fiscal Year Ended



January 29, January 30, January 31, 2012 2011 2010

NET SALES Cost of sales Gross Profit

$70,395 67,997 $66,176 46,133

44,693

43,764

24,262

23,304

22,412

OPERATING EXPENSES Selling, general and administrative Depreciation and amortization Total Operating Expenses OPERATING INCOME (earnings before interest and taxes or debit) Interest expense EARNINGS BEFORE INCOME TAXES Provision for income taxes Net Earnings Number of common shares

16,028

15,849

15,902

1,573

1,616

1,707

17,601

17,465

17,609

6,661

5,839

4,803

593

566

821

6,068 5,273 3,932 2,185

1,935 1,362

$3,883

$3,338

$2,661*

1,562

1,648

1,683

Earnings Per Share

$2.49 $2.03 $1.58

Diluted Earnings Per Share

$2.47 $2.01 $1.57

*Note: 2010 net earnings include $41 in earnings from discontinued operations, net of tax, while the amount included in earnings before income taxes includes only continuing operations Source: Adapted from The Home Depot Annual Report, 2011

revenues (sales): The resource inflow to a firm through the sale of goods or the provision of services costs of sales (cost of goods sold): The total of all costs, excluding selling and administrative expenses, required to acquire or prepare goods or services for sale

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Revenues (more specifically, net revenues after deducting returns, allowances for damages, cash discounts, etc.) come mainly from the firm’s business operations in the form of sales of products or services. In some cases, revenue can also come from other noncore business sources, such as interest earned on marketable securities. Cost of sales (or cost of goods sold) refers to the direct expenditures associated with generating goods or providing services, including the cost of materials and direct labor costs. In the case of a wholesale firm, the cost of sales (or cost of goods sold) for a particular period can be estimated in a simple manner by considering all the materials the firm purchased during that period in order to produce goods, as well as any changes in inventory. The first step in calculating the cost of sales is to add the cost of the inventory on hand at the start of the period (known as beginning inventory) plus the cost of any purchases of materials during the year. Adding these two values yields the total cost of all goods that were available for sale during the period. We can then subtract the cost of the ending inventory for our period of interest to arrive at the firm’s total cost of sales. This relationship is depicted in the following equation: Cost of sales = cost of beginning inventory + cost of purchases - cost of ending inventory

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Next, to determine the firm’s gross profit (or gross margin), we simply subtract the firm’s cost of sales from its revenues: Revenues - cost of sales = gross profit Thus, for Home Depot, net sales of $70,395 less cost of sales of $46,133 results in a gross profit of $24,262. Gross profit does not represent the amount of money that the firm actually pockets, because this figure does not account for expenses or other costs associated with doing business. Expenses can be split into several categories. All firms have certain operating expenses, or expenses directly related to the operations of the business. Typical operating expenses include the following: Any selling, general, and administrative expenses (sometimes referred to as SG&A) associated with running the business and selling products or offering services Depreciation and amortization charges Research and development expenses (R&D), where applicable Most firms have expenses related to financing, such as interest expenses related to outstanding loans. After a firm’s total operating expenses have been calculated, we can subtract these expenses from the firm’s gross profit to determine a value known as the firm’s earnings before interest and taxes, also called EBIT (variously pronounced as either “EBB-it” or “EEE-bit”) or operating income. The resulting relationship is expressed as follows: Gross profit - operating expenses = earnings before interest and taxes To return to the Home Depot example, we can subtract the company’s operating expenses of $17, 601 from its gross profit of $24,262 to arrive at an operating profit, or EBIT, of $6,661.

gross profit (gross margin): The difference between revenues and costs of sales expenses: Costs, such as those related to selling as well as financing, associated with doing business operating expenses: Costs, such as selling, administrative, depreciation, and research and development, associated with the operations of a business earnings before interest and taxes (EBIT) (operating income): A measure of profitability calculated as the difference gross profit and operating expenses earnings before interest, taxes, depreciation, and amortization (EBITDA): A measure of profitability calculated as the difference gross profit and operating expenses excluding depreciation and amortization. Also measured as EBIT plus depreciation and amortization

In-Depth

EBIT versus EBITDA

As we’ve just seen, EBIT is a measure of a firm’s operating profit that can be determined by subtracting the firm’s operating expenses—including depreciation and amortization— from its gross profit. However, depreciation and amortization are noncash items, so EBIT does not reflect the cash that is generated from a business. To get a rough estimate of a firm’s ability to generate cash from its operations, we add these two noncash items back to the firm’s EBIT. By adding the amount of depreciation and amortization to a firm’s EBIT, we arrive at a measure of the firm’s earnings before interest, taxes, depreciation, and amortization, also known as EBITDA (pronounced “ebb-it-DAH” or “EEE-bit-DAH”). The relationship between EBIT and EBITDA is expressed by the following equation: EBITDA = EBIT + depreciation and amortization Thus, for Home Depot, EBIT of $6,661 plus depreciation and amortization of $1,573 results in EBITDA of $8,234. Knowing a firm’s EBITDA is useful for several reasons. As previously discussed, this number provides a look at how much cash is generated by a business. Also, as we’ll see in Chapter 10, many analysts and investors focus on EBITDA when trying to establish the value of a firm’s equity by determining how many times the projected EBITDA they would be willing to pay for the firm.

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In many firms, operating income, or EBIT, is an important metric because it describes the overall profit a firm is able to generate from its operations, regardless of the amount of debt the firm has (and consequent interest payments) or the amount of taxes it pays. Also, EBIT can easily be calculated for each division of a firm. After calculating a firm’s operating income, or EBIT, we need to account for the interest expense associated with any interest-bearing debt or loans the firm may have. Here, we simply subtract the firm’s interest expense from its operating income, or EBIT, to determine how much the company has earned before consideration of income taxes: Operating income - interest expense = earnings before income taxes So, for Home Depot, we can subtract interest expenses of $593 from the company’s operating income of $6,661 to yield $6,068 in pretax earnings (i.e., earnings before income taxes). Finally, we can determine the “bottom line” of a firm’s earnings by subtracting the company’s income taxes from its pretax earnings. In the United States, income taxes are usually calculated to be around 35 percent of a firm’s pretax income. When we subtract this amount from the firm’s earnings before income taxes, we arrive at the net earnings (or loss) of the firm for that particular period. Net earnings are also referred to as net income, net profit, net income after taxes, or net profit after taxes. The relationship is as follows: Earnings before income taxes - income taxes = net earnings

net earnings (net income, profits, net profits): The difference between revenue and all associated expenses over a particular time period stock options: Often provided to managers as a form of compensation, giving the holder the right to purchase shares at a particular price for a particular time convertible shares: Securities such as bonds or preferred shares that allow the holder to convert to a fixed number of common shares if the stock prices rises above at a predetermined threshold diluted earnings per share (EPS): A measure of the claim on earnings for each common share: earnings after tax, less any preferred dividends, divided by the number of common shares including potential shares associated with the exercise of stock options and convertibles

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To return to our ongoing example, Home Depot’s earnings before income taxes are equal to $6,068. If we subtract the provision for income taxes of $2,185, we find that Home Depot’s net earnings for the fiscal year ending January 29, 2012, are $3,883. We can then divide this amount by Home Depot’s number of outstanding common shares (1,562) to arrive at an earnings per share (EPS) value of $2.49. One last item often reported on a firm’s income statement is diluted earnings per share, or diluted EPS. However, before we can truly understand what diluted EPS indicates, we must first be familiar with two related concepts: stock options and convertible shares. Stock options: Many firms offer stock options to their managers as incentives or a form of compensation. Stock options give the holder the right to purchase shares at a particular price for a particular time. For example, if Home Depot shares are trading at $50, senior management may be given stock options that allow them to buy Home Depot shares at a price of $50 anytime in the next three years. These options would provide an incentive for management to increase Home Depot’s share price, making the stock options more valuable. Convertible shares: Some firms also issue convertible shares, which are issued as bonds or preferred shares but may be converted to common shares if a firm’s share price increases above a predetermined threshold. For example, if Home Depot issued convertible shares when its stock was trading for around $50 per share, these convertible shares might allow the investor to convert to stock anytime Home Depot’s share price went above $60. There would be a stipulated number of common shares converted for each bond owned. Thus, although a firm has a certain amount of shares outstanding at any given time, there might be more common shares waiting to be created because of stock options and convertible bonds. Diluted EPS takes these potential shares into account

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by dividing a firm’s net earnings by the total number of shares the firm would have if all options holders exercised their option to purchase shares and all convertible shareholders converted their shares. In the case of Home Depot, the firm has 1,570 diluted common shares (as compared 1,562 undiluted common shares). So, if we take Home Depot’s net earnings of $3,883 (millions) and divide it by the number of diluted common shares, we arrive at diluted EPS of $2.47. Note that a firm’s diluted EPS will always be smaller than its undiluted EPS, although if a firm has a relatively small amount of stock options and convertible shares, the difference may be negligible.

3.2.2 Connecting a Firm’s Income Statement and Balance Sheet We’ve now discussed balance sheets and income statements and the key elements of each. However, it’s important to note that these two statements are not completely independent of each other. To understand the connection between the two, it’s useful to take the perspective of common shareholders—the ultimate owners of the firm. We can then ask two simple questions: What did the firm earn for us last year? and What is the firm now worth? To answer the first question, we start with the firm’s net earnings, or the “bottom line” of the income statement. If the firm has any preferred shares, then the preferred dividends would be paid out of the net earnings first, leaving behind the income that is available to common shareholders: Net earnings - preferred dividends = net earnings available to common shareholders If a firm does not have preferred shares, then its net earnings and net earnings available to common shareholders are the same thing. This value represents the total amount that the firm’s common shareholders earned in that particular year. To address the second question—What is the firm now worth?—our focus turns from the income statement to the balance sheet, specifically the equity section. At this point, we also need to consider the dividend policy chosen by the firm’s senior management. Dividend policy refers to a firm’s approach to determining how much of the earnings available to common shareholders should be paid in cash dividends and how much should be retained in the firm. For example, a firm may specify that, as a target, approximately 30 percent of its yearly net earnings available to common shareholders will be paid as common dividends (and hence, 70 percent will be retained).3 The amount kept or retained by the firm (in other words, the amount not paid out as a common dividend) would be reflected on the balance sheet as an increase in retained earnings. The resulting amount of total equity provides a direct answer regarding the firm’s current worth and completes the connection between the income statement and balance sheet. Figure 3.4 captures the relationship between the income statement and balance sheet for Home Depot. As shown in the figure, the firm’s retained earnings for 2011 are $14,995, and the net earnings available to common shareholders are $3,883. After the $1,632 common share dividend payment, the firm’s retained earnings increase by $2,251 to $17,246.

dividend policy: The approach by which a firm determines how much it will pay its common shareholders in dividends

3

Here, it’s important to note that a firm is under no obligation to pay common dividends. In fact, some newer firms that are in a growth stage have a policy not to pay any common dividends. The hope, for common shareholders, is that by reinvesting any profit, the business can grow even more in the future.

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Fig 3.4 The Relationship between Net Earnings and Retained Earnings (Home Depot, in millions of dollars)

Balance Sheet, January 30, 2011

Balance Sheet, January 29, 2012

Assets

Assets

$40,125

$40,518

Liabilities 21,236 Liabilities 22,620 Equity Equity Common Shares

3,894 Common Shares

652

14,995 Retained Earnings

Retained Earnings

Total Liabilities $40,125 Total Liabilities and Equity and Equity

17,246

=

$40,518

Income Statement, Year-End January 29, 2012 Revenue $70,395 Less cost of sales Gross profit

46,133 24,262

Less expenses

18,194

Income before taxes

6,068

Less income taxes

2,185

Net earnings (avail. to com. shareholders) Less common dividend Increase in Retained Earnings

3,883 1,632 $2,251

+

3.3  Understanding Cash Flow Statements Objective 3.3

Explain the various components of the cash flow statement.

accrual accounting method: A method of accounting recognizing revenues when earned and expenses when incurred, regardless of the time of cash flows sources and uses statement (statement of change in financial position): A financial statement that documents all fund inflows and outflows over a period of time, based on changes in balance sheet item amounts cash flow statement: A financial statement reflecting a firm’s cash inflows and outflows categorized into cash related to operating, investing, and financing

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Before we consider the third key financial statement, the cash flow statement, we first need to understand some limitations of a firm’s income statement. Unless we’re examining a business that deals only with cash for all sales and purchases, a firm’s income recognized and costs incurred in any particular year won’t necessarily correspond to its cash inflows and outflows during that year. For example, if a large sale is made late in the year and the customer buys the product or service on credit, then the firm’s income generated will not correspond with its cash received from customers during that year. Similarly, if the firm makes a large purchase from a supplier late in the year, then the firm’s cost incurred won’t correspond with its cash paid during that year. These discrepancies occur because a firm’s income statement is prepared according to the accrual accounting method, which attempts to match corresponding events (such as the generation of revenue and incurrence of expenses) regardless of when the related cash transactions actually occur. In addition, there are some expenses on a firm’s income statement that are not associated with cash outlays, which means that the income statement doesn’t indicate all of a firm’s sources and uses of cash. For example, as previously noted, depreciation and amortization both appear as expenses on a firm’s income statement even though they are noncash expenses. Given these factors, there are two statements that can help to identify where a firm gets its cash and where that cash goes. A sources and uses statement compares changes in balance sheet items. A cash flow statement is also a highly useful financial statement because it captures a firm’s actual inflow

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and outflow of cash, neither of which is captured on the firm’s income statement, categorized in a specific manner related to the three main decision-making areas we highlighted in our financial management framework: operating, financing, and investing. Let’s briefly examine the sources and uses statement, which we will reexamine in Chapter 5 when we look at managing day-to-day cash flows. A simple approach to identifying cash inflows and outflows is to determine a firm’s sources and uses of cash during a particular period, between two dates on which financial statements are available. This can be done, for example, by comparing the most recent balance sheet with the balance sheet from the previous year. Sources of cash are any items that result in an increase in liabilities, an increase in equity, or a reduction in assets from the previous year to the current year. For example, if a firm borrows more money, increases its accounts payable (i.e., takes longer to pay its suppliers), issues more common shares, sells some equipment, reduces its accounts receivable (i.e., receives payments quicker from its customers), or reduces its inventory, it will have generated cash. Conversely, uses of cash are any items that result in a decrease in liabilities, a decrease in equity, or an increase in assets from the previous year to the current year. For instance, a firm would be using cash if it pays down debt, decreases its accounts payable, repurchases common shares, buys some equipment, increases its accounts receivable, or increases its inventory. Understanding a firm’s sources and uses of cash is an important step to understanding its cash flow statement. The cash flow statement focuses, not surprisingly, on the firm’s flow of cash or change in cash position between the beginning and end of some specified period (e.g., during the past year). Recall that while the income statement also examines monetary flows during a given period, that statement uses the accrual method of accounting. In contrast, the cash flow statement reports the straightforward inflow and outflow of cash. Cash flow statements are particularly useful in determining the future needs of a firm. For example, a growing business will usually have increased needs for cash related to accounts receivable and inventories. Cash flow statements are also important to firms that are facing financial difficulty and need to manage their cash inflows and outflows very carefully. Figure 3.5 presents the consolidated statements of cash flows for Home Depot for the fiscal years ending on January 31, 2010; January 30, 2011; and January 29, 2012.

3.3.1 Cash Flows Related to Operating Activities As shown in Figure 3.5, there are three main categories of cash inflows and outflows, each of which maps directly to our unifying financial management framework highlighting the three major decision-making areas within a firm: operating, investing, and financing. The first category includes any cash flows related to the operating activities of the firm. This refers to any day-to-day activities that bring in cash from customers or pay cash out to suppliers. A usual starting point for determining cash flows related to operating activities is the firm’s net earnings or net income, as reported on the income statement. However, because that number is based on the accrual method, adjustments must be made to convert it to a cash basis: A first adjustment to our starting point of net income is to add back any depreciation, amortization, and stock-based compensation expenses (such as the awarding of stock options to senior management, which does not involve any immediate cash flow implications), because these are noncash items. A second adjustment focuses on any changes in operating assets and liabilities. For example, an increase (or decrease) in accounts receivable represents a cash outflow (or inflow); an increase (or decrease) in inventory represents a cash outflow (or inflow); and an increase (or decrease) in accounts payable represents a cash inflow (or outflow).

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Fig 3.5 Home Depot Consolidated Statements of Cash Flows

Home Depot and Subsidiaries Consolidated Statement of Cash Flows (Amounts in millions)



Fiscal Year Ended



January 29, January 30, January 31, 2012 2011 2010

CASH FLOWS FROM OPERATING ACTIVITIES Net earnings

$3,883

$3,338

$2,661

Reconciliation of net earnings to net cash provided by operating activities Depreciation and amortization Stock-based compensation expense Other

1,682

1,718

1,806

215

214

201

— — 163

Changes in assets and liabilities (net of acquisitions and dispositions) Receivables (net)

(170)

(102)

(23)

Merchandise inventories

256

(355)

625

Accounts payable and accrued expenses

422

(133)

59

Deferred income taxes

170

104

(227)

Other Net Cash Provided by Operating Activities

193 (199) (140) 6,651

4,585

(1,221)

(1,096)

5,125

CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures

101

Payments for business acquired (net)

(65)

—

—

56

84

178

—

—

33

Proceeds from sales of property and equipment Proceeds from sales and maturities of investments Net Cash Used in Investing Activities

—

(966)

Proceeds from sale of business (net)

—

(1,129) (1,012) (755)

CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from (repayments of) long-term borrowing

(31)

(1,774)

Proceeds from (repurchase of) common stock

(3,164)

(2,504)

(140)

Cash dividends paid to stockholders

(1,632)

(1,569)

(1,525)

Other financing activities Net Cash Used in Financing Activities Change in cash

966

(218) (347) (64) (4,048) (4,451) (3,503) 1,474

(878)

867

Effect of exchange rate changes on cash

(32)

2

35

Cash at beginning of year

545

1,421

519

$1,987

$545

$1,421

Cash at end of year Source: Adapted from The Home Depot Annual Report, 2011

A third adjustment is to add (or subtract) any increase (or decrease) in deferred income taxes, since this is another noncash item. Let’s apply this process to the Home Depot. For the fiscal year ending on January 29, 2012, we start with net earnings of $3,883. We then add back noncash items totaling

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$1,897 (depreciation and amortization of $1,682 and stock-based compensation expense of $215). The net impact of changes in the company’s operating assets and liabilities is $871—in other words, Home Depot had less money tied up in operating assets or working capital than it did during the previous fiscal year. The net result is that Home Depot has cash flows from operating activities of $6,651 ($3,883 plus $1,897 plus $871). We should not be surprised that this is a positive number. After all, if any firm consistently has negative cash flows from operating activities, it will cease to stay in business—with a possible exception of start-up firms in their early years. What is somewhat surprising, though, is how large this number is relative to the company’s net earnings, which highlights the amount of noncash items such as depreciation, and other differences between net earnings and cash from operations.

3.3.2 Cash Flows from Investing Activities The second major category of cash flows consists of a firm’s cash flows from investing activities. Any investments in new business, acquisitions, or purchases of new equipment represent cash outflows, whereas any divestitures, or asset sales, represent cash inflows. Firms primarily engage in investing activities to ensure the future viability of the business. For example, the capital expenditures item, which is typically the largest item in this category, represents the firm’s investment in plant and equipment that will help it generate revenue in future years. Capital expenditures also reflect the extent to which a firm is maintaining up-to-date equipment. If a firm is in a temporary cash bind, it might consider postponing major capital expenditures, which may help in the short run, but doing so may hurt the firm’s competitive position in the long run. One interesting point of comparison is between a company’s depreciation and its capital expenditures. If a company is not growing, then we would expect its capital expenditures to be roughly equal to depreciation. One exception would be if a firm is becoming more efficient. In such a case, a firm may be able to generate more sales with less plant and equipment, in which case its capital expenditures might be less than depreciation. Returning to our example cash flow statement, we see that Home Depot has spent a total of $1,129 in cash on investing activities, which includes $1,221 spent on capital expenditures. We shouldn’t be surprised that most firms spend (rather than generate) money in this category. In fact, if a firm consistently realizes more cash than it spends in investments (meaning its net cash flow from investing activities is positive), this might imply that the firm is no longer investing for the future and may simply be liquidating divisions or assets.

3.3.3 Cash Flows from Financing Activities The third major category of cash flows consists of flows from a firm’s financing activities. Here, the issuance of any new debt or equity represents a cash inflow to the business, whereas the retirement of any debt or the buyback of any stock represents a cash outflow. Similarly, the payment of any preferred or common dividends also represents a cash outflow. Looking at our example cash flow statement, we see that Home Depot increased its net borrowing (long-term debt including installments) by $966 in the latest fiscal year.4 (Note, however, that in each of the previous two years, the company used cash to pay 4

The financial statements presented in this chapter are somewhat simplified and do not contain additional notes and explanations. As such, keen readers might notice that it is not possible to reconcile, say, changes in balance sheet items such as debt with corresponding items on the cash flow statements.

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down its debt.) We also see that the firm used $3,164 to repurchase common stock, a trend that it continued from the previous two years. In addition, it paid cash dividends of $1,632, also an increasing trend. Finally, the firm spent $218 on other financing activities. Thus, Home Depot’s net cash use on financing activities was ($4,048). Although we noted that cash flows from operating activities are almost always positive and cash flows from investing activities are almost always negative, cash flows from financing activities vary from firm to firm and from year to year. It all depends on the

In-Depth

U.S. versus International Accounting and Financial Statement Presentation

Within the United States, businesses and other organizations base their financial recordkeeping on Generally Accepted Accounting Principles, or GAAP. These principles are actually rules related to the presentation of financial statements, such as how to state the value of an asset, when to recognize revenue, and how to match revenues with expenses. At the request of the U.S. Securities and Exchange Commission (SEC), these principles are developed and updated by a private, not-for-profit entity called the Financial Accounting Standards Board, or FASB. In comparison, the International Accounting Standards Board (IASB) is an indepen­ dent organization that was established in London in 2001 with the goal of developing ­International Financial Reporting Standards, or IFRS. Unlike U.S. GAAP, IFRS are principle-­ based rather than rule-based standards that set out a framework for preparing and presenting financial statements. Over 100 countries require or permit firms to use IFRS, including Australia, Canada, India, and various countries in Europe. In 2002, the FASB and the IASB agreed to work toward convergence in standards. Thus, in 2008, the SEC issued a roadmap whereby U.S. firms could convert to IFRS by 2014, although the actual date of implementation may not be until 2015 or 2016. International firms with stock trading on U.S. exchanges are currently allowed to present IFRS statements without having to reconcile those statements to U.S. GAAP. In addition to different accounting principles, the presentation of financial statements tends to differ depending on the country. The most notable difference is between the presentation style used in the United States, United Kingdom, and Canada (known as Anglo-American style) and that used in Belgium, France, Germany, Switzerland, and other parts of continental Europe. The Anglo-American style organizes income statements “by function” and balance sheets “by term,” whereas the continental European style orga­ nizes both income statements and balance sheets “by nature.”5 Income statements “by function” or type of operation include categories for net sales, cost of sales, gross margin, selling and general expenses, and other operating expenses. In contrast, income statements “by nature” or type of expenditure include categories for net sales, other operating revenues, purchases of merchandise, changes in inventories, labor expenses, other operating expenses, and depreciation expense. Similarly, balance sheets “by term” include categories for short-term (current) and long-term liabilities, whereas balance sheets “by nature” include categories for intangibles (e.g., goodwill), tangibles, financial liabilities (regardless of their due date), and trading liabilities (e.g., related to operations such as accounts payables). 5 For

a more detailed discussion of this difference, see Ding, Yuan, Thomas Jeanjean, and Herve

Stolowy, 2008, “The Impact of Firms’ Internationalization on Financial Statement Presentation: Some French Evidence,” Advances in Accounting, Incorporating Advances in International Accounting 24, 145–156.

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extent to which a firm’s cash flows from operating activities either exceed or fall short of its cash flows from investing activities. In the case of Home Depot, the company’s cash flows from operating activities of $6,651 far exceeded its cash flows from investing activities of ($1,129), with a difference of $5,522. As such, the firm was well positioned to pay dividends and repurchase shares. On the other hand, if Home Depot had decided to invest heavily in capital expenditures that were well in excess of its cash flows generated from operating activities, then the company’s cash flow from financing activities would have needed to be positive. (For example, the company may have sought cash through aggressive borrowing.) Beyond the three categories we’ve discussed so far, one additional category may appear on the cash flow statements of firms with nondomestic activities: cash flow attributable to exchange rate movements. This item can arise, for example, if a firm agrees to pay a foreign supplier a set amount of foreign currency but ends up paying more (or less) depending on the prevailing exchange rate. For Home Depot, which has foreign operations in Canada, Mexico, and China, the net impact of exchange rate changes was a modest ($32). Putting all of this information together, we see that Home Depot’s cash flows from operating activities of $6,651, cash flows from investing activities of ($1,129), and cash flows from financing activities of ($4,048) yield a total change in cash of $1,474. After adjusting for exchange rate changes of ($32), we find that Home Depot increased its cash by $1,442, from $545 at the beginning of the year to $1,987 at the end. Consequently, we are able to reconcile the change in Home Depot’s cash balance between 2011 and 2012, as shown on the balance sheets in Figure 3.2.

3.4 Relevance for Managers Every publicly traded firm is required to issue financial statements. Whether you are a manager of a firm, a lender to the firm, an investor in the firm, or a competitor, it is crucial that you have the ability to read and understand the basic financial statements—balance sheets, income statements, and cash flow statements. Although some managers may be assigned to a particular functional area such as marketing, operations, or human resources, whereas other managers work in a particular division and have profit-andloss responsibility for that division, it is critical to know how your function or your division is contributing to the overall financial health of the firm. Understanding balance sheets helps you know what the firm owns and what the firm owes. Understanding income statements helps you know how much revenue was generated, what costs and expenses were incurred, and how profitable the firm was. Understanding cash flow statements helps identify the extent to which cash was generated from operating activities, how much cash was invested, and how much cash was used to finance the activities with which the firm was involved. You don’t need to be an accountant to be an intelligent consumer of financial statements.

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Objective 3.4

Explain why understanding financial statements is relevant for managers.

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Summary

1. Financial statements are the key scorecards that allow for assessment of a firm’s financial health. 2. Balance sheets provide a snapshot of a firm’s assets as compared to its liabilities and equity at a particular time. Balance sheets always balance. 3. Income statements examine a firm’s revenues, costs, expenses, and profits over a particular time.

4. Balance sheets and income statements connect through the retained earnings account. 5. Cash flow statements reconcile any changes in cash balances between two periods. They also examine cash inflows and outflows generated by operating activities, investing activities, and financing activities.

Additional Readings and Information

A classic, solid foundation of the principles of accounting can be found in: ­Horngren, Charles, Walter Harrison, Jr., and Suzanne Oliver. Accounting, 9th ed. Boston: Prentice Hall, 2012. The conceptual background and analytical tools necessary to understand and interpret business financial statements is in: Ormiston, Aileen, and Lyn Fraser. Understanding Financial Statements, 10th ed. Boston: Prentice Hall, 2013.

Problems

1. Explain why equity is not the same as cash. 2. Describe the purpose of each of the three financial statements. 3. If a firm has goodwill on its balance sheet, what, if anything, does this imply about the firm’s previous acquisition activities? 4. Distinguish between operating, investing, and financing activities. 5. At the beginning of the year, Adam Co. had total assets of $100,000 and total liabilities of $60,000. Based on this information, answer the following questions. a.  If total assets increased by $17,000 during the year and total liabilities decreased by $8,000, what should be the retained earning amount at the end of the year? b.  If total assets decreased by $8,000 and retained earnings increased by $15,000 during the year, what is the amount of total liabilities at the end of the year? 6. Jesters-R-Us, Inc. is a publicly traded company that has assets on its balance sheet of $125 million and liabilities of $75 million. The firm also has 4 million common shares that are currently trading for $21 per share. Estimate the firm’s market-to-book ratio. 7. Wholesale Lumber, Ltd. is a firm that distributes lumber to building supply and home improvement retail stores.

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The firm’s cost of sales for the most recent year was $45 million, its beginning inventory was $16 million, and its ending inventory was $18 million. Estimate Wholesale Lumber’s purchases of lumber materials for the year. 8. Number One Retail, Inc. has a gross profit of $55 million, operating expenses of $22 million (which includes $6 million in depreciation and amortization), and interest expenses of $8 million. Its corporate tax rate is 35 percent. Calculate the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA). 9. Indicate whether the following items would appear on the income statement (IS), or balance sheet (BS). ______ a.  Account Payable ______ b.  Advertising Expense ______ c.  Rent Revenue ______ d.  Cash ______ e.  Utilities Expense 10. Smallco has cash from operating activities of $220 million, cash from investing activities of ($93 million), cash from financing activities of ($107 million), and a beginning cash balance of $27 million. What will Smallco’s ending cash balance be? 11. Identify the sources and uses of cash for Home Depot by comparing the 2011 and 2012 balance sheets.

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4

Measuring Financial Performance Learning Objectives Obj 4.1

This chapter is the third of four that focus on assessing the current business of a firm. In Chapter 2, we learned how to size-up a business from a nonfinancial perspective, in Chapter 3, we focused on understanding financial statements, and in Chapter 5, we’ll learn how to assess a firm’s day-to-day cash management. In Chapter 4, however, we concentrate on sizing up a business from a financial perspective by examining its key financial statements, historical financial ratios, and related performance measures. We begin the chapter by exploring how the information in a firm’s financial statements can be used to develop various performance measures, including return on equity and measures related to profitability, resource management, liquidity, and leverage. We’ll continue to utilize Home Depot as our primary sample firm and assess its financial performance. After applying these concepts, we conclude the chapter with a discussion of how to read a firm’s annual report. This chapter is related to our unifying theme as depicted in Figure 4.1. Recall that we identified three key decision-making areas within an enterprise—­ operating, investing, and financing. Also, within each of these three areas, there are relevant performance measures. As we move through the chapter, we’ll learn how the key performance measures in these three areas combine to provide an overall measure of a firm’s return on equity. Later, in Chapter 6, we’ll consider why return on equity is an important driver of a firm’s growth—of profits, dividends, and cash flows.

Explain how to estimate and interpret return on equity, profitability measures, resource management measures, liquidity measures, and leverage measures. Obj 4.2

Describe the key components in annual reports. Obj 4.3

Explain why measuring financial performance is relevant for managers.

4.1  Performance Measures After a firm’s financial statements have been compiled, the next step is to interpret how these statements reflect performance. There are a number of diverse stakeholders who are concerned with a firm’s financial performance, including its management team, current and potential shareholders, analysts, and lenders. Each of these stakeholders has a particular focus, and some of them place more emphasis on a specific measure than others. Although a company’s performance measures reflect past performance, these measures can often be used to assist in forecasting future financial statements. Thus, performance data provide an important bridge from a firm’s past to its future. Because most performance measures

Objective 4.1

Explain how to estimate and interpret return on equity, profitability measures, resource management measures, liquidity measures, and leverage measures.

89

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Fig 4.1 Financial Management Framework: Focus on Key Decision-Making Areas within an Enterprise

the enterprise

financing Financial Leverage

operating

investing

Profit Margin

Asset Turnover

Growing profits, dividends, cash flow

growth Return on equity

represent calculations based on two items from a firm’s financial statements—a numerator and a denominator—these measures are often known as financial ratios or ratio analysis. Performance measures allow for both an internal assessment and an external assessment of the firm. Internally, ratios can be compared across time. Externally, a firm’s ratios can be compared with those of other firms in the industry or with overall industry benchmarks. In this way, performance measures can help raise red flags related to both present and anticipated future financial performance. It’s important to keep in mind that all accounting values have limitations. They are simply estimates and, as such, they are often incomplete. Thus, you must always consider where these numbers are coming from, because if they are not reflective of true values, then any financial ratios will not be meaningful.

4.1.1 Return on Equity ratio analysis (financial ratios): The use of financial statementrelated ratios to analyze the performance of the firm return on equity (ROE): A measure of the effectiveness of the utilization of common shareholders’ equity: the ratio of net earnings less preferred dividends, to common shareholders’ equity

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Let’s begin to assess the financial performance of Home Depot, our primary sample firm. There are virtually countless ratios that can be generated from a firm’s balance sheet and income statement. In the following sections, we’ll focus on some major ratios that are particularly useful. An interesting starting point is the return on equity (ROE) measure, which is a key element in our financial management framework and one of the most important financial benchmarks. A firm’s ROE measures its profitability relative to its equity investment, and it can be calculated as follows: Return on equity =

net income available for common shareholders common shareholders> equity

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Fig 4.2 Return on Equity by Sector, 2012

60%

50%

40%

30%

20%

10%

–10%

Homebuilding Steel Trucking Advertising E-commerce Entertainment Industrial services Natural gas utility Oil/gas distribution Automotive Total market Retail/wholesale food Newspaper Office equipment/supplies Telecom services Apparel Internet Packaging & container Electronics Retail building supply Auto parts Retail store Beverage Household products Semiconductor Aerospace/defense Computer software Restaurant Toiletries/cosmetics Tobacco

0%

Source: Aswath Damodaran. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pbvdata .html (accessed March 30, 2012)

Notice that the net income or net earnings in the ROE calculation is actually the amount available for common shareholders, with any preferred dividends subtracted. Recall from our investigation of financial statements in Chapter 3 that Home Depot doesn’t have any preferred shares, so all of the company’s net income or net earnings is available to its common shareholders. Thus, to find Home Depot’s ROE, we divide the company’s net income or net earnings of $3,883 by its equity of $17,898 (both numbers are in millions). This gives us an ROE of 21.7 percent. For comparison’s sake, Figure 4.2 shows that across all publicly traded U.S. firms, the average ROE was 11.4 percent, whereas the average ROE within the retail building supply sector (of which Home Depot is a part) was approximately 15.3 percent. Return on equity is an important benchmark because it indicates the overall profits of a firm for a particular period relative to the shareholders’ investment in the firm. Recall that the primary goal of a firm is to maximize the value to its shareholders. The ROE measure is one indication of the firm’s success in meeting this goal. There are, however, some limitations to this measure. For example, there may be differences between the book value of the company’s equity and the market value of that equity, as noted in Chapter 3. Still, ROE is a vital measure for all businesses. There are a number of ways that ROE can be estimated. For example, equity can be estimated as the beginning equity, the ending equity, or the average between the beginning and ending equity amounts. There is no right or wrong method, but consistency is

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important. In the equation provided earlier in this section, ROE refers to the return on common equity. This implies that if a firm also has preferred equity, any preferred dividends must first be subtracted from the firm’s net income in order to arrive at the amount available for common shareholders. Additional insight can be gained by decomposing, or breaking down, the ROE measure into three separate components—profit margin, asset turnover, and financial leverage—that are multiplied together. This decomposition was first established by DuPont Corporation in the 1920s and is often referred to as the DuPont method. The DuPont decomposition is as follows: ROE = profit margin * asset turnover * financial leverage =

net income revenues assets * * revenues assets equity

Note that, using basic algebra, this decomposition simplifies to “net income divided by equity,” as presented in the equation near the beginning of the section: ROE =

net income revenues assets net income * * = revenues assets equity equity

Let’s take a closer look at what each part of the decomposition equation can tell us: First, the profit margin measure, or net income divided by revenues, indicates how much the firm’s profits contribute to ROE. This ratio measures how effective management is at creating earnings for every dollar of sales generated. Next, the asset turnover measure, or revenues divided by assets, indicates how much effective resource management contributed to the firm’s ROE. This ratio measures management’s ability to harvest or “sweat” the assets in order to generate sales. Finally, the financial leverage measure, or assets divided by equity, indicates the degree to which effective use of borrowing contributed to the firm’s ROE. Note that assets are equal to debt (or liabilities) plus equity. As such, the ratio of assets to equity is also the ratio of debt plus equity divided by equity.

profit margin: The ratio of net earnings to revenue asset turnover: A measure of the firm’s ability to generate revenue from its asset base; the ratio of revenues or sales to total assets financial leverage: The use of debt in order to increase the firm’s return on equity while increasing risk exposure. Also the ratio of a firm’s assets to equity

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It’s easy to remember the DuPont method if you use the following mnemonic: “ROE is your PAL.” Here, P stands for profits, A stands for asset turnover, and L stands for leverage. To see how the DuPont method works in practice, let’s return to our example. For Home Depot, we can divide the company’s net earnings of $3,883 (all numbers are in millions) by its net sales of $70,395 to arrive at a profit margin measure of 5.5 percent. We can then divide Home Depot’s net sales of $70,395 by its assets of $40,518 to get an asset turnover measure of 1.74. Next, we can divide the company’s assets of $40,518 by its equity of $17,898 to find a financial leverage ratio of 2.26. Last, by multiplying these three ratios (5.5 percent * 1.74 * 2.26), we arrive at an ROE of 21.7 percent—which is the same value we got using the more direct method described earlier in the section: ROE =

$3,883 $70,395 $40,518 $3,883 * * = = 21.7% $70,395 $40,518 $17,898 $17,898

If we compare each of these numbers to those in previous years, we find that Home Depot has shown steady improvement. More specifically, its profit margin increased from 4.0 percent in 2010 to 4.9 percent in 2011; its asset turnover increased from 1.62 in 2010 to 1.69 in 2011; and its financial leverage increased from 2.11 in 2010 to 2.12 in 2011. Subsequently, the company’s ROE increased from 13.7 percent in 2010 to 17.7 percent in 2011.

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Case Study

ROE Drivers across Industries: Tiffany and Kroger

How do the drivers of ROE differ across industry? Let’s compare Tiffany & Co., a high-end international jeweler with over 250 stores, with The Kroger Co., which operates over 2,400 supermarkets in the United States, for the year ending January 31, 2012. Profit Margin

Asset Turnover

Financial Leverage

ROE

Tiffany

12.77%

0.876

1.771

19.81%

Kroger

1.32%

3.850

5.897

29.96%

Note that Tiffany has a high profit margin but a low asset turnover ratio, which is what we would expect from a high-end jeweler. The company has a reasonably prudent amount of debt relative to equity with a financial leverage ratio less than two times, which implies that the firm has more equity than debt. We see a very different picture with Kroger. The grocery business has much lower profit margins but a very high asset turn­ over, which is what we would expect in an industry that deals with perishable goods. Also, since cash flows in this industry tend to be relatively stable—even in a recession people have to eat food—lenders are satisfied with allowing much higher financial ­leverage ratios than would be the case with high-end jewelers.

In the remaining subsections, we’ll examine some other elements that drive a firm’s ROE, including various profitability measures, resource management measures, liquidity measures, and leverage measures. One final note before proceeding: If we combine the first two terms of the DuPont formula (the profit margin and asset turnover measures), we get what is known as the return on assets (ROA) measure: ROA =

revenues net income * = profit margin * asset turnover revenues assets

The return on assets measure looks at profitability from the perspective of the asset base, regardless of how that asset base is financed. When comparing firms with a different mix of debt and equity, ROA is a useful measure. For Home Depot, we can multiply the company’s profit margin of 5.5 percent by its asset turnover of 1.74 to arrive at an ROA of 9.6 percent, which is an increase over the 2011 measure of 8.3 percent and the 2010 measure of 6.5 percent.

4.1.2 Profitability Measures Profitability measures typically focus on elements of a firm’s income statement and examine how the firm is able to generate profits from a particular level of revenue generation. In general, a firm’s goal should be to increase its profit per unit of revenue, all else being equal. The first ratio we consider looks at a company’s gross profit relative to its sales or revenues from operations: Gross margin percentage =

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gross profit revenues

return on assets (ROA): A measure of the effectiveness of the utilization of a firm’s assets: the ratio of net earnings less preferred dividends, to total assets

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As shown in this equation, the gross margin percentage focuses on a firm’s profit after its cost of sales is deducted from its revenues. This measure is important because it tells managers what percentage of sales dollars is available to cover other expenses (such as interest and taxes) and to provide a return to investors. Gross margins vary across industries depending on factors such as cost structure and competitiveness. Ideally, we would prefer to separate a firm’s costs into variable costs (i.e., those that vary directly with sales, such as unit costs associated with manufacturing a good) and fixed costs (i.e., those that are fixed over a course of time and do not vary regardless of sales levels, such as head office costs, insurance costs, etc.). In general, a firm’s cost of sales tends to be variable, whereas its operating expenses tend to be fixed. A firm’s proportion of fixed versus variable costs can affect its profitability as demand changes. For example, a company with relatively high fixed costs can substantially increase its profitability by its increasing volume, but doing so also makes the company more susceptible to a downturn in sales. As long as a firm’s costs of sales are primarily variable, then the firm’s gross margin percentage should be comparable from year to year. Beyond gross margin percentage, two related ratios focus on different types of profits as a percentage of a firm’s revenues: EBIT margin percentage =

EBIT revenues

EBITDA margin percentage =

gross margin percentage: The difference between revenues and costs of sales, divided by revenues EBIT margin percentage: A profitability measure: the ratio of operating profits to revenues EBITDA margin percentage: A profitability measure: the ratio of operating profits, plus depreciation and amortization, to revenues expense ratio: A cost measure: the ratio of expenses to revenues

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EBITDA revenues

The EBIT margin percentage measure focuses on a firm’s operating income (i.e., its earnings before interest and taxes) relative to its revenues. This measure takes into account both operating expenses and the direct cost of sales. The EBITDA margin percentage measure is similar, but depreciation and amortization are added back to EBIT in order to provide a measure of the cash generated from operations relative to revenues. Like the gross margin percentage, these measures are important because they tell the firm what percentage of sales dollars is available to cover interest and taxes and provide a return to investors. EBIT and EBITDA margins also vary across industries. These mea­ sures allow investors to more accurately compare multiple firms within an industry because they are not affected by the proportion of debt one firm might have versus another (and hence the amount of interest expenses). Thus, for Home Depot, we can divide the firm’s gross profit of $24,262 (again, all numbers are in millions) by its net sales of $70,395 to arrive at a gross margin of 34.5 percent. Similarly, we can divide the company’s EBIT or operating income of $6,661 by its revenues (or net sales) of $70,395 to calculate an EBIT margin of 9.5 percent. When depreciation and amortization of $1,573 are added to the company’s EBIT, we get an EBITDA of $8,234. Then, if we divide this amount by net sales of $70,395, the resulting EBITDA margin is 11.7 percent. Examining these ratios over time or in comparison to industry averages provides important insights as to the cost structure of a firm. For example, due to a recession or the entry of new competitors, a firm’s margins may have become squeezed over time—as would be the case if the firm opted to lower its selling price in response to a similar move by a competitor. This example highlights the importance of thoroughly sizing up both a firm and the industry to which it belongs in order to better interpret various performance ratios and trends. Let’s now consider a different yet equally important profitability ratio that focuses on a firm’s expenses, as shown here: Expense ratio =

expenses revenues

The expense ratio highlights the impact of a company’s expenses on its profitability. This ratio is important because a firm’s percentage of expenses can have a huge

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impact on its bottom line. Expenses vary across industries and firms. Here, expenses may be measured exclusively as operating expenses, or they may include interest expenses as well. If most of a firm’s operating expenses are fixed (rather than variable) costs, we might expect the firm’s expense ratio to decline as its sales increase over time. Of course, at some point, the firm’s fixed costs might increase as the business grows, thereby increasing the expense ratio. For example, additional administrative staff may need to be hired as a company gets larger and its operations become more complex. So, for Home Depot, operating expenses of $17,601 divided by net sales of $70,395 results in an operating expense ratio of 25.0 percent. This is slightly lower than the firm’s ratio of 25.7 percent in 2011 (operating expenses of $17,465 divided by net sales of $67,997) and 26.6 percent in 2010 (operating expenses of $17,609 divided by net sales of $66,176), which supports our conjecture that if most of a firm’s operating expenses are fixed, its expense ratio will tend to decline as its sales increase. Now, let’s assume that most of a firm’s costs of sales are variable, and that both its operating expenses and interest expenses are primarily fixed. In this case, we can utilize the firm’s gross margin and total fixed costs to determine a breakeven amount of sales for the firm. Breakeven analysis gives us a minimum sales target that the firm must achieve before it begins making a profit. In order to calculate the breakeven point of sales, we begin with the relationship among sales, costs, and earnings. We can rewrite the firm’s earnings (before taxes) as follows: Earnings = Net sales - variable costs - fixed costs Recognizing that net sales less variable costs equals gross profit, which is the same as net sales times the gross margin percentage, we can also calculate a firm’s earnings as follows: Earnings = Net sales * gross margin percentage - fixed costs For a breakeven calculation, we assume that the firm’s earnings are equal to zero. So, if we rearrange the preceding equation to solve for net sales, the equation becomes: Breakeven net sales =

fixed costs gross margin percentage

Let’s see how this works in practice. For Home Depot, let’s assume the company’s fixed costs consist of operating expenses of $17,601 plus interest expenses of $593, which together equal $18,194. Then, we can divide these fixed costs by the gross margin of 34.5 percent to calculate a breakeven level of net sales of $52,789. Fortunately for Home Depot, its sales were actually $70,395, which means the company significantly exceeded its breakeven point. One final profitability measure, return on invested capital (ROIC), compares operating profits adjusted for taxes relative to the amount of invested capital. There are different versions of the measure. We consider two versions: one that focuses on assets in the denominator, and another that focuses on debt and equity: ROIC =

EBIT * (1 - tax rate) EBIT * (1 - tax rate) = net working capital + fixed assets interest@bearing debt + equity

This metric is an important one because it measures a firm’s ability to generate profit relative to its investments. With ROIC, the numerator represents operating profits after tax, and the denominator represents either the investment in working capital and fixed assets or alternatively the amount of capital used to acquire the assets. In Chapter 9, we will focus on the concept of cost of capital, which essentially measures

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return on invested capital (ROIC): A measure of the effectiveness of the utilization of a firm’s capital: the ratio of after-tax operating profits, to capital employed. Capital employed is measured as net working capital plus fixed assets, or alternatively as interest-bearing debt plus equity

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the cost a firm faces when borrowing and issuing equity. Return on invested capital is an important metric because we would like to ensure that a firm’s return on its invested capital exceeds the cost of acquiring that capital. Note that even though we are measuring operating profit adjusted for taxes, we intentionally do not consider any interest expense because the cost of debt financing is considered as part of the cost of capital measure. Let’s now take a closer look at the denominator of the ROIC equation. Net working capital essentially measures the amount of money a firm has tied up in accounts receivable and inventories less accounts payable. (Alternatively, it can be measured as the difference between current assets and current liabilities.) Fixed assets include a firm’s net property, plant, and equipment. Together, net working capital and fixed assets represent the firm’s investments in projects that are expected to earn profits. We can also think of the denominator of the ROIC equation as a firm’s sources of capital, including any interest-­bearing debt and equity investments. So if a firm consistently generates strong after-tax operating profits relative to its assets—with its return on capital or ROIC exceeding its cost of capital—it will help to drive up its stock price. To measure ROIC for Home Depot, we need to make some assumptions. First, we’ll assume the company’s tax rate is around 35 percent. We’ll also estimate invested capital in a more direct manner by focusing on the right side of the balance sheet rather than the left side. Although invested capital equals net working capital plus fixed assets (on the left side of the balance sheet), it is also equal to interest-bearing debt plus equity (on the right side of the balance sheet). Last, we’ll assume that “other long-term liabilities” represents borrowed money, such as leases, and therefore we’ll include it with the firm’s interest-bearing debt. As such, Home Depot’s interest-bearing debt includes current installments of long-term debt of $30, long-term debt of $10,758, and other longterm liabilities of $2,146, which together total $12,934. Adding equity of $17,898 to this amount results in invested capital of $30,832, thereby giving us the denominator of the ROIC equation. Next, to find the numerator, we multiply our EBIT of $6,661 times 1 minus the tax rate of 35 percent. This yields an operating profit adjusted for taxes of $4,330. Finally, to complete the equation, we divide this $4,330 by our invested capital of $30,832, which gives us an ROIC of 14.0 percent, as shown here: ROIC =

EBIT * (1 - tax rate) $6,661 * (1 - 0.35) = = 14.0% invested capital $30,832

4.1.3 Resource Management Measures Resource management measures focus on management’s ability to effectively utilize the resources at their disposal, such as fixed assets and working capital. To better understand these measures, let’s circle back to our first key performance measure, return on equity (ROE). Recall that with the DuPont method, one of the three components of ROE is the asset turnover measure. The asset turnover ratio considers how much revenue a firm is able to generate relative to its asset base. Ideally, a firm would like to have as high an asset turnover ratio as possible, as this will lead to a higher ROE all else being equal—which in turn will generally be associated with a higher stock price. Thus, the asset turnover measure captures the capital intensity of a business: The more capital intense a firm is, the lower its asset turnover. Not surprisingly, however, companies with higher profit margins tend to have lower asset turnover ratios. The asset turnover measure also highlights the importance of managing the resources available to a firm, such as net property and equipment, as well as money tied up in inventory and accounts receivable.

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As alluded to in our ROIC discussion, assets can be placed into two general categories: fixed assets and working capital-related assets. Our first resource management measure considers fixed assets: Fixed asset turnover =

revenues net property and equipment

The fixed asset turnover measure is particularly relevant in a capital-intense business, such as manufacturing. The measure examines the extent to which a firm is able to generate revenues relative to the property and equipment in which it has invested. The higher this ratio, the more efficiently a business is deploying its fixed assets. For Home Depot, net sales of $70,395 divided by net property and equipment of $24,448 results in a fixed asset turnover measure of 2.9. Whether this is a good or bad number depends on the nature of the industry, but in general, higher numbers are better because they lead to a higher ROE. Our remaining resource management measures focus on working capital management, or management of short-term assets (i.e., inventory and accounts receivable) and accounts payable. The three main working capital measures are age of inventory, age of accounts receivable, and age of accounts payable, each of which combines information from a firm’s income statement and its balance sheet. In the remainder of this section, we’ll explore all three measures and some related ratios. In Chapter 5, we’ll take a closer look at the three main measures and what they can tell us about a firm’s day-to-day cash flow. The first working capital measure we’ll consider focuses on inventory: Age of inventory (in days) =

inventories average daily costs of sales

The age of inventory, also known as the inventory period, measures the average time between a firm’s purchase of materials (to create goods) and the sale of the goods created from those materials. (Keep in mind that firms often have a variety of raw materials, work in progress, and finished goods in their inventories.) The numerator of the age of inventory ratio is typically measured by examining a snapshot at a particular point in time, say, December 31, on the basis of outstanding inventory on that day. An alternative measure is the firm’s average inventory throughout the year, which may be more appropriate in seasonal businesses. The denominator of the age of inventory measure is calculated by taking the total costs of goods sold (or costs of sales) for the year and dividing by 365, as shown here: Average daily cost of sales =

annual costs of sales 365

The age of inventory measure represents how long a firm’s assets are typically tied up in inventory before sales are made. The interpretation of this ratio—whether longer ages are typical or whether just-in-time inventory practices are more prevalent—depends very much on the type of industry. For example, we would expect the average age of inventory to be low in the grocery industry and much higher in the manufacturing industry. An alternative representation of the age of inventory, known as the inventory ­turnover measure, simply divides the costs of goods sold by the ending inventory: Inventory turnover =

annual cost of sales inventories

This representation indicates how many times per year, on average, the firm’s inventory “turns,” or needs to be replaced. A mathematically equivalent method of determining inventory turnover is to divide 365 by the firm’s age of inventory.

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fixed asset turnover: A measure of a firm’s ability to generate revenues relative to the amount of net property and equipment age of inventory (inventory period): A measure of the average number of days over which inventory is in stock inventory turnover: A measurement of a firm’s control of its investment in inventory: the ratio of cost of sales to (ending or average) inventory

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So, to find the average age of inventory for Home Depot, we begin by dividing the company’s annual cost of sales of $46,133 by 365 to yield an average daily cost of sales of $126. After that, we divide the firm’s inventories of $10,325 by the average daily cost of sales of $126, which results in an age of inventory of 81.7 days. In other words, an average of 81.7 days elapse from the time Home Depot acquires goods until those goods are actually sold. Using the same set of figures, we can calculate Home Depot’s inventory turnover measure by dividing the firm’s annual cost of sales of $46,133 by its inventories of $10,325, resulting in 4.47 turns per year. Note that if we divide 365 by the inventory turnover measure of 4.47, we get 81.7 days, which matches the age of inventory we calculated earlier. As previously mentioned, our second major working capital measure focuses on accounts receivable: Age of accounts receivable (in days) =

accounts receivable average daily (credit) sales

The age of accounts receivable, also known as the collection period, measures the average time between credit-based sales and the collection of payments for those sales. A firm’s age of receivables is important because it represents money that is tied up while the firm waits to be paid for goods or services that have already been sold. Firms typically offer customers terms of up to 30 days within which to pay for goods or services received. As with the age of inventory ratio, the numerator of the age of receivables ratio either provides a snapshot at a particular time (say, December 31) based on outstanding accounts receivable that day, or it reflects a yearly average. If a business offers credit to all of its customers, the denominator is calculated by taking the total revenue for the year and dividing it by 365, as shown: Average daily (credit) sales =

age of accounts receivable (collection period): A measure of the average number of days over which accounts receivable are outstanding

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annual (credit) sales 365

Of course, many businesses deal in a mix of cash and credit—but financial statements usually don’t break down which sales are cash and which are credit. In such cases, it is typical to simply use the overall revenue number when estimating the age of receivables. From an interpretation perspective, unless the mix of cash and credit sales changes over time or is very different from the industry average, the age of receivables ratio, however measured, can provide important insights. If the business is all credit, then a benchmark of comparison is the stated credit term. For example, if the firm requests payment in 30 days yet the age of accounts receivable is 50 days, this suggests lax enforcement of credit terms, so further investigation into the reason for this situation is warranted. Thus, to find the average age of accounts receivable for Home Depot, we start by dividing the company’s net sales of $70,395 by 365, which gives us average daily sales of $193. Then, we divide the firm’s accounts receivable of $1,245 by its average daily sales of $193 to calculate an age of accounts receivable of 6.5 days. In other words, an average of 6.5 days elapse from the time that Home Depot makes a sale until those goods are paid for. This low number most likely reflects the fact that most of Home Depot’s transactions are cash based (including credit card purchases, which are like cash from the perspective of Home Depot). Our third major working capital measure, age of accounts payable, focuses on the liability side of the balance sheet and is a mirror image of the accounts receivable measure: Age of accounts payable (in days) =

accounts payable average daily purchases

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The age of accounts payable, also known as the payable period, measures the average time between the firm’s purchase of materials (assumed to be on credit) and its payment to the suppliers of those materials. As with the previous ratios, the numerator of this ratio either provides a snapshot at a particular time (say, December 31) based on outstanding accounts payable on that day, or it is based on a yearly average. The denominator is calculated by dividing the total purchases for the year by 365, as shown: Average daily purchases =

annual purchases 365

In some cases, financial statements or even the notes accompanying financial statements do not provide the specific amount of material purchases made by a firm in a particular year but instead provide only the overall cost of sales. In such cases, it’s common to use costs of sales as a proxy for purchases, because purchases of materials are usually a major component of cost of sales. Still, cost of sales is only an approximation for two reasons: Inventory may be higher or lower at the end of the year than at the beginning, implying that the cost of sales might differ from purchases by the amount of change in inventory; and Cost of sales may include a labor component rather than just materials purchased. What is important is to be consistent with the age of payables measure, making sure to calculate it in the same manner each year. When the same method is used from year to year, important insights can be gained from examining trends and comparing a firm’s values with industry averages. One benchmark of comparison is the stated payment term. For example, suppliers typically offer customers terms of up to 30 days within which to pay for materials, and they often offer discounts of, say, 2 percent if payment is made within 10 days. If a firm’s suppliers request payment in 30 days, yet the firm’s age of accounts payable is 45 days, this suggests the firm may have stretched its payments to suppliers as much as possible. Accordingly, the firm may need to be prepared to reduce its age of payables. So, to determine Home Depot’s age of accounts payable, we first divide the ­company’s cost of sales of $46,133 by 365, which results in an average cost of sales (and hence an estimate of average daily purchases) of $126. After that, we divide the firm’s accounts payable of $4,856 by its average daily cost of sales (purchases) of $126, which yields an age of accounts payable of 38.4 days. In other words, an average of 38.4 days elapse from the time that Home Depot receives supplies until it pays its suppliers for those goods. If the suppliers’ payment terms average around 30 days, this implies that Home Depot is able to get away with paying slowly. Slow payment is beneficial from Home Depot’s perspective because it means that the company is effectively relying on its suppliers to fund its own business. In terms of overall resource management, a firm would like to generate as much revenue as possible for a given level of fixed assets, have as little money tied up in inventory as possible, receive payment from customers as quickly as possible, and take as long as possible to pay its suppliers. By generating the highest revenues possible for a given asset base, a firm increases its asset turnover measure, which in turn—as we see with the DuPont method—increases its ROE.

4.1.4 Liquidity Measures Liquidity or solvency focuses on a firm’s ability to meet its short-term obligations. Firms use different measures of liquidity, but most of these ratios focus primarily on balance sheet items, as we’ll see throughout this section.

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age of accounts payable (payable period): A measure of the average number of days over which accounts payable are outstanding

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There are two main short-term measures of liquidity: the current ratio and the quick ratio. The current ratio simply compares a firm’s current assets and current liabilities, as follows: Current ratio =

current assets current liabilites

This ratio measures the extent to which a firm is able to cover its short-term obligations (usually defined as obligations due within the next year) with its short-term assets. In general, a firm’s current ratio should be far greater than one-to-one. The rationale for why this ratio should be greater than one is that if the firm were to liquidate all of its short-term assets (such as by turning accounts receivables into cash and selling its inventory), then it would have more than enough cash to meet its short-term obligations. In comparison, a firm’s quick ratio, also known as the acid test ratio, is calculated as follows: Quick ratio =

cash + accounts receivable current liabilites

Here, cash includes any cash equivalents or marketable securities. Although the quick ratio is similar to the current ratio, it is a tougher test of liquidity. In the case of a forced liquidation, a firm would have a more difficult time turning inventory and other current assets (prepaid expenses in particular) into cash. By excluding these items, the quick ratio provides a more realistic picture of the firm’s ability to meet its short-term obligations with short-term assets. As with the current ratio, it is desirable for a company’s quick ratio to be greater than one-to-one. To return to our ongoing example, we can divide Home Depot’s current assets of $14,520 by its current liabilities of $9,376 to calculate a current ratio of 1.5. Similarly, to find Home Depot’s quick ratio, we begin by adding the company’s cash of $1,987 to its accounts receivable of $1,245, which gives us $3,232. If we then divide this number by the firm’s current liabilities of $9,376, our result is a quick ratio of 0.3. Although this ratio is quite low, it is less of a concern for a company such as Home Depot, which has inventory that could be readily sold, than it would be for, say, a company in the technology industry that might be concerned with possible obsolescent inventory.

4.1.5 Leverage Measures

current ratio: A measure of a firm’s liquidity: the ratio of current assets to current liabilities quick ratio (acid test): A measure of a firm’s liquidity: the ratio of current assets, excluding inventories, to current liabilities debt-to-assets: A measure of financial leverage: the ratio of a firm’s debt to assets debt-to-equity: A measure of financial leverage: the ratio of a firm’s debt to shareholders’ equity

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Leverage measures look at a firm’s ability to meet its long-term obligations, as well as its overall optimal use of debt. Utilizing debt can be good for a firm and can assist in generating higher returns for shareholders, as we saw in our discussion of ROE, but it also involves greater risk. Most leverage ratios focus primarily on balance sheet items. Three important longterm measures of leverage and a firm’s overall capacity for debt include the debt-to-assets ratio, debt-to-equity ratio, and long-term-debt-to-total-capital ratio. The debt-to-assets and debt-to-equity ratios are each calculated in a straightforward manner, as illustrated here: Debt@to@assets ratio =

total liabilities total assets

Debt@to@equity ratio =

total liabilities equity

Both of these ratios indicate the proportion of debt used to acquire the firm’s assets. Specifically, the debt-to-assets ratio is a measure relative to the firm’s total assets, whereas

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the debt-to-equity ratio is a measure relative to the firm’s equity. The lower these ratios, the more room a company has to issue new debt or take on other liabilities in the future. There is no general benchmark for these ratios, and ideal values vary from industry to industry. More stable industries and industries with higher fixed costs, such as utilities, tend to have higher debt-to-equity ratios because banks are more willing to lend to these firms. So, for Home Depot, we can divide the company’s total liabilities of $22,620 by its total assets of $40,518 to arrive at a debt-to-assets ratio of 55.8 percent. This tells us that Home Depot relies more on debt as a source of capital than it does on equity. If we instead divide the company’s total liabilities of $22,620 by its equity of $17,898, we get a debt-to-equity ratio of 126.4 percent, which also indicates that a greater proportion of Home Depot’s financing comes from debt rather than equity. Often, it’s useful for a firm’s managers to focus on interest-bearing debt (such as bank loans) versus non–interest-bearing debt (such as accounts payable), since the latter are simply part of working capital. Interest-bearing debt is generally considered to be long-term debt, even if the current portion of long-term debt appears on the balance sheet as a current asset. One useful leverage ratio that focuses on interest-bearing debt is the long-term debt-to-capital ratio, sometimes referred to simply as the debt-to-­capital ratio, which is calculated as follows: Long@term debt@to@capital =

interest@bearing debt interest@bearing debt + equity

This ratio, which measures the percentage of a firm’s capital that is made up of debt, provides a better picture of what is known as the capital structure of the firm because it focuses on “permanent” or long-term capital. An alternate version of the long-termdebt-to-capital ratio uses the market value rather than the book value of equity. Market values can be thought of as representing a more current perspective. We’ll examine the importance of this ratio in much more detail in Chapter 12, but for now, it’s enough to note that the higher a firm’s long-term-debt-to-capital ratio is, the more financial risk the firm is taking on. So, what can we learn from Home Depot’s long-term-debt-to-capital ratio? To find this ratio, we begin by adding the company’s current installment of long-term debt of $30, plus its long-term debt of $10,758, plus its other long-term liabilities of $2,146. Together, these figures give us a total interest-bearing debt of $12,934 —which forms the numerator of our ratio. Next, we add Home Depot’s interest-bearing debt of $12,934 to its equity of $17,898. This adds up to $30,832 and makes up the denominator of the ratio. Finally, we divide the numerator by the denominator to arrive at a long-term-debtto-capital ratio of 41.9 percent, which suggests that Home Depot relies more on common shareholders than on lenders as a source of capital. One final set of leverage-related ratios is known as coverage ratios. Of these ratios, the interest coverage ratio and debt service coverage ratio are especially important. A firm’s interest coverage ratio is calculated as follows: Interest coverage =

earnings before interest and taxes interest expenses

This measure, which is calculated by dividing a firm’s EBIT by its interest expenses, is of particular interest to lenders. If a firm’s interest coverage ratio is less than one-toone, then lenders know that the firm is in danger of defaulting on its existing loan obligations, which could have serious consequences for the future. Acceptable ratios depend on the type of firm and the underlying cash flows. A bare minimum from a lender’s perspective might be 1.5, but if the firm’s cash flows are quite volatile, then a lender might require a much higher minimum, say 3.0.

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long-term debt-to-capital: A measure of financial leverage: the ratio of a firm’s long-term debt (or interest-bearing debt) to long-term debt plus shareholders’ equity debt-to-capital: A measure of financial leverage: the ratio of a firm’s interest-bearing debt to capital. Capital is measured as interest-bearing debt plus equity coverage ratios: Measures of a firm’s ability to meet its debt obligations interest coverage: A measure of a firm’s ability to meet its debt obligations: the ratio of operating income before tax to interest expenses

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A second important coverage ratio is the debt service coverage ratio, which can be found using the following equation: Debt service coverage =

earnings before interest, taxes, depreciation, and amortization principal repayments b interest + a 1 - tax rate

There are a variety of versions of this ratio. In the version presented here, the numerator consists of a firm’s EBITDA, which is a measure of cash from operations because it adds back the noncash items of depreciation and amortization. The denominator in this version considers more than just interest expenses (as was the case with the interest coverage ratio). In particular, it includes principal repayments, since such repayments are an important cash flow requirement. We can estimate a firm’s total principal repayment as its current portion of long-term debt, because that number represents the amount of debt to be paid by the firm within the next year. Note that unlike interest payments, which are recorded as an expense and can be used to reduce taxes paid, principal repayments come from after-tax profits. As such, we need to adjust the principal amount to a before-tax equivalent by dividing by one minus the tax rate. For example, if the tax rate is 35 percent and Home Depot has principal repayments totaling $1,000 in the upcoming year, then the firm needs $1,000/0.65 or $1,539 in earnings before taxes to be able to make the $1,000 principal repayment—which is equivalent to $1,539 * (1 - 0.35). With these ideas in mind, we can now calculate Home Depot’s actual interest coverage and debt service coverage ratios. To find the company’s interest coverage ratio, we simply divide its EBIT of $6,661 by its interest expenses of $593, which gives us a result of 11.2. To find its debt service coverage ratio, we start by calculating the firm’s EBITDA, which is equal to its EBIT of $6,661 plus depreciation and amortization of $1,573. The resulting total of $8,234 makes up the numerator of our ratio. Next, for the denominator, we begin by dividing Home Depot’s principal repayments of $30 by one minus the tax rate (i.e., 1 - 0.35) to arrive at a before-tax equivalent repayment amount of $46. We then add this number to the company’s interest expenses of $593, which results in a total of $639. Finally, we divide our numerator of $8,234 by our denominator of $639 to arrive at a debt service ratio of 12.9, as shown here: Debt service coverage =

$8,234 = 12.9 $30 b $593 + a 1 - 0.35

For Home Depot, both the interest coverage ratio of 11.2 and the debt service coverage ratio of 12.9 are extremely strong, which means that potential lenders would likely be quite comfortable with the firm’s ability to repay any new loans. All of the performance ratios we’ve discussed in this chapter are summarized in Figure 4.3. Each ratio is clearly delineated into a numerator component and a denominator component. Remember, the information needed to calculate each ratio is generally found on either a firm’s income statement or its balance sheet. The only exceptions are the return on invested capital (ROIC) and debt service coverage ratios, because they require us to estimate an income tax rate. For simplicity and consistency, we assumed a rate of 35 percent in all previous examples. Alternatively, we could have found each particular year’s income tax rate by dividing the provision for income tax by the amount of earnings before tax. debt service coverage (cash flow coverage ratio): A ratio of the amount of cash from operations (usually measured as EBITDA) available to pay interest and principal due within a year

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4.1.6 Application: Home Depot Earlier, as we looked at each of the ratios described in Figure 4.3, we calculated the corresponding values using information from Home Depot’s financial statements. Now, in this section, we’ll more closely consider what these performance measures tell us about

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Chapter 4  Measuring Financial Performance



Performance Measure Numerator Denominator Return on equity

=

Profitability

Net income / Equity

=

EBIT margin

=

Operating expense ratio

=

Return on invested capital

= EBIT × (1 − tax rate) / Interest-bearing debt + equity

Gross profit / Revenues EBIT / Revenues Operating expenses / Revenues



Fixed asset turnover

=

Revenues / Net property and equipment

Age of inventory

=

Inventory / Avg. daily cost of goods

Age of receivables

=

Age of payables

=

Liquidity



Accounts receivable / Avg. daily sales Accounts payable / Avg. daily purchases



Current ratio

=

Quick ratio

= Cash + acc. receivable / Current liabilities

Leverage



Current assets / Current liabilities



Debt-to-assets

=

Total liabilities / Total assets

Debt-to-equity

=

Total liabilities / Equity

Long-term debt to capital

=

Interest coverage

=

Debt service coverage

=

Fig 4.3 Summary of Performance Ratios



Gross margin

Resource Management

103

Long-term debt / Long-term debt + equity EBIT / Interest expenses EBITDA / Interest + principal grossed-up

the company’s overall financial health. Of course, in a real-life situation, our financial analysis would be combined with the nonfinancial analysis described in Chapter 2. Recall that the nonfinancial analysis examined a firm’s external environment (the economy and the industry), key success factors, and internal strengths and weaknesses in the areas of operations, marketing, and human resource management. A solid nonfinancial analysis is important because it helps us better interpret the numbers in our financial analysis. We began this chapter by noting that the goal of financial analysis is to uncover information that will aid in financial assessments and decisions. For a firm’s managers, such decisions relate to questions such as “Do we need to improve our operations?” “What investments do we need to make?” and “How should we finance those improvements and investments?” In comparison, the main decisions facing a firm’s lenders are “Should we continue to lend?” and “Can we expect to get our money back?” Meanwhile, the main decision facing potential investors is “Should I buy equity in this firm?” As we’ll see in the remainder of this section, financial ratio analysis will assist in answering each of these questions. We can examine each of the financial ratios introduced in this chapter on its own, as part of a trend, or relative to some kind of industry benchmark. To make comparison easier, various financial services firms gather information across firms and calculate average ratios by sectors. One such firm is Dun & Bradstreet. (See this reference in the Additional Readings and Information section at the end of this chapter.) For our purposes, however, we’ve identified only a single firm that happens to be Home Depot’s main competitor: Lowe’s Companies, Inc. Lowe’s is the world’s second-largest home improvement retailer, with more than 1,700 stores in the United States, Canada, and Mexico. The two

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Fig 4.4 Performance Ratios for Home Depot and Lowe’s



Home Depot Lowe’s

Num.1

Den.1

Measure

2012 Performance Measure Return on equity





2011 2010

2012 2011 2010



3,883

17,898

21.7%

17.7%

13.7%

11.1%

11.1%

9.4%

3,883

70,395

5.5%

4.9%

4.0%

3.7%

4.1%

3.8%

Asset turnover

70,395

40,518

1.74

1.69

1.62

1.50

1.45

1.43

Financial leverage

40,518

17,898

2.26

2.12

2.11

2.03

1.86

1.73

Profit margin

Profitability



Gross margin

24,262

70,395

34.5%

34.3%

33.9%

34.6%

35.1%

34.9%

EBIT margin

6,661

70,395

9.5%

8.6%

7.3%

6.5%

7.3%

6.6%

17,601

70,395

25.0%

25.7%

26.6%

28.0%

27.8%

28.3%

Operating expense ratio Return on invested capital2

4,330 30,832 14.0%

12.3% 10.0%

Resource Management

6.5% 6.8% 6.2%



Fixed asset turnover

70,395

24,448

2.9

2.7

2.6

2.3

2.2

2.1

Age of inventory

10,325

126

81.7

86.8

85.0

92.8

95.9

97.9

6.5

5.8

5.3

—

—

—

Age of receivables

1,245

193

Age of payables3

4,856

126 38.4

38.5 40.6

Liquidity Current ratio Quick ratio

48.3 50.2 50.9



14,520

9,376

1.5

1.3

1.3

1.3

1.4

1.3

3,232

9,376

0.3

0.2

0.2

0.2

0.2

0.1

Leverage



Debt-to-assets4

22,620 40,518 55.8%

52.9% 52.5%

50.7% 46.3% 42.2%

Debt-to-equity4

22,620 17,898 126.4%

112.4% 110.8%

103.0% 86.1% 73.1%

Long-term debt to capital 5

12,934 30,832 41.9%

38.6% 37.9%

33.9% 29.0% 23.9%

Interest coverage

Debt service coverage2

6,661

593

11.2

8,234

639 12.9

10.3 3.4

5.9

8.8

10.7

10.8

2.7

3.7 13.3 4.2

1 in $millions  2 assumes tax rate of 35%  3 based on cost of sales  4 debt measured as total liabilities  5 based on all interest-bearing debt

firms’ performance ratios for 2010, 2011, and 2012 are summarized in Figure 4.4. For Home Depot’s 2012 ratios, the numerator and denominator values are also presented. As shown in Figure 4.4, Home Depot has seen a steady improvement in its ROE, from 13.7 percent in 2010 to 17.7 percent in 2011 and 21.7 percent in 2012. This is well above the average market ROE of 11.4 percent and average sector ROE of 15.3 percent (as indicated in Figure 4.2). Examining the ROE drivers as indicated by the DuPont decomposition, Home Depot’s profit margin and asset turnover measures have both steadily increased, as has its financial leverage measure. Lowe’s has experienced similar trends, but its overall ROE mea­ sure for 2012 is only about half as large as Home Depot’s. The implication is that Home Depot has provided strong and increasing returns to its equity shareholders, both on a relative and absolute basis, and has been able to grow internally by reinvesting equity into the firm. Moving down the columns of Figure 4.4, Home Depot’s gross margin percentage has remained fairly stable and at a similar level to that of Lowe’s. This is a healthy sign.

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Home Depot’s operating expenses have trended downward, perhaps due to a large fixed cost proportion, thus indicating that the company is able to take advantage of economies of scale. The most recent operating expense percentage is a full three percentage points below that of Lowe’s, resulting in a stronger EBIT margin. Similar to the ROE measure, Home Depot’s ROIC has grown steadily over the past three years and is more than double that of Lowe’s, suggesting Home Depot is able to generate much stronger returns than Lowe’s relative to the amount of capital each firm has. In terms of resource management, Home Depot has improved its fixed asset turnover measure from 2.6 to 2.9, suggesting that the firm has been able to generate more revenue for each dollar it invests in property and equipment. Although Lowe’s has improved as well, its turnover ratio is at a lower level. Home Depot’s level of inventory has declined only marginally, with little change in the age of receivables or payables. Lowe’s level of inventory is slightly higher, as is its age of payables. Since Lowe’s deals strictly in cash, it doesn’t have any receivables. Figure 4.4 also shows that Home Depot’s current ratio and quick ratio improved marginally and are at similar levels to those of Lowe’s. Home Depot’s current ratio does not appear to be problematic. Also, even though the quick ratio for Home Depot appears to be quite low, there are two mitigating factors. First, unlike some firms that may have a lot of work-in-progress inventory or inventory that is in danger of obsolescence, Home Depot’s inventory would probably face a reasonably high recovery rate if there was a forced liquidation. Second, if Home Depot has untapped borrowing capacity through lines of credit with banks, then it may be able to function well with a low quick ratio. Home Depot’s leverage ratios have increased, as noted earlier in our discussion of ROE drivers. Lowe’s leverage ratios have increased as well, but Lowe’s has not taken on as much debt relative to its assets as Home Depot. One major difference between the two firms can be seen in their coverage ratios. In terms of interest coverage, Lowe’s ratio has declined, while Home Depot’s ratio has improved because it has been able to generate proportionately more operating profits. Another way to examine ratios is to create common-size ratios that show the breakdown of income statement items relative to net sales (as in Figure 4.5) or balance sheet items

105

common-size ratios: Standardized financial statement measures, between various balance sheet items as a percentage of assets, and between various income statement items as a percentage of revenue

Fig 4.5 Home Depot and Lowe’s Common-Size Income Statements



Home Depot Lowe’s

NET SALES

2012 2011 2010 100.0% 100.0% 100.0%

Cost of sales

65.5%

65.7%

GROSS PROFIT

34.5% 34.3% 33.9%

Operating expenses Selling, general, and administrative costs

22.8%

23.3%

66.1%

2012 2011 2010 100.0% 100.0% 100.0% 65.4%

64.9%

65.1%

34.6% 35.1% 34.9%

24.0%

25.1%

24.6%

24.9%

Depreciation and amortization

2.2%

2.4%

2.6%

2.9%

3.2%

3.4%

Total Operating Expenses

25.0%

25.7%

26.6%

28.0%

27.8%

28.3%

OPERATING INCOME (EBIT)

9.5% 8.6% 6.0%

6.5% 7.3% 6.6%

Interest expense

0.8% 0.8% 1.2%

0.7% 0.7% 0.6%

EARNINGS BEFORE INCOME TAXES

8.6% 7.8% 6.1%

5.8% 6.6% 6.0%

Provision for income taxes

3.1%

2.1%

NET EARNINGS

5.5% 4.9% 4.0%

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2.8%

2.1%

2.5%

2.2%

3.7% 4.1% 3.8%

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Fig 4.6 Home Depot and Lowe’s Common-Sized Balance Sheets



Home Depot Lowe’s



2012 2011 2010

2012 2011 2010

Cash and cash equivalents

4.9%

3.9%

Accounts receivable

3.1% 2.7% 2.4%

ASSETS Current assets

Inventories

1.4%

3.5%

25.5% 26.5% 24.9%

Other current assets

3.3%

3.2%

0.0% 0.0% 0.0% 24.9% 24.7% 25.0%

2.4%

3.1%

3.2%

1.2%

1.6%

1.3%

Total current assets

35.8%

33.6%

34.0%

30.0%

29.6%

29.5%

Net property and equipment

60.3%

62.5%

62.5%

65.5%

65.5%

68.2%

Goodwill

2.8% 3.0% 2.9%

—

Other assets

1.1%

4.5%

Total Assets

1.0%

0.7%

100.0% 100.0% 100.0%

— — 4.9%

2.3%

100.0% 100.0% 100.0%

LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Accounts payable

12.0% 11.8% 11.9%

Cur. installments of long-term debt Other current liabilities Total current liabilities Long-term debt (Excl. cur. installments) Deferred income taxes

13.0% 12.9% 13.0%

0.1%

2.6%

2.5%

1.8%

0.1%

1.7%

11.1%

10.9%

11.0%

8.8%

8.1%

7.6%

23.1%

25.2%

25.3%

23.5%

21.1%

22.3%

26.6%

21.7%

21.2%

21.0%

19.4%

13.7%

0.8%

0.7%

0.8%

1.6%

1.4%

1.8%

Other long-term liabilities

5.3%

5.3%

5.2%

4.7%

4.3%

4.4%

Total Liabilities

55.8%

52.9%

52.5%

50.7%

46.3%

42.2%

44.2%

47.1%

47.4%

49.3%

53.7%

57.8%

STOCKHOLDERS’ EQUITY

Total Liabilities and Stockholders’ Equity 100.0% 100.0% 100.0%

100.0% 100.0% 100.0%

relative to assets (as in Figure 4.6). These common-size ratios allow us to level the playing field by examining trends across time or among competitors by focusing on percentages. We’ve already examined several income statement items, such as gross profits and net earnings relative to sales (which we referred to as profit margin in our ROE discussions). In Figure 4.5, we have a more detailed breakdown of some of the expense items, such as selling, general, and administrative costs. In terms of the common-sized balance sheets shown in Figure 4.6, we see the breakdown between current assets and property and equipment. We also see the mix of current versus long-term liabilities. In general, we should not be surprised to see relatively similar proportions between Home Depot and Lowe’s, given that the firms are in the same industry. Overall, we can conclude that Home Depot is in strong financial shape and has gotten stronger over the past three years on both an absolute basis and a relative basis. Although our analysis has focused on accounting measures, we would expect to see a relationship between accounting measures and actual performance of the company’s stock price, bearing in mind that stock prices reflect anticipated performance. In fact,

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between 2010 and 2012, Home Depot’s stock price increased by 102 percent (excluding returns from dividends), whereas Lowe’s stock price increased by only 39 percent and the overall market (S&P 500) increased by roughly 55 percent.

4.2  Reading Annual Reports Now that we have a better understanding of financial statements and performance mea­ sures, we can put those statements and measures in the broader context of the information that a firm’s senior management discloses to investors in the firm’s annual report. Financial statements are important components of the annual reports that public companies are required to develop and present to their shareholders. Often, the information presented in a company’s annual report overlaps with information required by government regulators. For example, the U.S. Securities and Exchange Commission requires companies (domestic as well as foreign firms with shares listed in the United States) to file annual 10-K reports that describe the business and present its financial statements. In some cases, firms will simply take the 10-K document and make it part of their annual report, often adding additional sections and photos. Most annual reports consist of multiple sections, including a letter to shareholders, management discussion and analysis, financial statements, and footnotes to the financial statements. The letter to shareholders is written by a firm’s chief executive officer or board chair and is usually fairly brief (a few pages). It describes how the company performed during the past year and what goals or strategy management has set for the upcoming year. It may also include additional insights in terms of the firm’s achievements and challenges. The overall strategy of a firm should also be reflected in its financial statements. For example, a firm might pursue a strategy of aggressive growth by competing on price. In this case, the company’s financial statements would likely show a large change in net sales but a lower gross margin percentage. If a firm includes the 10-K or similar regulatory documents as part of its annual report (as is the recent practice of Home Depot), there are a number of key sections on which you can focus. (If the firm does not include the 10-K directly, it will generally provide commentary on these areas elsewhere in its annual report.) The most important sections of the 10-K document are as follows:

Objective 4.2

Describe the key components in annual reports.

Item 1 of a 10-K includes a description of the company’s operations and usually includes an overview of its strategy. This section is a useful place to start in order to understand the business. Item 1A describes any risk factors that could have a material impact on the firm’s financial results and therefore might cause actual results to differ from management’s forecasts. Consequently, these factors should be taken into account when reading the management discussion and analysis section. Common categories of risks include economic factors, supply prices, competitive factors, changing consumer needs, relationships with suppliers, and availability of financing. Some of these risks may be typical of what most firms face, but be careful to watch for anything that appears unusual. Item 3 describes any legal proceedings in which the firm is involved that might cause potential surprises related to financial results. Item 7 is management’s discussion and analysis of financial conditions. This section often presents highlights and commentary related to key results, such as revenue

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and earnings. For example, this part of the report may describe management’s view of any significant increases or decreases in key variables. Liquidity and debt capacity, any major changes in the business and its competitive environment, and management’s assessment of the future outlook are typical topics. After reading Item 7, you can reexamine the ratio analysis to see whether management’s comments appear to explain any unusual results. We’ve now examined the three major financial statements of any firm: the income statement, the balance sheet, and the cash flow statement, all of which are included in the firm’s annual report. As you look through these statements, you can focus on the “top line” of sales, the “bottom line” of earnings, debt levels, cash inflows and outflows, and any apparent trends. Of course, ratio analysis will provide additional insights. Be aware that there is also one other financial statement presented in a company’s annual report: the statement of change in stockholders’ equity. This statement provides additional details that reconcile any changes in equity. Thus, it will indicate the beginning equity value, any change in retained earnings (net earnings less any cash dividends), and any other changes, such as share issues or repurchases. Footnotes to the firm’s financial statements are also included in the annual report, and they can serve as an additional source of detailed information. These footnotes typically include descriptions of accounting policies, details concerning income taxes, specifics related to debt obligations (such as rates and repayments schedules), hedging policies, pension plan details, segmented and geographic breakdowns of revenue or profits, any future financial obligations that the firm is facing (such as those related to employee benefits), and any related-party transactions. Footnotes can be an important source of information for “off balance sheet” items such as operating leases, which may change the nature of how various performance ratios are interpreted. Other sections of an annual report include an auditor’s letter that will usually give an “unqualified opinion” that the financial statements fairly present the financial position of the firm (if the opinion is “qualified” it suggests that not enough information was provided to the auditors or proper accounting principles have not been employed, which sends a negative signal to readers of the financial statements); a five- or ten-year summary of financial results, including a few key financial ratios; a list and brief biographical sketch of the firm’s officers and directors; and a five-year stock price history, usually compared to the overall market and sector.

4.3  Relevance for Managers Objective 4.3

Explain why measuring financial performance is relevant for managers.

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Understanding financial statements is useful, but understanding the relationships among the financial statements is even more important. We need to set benchmarks for performance in order to determine whether the firm has become more financially healthy over time and to be able to compare our firm’s performance with other firms in the industry. Financial ratios serve a number of purposes. From a lender’s perspective they often form the basis for covenant restrictions. For example, if we want to increase our borrowing, we may need to generate increased cash flows because a bank might restrict its lending to a maximum multiple of EBITDA. Or we may need to ensure that our coverage ratio exceeds a minimum threshold. Financial ratios are also useful for planning and budgeting purposes. We may start by assuming that our future working capital needs— related to the age of inventory, age of receivables, and age of payables—are related to our current working capital ratio levels.

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The ROE measure helps us understand how well we are rewarding our investors. As we will see in Chapter 6, it is also a major factor in determining the extent to which the firm can grow. In general, being able to measure helps us to manage better. Since all public firms need to issue annual reports, every manager needs to be able to read and understand these reports—and not just look for pictures of coworkers! How have senior executives interpreted recent results and where does the firm appear to be headed?

Summary

1. Performance measures focus on the profitability, resource management, liquidity, and leverage position of a firm. 2. One important overall measure of performance is return on equity (ROE), which examines the net income generated relative to the equity of the firm. 3. Profitability measures such as the EBIT margin and ROIC focus on the ability of a company to earn a sufficient operating profit with reasonable expenses. 4. Resource management measures focus on the ability of a firm to utilize fixed assets (the fixed asset turnover ratio) and manage its inventory (inventory period), accounts receivable (collection period), and accounts payable (payable period).

5. Liquidity measures such as the current ratio and quick ratio focus on the ability of a firm to meet its short-term obligations. 6. Leverage measures such as debt-to-capital along with coverage ratios focus on a firm’s ability to meet its long-term debt obligations, as well as its overall optimal use of debt. 7. A company’s annual report contains key financial statements, management insights about performance and outlook, and additional financial details that can aid in interpretation of ratio analysis.

Additional Readings and Information

A classic, solid foundation of the principles of accounting can be found in: ­Horngren, Charles, Walter Harrison, Jr., and Suzanne Oliver, Accounting, 9th ed. Boston: Prentice Hall, 2012. The conceptual background and analytical tools necessary to understand and interpret business financial statements is in: Omiston, Aileen, and Lyn Fraser. Understanding Financial Statements, 10th ed. Boston: Prentice Hall, 2013. Merrill Lynch, now a division of Bank of America, regularly published a short classic: Merrill Lynch. How to Read a Financial Report. New York: Merrill Lynch, Pierce, Fenner & Smith, 2000. Renowned investor and chairman of Berkshire Hathaway Inc., Warren Buffett is well known for his witty and astute letters to shareholders, written annually since 1977: http://www.berkshirehathaway.com/letters/letters.html Usually available through major business libraries, key financial ratios—including medians, top quintile (i.e., best 25 percent), and bottom quintile (i.e., worst 25 percent)—are collected by industry and reported in: Dun & Bradstreet Industry Norms & Key Business Ratios. Securities and Exchange Commission 10-K filings are available through the EDGAR system at: http://www.sec.gov/edgar.shtml

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Problems

1. Star Inc. has year 1 revenues of $80 million, net income of $9 million, assets of $65 million, and equity of $40 million, as well as year 2 revenues of $87 million, net income of $22 million, assets of $70 million, and equity of $50 million. Calculate Star’s return on equity (ROE) for each year based on the DuPont method and compare it with a direct ROE measure. Next, explain why the firm’s ROE changed between year 1 and year 2. 2. Nextime Ltd. has operating profits (EBIT) of $87 million, a tax rate of 35 percent, net working capital of $129 million, and fixed assets of $285 million. Calculate Nextime’s return on invested capital, or ROIC. Then describe three methods by which a firm can increase its ROIC. 3. Air Tech Co. manufactures a component used in aircraft radar systems. The price of each component is $5,000. The firm’s annual fixed costs are $480,000. Its gross margin percentage is 30 percent. What is the breakeven point in sales? 4. Crystal Corporation has a gross profit of $15.5 million and net revenue of $70 million in 2014. Its property and equipment cost $15 million at the beginning of the year. The depreciation and amortization is $5 million. What is the company’s fixed asset turnover and gross profit margin? 5. Hadry Corporation has accounts receivable of $540,516, ending inventory of $862,000, sales of $5,258,400, and cost of goods sold for the year just ended of $5,519,500. What is the receivable turnover and age of inventory? How long, on an average, did a unit of inventory sit on the shelf before it was sold?

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6. Beware Securities has net working capital of $35,000, current liabilities of $18,000, cash of $10,000, and accounts receivable of $5,000. What is the current ratio? What is the quick ratio? 7. Deb Co. has interest-bearing debt of $122 million, non–interest-bearing debt of $33 million, and equity of $76 million. Calculate Deb Co.’s debt-to-assets, debt-to-equity, and long-term-debt-to-capital ratios. 8. IOU Inc. has EBIT of $58,000, depreciation and amortization of $12,000, interest expenses of $21,000, principal repayments of $17,000, and a tax rate of 35 percent. Calculate IOU Inc.’s interest coverage ratio and debt service coverage ratio. 9. Using Home Depot’s 2010 and 2011 balance sheets in Figure 3.2 and statements of earnings in Figure 3.3 in Chapter 3, set up the ratios presented in Figure 4.4 for Home Depot for 2010 and 2011, indicating the numerator and denominator of each. Confirm the answers presented in Figure 4.4. 10. Which financial statement presents information related to changes in retained earnings and share repurchase?

7/30/14 2:09 PM

5

Managing Day-to-Day Cash Flow Learning Objectives Obj 5.1

Explain what the cash flow cycle is and how to identify sources and uses of cash. Obj 5.2

This chapter is the last of four chapters that focus on assessing a firm’s performance. In the previous three chapters, we looked at some long-term factors and measures that can help us gauge a firm’s financial health, such as overall economic conditions and yearly financial statements. Now, in Chapter 5, we’ll turn our attention to the short term by considering day-to-day cash management. As discussed in Chapters 1 and 4, a firm’s cash inflows and outflows can arise from its operating, investing, or financing activities. Properly managing these inflows and outflows is a key factor in any firm’s success—not just in the short term, but also in the long term. In fact, day-to-day cash flow management has important implications for the long-term financial requirements of a company, because if the company does not manage its cash flows carefully and grows too quickly, it may need to rely too heavily on external funding, such as bank loans. This chapter begins with a simple description of the typical cash flow cycle a business faces as it tries to balance both its cash inflows (or sources of cash) and its cash outflows (or uses of cash). After that, we examine cash flows related to operations or working capital, focusing on inventory management, accounts receivable management, and accounts payable management. Then short-term financing vehicles are discussed. To understand how this chapter relates to our unifying theme, we must first recall the three financial-related decision-making areas within an enterprise: operating, investing, and financing. This chapter focuses on operating decisions— specifically those involving working capital, because working capital is related to the cash inflows and outflows that arise from operating an enterprise. As shown in Figure 5.1, operating decisions also affect the growth of a firm’s profits.

Explain how to manage inventory, accounts receivable, and accounts payable. Obj 5.3

Describe different forms of short-term financing. Obj 5.4

Explain why understanding day-to-day cash flows is relevant for managers.

cash flow cycle (cash conversion cycle): The pattern and timing of where cash comes from and where it goes in a firm

5.1  Cash Flow Cycles Cash is the bloodline of any firm, and financial management is all about balancing cash inflows and outflows. Balancing cash flows is especially important as it relates to the operating decisions of a business, but it affects a firm’s investing and financing decisions as well. The cash flow cycle, also called the cash conversion cycle, was introduced in Figure 1.2 and indicates the length of time it takes for a firm to convert its inputs (such

Objective 5.1

Explain what the cash flow cycle is and how to identify sources and uses of cash.

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Fig 5.1 Financial Management Framework: Key Decision-Making Areas

the enterprise

financing

• Operations/ suppliers • Marketing/ customers • Working capital • People

operating

investing

Growing profits, dividends, cash flow

growth

double-entry bookkeeping (dual entry accounting): A financial recording system whereby each entry impacts at least two accounts (debits and credits) while preserving the relationship: assets = liabilities + equity Fig 5.2 Kwik Koffee Opening Balance Sheet

as inventory) into cash, accounting for both converting credit sales into cash and paying suppliers. Thus, the notion of a cash cycle refers to the continual process of generating cash through sales, preserving cash by taking advantage of credit offered by suppliers, and utilizing cash by investing in inventory and offering credit to customers. To better understand the connection between a firm’s cash flow and its operating, financing, and investing decisions, let’s consider the example of a simple business in the startup phase, then carefully follow the flow of cash as the example builds. As we go through the example, we will be presenting the double-entry bookkeeping system, also known as dualentry accounting, whereby every transaction or event has an impact on at least two accounting entries while preserving the simple accounting equation: assets = liabilities + equity. Let’s say Anne Treprenoor invests $1,000 of her own cash in a new business, which she calls Kwik Koffee. Anne plans to buy prepackaged coffee for use in office coffee machines. She then plans to sell the coffee to offices within walking distance of her downtown home. Initially, Anne plans to run her business on an all-cash basis, so her first step is to place her $1,000 in start-up funds into Kwik Koffee’s bank account. Here, Anne has made a financing decision by contributing her own equity to the business. The Kwik Koffee opening balance sheet is shown in Figure 5.2. Assets Cash Inventory



Liabilities and Equity

$1,000 Liabilities 0

Initial equity

Total Assets $1,000 Total Liabilities and Equity

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$0 1,000 $1,000

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Assets Cash $1,000 − 1,000 = 0 Inventory

Liabilities and Equity

$1,000

$1,000

Liabilities Initial equity

Total Assets $1,000 Total Liabilities and Equity

$0 1,000

113

Fig 5.3 Kwik Koffee Balance Sheet after Initial Purchase of Inventory

$1,000

Next, Anne makes an investment decision by purchasing $1,000 in coffee packages as her initial inventory. (Note that Anne’s decision differs from most investment decisions, such as the purchase of fixed assets, which are long term in nature.) She hopes to be able to sell each package for twice as much as she paid for it. The Kwik Koffee balance sheet after Anne’s initial investment in inventory is shown in Figure 5.3. At this point, the company’s total assets amount remains the same, but the cash item has decreased by $1,000 and the inventory item has increased by $1,000. In this and other figures, the box and arrow indicates the amount and direction of change—in this case the $1,000 from cash to inventory—while the up or down arrows indicate an increase or decrease in the value of the account. Note the example of the double-entry system: The decrease in cash is offset by the increase in inventory leaving total assets (and equity) unchanged. The following day, Anne spends the morning phoning various offices. She is successful in her efforts and ends up with more coffee orders than she can fill with her initial inventory. Anne then calls her coffee supplier and asks for an additional $500 in inventory, promising to pay the next week with the proceeds from her sales. The supplier agrees. The new Kwik Koffee balance sheet is shown in Figure 5.4. Note that the company’s assets and liabilities have both increased by $500. On the asset side, Anne’s inventory has increased by $500 to $1,500, while on the liability and equity side, her liabilities have grown (since they were previously zero) and her accounts payable amount is now $500. The arrow indicates the association between the increase in accounts payable and the corresponding increase in inventory. As always, Kwik Koffee’s balance sheet continues to balance. Soon after placing her second coffee order, Anne is able to convert $1,200 of her $1,500 in inventory into $2,400 in sales, based on the operations of her business. (Remember, Anne is able to sell the coffee for twice as much as she paid for it.) Of this $2,400, she receives $400 in cash. Anne sells to customers on credit, and they have agreed to pay her the remaining $2,000 within the next week. Thus, Kwik Koffee’s inventory decreases by $1,200, from $1,500 to $300. Meanwhile, the company’s cash increases from $0 to $400, and its accounts receivable increase from $0 to $2,000. For this simple example, we’ll ignore taxes, which means that Anne’s profits of $1,200 result in an increase in retained earnings of $1,200 (from a previous balance of $0). At the end of the day, the Kwik Koffee balance sheet and income statement appear as shown in Figure 5.5. Note that Anne’s equity is equal to the sum of her initial investment of $1,000 plus her retained earnings of $1,200, for a total of $2,200.

Assets Cash Inventory

Liabilities and Equity

$0 $1,500

$500

Accounts payable Initial equity

Total Assets $1,500 Total Liabilities and Equity

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$500 1,000

Fig 5.4 Kwik Koffee Balance Sheet after Second Purchase of Inventory

$1,500

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Fig 5.5 Kwik Koffee Balance Sheet and Income Statement after Initial Sales and Collections

Balance Sheet Assets

$400

Accounts receivable Inventory

Liabilities and Equity



Cash

$400

2,000 $2,000

$1,500 − 1,200 = 300

Accounts payable

$500

Initial equity

1,000

Retained earnings

1,200

Total Assets $2,700 Total Liabilities $2,700 and Equity $1,200 $1,200 Income Statement Sales $2,400 Cost of sales

1,200

Profits $1,200

This simple example shown in Figure 5.5 demonstrates the cycle of cash flows. To summarize, the cash item on Kwik Koffee’s balance sheet initially increased from $0 to $1,000 on the basis of Anne’s equity contribution, then dropped to $0 with the first purchase of inventory, then rose to $400 when Anne received the cash portion of her sales. The company’s accounts receivable increased to $2,000 with the credit sales. The inventory portion of the balance sheet went from $0 to $1,000 with Anne’s purchase of the initial inventory, then increased to $1,500 with the addition of $500 in extra inventory, then decreased by $1,200 to a final value of $300 after Anne’s first day of sales. On the right side of the balance sheet, Kwik Koffee’s accounts payable increased to $500 when Anne made her second inventory purchase on credit. Finally, on the income statement, the day’s sales of $2,400 less the cost of sales of $1,200 resulted in total profits for the day of $1,200. As shown by the arrow, these profits increased Anne’s equity by $1,200, from the initial amount of $1,000 to a total of $2,200 by the end of the day. Note that the assets on the left side of the balance sheet represent any investments Anne has made. In this example, Kwik Koffee’s current assets, accounts receivable, and inventory directly relate to the operations of the business. In the future, if Anne decides to buy a car or equipment to store materials, then she will be investing in fixed assets. Any such investment decisions should be made on the basis of the return Anne anticipates receiving. For example, Anne might decide to purchase a car if she expects that doing so will enable her to cover a larger territory in a faster time, thus resulting in greater sales. In comparison, the liabilities and equity listed on the right side of the balance sheet represent Anne’s financing. However, part of the financing, through accounts payable, was directly related to the operations of her business. Most financing decisions relate to the desired mix of long-term debt and equity (which will be examined in Chapter 11). If Anne does decide to make some major fixed asset purchases, she may need to approach a bank and get the bank to act as a lender. In that case, Anne would incur a long-term debt obligation, rather than a short-term obligation to her supplier. Last but not least, Kwik Koffee’s income statement, which appears in the middle of Figure 5.5, represents the results of the operating activities of the business. Note that the income statement is connected to both the left and right sides of the balance sheet. In Chapter 3, we introduced the statement of change in financial position—also known as the sources and uses statement. This statement identifies where a firm gets its

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sources of cash Increase in accounts payable

$500

Increase in retained earningss

1,200

115

Fig 5.6 Kwik Koffee Statement of Change in Financial Position

$1,700 Uses of Cash Increase in accounts receivable

$2,000

Increase in inventory

300

$2,300 Increase (decrease) in cash

($600)

Beginning cash

1,000

Ending cash

$400

cash and where the cash goes. We create such a statement for Kwik Koffee in Figure 5.6. This statement focuses on balance sheet changes over time and is useful in highlighting the cash impact of each. Unlike the cash flow statement described in Chapter 3, this statement groups items together not on the basis of activities, but instead on the basis of their positive or negative impact on cash. Figure 5.6 shows that Anne’s source of cash (or her ability to invest) came from the credit terms offered by her supplier, as well as the profitability of the business (as indicated by Kwik Koffee’s retained earnings). It also shows that Anne’s uses of cash came from both the credit terms she offered to her customers and her purchase of inventory. Because Anne’s uses of cash exceeded her sources by $600, her cash balance decreased from $1,000 to $400. In general, when considering statements of change in financial position, we find that a firm’s potential sources of cash are mirror images of its potential uses of cash. A variety of potential sources and uses are summarized in Figure 5.7.

Sources of Cash Decreases in current assets, such as accounts receivables and inventory

Fig 5.7 Potential Sources and Uses of Cash

Increases in current liabilities, such as accounts payable (slower payments) Decreases in fixed assets and other investments (sell-offs) Increases in long-term debt (taking out loans or issuing bonds) Increases in retained earnings (profits) Increases in equity (issuing common shares) Uses of Cash Increases in current assets, such as accounts receivables and inventory Decreases in current liabilities, such as accounts payable (faster payments) Increases in fixed assets and other investments (new purchases and acquisitions) Decreases in long-term debt (principal repayment) Decreases in retained earnings (losses) Decreases in new equity (share repurchases)

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5.2 Working Capital Management Objective 5.2

Explain how to manage inventory, accounts receivable, and accounts payable.

Cash flows related to a firm’s operating activities primarily affect the firm’s current assets and current liabilities. Specifically, the two key current asset items affected by these cash flows are inventory and accounts receivable, whereas the key current liabilities item is accounts payable. Management of these three items (inventory, accounts receivable, and accounts payable) is collectively known as working capital management. Before we analyze the relationship among these three areas, let’s get some background information about the benefits and costs of each.

5.2.1 Managing Inventory

working capital management: The process of managing shortterm decisions pertaining to current assets and current liabilities

Inventory management is usually extensively covered in books devoted to operations management, not financial management. Nonetheless, it’s important that financial managers have a basic understanding of this topic because they are the ones responsible for arranging the financing necessary to acquire a firm’s inventory. Inventory affects a firm’s sales and hence its profitability. If the firm doesn’t have enough inventory, this is an opportunity cost. In turn, profitability affects the overall value of the firm, because investors are willing to pay more for a company that turns a healthy profit. Inventory is an especially important consideration for any firm that faces seasonal fluctuations in demand. For example, many retail stores experience a surge in holiday-related demand in late November through December and thus need to build up their inventory in October and early November in anticipation of increased sales.

In-Depth

Inventory Management Systems

Large retailers may stock thousands of items from around the world, worth billions of dollars. For example, Walmart has over one million products available and carries, on average, over $40 billion in inventory with suppliers from over 70 countries. Given the magnitude of the investments and the logistics involved, it is crucial for firms to have efficient and effective inventory management systems. The goal is to balance customer needs—to have enough of what they want—with a firm’s financial needs to maintain as little stock as possible. Inventory management systems must be able to track sales and available inventory, communicate with suppliers, and communicate with merchants when it is time to reorder products. Recent technology innovations include radio frequency identification to transmit product information. One type of system, vendor-management systems, puts the onus on vendors or sellers for keeping its products stocked by working closely with the retailer. Many inventory management systems strive to have a bare minimum of stock in store, given the cost tied up in inventory—for example, just-in-time systems. Over a century ago a framework was developed to determine the economic order quantity, or EOQ, that minimized inventory holding costs and ordering costs. The process accounts for the purchase price, order quantity, demand, order costs, as well as storage costs. In general, managers must examine the costs and benefits of any inventory management system. Source: This discussion is based on “How Inventory Management Systems Work,” by Tim Crosby, July 23, 2007, HowStuffWorks.com. http://money.howstuffworks.com/how-inventory-management-systems-work .htm (accessed January 16, 2013). For the original discussion of EOQ, see “How Many Parts to Make at Once,” by Ford W. Harris, 1990 (reprint from 1913), Operations Research (INFORMS) 38, pp. 947–950.

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Maintaining inventory therefore has several potential benefits—but it also clearly has a cost. For one, a firm must spend money to order and acquire inventory. Firms also have money tied up in inventory needlessly at times and are paying for insurance and storage. In addition, companies risk losing inventory due to obsolescence if demand for a particular product changes. Thus, managing inventory involves trading off the benefits of availability with various financial concerns, as we’ll see later in this section.

5.2.2 Managing Accounts Receivable Accounts receivable, or the practice of extending credit to customers, is also known as trade credit. If a firm deals only in cash, then it will have no accounts receivable. Among firms that do offer trade credit, the typical credit terms are such that customers are allowed to repay within 30 days (or sometimes longer), and they are often provided an incentive to pay quickly, sometimes in the form of a 2 percent discount for repayment in 10 days. In this example, the credit terms would be described as “2/10 net 30” (implying that customers will receive a 2 percent discount for payment in 10 days, with full payment due within 30 days). The benefit of providing trade credit is that it allows a firm to remain competitive with other companies in the industry that are doing the same. Thus, offering credit assists a firm in generating sales. The cost of providing trade credit is that the firm is delayed in receiving money from its customers. Also, any discounts offered for prompt repayment present an opportunity cost to the firm, as they may result in lower revenue. To balance these costs and benefits, it’s important for a firm to establish clear policies related to managing its accounts receivable. For example, the company should determine

trade credit: The practice of extending credit to customers, allowing for deferred payment

In-Depth

Aging Schedules and Bad Debt

What is the likelihood that a firm will be able to collect all of its accounts receivable and how can it prepare for incurring bad debts? An aging schedule can keep track of how current a firm’s accounts receivable are. For example, consider a breakdown of the dollar amount owed to a firm by its customers, all of which were offered 30 days to repay: Days Outstanding 1–30

Amount ($)

Percentage (%)

872,000

59.2

31–60

348,000

23.6

61–90

143,000

9.7

91–120

78,000

5.3

120+

32,000

2.2

Total

1,473,000

100.0

We see that 59 percent of the firm’s accounts receivable are current—in other words, not past the due date. Another 24 percent are overdue by a month or less. The remaining 17 percent are overdue by more than a month, including 2 percent that are overdue by more than three months. The firm may need to investigate why these later accounts receivable have been outstanding for such a long period. For example, it may be the case that one of the customers is experiencing financial distress and has entered bankruptcy proceedings and as such there is little likelihood that the firm will be repaid. If that is the case, then the firm can expect to incur a bad debt and may consider writing off the loss as a bad debt expense. Based on past experience, a large firm may expect that some of its accounts receivable will need to be written off and may consider budgeting for an allowance of bad debts each year.

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whether all customers should be offered similar terms, what the collection period should be, and how receivables should be managed if customers are slow at repayment. Note that credit terms depend on the industry as well as the nature of the product or service being offered, which is why we tend to see differences in the age of accounts receivable (as well as accounts payable) across industries and firms.

5.2.3 Managing Accounts Payable Accounts payable are the “flip side” of accounts receivable, since the receivables for a firm that provides goods or services is simply the payables for the firm that acquired those goods or services. As in the case of receivables, suppliers will often offer customers terms such as “2/10 net 30,” meaning that a 2 percent discount is provided if payment is received in 10 days, with the full payment due within 30 days. Depending on the relationship between a firm and its suppliers, the firm may even be able to stretch payments beyond the stated terms (such as 30 days). In other words, a supplier may be willing to turn a blind eye to a firm that is a bit tardy in repayment as long as it is able to retain the firm as a customer. This is particularly true in competitive supply industries. The major benefit to a firm that relies on accounts payable as a source of short-term funding is that it can defer payment on goods and services it has received. A potential cost is that the firm might be foregoing discounts for early repayment.

5.2.4 Application: Home Depot To better understand how working capital management affects a firm’s cash flow and the power of some simple working capital management tools, let’s consider two examples: First we will set the stage by considering a hypothetical firm; then we will compare Home Depot with its main competitor, Lowe’s, to see if we can identify an actual billion-dollar opportunity. In-Depth

The Cost of Foregoing Discounts on Payables

Let’s suppose your supplier offers you 2/10 net 30 payment terms. You make a $1,000 purchase of supplies and you have taken delivery of those supplies. You currently have a line of credit at a 7 percent interest rate. You don’t have cash on hand to pay the supplier in 10 days in order to get the 2 percent discount. What is the opportunity cost of foregoing the discount? Let’s look at the situation in a different light by thinking of it like a “loan”: You are effectively “borrowing” $980 from your supplier that you can repay without “interest” in 10 days. If you don’t want to repay it within 10 days, then you have an additional 20 days on which to pay $20 in “interest.” In other words, you owe your supplier $1,000 in 30 days, as per the terms for accounts payables. We can work out the implied annualized “interest rate” on the “loan” as follows: a

365 days $20 b * a b = 0.37 or 37% 20 days $980

The $20 is the “interest,” the $980 is the value of the “loan,” and 20 days is the length of the “loan,” and so we are taking the interest divided by the loan value and annualizing it. The resulting opportunity cost is quite high at 37 percent. In other words, if we don’t take advantage of the purchase discount, we are foregoing a 37 percent “return.” If there is an available line of credit at 7 percent, it would make sense to borrow in order to get the purchase discount.

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5.2.4.1  Orange Computers and Little Orange Computers  Let’s start by considering a firm named Orange Computers Inc. (OCI). The company manufactures personal computers—and in order to build the computers, it must purchase a variety of materials, including processing chips and hardware parts. Orange Computers orders and takes delivery of these materials and agrees to certain credit terms, such as repayment within 30 days. The materials then become part of OCI’s inventory and are assembled over the next few weeks. After assembly, the finished goods may remain in OCI’s warehouse for several more weeks or months until they are sold to retail stores. Orange ­Computers offers these stores credit terms, such as payment within 30 days. Suppose OCI is quite large and has the opportunity to choose among a number of different suppliers. The company chooses its suppliers based on several factors, including available credit terms. Although the suppliers’ stated terms call for repayment within 30 days, in practice, OCI averages 45 days to repay. In the area of production, OCI has an efficient operations process and inventory management system and attempts to assemble its computers in only a few days. The company also minimizes its finished goods inventory through what is commonly known as a just-in-time inventory system, whereby inventory levels are kept as low as possible. Therefore, on average, the firm’s inventory is only carried for 15 days. Finally, given OCI’s importance in the industry and the high demand for its product, the company’s customers (retail stores) attempt to maintain good relations with OCI by paying for any computers they purchase within the agreed-on 30 days. Using this information, we can approximate OCI’s cash flow cycle by focusing on three key ratios described in Chapter 3: age of inventory, age of receivables, and age of accounts payable. Age of inventory, 15 days in this example, indicates the time between the receipt of materials and OCI’s sale of finished goods built from those materials. Age of receivables, 30 days in this example, indicates the time between OCI’s credit sales to its customers and its receipt of cash from those customers. This is also known as the collection period. Together, OCI’s age of inventory and age of receiv­ ables mean that a total of 45 days elapse between the firm’s receipt of materials and its receipt of cash from the sales of finished goods built from those materials. This time period represents the cash outflow (or use of cash) part of the cycle. Finally, age of accounts payable refers to how much time it takes OCI to pay its suppliers after placing an order for materials—45 days in this case. This period represents the inflow (or source of cash) portion of OCI’s cash cycle. In this example, which is also illustrated in Figure 5.8, the cash inflows and outflows from OCI’s operating activities just happen to be in balance. This finding suggests that OCI is generally able to manage its day-to-day operations efficiently by matching its Materials ordered

Inventory sold

Age of Inventory = 15 days

Payment from customers

Fig 5.8 Operating Cash Flow Cycle for Orange Computers Inc.

Age of Accounts Receivable = 30 days Payment to suppliers

Age of Accounts Payable = 45 days

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Fig 5.9 Operating Cash Flow Cycle for LOCI

Inventory sold

Materials ordered

Age of Inventory = 45 days

Payment from customers

Age of Accounts Receivable = 40 days

Payment to suppliers

Age of Accounts Payable = 30 days

Gap = 55 days

primary current liability of accounts payable with its primary current assets of inventory and accounts receivable. Now, let’s consider a different firm in the same industry, Little Orange Computers Inc. (LOCI). Suppose LOCI is much smaller than OCI and does not have the opportunity to choose among a number of suppliers. Given these factors, LOCI purchases materials from its only available supplier, and it must stay strictly within the supplier’s 30-day repayment terms or risk losing the supplier. In addition, LOCI has a less efficient operations process than OCI and a primitive inventory management system. On average, the firm carries its inventory for 45 days. Finally, given LOCI’s relatively small size in the industry and lack of reputation, its customers (retail stores) can stretch their payment period to 40 days instead of the stipulated 30 days. Thus, in the “sources of cash” part of its cash cycle, once materials have been ordered, LOCI takes approximately 30 days to repay its suppliers, as measured by the age of accounts payable. However, the firm’s cash outflows require a much longer period, estimated as the sum of the age of inventory (45 days) and the age of receivables (40 days), for a total outflow cycle of 85 days. Little Orange Computers’ operating cash flow cycle is illustrated in Figure 5.9. Note that in Figure 5.9, there is a 55-day gap (on average) between the time that payment to suppliers is required and the time that payment from customers is received, which we refer to as the working capital gap. Little Orange Computers must be able to bridge this gap by borrowing funds in order to pay suppliers before payment is received from customers, perhaps through a bank line of credit or a revolving short-term loan. As LOCI’s revenues grow, the financial implications of funding the gap are even greater, as more money must be invested in working capital. In addition, this analysis does not consider other implications of revenue growth, such as the need for additional capital expenditures on plant and equipment.

5.2.4.2  Home Depot  Let’s return to our comparison of Home Depot and Lowe’s working capital gap: The difference (measured in days) between the time payment to suppliers is required and payment from customers is received line of credit: An agreement between a lender and a firm in which the firm can borrow up to a maximum amount at any time during a specified period

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in order to investigate the working capital gap of actual firms and identify a simple ­billion-dollar opportunity. Based on the 2012 management resource (or working capital) ratios presented in “Measuring Financial Performance,” we can find the age of inventory, age of accounts receivable, and age of accounts payable for each company, as presented in Figure 5.10. As shown in the figure, Home Depot has a working capital gap of 49.7 days (age of inventory of 81.7 days plus age of receivables of 6.5 days, less age of payables of 38.4 days). In contrast, Lowe’s has a slightly shorter working capital gap of 44.5 days (age of inventory of 92.8 days plus age of receivables of 0 days, less age of payables of 48.3 days).

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Home Depot

Lowe’s

Age of InvenTory Inventory (Inv)

$10,325m

Cost of sales (CoS) Inventory days = Inv/(CoS/365)

121

Fig 5.10 Home Depot and Lowe’s Working Capital Gap

$8,355m

$46,133m

$32,858m

= 81.7 days

= 92.8 days

$1,245m

$0m

Age of Receivables Accounts receivable (AR) Sales

$70,395m $50,208m

AR days = AR/(Sales/365)

= 6.5 days

= 0 days

$4,856m

$4,352m

Age of Payables Accounts payable (AP) Purchases (assume COS)

$46,133m

$32,858m

AP days = AP/(CoS/365)

= 38.4 days

= 48.3 days

81.7 + 6.5 − 38.4

92.8 + 0 − 48.3

= 49.7 days

= 44.5 days

Working capITal GAP Days of inv + AR − AP

The implications of having a larger gap and hence having more money tied up in working capital can be huge. On the surface, the management of operating cash flows appears to be quite straightforward. If a firm is facing a gap, there are three obvious ways to reduce or eliminate this gap and hence reduce the firm’s financing requirements: 1. Decrease the age of inventory, 2. Decrease the age of accounts receivable, or 3. Increase the age of accounts payable. For example, in 2012, Lowe’s age of inventory was 92.8 days, as calculated by dividing the company’s end-of-year inventory of $8,355 million by its average daily cost of sales of $90 million. (Recall that we found the company’s average daily cost of sales by dividing its yearly cost of sales of $32,858 million by 365.) If Lowe’s was able to reduce its age of inventory from 92.8 days to something closer to Home Depot’s average of 81.7 days, then it would have much less money tied up in inventory. We can estimate the resulting amount of inventory as follows: Age of inventory days = ending inventory>(cost of goods sold>365 days) Rearranging the equation to solve for ending inventory gives us: Ending inventory = age of inventory days * (cost of goods sold>365 days) = 81.7 days * ($32,858 million>365 days) = 81.7 * $90.0 million = $7,353 million Here’s the billion-dollar opportunity facing Lowe’s. Based on the new inventory level of $7,353 million, Lowe’s would have freed up $1,002 million ($8,355 million less

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$7,354 million), which could then be deployed elsewhere to earn profits—such as through expansion into additional retail outlets—without the need for additional financing; to reduce existing debt and hence reduce interest expenses; or to pay a special dividend to shareholders. We could go through a similar exercise for reducing accounts receivable or increasing accounts payable. Freeing up cash is the main benefit of reducing inventory amounts, reducing receivables, and extending payables. In-Depth

Working Capital Management Ratios across Industries

A firm’s working capital gap is equal to its age of inventory plus its age of receivables, less its age of payables. The size of this gap clearly depends on each of the three elements: how much inventory a firm has, how fast it collects receivables, and how long it takes to pay suppliers. For each of these elements, we tend to see differences across industries given the different nature of their business. The chart below presents the average working capital gap for a variety of firms in different industries. On this chart, we see a large range in average age of inventory, from 2 days for McDonald’s (which is not a surprise, given that we expect food to be fresh) to over a year for Lennar, a corporation that builds homes. Note also that the average age of receivables is low in industries that tend to have prepayments, such as the airline industry, or that operate primarily on a cash basis, such as the food retail industry. (Remember, even if customers pay retailers using credit cards, the transactions are like cash for the retailers because the credit card companies pay the retailers cash when they receive the credit card receipts.) Finally, among the companies shown on the chart, the average age of accounts payable depends on the terms offered by suppliers and the strength of the relationship between each company and its suppliers. Looking at the chart, we see that the working capital gap for the selected firms ranges from negative nine days for Southwest Airlines (meaning the firm receives payment from many customers far in advance of most flights and takes longer to pay suppliers) to well over a year for Lennar. Southwest’s negative gap effectively allows the firm to grow by using other people’s money. For all of the other firms listed here, their positive gap implies that an investment in working capital is required.

Inventory (days)

Accounts Receivable (days)

Accounts Payable (days)

Gap (days)

Firm

Industry

Southwest Airlines

Airlines

  7

 6

22

 -9

Safeway

Food Retailers

 22

 5

22

  5

McDonald’s

Restaurants

  2

18

14

  6

Best Buy

Specialty Retailers

 40

15

38

 17

Abercrombie & Fitch

Apparel Retailers

 39

11

18

 32

Allergan

Pharmaceuticals

 17

47

16

 48

Starwood Hotels

Hotels

 58

36

10

 84

Hasbro

Toys

 33

86

12

107

Boeing

Aerospace

138

29

43

124

Lennar

Home Construction

493

 4

20

477

Note: Fiscal years ending in 2010 Source: Bureau van Dijk OSIRIS Industrials—Financials database.

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Of course, there are also potential costs to reducing inventory amounts, reducing receivables, and extending payables. To remain competitive, a retailer may need to maintain a large inventory of goods so that customers have a greater selection from which to choose. In terms of receivables, liberal credit terms may have a positive impact on sales, particularly during weak economic conditions or during times of higher interest rates. In terms of payables, depending on the power of its suppliers, a firm may not be able to stretch payments beyond stated terms and may need to be prompt in paying its suppliers. Also related to payables, suppliers often offer discounts for quick repayment—for example, a 2 percent discount for payment within 10 days instead of the regular 30-day terms—that may make it attractive to the firm to pay sooner rather than stretch payments. Thus, our discussion of working capital management (i.e., inventory, receivables, and payables) relates back to our examination of the business size-up process discussed in “Sizing up a Business: A Nonfinancial Perspective,” whereby we highlighted the importance of understanding the economy and the industry before determining the viability of alternative strategies. Nonetheless, we see the power of managing working capital for many firms rather than just focusing on fixed asset investments.

5.3 Short-Term Financing One important principle that financial managers try to follow is to match sources of funds with uses of funds. For example, if a firm is buying a long-lived asset, such as equipment that is expected to last for 20 years, then that asset should be financed with a longterm loan. That way, the firm can match the cash inflows derived from the asset with the cash outflows to service financing the asset. Similarly, if a firm has short-term needs, such as needs related to seasonality in sales, then short-term financing is appropriate. So far in this chapter, we’ve examined working capital needs that arise as part of a firm’s operating cycle, through inventory and receivables less payables. In particular, we’ve measured any gap among these three items at a particular time. (For example, on Home Depot’s year-end financial statement issued on January 31, 2012, the company’s working capital gap was 49.7 days.) However, if we’d measured this gap at a different time in the year, it might have been much larger. For instance, we’d expect to see a much greater gap during a period when Home Depot was temporarily building up its inventory. Therefore, we need to distinguish between permanent working capital needs, assuming the gap remains the same from year to year, and temporary working capital needs, or needs that vary over the course of a year. Temporary needs should be met through shortterm financing, whereas permanent needs should be met through long-term financing such as a long-term loan or an equity issue. There are a variety of sources of short-term financing—including bank loans, commercial paper, and banker’s a­ cceptance—each of which is examined in greater detail in the remainder of this section.

5.3.1 Bank Loans The most common source of short-term financing, especially for small and mediumsized firms, is bank loans obtained through commercial banks. Often, these loans take the form of promissory notes, which are simple promises or IOUs by a firm to repay the bank a certain amount of money by a specified date at a specified interest rate. Interest rates may be fixed or variable. Fixed rates are specified as part of the terms of the loan and don’t change during the term of the loan. Variable rates are often tied to specific benchmarks, such as a bank’s prime rate—or the rate offered to its most creditworthy

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Objective 5.3

Describe different forms of short-term financing.

promissory notes: Promises by a firm to repay the lender, such as a bank, a certain amount of money by a specified date at a specified interest rate prime rate: The rate offered by lending institutions, such as banks, to their most creditworthy customers

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customers. For example, a loan might have an interest rate that is set at 1.5 percent above the prime rate. Prime rates can change at any time at a bank’s discretion, and they usually move in the same direction as key central bank rates. Another common benchmark rate, particularly in Europe, is the London Inter-Bank Offered Rate, known simply as LIBOR (pronounced “lie-boar”). This is the rate at which banks can borrow from one another. Beyond promissory notes, an alternative bank funding vehicle is a line of credit (or revolving line) that allows a borrower to tap into an agreed-on maximum loan amount on an as-needed basis. The advantage from the borrower’s perspective is that interest is only charged on the amount that is actually utilized. A firm’s line of credit is usually renewed annually. Finally, another option is a bridge loan, or an interim loan provided by a bank before long-term funding can be secured. For example, say a firm has made arrangements for an injection of private equity, but it requires cash before the equity deal is complete. In this situation, a bridge loan would be appropriate. Each of these various types of bank loans may be either secured or unsecured. Unlike unsecured loans, secured loans provide lenders with protection, as they are backed by assets of the firm as collateral. The most common form of collateral is shortterm assets such as receivables and inventory. For example, a bank might agree to lend up to 75 percent of the value of a firm’s receivables and 50 percent of its inventory. Although not a bank loan, another form of secured financing is known as factoring of receivables, whereby the firm sells receivables to a lender (known as the factor) at a discount (say 2 percent) to the actual value of the receivables. Customers then repay the money they owe to the firm directly to the lender instead. Inventory may also be used directly to secure a loan. The claim that the lender has against the firm’s inventory is known as a lien.

5.3.2 Commercial Paper LIBOR (London Inter-Bank Offered Rate): The rate at which banks offer to lend in the London inter-bank market; often used as the basis for floating-rate loans bridge loan: Short-term financing often to bridge to a long-term financing arrangement or another source of raising capital secured loans: Loans backed by assets of a firm as collateral factoring: A process by which a firm sells accounts receivable to a lender at a discount lien: The right or claim by a creditor to sell an asset assigned by a debtor who fails to meet contractual obligations commercial paper: Unsecured short-term debt issued by a firm, usually with a repayment term of up to nine months banker’s acceptance (BA): A security issued by a firm as a form of borrowing with a promised repayment accepted or backed by a financial institution

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Commercial paper is short-term debt issued by a firm, usually with a repayment term of up to nine months. This financing mechanism is typically employed by large and socalled blue-chip, or high-quality, firms generally with a credit rating of A and above, since the debt is unsecured, or not backed by collateral. Given their status, such firms are able to issue debt directly to large investors and bypass banks. Often, companies will have a revolving line of credit as a backup to the commercial paper program. To better understand how commercial paper works, let’s look at an example involving Home Depot. Although Home Depot did not have any outstanding commercial paper as of its year end on January 31, 2012, the firm did have a program in place whereby it was ready to issue commercial paper as needed. According to its annual report, during the preceding year, Home Depot had a maximum of just over $800 million of outstanding commercial paper. Since its year-end commercial paper balance was $0, this suggests Home Depot used commercial paper borrowing to meet seasonal needs.

5.3.3 Banker’s Acceptance One final source of short-term financing is most common in international trade, such as when a firm exports goods. In this case, the seller or exporting firm arranges a draft or an IOU and sends it to the buyer’s or importer’s bank. This IOU sets forth a specified payment date—for example, it might state that the importer needs to pay the exporter within 60 days. The importer then indicates to its bank that it has accepted the debt it owes to the exporter—in other words, it indicates that the IOU is legitimate. Often, the importer has prearranged with its bank to accept the draft immediately, whereby the bank guarantees that the exporter will be repaid. Thus, if the importer isn’t able to pay, the bank will send payment instead. (Of course, there is a cost to the importer in order to get the bank to provide this guarantee.) The draft now becomes a banker’s acceptance (BA).

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Case Study

Commercial Paper and the 2007–2009 Financial Crisis

At the start of 2007, commercial paper was the largest U.S. short-term debt instrument with almost $2 trillion outstanding. There are three categories of commercial paper. Financial commercial paper is issued by large financial institutions with strong balance sheets and is unsecured with no pledged assets as collateral. It accounted for 92 percent of the commercial paper market in 2007. Corporate commercial paper is issued by large, creditworthy nonfinancial firms with strong balance sheets and is also unsecured. Among the main issuers were General Electric and Coca-Cola. The third category, asset-backed commercial paper (ABCP), was at the heart of the financial crisis. This type of commercial paper is issued by offshoot or affiliated firms of large financial institutions known as “off-balance-sheet conduits.” The notion of offbalance-­sheet is that the assets and liabilities are not included in the financial institutions’ balance sheets but are nonetheless under the control of the financial institution. Historically, these conduits invested only in short-term and relatively safe assets such as the accounts receivable of the financial institution, but by the early 2000s many were invested more heavily in longer-term assets such as mortgage-backed securities. Consequently, these conduits had a maturity mismatch between the long-maturity assets and the shortmaturity ABCP. The financial institutions were now exposed to rollover risk: the risk that investors would stop refinancing the ABCP. That risk became a reality during the 2007– 2009 financial crisis. A number of events occurred, including a collapse of the subprime mortgage market and the related default of two large hedge funds run by investment bank Bear Stearns. Investors in ABCP became concerned about the quality of the assets and many stopped refinancing maturing commercial paper. This had a ripple effect as the financial institutions needed to find alternative sources of funding. The key observation is that while the commercial paper market has long been viewed as highly liquid and low risk, occasional crises have led to the temporary dryingup of the market. Firms need to be cautious when relying on short-term financing for long-term needs. Source: This discussion is based on “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–3009,” by Marcin Kacperczyk and Philip Schnable, 2010, Journal of Economic Perspectives 24, pp. 29–50.

For the exporter to lose money, both the customer and the bank would need to default on their obligations, so BAs are considered highly reliable. In fact, they are generally viewed as so reliable that a secondary market has developed whereby BAs are bought and sold in the marketplace and are a common investment in money market funds (mutual funds that hold very liquid, very safe short-term investments).

money market funds: A type of mutual fund that hold very liquid, safe, short-term investments

5.4 Relevance for Managers Managing day-to-day financing is crucial for any manager. If a firm has short-term financing issues, it may not survive in the long term. It is critical to know where the cash is coming from and where it is going. When managing cash flow related to operating activities, it is important to recognize the three key levers. All else being equal, reducing inventory levels, reducing

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Objective 5.4

Explain why understanding day-to-day cash flows is relevant for managers.

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accounts receivable, and increasing accounts payable will combine to reduce any working capital gap between cash tied up in inventory and receivables versus cash owed to suppliers. Of course all tactics are not always equal. Inventory levels have implications for sales because if customers can’t find the goods they are looking for, the firm will lose sales opportunities. If your firm’s collection policy is too stringent relative to your competitor firms, your customers may migrate to your competition. Your ability to stretch payments with suppliers depends on your relationship with those suppliers and the relative strength you have dealing with them. In addition, there may be a high opportunity cost to stretch payments while foregoing purchase discounts. Investors are looking for a strong return on the amount of capital invested and hence such measures as return on invested capital (ROIC) provide important benchmarks to measure the strength of performance. It is important for managers to assess how much money is invested in capital, recognizing that, depending on the nature of the business, a large proportion may be in net working capital (compared with investments in fixed assets). By more effectively managing working capital—for example, by better managing inventory—a firm may be able to reduce the amount of money tied up in working capital and hence redeploy the money elsewhere, or return it to investors.

Summary

1. The statement of change in financial position reconciles all of a firm’s cash inflows versus outflows, highlights the firm’s sources, and uses of cash during the year. 2. Decreases in assets and increases in liabilities and equity represent sources of cash, whereas increases in assets and decreases in liabilities and equities represent uses of cash. 3. The operating cash flow cycle compares the combined age of inventory and receivables with the age of payables in order to identify a funding gap.

4. The funding gap can be reduced by a combination decreasing inventory (or faster inventory turnover), decreasing receivables (or collecting faster from customers), and increasing payables (or paying suppliers slower). 5. Some of the short-term financing alternatives available to a firm include promissory notes, lines of credit, bridge loans, commercial paper, and banker’s acceptances.

Additional Readings and Information

An in-depth discussion of accounting issues can be found in: Anthony, Robert, and Leslie Breitner. Essentials of Accounting, 11th ed. Boston: Prentice-Hall, 2012. A solid examination of working capital management can be found in: Sagner, James. Essentials of Working Capital Management. New York: Wiley, 2010.

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Problems

Consider the financial statements for Ace Inc. for questions 1 to 8: Ace Inc. Income Statements ($000s) Year 1

Year 2

$

$

Sales

500,000

580,000

Cost of goods sold

330,000

346,000

Gross margin

170,000

234,000

Selling & admin expenses

136,000

152,000

26,000

28,000

Operating income

8,000

54,000

Interest expense

1,800

1,600

Profit before tax

6,200

52,400

Income tax (at 35%)

2,170

18,340

Net income

4,030

34,060

Common dividend paid

2,000

2,000

 

Depreciation

1. Identify the sources of cash and its uses for each year. Create a statement for the sources and their uses. 2. Estimate the age of inventory for each year. 3. Estimate the age of accounts receivable for each year. 4. Estimate the age of accounts payable for each year. 5. Estimate the working capital gap for each year. 6. Suppose year 2’s days of inventory were reduced to 25. How much cash would be freed up? 7. Suppose year 2’s days of accounts receivable were reduced to 30. How much cash would be freed up? 8. Suppose year 2’s days of accounts payable were increased to 45. How much cash would be freed up? 9. Define working capital management, and identify the importance of maintaining a sustainable working capital for an organization. 10. From a lender’s (or an investor’s) perspective, which is safer and why: commercial paper or banker’s acceptances?

Ace Inc. Balance Sheets at 31 December ($000s)  

Year 1 $

Cash

Year 2 $

4,800

5,600

Accounts receivable

60,000

64,000

Inventories

36,000

40,000

Total current assets Net property and equipment Total assets

100,800 109,600 40,000

48,000

140,800 157,600

Notes payable: Bank

40,370

25,110

Accounts payable

28,000

32,000

Total current liabilities

68,370

57,110

Long-term debt

44,000

40,000

Common equity

28,430

60,490

Total liabilities and equity

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140,800 157,600

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Part 2    Assessing Future Financial Needs

6

Projecting Financial Requirements and Managing Growth

Learning Objectives Obj 6.1

Explain how to generate pro forma income statements. Obj 6.2

Explain how to generate pro forma balance sheets. Obj 6.3

Explain how to generate pro forma cash budgets. Obj 6.4

Explain how to perform sensitivity analysis on pro forma statements. Obj 6.5

Describe the concept of sustainable growth and explain why it is important. Obj 6.6

Explain why projecting financial requirements and managing growth is relevant for managers.

Chapters 2 through 5 of this book focused on assessing a firm’s current busi­ ness from both a financial and a nonfinancial perspective. Now, in Chapter 6, we’ll turn our attention toward a firm’s financial future, concentrating on three critical questions: How profitable do we expect the firm to be next year and beyond? What is the anticipated amount of financing required for the firm? What is the right amount of sales growth, and what are the implications if the firm’s sales increase too quickly or too slowly? A firm’s senior managers must understand how profitable the company is anticipated to be, what funding it might need in the future, and how fast it should grow in order to make appropriate financing arrangements. It’s often said that the best time to get a bank loan is when you don’t need one. This quip highlights the importance of planning ahead and arranging for financing before a firm is in dire need of funds. Remember, banks and other lenders like to ensure that a firm has a good plan in place before they agree to lend. Pro forma financial statements, which are simply predicted financial statements by pro­ jecting how much a firm will generate in profits and how much financing the firm will require, are a crucial part of that plan. A simple way to think about the anticipated external funding required next year is to estimate how much the firm will have in assets, how much it will owe (excluding external financing), and how much it will have in equity, as the following equation indicates: External funding required = assets - liabilities - equity

pro forma financial statements: The presentation of financial statements, such as income statements and balance sheets, typically used as forecasts, on an “as if” basis

By estimating a pro forma income statement including profitability and hence any increase in retained earnings, we can estimate projected equity. We can project assets and liabilities through a pro forma balance sheet. External fund­ ing required, for example, through a bank loan becomes our “plug,” or final line item, inserted in the balance sheet to make the balance sheet balance. We begin our discussions by showing how to create pro forma income statements and balance sheets. We then examine pro forma cash budgets. Such budgets are an alternative method of identifying a firm’s projected financial requirements, particularly if the business has seasonal requirements. The

128

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129

Fig 6.1 Financial Management Framework: Focus on Financing and Growth

financing Financial Leverage

• Debt financing

operating

investing

Profit Margin

Asset Turnover

Growing profits, dividends, cash flow

growth Return on equity

importance of sensitivity analysis is examined, since any pro forma statement is simply a best guess of what the future might look like. Next, we present the concept of a sustain­ able growth rate, the maximum rate of growth of sales that a firm can sustain while maintaining its current debt policy (debt-to-equity mix) and dividend policy (payout as a fixed percentage of earnings). If a firm grows at this rate, then the only new equity it requires will be satisfied through retained earnings. We also discuss the implications of growing too fast or too slow relative to the sustainable rate. Chapter 6 is related to the unifying theme of the textbook as depicted in Figure 6.1. As shown in the figure, profitability and financial requirements (such as amount of debt financing) are closely related to the growth of a firm. In this chapter, we examine financ­ ing decisions by projecting the amount of external funding (loans, etc.) a firm will need. We also focus on growth in general and sustainable growth in particular, which is related to return on equity and the proportion of earnings retained in the firm. In turn, a firm’s return on equity depends on its profit margin, asset turnover, and financial leverage.

6.1 Generating Pro Forma Income Statements In order to set the stage in this section, Figure 6.2 presents a summary of the key vari­ ables required to create pro forma income statements, along with common assumptions used to estimate each of the variables. In order to generate a pro forma income statement we will start with an estimate of projected sales, then make assumptions about the firm’s projected income statement

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Objective 6.1

Explain how to generate pro forma income statements.

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Part 2  Assessing Future Financial Needs

Fig 6.2  Summary of Pro Forma Income Statement Key Variables and Common Assumptions

1. Sales (management forecast or growth rate applied) 2. Cost of goods sold or gross profit (percentage of sales) 3. Selling, general, and administrative expense (percentage of sales) 4. Depreciation expense (percentage of fixed assets) 5. Interest expense (interest rate applied to interest-bearing debt) 6. Taxes (tax rate applied to earnings before taxes) 7. Dividends (policy or payout ratio) 8. Changes in retained earnings (pro forma net earnings less dividends)

relationships that are often related to past relationships.1 This approach should make sense for two reasons: First, in almost any firm, the senior management team is able to make an educated guess about future sales—the “top-line” income statement item—either because of past experience or as the culmination of a budgeting process. Many firms even have a five-year plan with targeted revenue growth. Second, past relationships among variables are often the best predictors of the future. For example, a firm’s gross margins tend to be relatively stable percentages of sales unless there is a major disruption in the industry, such as due to increased competition. Work­ ing capital measures such as days of inventory also tend to be similar from year to year. Of course, there is no secret formula for pro forma analysis such that we always take last year’s ratios or an average of the ratios for the last three years. Rather, pro forma analysis is as much an art as a science, and it depends on our nonfinancial size-up (as described in Chapter 2). It’s also important to note that this section presents one com­ mon approach to creating pro forma financial statements, but there are numerous other variations that can be used as well. The choice of which variation to use depends on the availability of data, the importance of the particular assumptions associated with each variation, and the potential use of the resulting financial statements. In this section and the next, we’ll consider the example of a growing firm that is trying to answer two questions: “How profitable is the company anticipated to be next year?” and “How much of an increase in bank loans might the company require?” Our example firm, Wood-4-All Inc., is a large distributor that sells lumber to retail home-improvement firms. It has been in business for decades and currently has a banking relationship with Southeast Financial Corp. We’ll begin in this section by developing a pro forma income statement for Wood-4-All, which will answer our first question. That way, we can determine the impact of retained earnings on the balance sheet. After that, in Section 6.2, we’ll create the firm’s pro forma balance sheet, which will answer our second question. In the first stage, rather than making assumptions about any pro forma loan required, we’ll allow the other vari­ ables to determine how large a loan is needed to make the firm’s balance sheet balance.

6.1.1 Establishing Cost of Goods Sold and Gross Profit Our first step in creating Wood-4-All’s pro forma income statement is to establish the company’s anticipated cost of goods sold and gross profit. As in most firms, Wood-4-All’s 1 Note that a number of examples in this chapter are also presented in an Excel workbook called Financial Forecasting Spreadsheet, available through MyFinanceLab. Footnotes throughout this chapter will indicate the specific spreadsheets that are part of the workbook. The first example is the “Pro Formas (1)” spreadsheet.

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senior management team has developed projected sales (or revenues) for the next several years as part of the firm’s regular internal budgeting process. The sales estimates for next year of $300 (all amounts in this example are in millions of dollars) are based on volume changes as well as unit price changes. When creating this forecast, Wood-4-All’s manage­ ment team considered a variety of economic and industry-wide factors, as described in Chapter 2. We can now estimate Wood-4-All’s gross profit in the coming year by calculating the firm’s projected gross margin as a percent of sales, then multiplying our result by the sales dollar value. Implicitly, this assumption also provides us with an estimate of the firm’s cost of goods sold (expressed as a percentage of sales). Based on historical relation­ ships, Wood-4-All has estimated a projected gross margin of 21 percent of sales, which results in a gross profit of $63 (i.e., $300 * 0.21) and hence a cost of goods sold equal to 79 percent of sales, or $237. Cost of goods sold is often presented on a firm’s income statement in greater detail. For example, both beginning and ending inventory are usually presented. “Understanding Finan­ cial Statements” discussed the relationship among cost of goods sold, inventory, and pur­ chases as established in Chapter 3, which relates to a typical wholesale or distribution firm: Cost of goods sold = beginning inventory + purchases - ending inventory Note that for a manufacturing firm, other items such as labor costs, manufacturing over­ head, and depreciation of manufacturing equipment would also be included. With this equation in mind, let’s take a look at Wood-4-All’s beginning inventory, ending inventory, and purchases. The firm’s beginning inventory is readily available from its existing financial statements. In fact, the pro forma beginning inventory for the upcoming year is simply last year’s ending inventory, which was $35. Wood-4-All’s pro forma ending inventory can then be estimated from an assumption of inventory turn­ over or the age of inventory: Age of inventory (days) =

ending inventory average daily costs of sales

Because we now know Wood-4-All’s pro forma annual cost of sales is $237, we can find the pro forma average daily cost of sales as follows: Pro forma average daily cost of sales =

pro forma annual cost of sales $237 = = $0.65 365 365

Also, based on recent statistics, Wood-4-All’s management team has a projected age of inventory of 57.80 days. With these numbers in mind, we can solve for the firm’s pro forma ending inventory by rearranging the equation above: Pro forma ending inventory = pro forma age of inventory * pro forma average daily cost of sales = 57.80 * $0.65 = $37.5 Next, we can estimate Wood-4-All’s purchases during the coming year by rearrang­ ing the equation for finding a firm’s cost of goods sold, as follows: Pro forma purchases = cost of goods sold - beginning inventory + ending inventory = $237 - $35 + $37.5 = $239.5

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6.1.2 Establishing Expenses Now that we’ve established Wood-4-All’s pro forma cost of goods sold and gross margin, we can estimate the firm’s expenses for the upcoming fiscal year: SG&A, depreciation, and interest. Selling, general, and administrative (SG&A) expenses can be estimated as a percent of sales, assuming these expenses are all variable, or they can be estimated sepa­ rately as either fixed or variable. In this case, based on historical relationships, Wood-4All’s management team has estimated that the firm’s SG&A expenses will equal 15 percent of sales, or $45 (i.e., $300 * 0.15). Estimated depreciation expenses (not included in the cost of goods sold section) depend on the firm’s amount of fixed assets and depreciation schedule. Here, Wood-4All has estimated the average useful life of its fixed assets to be five years, which implies a depreciation rate of 20 percent of fixed assets each year (i.e., 1/5 of the assets’ pur­ chase price each year, based on straight-line depreciation). So, because Wood-4-All has $30 in fixed assets, its estimated depreciation expenses are $6 (or $30 * 0.20) in the upcoming year. The most challenging expense to estimate is Wood-4-All’s interest expense. Here, we’re assuming that the firm already has a loan, which means we can expect the com­ pany to continue incurring interest expenses. A firm’s interest expenses are not directly related to sales, but rather to the amount of interest-bearing debt it has, as well as the anticipated interest rate. If a firm currently has a fixed-rate loan, then estimating the loan’s projected interest rate is straightforward. In contrast, if the firm has a variable-rate loan, then an estimate of expected interest rates must be established. However, there is still another challenge in estimating interest expenses, regardless of whether the interest rate on a firm’s loans is fixed or variable. Specifically, in order to determine a firm’s pro forma interest expenses, we must also determine what size loan the firm will need in the coming year. Thus, we’ve stumbled across a chicken-and-egg problem, since we cannot determine the pro forma loan amount until we estimate all other items, including the pro forma change in retained earnings. However, we can’t establish the pro forma change in retained earnings until we establish the pro forma profits, which in turn depend on an estimate of pro forma interest rates. Fortunately, there are a number of potential solutions to this problem. Here, we’ll deal with the dilemma in the simplest possible manner. For our initial estimate, we’ll base Wood-4-All’s interest expenses on our best guess of what the loan amount will be. Management usually has a rough idea, for example, of what increase in the outstanding loan will be required in order to meet sales growth. For our purposes, let’s initially assume the best guess of next year’s loan amount for Wood-4-All is simply the current year’s loan amount of $40. Thus, with an expected interest rate of 10 percent, Wood-4All’s anticipated interest expense in the coming year will be $4 (or $40 * 0.10). Although this approach provides an estimate based on the status quo, it highlights an important point related to pro forma statements in general: It’s not critical to get every number exactly correct. Rather, it’s more important to understand the big picture that emerges from all the statement’s assumptions, because this can help a firm make decisions such as whether to ask for a larger bank loan. An alternative approach to esti­ mating interest expenses, sometimes referred to as the iterative method, is presented in the appendix to this chapter and involves some simple spreadsheet adjustments.

6.1.3 Establishing Earnings After a firm’s expenses have been determined, its pretax earnings are estimated in the usual way (i.e., by subtracting the firm’s expenses from its gross profit). In our

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case, Wood-4-All has a projected gross profit of $63 and operating expenses of $51 (i.e., SG&A expenses of $45 plus depreciation expenses of $6). Thus, we can estimate the firm’s operating profits or EBIT to be $12 (i.e., $63 - $51). We can then subtract the company’s anticipated interest expenses of $4 to arrive at projected pretax earn­ ings of $8. Our next step is to estimate Wood-4-All’s taxes as a percentage of the firm’s pro forma earnings before tax. Rather than using the previous year’s tax rate, we should use a projected rate that reflects any proposed tax law changes. Here, Wood-4-All’s manage­ ment team projects a tax rate of 40 percent, which implies that the firm will pay $3.2 in taxes (i.e., $8 * 0.40). We can now estimate the company’s pro forma net earnings by subtracting its taxes from its pro forma pretax earnings. In our case, doing so reveals projected net earnings of $4.8 (i.e., $8.0 - $3.2). Finally, any projected dividends must be accounted for in order to establish the projected change in retained earnings. Wood-4-All expects to pay a dividend of 40 percent of net earnings, which means its total dividend payment will be $1.9 (i.e., 4.8 * 0.4). Consequently, the firm’s retained earnings are anticipated to increase by $2.9 (i.e., $4.8 - $1.9). These and all of Wood-4-All’s pro forma income statement details are presented in Figure 6.3. The bracketed number directly beside each income statement item represents the order in which the item was estimated, as described in Figure 6.2.

  Assumption Sales [1]

Management estimate

$300.0

Cost of goods sold (CGS) Beginning inventory

Last year’s ending inventory

35.0

+ purchases

CGS + end. inv. − beg. inv.

239.5

Cost of goods available

274.5

− ending inventory

  37.5

57.8 days of costs of sales

Cost of Goods Sold Gross Profit [2]

Fig 6.3 Wood-4-All’s Pro Forma Income Statement (in millions of dollars)

237.0

0.21 fraction of sales

63.0

Selling, general, and administrative [3]

0.15 fraction of sales

45.0

Depreciation [4]

0.20 fraction of beginning fixed assets

6.0

Total Operating Expenses

51.0

Operating expenses

Earnings before interset and taxes (EBIT) 12.0 Interest expenses [5]

0.10 fraction of current loan

4.0

Earnings before taxes (EBT)

8.0

Taxes [6]

0.40 fraction of EBT

3.2

Net Earnings (NE)

4.8

Dividends [7]

0.40 fraction of NE

1.9

Change in Retained Earnings [8]

2.9

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6.2 Generating Pro Forma Balance Sheets Objective 6.2

Explain how to generate pro forma balance sheets.

In order to set the stage in this section, Figure 6.4 presents a summary of the key vari­ ables required to create pro forma balance sheets, along with common assumptions used to estimate each of the variables. A firm’s pro forma balance sheet typically starts with assets, then proceeds to liabili­ ties and equity, with the bank loan (or long-term debt) serving as the balancing amount. As mentioned earlier, the loan or long-term debt is referred to as the balancing amount, or “plug,” because it is the final line item that is estimated or plugged in to ensure that the balance sheet balances.

6.2.1 Establishing Assets When generating a pro forma balance sheet, a firm’s management often makes an initial assumption regarding the minimum cash balance sufficient for the firm to meet its dayto-day requirements. Alternatively, if a firm runs on a revolving line-of-credit basis (whereby money is borrowed from the bank only when needed), then its cash balance may be assumed to be zero. For purposes of our example, Wood-4-All’s managers have estimated the firm’s minimum cash requirements to be $10.7 in the coming year (a slight increase from this year’s ending cash balance, because cash needs tend to increase as sales increase). Once a business’s minimum cash requirement has been determined, its accounts receivable can be estimated from an assumption related to the age of receivables: Age of accounts receivable (days) =

accounts receivable average daily sales

Because we already know that Wood-4-All’s pro forma annual sales are $300, we can calculate the firm’s pro forma average daily sales as follows: Pro forma average daily sales =

pro forma annual sales $300 = = $0.82 365 365

Based on recent statistics, Wood-4-All’s management has projected the age of accounts receivable of 32.61 days. Thus, we can find the firm’s pro forma accounts receivable by rearranging the age of accounts receivable equation, as shown here: Fig 6.4 Summary of Pro Forma Balance Sheet Key Variables and Common Assumptions

1. Cash (minimum balance required) 2. Accounts receivable (collection period) 3. Inventory (inventory period) 4. Fixed assets (management forecast of new assets accounting for depreciation or as a fixed asset turnover ratio) 5. Total assets (sum of current assets and fixed assets) 6. Total liabilities and equity (same as pro forma total assets) 7. Equity (beginning equity plus pro forma change in retained earnings) 8. Total liabilities (pro forma total liabilities and equity, less pro forma equity) 9. Accounts payable (payables period) 10. Long-term debt or external financing (total liabilities less accounts payable; the “plug”)

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Pro forma accounts receivable = pro forma age of receivables * pro forma average daily sales = 32.61 * $0.82 = $26.8 The next item in the assets section of the balance sheet is inventory. In Section 6.1.1, we estimated the pro forma ending inventory as $37.5. Recall that this calculation involved multiplying the pro forma age of inventory (57.8 days) times the pro forma average daily cost of sales ($0.65 per day). Fixed assets are estimated next. If a firm makes no new purchases of fixed assets, then its ending net fixed assets will equal its beginning net fixed assets less any projected yearly depreciation (alternatively, fixed assets could be estimated based on a particular fixed asset turnover ratio). In our case, however, Wood-4-All plans to purchase new fixed assets worth $8.2 late in the coming year—so we must account for this increase in fixed assets. (If the fixed assets were purchased early in the year we would also need to adjust for depreciation.) Given the firm’s current fixed assets of $30 and anticipated depreciation of $6 as indicated on the pro forma income statement in Figure 6.3, we find that Wood-4-All is anticipating ending fixed assets of $32.2 1i.e., $30 - $6 + $8.22 in the coming year. Next, all of a firm’s current and fixed assets can be added to determine its projected total assets. Here, Wood-4-All is projecting total assets of $107.2, based on its anticipated cash of $10.7, anticipated accounts receivable of $26.8, anticipated inventory of $37.5, and anticipated fixed assets of $32.2. We can then use this total assets number from the left side of the balance sheet as the final number on the right side of the balance sheet: total liabilities and equity. In this manner, we ensure that the pro forma balance sheet for Wood-4-All will actually balance!

6.2.2 Establishing Liabilities and Equity Let’s now move up the right side (or lower part) of the balance sheet to the equity item. Recall that a firm’s ending equity equals its beginning equity plus any change in retained earnings. Thus, the change in retained earnings—which we can estimate after we’ve completed the pro forma income statement—is the crucial connection between the pro forma balance sheet and the pro forma income statement. This amount is reflected directly on the pro forma bal­ ance sheet in the equity section. In our example, Wood-4-All’s ending equity for the previous year is equal to its beginning equity for the subsequent year: $40. So, to find the firm’s pro­ jected equity, we simply add the firm’s pro forma change in retained earnings based on pro­ jected profitability and dividend payments, which is $2.9. Consequently, Wood-4-All’s total projected equity is $42.9 (i.e., $40 + $2.9). Furthermore, by subtracting this pro forma equity amount from the firm’s pro forma total liabilities and equity amount of $107.2, we are left with Wood-4-All’s pro forma total liability amount of $64.4 1i.e., $107.2 - $42.92.2 Now that we’ve determined Wood-4-All’s total equity and liabilities, we can proceed to its current liabilities. The firm’s main current liability is the accounts payable item. As with inventory and accounts receivable, accounts payable can be estimated from an assumption related to the age of payables. (Note that the asterisk indicates that we may use the average daily cost of sales if purchases are not available.) Age of accounts payable (days) =

accounts payable average daily purchases*

2

Some of the calculations may appear to be slightly off due to rounding, but you will see more precise calculations in the spreadsheets in MyFinanceLab.

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Because we know that Wood-4-All’s pro forma annual purchases are $239.5 (esti­ mated as part of the cost of goods sold component on the income statement), we can find its pro forma average daily purchases as follows: Pro forma average daily purchases =

pro forma annual purchases $239.5 = = $0.66 365 365

Again, based on recent statistics, Wood-4-All’s management has projected age of accounts payable of 33.02 days. Thus, we can rearrange the age of accounts payable equa­ tion to solve for the firm’s pro forma accounts payable, as shown here: Pro forma accounts payable = pro forma age of accounts payable * pro forma average daily purchases = 33.02 * $0.66 = $21.7 To complete the firm’s pro forma balance sheet, the final item we need to determine is Wood-4-All’s projected bank loan balance or amount of long-term debt. (Recall that we previously referred to this item as the “plug,” or balancing amount.) Because we know that Wood-4-All’s pro forma total liabilities are $64.4, we can subtract the company’s pro forma current liabilities of $21.7 from this amount to arrive at a pro forma bank loan or long-term debt amount of $42.7 1i.e., $64.4 - $21.72 . When making projections like these, be aware that it’s possible for a firm’s total liabilities to be less than its current lia­ bilities. When this occurs, the negative loan balance implies that no loan is required. In fact, the negative balance can be interpreted as excess cash. All of our pro forma balance sheet details are presented in Figure 6.5.3 The brack­ eted number directly beside each balance sheet item represents the order in which the item was estimated, as described in Figure 6.4. Fig 6.5 Wood-4-All’s Pro Forma Balance Sheet (in millions of dollars)

    Year 0 Year 1 Pro Assumption Forma Assets Cash [1]

Assumed minimum

Accounts receivable [2]

32.6 days of accounts receivable

$10.0

$10.7

25.0

26.8

Inventory [3]

57.8 days of costs of sales

35.0

37.5

Fixed assets [4]

8.2 new assets (before depreciation)

30.0

32.2

100.0

107.2

20.0

21.7 42.7

Total Assets [5] Liabilities Accounts payable [9] Long-term debt [10] Total Liabilities [8] Equity [7] Total Liabilities and Equity [6]

3

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33.0 days of payables Balancing amount

40.0

Total liability and equity − equity

60.0 64.4

Beginning equity + change in retained earnings

40.0

42.9

100.0

107.2

Same as total assets

See the “pro forma (1)” spreadsheet.

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137

A few final observations are in order. We have used the long-term debt as our plug, which is appropriate if the firm has existing long-term debt. If instead Wood-4-All had a short-term bank loan, then we could use that item as our balancing plug. Alternatively, we could use cash as our plug. In this example, the cash plug would be negative $32.0, or $10.7 minus $42.7. We would simply interpret the negative cash balance as the need for some kind of debt financing—in this case $32.0 in financing plus any required cash bal­ ance, such as our assumed minimum of $10.7. Recall from section 6.1.2 that for the sake of simplicity when we were estimating our pro forma income statement, we assumed an interest expense based on the current longterm debt. Now that we anticipate a slightly higher long-term debt amount of $42.7 instead of $40.0, we can revisit our pro forma income statement and use a more precise estimate of our interest expense. A simpler iterative spreadsheet approach is presented in the appendix to this chapter.

6.3 Generating Pro Forma Cash Budgets An alternative (and equivalent) method of projecting a firm’s future financial needs (such as bank loans or long-term financing) involves creation of a pro forma cash budget. A cash budget is a more direct cash flow forecast because it’s based on the assumption that a firm is often currently borrowing money and will need to increase or decrease its loan amount in the coming year. A cash budget forecasts the timing and amount of cash inflows and outflows, and it is often created based on monthly cash flows. This type of budget is particularly useful for firms that face seasonal financing needs. Thus, a cash budget is often more valuable as a short-term rather than a longterm financial forecasting vehicle. In the remainder of this section, we’ll explore the process of generating a pro forma cash budget. In doing so, we’ll use forecasted cash inflows and outflows that are meant to be consistent with the Wood-4-All example assumptions and pro forma financial statements.

Objective 6.3

Explain how to generate pro forma cash budgets.

6.3.1 Establishing Cash Inflows The first step in creating a pro forma cash budget is to forecast the amount and timing of any cash inflows. The primary source of such inflows is the firm’s anticipated sales. If a firm’s sales are on a cash-only basis, then the sales forecast and the cash inflow forecast will be identical. However, if a firm’s sales are on credit, then its cash flows will depend on the credit terms. For example, if the terms require payment within 30 days, then any sales made in a particular month should translate to cash inflows in the following month.

6.3.2 Establishing Cash Outflows The next step in the cash budgeting process is to forecast the amount and timing of any cash outflows. Some outflows—such as purchases of supplies or materials—result from the operations of the business. As a preliminary step, these purchases can be forecasted on a monthly basis, then the payment terms can be incorporated to forecast the timing of the outflows. For example, if the purchase terms require payment within 60 days, then any purchases made in a particular month should translate into cash outflows two months later.

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cash budget: A plan or projection of cash inflows and outflows over a specified time period

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Beyond operational expenses, there are a number of other cash outflow categories. Selling, general, and administrative expenses are either fixed (i.e., stable from month to month) or variable (i.e., related to sales in a particular month). Any capital expenditures (e.g., purchases of new equipment) need to be forecast depending on the firm’s need for new capital, and any outstanding loans require an estimate of interest payments (although, as discussed in Section 6.1.2, this can be difficult to forecast because interest may depend on the firm’s ability to secure new financing). Forecasted taxes depend on anticipated sales and profitability and should be estimated using the prevailing corporate tax rate. Finally, any dividend payments must be forecasted, usually on the basis of the firm’s current dividend policy.

6.3.3 Establishing Net Cash Flows Once a firm’s monthly cash inflows and outflows have been estimated, its net monthly cash flow is calculated simply as the difference between the inflows and outflows. Then, the net cash flow for any month is added to (in the case of an outflow) or subtracted from (in the case of an inflow) the beginning loan amount in order to calculate the end­ ing loan amount. (In some cases, the loan amount is estimated in excess of any cash on hand.) This process is continued on a month-by-month basis. An example of a cash budget is presented in Figure 6.6.4 Here, Wood-4-All gener­ ates monthly sales on a credit-only basis, with receivables due within 30 days. For Fig 6.6 Wood-4-All’s Pro Forma Cash Budget (in millions of dollars)

 

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total

Sales (all on credit)

$25.0 25.0 25.0 25.0 23.2 23.2 23.2 23.2 26.8 26.8 26.8 26.8 300.0

Cash Inflows (AR = 30 days)



25.0 25.0 25.0 25.0 25.0 23.2 23.2 23.2 23.2 26.8 26.8 26.8 298.2

Operations Purchases

20.0 20.0 20.0 20.0 18.0 18.0 18.0 19.0 21.5 21.6 21.7 21.7 239.5

Cash outflows Payables (AP = 30 days)



20.0 20.0 20.0 20.0 20.0 18.0 18.0 18.0 19.0 21.5 21.6 21.7 237.8

SG&A

4.0 4.0 4.0 3.5 3.0 3.0 3.0 3.0 4.0 4.5 4.5 4.5 45.0

New equipment

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 8.2 8.2

Interest

0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 4.0

Taxes

0.0 0.0 0.8 0.0 0.0 0.8 0.0 0.0 0.8 0.0 0.0 0.8 3.2

Dividends Total cash outflows

0.0

Net monthly cash flows Beg. of month net loan End of month net loan

0.7

0.5

0.0

0.0

0.5

0.0

0.0

0.5

0.0

0.0

0.5

1.9

0.7

30.0 29.3

–0.6 1.2 1.7 0.6 1.9 1.9 –1.4 0.5 0.4 –9.2

–1.9

28.7 29.3 28.1 26.4

30.0

25.8 23.9 22.1 23.5 23.0 22.9

$29.3 28.7 29.3 28.1 26.4 25.8 23.9 22.1 23.5 23.0 22.7 31.9 31.9

4

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0.0

24.3 24.3 25.6 23.8 23.3 22.6 21.3 21.3 24.6 26.3 26.4 36.0 300.1

See the “Cash budget” spreadsheet.

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simplicity, let’s assume that all the firm’s customers are diligent and pay within the 30-day time frame. Let’s also assume that any supplies the firm purchases must be paid for within 30 days, and the firm always meets this deadline. Thus, the company’s accounts receivable and accounts payable items for the month of January actually reflect sales and purchases that occurred during the previous month. As you look at the budget, notice that the beginning net loan of $30 is consistent with the beginning loan (longterm debt) in excess of the cash balance, as presented on the “Year 0” column of the bal­ ance sheet in Figure 6.5 (i.e., $40 - $10). Note also that the ending net loan of $31.9 is consistent with the ending loan in excess of the cash balance, as presented on the pro forma balance sheet in Figure 6.5 (i.e., $42.7 - $10.7; the minor difference is due to rounding). Thus, the generation of cash budgets and pro forma financial statements are equivalent ways of forecasting financing needs, although each process has a different emphasis.

6.4  Performing Sensitivity Analysis Up to this point in the chapter, we’ve focused primarily on the development of pro forma financial statements, with special emphasis on determining a firm’s required long-term debt financing. After this considerable investment of time, it turns out that the fun is only beginning! We’re now in a position to step back and thoroughly understand the impact of changing relationships among the many variables that make up a firm’s finan­ cial statements. Although the initial development of pro forma statements represents our best guess of the relationships among income statements and balance sheets, each assumption required judgment and was made with a particular degree of confidence. For example, we needed to project revenue, gross margins, expenses, and working capital relation­ ships. Unfortunately, one thing we know for certain about all financial forecasts is that they are almost always wrong! Still, this doesn’t mean our efforts have been for naught. Even if our projected statements are “wrong” down to the last dollar, as long as our best guesses have been reasonably accurate, then the statements will provide a u ­ seful picture of what to expect in the future. They can also assist us in making good business decisions. Say, for example, that a firm has a current bank loan of $250,000 but forecasts the need for a $400,000 loan in the coming year. In this case, the firm can take action now to secure an increase in its bank loan. Later, as the new year progresses, it may turn out that the firm really needed only $350,000. In this case, the financial forecast was not 100 percent accurate, but it nonetheless helped the firm make a good decision by prepar­ ing for an anticipated increase in borrowing needs. Pro forma financial statements allow us to examine how profitable a firm is expected to be, how much debt financing will be required, and how readily might a bank provide such financing through a loan. For example, a bank will focus on a firm’s pro forma debt-to-equity ratio and interest coverage ratio before granting a loan. Besides providing the best guess of a firm’s projected financial position, pro forma statements are powerful tools for addressing critical “what if?” questions. We can address these “what if?” ques­ tions through sensitivity analysis—a process that involves investigating a firm’s pro forma statements and quantifying the effects of changing an assumption on a key vari­ able. Of course many key variables don’t change in isolation and as such we may want to change several variables simultaneously, in a process known as scenario analysis. For

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Objective 6.4

Explain how to perform sensitivity analysis on pro forma statements.

sensitivity analysis: A process that involves investigating a firm’s pro forma statements and quantifying the effects of changing an assumption on a key variable such as net earnings or required financing scenario analysis: A process similar to sensitivity analysis whereby several variables are changed simultaneously

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simplicity, we’ll examine s­ everal key variables separately through sensitivity analysis in order to isolate the effect of each. Through sensitivity analysis, we can better understand the implications a firm faces related to growth, as well as the risks it faces if our “best guess” outcomes fail to materialize. The various “what if?” questions that we address through sensitivity analysis all relate to the key assumptions we made when building our pro forma statements. These questions usually focus on determining what will happen to a firm’s projected loan requirement if one or more key variables change. In particular, sensitivity analysis attempts to quantify how sensitive the projected loan amount—and hence the firm’s debt-to-equity ratio and interest coverage ratio—are to changing assumptions. For example, a large change in one variable may have less of an impact than a small change in a different variable. Let’s take a closer look at some such variables in the following paragraphs.

6.4.1 Sales Sensitivity Often, the most critical assumption made when creating pro forma statements is the projected sales assumption. Recall that many of the items on a pro forma income state­ ment, such as the gross margin and multiple expense items, were estimated as a per­ centage of forecasted sales. However, if the economy unexpectedly slows down, sales may be severely impacted. What will happen if actual sales are 10 percent below our forecast? In this case, even though profits may decline, the loan amount will also change. Alternatively, what will happen if sales are 10 percent above our forecast? Here, if the firm is growing at a rate far in excess of its sustainable rate (as we will examine in section 6.5), then it may require more external financing. To see how this works, let’s return to our Wood-4-All example. What would happen if Wood-4-All’s sales were actually 10 percent greater than forecast (i.e., $330 instead of $300)? To give you a sense of the impact this would have, the first part of the revised pro forma income statement (up to the gross profit) is presented in Figure 6.7. In this situation, the firm’s net earn­ ings would increase from $4.8 to $5.9. Meanwhile, Wood-4-All’s loan requirement would grow from $42.8 to $46.0, an increase of $3.2.5 Therefore, a 10 percent increase in sales results in a 7.7 percent increase in the required loan, while all other assump­ tions remain the same.

Fig 6.7 Wood-4-All’s Pro Forma Income Statement with Increased Sales (in millions of dollars)

  Assumption Sales

Management estimate

Cost of goods sold (CGS) Beginning inventory

Last year’s ending inventory

35.0

+ purchases

CGS + end. inv. − beg. inv.

267.0

Cost of goods available

302.0

− ending inventory

  41.3

57.8 days of costs of sales

Cost of Goods Sold Gross Profit

5

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$330.0

0.21 fraction of sales

260.7 69.3

See the “Sensitivity (1)” spreadsheet.

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141

6.4.2 Interest Rate Sensitivity Another key assumption behind our pro forma statements is the projected interest rate. If a firm has “locked in” a fixed loan rate for a number of years, then this may not be a concern. However, many firms have variable-rate loans tied to the prime rate or some other floating interest rate. Recall that the prime rate is the rate at which a bank lends money to its most creditworthy customers. Depending on a firm’s credit rating, a bank might charge prime plus 1/2 percent or prime plus 2 percent (or more). The bank can change the prime rate at any time, depending on overall market conditions and general interest rate levels. So, if there is unexpected increase in inflation, a bank’s prime rate may be much higher than anticipated by a firm’s financial managers. Moreover, if the firm has a high debt ratio, then increases in a loan’s interest rate may have a substantial negative impact on projected profits— and if the firm’s profits decrease to a certain point, then the company might require a larger loan amount.

6.4.3 Working Capital Sensitivity Of course, there is also a key set of balance sheet assumptions related to working capital items: inventory, accounts receivable, and accounts payable. Recall that these three vari­ ables combine to determine a firm’s financing gap, as discussed in Chapter 5. Let’s take a moment to reexamine how each of these three items might affect a firm’s loan requirement: First, a firm’s actual collection period may differ from its anticipated collection period due to a number of factors, including overall economic conditions and the firm’s competitive position. An extended age of accounts receivable (which is a use of cash), all else equal, will lead to an increased loan requirement. Second, a business’s in-stock inventory will depend, in part, on management’s abil­ ity to anticipate customer needs. An extended age of inventory (which is also a use of cash), all else equal, will lead to an increased loan requirement. Third, the age of accounts payable depends on the relationship between a firm and its suppliers, as well as the firm’s competitive position. An extended age of accounts payable (which is a source of cash), all else equal, will lead to a decreased loan requirement. So, returning to the Wood-4-All example, what would happen if the firm’s customers are much slower than expected in paying back credit sales, taking an average of 45 days instead of 32.6 days? Here, the result would be an increase in the ­company’s loan requirement, from $42.7 to $52.9, as indicated in Figure 6.8.6 Similarly, if Wood-4-All’s sales are 10 percent greater than expected but customers still take longer to pay, then the firm’s loan requirement increases to $57.2. (Another version of this sensitivity analysis is described in more detail in the appendix to this chapter.) In all cases, it’s important to tie this sensitivity analysis back to the business size-up process described in “Sizing up a Business: A Nonfinancial Perspective.” In short, the main purpose of understanding the economy, the industry, and the firm itself is to understand what factors lay behind the numbers on a firm’s projected financial state­ ments. Thus, a proper and thorough size-up provides guidance in determining not only 6

See the “Sensitivity (2)” spreadsheet.

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Fig 6.8 Wood-4-All’s Pro Forma Balance Sheet with Increased Accounts Receivable (in millions of dollars)

 

 

 Year 0

Year 1

$10.0

$10.7

Assets Cash

Assumed minimum

Accounts Receivable

45.0

change this amount 25.0 37.0

Inventory

57.8 days of costs of sales

35.0

37.5

Fixed assets

8.2 new assets (before depreciation)

30.0

32.2

$100.0

$117.4

20.0

21.7 52.9

Total Assets Liabilities Accounts payable Long-Term Debt Total Liabilities Equity Total Liabilities and Equity

33.0 days of payables new loan amount

40.0

Total liability and equity − equity

60.0 74.5

Beginning equity + change in retained earnings

40.0

42.9

$100.0

$117.4

Same as total assets

what assumptions to make as part of the pro forma statement development, but also which variables to focus on as part of the sensitivity analysis.

6.5  Understanding Sustainable Growth and Managing Growth Objective 6.5

Describe the concept of sustainable growth and explain why it is important.

sustainable growth rate: The rate of growth in revenue that a firm can sustain without negatively impacting its financial resources such as needing to issue new equity, changing its payout of dividends, or changing its debt policy

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Now that we understand how to estimate a firm’s future financing needs through pro forma statements, we want to relate those anticipated needs to a firm’s revenue growth. A firm’s requirements for funding often depend on what life cycle stage it is in. In particular, firms that are in a growth phase may face funding challenges. We will show that the need for additional financing during the growth phase depends on the firm’s growth in revenues relative to its sustainable growth rate—meaning the maximum rate at which revenues can grow without negatively impacting its financial resources such as a needing to issue new equity, changing its payout of dividends (relative to earnings), or changing its debt policy (i.e., mix of debt relative to equity). Suppose a firm’s revenues are growing rapidly. On the asset side, this generally implies that it will need more inventory, will have more accounts receivable outstanding, and will invest in more fixed assets. Since assets are expanding and we know that balance sheets must balance, this implies that liabilities and equities must increase proportion­ ately. Let’s initially assume that most firms are reluctant to: Issue new equity (since this can negatively impact on the ownership stake of exist­ ing shareholders), Change dividend payouts (since many shareholders are used to a certain dividend stream and expect a firm’s dividend policy to be consistent), or Change debt policy (since lenders may be reluctant to lend more if a firm’s equity base is not increasing proportionately).

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143

Given these assumptions, what are the limits to a firm’s ability to increase revenue? It turns out that it all comes down to a firm’s ability to increase its equity. Since the firm has a given debt policy, it can increase its debt only if its equity increases, and even then only in proportion to the increase in equity. The growth of equity and debt limit the growth in assets (again, since the balance sheet must balance), which in turn limits the growth of sales. So the sustainable growth rate depends on the growth in equity, which in turn depends on the return on equity and the proportion of equity retained in the firm (retention ratio): Sustainable growth rate = return on equity * retention ratio Recall that return on equity (ROE) is calculated by dividing a firm’s after-tax net income available to common shareholders by its amount of beginning common equity. The retention ratio (RR) is the fraction of net income after taxes available to common shareholders that is not paid out in common dividends but is instead reinvested, or retained, in the firm. The retention ratio is the inverse of the dividend payout ratio, which indicates the fraction of after-tax net income available to common shareholders that is paid out as common dividends. For example, if a firm’s ROE is 12 percent and its RR is 0.6, then its sustainable growth rate is 12 percent * 0.6 = 7.2 percent. If the firm’s sales grow at this rate, then no new equity issues, changes in debt-to-equity ratios, or changes in dividend payouts are required. Note that if a firm does not pay common dividends but rather reinvests all of its retained earnings, then its RR is 1.0 and its sustainable growth rate will simply equal its return on equity. We use the DuPont method to break down the ROE measure into three separate components—profit margin, asset turnover, and financial leverage—that are multiplied together in order to understand the key drivers of ROE. Using this method, the equation for ROE can be rewritten as: ROE = profit margin * asset turnover * financial leverage =

revenues assets net income * * revenues assets equity

This, in turn, implies: Sustainable growth = profit margin * asset turnover * financial leverage * retention ratio = PM * AT * FL * RR Let’s see what the sustainable growth equation implies. Sustainable growth depends on a firm’s operating activities (PM), its investing activities (AT), and its financing activi­ ties and policies (FL and RR). The sustainable growth rate is the only rate at which reve­ nue can grow and all of the four variables will remain constant. Given our assumptions, if a firm is reluctant to change its debt policy (FL) or its dividend policy (RR), then if it grows at a rate greater than the sustainable rate it must either improve its profit margin (PM) or generate more revenues relative to its asset base (AT)—otherwise, despite its reluctance to do so, it will need to change FL or RR. Often the strain is on financial lever­ age since many growth firms don’t pay dividends (and hence RR is already at the maxi­ mum amount of 1.0). Of course, it’s extremely unlikely that a firm’s yearly growth will always occur at a rate exactly equal to its sustainable growth rate—inevitably, there will be year-to-year fluctuations in growth rates. However, if the difference between a firm’s actual growth

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retention ratio: The proportion of earnings reinvested in the firm and not paid out as dividends dividend payout ratio: A ratio of the amount of dividends distributed to shareholders relative to the amount of net earnings

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rate in revenue and its sustainable growth rate is wide and not a temporary fluctuation, then the firm will need to take action. For example, suppose a firm’s actual growth rate is higher than its sustainable growth rate. This scenario is common among firms that are in the start-up phase. A firm can try to increase its profit margin, or PM, by increasing prices or decreasing costs and expenses; or it might try to increase its asset turnover, or AT, by becom­ ing more efficient. If we multiply PM by AT, we get return on assets, or ROA. So another way of looking at the situation is that the firm can initially try to improve its ROA. After that, the firm has three possible financially related courses of action. First, it can cut its dividends (assuming it was paying dividends) in order to increase its reten­ tion ratio, or RR. This alternative assumes the firm is facing attractive projects in which to invest and thus by investing in these attractive projects it can provide a better return to its shareholders than they might be able to obtain by investing any cash on their own. Note, however, that even though this alternative appears to meet the requirements of increasing the sustainable rate, a firm’s dividend policy often acts as a signal to equity investors. Thus, firms are often reluctant to reduce dividends, because investors might interpret the cut as a desperate measure to preserve cash. (Dividend policy is discussed in more detail in Chapter 11.) A firm’s second alternative is to issue debt in order to increase its financial lever­ age ratio or FL, hence increasing both its ROE and its sustainable growth rate. A firm will often consider this alternative if it deems it has available debt capacity—meaning it believes that banks are willing to lend more to it. Of course, there are limits to a firm’s ability to borrow or issue additional debt. If a firm is deemed to be too risky, then lenders may be unwilling to lend to it. As a result, this second alternative will not be feasible. Finally, the third alternative is for a firm to issue more equity. In other words, if a firm can’t rely on either internal equity (through retained earnings) or borrowing to finance its growth, then it may have to rely on external equity. However, issuing equity can be difficult depending on prevailing market conditions. (The process of issuing equity is discussed in more detail in Chapter 9.) Naturally, a different situation occurs if a firm’s actual revenue growth is consis­ tently below its sustainable growth rate—and this is unique to the firm rather industrywide. Here, even though the firm will not face the problem of needing additional funds, its investors may be dissatisfied with its low growth prospects. In this case, the firm again faces three alternatives: First, it can do nothing, in which case it will generate excess cash. The problem with this approach is that it signals the underutilization of assets, which often has a nega­ tive effect on a firm’s stock price or may attract potential acquirers. Second, a firm can increase its dividends, thereby decreasing its retention ratio and hence its sustainable growth rate such that this rate is closer to the firm’s actual growth rate. Shareholders, however, may not like this option because individual investors face taxes on dividends. Finally, a firm can use its excess cash to acquire other businesses. This strategy makes sense only if the acquisitions occur at a reasonable price (otherwise, the firm might be destroying value for its shareholders) and if the acquired businesses are a good fit with the firm’s existing business (otherwise, the acquisition would not make sense strategically). So the bottom line is that it is often desirable for firms to take a balanced growth approach and grow revenue in line with the sustainable growth rate.

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Case Study

Home Depot’s Pro Forma Statements and Sustainable Growth

Let’s see what happens if a firm grows faster or slower than the sustainable rate by generating pro forma income statements and pro forma balance sheets for Home Depot under a variety of growth scenarios. Recall we presented Home Depot’s financial statements for 2012 in Chapter 3 and financial ratios in Chapter 4. Let’s first estimate Home Depot’s sustainable growth rate as of that time. Its ROE was 21.70 ­percent. Given its net income of $3,883 million and its dividends of $1,632 million, its increase in retained earnings was $2,251 million, implying a retention ratio of 0.580 (or $2,251>$3,883). So its sustainable rate was 21.7 percent × 0.580, or 12.58 percent. Now let’s start with the pro forma income statement assuming sales growth at the sustainable rate, and other assumptions primarily based on 2012 ratios. The various steps correspond with those in Figure 6.2. We anticipated net earnings of $4,530 million.

Pro Forma Income Statement ($millions) NET SALES [1]

 

Assumption

growth at sustainable rate: 12.58% $79,248

Cost of sales [2] GROSS PROFIT OPERATING EXPENSES:

fraction of sales:

0.655 51,935

 

  27,313

 

   

Selling, general, and administrative [3] Depreciation and amortization [4]

fraction of sales:

0.228 18,044

fraction of beginning fixed assets:

0.063  1,535

TOTAL OPERATING EXPENSES  

  19,578

OPERATING INCOME  (EARNINGS BEFORE   INTEREST AND TAXES or EBIT)  

    7,735

Interest expense [5] EARNINGS BEFORE   INCOME TAXES

fraction of beginning loan:  

Provision for income taxes [6]

fraction of EBT:

Less: dividends [7]

payout ratio:  

$656

  7,079

NET EARNINGS  

Change in retained earnings [8]

0.061

0.360

2,549

  4,530 0.420

1,904

  $2,626

Now let’s generate its pro forma balance sheet. Again we will rely on the sustainable growth rate for some of the assumptions as well as other ratios based on 2012. The various steps correspond with those in Figure 6.4, with a few extras given the additional complexity of Home Depot’s balance sheet (items 3b, 4b, 8b, and 9b). We anticipate required funding of $12,062 million.

(continued)

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Pro Forma Balance Sheet ($millions)   Assumption ASSETS  

  

Current Assets:

  

 

Cash [1]

assumed to grow at sales growth:

12.58% $2,237

Accounts receivable [2]

days same as last year:

6.46

1,402

Inventories [3]

days same as last year:

81.69

11,624

Other current assets [3b] Total Current Assets

assumed to grow at sales growth:

12.58%

 

Property and equipment, at cost:

1,084

  16,346 assumed to grow at sales growth: 12.58% 43,877

Less accumulated depreciation and amortization

last year + this year’s depreciation:

  16,062

Net property and equipment [4] 

  27,815

Goodwill & other assets [4b]

assumed to grow at sales growth:

12.58%

Total Assets [5]    

  $45,906

 

   

LIABILITIES AND STOCKHOLDERS’ EQUITY   Current liabilities:

  days same as last year:

Other current liabilities [9b] Total Current Liabilities

assumed to grow at sales growth:   PLUG: assumed to grow at sales growth:

Total Liabilities [8]   STOCKHOLDERS’ EQUITY [7]

38.42

  $5,467

12.58%

5,055

  10,521

Long-Term Debt, including Current Installments [10] Deferred Income Taxes & Other Long-Term Liabilities [8b]

   

 

Accounts payable [9]

1745

  12,062

12.58%

2,799

  25,382

beg. + change in retained earnings:   20,524

Total Liabilities and Stockholders’ Equity [6]  

  $45,906

Now what happens if Home Depot grows at a rate substantially lower than the sustainable rate—say only 5 percent—or substantially higher—say 20 percent? Without getting into the details, here’s a quick summary:

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Sales growth Sales Net earnings

5.00%

12.58%

20.00%

$73,915 $79,248 $84,474 $4,131

$4,530

$4,921

Long-term debt

9,020

12,062

15,043

Profit margin (PM)

0.056

0.057

0.058

Asset turnover (AT)

1.771

1.726

1.690

Financial leverage (FL)

2.057

2.237

2.409

ROE

147

20.36% 22.07% 23.71%

Not surprisingly, we see that if sales grow slower, then earnings are lower as well, with the reverse true if sales grow faster. We also see that if sales growth is slower than the sustainable rate, then the ROE is lower, which risks disappointing investors. However, if sales growth is faster, then the financial leverage ratio increases, as does the amount of long-term debt. In this example we have assumed a constant retention ratio as well as assumed relationships that result in similar profit margins and asset turnover ratios across the scenarios, so the biggest impact is on financial leverage. A key message is that managers should carefully monitor the impact of growth on financial needs.

6.6 Relevance for Managers In this chapter, we have focused on how pro forma statements provide answers to three critical questions: How profitable do we expect the firm to be? What is the anticipated amount of financing? What is the right amount of sales growth?

Objective 6.6

Explain why projecting financial requirements and managing growth is relevant for managers.

The answers to these questions are critical not only to senior managers, such as the CEO and CFO, but to all managers—including nonfinancial managers. Most managers are involved in the budgeting process in some way, and part of that process involves project­ ing sales and profits for a division or business unit. Understanding the financial pros­ pects of these units helps senior management understand the overall financial picture of the firm as a whole, and it helps determine the extent to which a firm will be required to increase its borrowing or be able to pay back some of its loans. Developing pro forma statements helps managers understand the key drivers of profits as well as financial requirements. Pro forma income statements and balance sheets are probably the most important risk management tools available because manag­ ers can use them to quickly get a sense of what might happen if key targets—such as sales—aren’t met and how rapid growth might impact borrowing. Since pro forma state­ ments are often required by external lenders, it is prudent for managers to pro act and to develop these statements before requesting external funding. Sensitivity analysis and scenario analysis are crucial tool to answer the “what if?” questions that managers need to know.

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Every firm faces challenges related to growth—either too much or too little. Manag­ ers need to understand the impact of growth on the firm and recognize that “growth at all costs” should not be the main objective of a firm. Understanding the concept of sus­ tainable growth and its key drives—profit margins, asset turnover, financial leverage, and the earnings retention ratio—is crucial for every manager, particularly those whose businesses are in a growth phase. Grow too quickly and you risk taking on too much financial leverage; grow too slowly and you risk disappointing investors.

Summary

1. Pro forma income statements are primarily based on forecasted sales and assumed relationships related to sales. 2. Pro forma balance sheets are derived from a firm’s projected change in retained earnings, projected working capital relationships, and projected fixed asset changes. The required bank loan or long-term debt amount is often used as the balancing amount to make the pro forma balance sheet balance. 3. Pro forma (monthly) cash budgets are useful for highlighting seasonal financing needs. 4. The pro forma loan requirement calculated from a firm’s cash budget should be consistent with the loan requirement on the firm’s pro forma balance sheet.

5. Sensitivity analysis highlights the impact of a change in one key variable (such as sales) on another key variable (such as the loan requirement) in a firm’s pro forma financial statements. 6. The sustainable growth rate is the maximum rate of growth of sales that a firm can sustain while main­ taining its current debt policy and dividend policy. 7. Sustainable growth is driven by profit margins, asset turnover, financial leverage, and the earnings retention ratio. 8. If sales grow at a rate exactly equal to a firm’s sustainable growth rate (and the firm’s dividend policy remains stable), then the firm’s pro forma financial ratios should remain constant.

Additional Readings and Information

A useful book describing financial applications using spreadsheets is: Benninga, Simon. Financial Modeling, 3rd ed. Boston: MIT Press, 2008. A good example of sustainable growth can be found in this article: Taggart, Robert. “Spreadsheets Exercises for Linking Financial Statements, Valuation, and Capital Budgeting.” Financial Practice and Education 9, No. 1 (1999): 102–110. A further description of sustainable growth is in: Higgins, Robert. Analysis for Financial Management, 10th ed. New York: McGraw-Hill Irwin, 2012. A variety of free downloadable Excel spreadsheet templates, including financial forecasting templates, are available online at: http://www.exinfm.com/free_ spreadsheets.html

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149

Problems

For questions 1 to 7, please use the following projections for Top-A1 Inc.: Total sales of $150,000 Cost of goods sold equal to 76 percent of sales Total expenses equal to 14 percent of sales Tax rate of 35 percent Beginning equity of $50,000 Beginning inventory of $12,000 Age of ending inventory of 60 days Minimum cash balance of $10,000 Accounts receivable of 30 days Fixed assets of $60,000 Accounts payable of 35 days 1. Calculate the projected margin for Top-A1 Inc. 2. Calculate the projected mark-up for Top-A1 Inc. 3. Create an entire pro forma income statement for Top-A1. Be sure to calculate the projected net earnings. 4. Assume Top-A1 has a dividend payout of 40 percent. Calculate the projected change in retained earnings for Top-A1.

5. Calculate the projected accounts receivable for Top-A1 assuming credit sales are 60 percent of total sales. 6. Calculate the projected accounts payable for Top-A1 assuming that credit purchases constitute 20 percent of the cost of goods sold. 7. Create a pro forma balance sheet. Calculate the long-term debt as the balancing amount. 8. What would be the impact on Top-A1’s pro forma net earnings if sales were to change to $200,000? 9. What would be the impact on Top-A1’s pro forma long-term debt if sales were to change to $200,000 and the age of payables were to change to 45 days? 10. Now, assume Top-A1’s sales in the subsequent year increase by 15 percent. If all the other relationships remain the same, what will be the pro forma net earnings in two years? 11. Again, assume Top-A1’s sales in the subsequent year increase by 15 percent. If all the other relationships remain the same, what will be the pro forma loan requirement in two years?

Appendix: Spreadsheet Analysis

It’s often reasonably straightforward to change one assumption in a pro forma financial statement—for example, age of accounts payable—then determine the impact of that change on a firm’s loan requirement. However, a more accurate and versatile approach is to develop pro forma statements using commonly available software spreadsheet packages (such as Microsoft Excel). Spreadsheet analysis is particularly useful because it allows you to see the effects of changing more than one variable at the same time. This appendix describes some basic spreadsheet approaches to sensitivity analysis, in the context of Excel. Before proceeding with our analysis, we need to develop some simple spreadsheets. Making spreadsheets is an extremely useful way to better understand the relationships between different elements of a firm’s financial statements. The spreadsheet creation process is relatively straightforward. If you’ve never before had the opportunity to make your own spreadsheet, now is your chance! The spreadsheet creation process involves inputting formulas or equations into spreadsheet cells, in addition to inputting text (i.e., actual words) and numbers. The formulas represent simple income statement and balance sheet relationships. An example is presented in Figure A6.1.7 This example incorporates the pro forma income statement developed in Figure 6.3 and the pro forma balance sheet developed in Figure 6.5. The actual spreadsheets can also be copied from the MyFinanceLab site. 7

See the “Spreadsheet” spreadsheet.

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The first step is to input as text, in column A of your blank spreadsheet, the various financial statement items as indicated in Figure A6.1. For example, in cell A2 (where A represents the column and 2 represents the row), type “Sales” (without the quotation marks). For clarity, you may wish to input, also as text, explanations of your assumptions in column C. Note that the spreadsheet applications allow you to change the width of each column, as well as other style-related items such as the number of decimal places that are presented. (Don’t worry if your spreadsheet looks a bit different, but do make sure you are using exactly the same columns and rows as indicated in Figure A6.1; Fig A6.1 Spreadsheet Development  A 1

Income Statement

2

Sales

3

Cost of goods sold

B

C

D

Assumption

Col. F formulas

E

F 300.0 35.0

4

Beginning inventory

Last year’s end. inv.

=E25

5

+ purchases

CSG + end. inv. – beg. inv.

=F6–F4

239.5

6

Cost of goods avail.

=F8+F7

274.5

7

– Ending inventory

8

Cost of goods sold

9

Gross profit

10

Operating expenses

57.8

Days of cost of sales

=B7*(F8/365)

37.5 237.0

=F2*(1–B9) 0.21

Fraction of sales

=F2*B9

63.0 45.0

11

SG&A

0.15

Fraction of sales

=B11*F2

12

Depreciation

0.2

Frac. of beg. fixed assets

=B12*E26

13

Total op. expenses

14

Earn. before int. & taxes

15

Interest expenses

16

Earn. before tax (EBT)

17

Taxes

18

Earn. after tax (EAT)

19

Dividends

20

Change in ret. earn.

21

Balance Sheet

22

Assets

0.1

Frac. of current loan

0.4

Fraction of EBT

0.4

Fraction of EAT

6.0

=SUM(F11:F12)

51.0

=F9–F13

12.0

=B15*E30

4.0

=F14–F15

8.0

=B17*F16

3.2

=F16–F17

4.8

=B19*F18

1.9

=F18–F19

2.9 Year 0

Year 1

23

Cash

Assumed minimum

=10.7

10.0

10.7

24

Accounts receivable

32.6

Days of acc. rec.

=B24*F2/365

25.0

26.8

25

Inventory

57.8

Days of cost of sales

=F7

35.0

37.5

26

Fixed assets

New assets (before dep.)

=E26+B26–F12

30.0

32.2

=SUM(F23:F26)

100.0

107.2

=B29*F5/365

20.0

21.7

27

Total assets

28

Liabilities

29

Accounts payable

8.2

33

Days of payables Balancing amount

=F31–F29

40.0

42.7

31

Total liabilities

Total liab. & eq. – equity

=F33–F32

60.0

64.4

32

Equity

Beg. + change in ret. earn.

=E32+F20

33

Total liab. and equity

Same as total assets

=F27

30

Long-term debt

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40.0

42.9

100.0

107.2

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151

otherwise, the formulas won’t work.) Now, the next step is to input the actual numbers in column B (these will be used in the formulas described below) and in column E (under the “year 0” text heading, or current balance sheet). Once you’ve added these numbers, proceed directly to column F. In cell F2 (where F represents the column and 2 represents the row), the projected sales number of 300 has already been inputted. You are now ready to input the formulas related to your pro forma statements. Note that the 0.21 previously inputted in cell B9 represents the firm’s gross margin, or its gross profit as a fraction of sales. Thus, your next step is to enter a formula that combines this gross margin percentage with the firm’s projected sales to arrive at the gross profit in dollars. In most spreadsheets, a formula is generally recognized as an information sequence that starts with = . So, entering the formula = F2*B9 in cell F9 indicates that the firm’s gross profit is equal to its sales multiplied by its gross margin (the multiplication sign is represented in Excel by *). Important note: The formulas described in this section appear in column D in Figure A6.1. They are presented only to show you what formulas to enter in column F. These formulas are not to be entered in column D, but rather are to be entered two cells to the right, in column F. Nothing should appear in your spreadsheet in column D. Other formulas in your spreadsheet simply represent the various income statement and balance sheet relationships. For example, ending inventory is estimated as the age of inventory times the average daily cost of goods sold. Here, the projected age of inventory in days is 57.8, as indicated in cell B7, and the average daily cost of goods sold equals the projected annual cost of goods sold in cell F8 divided by 365. The resulting formula in F7 is = B7*(F8>365). Note that many spreadsheet packages, including Excel, have built-in functions that provide shortcut calculations. For example, total operating expenses in F13 are calcu­ lated using the SUM function that indicates the range of numbers to add. In Section 6.1.2, we discussed the initial calculation of a firm’s interest expense using its current loan as the best guess of the pro forma loan amount. Using a spreadsheet pack­ age, we can now refine this calculation by using the iteration method that is built into the package. This approach allows us to estimate pro forma interest based directly on the pro forma loan. Recall the chicken-and-egg problem described in Section 6.1.2. We needed to estimate interest expenses before completing the income statement, but in order to do so, we needed to know what the projected loan balance was going to be. To get around this chicken-and-egg problem, we use a spreadsheet option that effectively starts with the first-pass estimate described in Section 6.1.2, checks whether the first-pass pro forma loan amount is greater or less than the best guess, then does a s­ econd-pass calculation and continues to iterate until it has precisely estimated the pro forma loan. The process appears seamless and the iteration routine is virtually instantaneous. To ensure that our software will perform this iterative calculation (without giving a “circular reference” error message), we first need to ensure that the spreadsheet allows iterations. To do this in an Excel spreadsheet, you need to search for the iterative option. In later versions select the “File” tab, then click “Options.” Next, click “Formulas,” fol­ lowed by “Enable Iterative Calculations,” then press the “OK” button. (In older versions of Excel, you may find the iteration box in a different manner. For example, you may need to select “Tools” from the menu; then click “Options” and go to the “Calculations” menu; then click the “Iteration” box so that a check mark appears; then click the “OK” button.) Finally, going back to our spreadsheet, we can modify the interest expense calcu­ lation, referring to the pro forma loan in cell F30 rather than the current loan in E30. The modified line is highlighted in Figure A6.2.8 Note that in this example, there is a 8

See the “Pro forma iter (2)” spreadsheet.

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Fig A6.2 Interest Expense: Iteration Method  A 1

B

C

0.1

Fraction of pro forma loan

D

E

F

Income Statement

14 15

Interest expenses

=B15*F30

4.3

16

slight increase in the interest expense amount. This is the case because the pro forma loan based on the iteration method is $42.8 (only slightly higher than our $42.7 in the first-pass analysis). Because this loan is $2.8 higher than our initial guess of $40, we can assume the loan’s interest expense will be higher by 10 percent (the loan interest rate) of this $2.8, or $0.28. Therefore, the resulting pro forma interest expense is $4.3 instead of $4.0. We’re now in a position to demonstrate the power of spreadsheet sensitivity analysis by asking a series of “what if?” questions and letting the spreadsheet package do all the work. Let’s begin with a focus on sales. (We will perform our sensitivity analysis based on the iterated method of interest expenses.) What if sales are actually 10 percent greater than forecast?9 In this case, we would replace our pro forma sales number of 300 with 330. Consequently, the loan requirement will go from $42.8 to $46.2, an increase of $3.4. Thus, a 10 percent increase in sales results in a 7.9 percent increase in the required loan, assuming all other variables remain the same. Spreadsheets also allow us to easily consider changes in a firm’s working capital ratios. For example, what if customers are much slower than expected in paying for credit sales, taking 45 days instead of the anticipated 32.6 days?10 Here, the increase in the age of accounts receivable causes the firm’s loan requirement to rise from $42.8 to $53.3. Using our spreadsheet, we can also quickly see that if the firm’s sales are 10 percent greater than expected and its customers take longer to pay, then its loan requirement will increase to $57.8.

9

See the “Sensitivity iter (1)” spreadsheet.

10

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See the “Sensitivity iter (2)” spreadsheet.

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7

Time Value of Money Basics and Applications Learning Objectives

Remember that time is money. – Benjamin Franklin

So far in this book, we’ve learned how to evaluate a firm’s current financial status, manage its day-to-day cash flow, and project its financial needs in the immediate future. Now, in this chapter, we’ll begin to consider how a manager can use this information to make sound investment decisions. Any good investment decision involves an examination of the trade-offs between the expected cash flows generated from the investment and the cost of financing the investment. To conduct this sort of analysis, a manager must understand various concepts related to the time value of money, which impact both financing and investing decisions. As we move through the chapter, we’ll first develop key time value of money concepts and then apply them to the financing side with the valuation of financial securities such as bonds, preferred shares, and common stocks. In Chapter 8, we’ll apply these concepts to the investing side to evaluate capital projects. Later in this book, we will apply time value of money concepts in more complex settings related to the value of the overall firm. We can see how the themes of financing and investing fit with our overall financial management framework and unifying theme presented in Figure 7.1. Financing and investing decisions are two of the three main types of decisions that managers face. We will focus on financing decisions while recognizing that these time value of money concepts are critical for investing decisions as well.

obj 7.1

Explain the concepts of future value, present value, annuities, and perpetuities. obj 7.2

Explain how bonds, preferred shares, and common equity prices relate to time value of money concepts. obj 7.3

Explain why understanding time value of money concepts is relevant for managers.

7.1  Exploring Time Value of Money Concepts Simply stated, the time value of money refers to the idea that one dollar today is worth more than one dollar tomorrow. Although this may seem like a straightforward notion, it is one that is often overlooked. To better understand how the time value of money works, consider the lottery. Many lotteries boast huge sums of prize money—but because these amounts are usually paid out over many years (rather than immediately), the amounts appear more attractive than they really are. For example, on October 14, 2011, a major U.S. lottery had a jackpot of $30 million—but only if the winner agreed to thirty payments of $1 million per year spread over 30 years. In comparison, the cash option prize, or the amount the winner would receive if he or she opted for a one-time lump-sum payment, was only $21.7 million. Although $21.7 million is still a sizeable amount, we see a

Objective 7.1

Explain the concepts of future value, present value, annuities, and perpetuities.

time value of money: The idea that one dollar today is worth more than one dollar tomorrow because of its earning potential

153

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Fig 7.1 Financial Management Framework: Financing and Investing Decisions

the enterprise

financing

operating

• Debt financing • New equity • Dividend policy

investing

Growing profits, dividends, cash flow

• Capital expenditures • Long-term projects

Managing the risk profile

growth

risk

value creation

opportunity cost: The cost of the next best forgone alternative activity

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substantial difference between the quoted jackpot and the value today, which reflects the importance of recognizing the time value of money. Essentially, we would rather have $21.7 million today—which if we chose to invest it wisely would provide even more money in the future—than the promise of the greater amount of money in the future. In other words, a dollar today—or $21.7 million today if you are lucky enough to win the lottery— is worth more than a dollar—or $30 million—tomorrow. Concepts related to the time value of money are often confused with concepts related to risk and inflation. For example, we often think the reason we might prefer a dollar today instead of a dollar tomorrow is because prices will rise, or perhaps the money we invest today will not yield any dividends in the future. Although these are both valid concerns, they obscure the fundamental premise behind the time value of money: the concept of opportunity cost, or the cost of a foregone alternative. Consider the following example: You and a friend are passing by Mama’s Homemade Cookie Store, a favorite local establishment. The store’s specialty is huge chocolate chip cookies, which it sells for five dollars each. You happen to have exactly five dollars in your pocket, but your friend doesn’t have any money—and sharing a cookie is not an option. Your friend asks you if he can borrow five dollars now and pay you back next week. Moreover, he insists on paying you back a fair amount for agreeing to lend the money today. But what is a fair amount? In other words, how much money would you require beyond the five dollars to make the loan worth your while? The answer to this question demonstrates what the time value of money represents: a fair return for the opportunity cost of foregoing consumption today. The only reason

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that rational individuals would forego consumption today is if they can consume even more in the future. To frame this in terms of our example, by giving up the consumption of one cookie today, you should be able to consume more than one cookie in the future, so you would require five dollars—the price of the cookie—plus something more for the opportunity cost. Notice that in this scenario, we have implicitly assumed that cookie prices are not anticipated to increase (that is, there is no inflation), and there is also no risk that your friend will not pay you back. If either of these events were expected, however, you would want to ask for an even greater payback for lending the money today, to cover more than the anticipated cost to buy a similar cookie and to be compensating for taking on risk. In this situation, the higher opportunity cost of the loan would justify the larger payback amount. As this example illustrates, all such financial decisions come with an opportunity cost—but in some cases, this cost is greater than in others. After we develop a number of time value of money concepts and introduce a number of formulas and components for each concept in this section, we will apply the concepts to bonds, preferred shares, and common equity in the next section.

7.1.1 Future Values Time value of money looks at cash flows now and in the future. Thus, to better understand time value, we need to examine the concept of future values of single amounts, or cash flows at some specified upcoming date. Suppose you are given $100 today, but you are prepared to forgo spending that money. Instead, you choose to put the money in a safe investment, such as a one-year treasury bill that at the time yields 3 percent. What is the future value, in one year, of $100 invested in the treasury bill? You should also ­consider—as we did in the cookie example—if this value will make you as satisfied in the future as having $100 could make you today. It is also worth noting that the treasury bill return compensates you for the opportunity cost of not buying and consuming something today with your $100. In one year, you will receive the principal you invested, plus 3 percent interest. Three percent of $100 is $3, so you will receive a total of $103 (i.e., $100 principal plus $3 interest). In other words, the future value (FV) of $100 invested today for one year at a rate of 3 percent is $103. The specific calculation for determining this value is as follows: FV = $100(1 + 0.03) = $100(1.03) = $103 In this example calculation, 1 represents the principal, and 0.03 represents the interest rate (in decimal form). We can write a generalized form of this equation as shown in Figure 7.2. Note that this equation assumes that the interest is calculated only once—at the end of a single period. Now, suppose you instead chose to invest your $100 in a two-year investment certificate that guaranteed an annual return of 4 percent each year. In this situation, any interest earned after one year is compounded, or included in the interest calculation for FV = PV(1 + r) where

FV = future value PV = present value

future value: The value of an asset at a specified time in the future that is equivalent to a specified amount today; the value that an investment today will grow to at a specified time in the future given an interest rate compounding: Generating interest on both principal and accrued interest Fig 7.2 Future Value of a Single Amount, One-Period Example

r = interest rate or rate of return on the investment (in decimal form)

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the second year. In other words, during year two, you’ll receive interest on both your principal and any interest earned in year one. In this scenario, how much money would you receive at the end of two years? Let’s crunch the numbers. At the end of the first year, you will have the principal you invested, plus 4 percent earned in interest. Four percent of $100 is $4, so you will have a combined total of $104. But what happens during the following year? To determine how much money you’ll have at the end of year 2, you can perform the same series of calculations as with the one-year investment; however, instead of beginning with $100 principal, you’ll instead use a starting value of $104 principal. Consequently, after two years, you will have the principal and earned interest reinvested after one year ($104), plus interest earned on that full amount in the second year. Four percent of $104 is $4.16. Thus, the total amount you will receive is $108.16. In other words, the future value of $100 invested today for two years at a rate of 4 percent is $108.16. The specific calculation used to determine this amount is as follows: FV = $100(1 + 0.04)(1 + 0.04) = $100(1.04)2 = $108.16 We can continue with this example to show how much money you would have at the end of each of the next 10 years: Year 0 1 2 3 4 5 6 7 8 9 10

timeline: The representation of the amount and timing of cash inflows or outflows Fig 7.3 Future Value of a Single Amount, Multi-Period Example

Amount $100.00 $104.00 $108.16 $112.49 $116.99 $121.67 $126.53 $131.59 $136.86 $142.33 $148.02

                     

We can generalize our two-period example to a multi-period example occurring over n periods (where n is greater than 1), as shown in Figure 7.3. In our example, $100 represented the amount of money we had today, or the present value (PV); the interest rate (r) was 0.04; and the number of periods (n) was 2. Thus, (1 + r) = 1.04, and (1 + r)n = (1.04)2, which is 1.0816. At this point, it is worthwhile to pause and consider a graphic representation of the concepts covered so far. We can do this through drawings of timelines. A timeline represents cash inflows or outflows, the information we have in order to solve a particular FV = PV(1 + r)(1 + r) . . . = PV(1 + r)n where

FV = future value PV = present value r = interest rate or rate of return on the investment (in decimal form) n = number of periods

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Fig 7.4 Timeline Depicting a Future Value Calculation

FV = ?

r = 4% 0

1

2

PV = $100

problem, and the unknown element we are trying to solve for. A timeline for our previous two-period problem is presented in Figure 7.4. The timeline in Figure 7.4 indicates multiple points in time, starting with today at time 0. Two subsequent periods are also shown: time 1 at the end of the first period, and time 2 at the end of the second period. In this example, each period is one year, but a period could be any length of time, such as a week, a month, or six months. Regardless of period length, it’s assumed that cash flows only occur at the end of each period. On our timeline, the downward arrow and the $100 below the line at time 0 indicate our initial cash outflow of $100 today. This is the present value of the investment. The $100 is placed under the line to emphasize that it is a cash outflow—think of it as money coming out of your pocket today, which is a negative event. (If you are using a spreadsheet or some financial calculators then cash outflows will be inputted as negative numbers.) The timeline also indicates that we are trying to find the future value of the $100 investment at time 2, as shown by the upward arrow and FV label. This future value represents a cash inflow—or money going into your pocket—which is a positive event. Again, a quick look at the timeline tells us that the investment is for a two-year period, and the interest rate is 4 percent. Although this particular timeline depicts a straightforward situation, other timelines are more complicated, depending on the timing and nature of cash flows. For example, some cash flows might be positive (inflows) in some periods and negative (outflows) in other periods. Similarly, some cash flows might occur at the beginning or at the end of periods. (Most of our examples and the accompanying formulas assume end-ofperiod cash flows.) Thus, it’s always worthwhile to draw timelines in order to clearly note the timing and nature of cash flows.

7.1.2 Present Values Now that we’ve illustrated the concept of future value, the concept of present value is straightforward. Think of present value as the reverse of future value. Therefore, instead of asking what a particular investment today will grow to in the future, we instead ask how much money we need to invest now to receive a specific cash flow in the future. For example, suppose we know that in one year, we’ll require $500 to pay for a furniture purchase. If we can earn a return of 9 percent, how much money should we set aside today? In other words, what is the present value of $500 received one year from now if the investment rate is 9 percent? In the context of present value calculations, we refer to the interest rate or investment rate as the discount rate. This discount rate reflects the opportunity cost or, more specifically, the return required by investors that accounts for the risk of the investment. In Chapter 10, we will reinterpret the discount rate as the cost to the firm of raising capital in order to invest in a particular project with a particular level of risk, known as the cost of capital. For now, we’ll simply focus on present value calculations assuming a given discount rate. Note that discounting is simply the opposite of compounding.

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present value: The current value of the value of an asset at a specified time in the future; the current value of an investment today that will grow to a specified amount by a specified time in the future given an interest rate discount rate: An interest rate used in the calculation of present values

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Fig 7.5 Present Value of a Single Amount, One-Period Example

PV =

FV (1 + r)

where

PV = present value FV = future value r = interest rate or discount rate (in decimal form)

To return to our example, we know that we must currently set aside a principal amount that will earn 9 percent interest and be equal to $500 in one year. So, instead of starting with a known investment, or present value, and multiplying by 1 plus the interest rate, we take the future value and divide by 1 plus the interest rate. The specific calculation is as follows: PV = =

500 11 + 0.092 500 11.092

= $458.72 To check the calculation, note that 9 percent of $458.72 is $41.28. If we add the principal of $458.72 to the interest of $41.28, we end up with exactly the desired future value of $500. We can generalize this equation for determining present value in a one-period situation as shown in Figure 7.5. Now, suppose we require the $500 in two years rather than one. Recall that any interest earned each year is compounded. In this situation, we must work backward from the final period—meaning the end of year 2. We know that exactly one year earlier (at the end of year 1), we must have enough money such that this amount plus interest will yield $500 in one year. We also know from the previous example that this amount is $458.72, or $500/(1.09). We are now left with another one-period calculation. This time, however, we repeat the process to determine what amount must be invested for one year at 9 percent interest to yield an end-of-period value of $458.72. That amount is $458.72/ (1.09), or $420.84. The full calculation is shown below:

PV = =

a

$500 b 1.09 1.09

$458.72 (1.09)

= $420.84 or, PV =

$500 [(1.09)(1.09)]

= $500>1.1881 = $420.84 Note that the two representations above result in the same answer. The major difference between the two is their order of operations. Specifically, the first version divides each time, whereas the second version multiplies the terms in the denominator first, then divides.

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Fig 7.6 Timeline Depicting a Present Value Calculation

FV = $500

r = 9% 0

1

2

PV = ?

PV = =

Fig 7.7 Present Value of a Single Amount, Multi-Period Example

FV [(1 + r)(1 + r) . . . ] FV (1 + r)n

where

FV = future value PV = present value r = interest rate or discount rate (in decimal form) n = number of periods

We can also describe the two-step process in a timeline, as shown in Figure 7.6. The $500 amount represents cash to be received in two years. The discount rate is 9 percent. In addition, we can generalize this two-period example to a multi-period example over n periods (where n is greater than 1) as shown in Figure 7.7. Note that this general formula for present value is simply a rearrangement of the general formula for future value provided in Figure 7.3.

7.1.3 Annuities In many situations, cash flows occur in an equal stream. This stream of equal cash flows is known as an annuity. For example, a bond has an annuity stream of coupon payments, typically paid every six months. Managers are interested in examining the present value of annuities because many projects are anticipated to have cash flows in the form of an annuity, such as the cash flows from production for a mining company. To better understand annuities, let’s consider an example. Suppose you have a retirement account from which you plan to withdraw $1,000 each year for the next four years, starting one year from now. How much money do you need to invest today in a guaranteed certificate that promises to pay 7 percent each year such that you have just enough money to cover a $1,000 withdrawal in each of the four years? You can start by drawing a timeline, as in Figure 7.8.

Fig 7.8 Timeline Depicting the Present Value of an Annuity

PMT $1,000

$1,000

$1,000

annuity: A stream of equal regular payments over a specified period of time

$1,000

r = 7% 0

1

2

3

4

PV = ?

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Fig 7.9 Formula for the Present Value of an Annuity

PVA =

1 PMT 1− (1 + r)n r

where

PVA = present value of annuity PMT = annuity payments = interest rate or rate of return on the investment (in decimal form)

r

n = number of periods

The actual formula for determining the present value of an annuity, as shown in Figure 7.9, is rather complex. Instead of trying to solve this equation algebraically, it is much simpler to use a spreadsheet function or financial calculator. To perform this calculation using a spreadsheet such as Excel, we would insert the existing PV function. In Excel, find the “Insert Function,” then select category “Financial,” then “PV.” The form of this function is PV (rate, Nper, PMT, FV, type). To use this formula with the information in our example annuity, choose a cell in your spreadsheet and enter the following information: = PV(.07,4,1000,0,0)   or    = PV(.07,4,1000,0) Note that each of the function versions are equivalent in this case because we are assuming the default end-of-period cash flows, thus “type” is 0. The same answer, - 3387.21, should appear regardless of which version of the formula you enter. We can recreate this example by giving labels to each of the components and then referencing each of the components of the function separately, as indicated in Figure 7.10. This has the advantage of showing each input more visibly and making it easier to change. Figure 7.11 shows how to find the same result using a financial calculator.

7.1.4 Perpetuities

perpetuity: A stream of equal and regular payments forever

Up to this point, we’ve examined present and future values assuming a finite set of cash flows—for example, a project that is expected to generate cash flows each year for the next four years. But what if a project or financial instrument promised to generate cash flows indefinitely? Such a stream of continuous cash flows—assuming the cash flows are the same each period—is known as a perpetuity. A perpetuity is just like an annuity but with no end to the stream of cash flows. The reason we care about perpetuities is twofold: Fig 7.10 Spreadsheet for Determining the Present Value of an Example Annuity

Fig 7.11 Financial Calculator Entry for Determining the Present Value of an Example Annuity

1 2 3 4

B .07 4 1000 0

C

PMT

Type 1000, then press PMT.

7

i [or r]

Type 7, then press i [or r].

4

n

Answer is

D

=PV(B1,B2,B3,B4)

1000

PV

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A Rate Nper Pmt Fv

E

–3387.21

Type 4, then press n. Press PV [or press COMP button first, if there is one].

3387.21

This answer should appear [on some calculators it may appear as a negative number to reflect that it is a cash outflow].

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161

First, there are some financial instruments, such as preferred shares (which we’ll examine in more detail in the next section), that are perpetuities. Second, for computational purposes, it’s often easier to assume that a project, or a financial instrument such as common stock, generates a stream of cash flows indefinitely rather than just for, say, the next 100 years. (We’ll see why this is the case in the following example.) To better understand the notion of a perpetuity, consider three different projects: Project A is expected to generate cash flows of $1,000 per year for the next four years, starting one year from now; Project B is expected to generate cash flows of $1,000 per year for the next 100 years, starting one year from now; and Project C is expected to generate cash flows of $1,000 per year indefinitely, starting one year from now. We wish to estimate the present value of the cash flows generated from each of the projects, assuming that in each case, the appropriate discount rate is 7 percent. How do the present values of the three projects compare? The present value for Project A is $3,387.21, as calculated in Figure 7.10. Similarly, the present value for Project B is $14,269.25 (found by

In-Depth

Spreadsheet and Financial Calculator Tips

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Although it may ultimately be necessary to read your financial calculator’s instruction manual or use a spreadsheet’s help function, these tips may be useful: 1. It’s always good practice to clear your calculator between calculations, using the Clear or C key. 2. Most calculations assume cash flows occur at the end of each period, as in the examples in this chapter. Alternatively, if a time value of money problem is structured such that cash flows occur at the beginning of each period (for example, if you invested in a retirement fund at the start of each year), most financial calculators can be set to deal with this by pressing a Begin or BGN key. For spreadsheets, in the PV function you will need to set “type” to be equal to 1. 3. Some cash flows are inflows; others are outflows. In some applications, it is critical to distinguish between inflows and outflows. For example, if you are making an investment today (PV ) and wish to calculate what the investment will grow to in several years (FV ), the initial investment represents a cash outflow, while the amount in the future is like a cash inflow. With many calculators, it will be important to enter the PV amount as a negative number (i.e., an outflow) so that the FV amount is positive (i.e., an inflow). To do this, you need to use the plus/minus (+ > - ) key. For example, to enter a PV of $100, type 100, then press the + > - key ( - 100 should now appear), then press PV. 4. When entering a percentage in a time value calculation, most financial calculators require you to enter the actual number in conjunction with the i or r key. For example, 8 percent is typically entered as 8. However, with some calculators and most spreadsheets, you may need to enter .08. 5. Some calculators allow you to display a different number of digits to the right of the decimal point. For most calculations, rounding is not critical, so it does not matter if your calculator displays 150.27 or 150.26666667. 6. Some financial calculators are preset based on monthly compounding (i.e., 12 payments per year), often indicated as “ P>Y = 12.” You may need to reset this to “ P>Y = 1,” or regular annual compounding.

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Fig 7.12 Timeline Depicting the Present Value of a Perpetuity

$1,000

$1,000

$1,000

$1,000

...

r = 7% 0

1

2

3

4

...∞

PV = ?

growing perpetuity: A stream of regular payments that grows at a steady rate forever

Fig 7.13 Formula for the Present Value of a Perpetuity

replacing n = 4 in Figure 7.10 with n = 100). Not surprisingly, the present value of Project B is much larger than the present value of Project A, because Project B lasts an additional 96 years. However, it’s important to note that the present value of only the first four annual cash flows (i.e., the value of Project A) represents approximately one-quarter of the value of Project B, which has 25 times as many annual cash flows. This comparison highlights an important time value of money concept: We put much more weight on earlier cash flows than on later cash flows. For example, the pres­ ent value discount factor for 7 percent and n = 1 is 0.935 (i.e., 1/(1.07) = 0.935), which implies that a dollar to be received one year from now—assuming a discount rate of 7 percent—is worth $0.935 today. The present value discount factor for 7 percent and n = 100 is 0.001 (i.e., 1>(1.07)100 = 0.001), which implies that a dollar to be received in 100 years is only worth $0.001 today. Now let’s consider Project C, which is a perpetuity. The timeline for this project is depicted in Figure 7.12. With Project B, we know the present value of the first 100 cash flows, but for Project C, how do we continue to calculate present values through infinity (represented by the ∞ symbol)? If we return to our present value of an annuity formula and choose a really large number of periods—say 1,000—then assuming a stream of payments of $1,000 each year for 1,000 years gives a present value of $14,285.71. Notice that the present value of cash flows from year 101 through year 1,000 is only $16.46, or the difference between $14,285.71 and the present value of Project B of $14,269.25. In fact, if we continued to add the present values of all of the cash flows beyond year 1,000, we would have less than one cent! Obviously, performing hundreds or even thousands of calculations to determine the present value of a perpetuity is impractical and time consuming. Fortunately, there is a convenient mathematical shortcut for finding the present value of a perpetuity, as shown in Figure 7.13. Thus, for Project C, the present value is simply $1,000/0.07 = $14,285.7143, which is the same as the amount we found when assuming the project lasted 1,000 years (except for some rounding of less than half a cent). This formula is certainly much simpler to apply. One final time value of money concept is the growing perpetuity. A growing perpetuity is an infinite stream of cash flows, like a perpetuity, but unlike a “regular” perpetuity, the cash flows in a growing perpetuity increase each period by a constant amount. To better understand how this works, suppose we modify Project C by assuming that the $1,000 cash flow after one year increases in subsequent years by 3 percent, as indicated

PV =

CF r

where

CF = perpetual annual cash flow r = discount rate (in decimal form)

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Fig 7.14 Timeline Depicting the Present Value of a Growing Perpetuity

$1,092.73 $1,000.00

$1,030.00

$1,060.90

r = 7% 0

1

2

3

4

...∞

PV = ?

PV =

CF1 (r − g)

where

CF1 = next year’s anticipated cash flow

Fig 7.15 Formula for the Present Value of a Growing Perpetuity

r = discount rate (in decimal form) g = anticipated perpetual annual growth rate of cash flows (in decimal form)

in Figure 7.14. As such the year 2 cash flow is $1,030.00 1or $1,000 * 1.032 , the year 3 cash flow is $1,060.90 1or $1,000 * 1.03 * 1.032 , and so on. The general formulation of the present value of a growing perpetuity is CF1 > (1 + r)1 + [CF1 * (1 + g)]>(1 + r)2 + [CF1 * (1 + g) * (1 + g)]>(1 + r)3 +. . . . Yet again, it would take a long time to calculate the present value of each of the cash flows and then sum those cash flows. Fortunately, there is there is another convenient mathematical shortcut for growing perpetuity calculations, as shown in Figure 7.15. Using this formula, we find that the present value of modified Project C is $1,000>(0.07 - 0.03) = $1,000>0.04 = $25,000. Note that in the formulation of a growing perpetuity, we are making the implicit assumption that the perpetual growth rate is always less than the discount rate.

7.2 Applying Time Value of Money Concepts to Financial Securities

Now that we understand major time value of money concepts, we can apply these concepts to three basic financial securities: bonds, preferred shares, and common equity. All three types of securities are issued by companies in need of capital, and once they’ve been issued, they may be traded in secondary markets. Although the prices are set in the marketplace for each of these securities, when buyers and sellers come together, the agreedon prices should simply represent the present value of expected cash flows to the ­investors. Our focus in this chapter is simply on the price at which these securities should trade. Later, in Chapter 9, we’ll discuss the features of and markets for these securities.

Objective 7.2

Explain how bonds, preferred shares, and common equity prices relate to time value of money concepts.

7.2.1 Bonds From an investor’s perspective, bonds represent a form of lending to a firm. In time value of money terminology, the amount lent to the firm today—which is also the price of the bond—is the present value (PV ) of expected future payments to the lender or

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face value: The principal amount due to an investor in securities upon the maturity of the security, such as a bond yield to maturity (YTM): The internal rate of return (IRR) of a bond when held to maturity par value: An arbitrary amount set as the face value of a security zero coupon bond: A type of bond with no coupon payments coupon rate: The specified rate of interest on coupons attached to bonds, expressed as a percentage of the face value

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buyer of the bond. The length of maturity or time to maturity is represented by the number of periods (n). We typically think of a series of six-month periods for bonds since interest payments or bond coupons are usually paid every six months. So a bond that matures in 5 years would have 10 six-month periods. Bonds are a combination of single amounts and annuities. The single amount is the principal amount that is lent to the firm and will be repaid by the firm in the future (FV ); this is also known as the face value of the bond. The interest or coupon payments represent annuity streams (PMT ). The discount rate (r) used to calculate the present value of the interest (or coupon) payments and the principal amount—and hence the bond price—is known as the yield to maturity, or YTM. Yield to maturity for a particular bond is like an interest rate or the anticipated rate of return if the bond is bought today and held until maturity. Bonds are typically issued with a face value—also known as the par value—of $1,000. Most bonds pay interest on a semiannual basis. The major exception is zero coupon bonds that don’t pay interest but instead are issued at a deep discount to their face value—for example, they may be issued today for $600 and the buyer will receive the face value of $1,000 in 10 years. For all other bonds that have coupons, most of which are issued at par or $1,000, at the time of issue, the coupon rate, which is the percentage of the par value of the bond paid annually as interest, is equal to the yield to maturity. However, after the issue, the general level of interest rates may change—for example, investors may increase or decrease their assessment of anticipated inflation—thus causing the bond’s yield to maturity to change as well. As we’ll examine more thoroughly in our next example concerning Ace Company, yield to maturity and bond prices are connected like two children on a teeter-totter: As the price of the bond goes down, the yield to maturity rises and vice versa. For instance, say that because of an increase in the perceived risk of a company, you are not willing to pay as much for a particular bond—or in other words, you require a higher expected return or yield for buying a bond from that company. In this case, the price of the bond will go down and simultaneously the yield to maturity (or expected return) will increase. To better understand how bonds work, let’s consider an example. Say that Ace Company needs capital and decides to issue three-year bonds. Each bond has a face value (and thus future value [FV ] in three years) of $1,000; this is the amount to be repaid to Ace bond investors or lenders at the end of the three-year period. As is standard practice, coupons are paid on a semiannual basis. The coupon rate is set at 5 percent, which reflects current economic conditions as well as the perceived riskiness of Ace bonds. This coupon rate indicates the total annual payments to bond investors as a percent of the face value—in other words, $50 (5 percent of $1,000) in coupon payments are made each year, so each semiannual payment (PMT ) is $25. So, if the price of the bond is initially the same as the $1,000 face value—and hence the coupon rate is equal to the yield to maturity—even though the coupon rate is 5 percent, the initial semiannual yield to maturity (r) is simply the coupon rate divided by two (i.e., divided by the number of sixmonth periods in a year), or 2.5 percent. With this information in mind, let’s apply our time value of money concepts to confirm that the present value (PV ) of the cash flow streams associated with the Ace bond equal the par value of the bond, or the $1,000 originally lent to Ace by each bond investor. Let’s begin the calculation process by drawing a timeline, as in Figure 7.16, that depicts the coupon payments (PMT ) and the face value (FV ) to be received in three years. Note that each time period (1 through 6) represents a six-month period. We have also indicated the semiannual discount rate, r. Our goal is to find the price of the bond, PV. Now, let’s look at the situation from the viewpoint of Lisa, an investor who has purchased a single $1,000 bond. We wish to confirm, by applying time value of money concepts, that Lisa’s bond is actually worth $1,000 initially—in other words, that she paid a

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FV = $1,000

Fig 7.16 Bond Valuation Timeline

PMT $25

$25

$25

$25

$25

$25 r = 2.5%

0

1

2

3

4

5

6

PV = ?

fair price. Note that because Ace’s bond pays semiannual coupons and matures in three years, the timeline has six periods, with each period representing an incremental six months. We can now proceed in two steps: 1. First, we can calculate the present value of the principal amount or face value or par value ($1,000) to be repaid to Lisa six periods from now (i.e., in three years or six six-month periods from now), discounted at the semiannual rate of 2.5 percent. 2. Second, we can calculate the present value of an annuity of $25 for six periods, also discounted at the semiannual rate of 2.5 percent, representing the present value of the coupon payments Lisa expects to receive. The sum of these two amounts is the present value, or the price Lisa should be willing to pay for the bond. With a financial calculator or spreadsheet, we can combine the two steps because we have the same number of periods and the same discount rate for each step. The exact series of calculations is presented in Figure 7.17. Note that the order doesn’t matter. To perform this calculation with a spreadsheet such as Excel, simply use the present value (PV ) function. Recall that the form of this function is PV (rate, Nper, PMT, FV, type). So, for our example, we’d enter the following information: = PV(.025,6,25,1000,0)

or

= PV(.025,6,25,1000)

Not surprisingly, the present value is $1,000, which is the initial amount Lisa lent to the company. In other words, $1,000 represents Lisa’s initial cash outflow—or the purchase price of the bond—and confirms that Lisa paid a fair price. For many large bond issues, there is an active secondary market in which bonds can be traded. Let’s say this is the case for Ace’s bonds. As a result, Lisa is not obliged to hold the Ace bond to maturity in three years, and she may choose to sell the bond to someone else—for example, to another investor named Bob. Lisa wants to examine how the price of 25

PMT

2.5

i [or r]

6

n

1000

FV

PV Answer is

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Type 25, then press PMT. Type 2.5, then press i [or r]. Type 6, then press n.

Fig 7.17 Using a Financial Calculator to Find the Present Value of an Example Bond

Type 1000, then press FV. Press PV [or press COMP button first, if there is one].

1000

This answer should appear. [on some calculators it may appear as a negative number to reflect that it is a cash outflow].

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the Ace bond—initially $1,000—might change through time. Suppose all interest rates changed the day after Lisa purchased the bonds (i.e., when she lent $1,000 to Ace) because newly released economic information suggested inflation was going to be much lower than investors had previously expected. For a bond with Ace’s particular level of perceived risk, new investors like Bob would now be willing to accept a yield to maturity of, say, 4 percent (or 2 percent on a semiannual basis) instead of the 5 percent that Lisa and other Ace bond investors initially required. Thus, if Ace were to issue a new bond today (instead of yesterday), that new three-year bond with a $1,000 face value issued at par would need to pay semiannual interest of only $20 instead of the $25 coupons that Lisa was to receive. What impact will this change have on the price of the bond that Lisa purchased yesterday? We can find an answer by recalculating the price of Lisa’s bond—except this time, we’ll use a semiannual interest rate (or yield to maturity) of 2 percent instead of 2.5 percent. (For simplicity, we’ll ignore the fact that Lisa’s bond matures in three years less one day.) After making this single change, we see that the price of Lisa’s bond goes up from $1,000 to $1,028.01, based on the following spreadsheet formula: = PV(.02,6,25,1000,0)   or    = PV(.02,6,25,1000) The reason behind the price increase in Lisa’s bond is as follows. Bob, the new bond buyer, has a choice: He could buy a new bond directly from Ace for $1,000 with the lower 4 percent coupon rate, or he could offer to buy Lisa’s bond from her with the more attractive 5 percent coupon rate—but he would need to pay her the higher price of $1,028.01. At that specific price, Bob should be indifferent between the two options, because in each case, he receives a bond with a yield to maturity of 4 percent per annum (i.e., semiannual yield to maturity of 2 percent). In other words, one bond is cheaper but has lower coupon payments, while the other bond has higher coupon payments but is more expensive to buy. However both have the same yield to maturity, which is why Bob would be indifferent between the two—which also explains why bond prices move in reaction to changes in interest rates. To reiterate, coupon rates are set when a bond is issued and never change, but yields (and correspondingly, prices) can change at any time. This example highlights a fundamental concept related to bonds, and one that may sound counterintuitive without the benefit of the preceding example: When interest rates, or yields, go down, bond prices go up (and vice versa). Thus, investors would ideally prefer to buy bonds when interest rates are high (especially when they feel interest rates might decline), but firms would rather issue bonds when interest rates are low (especially when they feel interest rates might rise). We can see this relationship between yields and bond prices in Figure 7.18. Fig 7.18 The Relationship between Bond Yields and Prices

Yield

Y1

Y2

P1

P2 Price

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167

In-Depth

Bond Prices and Yields: Home Depot Inc. Example

Let’s show that these bond price formulas actually work—if we know the yield to maturity of a bond we can double-check its proper selling price. According to Morningstar Inc., a research firm that compiles and analyzes market data, Home Depot issued $3 billion worth of bonds in December 2006. These bonds had a par value of $1,000, a coupon rate of 5.875 percent, semiannual coupon payments, and a maturity date 30 years later, on December 16, 2036. On November 23, 2011, nearly five years after their issue, these bonds had 25.1 years to maturity (it doesn’t matter for our bond formula that this isn’t a nice round number). These bonds had a yield to maturity of 4.67 percent (per annum). Let’s check that the market is giving the bond a fair valuation of $1,177 based on the bonds’ yield to maturity by entering the following data into a spreadsheet’s present value function: Rate = 4.67%>2 = 2.335% (semiannual yield to maturity) Nper = 25.1 * 2 = 50.2 (number of six-month periods) PMT = ($1,000 * 5.875%)>2 = $29.375 (semiannual coupon payments) FV = $1,000 (face value or par value of the bond) Sure enough, this function returns a value of - 1,177, meaning that the price (or required cash outflow) to purchase a single bond is $1,177. Alternatively, to confirm the bonds’ yield to maturity based on their selling price, we can use another spreadsheet function known as the “rate” function, where the rate is what we have been referring to as the yield to maturity. Consider the following spreadsheet “rate” function inputs: Nper = 25.1 * 2 = 50.2 (number of six-month periods) PMT = ($1,000 * 5.875%)>2 = $29.375 (semiannual coupon payments) PV = - $1,177 (the current price of the bond, expressed as a negative number) FV = $1,000 (face value or par value of the bond) The resulting semiannual yield to maturity is calculated by = rate(50.2, 29.375, - 1177, 1000), resulting in an answer of 2.3335%. We can then multiply that number by 2 to get 4.67% as the yield to maturity (on a per annum basis).

Based on this graph, it makes sense that the price of Lisa’s bond increased from $1,000 1P1 2 to $1,028.01 1P2 2 as its yield to maturity dropped from 5 percent 1Y1 2 to 4 percent 1Y2 2 . In other words, because Bob was willing to pay $1,028.01 for Lisa’s bond, the yield on the bond decreased. Now we see why yield to maturity and bond prices are like two children on a teeter-totter: When one goes up, the other goes down.

7.2.2 Preferred Shares Preferred shares are discussed in more detail in Chapter 9, but for purposes of this chapter, we’ll examine the pricing of preferred shares to provide an example of time value of money concepts. Traditional “plain vanilla” preferred shares are like a hybrid between bonds and common equity: They provide preferred shareholders with a steady stream of expected dividends, but with no principal repayment. To better understand how this works, consider Peter, an investor who buys one of Ace Company’s preferred shares, when it is issued, for $50 (the par value). In return, Peter expects to receive a preferred dividend of $4 from Ace each year. (In this example, we will

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Fig 7.19 Preferred Share Valuation Timeline

$4

$4

$4

$4

... r = 8%

0

1

2

3

4

...∞

PV = ?

assume the dividends are paid annually starting in one year, although in real life, preferred dividends are usually paid quarterly.) Note that the dividend is specified as 8 percent of the par value (or $4>$50). This is also known as the initial preferred dividend yield. In this situation, we want to show that Peter paid a fair price of $50 per share, which represents the present value of anticipated cash flows. We can draw a timeline to demonstrate that the initial price represents the present value of anticipated annual dividends of $4, discounted at a rate of 8 percent, as shown in Figure 7.19. Let’s see if we can justify the $50 purchase price by examining the present value of annual dividend streams of $4. Suppose we were to apply our annuity formula to calculate the present value of the first five dividends. Using our spreadsheet’s present value function PV (rate, Nper, PMT, FV ), where rate is 0.08, Nper is 5, PMT is $4, and FV is zero, we end up with a present value of $15.97. However, as we increase the number of periods, the present value also increases. For example, as we increase Nper to 10, 20, 50, and 100, we obtain present values of $26.84, $39.27, $48.93, and $49.98, respectively. Thus, when Nper is very large, we have an approximate present value for our perpetuity or infinite dividend stream, which we know should be $50. Fortunately, there is an easier way to calculate the present value of a perpetuity, or the value of a perpetual preferred share, as shown earlier in the formula in Figure 7.13: PV = CF>r, where CF is the anticipated annual dividend and r is the initial dividend yield, or the expected return that Peter had in mind when he initially bought his preferred share. Thus, the value of the preferred share is simply equal to $4>0.08, or $50. There are two major factors that influence the price of preferred shares, both of which affect interest rates or yields: 1. First, from an investor’s perspective, the dividend yield should be appropriate given the risk of the investment, as well as the other opportunities the investor faces, such as long-term corporate bonds. In other words, preferred share prices are generally inversely related to long-term bond yields. 2. Second, investors should also consider the riskiness of the corporation, because if the firm is forced into bankruptcy, preferred shareholders may no longer receive their dividends. These factors combine to determine an appropriate dividend yield. Just as a bond’s yield to maturity can change on a day-to-day basis, so can a preferred share’s dividend yield. Consider the Ace preferred share that Peter purchased for $50. Now, suppose the general level of interest rates goes up shortly after Peter buys his share. As a consequence, firms with a risk profile similar to Ace’s are issuing new preferred shares with initial dividend yields of 9 percent instead of 8 percent. If the dividend yield on new preferred shares increases (i.e., investors demand a higher yield because Ace is now viewed as a riskier firm than it was before), this should have a negative impact on the value of Ace’s preferred shares, just as increasing interest rates had a negative impact on the value of Ace’s bonds as discussed in the previous section and shown in Figure 7.18. We can find the new price of the Ace preferred shares using the following equation from Figure 7.13: PV = DIV>r = $4>0.09 = $44.44. Note that the amount of

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In-Depth

Preferred Share Prices and Bond Yields: Kansas City Railroad

Kansas City Southern Railroad Preferred Shares, 1962-2011 Comparison with U.S. 10-year Bond Yields

30

Preferred share price 10-year government bond yield 25

20

15

10

1/26/2010

1/26/2008

1/26/2006

1/26/2004

1/26/2002

1/26/2000

1/26/1998

1/26/1996

1/26/1994

1/26/1992

1/26/1990

1/26/1988

1/26/1986

1/26/1984

1/26/1982

1/26/1980

1/26/1978

1/26/1976

1/26/1974

1/26/1972

1/26/1970

1/26/1968

1/26/1966

0

1/26/1964

5

1/26/1962

Preferred Share Price in Dollars, Bond Yield in Percent

In 1962, Kansas City Southern Railroad issued noncumulative preferred shares with a 4 percent dividend and a par value of $25. For over 60 years, they have paid annual dividends of $1.00. The price of the preferred shares has fluctuated between $7.75 and $24.75.

Source: Kansas City Railroad preferred share prices pre-1973 are from the New York Times (various editions, 1962–1972) and post-1973 are from Datastream; bond yield data are from the Federal Reserve Board website http://www.federalreserve.gov/releases/h15/data.htm (accessed November 25, 2011).

As the chart indicates, the primary driver of changes in the price of the company’s preferred shares has been changes in long-term interest rates. Notice that the price of preferred shares is virtually a mirror image of long-term government bond yields. In other words, as the general level of interest rates has declined, the price of the preferred shares has increased. In fact, the correlation between the two series is –0.82, which is a very strong negative correlation. This example clearly illustrates that the price of preferred shares tends to act much like the price of bonds—so long as a firm is not experiencing any financial distress.

dividends has not changed (because it remains the same for these types of preferred shares), but because the required dividend yield has increased, the price must decrease. Now, investors are indifferent between buying existing preferred shares from Peter and other investors at a lower price or any new preferred shares that Ace may issue.

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7.2.3 Common Equity

dividend discount model: A model of the intrinsic value of a dividendpaying stock based on the present value of anticipated dividends

Now consider an investment in common equity or common shares, which we defined in Chapter 1 as a stake or share in the ownership of the firm in exchange for a cash investment. Thus, unlike bondholders that are strictly lenders for a fixed term and preferred shareholders that don’t share in the profits of the firm, common shareholders are the residual claimants after other stakeholders have received their interest payments of preferred dividends. In the following example, we present a way of determining the price of a common share for a firm that is expected to pay a stream of common share dividends, known as the dividend discount model approach. Let’s say that Christopher is considering investing in one common share of Ace Company stock that pays a dividend. Christopher plans to buy and hold the security and is not interested in selling it. What should Christopher be willing to pay for a share of Ace’s stock? The answer to this question depends on a number of factors. First, Christopher must anticipate the expected future stream of dividends. Second, he must estimate the present value of that stream of dividends based on discounting the anticipated cash flows at an appropriate discount rate. This discount rate should reflect the riskiness of the anticipated cash flows, or dividends, and should therefore represent Christopher’s required return for investing in such a stock. In Chapter 10, we will describe a model known as the Capital Asset Pricing Model or CAPM as a way of estimating a common equity investor’s required return. We can use that model as a method of specifying a discount rate—for now we will simply assume a particular discount rate of x percent. Once we know the anticipated stream of dividends and have determined an appropriate discount rate, we can determine the price that Christopher should be willing to pay for a share. In general, we can represent the value of a common share as the present value of dividends, as indicated in the timeline in Figure 7.20. For simplicity, we are assuming that Ace pays dividends once a year, at the end of each year. We can also formalize the present value calculation as shown in Figure 7.21. We could find the present value of Christopher’s common share if we could estimate the anticipated dividend stream. However, similar to the challenge we faced with the perpetual preferred stock, we would need to calculate the present value of each cash flow or dividend in order to do so. What’s even more complicating in this situation is that firms like Ace tend to increase their common share dividend over time, particularly if their business is growing. Consequently, we can’t rely on the annuity formulas presented in Section 7.1.3 to find the present value of Christopher’s stock.

Fig 7.20 Common Share Valuation Timeline

DIV1

DIV2

DIV3

DIV4

... r = x%

0

1

2

3

4

...∞

PV = ?

Fig 7.21 General Formula for Present Valuation of a Common Share

PV =

DIV2 DIV3 DIV4 DIV1 + + + +... (1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4

where

PV = current price of common share DIVt = anticipated dividend in t periods r

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= return required by common share investor

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PV =

DIV1(1 + g) DIV1 DIV1(1 + g)2 + + +... (1 + r)1 (1 + r)2 (1 + r)3 PV = current price of common share

where

r

= return required by common share investor

171

Fig 7.22 General Formula for Valuation of a Common Share Assuming Perpetual Constant Growth

DIV1 = anticipated dividend in one period g = constant growth rate of dividends (in decimal form)

Fortunately, there is a solution that makes our calculations a lot easier. If we’re willing to make an assumption that Ace’s dividends will grow at a constant rate g, then we can reestimate our general formula. Here, while DIV1 remains the same, we replace DIV2 with DIV1(1 + g). For example, suppose Ace’s common dividend next year is anticipated to be $1, and this dividend is anticipated to forever grow at an annual rate of 5 percent. In this case, DIV2 would be estimated as $1.00(1.05) = $1.05; DIV3 would be estimated as DIV1(1 + g)(1 + g) or DIV1(1 + g)2, and so on. To find the present value of each cash flow, the discount factor for the first period is 1>(1 + r), for the second period is 1>(1 + r)2, and so on. Thus, the general formula for the present value of perpetually growing dividends would be as shown in Figure 7.22. Although the formulation as presented in Figure 7.22 appears to be rather complex, recall the convenient mathematical formula for finding the present value of a growing perpetuity. In the context of dividend-paying stocks, we refer to this formula as the constant growth dividend discount model, as presented in Figure 7.23. So, returning to the previous Ace example, DIV1 is estimated to be $1.00, and g is estimated to be 5 percent (or 0.05). Suppose r is estimated to be 12 percent (or 0.12). In this case, the stock price should be $1.00>(0.12 - 0.05) - $1.00>(0.07) = $14.29, which is what Christopher should be willing to pay for one share. Note that this formulation makes sense only if r is greater than g—but this is a reasonable assumption because the expected return on a stock should be more than just the anticipated growth in dividends. The simple-looking formula in Figure 7.23 provides some powerful insights into why stock prices go up or down each day. The price of a stock depends on two—and only two—simple factors: the anticipated growth rate of dividends and the perceived riskiness of the dividend stream. An easy way to remember these factors is as follows: Growth is good! Risk is rotten! Notice that if Christopher anticipates an increase in the growth of dividends, g (g as in Growth is good!), he should be willing to pay more for the stock. Conversely, if Christopher anticipates an increase in the risk of the future cash flows, as captured by the higher required return, r (r as in Risk is rotten!), he should only accept a lower stock price.

PV =

DIV1 (r − g)

where

PV = current price of common share r

= return required by common share investor

Fig 7.23 Simplified Formula for Valuation of a Common Share Assuming Perpetual Constant Growth

DIV1 = anticipated dividend in one period g = constant growth rate of dividends (in decimal form)

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In-Depth

Multistage Dividend Discount Model

Is there a middle ground between the general dividend discount model formulation in Figure 7.21 and the perpetual constant growth formulation in Figure 7.23? We can think of the model in Figure 7.21 as an infinite-stage model, with each year’s anticipated dividend representing a stage of growth, whereas we can think of the model in Figure 7.23 as a one-stage model because dividends always grow at one same rate from year to year. Bloomberg L.P. is a wellknown global business and financial information service provider, and they provide their assessment of the fair value of a firm’s share based on an arbitrary middle ground of three stages of dividend growth. Stage 1 includes a number of years of prespecified above-average growth of dividends. Stage 2 includes a number of years of dividend growth transitioning from the above-average Stage 1 to the perpetual Stage 3 growth. (Note that the perpetual constant growth model described in Figure 7.23 skips the first two stages and just contains Stage 3.) A spreadsheet with the model applied to Home Depot is available through MyFinanceLab. A multistage approach to the dividend discount model is much more appealing than the perpetual constant growth version, particularly for firms that are growing at a rate greater than overall GDP growth because it allows for more realistic estimates of anticipated dividends. However, if we are simply interested in determining whether the market as a whole, such as the S&P 500, is over- or undervalued, then the perpetual constant growth model is reasonable.

For example, if g is 6 percent instead of 5 percent (Growth is good!), then the value of Ace’s common stock will be $1.00>(0.12 - 0.06) = $1.00>(0.06) = $16.67. Alternatively, if Christopher’s required return is only 11 percent instead of 12 percent (Risk is rotten!), then the value of Ace’s common stock will be $1.00>(0.11 - 0.05) = $1.00>(0.06) = $16.67. Moreover, if g is at the higher level of 6 percent but r has also increased such that ­Christopher’s required return is now 13 percent instead of 12 percent, then the value of Ace’s common stock will be $1.00>(0.13 - 0.06) = $1.00>(0.07) = $14.29. As you can see from this example, there is an offsetting trade-off between growth and riskiness.

7.3 Relevance for Managers Objective 7.3

Explain why understanding time value of money concepts is relevant for managers.

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Making investment decisions is a critical function of almost every operating manager. Understanding time value of money concepts is also critical for any manager involved in the financing of a firm. Firms rely on fundamental financial securities—such as bonds, preferred shares, and common equity—to finance ongoing capital investments. The price investors are willing to pay for these securities is equivalent to the present value of the expected return. For example, the price of a bond represents the present value of anticipated coupon payments and principal repayment, discounted at the bond investor’s required return. Similarly, the price of a preferred share represents the present value of an anticipated perpetual stream of dividends discounted at the preferred share investor’s required return. Finally, the price of a common share represents the present value of anticipated dividends discounted at the common equity investor’s required return. Time value of money concepts are also the foundational building blocks on which to make effective investment decisions. In particular, investment in any project relies on basic present value calculations—in other words, comparing initial investments with the

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present value of anticipated net cash flows, discounted at an appropriate hurdle rate to reflect the perceived riskiness of the project.

Summary

1. The time value of money implies that one dollar today is worth more than one dollar tomorrow, due primarily to the opportunity cost of foregoing consumption today. 2. A timeline is an essential tool in analyzing time value of money problems because it allows us to identify the timing and magnitude of projected cash flows. 3. Basic time value of money concepts include present values and future values of single amounts and present values of annuities.

4. Bond valuation, preferred share valuation, and common share valuation all represent applications of time value of money because each represents the present value of projected cash flows. 5. A fundamental bond valuation concept is that bond prices move inversely to changes in yields (or interest rates). 6. The constant growth dividend discount model highlights the importance of growth and riskiness as stock valuation drivers.

Additional Readings and Information

See any of the corporate finance textbooks listed at the end of Chapter 1 that contain extensive sections related to time value of money. A book that focuses exclusively on time value of money concepts is: Drake, Pamela Peterson, and Frank Fabozzi. Foundations and Applications of the Time Value of Money. New York: John Wiley & Sons, 2009.

Problems

1. Assume you placed $25,000 in a savings account that pays an annual compound interest of 8 percent for three years. Later, you decide to move the sum of money into another savings account that pays 10 percent interest compounded annually. Calculate the amount of money that you will have at the end of six years. 2. Calculate the present value (PV ) of an annuity stream of five annual cash flows of $1,200, with the first cash flow received in one year, assuming a discount rate of 10 percent. 3. What is the present value of a perpetual stream of annual cash flows of $100, with the first cash flow to be received in one year, assuming a discount rate of 8 percent?

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4. Ramanujan has been awarded a bonus for his outstanding work. His employer offers him a choice between accepting a lump sum of $5,000 today, or an annuity of $1,250 a year for the next five years. Which option should Ramanujan choose if the interest rate is 9 percent? 5. Consider two bonds, Bond A and Bond B, both with a coupon rate of 10 percent and a yield to maturity of 10 percent. These are standard bonds with semiannual coupon payments. Bond A matures in 5 years; Bond B matures in 10 years. What is the price of each bond?

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6. Consider the bonds in question 5. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? (Hint: Consider the semiannual yield to maturity.) 7. Consider two bonds, Bond C and Bond D, both with a yield to maturity of 10 percent and with 5 years to maturity. These are standard bonds with semiannual coupon payments. Bond C has a coupon rate of 10 percent (with semiannual coupon payments); Bond D does not pay any coupons (i.e., it a zero-coupon bond). What is the price of each bond? 8. Consider the bonds in question 7. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? (Hint: Consider the semiannual yield to maturity.)

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9. Danish Adam Co. wishes to estimate the value of its outstanding preferred stock. The preferred issue has an $80 par value and pays an annual dividend of $6.40 per share. Similar risk preferred stocks are currently earning a 9.3 percent annual return. What is the fair value of the outstanding preferred stock? 10. What is the fair value today of a common share with expected annual dividends of $1.00, $1.05, and $1.10 in each of the next three years and an expected share price of $20 in three years, assuming a required return of 9 percent? 11. Green Leaves Company has issued its common shares at the price of $4.05 per share. A dividend of $0.24 per share is expected to be paid at the end of this year, and is expected to experience a fixed growth of 7 percent per year. What is the value of these common shares?

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8

Making Investment Decisions Learning Objectives

Price is what you pay; value is what you get.1 – Warren Buffett (lesson learned from Ben Graham)

In the last chapter we introduced time value of money basics and applied those concepts to the valuation of basic financial securities. We noted that any good investment decision involves an examination of the trade-offs between the expected cash flows generated from the investment and the cost of financing the investment. We begin this chapter by examining the investment decision-making process. We’ll then apply these same time value of money concepts discussed in the last chapter to the investing rather than the financing side. We will examine concepts such as net present value and internal rate of return, which are measures of the potential success of any proposed capital budgeting project. Later in this book we will apply the net present value technique in a more complex setting to determine the value of the overall firm, which is like valuing the entire set of projects that a firm is considering. We can see how the theme of investing fits with our overall financial management framework and unifying theme presented in Figure 8.1. Investing decisions are one of the three main types of decisions that managers face. Investing includes both capital expenditures such as purchases of equipment, as well as longer-term projects such as the building of a new plant or a new franchise. We will see how both the prospects for growth of cash flows and the perceived riskiness of projects impacts our assessment of the viability of taking on a proj­ect and hence impacts value creation.

obj 8.1

Describe the decisionmaking process. obj 8.2

Describe various capital budgeting techniques, including payback, net present value, and internal rate of return. obj 8.3

Describe the profitability index, equivalent annual costs, mutually exclusive projects, and capital rationing. obj 8.4

Explain why making investment decisions is relevant for managers.

8.1  Understanding the Decision-Making Process Business management is all about making decisions—and better managers make better decisions. Throughout this book, we’ve alluded to numerous types of decisions that financial and nonfinancial managers face. For example, in Chapter 5, we examined decisions related to working capital management and financing. Capital budgeting is a specific decision-making process that involves yet another type of decision, such as whether or not to proceed with a project, like investment in a new plant. All of these decisions, including those associated with the capital budgeting process, can be described in terms of an overall business decisionmaking framework. The steps of this framework are outlined in Figure 8.2. As shown in the figure, the first step in the decision-making framework involves defining the decision to be made. Say Ace Company needs to make a decision about how 1Material

Objective 8.1

Describe the decisionmaking process.

capital budgeting: The process of selecting investment projects

is copyrighted and used with permission of the author

175

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Fig 8.1 Financial Management Framework: Investing Decisions

the enterprise

financing

operating

investing

• Capital expenditures • Long-term projects

Growing profits, dividends, cash flow

Managing the risk profile

growth

risk

value creation to improve the profitability of its Southwest division. There may be a number of short-term and long-term concerns related to this decision. For example, in the short-term, Ace might face several issues (including the possible purchase of new equipment) that will result in the need for less labor, and these issues might in turn raise the possibility of a strike among the division’s unionized workers. In the long-term, Ace might need to determine how to keep the Southwest division competitive while better motivating its employees. After determining the choice to be made and any related short- and long-term issues, the second step in the decision-making process involves developing a list of c­ riteria that will be used to evaluate any alternative strategies the firm is considering. Returning to our example, let’s say that Ace identifies three main evaluation criteria: maximization of profitability, minimization of risk, and maintenance of good relations with the union. In this situation—as in real life—it might not be possible for any one alternative to satisfy every criterion. In such cases, a firm must prioritize which criteria are most important. The third step of the decision-making framework involves generating alternatives. Each of these alternatives should be feasible to achieve. One alternative is invariably the “do nothing” or “status quo” alternative. Beyond this option, management should Fig 8.2 Decision-Making Framework

1. Define the decision to be made and any related issues. 2. Determine the criteria to be used when evaluating alternatives. 3. Generate alternatives. 4. Analyze and assess the alternatives. 5. Decide on an alternative and begin implementation.

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typically consider at least two more alternatives, so as not to overlook some possible viable solutions; however, management should not consider so many alternatives that evaluation becomes excessively time consuming. Usually three to four distinct alternatives are appropriate. Sometimes it is useful to consider some out-of-the-box alternatives in order to stretch one’s thinking. For example, when dealing with the issue of raising profitability, Ace’s alternatives might include deciding whether to purchase a new piece of equipment to replace the existing machinery, whether to upgrade the existing equipment, whether to outsource and scrap the existing equipment (which might be a radical departure for Ace), or whether to take no action at all. Similarly, Ace’s management would also generate a series of alternatives related to how to deal with the union. The fourth step in good decision making involves analysis and assessment of the alternatives. This is usually the most critical and most time-consuming step. Note that with each alternative, we should be able to quantify the potential benefits, such as increased profitability. However, once we quantify these benefits, we need to balance them by considering the possible negative outcomes of each alternative. Management plays a key role in this step because it assesses the trade-offs involved in any decision. For example, quantitative benefits must be weighed against other qualitative factors. Although developing the numbers cannot answer all questions, it does play an important role in articulating the trade-offs involved. For example, Ace may have a clear “winning” alternative from the perspective of maximizing profitability—but this alternative might also be the riskiest, or it might involve major layoffs that will damage future relationships with the union. Finally, the fifth step in the decision-making framework involves choosing the preferred alternative and developing an implementation plan. This requires management to choose among the various alternatives that have been generated using the predetermined criteria. For example, Ace management may decide to replace the old equipment with newer and more efficient equipment that will require fewer employees. Part of the implementation plan will involve a communication strategy for explaining the impact of this decision on the union. We can apply the general decision-making framework specifically to the capital budgeting or investment process. Although most of the steps are fairly straightforward, later in this chapter we will provide examples that concentrate on the analysis step. In terms of capital budgeting decisions, this step invariably involves an assessment of tradeoffs—namely, the initial cost of investment versus the expected benefits in terms of future cash flows and profitability. Thus, with capital budgeting decisions, there is always a quantitative component to the analysis. The easiest part of the quantitative analysis involves knowing the initial cost of a potential investment, such as new equipment. We can think of this as a cash outflow today, when the decision is being made. The next part of the process involves estimating any future costs and benefits, or cash outflows and inflows. Here, it is the net cash flow that is relevant. In addition, we need to examine the incremental cash flow compared with that of the “do nothing” alternative. Finally, the last part of our analysis involves comparing the net cash flows and considering their timing, or what is known as the time value of money.

8.2 Capital Budgeting Techniques Now that we have an appreciation of time value of money concepts and understand how these concepts relate to the valuation of bonds, preferred shares, and common shares, we are finally in a position to appreciate the various capital budgeting techniques, because many of them rely on time value of money concepts. These capital budgeting techniques are quantitative assessment tools to determine whether a firm should proceed with an

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Objective 8.2

Describe various capital budgeting techniques, including payback, net present value, and internal rate of return.

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investment in a project. We begin with the simplest assessment technique: the payback method. This method provides the number of years by which a project’s cash flows cover the initial investment but does not rely on time value of money concepts (which is the major weakness of this technique). We then examine the related techniques of net present value and internal rate of return.

8.2.1 Payback

payback method: A method for evaluating investment projects that measures the time it takes for an investor to recover his or her initial investment

Fig 8.3 Payback Method with Smooth or Even Cash Flows

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Recall the capital budgeting process described in the previous section. As explained in that section, the first step in the process involves determining the initial cost of an investment. This is the required cash outflow today, when the decision is being made. We then estimate any future costs and benefits, or cash outflows and inflows, focusing specifically on the net cash flows (i.e., cash inflows less cash outflows). On average, these net flows should be cash inflows; otherwise the investment would certainly not be worthwhile. Finally, we compare the estimated net cash flows to the initial investment. The payback method is the simplest method for assessing capital budgeting decisions. We will review two versions of the payback method. First, for projects with an upfront investment and smooth or even annual cash flows, the payback period is estimated as shown in Figure 8.3. To better understand the payback method with smooth or even cash flows, let’s consider an example. Suppose Ace Company is considering an investment in new state-ofthe-art equipment that requires an initial outlay of $100,000. The investment is expected to generate average annual net cash flows of $20,000 for the next eight years, primarily related to the superior efficiency of the new equipment as compared to the company’s old equipment. Here, the payback period is calculated by dividing $100,000 (the cost of the initial investment) by $20,000 (the average annual net cash inflow). Our result is a payback period of five years. In general, the payback period represents the length of time required to repay the initial investment—in other words, how long it takes for Ace to recoup its investment in the new equipment through annual cost savings. In a sense, the payback method attempts to capture the riskiness of a project. If the payback period is very short, then the project is less risky. Thus, some firms have guidelines stating they will only accept projects with payback periods of, say, three years or less. Second, let’s examine a more general estimation of payback when net cash flows are uneven. In this case we simply cumulate the net cash flows in each year. The approximate payback period is the year in which the cumulative net cash flows become positive. We will show a more precise measure in the following example. Suppose Ace Company made the same equipment purchase for $100,000 today (at year 0) but instead of smooth net cash flows, it had some initial problems that caused a negative net cash flow in year 1 and then lower-than-anticipated net cash flows in earlier years, but higher-than-expected net cash flows in the later years. Its net cash flows in years 1 through 8 were as follows: - $10,000, $5,000, $12,000, $18,000, $22,000, $27,000, $33,000, and $35,000. Net cash flows for each year as well as cumulative net cash flows are shown in Figure 8.4. We notice that cumulative net cash flows became positive in year 7, which is the approximate payback period. For a more precise estimate we note that at the end of year 6 the cumulative net cash flows were - $26,000 and during year 7 there were net cash flows of $33,000. So partway through year 7 cumulative cash flows turned positive, which implies the actual payback was in less than 7 years. We can interpolate by

Payback period =

initial investment average annual net cash inflow

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Year

Net Cash Flow ($)

Cumulative Cash Flow ($)

0

(100,000)

(100,000)

1

(10,000)

(110,000)

2

5,000

(105,000)

3

12,000

(93,000)

4

18,000

(75,000)

5

22,000

(53,000)

6

27,000

(26,000)

7

33,000

7,000

8

35,000

42,000

179

Fig 8.4 Payback Method with Uneven Cash Flows 

calculating the fraction $26,000/$33,000 or 0.79 year. In other words, given the total year 7 net cash flow of $33,000, by the 0.79 year point, the start-of-year $26,000 cumulative deficit would have been eliminated. As such, the precise payback is 6.79 years.

8.2.1.1  Strengths and Weaknesses of the Payback Method  The main

strength of the payback method is its relative ease of calculation. It can provide a quick screen of which projects may warrant further in-depth analysis, since if the payback period is quite long it is less likely that any of the other capital budgeting methods would find it acceptable. It is a quick measure of the inherent risk of a project, as those with longer payback periods create additional risk of recovering initial investment costs. In terms of weaknesses, given our knowledge of the time value of money, we can easily identify the major deficiency with the payback method: There is no attempt to distinguish between cash flows in the earlier years and cash flows in the later years; all are treated the same. As well, it does not given any consideration to cash flows expected to occur beyond the payback period. Although some firms use internal guidelines—for example requiring any new project to have a payback of less than five years—any such guideline measure of a desired payback period is arbitrary. Also, there is no incorporation of opportunity cost.

8.2.2 Net Present Value The net present value (NPV) method of capital budgeting attempts to capture the net value added to a firm by taking on a particular project. Consider the simple example of a project with a cash outflow today and an anticipated cash inflow in one year. In this oneperiod example, NPV is calculated as shown in Figure 8.5. Note that in Chapter 10, we will see that the discount rate used to evaluate projects is directly related to the cost of capital, or the firm’s cost of financing. If the particular project is the same risk as the overall firm, then the discount rate should be closely related to the cost of capital. In the context of project evaluations, the discount rate is also known as the hurdle rate, and it will be examined in more detail in Chapter 10 as NPV = −C0 + where

C1 (1 + r)

cost of capital (weighted-average cost of capital or WACC): The weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shares, and common shares hurdle rates: The minimum acceptable rate of return for investments, depending on the nature and risk of the investment Fig 8.5 Net Present Value OnePeriod Example

NPV = net present value −C0 = initial cash outflow today (i.e., time zero) Ct = anticipated net cash inflow in one year r

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= discount rate (or hurdle rate) in decimal form

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Fig 8.6 Net Present Value Multi-Period Example

NPV = −C0 + where

C1 C2 C3 + + +... (1 + r)1 (1 + r)2 (1 + r)3

NPV = net present value −C0 = initial cash outflow Ct = anticipated net cash inflow at time t r

net present value rule: A method for evaluating investment projects that states that a firm should accept any project with a net present value greater than or equal to zero.

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= discount rate (in decimal form)

well. There, we’ll see that the appropriate hurdle rate for a particular project reflects the perceived riskiness of the project: Less risky projects have lower hurdle rates, whereas riskier projects have higher hurdle rates. Our focus in this chapter, however, is simply a basic understanding of the mechanics of net present value. Suppose Ace is considering a new project. The firm’s initial outlay in the project 1C 0 2 is $80,000, the project’s net cash inflow in one year 1C 1 2 is anticipated to be $100,000, and the appropriate discount rate (r) is 10 percent. The net present value is calculated in two stages. First, the present value of the expected cash flow is calculated on the basis of the time value of money concepts described in Chapter 7. Specifically, to find the present value, we divide $100,000 by 1.10, which gives us a result of $90,909. Second, the initial investment of $80,000 is subtracted from this amount, leaving $10,909, or the net present value of the investment. The net present value rule states that a firm should accept any project with a net present value greater than or equal to zero. Here, we assume that the firm is not facing any capital constraints—in other words, if a project is identified that is shown to add value by providing a return above its cost, then the firm will be able to borrow or to attract new equity investors in order to invest in the project. Note that the special case of zero NPV results from a project that provides just enough compensation for its level of riskiness—in other words, enough compensation to satisfy all of its lending or investing stakeholders. We can also generalize the net present value calculation to situations that involve cash flows in more than one period, as shown in Figure 8.6. Suppose, for example, that Ace is now considering investing in a new piece of equipment, the Cost-Saver 300, that costs $300,000. The firm anticipates net cash inflows resulting from installing the Cost-Saver 300 in the next three years of $100,000, $150,000, and $200,000, and the appropriate discount rate is again assumed to be 10 percent. What is the net present value of this project? Moreover, should Ace purchase the Cost-Saver 300? To answer these questions, we must first calculate the present value of each of the three expected cash flows. Upon doing so, we find that the present value of the first inflow is $90,909 (or $100,000>(1.10)1), the present value of the second inflow is $123,967 (or $150,000>(1.10)2), and the present value of the third inflow is $150,263 (or $200,000>(1.10)3). Next, we calculate the sum of the three present values: $365,139. After that, we subtract the initial investment of $300,000, leaving us with a net present value of $65,139. Thus, based on the NPV rule, Ace should purchase the Cost-Saver 300. Net present value can also be calculated using a spreadsheet NPV function, but be forewarned that calling it “NPV” is somewhat of a misnomer and the function should be used carefully. In Excel, find the “Insert Function,” then select category “Financial,” then “NPV.” The form of this function is NPV(rate, value1, value2, . . . ), but note carefully that the function assumes “value1” is not the initial cash outflow today but rather the net cash outflow one period from now. Thus, in order to do an NPV calculation in Excel, you must perform the separate step of subtracting the initial investment. Using our notation, rate is the discount rate or r, in decimal form; value1 is the net cash flow one year from now (assuming we are examining annual cash flows); value2 is the net cash flow two years from now; and so on. We subtract the initial investment because it is a cash

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A 1 Rate 2 Initial investment 3 value1 4 value2 5 value3

B

C

D

Fig 8.7 Spreadsheet Net Present Value Example

E

.10 –300000 =B2 + NPV(B1,B3,B4,B5) 100000 or =B2 + NPV(B1,B3:B5) 150000 200000

65.139

outflow today. So, to run the NPV function using the information from our example, choose a particular cell and enter the following: = - 300,000 + NPV(.10,100000,150000,200000) The same answer that we found previously—65,139—should appear. We can recreate this example by giving labels to each of the components and then referencing each of the components of the function separately, as indicated in Figure 8.7.

8.2.2.1  Strengths and Weaknesses of the Net Present Value Method 

The major strength of the net present value method is that it takes into account the time value of money through the discount rate. It implicitly makes the reasonable assumption that any interim cash flows from the project are reinvested at the firm’s cost of capital. One weakness of the net present value method is that it provides an answer in dollar terms while many managers focus on percentage returns when assessing projects. The greatest challenges with the net present value approach are determining realistic cash flow estimates and estimating an appropriate hurdle rate.

real option definition: The alternative or choice, but not obligation, to make a particular business investment decision, often related to timing

In-Depth

Real Options

We have simplified our investment discussions by assuming that, if a manager is deciding whether to invest, a yes-no decision must be made today. But what if there is an option to postpone the decision—say, until a project becomes more attractive? This is the notion of a real option or the right (but not obligation) to make a particular business decision.1 Let’s contrast two types of decisions. Here is a very simple example of a traditional investment that requires a decision today, and the resulting profits depending on whether there is good or bad news subsequent to our decision. good news

$100

bad news

−$50

invest

don’t

$0

1 A broader issue is how to price such a real option, which is beyond the scope of this book. Part of

the answer requires an understanding of financial options such as call options, and the well-known Black-Scholes model. Two finance professors—Myron Scholes and Bob Merton—won Nobel Prizes in Economics for their insights into option pricing, and would almost certainly have shared the award with another finance professor, Fisher Black, who unfortunately passed away before being recognized with the prize. (continued)

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Now let’s suppose we don’t have to decide today but can wait to hear the news first. invest

$100

good news don’t invest

$0 −$50

bad news don’t

$0

We can clearly see that there is value in having the option to wait before deciding. If news is good then we invest, but if news is bad we don’t. Options are usually very specific to the type of project that a firm is facing and are certainly more complex than our simple example. However, we can generalize some of the main types of options that managers typically face. These include the option to wait until an optimal time before making an investment, the option to grow, and the option to terminate an underperforming project. The preceding example showed the value of delaying an investment opportunity. As an example of the option to grow, we observe that firms like Google often make acquisitions in businesses that don’t have positive cash flows but are thought to be on the verge of huge growth opportunities. Not all acquisitions will work out, but some may be real winners. Finally, the abandonment option is valuable when a project requires various stages of investments. Managers can reassess the profitability of proceeding further with the investment at each stage and only proceed if future benefits outweigh future costs, regardless of any sunk costs. The value of a real option stems mainly from two factors. One is the value of time, since by waiting, a more favorable investment outcome may present itself. Another source of value relates to the riskiness of the project. If there is no risk then a decision is straightforward as future benefits can easily be quantified. If a project is much more risky, there may be a chance that there is a huge value at some future date from investing in the project. The key message for managers is that there is value in the ability to wait before making an investment decision and we may not capture the value of that real option in our traditional NPV and IRR approaches. Real option analysis can supplement our traditional investment analysis.

8.2.3 Internal Rate of Return

internal rate of return rule: A method for evaluating investment projects that states that a firm should accept any project with an internal rate of return greater than or equal to a prespecified hurdle rate

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Although the net present value method has tremendous intuitive appeal, a related ­measure—the internal rate of return (IRR)—is often more popular in practice. The IRR measure is similar to the yield to maturity measure for bonds, as examined in Chapter 7. This technique tells us what particular discount rate will result in a zero NPV project. Therefore, unlike the NPV method, which gives a dollar figure for the amount of value added, the IRR method gives a percentage return to assess the viability of a project. This method also has a “rule” of its own. Whereas the NPV rule states that a firm (not facing any capital constraints) should accept any project with a net present value greater than or equal to zero, the IRR rule states that a firm should accept any project with an internal rate of return greater than or equal to a prespecified hurdle rate. Note that the hurdle rate should be the same as the discount rate used in the NPV assessment. Consequently,

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A 1 Guess 2 Initial investment 3 value1 4 value2 5 value3

B

C

D

E

.10 –300000 100000 150000 200000

=IRR(B2,B3,B4,B5,B1) or =IRR(B2:B5,B1)

183

Fig 8.8 Spreadsheet Internal Rate of Return Example

20.61%

both NPV and IRR decisions should be consistent (at least for most straightforward situations with an initial cash outflow and subsequent cash inflows). In other words, if a project has a positive NPV, it should also have an IRR greater than the hurdle rate. To see how the IRR method works, let’s revisit the example described in the latter part of Section 8.2.2. In that example, Ace is considering an investment of $300,000 and anticipates net cash inflows in the next three years of $100,000, $150,000, and $200,000. The appropriate hurdle rate is assumed to be 10 percent. What is the internal rate of return for this project, and should Ace accept it? For a multi-period problem like this one, it turns out that there is no easy method to calculate the IRR by hand or even using many standard financial calculators (except for a bruteforce trial-and-error process). However, the process is quite straightforward when using spreadsheets (as well as some more advanced calculators). In Excel, find the “Insert Function,” then select category “Financial,” then “IRR.” Note that the form of this function is IRR(values, [guess]). The values represent an array and must be specified in a particular manner. Note also that there is an inconsistency between the NPV and IRR functions in Excel. The first value in the IRR function is the initial cash outflow, expressed as a negative number, - 300000. This first value must represent a cash outflow today, unlike the NPV formula that excluded the initial cash outflow in its formula. The subsequent values represent the net cash flows, first starting one year from now (100000), then two years from now (150000), then three years from now (200000). This process would continue for as many years as appropriate. The “guess” in this formula is optional and represents an estimate of what the IRR might be. (Because the spreadsheet function is based on an iterative trial-and-error process, it often needs a reasonable place to start.) In most cases, simply starting with the hurdle rate or even 0.10 should suffice. Thus, to use the IRR function for our Ace example, chose a particular cell and enter the following information precisely as shown: = IRR({ - 300000; 100000; 150000; 200000}, .10) An answer of 20.61% should appear. This indicates that the internal rate of return for purchasing the equipment is 20.61 percent. We can recreate this example by giving labels to each of the components and then referencing each of the components of the function separately, as indicated in Figure 8.8. In this example, consistent with our NPV analysis, the IRR of 20.61 percent is above the hurdle rate of 10 percent, so Ace should take on the project. How does the discount rate impact the NPV value? For the Ace example, the relationship between NPV and different discount rates or hurdle rates is shown in Figure 8.9. We see from this figure that when the discount rate is exactly 20.61 percent, then the NPV is zero. In other words, we can confirm that the IRR is 20.61 percent, because this is the discount rate that makes the NPV exactly equal to zero. In general, the higher the discount rate, the lower the NPV.

8.2.3.1  Strengths and Weaknesses of the Internal Rate of Return Method 

A major strength of the internal rate of return method is that, like the net present value method, it takes into account the time value of money. It also has the convenient benefit

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Fig 8.9 NPV for Different Discount Rates Example

$80,000

$60,000

NPV

$40,000

$20,000

0

–$20,000 –$40,000

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Discount Rate (%)

of providing results as a return measure rather than a simple dollar measure. If there is an unusual cash flow pattern—for example a mix of positive and negative cash flows throughout the life of the project rather than the usual negative cash flows in early years followed by positive cash flows in later years—it is possible that there is more than one internal rate of return. There is one other cautionary note related to the IRR method: An implicit assumption is that any cash inflows generated in the earlier years can be reinvested (for example, in other new projects that Ace is taking on) at the rate of the IRR. In many cases, this is not a realistic assumption. So, even though the appropriateness of the reinvestment assumption does not affect the “accept” or “reject” decision in our preceding example, the resulting rate of return should be interpreted cautiously.

8.2.3.2  Modified Internal Rate of Return  In order to overcome some of the

weaknesses of the internal rate of return method—in particular the possibility of multiple answers and the assumed reinvestment rate—an alternative method known as the modified internal rate of return (MIRR) has been developed. Although the calculation appears to be somewhat complex, the good news is that the MIRR calculation is built in to common spreadsheet applications such as Excel. The MIRR method requires the specification of two rates. First, we need to specify a hurdle rate or cost of capital the same as with the NPV method, which we can generically refer to as the finance rate. Second, we need to specify a reinvestment rate at which we assume the firm can invest any positive net cash flows from the project. We then segregate positive cash flows from negative cash flows. We take the future value of the positive cash flows compounded at the reinvestment rate. We also take the present value of the negative cash flows discounted at the finance rate. We then estimate an IRR based on these two values. The formula is as follows:

modified internal rate of return (MIRR): A modification of IRR that assumes cash flows are reinvested at the financing rate, such as the cost of capital, rather than at the IRR

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MIRR =

FV of positive cash flows compounded at the reinvestment rate -1 B PV of negative cash flows discounted at the finance rate n

where n is the number of periods and represents the “root” of the equation (for example, if n is 2, then it is a square root equation, if n is 3, it is a cube root equation, etc.).

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Chapter 8  Making Investment Decisions



Year

Net Cash Flow ($)

0

(100,000)

FV of Positive Cash Flows

–PV of Negative Cash Flows

185

Fig 8.10 MIRR Example 

100,000 9,091

1

(10,000)

2

5,000

9,869

3

12,000

21,148

4

18,000

28,323

5

22,000

30,908

6

27,000

33,869

7

33,000

36,960

8

35,000

35,000

Total

196,078

Finance rate

10.00%

Reinvestment rate

12.00%

Ratio of FVs/–PVs

1.80

MIRR

7.60%

109,091

Let’s consider an example using the same cash flows as in Figure 8.4. The finance rate is 10 percent. Let’s assume that the reinvestment rate is 12 percent since Ace is able to find new opportunities slightly above its hurdle rate. The MIRR calculation is presented in Figure 8.10. The ratio of the future value of the positive cash flows compounded at the reinvestment rate ($196,078) to the present value of the negative cash flows discounted at the 8 finance rate ($109,091) is 1.80. If we take the eighth root of 1.80, or 21.80 (which is also 1 ( ) the same as writing 1.80 8 ), we get 1.076. Finally, when we subtract 1 we get 0.076 or 7.60 percent the MIRR.

8.3 Capital Budgeting Extensions There are a number of nuances related to capital budgeting that we will explore in this section. First, we describe an alternative method for interpreting NPV results and assessing which projects to undertake. Second, we consider how to compare projects of different lengths. And third, we look at mutually exclusive projects and what happens when a firm is limited to the amount of capital it can spend on projects.

Objective 8.3

Describe the profitability index, equivalent annual costs, mutually exclusive projects, and capital rationing.

8.3.1 Profitability Index In Section 8.2.2, we discussed the NPV approach to evaluating projects and examined a project that Ace Company was considering: purchasing the Cost-Saver 300. Recall that this equipment cost $300,000 and the present value of the first three years of net cash inflows was $365,139. We can evaluate the feasibility of such an investment in a different manner. Instead of taking the difference between the benefits and costs, expressed as a

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dollar amount—the NPV method—we can instead take a ratio of the benefits and costs. We refer to this ratio as the profitability index: Profitability index =

present value of net cash flows initial investment

So, for the Cost-Saver 300, the profitability index measure is simply $365,139>$300,000 = 1.22. According to this method, a project should be undertaken if its profitability index measure is greater than 1.0 because any ratio greater than 1.0 indicates that benefits exceed costs. Thus, as we saw with the NPV rule, Ace should purchase the Cost-Saver 300. The profitability index measure is useful for ranking a series of projects based on the notion of getting a “bang for your buck,” or receiving as much value added as possible in excess of each dollar of investment. There are limitations to using the profitability index, however. Note that a very small project might have a high profitability index, but in dollar terms, it might add only a small amount of value compared with a larger project with a lower profitability index.

8.3.2 Equivalent Annual Cost and Project Lengths How can a firm compare projects with different project lengths? The answer is to create an apples-to-apples comparison by estimating and comparing annual costs. The equivalent annual cost method measures the annual cost related to a project over the lifetime of that project. If we are creating equivalent annual costs, then we are essentially creating an annuity. Recall from Chapter 7 the formula for the present value of an annuity (PVA): PVA =

1 PMT c1 d r (1 + r)n

where in this context PMT represents the annual annuity payments or equivalent annual costs, r is the discount rate or hurdle rate in the present context, and n is the number of periods of the project. To initially simplify matters, if there is a simple one-time initial investment at time 0 and there are no ongoing costs associated with the n years of the project, then we can think of the initial investment as equivalent to the PVA. Since we know n (the anticipated length of the project) and r (the hurdle rate), we can solve for PMT. In other words, PMT represents an equivalent annual cost we would need to pay during the lifetime of the project (with the first payment at the end of the first year) instead of making the initial upfront investment. So rearranging the PVA formula to solve for PMT: PMT = [r * initial investment]/c [1 -

profitability index: A method for evaluating investment projects that takes the ratio of present value of net cash flows to the initial investment equivalent annual cost: The annual cost related to a project over the lifetime of that project

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1 d (1 + r)n

Of course as we’ll see shortly, if we are using a spreadsheet, our lives are much simpler as we can solve for PMT directly using the PMT function. Now let’s consider a slightly more complex situation by adding ongoing costs and run some numbers. Suppose Ace is considering the purchase of a new machine, and it has two models from which to choose—both of which will generate identical annual cash flows. The Super-3 model costs $30,000, is expected to last for three years, and requires annual maintenance of $6,000, whereas the Super-8 model costs $100,000, is expected to last for eight years, and requires annual maintenance of only $1,000. The appropriate hurdle rate is 10 percent. Given these factors, which machine should Ace purchase? We know the annual maintenance cost for each machine, and on that basis, the Super-8 looks better because its annual costs are much lower. However, to make a fully informed decision, we also need to amortize each machine’s purchase price over the life of the machine. The easiest way to do this is to use a spreadsheet function that solves for

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the annual payment, or PMT, given the initial price or present value of each machine. In Excel, find the “Insert Function,” then select category “Financial,” then “PMT.” The form of this function is PMT(rate, Nper, PV, [FV ], [type]). For the Super-3 machine, rate is the hurdle rate or 10 percent; Nper is the life of the machine, or three years; and PV is the initial investment in the machine, or –30,000. (Because it represents a cash outflow, the initial investment is expressed as a negative number.) We don’t need to enter any information for FV, or future value, and would only do so if there was any salvage value at the end of the life of the machine. We also don’t need to enter any information for type, because the default assumption is that the annual cash outflows occur at the end of each year. So, we would enter the following values in our function in order to assist in estimating the equivalent annual cost: = PMT(.10, 3, - 30000)   or    = PMT(.10, 3, - 30000,0,0) The function returns a result of $12,063.44. Or using a financial calculator: 30,000 S S 10 3 PMT

S

PV i [or r] n Answer is 12,063.44

If we add this amount to the annual maintenance cost of $6,000, we have the equivalent annual cost of the Super-3 machine: $18,063.44. We can then repeat this procedure for the Super-8 machine using the function PMT(.10, 8, –100000). This function yields a result of $18,744.40, which is the amortized cost of the machine. When this amount is added to the annual maintenance of $1,000, we arrive at the equivalent annual cost of the Super-8 machine: $19,744.40. Because the equivalent annual cost of the Super-3 machine is lower than that of the Super-8 machine, Ace should purchase the Super-3 machine. Notice that we are making some important assumptions in this example. If we anticipate needing the machine for at least eight years—the anticipated life of the Super-8 machine—then we will need to replace the Super-3 machine at least two times. We are making an implicit assumption that the cost of a new Super-3 machine three and six years from now will be the same as today’s $30,000 cost. We’re also assuming that a new machine purchased three or six years in the future will have the same annual maintenance costs. If these assumptions are not valid, then we need to be careful in the decision we make.

8.3.3 Mutually Exclusive Projects and Capital Rationing A firm may face some complicating factors when it is making investment decisions. In most of the examples in the chapter, we’ve implicitly assumed that every project Ace was considering was independent of other projects. In other words, we assumed that Ace could make “accept” or “reject” decisions for every project without considering the effects of these decisions on other projects. The one exception was the consideration of whether to purchase either the Super-3 machine or the Super-8 machine. We refer to those two machine purchases as being mutually exclusive projects. In other words, if Ace purchases the Super-3 machine, it will not purchase the Super-8 machine, and vice versa. If all projects are independent, then both the NPV and IRR methods should result in consistent “accept” or “reject” decisions. If projects are mutually exclusive, then the NPV rule still applies: Invest in the project with the highest positive net present value. However, trying to rely on IRR and simply choosing the project with the highest IRR above the hurdle rate may be inconsistent with the NPV rule. For example, a 30 percent return on a $1,000 investment is $300, whereas a 20 percent return on a $1 million investment is much greater $200,000. Thus, while the 30 percent IRR is clearly greater than the

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mutually exclusive projects: Projects that are similar—however, if one is chosen the other cannot be

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capital rationing: The act of placing restrictions on the amount of money available for investments, forcing firms to choose among worthwhile projects

20 percent IRR, the $1,000 return is a much lower dollar amount than the $200,000 return. This critique—that we need to be careful when interpreting which project is ­“better” simply by relying on which one has the highest IRR—can be applied to evaluating projects solely on the basis of the profitability index as well. One suggested solution, particularly for comparing two mutually exclusive projects with identical lives, is to focus on the incremental initial outlays and incremental cash flows of the two projects. Still, there are limitations in practice based on implicit assumptions related to the IRR method. For example, there may be more than one IRR (i.e., more than one value that makes the NPV equal to zero) depending on the complexity of the resulting incremental cash flow stream. Another complicating factor when a firm is making investment decisions relates to the amount of money that the firm has available for investing. Capital rationing occurs when a firm puts a limit on the amount of its investments—for example, by having a fixed budget for capital expenditures in a particular year. Capital rationing may also occur when a firm imposes a higher hurdle rate, which is associated with a higher cost of capital—for example, if a firm decides to reduce its borrowing. Capital rationing may be imposed externally—for example, loan provisions may limit the issuance of additional debt, or it may be imposed internally. Capital rationing may be imposed within firms that have had a poor track record of overinvesting in underperforming assets—even though a more logical response might be to review the capital expenditure process. Or it may be imposed because a firm’s senior managers are reluctant to issue external debt. For example, Ace may decide that it is investing a total of only $50 million next year in new equipment, so it will undertake only the “best” equipment investments. But what does “best” mean? Ace should compare the initial cost of various investments, the NPV of each, the IRR, and the profitability index. Selecting projects based on NPV might not be optimal since a particular project might have a very high initial cost compared to another but only marginally higher NPV than other projects with much lower initial investments. For example, Project A might require an initial investment of $40 million and provide an NPV of $1 million, the highest NPV among all projects under consideration. However, Project B might have an initial investment of only $5 million with an NPV of $900,000, and Project C might have an initial investment of only $4 million with an NPV of $800,000. Other projects might cost less than $4 million but with still sizeable NPVs. Therefore Ace might be better off foregoing Project A and instead take on a series of smaller projects that cumulatively have a much higher NPV than Project A. So how should Ace determine which projects to take on? Usually, the IRR method and the profitability index will be more informative than the NPV method when facing capital rationing and should provide identical rankings. In time, if there are conflicts, the profitability index should provide the best rank order in a capital rationing situation. Ultimately, Ace should consider the combination of projects that provide the highest NPV, and the profitability index will be a useful tool to assist.

8.4 Relevance for Managers Objective 8.4

Explain why making investment decisions is relevant for managers.

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Making investment decisions is a critical function of almost every operating manager. Thus, it’s important for all managers to have a framework for effective decision making. Such a framework involves defining the decisions to be made, developing criteria for evaluating alternatives, generating and assessing alternatives, and finally, choosing an alternative and implementing an action plan. Time value of money concepts are also the foundational building blocks on which to make effective investment decisions. In particular, investment in any project relies on

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basic present value calculations—in other words, comparing initial investments with the present value of anticipated net cash flows, discounted at an appropriate hurdle rate to reflect the perceived riskiness of the project. Managers strive to add value to their firms, and they can accomplish this goal by undertaking positive net present value projects. It is critical for managers to understand the pros and cons of a variety of capital budgeting metrics, including those that rely on time value of money concepts such net present value, internal rate of return, and the profitability index, and those that don’t, such as payback. To what extent do managers rely on the capital budgeting techniques described in this chapter? A survey of American CFOs conducted by academics John Graham and Campbell Harvey asked the CFOs to rate the frequency of their use of various capital budgeting techniques. Graham and Harvey found that 75.7 percent of CFOs always or almost always relied on IRR to make capital budgeting decisions, and 74.9 percent relied on NPV. In particular, larger firms were more likely to rely on these techniques, as were firms with proportionately more debt. Perhaps surprisingly, payback was used by 56.7 percent of survey CFOs despite the obvious limitations of this method. Only around 12 percent of the surveyed CFOs used the profitability index method. Thus, we see that it is important for all managers to be aware of and utilize sound capital budgeting techniques.

Summary

1. The business decision-making framework involves five steps: definition of the decision to be made; identification of criteria to be used when evaluating alternatives; generation of alternatives; analysis and assessment of alternatives; and decision and implementation. 2. The payback method is the simplest capital budgeting technique, but it ignores the time value of money. 3. The net present value method of capital budgeting estimates how much value a firm will gain or lose by accepting a project with a particular initial investment and projected net cash flows.

4. A real option is the right but not obligation to make a particular business decision. 5. The internal rate of return method of capital budgeting estimates the discount rate such that the net present value of a project is just equal to zero. 6. The profitability index compares the present value of net cash flows to the initial investment. 7. Capital budgeting decisions are more complex when projects are mutually exclusive, when comparison projects are not of equal length, and when capital is rationed.

Additional Readings and Information

See any of the corporate finance textbooks listed at the end of Chapter 1 that contain extensive sections related to capital budgeting. Some books that focus exclusively on capital budgeting include: Peterson, Pamela, and Frank Fabozzi, Capital Budgeting: Theory and Practice. New York: John Wiley & Sons, 2002. Bierman, Harold, and Seymour Smidt. The Capital Budgeting Decision: Economic Analysis of Investment Projects, 9th ed. New York: Routledge. The capital budgeting survey described in this chapter is from: Graham, John, and Campbell Harvey. “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (Spring 2002): 8–23.

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Problems

1. D’Mangga Ltd. is considering a capital investment of $80,000 in additional equipment. The new equipment is expected to have a useful life of three years with no salvage value. During the life of the investment, annual net income and cash inflows are expected to be $15,500 and $35,500, respectively. D’Mangga Ltd. requires a 9 percent return on all new investments. Compute cash payback period of the investment. 2. What is the net present value for the investment in question 1? 3. A firm is considering the following mutually exclusive investment projects. Project ABC requires an initial outlay of $500,000 and will provide cash inflow of $120,000 per year for the next seven years. Project XYZ requires an initial outlay of $5,000,000 and will provide cash inflow of $1,350,000 per year for the next five years. The cost of capital is 10 percent. Calculate the NPV of both projects. Which project should the firm take on? 4. Based on question 3, calculate the profitability index (PI) of both projects. Which project should the firm accept?

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5. Should the firm achieve a zero NPV at the same cost of capital of 10 percent? 6. What is the net present value of a project with a $40,000 initial investment and expected net cash flows of $15,000, $20,000, and $25,000 in each of the next three years, assuming an appropriate discount rate of 10 percent? 7. What is the internal rate of return for the project in question 6? 8. What is the profitability index for the project in question 6? 9. What is the payback period for the project in question 6? 10. What is the modified internal rate of return for the project in question 6 if the finance rate is 10 percent and the reinvestment rate is 13 percent? 11. What is the equivalent annual cost of a piece of equipment that requires an initial investment of $50,000, is expected to last seven years, and requires annual maintenance costs of $4,000 if the appropriate discount rate is 9 percent?

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Part 3    Financing Long-Term Needs

Overview of Capital Markets: Long-Term Financing Instruments

9 Learning Objectives

There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. – Mark Twain

obj 9.1

Assess the key features of bonds and credit ratings. obj 9.2

Earlier in this book, we focused on sizing up a firm’s prospects and understanding the short-term financial requirements of the firm. In particular, Chapter 5 introduced short-term financing instruments with maturities less than one year, traded in what are known as money markets. Then, Chapter 7 presented a bridge between short-term and long-term financing and introduced the underpinnings of the valuation of financial securities such as bonds and stocks. Now, we’ll focus our attention on understanding the longterm financing instruments issued by firms and the markets in which they trade. This chapter is the first of four that examine various aspects of a firm’s financial needs for more than one year, with securities such as bonds and stocks traded in what are known as capital markets. If a firm is not able to meet its financial requirements through internally generated funds and some short-term borrowing, then it must seek external financing through capital markets. Later in the book, we’ll look at the cost of raising capital in Chapter 10, financing and dividend decisions in Chapter 11, and how to determine an appropriate mix of debt and equity in Chapter 12. But first, in this chapter, we examine the distinctive features of three important types of financial instruments that were briefly introduced in Chapter 7: bonds, preferred shares, and common shares. We then present an overview of capital markets, with a general focus on the stock market because it is more complex than the bond market. Later, we focus on the efficiency of stock markets, or the extent to which securities trade at fair prices, as this is an important consideration for firms issuing stocks. Finally, in the Appendix to this chapter, we present additional details on understanding bond and stock information from an investor’s perspective. Let’s see how financial instruments such as bonds and stocks fit in our financial management framework, as depicted in Figure 9.1. As shown in the figure, issuing financial instruments is part of a firm’s financing decisions, and accessing external financing impacts a firm’s ability to grow, as well as its overall risk.

Assess the key features of preferred shares. obj 9.3

Assess the key features of common shares, describe historical returns of major asset classes, and explain the difference between arithmetic and geometric returns. obj 9.4

Describe key elements of capital markets. obj 9.5

Explain the concept of market efficiency and describe the various forms of the efficient market hypothesis. obj 9.6

Explain why understanding capital markets and longterm financing instruments is relevant for managers.

money market: A financial market in which very liquid, safe, shortterm investments are traded capital markets (securities markets): Markets for long-term financing such as issuing bonds or equity

191

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Fig 9.1 Financial Management Framework: Long-Term Financing Decisions

the enterprise

financing

operating

• Debt financing • New equality • Dividend policy

investing

Growing profits, dividends, cash flow

Managing the risk profile

growth

risk

9.1 Bonds Objective 9.1

Assess the key features of bonds and credit ratings.

principal: The original or face amount of a loan on which interest is paid bondholders: Owners of bonds. securities markets: See capital markets. Markets for long-term financing such as issuing bonds or equity

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Let’s begin our exploration of capital markets by looking at bonds, which were briefly introduced in Chapter 7. From a firm’s perspective, bonds are simply a form of borrowing. At the most basic level, bonds are loan contracts or promises made by a firm indicating scheduled repayment of the principal amount—or the amount of money being lent—along with interest or coupon payments typically paid every six months. Bonds are issued by a firm, and because they represent a major form of long-term financing, they are a type of financial instrument. Bond investors, also called bondholders, can be thought of as a type of lender. The majority of these investors are commonly referred to as institutional investors, such as pension funds, mutual funds, endowment funds, and insurance companies. However, once a firm has issued a bond, the bondholder can choose to sell or trade that bond to another party in exchange for money equal to the value of the bond. In fact, there are usually active markets whereby corporate and government-issued bonds can be traded; these are known generically as securities markets (or capital markets) or specifically as bond markets.

9.1.1 Changing Bond Yields As we saw in Chapter 7, bond prices move inversely to changes in yields or interest rates—or conversely, yields move inversely to bond price changes. Let’s briefly examine the implications of this observation for firms that may be considering issuing bonds. As we do so, it is important for us to recognize that both short-term and long-term interest rates or yields change over time, sometimes substantially, usually in a similar direction

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Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



20 1-year 30-year 15

193

Fig 9.2 U.S. Treasury Yields Percent, One-Year and Thirty-Year Maturities, 1962–2012

10

5

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1962

–5

1964

0

Source: Federal Reserve http://www.federalreserve.gov/econresdata/statisticsdata.htm (accessed March 1, 2012)

but not always in lockstep. As a result, firms may be facing different costs today if they issue bonds with short maturities (such as one year) or long maturities (such as thirty years) compared with, say, issuing such bonds next year. Corporate bond yields often move in a similar direction to yields on governmentissued bonds, but of course, corporate bond yields are higher than similar time-to-­ maturity government bond yields because owning a corporate bond is riskier. Figure 9.2 shows the yield on U.S. treasuries (or government-issued bonds) with one-year and thirty-year maturities, from 1962 to 2012. Notice that yields or interest rates peaked around 1981, then steadily declined through 2012. As we will see in Chapter 10, this decline in rates resulted in a dramatic decline in firms’ cost of capital, which in turn impacted the attractiveness of projects in which firms considered investing. From the figure, we can also determine periods during which the yield curve was inverted by looking for times when short-term rates exceeded long-term rates, such as around 1980, 1988, 2000, and 2006. Each of these periods occurred just prior to the last four U.S. recessions, which started in 1981, 1990, 2001, and 2007. Key takeaways from this figure are (1) for investors, bond yields and hence prices can change dramatically over time; (2) firms may face different costs over time—as indicated by the varying yields—when issuing bonds; and (3) the relative cost of issuing short-term bonds (such as those with a one-year maturity) versus long-term bonds (such as those with a thirty-year maturity) may change over time, so firms need to carefully consider the length of the borrowing period.

9.1.2 Bond Features Issuing bonds is attractive from a firm’s perspective because any interest payments are deductible as expenses for tax purposes, making bonds a relatively low-cost alternative for obtaining capital. Bonds are typically issued at face value with a particular maturity date. Generally, maturity dates range from one year to thirty years. In rare cases, 100-year or century bonds have been issued—for example, the Walt Disney Company issued century bonds in 1993 that became known as Sleeping Beauty bonds. In an even more extreme example, the Toronto Grey and Bruce Railway issued a 1,000-year bond in 1883. That

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sinking fund: A cash fund set aside by the firm in order to meet future debt obligations variable rate: A floating or nonfixed loan rate, often tied to changes in the prime rate or LIBOR prime rate: The rate offered by lending institutions, such as banks, to their most creditworthy customers LIBOR (London Inter-Bank Offered Rate): The rate at which banks offer to lend in the London inter-bank market; often used as the basis for floating-rate loans

bond, which is due to mature in 2883, appears to have the longest term to maturity on record, and it remains on the books of the Canadian Pacific Limited. Bonds differ by the types of features they have. For example, some bonds include a sinking fund feature, which requires the firm to repurchase a portion of its bonds on a regular basis throughout the life of the bonds or set aside an equivalent amount. This feature is intended to reassure bondholders that they won’t be left with losses if the firm is unable to meet its principal repayment obligation at maturity. In some cases, the firm may repurchase a portion of its bonds in the bond market, or it may buy back bonds directly from the bondholders by paying the face value. Although most bond contracts specify a fixed coupon rate—recall that the coupon rate reflects the annual amount of interest payments and is expressed as a percentage of the face value of the bond—other contracts indicate a variable rate. For example, the contract might specify repayment at the prime rate plus a certain percent (often in the 1/2 to 3 percent range). The prime rate is a benchmark set by each financial institution as the rate at which interest is charged to its most-favored (i.e., least risky) customers. An alternative benchmark rate common in Europe (but used worldwide) is the London Interbank Offered Rate, or Libor. Libor is the average rate at which major banks in ­London borrow among themselves and is a benchmark rate for trillions of dollars of mortgages, loans, and payments to individuals and businesses.

In the News

The Libor Scandal

On June 27, 2012, British investment bank Barclays PLC agreed to pay a fine of $453 million to U.S. and British authorities to settle allegations that the firm manipulated Libor over a period of at least five years. Barclays’ CEO Robert Diamond was forced to resign. Suspicions of manipulation were originally raised by the Wall Street Journal in a May 29, 2008, article. Libor borrowing rates are set daily for ten currencies and 15 maturities. The most popular rate is the three-month dollar rate. A panel of 18 London-based banks submits estimates of their costs for borrowing at each rate. The actual rate is set as an average, excluding the four highest and four lowest submissions. Investigations into the Libor scandal revealed two types of manipulation used by Barclays and other investment banks to influence Libor. In one type of manipulation, which was used during the financial crisis of 2007–2009, Barclays submitted estimates that were lower than their true costs because they did not want to reveal to the marketplace how costly borrowing had become for fear it might make the bank’s financial position appear weak. In the other type, Barclays’ traders colluded with traders from other banks to influence certain Libor rates in order to increase profits or decrease losses on their exposure to products tied to Libor rates. The fallout from the Libor scandal continues. By early 2013, two other banks implicated in the rate manipulation scandal—the large Swiss investment bank UBS and the Royal Bank of Scotland—agreed to large settlements with various regulatory authorities. In mid-2013 it was announced that a subsidiary of NYSE Euronext was appointed as the new administrator of Libor, taking over from a subsidiary of the British Bankers Association, with a transfer expected in 2014. Sources: D. Enrich and M. Colchester, “Embattled FSA Is Under Fire for Libor Policing,” Wall Street Journal, July 6, 2012 and “NYSE Euronext Subsidiary to Become New Administrator Of Libor” (Press release). NYSE Euronext, July 9, 2013

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Issue size:

$3 billion

Face (par) value:

$1,000

Maturity date:

December 16, 2036

Coupon rate:

5.875%

Coupon frequency:

Semiannually

Sinking fund:

None

195

Fig 9.3 Home Depot Bond Features

Callable: Yes Type of rate:

Fixed

Payment currency:

U.S. dollar

Day/count basis:

30/360*

*For the purposes of quoting yields, the U.S. convention is to assume each month has 30 days and a year has 360 days. In some other countries, it is assumed that a year has 365 days for yield calculations. Source: Morningstar Inc. http://quicktake.morningstar.com/StockNet/Bondsquote.aspx?bid = 09db65ea 9d26041b644453391d82de18&bname = Hm + Depot + 5.875%25 + %7c + Maturity%3a2036&ticker = HD&country = USA&clientid = dotcom (accessed September 17, 2012)

Another common feature of some bonds is a call provision. With callable bonds (also known as redeemable bonds), a firm can choose to pay back the investor at a prespecified date prior to the maturity date, usually at a prespecified price above the face value, representing a premium to the bondholder. For example, when interest rates have declined and it is cheaper for the company to reissue new bonds with lower coupon rates, it may choose to call its outstanding bonds. This provision is beneficial to the firm because it adds flexibility to its financial strategy and gives the firm the option of refinancing its debt obligations at a lower rate if interest rates decline. Because bondholders do not have a direct say in how a firm is run, their interests are protected to a degree through bond covenants. These covenants place some restrictions on the firm in such a way as to improve the odds that the bondholders will be repaid. For example, covenants might specify a maximum allowable debt-to-equity ratio for the firm, a minimum level of working capital, a maximum limit on annual capital expenditures, or a limit on the amount of dividend payments. Figure 9.3 summarizes these features and other issue details for the Home Depot bond introduced earlier in “Time Value of Money Basics and Applications.”

9.1.3 Bond Ratings When a company is planning to issue a bond, potential investors want a method of assessing the perceived riskiness of the bond investment. In other words, they want to assess the possibility of default, or the firm’s failure to meet its interest and principal repayment obligations. Bond-rating agencies fulfill this need by providing an assessment of the creditworthiness of the firm. Major rating agencies include Moody’s, Standard & Poor’s (S&P), and Fitch. These agencies assess the financial health of a firm by completing a process similar to the business size-up process described in Chapter 2.They then assign the firm’s bonds a rating based on their findings. For long-term bonds (i.e., those with a maturity of more than one year), these ratings are based on the likelihood of repayment of principal, the capacity and willingness of the firm to meet its financial commitments, the nature of the financial obligation (such as the maturity and any special features of the bond), and any protection afforded to bondholders by the firm in the event of bankruptcy or reorganization.

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call provisions: A description of terms under which a firm may redeem all or part of a bond or preferred share issue callable (redeemable): A type of bond whereby the firm can choose to pay back the lender at a prespecified date prior to the maturity date covenants: Provisions in a bond or debt agreement specifying restrictions or requirements on the borrower default: Failure to make debt obligation payments

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In-Depth

What Credit-Rating Agencies Do

Credit-rating agencies such as Moody’s, S&P, and Fitch provide opinions about the creditworthiness of debt issues such as bonds issued by companies or governments. In short, these agencies assess the probability that an issuer may default on its obligation. Credit ratings are meant to be a forward-looking assessment that takes into account historical and current information about a firm, its industry, and general economic conditions. These ratings focus strictly on credit quality, not on the suitability or merit of the investment. The assignment of credit ratings is not an exact science, and much objective judgment is involved. Credit ratings are useful because they facilitate the issuance and purchase of debt. They also impact the cost of borrowing because an issuer with a higher rating is able to have a lower interest rate on its debt. Most ratings are determined by a team of analysts who obtain information from published sources (such as annual reports) and discussions with management. The process starts with a request for a rating from an issuer, followed by an initial evaluation, a meeting with management, and the analysis. Rating agencies typically have committees that review the analysis and vote on the rating to be assigned. After the issuer is notified of the rating, the agency’s opinion is published and made public. A credit analysis usually involves assessment of both business risk and financial risk. Business risk assessment examines country risk, industry characteristics, and a firm’s position relative to its peers. In comparison, financial risk assessment examines a firm’s accounting data and various ratios, liquidity, cash flows, capital structure, and overall governance. Rating agencies don’t offer their services for free; they have a financial incentive to do so. There are a variety of possible business models whereby rating agencies earn profits. The most common payment structure is the issuer-pay model, whereby the firm requesting the rating pays the credit-rating agency. This model has been criticized because it creates a potential conflict of interest for the rating agencies, but the agencies try to mitigate this effect by separating the parts of the business that negotiate business terms from those that perform the analysis. Potential conflicts of interest are also reduced by reputation effects. In other words, any incentive an agency has to issue a biased rating is offset by the likelihood that investors will come to see the agency’s ratings as biased and therefore no longer make decisions based on those ratings. This, in turn, makes firms less likely to contract with the agency in the future. Source: Much of this description is from Standard & Poor’s Guide to Credit Rating Essentials, 2010

Ratings range from Aaa—the highest rating—to Aa, A, Baa, Ba, B, and below. A summary of the various ratings, as provided by Moody’s investor service is presented in Figure 9.4.1 Bonds with ­ratings of Baa - and higher are known as investment grade bonds. Most institutional investors are restricted to investment grade bonds. Investments rated below Baa - are known as speculative, high-yield, or junk bonds. Prior to 1980, most high-yield bonds were so-called fallen angels—bonds that initially received an investment grade but had since become riskier. Since that time, due in part to financier Michael Milken, a huge market for firms to initially issue risky bonds has developed. 1

Fitch uses the same scale as S&P. Moody’s uses a similar but slightly different ratings scale: Aaa, Aa, A, Baa, Ba, B, and below. Also, instead of plus/minus notches, Moody’s uses numbers. So, within Baa, there is Baa1 (similar to S&P’s BBB +), Baa2 (BBB), and Baa3 (BBB -).

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Fig 9.4 General Summary of the Opinions Reflected by Moody’s Credit Ratings

Global Long-Term Rating Scale Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk. Aa

Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

A

Obligations rated A are judged to be upper-medium grade and are subject to low credit risk.

Baa

Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.

Ba

Obligations rated Ba are judged to be speculative and are subject to substantial credit risk.

B

Obligations rated B are considered speculative and are subject to high credit risk.

Caa Obligations rated Caa are judged to be speculative of poor standing and are subject to very high credit risk.

Ca

Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.

C

Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of principal or interest.

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aaa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Additionally, a “(hyb)” indicator is appended to all ratings of hybrid securities issued by banks, insurers, finance companies, and securities firms.* * By their terms, hybrid securities allow for the omission of scheduled dividends, interest, or principal payments, which can potentially result in impairment if such an omission occurs. Hybrid securities may also be subject to contractually allowable write-downs of principal that could result in impairment. Together with the hybrid indicator, the long-term obligation rating assigned to a hybrid security is an expression of the relative credit risk associated with that security.

Source: Moody’s Standing Committee on Rating Systems & Practices

9.2  Preferred Shares The second type of financial instrument we will look at—and the least frequently used of the three—is preferred shares. Issuance of preferred shares is another long-term form of financing available to firms. Preferred shares are often described as hybrid securities, or a mix of bonds and stocks. They have some similarities to bonds, but they have some major differences as well. Although categorized on the balance sheet as a form of equity (because from the debt holders’ perspective, preferred equity provides a cushion in the event of bankruptcy), preferred shares are also very different from common shares. Like bonds, preferred shares are issued with a face value. Unlike bonds, most preferred shares (known as perpetual preferreds) carry no obligation on the part of the firm to

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Objective 9.2

Assess the key features of preferred shares.

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cumulative feature: A feature of preferred shares whereby any missed dividend payments by the firm are cumulated and paid to preferred shareholders before common shareholders receive dividends dividend payout: The amount of dividends distributed to shareholders

repay the initial investment of the preferred shareholders. Instead, preferred shareholders receive a steady stream of dividends. The dividend is specified at a predetermined rate, a percentage of the face value. For example, if the preferred share is issued with a face value of $40 and the dividend is specified as 6 percent of the face value, preferred shareholders can expect to receive $2.40 per share in dividends each year (i.e., $40 * 0.06). As with common shares, preferred share dividends are typically paid quarterly, so in this example the preferred shareholder would receive $0.60 every three months for each share owned. Preferred shareholders have different rights than common shareholders. For example, a firm must make dividend payments to preferred shareholders before paying any dividends to common shareholders. Many preferred shares also have a cumulative feature. Here, if a firm is low on cash and can’t afford to make regularly scheduled preferred dividend payments, the dividends owed to preferred shareholders cumulate and must be paid before any further dividends can be paid to common shareholders. In addition, in the event of bankruptcy and liquidation by a firm, all preferred shareholders receive any claims before common shareholders but after both secured and unsecured creditors (although in most bankruptcy-related liquidations, there is no money left for any equity holders). From a firm’s perspective, preferred shares are not as desirable as bonds because the firm is not able to deduct preferred dividend payments for tax purposes like it can for bond interest expenses. As mentioned previously, preferred shares are generally the least common form of financing relative to bonds and common equity. Preferred shares tend to be issued by stable companies with expected steady cash flows, but they are also ­prevalent among private firms that have received funding from venture capitalists. Furthermore, due to regulatory capital requirements, there tends to be a concentration of preferred shares in the banking industry. From a preferred shareholder’s perspective, there tends to be an inverse relationship between preferred share prices and interest rates, as we saw in Chapter 7. Just like bonds, as interest rates increase, the price of preferred shares tends to decrease, and vice versa. However, the relationship between preferred share prices and interest rates can become uncoupled if a firm is experiencing financial distress and its long-term survivability is in question. In this situation, the firm may be viewed as a high credit risk, so its preferred shares will decline in value regardless of the general level of interest rates in the overall economy.

9.3 Common Shares Objective 9.3

Assess the key features of common shares, describe historical returns of major asset classes, and explain the difference between arithmetic and geometric returns.

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The third type of financial instrument we’ll consider is common shares or stocks. The issuance of common shares represents a very different form of financing than bonds. Common shareholders (or common equity holders) are the ultimate owners of a firm. They are often referred to as residual claimants because they have a claim on any of the income earned by the firm only after other stakeholders—such as bondholders—have been paid (for example, after bondholders have received their interest payments). Common shares are perpetual instruments, lasting as long as the firm itself lasts. As with bonds, an active market has developed for trading common shares. Common shareholders benefit directly or indirectly through the earnings of a firm. If the firm has earnings available to common shareholders, it has two choices of what to do with these earnings: It can either pay dividends to the common shareholders or retain the earnings to finance future projects and investments. Typically, established firms have dividend payout policies whereby a certain percentage of earnings, such as 30 percent, is paid in dividends on average over a long period. This is not to imply that firms strictly

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follow such a policy on a year-by-year basis, since earnings tend to fluctuate from year to year. Rather, we tend to observe that in the short run, firms stick to a stable dollar dividend policy. For example, let’s suppose a firm had a target payout of 40 percent. Let’s also suppose that average earnings per share over the past three years were $5.00. The firm might initially pay out $2.00 per share per year for several years. Then, a few years later, when average earnings per share have grown to, say, $6.00, the firm might increase its dividend to $2.40, again in line with the 40 percent payout target. Typically, dividends are paid on a regular quarterly schedule. However, in some cases, growing firms with frequent needs for additional investments might elect not to pay out any dividends. For instance, Microsoft Corporation went public in 1986 but didn’t start paying dividends until 2003. Note that although firms are obliged to make regular interest payments to bondholders, firms have no contractual obligation to pay dividends to common shareholders on a regular basis. Still, as the ultimate owners of the firm, common shareholders do have rights. One of the major shareholder rights is the right to vote; this right highlights the collective power that shareholders have over the firm. Voting enables shareholders to elect a board of directors to act in their best interest. The mandate of the board of directors is to ensure that management makes decisions that are consistent with maximizing the value of common shares. Thus, any action taken by the firm’s management team, including the chief executive officer, must be justified to the board. It is also important to note that different countries engage in different practices related to common shareholders and have different regulations governing shareholder rights. For example, in some countries, firms have more than one class of shares. A superior class of shares is typically held by a founding individual or family, and multiple votes may be associated with those shares. A multiple class share structure like this allows the individual or family to maintain control while still being able to raise capital through the issuance of inferior voting shares. This structure is not as common in the United States as in other countries because some stock exchanges (including the New York Stock Exchange) restrict dual class shares. However, there have been some high profile cases of dual class shares listed on the NASDAQ exchange, including Google and Facebook.

9.3.1 Historical Returns The return to investors from buying stocks varies considerably depending on the time frame associated with the purchase and sale. Figure 9.5 compares the average annual return (including the reinvestment of dividends or interest payments) on a variety of



Compound Returns (geometric)

Small stocks

Mean Returns (arithmetic)

Volatility (standard deviation)

16.9%

25.6%

49.1%

9.6%

11.6%

20.3%

Large stocks

9.2%

11.0%

19.2%

30-year treasury bonds

5.6%

6.3%

12.3%

90-day T-bills

3.9%

4.0%

3.4%

Inflation

3.0% 3.1% 4.1%

All stocks

Fig 9.5 U.S. Stock Returns, 30-Year Treasury ­Returns, 90-day T-Bill Returns, and Inflation, 1926–2012

Note: Thirty-year treasury bond returns are since 1942 Source: The Center for Research in Security Prices database (CRSP)

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investments and the volatility (or standard deviation) of annual returns since 1926. Note that the figure looks at stocks of various sizes, long-term treasury (government) bonds, and short-term treasury bills (T-bills), as well as inflation. As shown in Figure 9.5, returns may be measured either geometrically or arithmetically. Geometric returns compare the initial investment value with the final wealth value in order to determine the rate of return over the intervening period. The geometric return over n periods is calculated as follows: 1

final value 1n 2 b - 1 Geometric returnn = a initial value

For example, if a nondividend paying stock was selling for $10 per share and three years later it was selling for $13, its geometric or average annual compound return is2: 1

a

$13 13 2 b - 1 = 0.0914 = 9.14 percent $10

Arithmetic returns, on the other hand, are the mean (or average) return across each period (often a year) over n periods. They are calculated using the following equation: Arithmetic returnn = a n

returni n i=1

geometric returns: A return measure comparing initial wealth and ending wealth and the rate at which it grows arithmetic returns: A return measure that takes a simple average of returns, summing returns and dividing by the number of observations

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Reusing our same example stock, suppose that after starting out selling for $10, a year later the stock’s price is $9, after two years it is $11, and then finally, after three years, it is $13. Here, the return in each of the three years was –10.00 percent, 22.22 percent, and 18.18 percent, which gives us an overall arithmetic average of 10.13 percent. We can categorize stocks based on their size. Small stocks are defined by the Center for Research in Security Prices (CRSP) as those in the smallest decile (or 10 percent) of the entire U.S. stock sample as measured by market capitalization (the number of shares multiplied by the stock price), whereas large stocks are those in the largest decile. In ­Figure 9.5, we see that over the long run, stocks have tended to yield higher returns than bonds, but they have done so with greater volatility. Furthermore, both stocks and government bonds have provided returns greater than the rate of inflation, and small stocks have provided greater returns than large stocks. Figure 9.6 compares the extent to which a dollar invested on December 31, 1925, has grown over time if invested strictly in small stocks, large stocks, treasury bonds, or T-bills. As we look at the 87-year span, we see the dramatic impact on wealth from investing in small stocks compared to other stock investments. (Of course, there is no guarantee that that trend will continue in the future!) We also see the rather steady increase in the value of stock investments between the early 1940s and the late 1990s (as indicated on the chart by a fairly straight upward sloping line), but with flatter and bumpier performance since then. We additionally see a clear superior performance of stock versus bond investments during the period from the early 1940s to the late 1990s. Finally, we see how bond and T-bill investments have done somewhat better than inflation and stocks have done considerably better.

2 An alternative method of calculation is to use a spreadsheet such as Excel and insert into the “rate”

function the following information: Nper = 3, PMT = 0, PV = −10, FY = 13, or putting it all together, = rate(3, 0, - 10, 13).

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1,000,000 100,000

Small stocks All stocks Large stocks

30-yr Treasury Bonds 90-day T-bills Inflation

10,000 1,000

201

Fig 9.6 Relative Wealth of One Dollar Invested on December 31, 1925; U.S. Stock Returns (Small Stocks, Large Stocks, and All Stocks), 30-Year Treasury Returns, 90-Day T-Bill Returns, and Inflation, 1925–2012

100 10 1

1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012

0

Note: Assumed initial investment is $1; 30-year treasury returns start in 1942 at 90-day T-bill wealth level Source: The Center for Research in Security Prices database (CRSP)

9.4 Capital Markets Overview Up to this point, we have examined the three major types of financial instruments or securities: bonds, preferred shares, and common shares. Now, we step back and examine the overall markets in which these securities are issued and traded. Most of our discussion focuses on the preferred and common equity markets because these markets tend to be more complex and garner more attention, and also because bonds still tend to be traded predominately through investment banks that each hold their own inventory, rather than through large organized exchanges. There are several reasons why a firm’s management needs to understand capital markets. First, from the firm’s perspective, the issuance of financial instruments may seem like a one-time event; however, issuing bonds and shares is usually not a one-time occurrence. Most firms have ongoing financial needs, and even after a large bond issuance, a firm may be presented with a new opportunity—such as the acquisition of a competitor’s company—that requires additional long-term financing. Second, because active markets have developed for the trading of securities, management needs to understand how these markets impact the firm’s constantly changing shareholder base. Finally, capital markets evolve over time, so management needs to be aware of any new methods or new locations for issuing securities that may come available. Given their complexities and nuances, capital markets—and equity markets in particular—can be segmented and described in countless ways. Figure 9.7 presents one such segmentation. In the following sections, we will consider this segmentation scheme in depth, and we will also describe the role of financial intermediaries.

Objective 9.4

Describe key elements of capital markets.

9.4.1 Private versus Public Markets As mentioned earlier, capital markets can be segmented in a number of ways. One segmentation scheme is based on the method by which securities are issued. Suppose a firm

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Fig 9.7 Overview of Capital Markets

Capital Markets

Public

Private

Domestic

Cross-listing

Organized exchanges

Over-thecounter

Initial public offerings (IPOs)

Angel investors

Venture capital firms

Seasoned equity offerings (SEOs)

Shelf offering

Rights offering

wishes to raise capital via a bond issue. In many cases, the easiest and quickest method firms can use to raise such capital is the private placement process. A private placement involves the purchase of a large block of securities by a large institutional investor such as a pension fund, an endowment fund, or an insurance company. The process is very common with the issuance of debt securities but not with the issuance of equities. Because private placement investors are deemed more sophisticated than other investors, different regulations are involved in the security issuance process. From the firm’s perspective, the private placement process is much quicker and less expensive than a public offering in terms of administrative and selling costs. The private placement process does, however, place restrictions on institutional investors’ ability to resell the securities they have purchased unless they are reselling to other large institutional investors. Consequently, investors often demand a higher interest rate on bonds than would otherwise be charged. An alternative method for raising funds is a public offering. In this process, securities are offered to both large institutional investors and smaller “retail” investors. This is the most common process by which equities are issued. This process often takes six months or more and is more expensive than private placement. However, the result is typically a wider range of bondholders or stockholders. In the case of stockholders, the breadth of ownership is often important because it determines who ultimately controls the firm.

9.4.2 Venture Capital and Private Equity

private placement: The sale of securities to a selected group of well-informed investors public offering (public issue): The sale of newly issued securities to the public

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Capital markets can also be segmented by the life cycle stage of the firm. Initially, all firms are private. At some point, firms may choose to become public companies (described in Section 9.4.3). Prior to this point, however, private firms often need capital, just like public firms. When a firm is a very small start-up in need of capital, its riskiness may make it unable to borrow money. In this situation, the firm may need to rely on the friends and family of the founding entrepreneur to provide much-needed cash. Later, when the firm outgrows the ability of friends and family to supply capital, it may be able to secure

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Case Study

Private Placement Example—Sesac Inc. and the Music of Bob Dylan and Neil Diamond

In August 2012, Sesac Inc., a privately held Nashville-based firm that acts as a middleman between music companies, songwriters, and music broadcasters, announced plans for a unique private placement of $300 million of bonds. The firm had exclusive rights to the public broadcast of the music of Bob Dylan, Neil Diamond, Canadian rock band Rush, and others. The bonds were being issued as a Rule 144a private placement, a rule administered by the SEC that allowed certain “qualified institutional buyers” deemed to be large and sophisticated to trade with other such investors without having to register with the SEC. Such issues were not offered to the general public. The collateral for the five-year bond was the revenue that Sesac was to receive from the music rights. Source: L. Moyer and A. Yoon, “The Bonds, They Are A-Changin’,” Wall Street Journal, August 6, 2012

financing from angel investors who buy stakes in small private firms. Angel investors tend to invest locally and recognize the risk of investing in start-ups. They do not expect all of their investments to succeed, but they recognize that those investments that do succeed may offer payouts of five to ten times the invested capital. When a firm reaches the next stage of growth or is unable to identify angel investors, it may turn to venture capitalists as a source of capital. A venture capital firm is organized as a limited partnership with a venture capitalist as the general partner and various institutional investors—such as pension and endowment funds, as well as high net worth individual investors—as limited partners. The general partner runs the business and typically receives a fee of about 2 percent of the fund’s capital and 20 percent or more of any gains. The general partner may also have expertise to offer to the firms in which the partnership invests. Venture capital is a form of private equity financing. Private equity firms invest in venture capital, leveraged buyouts (which are discussed in more detail in Chapter 11), and “distressed” firms that are experiencing financial difficulties and are in need of a turnaround. Figure 9.8 shows the number of venture capital deals in the United States between 1995 and 2011, and Figure 9.9 indicates the dollar amount of these deals during the same time period. As shown, there has been a general upward trend in both the number and amount of these deals with two notable exceptions. First, venture capital deals and funding peaked in 2000 at the height of the technology bubble. Second, after resuming an upward trend between 2004 and 2007, funding declined again in 2009 during the recession that accompanied the financial crisis.

9.4.3 Initial Offerings versus Seasoned Issues In addition to the previous two schemes, capital markets can be segmented based on the timing of securities issues. For example, when a private firm makes its equity available to the public in order to meet its need for equity capital, it undertakes a process known as an initial public offering (IPO). “Going public” in this way is a major step in the life of a firm because the initial owners of the firm are now effectively sharing the ownership with a much larger group of shareholders. Typically, IPOs involve raising new capital by issuing new shares, but they may also involve selling the shares of existing shareholders (in which case the money goes to the selling shareholders).

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angel investor: An investor who buy stakes in small private firms venture capital firm: An investment firm that invests shareholders’ money in private start-up firms with high growth potential private equity firm: An investment firm that invests shareholders’ money in private firms, including those with high growth potential, leveraged buyouts, and distressed firms initial public offering (IPO): The initial sale of stock of a firm to the public

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Fig 9.8 Number of Venture Capital Deals in the United States, 1995–2011

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

0

1995

1,000

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data: Thomson Reuters

Fig 9.9 Amount Invested in U.S. Venture Capital, 1995–2011

($ in billions) $120

$100

$80

$60

$40

2011

2010

2009

2008

2007

2006

2005

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Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report based on data from Thomson Reuters

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In Depth

SOX and the Cost of Being a Public Firm

The Sarbanes-Oxley Act (known as SOX) is a federal law passed in 2002 in the wake of numerous corporate scandals, including those at Enron, WorldCom, and Tyco International. The law set new standards of accountability for public companies. It included rules requiring more independent auditors, increased corporate responsibility, enhanced financial disclosures, and increased white-collar crime penalties. Senior management was also required to certify the accuracy of a firm’s financial information. In addition, Section 404 of the act mandated that firms establish internal controls and report on the scope and adequacy of these controls, and it required senior managers and boards to be comfortable enough with the firm’s processes and monitoring to attest to their effectiveness. This section received considerable attention because of the cost associated with its implementation, which was severely underestimated when the law was enacted. Prior to SOX, experts estimated that audit fees for small firms (i.e., those with market capitalization less than $75 million) were equal to 0.64 percent of revenues. After SOX became law, this figure jumped to 1.14 percent—or nearly double the previous level.3 Thus, many listed public firms chose to “go dark” and become private companies rather than face the steep costs of compliance.

There are many advantages to going public. First, the firm is able to raise capital in order to make investments that can help it grow, and it has the ability to make acquisitions using existing stock. In addition, the initial owners have a much more liquid market in which to sell their stake in the firm, usually at a much higher per-share price than if the company were still private. Beyond that, management is able to improve recruiting by offering stock options and stock-related incentives to key employees. Finally, there is an overall increased public awareness of the firm. There are also a number of disadvantages to going public. Because shares are more dispersed, management must work with a more diverse group of stakeholders, including institutional and retail investors. The firm is more accountable to this larger group of stakeholders and faces more rigorous disclosure of its financial situation, and this disclosure requirement has both monetary and time costs. Finally, management needs to be more active in managing shareholder expectations and dealing with some investors who have a short-term focus on profitability rather than long-term growth. The IPO process begins with approval by the firm’s board of directors, followed by selection of a lead underwriter or investment bank to assist in structuring, pricing, and distributing the IPO. The underwriter is involved in conducting due diligence to ensure that everything indicated in the prospectus is accurate. The prospectus is a regulatory document filed with the SEC that describes the details of the IPO and is meant to help investors make informed decisions. Once a preliminary prospectus is drafted and filed, the firm applies for a stock exchange listing. Then, the underwriter and senior management conduct a “road show” by meeting with potential investors, explaining the purpose of the IPO, and outlining the potential benefits to investors. Throughout this process, the underwriter “builds the book” that describes the number of shares potential investors desire and the price they are willing to pay. This process allows the underwriter to recommend a price and offering size. Finally, just before the offering date, the IPO price is determined and indicated in the final prospectus.

3

See http://www.rand.org/pubs/research_briefs/RB9295/index1.html (accessed February 4, 2013).

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prospectus: A regulatory document filed with authorities, such as the SEC, that describes the details of a security offering in order to help investors make informed decisions

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Case Study

Google and Facebook IPOs

Not every firm has the same IPO experience. Let’s look at two leading Internet firms: Google and Facebook. Google, which started as a search-engine company, went public in August 2004, raising $1.7 billion. Instead of following a traditional underwriting process, Google chose an online auction process to sell roughly 20 million shares. Investors opened brokerage accounts and submitted their bids for a certain number of shares at a particular price. Google then identified the highest bid that would allow for the 20 million shares to be sold—which turned out to be $85—in a variation of the process known as a Dutch auction. Because Google was a well-known firm and had been profitable since 2001, its leadership felt there was no need for a traditional underwriter, which typically costs 3 to 7 percent of the amount of funds raised. There was also concern that firms tend to “leave money on the table” by underpricing IPOs, giving investors strong first-day returns to the firms’ detriment (because if the IPO had been priced higher, it could have raised the same amount of money with fewer shares issued and less loss of control). Google thus felt the auction process would result in lower overall costs and less “underpricing” of the firm’s stock. Even with the auction process, however, Google’s stock price rose 18 percent on its first day on the market, and by late 2007 Google was selling for over $700 a share. By late 2008, its share price dropped below $300, but it later recovered to over $600 by early 2010, and by the spring of 2013 it was selling for over $800. Unlike Google, Facebook chose to use the traditional underwriting process when it went public in May 2012, raising $16 billion. During its road show, underwriters increased the planned offer price range from $28 to $35 to a range of $34 to $38. Then, just prior to the IPO issue, Facebook decided to offer 25 percent more shares than originally planned at the high-end price of $38. On their first day on the market, the firm’s shares opened at $42 but promptly fell, ending the day at $38.23. Technical glitches in the NASDAQ system hampered trading, and the exchange apologized to customers who were not able to sell shares at posted prices, offering $40 million in compensation. Shortly after the IPO, it was also revealed that several investment banks had told their major clients that they were reducing their forecasted earnings for Facebook. By early June, share prices had fallen below $26 before recovering somewhat. In August 2013 shares finally traded above the IPO price. Sources: Benjamin Edelman and Thomas R. Eisenmann, “Google Inc.,” Harvard Business School case study, 2010; Shayndi Raice, Anupreeta Das, and Gina Chon, “Inside Fumbled Facebook Offering,” Wall Street Journal, May 23, 2012

The cost for issuing stock is not cheap. In the United States, for issues less than $500 million, the typical fee paid to underwriters is 7 percent of the amount of stock raised. As this amount gets larger, underwriting costs might decline to around 3 percent. (Given its prestige at the time of its IPO, Facebook was a rare exception with even lower fees—just over 1 percent.) There are a number of methods by which shares may be distributed. The most common method is a “firm commitment,” whereby the underwriter guarantees the sale of all stock at the offer price. Another method sometimes used in smaller IPOs is “best efforts,” whereby the underwriter doesn’t guarantee a particular price but attempts to get the highest price possible given current market conditions. A third method is the auction process, with Google as the best known example.

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Fig 9.10 Number of U.S. IPOs, 1960–2010

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Source: Jay Ritter’s website http://bear.cba.ufl.edu/ritter (accessed July 28, 2011)

As we see in Figure 9.10, IPOs tend to occur in waves of hot and cold markets. Hot markets with a high number of IPOs are often concentrated in certain industries. For example, in the mid-1990s, a vast number of IPOs were in the technology industry. Researchers have made several empirical observations—known as stylized facts— related to investors’ IPO returns. First, investors who receive shares as part of an IPO tend to experience high returns on the first day of ownership. Figure 9.11 shows firstday IPO returns over time. As you can see, negative average first-day returns have occurred in only two of the past fifty years, and returns peaked at 70 percent during the

Fig 9.11 U.S. IPO First-Day Returns, 1960–2010

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Source: Jay Ritter’s website http://bear.cba.ufl.edu/ritter (accessed July 28, 2011)

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Fig 9.12 International IPO First-Day Returns

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Source: Jay Ritter’s website http://bear.cba.ufl.edu/ritter (accessed July 28, 2011)

seasoned equity offering (SEO): The additional sale of equity securities to the public by an already-public firm shelf offering: A regulatory provision that allows a firm to issue more shares at a future date without issuing a new prospectus rights offer: A type of seasoned equity offering whereby shares are offered only to existing shareholders

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technology stock craze of the late 1990s. Second, as Figure 9.12 shows, large first-day returns are a worldwide phenomenon, and U.S. first-day returns of just under 17 percent fall in the middle of the pack. Finally, over the first three to five years following their issuance, IPOs tend to underperform relative to the market. In comparison, if a firm that is already public decides to issue additional common shares, the process is known as a seasoned equity offering (SEO). The SEO process is similar to the IPO process except there is already an established market price for the shares. Unlike an IPO, a seasoned offering is a much less dramatic step for the firm. However, depending on its size relative to the number of existing shares, an SEO can affect the existing common share price. Specifically, after the SEO, there will be more common shares outstanding. If the firm is not able to utilize its new funds in a way that creates additional profits and sufficient value for its common shareholders, then existing shareholders will find their claim on the firm’s profits has been diluted, and the share price will decline. In fact, one stylized fact noted by researchers is that stock prices tend to decrease upon the announcement of an SEO. Thus, a firm must clearly articulate its reasons for issuing additional shares and must indicate how the issuance will add value in the long term. Seasoned offerings may be available to the general public or offered to institutional investors through a private placement. To facilitate quicker and more cost-efficient issuance of shares, a firm may file in advance for a shelf offering that allows it to issue more shares at a future date without issuing a new prospectus. Also, to help protect existing shareholders against possible ownership dilution, a firm may issue a rights offer, which is a new share offer only available to existing shareholders. Although not very common in the United States, rights offerings are common in other countries, including the United Kingdom.

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Large firms, particularly multinationals, may raise capital outside of their domestic markets by cross-listing their shares on other exchanges (although cross-listing may also take place without raising capital). For example, non-U.S. firms may list on U.S. exchanges through American Depositary Receipts (ADRs), which are negotiable certificates issued by certain U.S. commercial banks that represent an equivalent amount of the foreign securities. These firms may also raise capital through an SEO at the time of cross-listing, or the cross-listing might be part of an IPO. Firms tend to cross-list in hopes of reducing their cost of capital or broadening their shareholder base, or as part of planning for a merger or acquisition.

9.4.4 Organized Exchanges versus Over-the-Counter Markets Traditionally, organized exchanges have played a dominant role in the trading of securities. However, organized equity or stock exchanges are much more prevalent than organized bond exchanges because bond trading tends to take place primarily among large institutional investors. One of the largest organized equity exchange operators is NYSE Euronext, a holding company that combined the NYSE Group, Inc. (including the New York Stock Exchange) with the Dutch company Euronext N.V. in 2007. NYSE Euronext securities represent about one-third of the world’s equity trading. Until the New York Stock Exchange (NYSE) became a public company in 2006 and facilitated electronic trading, NYSE membership was limited to those who purchased one of 1,366 “seats” on the exchange. Trading included face-to-face interactions on the exchange floor, with specialists making markets for particular securities by matching buy and sell orders to determine prices and ensuring that an orderly market transpired. The other large global equity exchange operator is NASDAQ OMX Group. In 2007, the National Association of Security Dealers Automated Quotation (NASDAQ) acquired OMX, which dated back to various mergers of European exchanges, primarily in Sweden, Denmark, and Finland. NASDAQ OMX has the most listed companies globally and the most share value traded. In contrast to the NYSE’s origins, NASDAQ originated in 1971 as an over-the-counter (OTC) market. Instead of having one specialist in a particular location setting the price for a stock, an OTC market allows for greater participation among a larger number of brokers who are prepared to make a market for a stock. Most bond markets are OTC. From its beginnings as an OTC market, the NASDAQ system grew to challenge the traditional dominance of the NYSE. On organized exchanges such as the NYSE or NASDAQ, firms must first apply to have their stock listed. There are strict listing requirements based on a firm’s size and financial performance track record, including number of shares, market capitalization, and earnings history. In years past, a NYSE listing meant prestige, and most firms strived to meet the qualifications for such a listing; consequently, more U.S. trading volume occurs on the NYSE than the NASDAQ. However, some of the best-known firms in the world—particularly in the technology sector—have chosen to list on NASDAQ rather than the NYSE, including Google, Facebook, and Microsoft, although part of their reason for doing so was probably that many other technology-related firms were already listed on NASDAQ.

9.4.5 Role of Intermediaries Traditionally, financial intermediaries have played an important role related to the issuance and trading of securities. Financial intermediaries include the exchanges discussed in the previous section, as well as investment banks such as Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, and Morgan Stanley. These intermediaries attempt to facilitate the buying and selling process, first between corporations and investors, and

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cross-listing: The process by which a firm lists its shares on a foreign stock exchange over-the-counter: A market for stocks that is decentralized and not a formal exchange American Depositary Receipt (ADR): Negotiable certificates issued by certain U.S. commercial banks that represent an equivalent amount of the foreign securities financial intermediaries: Stock exchanges, investment banks, or investment dealers that attempt to facilitate the buying and selling of securities, first between firms and investors and second among investors

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second among investors. For example, investment bankers have traditionally played a critical role in the IPO process. They provide advice related to the appropriateness and timing of an IPO, and they determine an appropriate share price to be offered. Then, they facilitate the issuing or underwriting process whereby the securities are actually sold to the public, often assuming the risk in the offer by buying the securities from the firm at a preset price and reselling them to the public at a (hopefully) higher price. The role of intermediaries is rapidly changing as the Internet provides more direct access to capital markets. Firms are increasingly considering initial public offerings and seasoned equity offerings over the Internet. For example, in 1999, investment banking firm W.R. Hambrecht and Company created OpenIPO as an online auction process for IPOs and seasoned equity offerings. OpenIPO has facilitated numerous offerings, including those of notable firms such as Google and Morningstar. Trading by individuals—who have access to more information and low-cost online trading options than ever before— is rapidly changing the role of intermediaries who must constantly assess how they can add value for their clients.

9.5  Market Efficiency Objective 9.5

Explain the concept of market efficiency and describe the various forms of the efficient market hypothesis.

underwriting: The process, initiated by investment banks, of marketing new security issues to the public market efficiency: The degree to which a security market is deemed to reflect all relevant information efficient market hypothesis (EMH), weak form, semistrong form, strong form: An investment theory that states that prices fully and immediately reflect all relevant information. The weak form defines relevant information as all historical price information; the semistrong form defines relevant information as all public information; and the strong form defines relevant information as all forms of information including private information

Market efficiency is an important way of thinking about and comparing the prices for securities in various types of markets, such as the bond market or the stock market. According to the efficient market hypothesis (EMH)4, a market is said to be efficient if prices fully and immediately reflect all relevant information. In other words, a market is efficient if the price paid for a security is the true price reflecting the intrinsic value of that security. The concept of market efficiency is critical to both firms and investors. In Chapter 1, we said a key objective of any firm is to maximize shareholder value, using the current stock price as a measure of shareholder wealth. If markets are efficient, this implies that the stock price should rise if the firm makes good decisions and fall if the firm makes bad decisions. But if markets aren’t efficient and prices don’t reflect intrinsic values, then there won’t be a relationship between stock prices and the objective of maximizing shareholder value. In addition, from a firm’s perspective, market efficiency has implications related to the timing of the issuance of securities. For example, if markets are not efficient and if management deems that a firm’s stock is overvalued, then it might be a good time to issue equity if the firm is in need of capital. From the investor’s perspective, efficiency has implications for overall investment strategies. For instance, it helps the investor determine whether to be passive and buy an index fund or actively trade in individual securities. Although the notion of market efficiency is fairly straightforward, it is important to note that market efficiency is not a statement of fact but rather a hypothesis put forward to describe a particular market, such as the U.S. stock market in general. Because we can never know the true price or intrinsic value of a security, we can never know with certainty whether a market is efficient. The challenge faced by countless academic researchers has been to develop empirical tests that yield results consistent or inconsistent with the notion of market efficiency without providing definitive proof. Researchers have developed three categories of hypotheses and tests related to market efficiency: weak form, semistrong form, and strong form. The words weak, semistrong, and strong are not meant to imply that one category is better than another; rather, each form relates to how we define relevant information. 4 In October 2013, University of Chicago finance professor Eugene Fama was announced as a co-recipient of the Nobel Prize in Economics for his work in defining and testing the concept of market efficiency.

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9.5.1 Weak Form The weak form of the efficient market hypothesis (EMH) states that market prices fully and immediately reflect all historical price (and trading volume) information. If the weak form of the EMH is deemed to be true—or more precisely, if the hypothesis is not rejected based on empirical tests—then this implies that the current price of a security already incorporates information regarding historical prices and volume. Thus, knowing the pattern of stock prices (for example, whether the current price is much lower or higher than the price one year ago) does not provide any insight about the future stock price. In other words, if the weak form is true, then technical analysis—or examining patterns and trends in historical stock prices—is not a fruitful investment strategy. Many tests that attempt to evaluate the weak form by replicating technical analysis strategies have failed to uncover reliable methods for outperforming the market over a long period of time. However, more recent studies have uncovered some viable strategies related to momentum investing (i.e., buying stocks that have done particularly well over the last six months or so and holding them for the next six months).

9.5.2 Semistrong Form The semistrong form of the EMH states that prices fully and immediately reflect all public information. If the semistrong form is deemed to be true based on empirical tests, then this implies that trading based on publicly available information in annual reports, in the newspaper, or on the Internet—known as fundamental analysis of a company—is not a viable investment strategy. (Fundamental analysis often refers to a top-down approach of investigating the economic outlook, the industry prospects, and the firmlevel analysis of growth and risk in order to estimate an intrinsic value of a firm ­compared to its actual selling price.) In other words, if the publically available information is relevant, then it should be incorporated into the stock price immediately, not through a gradual process. Semistrong form tests have focused on the immediacy of market reaction to events that provide new public information. These event studies have examined good-news announcements, such as an increase in dividends, and have found support related to the quickness with which this information is incorporated into the stock price. Figure 9.13 shows

Fig 9.13 Sample Event Study Result Testing the Semistrong Form of the Efficient Market Hypothesis

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technical analysis: A method of evaluating the worth of securities based on examining patterns and trends in historical prices fundamental analysis: A method of evaluating the worth of securities based on publicly available information such as news stories and annual reports event study: A research methodology for analyzing the impact of certain types of events, such as the announcement of dividend increases on security prices

Semistrong Not semistrong

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hypothetical results for event studies. The vertical axis shows a price index. The horizontal axis shows days relative to the event on day 0, such as an announcement of a proposed acquisition. If the price index follows the solid line, with a spike in prices on the day of the announcement, then the test result is consistent with semistrong market efficiency. In contrast, if the price index follows the dotted line with a more gradual price increase after the announcement, then the result is not consistent with semistrong market efficiency.

9.5.3 Strong Form The strong form of the EMH states that prices fully and immediately reflect all information, both public and private. If the strong form is deemed to be true, then this implies that insiders—senior management, the board of directors, and anyone with private information about a firm—would not be able to benefit from their knowledge. In other words, if a member of the board of a firm had private and nonpublic information about the firm—say, some pending good news about a new product development—and bought shares of stock before the information became public, the strong form of the efficient market hypothesis suggests the individual would not be able to earn excess profits (compared to noninsiders) on the stock purchase. Studies on the strong form have focused on the ability of insiders to capitalize on their ability to buy shares in their company prior to a rise in the stock price and sell prior to a decline. Not surprisingly, these studies have refuted the notion of strong form EMH. In other words, insiders do appear to have the ability to develop superior investment strategies and earn excess profits.

9.5.4 U.S. Stock Market Efficiency Empirical tests have focused on U.S. stock markets in particular, and they have provided mixed results. These studies appear to suggest that U.S. stock markets are generally ­efficient (but certainly not in the strong form); however, there may be pockets of inefficiency whereby investors may be able to profit. It should be emphasized that these studies are never free from controversy, given the challenges of empirical research and the lack of one agreed-on model related to the determination of stock prices. If stock markets are truly efficient, then managers should be less concerned with the timing of the issuance of securities, and investors should be less concerned with trying to pick one or two winning stocks than simply investing in a passive index fund strategy. In other words, investors should focus on buying a well-diversified portfolio of stocks and holding them for a long period of time.

9.6 Relevance for Managers Objective 9.6

Explain why understanding capital markets and longterm financing instruments is relevant for managers.

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Very few firms can exist in a vacuum without external sources of funds. As such, it is critical for managers to understand the nuances associated with financial instruments such as bonds, preferred shares, and common stocks, as well as the markets in which they trade. In fact, most firms need to access capital markets on a regular basis, particularly if they are growing or if they wish to acquire other firms and need to finance these purchases. Managers must appreciate the perspective of the firm’s lenders and investors and understand the trading environment, recognizing that their shareholder base is constantly changing. In addition, managers need to keep abreast of the evolution of capital markets, including new trading venues.

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Managers should also appreciate the concept of market efficiency. For many of us, when it comes to our own firm’s stock price, we often feel like comedian Rodney Dangerfield: “I don’t get no respect!” In other words, we often feel that the market doesn’t appreciate the true value of our stock and that it is constantly undervalued. (After all, how often do you hear of CEOs who are kept awake at night worrying about their overvalued stock?) Although it is true that on some occasions, stocks may be undervalued— or in the case of technology stocks in the late 1990s, overvalued—it is generally reason­ able to assume that markets are somewhat efficient and stock is being fairly valued.

Summary

1. A firm raises long-term financing by issuing securities such as bonds, common shares, or preferred shares. 2. Bonds are usually issued at face value and pay interest or coupons every six months. The principal amount is also repaid on the maturity date. The type of features associated with bonds often distinguishes them from one another. 3. The credit risk of bonds is assessed by various bond-rating agencies. Ratings typically range from AAA (most creditworthy) to C (least creditworthy). Bonds rated BBB and above are said to be investment grade, whereas bonds rated BB and below are referred to as speculative, high-yield, or junk bonds. 4. Common shareholders are the residual claimants of any earnings after other stakeholders, such as bondholders, have been satisfied. Common shareholders are collectively the owners of the firm. Any earnings available to common shareholders are either paid out as common dividends or retained in the business in order to generate future profits.

5. Preferred shares represent a hybrid security with some features of both bonds and common stocks. Preferred shares pay regular dividends, but the dividends are not tax deductible from the firm’s perspective. Typical preferred shares have no maturity and, consequently, no principal repayment. Preferred shareholders must typically receive their dividends before any dividends are paid to common shareholders. 6. Historically, stocks have outperformed bonds but have exhibited more volatility. Small stocks have outperformed large stocks. Both stocks and bonds have provided positive real returns over the long run. 7. Capital markets represent the markets in which securities are issued and traded. Markets can be distinguished by the method of issue, either to private investors such as pension funds and insurance companies or to the public at large. Most stocks are traded on organized exchanges and most bonds are not. Intermediaries such as investment banks play an important role in facilitating the buying and selling process. 8. Markets are said to be efficient if the prices of securities fully and immediately reflect all relevant information.

Additional Readings and Information

A useful overall investments book is: Bodie, Zvi, Alex Kane, and Alan Marcus. Essentials of Investments, 8th ed. New York: McGraw-Hill Ryerson, 2010. An interesting book focusing on bonds and fixed income securities is: Fabozzi, Frank. Bond Markets: Analysis and Strategies, 7th ed. Englewood Cliffs, NJ: Prentice Hall, 2009. A classic investment book with an efficient market perspective is: Malkiel, Burton. A Random Walk Down Wall Street, 10th ed. New York: W. W. Norton, 2010.

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Some important studies of market efficiency can be found in: Fama, Eugene. “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance 25 (1970): 383–417. Fama, Eugene. “Market Efficiency, Long-Term Returns, and Behavioral Finance.” Journal of Financial Economics 49 (1998): 283–306.

Problems

1. All things being equal, would you expect to receive a higher or lower interest payment if a bond had a sinking fund? 2. All things being equal, would you expect to receive a higher or lower interest payment if a bond had a call provision? 3. After the Egyptian Revolution of 2011, the three major credit rating agencies downgraded the rating of the listed common stocks of Commercial ­International Bank – Egypt from BBB (investment grade) to BB (speculative grade). Explain the effect on the stock price. 4. Calculate the average arithmetic return for stock whose price rises over three years from $20 to $34 to $25, and finally, to $30. 5. Calculate the average annual compound (geometric) return for the stock in question 4. Which result is more accurate? 6. Historical U.S. market returns tend to approximately follow a normal distribution, which implies that returns are plus or minus one standard deviation from the mean (arithmetic return) two-thirds of the time and are plus or minus two standard deviations from the mean 95% of the time. Based on the information in Figure 9.5 and focusing on the mean returns for “all stocks,” what is the range of returns that are one standard deviation from the mean? 7. Based on the information in Figure 9.5 and focusing on mean returns for “all stocks,” what is the range of returns that are two standard deviations from the mean? 8. What factors would impact the price of preferred shares?

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9. On the basis of the following bond information, describe the features of the bond and explain the timing of the expected cash flows (assuming today is January 1, 2014): coupon = 6.4 percent; maturity date = January 1, 2024; price = $103.42; yield = 5.94 percent. 10. On the basis of the following stock information, describe the features of the stock and assess its performance: dividends per share = $0.80, current share price = $28.50, current dividend yield = 2.8 percent, current P/E multiple = 24.5, share price one year ago = $24.00, and market total return over the past year = 16.5 percent. 11. What type of investor is most likely to purchase a private placement? 12. Given the “stylized facts” related to IPO performance, if you were able to obtain IPO shares at the issue price, when might be the best time to sell the shares: after the first day of trading or three-to-five years later? 13. If research employs an event study, what form of the efficient market hypothesis is it most likely testing? 14. Insider trading is prohibited by law since it is a blatant source of conflict of interest and a breach of the concept of equal opportunity. According to the strong-form efficient market hypothesis, can investors consistently earn excess returns? 15. Suppose a firm is involved in major litigation and is expected to lose its case, which would cost the firm millions of dollars. Surprisingly the firm wins the case and immediately the stock price jumps. Is the observation of the price increase consistent with the semi­ strong form of the efficient market hypothesis? Explain.

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Appendix: Understanding Bond and Stock Investment Information

In order to assist you in understanding more about the workings of capital markets, let’s examine bonds and stocks from the perspective of the investor rather than the firm. Whereas the firm is concerned with raising a particular amount of capital at one particular time, the investor is concerned with the day-to-day value of the investment. Information regarding the value of securities is available from a variety of sources, as described in the following sections.

Bond Information Given the predominance of large institutional bondholders (versus smaller retail investors), much less financial information is readily available about corporate bonds than stocks. Nevertheless, an example of corporate bond information is presented in Figure A9.1. In this example, Home Depot issued $1 billion worth of these bonds in late March 2011. The 30-year bond matures on April 1, 2041. Based on a face value of $100, annual coupon payments are $5.95, or $2.975 every six months. The current price of this bond is $131.50. Since most (but not all) bonds are issued at a price near the face or par value, we can surmise that when the bond was initially issued, interest rates were at a higher level than they are currently—because as rates have declined, the bond price has increased. It may also have been the case that Home Depot was viewed as a higher credit risk at issue compared to the current quote. Note that the bond represents a promise of fixed payments. Because interest rates have fallen, this bond with fixed annual coupon payments looks more attractive than a similar (in terms of creditworthiness) bond issued today with lower annual coupon payments. This is why the bond price is more than $100. The bond yield essentially indicates the coupon rate that would be attached to a similar bond if it were issued at par today. Given that the Home Depot bond is selling for $131.50, it turns out that buying this bond for that price is just like paying $100 for a bond that pays a coupon rate of 4.08 percent, which is also the yield to maturity of the bond, as discussed in Chapter 7.

Stock Information The most common source of stock information is the Internet. An example of Home Depot stock information is presented in Figure A9.2. The figure examines information from a variety of sources, including Yahoo!Finance, Morningstar, Bloomberg, and NYSE (the stock exchange on which Home Depot is listed). Note that the different sources include different types of information, and there may be some slight discrepancies in terms of different measures (for example, trading volume). As you can see in the figure, the first section of information focuses on price. Price information is important because it is an indication of the market value of the firm’s stock. (Valuation is discussed in more detail in Chapter 13.) While the stock

June 29, 2012 Issuer Home Depot

Amount

Coupon %

Maturity

Price

Yield

$1,000 mil

5.95

April 1/41

131.50

4.08

Fig A9.1 Home Depot Bond Information

Source: Morningstar.com

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Fig A9.2 Home Depot Stock Information

 

Yahoo

Price $

51.65 51.65 51.65 51.65

Day change price $ (%)

Morningstar Bloomberg

NYSE

–0.57 ( 1.09%) –0.57 ( 1.09%) –057 ( 1.09%) –0.57 ( 1.09%)

Previous close $

52.22

52.22

52.22

52 .21

52.21

Open $

52.21

Bid $

51.65 51.65

52.21

Ask $

51.67 51.67

1-year target est $

55.39

Day’s range $

51.38–52.61 51.38–52.61 51.38–52.61 51.38–52.61

52-week range $

28.13–53.28 28.13–53.28 28.13–53.28 28.13–53.28

52-week high date

20-Jun-12

52-week low date

09-Aug-11

Volume

8,399,954 8,900,000 9,939,011 9,939,011

Average volume (3m)

11,976,200

Dividend amount $ Dividend yield EPS $ (ttm) Next earnings date

11,500,000

11,976,200

1.16 1.16 1.16 1.16 2.24% 2.24% 2.24% 2.24% 2.65

14-Aug-12

2.65

Shares outstanding mil

1,531

Enterprise value $mil (ttm)

86,799

Market cap $mil

87,570

2.65

16-Aug- 12 1,531

79,090 79,000 79,089 79,089

l-year return

46.12%

Beta coefficient

1.03 0.79

P/E (ttm)

19.50 19.7 19.81 19.72

Forward P/E

15.57

15.3

P/B (ttm)

4.45

4.4

4.4023

P/S (ttm)

1.12

1.1

1.1157

P/CF (ttm)

11.4

Operating margin % (ttm)

9.74

9.7

ROE (ttm)

22.7

22.7

ROA (ttm)

10.1

9.54

Debt/equity 0.6 EV/EBITDA (ttm)

10.16

Note: ttm = trailing twelve months Source: finance.yahoo.com, morningstar.com, Bloomberg.com, nyse.com (accessed July 11, 2012)

exchange is open and trading is occurring, the current price is updated throughout the day. Assuming the information in the figure is from today, we see that the change in the price (as well as the percentage change) is given relative to yesterday’s closing price (indicated in the figure as “previous close”), and yesterday’s closing price is indicated along with today’s opening price. During the day, the bid and ask prices are updated—the

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“bid” indicates the price at which a market maker is willing to buy a certain quantity of shares, whereas the “ask” is the price at which the market maker is willing to sell. A oneyear target estimate is the price at which analysts expect the stock to be selling one year from now. Stock price trading ranges are presented for both today and the past 52 weeks. The second section of the figure indicates the trading volume (number of shares) for today. The average daily trading volume over the past three months is also indicated. Trading volume indicates the amount of liquidity for the stock. The third section presents information related to dividends, earnings, and shares outstanding. The dividend amount of $1.16 represents the annual anticipated dividend based on the most recent quarterly dividend: Quarterly dividend: Times number of quarters: Equals annual dividend:

$0.29 4 $1.16

The dividend yield of 2.24 percent is the annual dividend divided by today’s price: Annual dividend: Divided by today’s price: Equals dividend yield:

$1.16 $51.65 2.24%

Earnings per share (EPS) of $2.65 are the total earnings of Home Depot divided by the number of shares outstanding: Total earnings last 4 quarters (millions): Divided by number of shares (millions): Equals earnings per share (EPS):

$4,057 1,531 $2.65

Firms tend to release information about quarterly earnings on a regular basis; thus, Yahoo!Finance and Bloomberg have separate estimates (differing by a couple of days) as to when the next quarterly earnings will be reported. In the fourth section of Figure A9.2, enterprise value is the market value of the entire firm, including the value of both equity and debt, or the value of the firm’s assets. Market capitalization (or “market cap” for short) is the value of the equity of the firm and is the current share price multiplied by the amount of shares outstanding. The one-year return is the return to an investor who bought the stock one year previous and represents the capital gain (in the case of a price increase) or capital loss (in the case of a price decrease) plus any dividends received. The beta coefficient is an estimate of the volatility of the stock relative to the volatility of the stock market as a whole (such as the S&P 500). By definition, the market has a beta of 1.00. There is no single method by which to estimate beta (which is why estimates may vary across information sources), but it is often estimated by examining historical information. The NYSE estimate of 0.79 for Home Depot implies that as the stock market as a whole goes up (or down) by 1 percent, then we would expect Home Depot’s stock price to go up (or down) by 0.79 percent. The last section of the figure presents information about various financial ratios, some of which were discussed in Chapter 4, including the operating margin, return on equity  (ROE), return on assets (ROA), and the debt-to-equity ratio. Other valuation metrics (which will be discussed further in Chapter 13) include the price-earnings (P/E) ratio, price-to-book (P/B) ratio, price-to-sales (P/S) ratio, price-to-cash flow (P/CF) ratio, and enterprise value (EV)-to-EBITDA.

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Assessing the Cost of Capital: What Return Investors Require

Learning Objectives Obj 10.1

Explain the general notion of cost of capital. Obj 10.2

Describe various ways to interpret the cost of capital. Obj 10.3

Describe different types of risks. Obj 10.4

Explain how to estimate the cost of debt. Obj 10.5

Explain how to estimate the cost of preferred shares. Obj 10.6

Explain how to estimate the cost of equity using the dividend model approach and the capital asset pricing model approach. Obj 10.7

Explain how to estimate the component weights when estimating the cost of capital. Obj 10.8

Describe the process for estimating Home Depot’s cost of capital. Obj 10.9

Explain what a hurdle rate is and how it is used. Obj 10.10

Explain why assessing the cost of capital is relevant for managers.

This chapter is the second of three examining the various aspects of a firm’s long-term financing needs. Chapter 9 provided an overview of financial instruments such as bonds, preferred shares, and common shares. In this chapter, we’ll focus on the explicit cost—from the firm’s perspective—associated with issuing each type of instrument. Later, in Chapter 11, we will examine the trade-offs a firm faces when issuing debt versus equity. The average cost of raising funds is known as the cost of capital. The cost of capital is a key driver of the overall value of a firm. If a firm is able to lower its cost of capital, then all of its potential investments appear more attractive. From a different perspective, the cost of capital reflects what investors (and lenders) require. A simple example of the cost of capital is presented at the beginning of this chapter, followed by a more detailed discussion of cost of capital implications. We then define risk and focus on the components of the cost of capital and the weights attributable to each component. These sections highlight the risk (from the perspective of the buyer) associated with each component or financial instrument. Next, we make the connection between the measure of the cost of capital and hurdle rates used by a firm’s management to assess the viability of projects. An actual example of the cost of capital calculation is then presented using information from Home Depot. Finally, the chapter concludes with a discussion of the relevance of these concepts to managers. The cost of capital is a key element of our financial management framework and the unifying theme of this book, presented in Figure 10.1. Note that the three decision-making areas within the firm—operating, investing, and financing—all involve some element of risk. For example, business risk affects a firm’s ability to make profits from its operations. Similarly, any investment decisions are impacted by the riskiness of the particular type of investment, whether a simple capital expenditure to replace a piece of equipment or the expansion of business into a new market. Most importantly, financial risk is inherent in the mix of debt and equity within a firm, as captured by the financial leverage measure. Thus, the cost of capital reflects the cost of raising funds as well as the overall perceived riskiness of the firm.

218

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Fig 10.1 Financial Management Framework: Cost of Capital

the enterprise

financing Financial Leverage

operating

investing

Profit Margin

Asset Turnover

Managing the risk profile

risk Cost of capital

10.1  Understanding the Cost of Capital: An Example To better understand what the cost of capital entails, let’s start with a simple example. Suppose an individual wants to start a new company and has identified the need for a $1 million capital outlay. After much deliberation, our entrepreneur determines that funds can be raised from three sources, in the following amounts: $200,000 through the issuance of a bond (debt financing), $100,000 through the issuance of preferred shares, and $700,000 through the issuance of common shares. To determine the cost of each source of financing, our entrepreneur must think of the terms cost and return interchangeably, or as different sides of the same coin. This is because cost to the firm can also be interpreted as return from a potential investor’s (or lender’s) perspective. Instead of considering costs, investors consider their potential return when choosing investments. So, to measure the cost to the firm of raising funds, our entrepreneur can examine the required return that would entice potential investors to buy the firm’s newly issued bonds (or debt), preferred shares, and common equity (or stocks). The general relationships between costs and returns for all three types of financial instruments are outlined in Figure 10.2. However, there is one wrinkle with this approach, caused by corporate taxes: Interest expenses reduce the amount of taxes payable by a firm. Thus, in the case of bonds (or debt issued by the firm), we must further distinguish between the firm’s cost and the investors’ required return. From the firm’s perspective, in terms of the cost of debt, what really matters is the after-tax cost.

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Objective 10.1

Explain the general notion of cost of capital.

cost of capital (weighted-average cost of capital or WACC): The weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shares, and common shares

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Fig 10.2 Relationships between Firm Costs and Investor-Required Returns

FIRM INVESTORS

Cost of raising funds = Investor-required return



Cost of debt (before tax) = Required return on bond investment



Cost of preferred shares = Required return on preferred shares



Cost of equity = Required return on equity investment

To illustrate, suppose our entrepreneur determines that the firm can issue a bond that pays interest at a rate of 5 percent, which is the return required by bond investors. Because the debt interest payments are a tax-deductible expense for the firm, and because the firm anticipates a tax rate of 35 percent, the effective after-tax cost of this debt to the firm is 3.25 percent (or the before-tax cost of 5 percent multiplied by 1 minus the tax rate of 0.35—since the firm effectively saves 35 cents of taxes for every dollar of interest expenses). In comparison, the entrepreneur decides the firm’s preferred shares can be issued to pay a dividend of 7 percent, as this is the return required by preferred share investors (because preferred dividends are not tax deductible for the firm). Finally, our entrepreneur also determines that the firm’s equity investors will expect (or require) a 15 percent return on their investment. The overall cost of raising capital from these sources (bonds, preferred shares, and common equity) can be determined by taking a weighted average of the three costs. The related calculations are presented in Figure 10.3. The resulting weighted-average cost of capital, also known as the WACC (which has a nice ring to it, like “whack!”), is 11.85 percent after tax. Later in the chapter, we’ll discuss how weights are determined; for now, simply note that the weights from all sources must add up to 1 (or 100 percent). We can generalize these calculations with some commonly used notations, whereby the weight of each component is represented by w and cost is represented by k. (I’m not really sure how the convention got started and why we don’t represent cost by C, but that’s the convention so we’ll run with it!) The generalized form of the weighted-average cost of capital formula is presented in Figure 10.4. Note in particular that we are representing kd as the after-tax cost of debt that recognizes the firm can deduct bond-related interest expenses for tax purposes. (As previously mentioned, no such adjustments are necessary for the cost of preferred shares and common equity.) Of course if a firm doesn’t have any preferred shares (and has no plans to issue any preferred shares), then wp is equal to zero and the WACC formula simplifies to: kc = (wd * kd) + (we * ke).

Fig 10.3 Simple Cost of Capital Example

Component weight After-Tax Cost Weighted Cost = weight × After-Tax Cost Debt

0.20

5% × (1 – 0.35) = 3.25%

0.65%

Preferred shares

0.10

7%

0.70%

Common equity

0.70

15%

Total weighted cost

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10.50% 11.85%

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Chapter 10  Assessing the Cost of Capital: What Return Investors Require



Component weight

After-Tax Cost Weighted Cost

Debt

wd

kd

wd × kd

Preferred shares

wp

kp

wp × kp

Common equity

we

ke

we × ke

Total weighted cost

Fig 10.4  General Cost of Capital Calculation

kc = (wd × kd) + (wp × kp) + (we × ke)

10.2 Understanding the Implications of the Cost of Capital

Now that we have a basic understanding of how the cost of capital is calculated, it is worthwhile to reflect on the importance of this cost to a firm before considering the costs of each component. The cost of capital can be interpreted in a number of ways. First, it can be thought of as a key value driver: At a firm level, the lower the cost of raising funds, the more valuable the firm will be. At a project level, a firm often faces many potential investments or projects and must determine which ones to take on. And so the lower the cost of undertaking these investments, the more profitable and attractive the investments are. For example, suppose a firm has three project opportunities within a similar class of risk: Project A offers a potential return of 7 percent, Project B offers 11 percent, and Project C offers 13 percent. If the cost of capital is 11.85 percent, then only Project C looks attractive, because it is the only project with a potential return greater than the firm’s cost of capital. However, if the firm had a lower cost of capital of 10 percent, then Project B would also look attractive. A second interpretation, as described in the example of our fictitious entrepreneur, is that the cost of capital is the average cost of financing the various investments or projects facing the firm. In that example, by accounting for the three sources of financing— debt, preferred shares, and common equity—and their relative weights, we found the firm’s average financing costs were 11.85 percent. A third interpretation, from an investor’s perspective, is that the cost of capital represents the minimum rate of return that must be earned on a firm’s investments in order to satisfy all its investors. For example, suppose we calculate our example firm’s after-tax cost of capital to be 11.85 percent, as indicated in Figure 10.3. On the basis of the $1 million capital outlay that was required to start the new company, suppose the firm generates a before-tax (and before financing costs) return of 18.23 percent. (This number is carefully chosen to be the “grossed-up” or pretax cost of capital equivalent: 11.85 percent divided by 1 minus the tax rate = 0.1185>(1 - 0.35) = 0.182308.) The resulting financial situation is presented in Figure 10.5. This example highlights some important implications related to an understanding of the cost of capital. Note that in this example, all the investors or stakeholders are satisfied with their investments. The bondholders receive their interest payments as expected, and as such, they are satisfied. The IRS is satisfied with the taxes it receives. The preferred shareholders receive their preferred dividends as expected and are also satisfied. Finally, just enough earnings are left available to the common shareholders to satisfy their required return of 15 percent. So everyone is satisfied. Suppose, however, that the amount available to common shareholders was only $70,000, or an amount less than the expected $105,000. Although still profitable from an accounting perspective, the firm would not be earning sufficient profits to satisfy all

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Objective 10.2

Describe various ways to interpret the cost of capital.

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Fig 10.5 Cost of Capital Implications

Earnings before interest and taxes (EBIT)

$1 million × 18.23%

Interest (paid to bondholders)

$200,000 × 5%

Earnings before taxes (EBT)

$182,308 – $10,000

Tax (at 35% rate)

$172,308 × 0.35

$182,308 10,000 $172,308 60,308

Earnings after tax (EAT)

$172,308 – $60,308

Preferred dividends

$100,000 × 7%

$112,000

Earnings available to common shareholders

$112,000 – $7,000

$ 105,000

Common shareholder required return

$700,000 × 15%

$ 105,000

Residual after required return

$105,000 – $105,000

$7,000

$0

investors, particularly the ultimate owners of the firm, the common shareholders. (These common shareholders might have to resort to singing the catchy but grammatically incorrect refrain from that old Rolling Stones tune, the one about not getting satisfaction.) In other words, the return on equity—in this case, $70,000 on an investment of $700,000, or 10 percent—would be less than the cost of equity or expected equity return of 15 percent. Conversely, if more than $105,000 was available—say $140,000—common shareholders would be more than satisfied because their return on investment would be 20 percent, or greater than what they required or expected. This result would make their ownership stake more valuable, thus increasing the overall value of their shares. Accordingly, the goal of the firm should be to maximize the value of its common shares. This can be achieved in part by minimizing the overall cost of raising funds or minimizing the overall cost of capital, WACC. We have now addressed why a firm should care about the cost of capital. To summarize, we can think of the cost of capital, in general, as the average minimum rate of return on future-oriented investments the firm makes today. The cost of capital is used to evaluate these future or incremental projects or investments. Thus, the overall cost of capital impacts which investments the firm makes. In these simple examples, we have intentionally glossed over a number of important issues related to the cost of capital. For example, what do we mean by risk, and what is the role of risk in the calculation of these costs? How do we estimate the cost of each of the components? And where did the component weights come from? We now address each of these issues in Sections 10.3 through 10.7.

10.3  Defining Risk Objective 10.3

Describe different types of risk.

pure risk: The chance of a loss but no chance of a gain

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Earlier in the chapter, we saw that a firm’s cost of raising funds is equivalent to its investors’ required returns. Now, let’s explore how risk factors into both the cost of funds and the required returns by defining what we really mean by risk. According to The Free Dictionary, the definition of risk is “exposure to the chance of injury or loss.” This definition focuses only on the bad things that could happen to you, such as getting into a car accident or losing your house to a fire. This type of risk is also known as pure risk. For our purposes, though, we must think about risk in a different context. From a firm’s perspective, suppose one division is producing a product with expected sales of $10 million in each of the next eight quarters, and this expectation is incorporated into the firm’s budget for planning purposes. There is a risk, however, that the actual sales in

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Expected Return

Fig 10.6 Expected Return and Risk Trade-Offs

Government bonds

Speculative stocks Blue-chip stocks Corporate bonds

Risk

each quarter will be greater than or less than $10 million. The extent to which the actual sales deviate from budgeted sales is known as speculative risk, or the uncertain prospects of gain or loss. When investors consider buying bonds, stocks, or any other financial instrument, they consider speculative risk (which we will simply refer to as risk for the remainder of this chapter)—and the greater the perceived risk of an investment, the greater the expected return. We can see this relationship in Figure 10.6, whereby we can think of government bonds (at least U.S. government bonds) as being risk-free and thus corresponding to the lowest expected returns; followed by investment-grade corporate bonds; then good quality, well-known “blue-chip” stock; and finally, more speculative stocks. So, our first key observation is that there is a risk-return trade-off. In other words, increased risk goes hand in hand with increased expected returns. We can also think of measures of risk as trying to capture the dispersion of possible outcomes. For example, Figure 10.7 presents possible return outcomes from the four categories of investments shown in Figure 10.6. Note that we view government bonds as riskless; in other words, there is no dispersion of possible outcomes if we buy and hold to

Corporate bonds

Government bonds

–20

0

20

40

60

–20

0

20

40

60

Blue-chip stocks

–20

0

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20

40

60

speculative risk: The chance of a loss or gain

Fig 10.7 Dispersion of Expected Returns

80

Speculative stocks

–20

0

20

40

60

80

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Part 3  Financing Long-Term Needs

standard deviation: A statistical measure that captures the extent to which actual outcomes deviate from average or expected outcomes diversification: The process or strategy of combining assets or investments in order to reduce risk

maturity. As we move to riskier investments, however, the dispersion of expected returns increases. Mathematicians have a way of measuring this dispersion, known as the standard deviation, which captures the extent to which actual outcomes deviate from average or expected outcomes. Although we won’t get into details about how to calculate standard deviation (which is available as a function in spreadsheet software), we should note that it is measured as a percent. Moreover, the riskier a security is, the higher its standard deviation will be. In fact Figure 9.5 presented standard deviations—which we referred to then more generically as volatility—of historical returns of various types of investments. Now that we understand how risk or dispersion of expected returns is measured, our second key observation is that, by nature, most of us don’t like risk—in other words, we are risk averse. All else equal, we prefer potential outcomes that have lower dispersions. Another concept related to risk is diversification, which refers to combining assets or investments in order to reduce risk. Suppose, for instance, you are planning to buy 20 stocks. If you choose all 20 from the oil and gas industry, your portfolio will not be diversified. Every stock in your portfolio will thus be expected to react the same way as general world oil prices change—increasing when the price of oil goes up, and decreasing when the price of oil goes down. But if you choose 20 stocks in 20 different industries, your portfolio will not be as volatile and will not be as susceptible to changes in oil prices. Researchers have shown the impact of adding more (randomly chosen) stocks to a portfolio. The general result is captured in Figure 10.8. The vertical axis is labeled “Portfolio Risk (Normalized).” Let’s see what this means. Let’s suppose we had a sample of 500 stocks and we measure the standard deviation of returns of holding any one stock, then take an average of these standard deviations. We can then “normalize” that average to be 1.0. Now consider new experiments by randomly choosing two-stock portfolios, then three-stock portfolios, and so on. As the portfolio size increases, there is a tendency for the overall portfolio risk or standard deviation to decline. For example, once we have, say, a 20-stock portfolio, we may have reduced a substantial proportion of the portfolio risk. The intuition is that firm-specific risk or risk specific to each individual stock, such as the risk that the CEO might suffer from a heart attack—also known as unsystematic risk in investment lingo—is reduced as more stocks are added because there tend to be offsetting ups and downs in their performance. Ultimately, we are left with a well-diversified portfolio that has eliminated virtually all of the unsystematic risk. Thus, we are left only with systematic or market risk—meaning the risk of investing in the market as a whole.

Fig 10.8 Stock Portfolios and Diversification

Portfolio Risk (Normalized)

224

Firm-specific (unsystematic) risk Total risk Market (systematic) risk 0

10

20

30

Number of Securities in Portfolio

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225

Accordingly, our third key observation is as follows: If investors are well diversified, the only risk that matters is systematic risk. We will see why this is the case in Section 10.6, when we examine the cost of equity or the required equity return.

10.4 Estimating the Cost of Debt Now that we understand the concept of risk, calculating the cost of debt is fairly straightforward. From the potential bond investor’s perspective, we begin by asking what the appropriate bond (or more generally, debt instrument) return is. If the firm has existing publicly traded debt, then the current yield to maturity—as described in Chapter 7— represents the before-tax cost of debt. (Technically, this is an approximation, but close enough for our purposes.) In some cases, the firm may have numerous outstanding bonds with different times to maturity and different yields. In those cases, a guideline is to match the bond maturity with the average length of the projects the firm is planning to undertake with any new funds. In almost all situations, firms tend to have long-term projects, so a long-term bond would be a match. (Long-term bonds typically mature in 10 or more years.) After the before-tax cost of debt has been estimated, this estimate is multiplied by 1 minus the estimated (future) tax rate. In most cases, the tax rate can be estimated by examining the amount of taxes paid in the last fiscal year relative to the before-tax earnings in that year. If the firm had unusual losses and did not pay taxes that year, then a simple estimate of future taxes—usually around 35 percent—will suffice. (Technically we are estimating the marginal tax rate or the corporate taxes paid on an incremental dollar of pretax income.) For example, if a firm’s long-term bond yield was 8 percent and the firm was expected to pay taxes at a rate of 35 percent, then the after-tax cost of debt would be calculated as follows: 8 percent * (1 - 0.35) = 5.2 percent. Of course, there would be some costs associated with the bond sale (such as fees to investment banks), but these are generally of secondary consideration and typically ignored in cost of debt estimates. If a firm does not have existing publicly traded debt, then an estimate must be made of the appropriate cost of debt. The usual approach is to examine the current yield to maturity on risk-free long-term government bonds, such as the 10-year treasury bond, then add an appropriate premium. (Recall from Chapter 2 that we can find the 10-year yield by examining the treasury yield curve.) This premium reflects the riskiness of the firm’s ability to repay its principal and make its interest payments. A firm’s premium is directly related to its bond rating (as discussed in Chapter 9) or to its perceived bond rating relative to similar firms if the firm has not currently issued any bonds. Thus, an AAA firm will have a very small premium, perhaps less than 0.5 percent, whereas a riskier firm rated BB or lower may have a premium of 2 to 3 percent or more. A firm often has numerous debt instruments with different maturities, some short term and others long term. One approach to estimating the cost of debt is to estimate a cost associated with each. An alternative approach is both simpler and intuitively appealing: Rather than estimating a separate cost associated with each debt instrument, we can estimate the firm’s amount of “permanent” debt—both short term and long term—and use one long-term yield to estimate the overall cost of debt. Here, we don’t mean “permanent” in the literal sense because, by nature, debt is always maturing. Rather, we consider debt permanent if our expectation is that the firm will always have debt. In other words, once the current debt matures, we expect the firm to “roll over” the obligation by issuing new debt of a similar amount.

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Objective 10.4

Explain how to estimate the cost of debt.

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Fig 10.9 Permanent Capital Current assets

permanent capital: The amount of interest-bearing debt plus preferred and common equity

Current liabilities Long-term debt

Net working capital

Long-term debt

Fixed assets

Preferred shares

Fixed assets

Preferred shares

Other assets

Common equity

Other assets

Common equity

The logic behind using just one rate—a long-term yield—for both short-term and long-term debt is that although short-term yields may differ from long-term yields (usually lower), over a long period, short-term rates on average tend to be similar to longterm rates. This logic is consistent with the “unbiased expectations theory” we used in Chapter 2 (Section 2.1.3) to explain the shape of the yield curve. One final issue concerning calculation of the cost of debt is the treatment of current liabilities such as accounts payable, which are related to the firm’s operating activities. Recall from Chapter 5 that there is an opportunity cost to forego any discounts on early payment to suppliers (for example, a typical 2 percent discount for paying in 10 days). Should we be incorporating this cost explicitly in our estimate of the cost of debt? The answer is generally no. Recall our discussion of working capital—the relationship among inventory, receivables, and payables—related to the firm’s operating activities in Chapter 5. There is a flip side to our discussion of accounts payable. On the current asset side, we have accounts receivable. In effect, we can think of current assets and current liabilities as netting out, to form net working capital. Thus, we can think of a revised balance sheet (as in Figure 10.9), whereby our costs, associated with the right-hand side of the balance sheet, are related to permanent capital: long-term debt (that we assume will be rolled over when it matures), preferred shares, and common equity.

10.5 Estimating the Cost of Preferred Shares Objective 10.5

Explain how to estimate the cost of preferred shares.

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Preferred shares are often issued by financial institutions and public utilities. Recall from our discussion in Chapter 7 that preferred shares generally trade like bonds, increasing in price when interest rates decline and vice versa, unless the firm is undergoing financial distress. For example, Figure 10.10 shows the price of Pacific Gas & Electric Company’s 5 percent cumulative redeemable preferred share compared with the yield on 10-year treasuries. We see a general trend of decreasing prices when treasury yields increase—in the 1973 to 1981 period— and increasing prices when treasury yields decline—in the post-1981 period. Based on a recent price of $25.36, the preferred shares were trading with a dividend yield of 4.9 percent (based on $1.25 annual dividends), whereas the trea­suries were yielding only 1.5 percent. Of course, from an investor’s perspective, there is risk in holding preferred shares, as Pacific Gas & Electric could experience financial distress and, in the event of bankruptcy, could even stop making preferred dividend payments. For example, between mid-1999 and early 2001, Pacific Gas & Electric’s common share price fell from over $32 per share to under $9 per share. As we see in the figure, the preferred share price fell substantially as well, which confounded the general inverse relationship between interest

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Fig 10.10 Pacific Gas & Electric Preferred Share Price and 10-Year Treasury Yields, 1973–2012

30

25

227

PG&E preferred price 10-year treasury yield

20

15

10

5

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

0

Source: Preferred share prices from Datastream; 10-year treasury bond yield data from the Federal Reserve Board website, http://www.federalreserve.gov/releases/h15/data.htm (accessed August 21, 2012)

rates and preferred share prices. Thus, we need to keep in mind that the preferred dividends are not guaranteed. Calculation of the cost of preferred shares is relatively straightforward. Recall from our discussion in Chapter 7 that the price of a preferred share is the present value of a perpetual stream of dividends—see the general formula in Figure 7.13. We now reproduce that formula in Figure 10.11, using a slightly modified notation. Using simple algebra, we can rearrange the equation in Figure 10.11 to solve for kp, or the expected return for the common equity investor, as shown in Figure 10.12. In other words, if a firm has existing preferred shares, such as with Pacific Gas & Electric Company, then the estimate of the cost of preferred shares is simply the current yield on existing preferred shares. For example, we noted that Pacific Gas & Electric Company was recently paying annual preferred dividends of $1.25 per share and the preferred shares were selling for $25.36 per share. Therefore, the current yield on the firm’s preferred shares is: $1.25 $25.36 = 4.9 percent

annual dividend current price current yield

P0 = where

DIV kp

Fig 10.11 Formula for the Present Value of a Perpetuity

P0 = price of a preferred share DIV = annual preferred dividend kp = expected or required return by preferred share investors

kp =

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DIV P0

Fig 10.12 Expected Preferred Return Based on the Perpetuity Formula

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But what if a similar firm—also in the gas and electric industry—did not have existing preferred shares but was planning to issue them? In this situation, one key question must be addressed: What yield does the firm need to offer if it issues new preferred shares today? Suppose, for example, the firm decides to issue new (perpetual) preferred shares today with a face value of $100 per share. Consequently, the annual dividend on the new preferred shares would be $4.90, for an identical (to Pacific Gas & Electric Company) yield of 4.9 percent. Note that, unlike the cost of debt, there is no after-tax adjustment needed because preferred dividends are already paid in after-tax dollars. Thus, if a firm does not currently have any outstanding preferred shares, then the appropriate cost can be estimated by examining the current yield of similar firms, such as those with similar debt ratings. Recall that the two main drivers of the current yield on preferred shares are current interest rates (because preferred shares are typically like bonds that have no maturity date) and the perceived riskiness of the firm.

10.6 Estimating the Cost of Equity Objective 10.6

Explain how to estimate the cost of equity using the dividend model approach and the capital asset pricing model approach.

Estimating the cost of debt and the cost of preferred shares is relatively straightforward— particularly if a firm has existing publicly traded debt and preferred shares—but the same cannot be said for estimating the cost of common equity. The estimation problem arises because, unlike bonds and preferred shares, common shares do not have a similar “guarantee” or implicit promise of returns. Instead, common shareholders are the residual claimants and own any remaining earnings after the other investors have received payment. Based on Figure 10.2, instead of focusing on the cost to the firm, we will take the approach of estimating the cost of equity by focusing on the investor. Thus, we need somehow to estimate what a common equity investor expects or requires when he or she is making an investment. In other words, we need a model of what drives stock prices and hence what drives expected returns. Researchers have uncovered a number of approaches that provide us with estimates of common equity investor expected returns, and thus an estimate of the cost of equity. One of the simplest approaches is to measure the average historical common equity return; however, such an approach does not necessarily capture expected returns and is not widely used. Instead, we examine two well-known approaches here: the dividend model approach, which is intuitively appealing and relates to our earlier time value of money discussions, and the capital asset pricing model, which is the most widely used.

10.6.1  Dividend Model Approach We introduced the dividend model in Chapter 7. The simplest form of the dividend model approach (presented in Figure 7.23), also known as the constant growth dividend discount model, is based on the premise that equity investors generally intend to hold a stock for a long period of time (perhaps even bequeathing it to their children). In this model, what matters to investors is the cash flow or dividends that they expect to receive over the life of owning the stock. We reproduce the Chapter 7 model in Figure 10.13 (using slightly modified notations with ke 2 . Using simple algebra, we can rearrange the equation in Figure 10.13 to solve for ke, or the expected return for the common equity investor, as indicated in Figure 10.14.

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P0 = where

DIV1 (ke − g)

229

Fig 10.13 Constant Growth Dividend Discount Model

P0 = current price (at time = 0) of common share DIV1 = anticipated dividend in one period ke = expected or required return by common share investor g = constant growth rate of dividends

Note that the expected returns are determined by the expected dividend yield as well as the expected growth in dividends over time. The expected growth in dividends can be thought of as the capital gain that investors expect (if they were to sell their stock). As an example, suppose a firm is expected to pay cash dividends of $1.50 per share over the next year. The current stock price is $37.50, so the expected dividend yield is 4 percent. In addition, it is estimated that the dividends will grow, on average, by about 8 percent per year for the foreseeable future. This estimated growth rate of dividends may be determined from the historical growth in dividends or from a current assessment of the firm by analysts. Adding these two components, the estimated required return to equity investors, and hence cost of equity, is 12 percent: ke = $1.50>$37.50 + 0.08 = 0.04 + 0.08 = 0.12 or 12 percent Of course, there are limitations to the dividend model approach. For one, if a firm does not currently pay dividends, it is difficult to estimate expected future dividends. Moreover, even if a firm does pay dividends, if future dividends are not expected to grow at a constant rate, then estimating the cost of equity becomes much more complicated. While the dividend yield component is generally easy to estimate, the anticipated growth in dividends is not. Fortunately, there is an alternative (and much more widely used) approach, as described in the next section.

10.6.2 Capital Asset Pricing Model The capital asset pricing model, or CAPM as it is affectionately known (pronounced “cap-M”), is an intuitively appealing model developed by Nobel Prize–winning financial economist Bill Sharpe. Sharpe’s work is an extension of the work of his mentor, Nobel Prize–winning financial economist Harry Markowitz. Markowitz showed that there were benefits to investing in a well-diversified basket of stocks, particularly in terms of enhancing potential rewards relative to risk exposure. Essentially, Markowitz’s key insight was the same as your mother’s when she told you: “Don’t put all of your eggs in one basket.” (Unfortunately, no matter how well-deserving, your mother did not receive a Nobel Prize.) Sharpe followed up on this idea, looking specifically at the expected stock returns to an investor who is well diversified among risky securities and has an opportunity to invest in risk-free securities as well. Although CAPM is called a “pricing” model, it actually refers to expected returns. There are three components to CAPM—the risk-free rate, the market risk premium, and

ke =

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DIV1 +g P0

Fig 10.14 Expected Equity Return Based on the Constant Growth Dividend Discount Model

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In-Depth

Investing in “the Market”

market risk premium: The difference between the expected return on a stock investment in the market and the expected return on a risk-free investment beta (b): A measure of the riskiness of a firm’s common equity relative to the risk of the overall stock market

Fig 10.15 Capital Asset Pricing Model

When we talk about stocks, what do we really mean by investing in “the market”? In CAPM theory, the market involves all global assets, including stocks, bonds, real estate, and more. In practice, however, we think of the market as a broad measure of domestic stocks. There are thousands of stocks listed on U.S. exchanges, and it would be impractical (and costly) for investors to buy shares in each and every one. Fortunately, there are funds that provide diversification benefits from investing in a large number of firms. Traditional mutual funds invest in stocks according to the fund’s mandate. For example, one fund manager might invest strictly in technology stocks, while another might invest only in stocks that pay dividends. Other funds that are actively managed might try to beat the performance of a particular stock market benchmark such as the S&P 500 Index. In contrast, yet other types of funds are known as passive or index funds: Rather than trying to beat the market, the fund manager’s mandate is simply to replicate the benchmark performance. Also, in recent years, a new class of funds has emerged to challenge traditional mutual funds, generally by offering lower commissions. These funds are called exchange traded funds, or ETFs. Thus, when we talk about buying into “the market” as a whole, we can think of buying a market index ETF.

beta, which we will explain in detail shortly. The intuition behind the model is as follows: If an investor is considering a risky investment in equities, there is always a riskfree alternative, and that would be government bonds. This is a minimum starting point for an investor’s expected return on an equity investment. The common notation for the return on a risk-free investment is R f . Given that stocks, in general, are viewed as riskier than government bonds, in order to be enticed into investing in the stock market as a whole, investors will expect a premium over government bonds. This premium is known as the market risk premium (MRP). Individual stocks can be viewed as being either more risky or less risky than the overall market. To capture the relative riskiness of an individual stock relative to the overall market, a stock’s beta (b) is estimated. The capital asset pricing model assumes investors are well diversified and therefore care only about market risk or systematic risk, which is captured by beta. By definition—and as our starting point—the market has a beta of 1. Riskier stocks have betas greater than 1, whereas less risky stocks have betas less than 1. The beta factor then acts as a multiplier for the market risk premium, providing an upward or downward adjustment. This overall model is presented in Figure 10.15. As an example, suppose the risk-free rate is currently 4 percent, a stock’s beta is estimated to be 1.2, and the market risk premium is estimated to be 5 percent. The resulting expected equity return or cost of capital is 10%, as shown here: E(Rs) = ke = 4% + 1.2 * 5% = 4% + 6% = 10%

E(Rs) = Rf + bs × MRP where

E(Rs) = expected return on stock s = ke = estimated cost of equity Rf = risk-free rate of return bs = beta for stock s MRP = market risk premium

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In terms of operationalizing the model, there are a number of important estimation issues related to each of three CAPM components. Each is dealt with in turn in the following sections.

10.6.2.1  Risk-Free Rate  Clearly, the risk-free rate of return is represented by a government bond yield because we assume that developed market governments generally do not default on their loan obligations. The central question thus becomes: Which government security should we choose? Likely candidates include short-term treasury bills and one-, five-, ten-, or thirty-year government bond yields. Unfortunately, the CAPM is based on theoretical assumptions and does not provide a correct answer to our question. Consequently, we must rely on intuition, logic, and best practices among corporations and financial analysts. The general principle is that we should be consistent with our cost of debt. So, if we are focusing on long-term debt, then we should use a long-term government yield. A generally accepted benchmark is the ten-year government bond yield, but sometimes other long-term yields (such as the thirty-year yield) are used instead. 10.6.2.2  Market Risk Premium The market risk premium represents the expected difference between the return on the stock market investment and the risk-free return. The market return combines capital gains (price appreciation) with any dividends received. In practice, the market is represented by a broad country index, such as the S&P 500 Index. Consequently, if we utilize the 10-year government bond as the riskfree rate, then the market risk premium is the expected difference between the return on the stock market index and the long-term government bond return. Before moving on, we need to address a potentially difficult issue related the estimation of the market risk premium. Specifically, we are trying to estimate the expected ­premium—yet short of surveying all investors and asking them what their long-term stock and bond return expectations are (estimates that might change daily), we have no way of truly capturing expected returns. One way out of this dilemma is to look to the past for our best guess as to what the future may look like. Researchers do this by examining stock and bond returns as far back as the 1920s. Although there are a number of statistical issues that create controversy, estimates show that stocks have tended to outperform long-term government bonds by about 4 to 6 percent per year. We presented some information about this in Figure 9.5 in Chapter 9. Assuming investors’ past expectations have been fulfilled, the average historical market risk premium is a useful estimate of the expected future market risk premium. 10.6.2.3  Beta  As introduced earlier, beta is a relative risk measure. It is calculated by examining the returns in a particular stock over time relative to the return on a market index, such as the S&P 500. If a stock is estimated to have a beta of, say, 1.2, this implies that a 1 percent increase in the market, in the absence of any firm-specific news, should coincide with a 1.2 percent increase in the value of the stock. Conversely, a 1 percent decline in the market should coincide with a 1.2 percent decline in the stock. Thus, in this example, the stock is riskier than the market. On the other hand, if the beta was estimated at, say, 0.75, then the stock would not be expected to fluctuate as much as the market. Although it is statistically straightforward to estimate betas (through a technique known as regression analysis), issues similar to those for estimating the market risk ­premium arise. Namely, while we can estimate a historical beta, what we really are interested in is an expected beta. To address this problem, we can rely on estimates of forward-­looking betas provided by well-known financial information firms such as

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Fig 10.16 Dow Jones Industrial Average Company Betas

Procter & Gamble Co.

0.28

The Home Depot Inc.

1.03

Kraft Foods Inc.

0.30

Chevron Corporation

1.06

McDonald’s Corp.

0.30

American Express Company

1.12

Merck & Co. Inc.

0.38

The Boeing Company

1.13

Wal-Mart Stores Inc.

0.40

Microsoft Corporation

1.13

Verizon Communications Inc.

0.43

Walt Disney Co.

1.15

The Coca-Cola Company

0.44

United Technologies Corp.

1.15

AT&T Inc.

0.44

Hewlett-Packard Company

1.34

Johnson & Johnson

0.48

Cisco Systems Inc.

1.43

IBM Corporation

0.60

E. I. du Pont de Nemours & Co.

1.43

Pfizer Inc.

0.65

General Electric Company

1.46

The Travelers Companies, Inc.

0.73

JPMorgan Chase & Co.

1.61

Exxon Mobil Corporation

0.81

Bank of America Corporation

1.81

Intel Corporation

0.98

Caterpillar Inc.

1.82

3M Co.

1.02

Alcoa Inc.

1.96

Note: As of September 20, 2013, Nike Inc. Visa Inc., and Goldman Sachs Group Inc. replaced Alcoa Inc., Hewlett-Packard Company, and Bank of America Corporation. Source: Yahoo! Finance http://ca.finance.yahoo.com/q/cp?s=%5EDJI (accessed September 13, 2012)

Value Line and Bloomberg. Historical betas are also available for free from Yahoo! Finance. Figure 10.16 presents estimates of betas for the 30 companies that make up the Dow Jones Industrial Average.

10.7 Estimating Component Weights Objective 10.7

Explain how to estimate the component weights when estimating the cost of capital.

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We have now estimated the cost of each component of capital: debt, preferred shares, and common equity. The final step in estimating the overall cost of capital is to assign an appropriate weight to each form of capital and calculate a weighted average. Once again, practice is not nearly as simple as theory. We face the usual issue of knowing what happened in the past but needing an estimate of what we think will happen in the future— namely, how the firm will raise funds in the future. The simplest approach to estimating component weights is not necessarily the most appropriate, but it is certainly the easiest and is commonly used in practice. With this approach, we examine the relative weights of the book values based on the most recent financial statements (focusing on the right-hand side of the balance sheet). For example, we could take the book value of any long-term debt (as well as any short-term interestpaying “permanent” debt), any preferred shares (assuming the firm has any intention of issuing preferred shares in the future), and any common equity (common shares plus retained earnings). In practice, we would generally ignore most other balance sheet items, particularly if they are not material in size (although an argument can be made to include deferred taxes as part of common equity if the firm is assumed to continue growing). For example, suppose the book value of interest-bearing debt was $60 million and the book value of equity was $40 million (and the firm didn’t have any preferred shares), then the total book value amount of capital is $100 million, with the debt

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c­ omponent weight of 0.60 (or $60 million divided by $100 million) and the equity component weight of 0.40 (or $40 million divided by $100 million). A similar yet alternative approach to estimating component weights is to estimate market values (instead of book values) for each component. This method is consistent with our forward-looking assessment, because market values represent current investor expectations. The approach is appropriate in the case of a publicly traded firm. In this case, we need to go beyond information in the annual report to examine the latest market prices for bonds, preferred shares, and common equity. Market values are simply calculated as the price per share of each security multiplied by the number of shares outstanding. If such information is not available for a particular component (for example, there is no publicly traded debt), then we often assume that the book values and market values are similar. Usually, the biggest difference between the cost of capital measured using book values versus market values is related to the common equity component. In some cases, we can use a third approach that relies on more direct information. Ideally, we would like to ask the company’s CEO or CFO about how he or she plans to raise capital in the future. Sometimes such information is disclosed publicly through management discussions in the annual report. For example, a firm might indicate a target capital structure that essentially indicates the target component weights. If we have this direct information, then we can use it to estimate component weights. Note also that many firms in a particular industry strive to have very similar capital structures. Thus, any information about a representative firm in an industry may be usefully applied to another similar firm.

10.8 Home Depot Application To apply what we just learned, we will now estimate the cost of capital of Home Depot, based on publicly available financial information. Home Depot has a variety of short-term and long-term debt instruments with both variable and fixed rates of interest. The company has a program of issuing commercial paper for short-term needs, but as of January 29, 2012, it had no commercial paper outstanding. The firm’s long-term debt primarily ranges from one- to thirty-year notes. Because most of Home Depot’s projects are of a long-term nature, we’ll focus on its longterm debt. We’ll use the long-term bond described in Section 7.2.1 to represent the longterm nature of the types of Home Depot projects. (Alternatively, we could have chosen a 10-year bond or taken an average yield of all of Home Depot’s long-term bonds.) Recall that the bond in question was issued in December 2006 at a rate of roughly 5.875 percent, but its more recent yield was 4.67 percent. We therefore use 4.67 percent as an estimate of the before-tax cost of debt. For the tax rate, we could incorporate a standard U.S. statutory tax rate of 35 percent, or we could measure what the actual rate has recently been for Home Depot. For its year-end January 29, 2012, consolidated statement of earnings, we note that Home Depot paid taxes of $2,185 million on before-tax earnings of $6,068 million. The corresponding tax rate was ($2,185>$6.068) = 0.36 or 36 percent, which is the rate we will use in our calculation. Note that we are assuming this rate is representative of the marginal or incremental tax rate Home Depot will face in the future. Thus, taken together, Home Depot’s after-tax cost of debt is as follows:

Objective 10.8

Describe the process for estimating Home Depot’s cost of capital.

kd = kd before tax * 11 - tax rate 2 = 4.67% * 11 - 0.362 = 3.0%

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Because Home Depot does not have any outstanding preferred shares, we will assume the firm also has no plans to issue preferred shares in the future. Accordingly, we will exclude any estimate of the cost of preferred shares. Next, in order to estimate Home Depot’s cost of equity, we will rely on the CAPM. As part of this estimation, we need a recent long-term (10-year) U.S. government bond yield (1.63 percent), an estimate of Home Depot’s beta (we’ll use the estimated beta of 1.03 from Yahoo!Finance),1 and an estimate of the market risk premium. On the basis of our earlier discussion, we will assume the risk premium is equal to 5 percent. We can then combine these terms as follows: ke = Rf + b * MRP = 1.63% + 1.03 * 5.0% = 6.8% Note that compared to long-term historical stock returns (see Figure 9.5), this cost of equity or expected stock return appears quite low. The main explanation is that we are doing the calculation at a time when long-term interest rates are near all-time historical lows. We next base our debt and equity component weights on market value weights. We assume that the market value of Home Depot’s debt is very close to its book value of debt (a reasonable assumption for a firm that is not experiencing any financial distress). For cost of capital calculation purposes, we generally refer to long-term debt as any permanent interest-bearing debt or long-term debt plus any short-term debt that is judged to be of a permanent nature. (For example, we would include current installments of long-term debt and any interest-bearing short-term debt such as commercial paper that we assumed would be constantly renewed.) For Home Depot, we saw in Chapter 3, Figure 3.2, that the firm’s long-term debt as of January 29, 2012, was listed as $10,758 million. The current installments of the long-term debt (as indicated in the current liabilities section of the balance sheet) were $30 million. Other long-term liabilities were $2,146 million, which we noted included a guarantee of debt of a subsidiary firm, capital leases, and other liabilities that we implicitly assumed were predominately interest bearing. Thus, Home Depot’s total permanent debt is estimated as $10,758 million plus $30 million plus $2,146 million, totaling $12,934 million. In Chapter 3, Section 3.1.3, we noted that Home Depot’s market value of equity was $69,931 million. As of January 29, 2012, there were approximately 1,562 million common shares of Home Depot stock outstanding, and the common share price was $44.77. Thus, the market value of equity was 1,562 million shares * $44.77 per share = $69,931 million, which is much greater than the book value of equity of $17,898 million. The total market value of the capital was $12,934 million + $69,931 million = $82,865 million. Based on these market value weights, the capital structure is 15.6 percent debt ($12,934 divided by $82,865) and 84.4 percent common equity ($69,931 divided by $82,865). Therefore, the overall cost of capital for Home Depot is estimated as follows: Type of capital

Capital cost (after tax) Weight Weighted cost

Debt

4.67% * 11 - 0.362 = 3.0% 15.6% 0.5%

Equity

1.63% + 1.03 * 5.0% = 6.8% 84.4% 5.7%

Cost of capital 1kc 2

6.2%

1

We will use the 10-year treasury yield and the beta as of July 2012. See Federal Reserve http://www .federalreserve.gov/econresdata/statisticsdata.htm for treasury yield information.

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10.9 Hurdle Rates Now that we have estimated the overall cost of capital, we need to examine how it is applied internally to the key decisions a firm’s management must make. Recall that the overall cost of capital is the minimum rate of return, on average, on future-oriented investments that the firm makes today. However, not all investments or projects that a firm is presently considering are of equal risk. It is critical that risk is explicitly accounted for in the decision-making process. If not, a firm might be tempted to focus exclusively on potentially high-return projects— and if these same projects are the riskiest ones, the firm may end up taking on too much risk. Fortunately, there is a way to incorporate risk through the use of hurdle rates, which are rates set by management as minimum required returns for certain types of projects. Typically, within a firm, various divisions or categories of potential projects are clearly identified and ranked according to perceived risk. For example, the expansion of an existing facility may be viewed as much less risky than investment in a new type of business unit. As such, it would be appropriate to require a higher threshold rate of return hurdle for investment in a riskier project. This is the purpose of hurdle rates, as illustrated in Figure 10.17. First, given the perceived riskiness of a division or type of project, a hurdle rate is assigned. Second, if the expected return on a potential project is assessed as being greater than the hurdle rate, then that project is deemed acceptable. Conversely, if the expected return is assessed as being less than the hurdle rate, then the project is rejected. In the examples in Figure 10.17, suppose a firm has an overall cost of capital or WACC of 11.5 percent. Suppose also that a particular project, Project Y, is assigned a hurdle rate of 10 percent (indicated as H1 on the line). Based on an assessment of expected future cash flows from the project, the expected return on the project is actually 11 percent. Given these figures, we would accept or undertake Project Y. Conversely, suppose a particular project, Project Z, is assigned a hurdle rate of 13 percent (indicated as H2 on the line). Based on an assessment of expected future cash flows from the project, the expected return on the project is actually only 12 percent. In this case, we would reject, or not undertake, Project Z. Thus, we are not basing our decision on the absolute

Expected Returns and Hurdle Rates

Accept projects for a given hurdle rate with expected returns on or above the blue line 13% 12% 11.5% 11% 10%

Hurdle rates H2

Objective 10.9

Explain what a hurdle rate is and how it is used.

hurdle rates: The minimum acceptable rate of return for investments, depending on the nature and risk of the investment

Fig 10.17 Expected Project Returns, Risk, and Hurdle Rates

Z WACC Y H1 Reject projects for a given hurdle rate with expected returns below the blue line Risk

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expected return compared to the firm’s overall WACC, but rather on the expected return based on the perceived riskiness of the project, relative to the appropriate hurdle rate. The challenge for firms is setting hurdle rates. Some firms set these on a project-byproject basis, whereas other larger firms have separate hurdle rates for each division. Many project hurdle rates are set based on a firm’s past experience. For example, an established fast-food chain that is opening a new domestic store understands the risks involved quite well and would set a lower hurdle rate for that project compared with expanding overseas for the first time or entering a different product market. For large and distinct divisions, hurdle rates can be set by assuming each division is a stand-alone firm and its cost of capital estimated as such. For example, if one division of a conglomerate is focused on aviation, then its hurdle rate may be estimated as an average of that of other public aviation firms. How do hurdle rates relate to the overall cost of capital? In the example in Figure 10.17, notice that one hurdle rate (H1) is below the WACC, and another (H2) is above the WACC. This is not surprising, because the overall WACC should be related to the types of projects the firm is considering undertaking. For instance, suppose the firm had two hurdle rates: 8 percent for type A projects and 12 percent for type B projects. If the firm anticipated accepting a similar number of type A and B projects, we might expect the WACC to be around 10 percent. Thus, we should expect the average of all hurdle rates within a firm to be approximately equal to the overall WACC.

10.10 Relevance for Managers Objective 10.10

Explain why assessing the cost of capital is relevant for managers.

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Not all managers have the good fortune to work in the finance department! As such, not all managers are directly involved in making decisions related the cost of capital, such as determining the relative mix of debt and equity as part of a firm’s capital structure. But the cost of capital is, nonetheless, important and relevant for nonfinancial managers. One reason why this information is valuable to nonfinancial managers is that their actions have an important indirect impact on the cost of capital. The cost of capital reflects the overall riskiness of the firm. Part of that risk is financial risk, and it depends on the amount of debt a firm has relative to the amount of equity—the greater the debt, the greater the financial risk, which can drive up the cost of equity as well. Thus, even though debt is lower cost than equity, having more debt than equity does not necessarily imply the cost of capital will be lower—a topic examined in more detail in Chapter 11. The other part is business risk. Any day-to-day actions that managers take to mitigate risk—such as better managing inventory levels to ensure steady sales—can reduce the perceived riskiness of the firm in the long run, leading to an overall lower cost of capital. Another reason why the cost of capital is important for operating managers and marketing managers—in fact, any managers who may be requesting funds to invest in projects—is to better understand how hurdle rates are determined. Once you understand what a hurdle rate represents and how it should be estimated, you are in a better position to plan your capital request. While I am certainly not advocating an internal revolution that might cost you your job, in some cases, it may be worthwhile to have a frank conversation with folks from your finance department in which they explain and justify the hurdle rates that have been chosen. All too often, hurdles rates are set and forgotten and not updated as often as they should be, even though the environment has changed—for example, interest rates may have declined or the firm’s risk profile may have changed.

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Do managers actually apply the concepts we have discussed in this chapter? An important survey of American CFOs was conducted by academics John Graham and Campbell Harvey and published in 2001. The survey found that almost three-quarters of CFOs used the CAPM to estimate their firm’s cost of equity. (Other popular methods included using average past stock returns and a multi-beta CAPM that added other factors to the CAPM model besides market return.) A smaller fraction of CFOs—about 15 percent—backed out a cost of equity estimate from the dividend discount model. When it came to using hurdle rates, the survey’s results were surprising. In a hypothetical example, the CFOs were asked whether they would use a company-wide hurdle rate or a project-specific hurdle rate if they were evaluating new projects overseas with a ­different risk profile. Somewhat surprisingly, almost 60 percent indicated they would use a company-wide rate. Almost half also indicated they would always or almost always use a risk-matched hurdle rate. If your firm is one of those that uses a company-wide hurdle rate for all projects regardless of their risk profile, you may wish to share this book with your CFO.

Summary

1. Cost of capital, a key value driver, is the average cost of raising funds. It is also the rate of return that must be earned on the firm’s investments, at a minimum, in order to satisfy all the investors. 2. The cost of raising funds, from the firm’s perspective, is equivalent to investor-required returns. 3. The cost of capital is used to evaluate incremental projects or investments. 4. Speculative risk captures the uncertain prospects of gains and losses and is measured by standard deviation. 5. Diversification of stocks reduces unsystematic or firm-specific risk, leaving systematic or market risk. 6. The cost of debt is measured on an after-tax basis and reflects the rate that the firm would need to offer if it issued new debt today.

7. The cost of preferred shares reflects the rate that the firm would need to offer if it issued new preferred shares today. 8. The cost of equity is usually estimated either by the dividend model or the capital asset pricing model (CAPM). 9. The CAPM incorporates the risk-free rate with the market risk premium and beta, a relative risk measure. 10. Component weights are estimated on the basis of book values, market values, or information related to the target capital structure. 11. Hurdle rates depend on the perceived riskiness of divisions or projects and are used to evaluate different types of potential investments.

Additional Readings and Information

An important article that summarizes the controversies surrounding the calculation of the cost of capital and the generally accepted best practices is: Bruner, Robert, Kenneth Eades, Robert Harris, and Robert Higgins. “Best Practices in Estimating the Cost of Capital: Survey and Synthesis.” Financial Practices and Education (Spring/Summer 1998): 13–27. An update of this article is: Brotherson, Todd, Kenneth Eades, Robert Harris, and Robert Higgins. “Best Practices in Estimating the Cost of Capital: An Update.” Journal of Applied Finance (No. 1 2013): 15–33. The cost of capital survey described in this chapter comes from: Graham, John, and Campbell Harvey. “The Theory and Practice of Corporate Finance: Evidence from the Field.” Journal of Financial Economics 60 (2001): 187–243.

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Problems

1. Explain the relationship between the cost of raising funds from the firm’s perspective and the required return on bonds, preferred shares, and common shares from the investor’s perspective. 2. Suppose Fastest Company, a new start-up firm, initially has $50 million in common equity and its common shareholders require or expect a return of 14 percent on this investment. After the first year, Fastest Company makes an after-tax profit of $6 million (assume for now that Fastest Company does not have any preferred shares). How satisfied would the common shareholders be with the profit? 3. Differentiate between systematic and unsystematic risk. 4. Suppose Fastest Company is offered accounts payable terms of “2 percent, 10 days, net 30 days” but its suppliers actually allow it to repay in 45 days. Estimate the annualized opportunity cost for not taking advantage of the 2 percent discount for the quick 10-day payment. 5. Mawar Corporation just issued a dividend of $2.50 per share on its common stock. The company is expected to maintain a growth dividend of 6 percent indefinitely. If the stock sells for $40 a share, what is the company’s cost of common stock? 6. Bank Utama has an issue of preferred stock with $5 stated dividend that just sold for $90 per share. What is the bank’s cost of preferred stock? 7. Fastest Company’s preferred shares were issued last year at $30 per share but are now trading at $28.50. Fastest pays annual preferred dividends of $2.25 per share. Estimate Fastest Company’s cost of preferred shares. 8. What would you expect to happen to the price of Fastest Company’s preferred shares if inflation increased and the Fed increased interest rates, with banks following suit? 9. D&A Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50 percent common stock. • The company can issue bonds at a YTM of 8.4 percent. • The cost of preferred stock is 9 percent. • The risk-free rate is 6.57 percent.

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• The market risk premium is 5 percent. • D&A Industries’ beta is equal to 1.3. • Hypothetically, the firm will be able to use retained earnings to fund the equity portion of its capital budget. • The company’s tax rate is 30 percent.

Calculate cost of debt after tax, cost of preferred stock, and cost of common stock. 10. Based on your answer from question 9, calculate the company’s WACC. 11. Based on the chart of betas in Figure 10-16, if an investment in the overall stock market was expected to return 10 percent over the next year, what return would you expect if you invested in IBM? 12. Based on the chart of betas in Figure 10-16, how would you describe the relative riskiness of investing in Bank of America? 13. Suppose the current long-term government bond yield is 2 percent and the estimated market risk premium is 5 percent. Fastest Company’s beta is estimated to be 1.15. Using CAPM, estimate Fastest Company’s cost of common equity. 14. How would your answer in question 13 change if the current long-term government bond yield was 3 percent and Fastest Company’s beta was 1.5? 15. Suppose Fastest Company’s current balance sheet showed book value weights of 32 percent debt, 11 percent preferred shares, and 57 percent common equity. Assuming its cost of debt was 3 percent, the cost of preferred shares was 5 percent, and the cost of common equity was 9 percent, estimate Fastest Company’s WACC (based on these book value weights). 16. Consider the same estimated costs as in question 15. Fastest Company is not planning to issue preferred shares in the future but anticipates a target capital structure of 40 percent debt and 60 percent common equity. Reestimate Fastest Company’s WACC. 17. Explain whether Fastest Company would consider investing in any project with an expected return less than the estimated WACC.

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11

Understanding Financing and Payout Decisions Learning Objectives

The only thing that gives me pleasure is to see my dividend coming in. – John D. Rockefeller

Obj 11.1

Explain why firms have different capital structures. Obj 11.2

As indicated in our unifying framework in Figure 11.1, there are three main decision-making categories within a firm: operating, investing, and financing. We previously examined operating issues in Chapters 5 and 6 and investing issues in Chapters 7 and 8. In Chapter 9, we began our discussion of long-term financing needs by presenting an overview of capital markets, and in Chapter 10, we examined the cost of capital. Now, in Chapter 11, we’ll turn our attention to other aspects of long-term financing—namely, understanding financing and payout decisions and why a firm’s capital structure, or mix of debt and equity, matters. In Chapter 12, we will build on this discussion of capital structure to focus on designing an optimal capital structure. As shown in Figure 11.1, a firm’s financing decisions are related to debt financing, new equity, and payout policy. (For simplicity, in our framework, we refer to dividend policy instead of the broader payout policy—more on the distinction in Section 11.4). Recall that firm value is driven by two key factors: growth and risk. Financing decisions will primarily affect the risk of a firm. For example, a firm’s risk level would fluctuate as its financial leverage (or debt-toequity ratio) changes. In turn, a firm’s risk is reflected in its cost of capital, with higher-risk firms having higher costs of capital, as described in Chapter 10. Thus, understanding a firm’s financing and payout decisions is important, because these decisions can affect the cost of capital, which in turn can affect the attractiveness of projects. A firm’s capital structure combines all forms of financing on which the firm relies: long-term debt, common equity, preferred shares, and hybrid securities, such as convertible debt. We begin with an overview of capital structure. Then we explore the ramifications of the Modigliani-Miller findings, a classic argument that shows why a firm’s capital structure decisions might not matter to the overall value of the firm, based on some restrictive assumptions. However, as we’ll see, once these restrictive assumptions are removed, capital structure decisions do indeed matter in the real world. As such, we need to take a close look at how corporate taxes and financial distress have an impact on a firm’s financial decision-making process. (Financial distress refers to the difficulties experienced by firms as they attempt to meet financial commitments to their creditors.) We will also see how a firm’s choice of financing may provide a signal of the firm’s future prospects to existing and potential shareholders.

Explain why the value of a firm doesn’t depend on the capital structure under certain conditions and why the cost of equity increases as a firm has proportionately more debt. Obj 11.3

Explain how taxes, financial distress, and asymmetric information affect capital structure decisions. Obj 11.4

Describe dividend policies and share repurchases, and explain why dividend policies don’t impact the value of a firm under certain conditions. Obj 11.5

Explain why financing and payout decisions are relevant for managers.

financial leverage: The use of debt in order to increase the firm’s return on equity while increasing risk exposure. Also the ratio of a firm’s assets to equity financial distress: Difficulties experienced by a firm in attempting to meet commitments to its creditors

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Fig 11.1 Unifying Framework

the enterprise

financing Financial Leverage

operating

• Debt financing • New equality • Dividend policy

investing

Managing the risk profile

risk Cost of capital

When we think about financing decisions, we are implicitly assuming that a firm is in need of cash in order to make investments. But what if a firm has more cash than it needs to fulfill its investment needs, or what if its investors expect to receive a share of the profits (for example, in the form of dividends)? We’ll consider such situations as we explore how managers factor in dividend and payout policies when making capital structure choices.

11.1 Capital Structure Overview Objective 11.1

Explain why firms have different capital structures.

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Capital structure is important because it can affect the overall value of a firm. But what exactly does capital structure entail? As shown in Figure 11.2, at the industry level, there is a large variation in the amount of debt that firms carry relative to their capital (or total of debt plus equity). Variations can also be large across firms within a particular industry. For example, Internet-related firms, such as Google, tend to have less than 10 percent of debt, whereas hotel firms tend to have over 60 percent of debt. The reason for this wide variation in debt levels can be explained by considering a bank’s perspective. Banks are more comfortable lending to firms with more stable cash flows than those with more volatile cash flows. Banks are also more comfortable lending against solid assets and therefore tend to lend to firms with more fixed assets. For example, firms in the hotel industry have more stable cash flows and more solid assets than Internet-related firms— particularly those that are less established than firms like Google—that are more likely to have more volatile cash flows and rely on intellectual capital rather than fixed assets.

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fig 11.2 Debt as a Percentage of Capital across Industries

70% 60% 50% 40% 30% 20%

Hotel

Packaging & container

Electric utilities

Paper & forest products

Oil & gas distribution

Overall

Restaurant

Auto parts

Retail store

Biotechnology

Drug

Semiconductor

0%

Internet

10%

Source: Aswath Damodaran website (data as of December 2009), http://pages.stern.nyu.edu/~adamodar/ New_Home_Page/data.html (accessed May 16, 2011)

Some reasons for this imbalance are that banks desire the comfort of stable interest repayments as well as collateral in case of a loan default, but firms also have their own reasons for borrowing a larger or smaller percentage of their total capital. We will examine these considerations in more detail in Chapter 12. There are, however, some exceptional cases in which a firm may take on a disproportionate amount of debt. For instance, a leveraged buyout (LBO) occurs when a publically traded firm is acquired by investors (often the management of the company) and is financed primarily through borrowing. Upon completion of an LBO, it is not uncommon for a firm to have more than 70 percent of its capital as debt. Of course, such debt levels usually aren’t optimal in the long run because they can be risky. The industry ­average might be, say, well below 50 percent, so the firm will strive to reduce its initially high debt level to a level closer to the industry average, perhaps by reducing costs and ­increasing profits, or perhaps by selling off some of the firm’s assets and paying down the debt. Chief executive officers (CEOs) generally do not directly determine and manage capital structure. However, they need to know why capital structure is important in order to make sound financial decisions through interaction with their chief financial officers (CFOs), who possess the technical financial skills. From CFOs’ perspectives, capital structure is a critically important issue because it adds value to a firm primarily through the management of the firm’s capital structure. Managing capital structure means determining a target mix of capital that results in the lowest cost of capital and hence maximizes firm value. In a 2006 survey of CFOs by Henri Servaes and Peter Tufano for Deutsche Bank, titled “CFO Views on the Importance and Execution of the Finance Function,” CFOs were asked, “How much value, as a percentage of market capitalization, does the finance function add or subtract to your company?” Respondents estimated they were able to add about 10 percent of the overall value of the firm through financial management. In fact, determining capital structure was ranked by CFOs as the most valuable finance function, followed closely by debt issuance and management and

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leveraged buyout (LBO): The process by which a publically traded firm is acquired by investors (often the management of the company) and is financed primarily through borrowing

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the maintenance of bank relationships. So, a key message here is that CEOs should be nice to their CFOs since they add value to the firm. Regardless of your function within an organization, you may even want to say thanks to its CFO every once in a while!

11.2 Understanding the Modigliani-Miller Argument: Why Capital Structure Does Not Matter

Objective 11.2

Explain why the value of a firm doesn’t depend on the capital structure under certain conditions and why the cost of equity increases as a firm has proportionately more debt.

According to legend, when New York Yankee baseball player and manager Yogi Berra was dining at an Italian restaurant, his waiter asked him into how many slices he wanted his pizza cut. Berra responded, “You better make it four. I don’t think I could eat eight.” Let’s think of the size of that pizza as representing the overall value of a firm. Let’s also think of each slice as a different form of financing, such as debt, common equity, and preferred equity. Just as one pizza can be sliced many different ways, a firm’s capital can be structured in various ways. For instance, one company might have financed its asset purchases with 50 percent debt and 50 percent equity, whereas another might have done so with 20 percent debt and 80 percent equity. But does it really matter precisely how this financing is “sliced”? The obvious initial reaction—perhaps obvious to everyone except Berra—is that the number or size of each slice doesn’t change the overall size of the pizza. In 1958, two financial economists, Franco Modigliani and Merton Miller (known affectionately as M&M), made a significant contribution to the field of corporate finance by examining the pizza slice issue, or rather the question of whether capital structure matters, in the sense of having an impact on the overall value of the firm. They were rewarded decades later with Nobel Prizes in Economics (Modigliani in 1985 and Miller in 1990). In this section, we review Modigliani and Miller’s model and their arguments, and how they were able to show that—given certain important assumptions—capital structure does not affect the overall value of a firm. As we’ll see shortly, although this model is an eloquent one, its assumptions don’t apply in the real world. So why, then, did Modigliani and Miller get Nobel Prizes, and why should we care? The answer, as we will find in the next section, is that when we relax Modigliani and Miller’s assumptions, capital structure does matter, so managers should pay close attention. Modigliani and Miller’s paper is known for two important propositions. Simply stated, Proposition I says that—given certain important assumptions—capital structure (meaning a firm’s mix of debt and equity) does not affect the overall value of a firm. The basic premise is that an investor could either buy an all-equity firm or one with debt. Instead of buying shares in the firm with debt, she could simply borrow herself and invest in the all-equity firm. Because the investment returns should be the same, the value of the all-equity firm should be the same as the value of the firm with debt. Next, Proposition II says that the cost of equity, or the expected return to equity investors, increases when a firm takes on a greater proportion of debt. Let’s examine each of these propositions in more detail. Proposition I suggests that the overall value of a firm does not depend on the firm’s mix of equity and debt. In other words: Overall market value of the firm = market value of equity + market value of debt Indeed, as shown in Figure 11.3, the value of the firm remains the same regardless of the proportion of debt.

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fig 11.3 Firm Value Compared to Proportion of Debt, Assuming Perfect Capital Markets

Market Value of the Firm



Debt as a Percentage of Firm Value

Proposition I can also be stated as follows: The value of a levered firm, VL (or one that relies on debt as a form of capital to finance any asset purchases), is equal to the value of an unlevered firm, or all-equity firm, VU. The Modigliani-Miller argument also indicates that the value of the firm is determined solely by the cash flows generated by the assets. In order for Proposition I to hold true, however, certain assumptions must be in place. These assumptions, known as the M&M or perfect capital markets assumptions, are as follows: We live in a world where there are no taxes and no chance that a firm will go bankrupt or face financial distress. Individuals can borrow (or lend) at the same rate at which a firm can borrow. Managers and investors have equal access to information about the future prospects of a firm, and there are no costs associated with raising capital. Given these perfect capital market assumptions, the value of the firm remains the same regardless of how the assets are financed. In other words, no matter how many slices you cut the pizza into, the size of the pizza never changes. It is obvious that we don’t live in the M&M world of perfect capital markets (although we might all like to live in a world of no taxes!). Still, creating such a world can help us better understand why capital structure is important. To develop this understanding, let’s relax the M&M assumptions to better reflect the real world in which we live. For example, consider All-E Inc., an all-equity1 pizza restaurant chain with one million shares outstanding and a current stock price of $10 per share. Big Tony is the CEO of All-E, and Little Tony is one of many individual shareholders. The market value of All-E’s equity (and hence the overall value of All-E) is $10 million (one million * $10). All-E pays all of its operating income to shareholders as a dividend, which represents the return to the shareholders. According to Big Tony, All-E’s operating income next year, and in all subsequent years, is anticipated to be $1.5 million. Note that this is not a guaranteed amount, but simply the best guess of what the operating income will be. Because Big Tony does not expect the operating income to grow, and because all operating income is paid in dividends, the return to all shareholders will be the same and will be the dividend yield they receive: $1.5 million relative to the $10 million market value of equity, or 15 percent.

levered firm: A firm that has some interest-bearing debt as part of its capital structure unlevered firm: A firm that does not have any interest-bearing debt as part of its capital structure; an all-equity firm perfect capital markets: Assumptions or conditions under which markets might operate, with full information available to all, and no frictions such as taxes or bankruptcy costs

1

Are there publically traded firms with no debt? Yes. Until 2010, Google Inc. had over $57 billion in assets but did not have any long-term debt. Similarly, as of 2011, Evolution Petroleum Corp. had over $40 billion in assets but no debt at all.

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Fig 11.4 All-E Inc.: All Equity versus Equity and Debt



ALL EQUITY

Number of shares

1,000,000

500,000

$10

$10

$10,000,000

$5,000,000

—

$5,000,000

$1,500,000

$1,500,000

Price per share Market value of shares Market value of debt Anticipated operating income Interest Earnings (after interest)

EQUlTY AND DEBT

— $500,000 $1,500,000

$1,000,000

$1.50

$2.00

15%

20%

Earnings per share Return on shares

Now suppose Big Tony decides to alter All-E’s capital structure to one with an equal amount of debt and equity by issuing $5 million of debt at an interest rate of 10 percent, and then using the proceeds to repurchase $5 million of equity. In such a case, if Big Tony achieves the anticipated operating income level, the shareholders—including Little Tony—will benefit from a higher return on their equity investment, as shown in Figure 11.4. Although it appears that Big Tony’s actions are benefiting the shareholders such as Little Tony, we have overlooked an important assumption. Recall that, in this example, Little Tony can borrow at the same rate as All-E. Therefore, even without a share repurchase by All-E, Little Tony (who owns, say, one share) can borrow $10 to purchase an additional share, as shown in Figure 11.5. Note also that by borrowing, Little Tony (as well as All-E) has taken on more risk. As shown in the figure, as long as Little Tony can borrow at the same rate as All-E, there is no benefit to Little Tony of having All-E borrow the funds instead of borrowing the funds himself. Therefore, a firm’s decision on leverage can be offset by investors through investors’ personal borrowing, and the value of the firm remains the same. Since the value of the firm does not change, this is what we mean when we say capital structure doesn’t matter, according to the M&M assumptions. In Proposition II, Modigliani and Miller also showed that the cost of equity for a levered firm, ke (which is also the expected equity return for shareholders of the levered firm), increases as a firm takes on proportionately more debt and includes a risk premium beyond what an unlevered equity investor would expect: D ke = ku + (ku - kd) a b E

where ku is the expected return for an all-equity or unlevered firm, kd is the cost of debt, and (D/E) is the firm’s market value debt-to-equity ratio. With more debt, both the cost Fig 11.5 Little Tony Borrowing and Investing in All-E Inc.

Equity investment (one share) Earnings per share (all equity firm)

$1.50

Total earnings for two shares

$3.00

Less interest on $10 borrowed

$1.00

Net earnings on investment

$2.00

Return on equity investment

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$10

20%

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Cost of Capital Sources

Cost of equity, ke

245

Fig 11.6 Cost of Equity, Debt, and Capital

20%

15%

Cost of capital, kc Cost of debt, kd

10%

0.5 Debt as a Percentage of Firm Value

of debt and the cost of equity increase, because both the debt and the equity become riskier. However, because the cost of debt is lower than the cost of equity, and because more weight is placed on the lower cost of debt, there is an offsetting effect and the overall cost of capital remains unchanged. We can see the relationship between the cost of equity and the cost of capital, the cost of debt, and the debt-to-equity ratio by returning to the example in Figure 11.4. Starting with All-E as an all-equity firm, the cost of equity, ku, is 15 percent. For the firm with both equity and debt, as presented in the right-hand column, we see that the cost of debt, kd, is 10 percent. The cost of equity for the levered firm is therefore equal to the cost of equity for an unlevered firm, plus the difference between the cost of equity for the unlevered firm and cost of debt, all multiplied by the debt-to-equity ratio of one (or $500,000 in debt divided by $500,000 in equity). Thus, the cost of equity is: D ke = ku + (ku - kd) a b = 0.15 + (0.15 - 0.10)(1.0) = 0.20 or 20 percent E

as indicated in the figure as the return on shares. Recall that with the all-equity firm, the weight of equity, we, is 100 percent (or 1.00), and the weight of debt, wd, is zero. Thus, the overall cost of capital is the same as the cost of equity, or 15 percent. Now consider the firm that has the weight of equity, we, of 50 percent (or 0.50) as well as the weight of debt, wd, of 50 percent. Note that the overall cost of capital remains the same as in the all-equity case: kc = wd kd + we ke = (0.50)(0.10) + (0.50)(0.20) = 0.15 or 15 percent We can see these relationships graphically in Figure 11.6.

11.3 Relaxing the Assumptions: Why Capital Structure Does Matter As you know, the real world is much different than the M&M world. In the real world, the M&M assumptions no longer apply since governments exist and firms are subject to the uncertainty and volatility of the world around them. However, Modigliani and Miller were certainly deserving of their Nobel prizes, because creating such a world helped us better understand why capital structure is important as we relax their assumptions.

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Objective 11.3

Explain how taxes, financial distress, and asymmetric information affect capital structure decisions.

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There are two main driving factors in particular that suggest capital structure does matter: corporate taxes and financial distress possibilities. Taken separately, corporate tax considerations would result in a firm taking on huge amounts of debt, whereas financial distress considerations would result in the firm taking on very little debt. When combined, however, these two factors result in the idea of an optimal capital structure with just the right amount of debt. Now, let’s begin our closer look at the impact of corporate taxes and financial distress considerations.

11.3.1  Understanding the Impact of Corporate Taxes The major real-world benefit of debt is that interest payments are a tax-deductible expense. To better understand this benefit, consider the example in Figure 11.7. ­Suppose All-E faces a corporate tax rate of 35 percent. Suppose also that the firm starts without any debt but eventually borrows $5 million at an interest rate of 10 percent. Notice that the combined amount of debt and equity income is always greater in the equity-and-debt case than in the all-equity case. Moreover, the difference between the allequity income ($975,000) and the equity-and-debt income ($1,150,000), which is $175,000 in this example, is equal to the amount of interest multiplied by the tax rate (or $500,000 * 0.35). This amount is also known as the interest tax shield. The interest tax shield represents the value of the reduction in taxes that results from allowable deductions from taxable income. Because this firm’s debt holders always earn 10 percent on their debt investment (no more and no less), the interest tax shield benefit must accrue directly to the equity shareholders. If we assume that the firm continues to maintain $5 million in debt each year, then the interest tax shield will also continue at a rate of $175,000 each year. Thus, the value of the levered firm (or one that has debt), VL, is now equal to the value of an all-equity firm, VU, plus the value of a stream of interest tax shields, which is equal to the amount of permanent debt, D, multiplied by the corporate tax rate, t: VL = VU + Dt

interest tax shield: The value of tax savings resulting from the tax deductibility of interest payments

Fig 11.7 The Impact of Corporate Taxes on Firm Value

Recall that in Figure 11.4, the value of All-E as an all-equity firm, VU, was $10 million. The value of All-E as a levered firm is worth an additional amount equal to Dt, or $1.75 million more than the unlevered firm (the value of debt, D, of $5 million multiplied by the tax rate, t, of 0.35). Thus, the value of this levered firm, VL, is $11.75 million ($10 million + $1.75 million). One important assumption is that any firm needs to be profitable in each year in order to take advantage of interest deductibility and the resulting tax shield—otherwise Dt will not be as large as we estimated. It turns out that (without worrying about the derivation of the formula) in a world with corporate taxes, the cost of equity is now modified accordingly: D ke = ku + (ku - kd)(1 - t) a b E Anticipated operating income Interest Earnings before tax Tax at 35% Earnings after tax Combined debt and equity income (interest plus earnings after tax)

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ALL EQUITY

EQUlTY AND DEBT

$1,500,000

$1,500,000

—

500,000

1,500,000

1,000,000

525,000

350,000

975,000

650,000

$975,000

$1,150,000

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247

Fig 11.8 Corporate Income Tax Rates (percent) across Countries

40 35 30 25 20 15 10

0

Ireland Czech Republic Hungary Poland Slovak Republic Chile Greece Iceland Slovenia Turkey Estonia Switzerland Israel Korea Austria Denmark Netherlands Finland United Kingdom Sweden Portugal Italy Canada New Zealand Norway Luxembourg Australia Mexico Spain Germany Belgium France United States Japan

5

Source: OECD Tax Database (data as of 2011), www.oecd.org/ctp/taxdatabase (accessed June 3, 2011)

Thus, the cost of equity still increases as a firm takes on more debt, but the increase is not as great once corporate taxes are considered. For example, let’s revisit All-E with ku of 15 percent, kd of 10 percent, a tax rate, t, of 0.35, and a debt-equity ratio, D/E, of 1.0. As we saw in Section 11.2, ignoring taxes, ke is 20 percent. Once we incorporate taxes, ke is 18.25 percent. As an aside, note that in a world of both personal and corporate taxes, individual investors may not be able to get the full advantage of debt by borrowing personally. Corporate borrowing rates, personal borrowing rates, and tax rates may differ. For simplicity, however, we will omit personal tax considerations. For our discussion, we see that the value of the interest tax shield will depend on the corporate tax rate. As shown in Figure 11.8, statutory corporate tax rates (including state/regional and local tax rates) vary considerably across countries, with the rates in the United States among the highest in the developed world. Now, let’s recall another key M&M assumption: Firms face no possibility of bankruptcy or financial distress. With bankruptcy off the table, our example suggests that a firm should continue to borrow in order to increase the interest tax shield. Thus, when a firm pays corporate taxes but has no threat of bankruptcy, its optimal capital structure is no equity and all debt, as shown in Figure 11.9. Of course, as we saw in Figure 11.2, we don’t tend to see many real-world firms with more than 70 percent of their capital structure as debt. This is primarily due to concerns about financial distress, as we’ll see in the next section of the chapter.

11.3.2  Understanding the Impact of Financial Distress Now that we’ve seen the impact of corporate taxes on firm value, let’s relax the other key M&M assumption of no bankruptcy or financial distress possibilities. Financial distress

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Fig 11.9 Firm Value Compared to the Proportion of Debt, Assuming Corporate Taxes and No Financial Distress

Market Value of the Firm

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Debt as a Percentage of Firm Value

bankruptcy: A legal process of disposing of the assets or the reorganization of a firm to satisfy creditor claims and protecting the firm from further legal actions

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occurs when a firm is not in a position to meet its debt obligations of interest or principal payments. In some cases, the firm must rely on the legal mechanism of bankruptcy to reorganize its obligations and repayment terms with its creditors and avoid liquidation. Bankruptcy describes a legal state whereby a firm cannot pay its creditors. Creditors may be banks that lend money to a firm, bondholders that have invested in a firm’s bonds, or suppliers that have provided materials or services to a firm in expectation of repayment (i.e., a firm’s accounts payables). Bankruptcy may be involuntary, meaning a firm’s creditors initiate proceedings, or voluntary, meaning the firm itself recognizes it will have difficulty repaying the money it owes and thus initiates proceedings. When a firm declares bankruptcy, it will often attempt to renegotiate with its lenders by restructuring its debt obligations, perhaps by asking for forgiveness of part of the debt owed and/or changing the terms of repayment. The intent of reorganization procedures is to allow a firm to continue and grow its operations. In the United States, this reorganization procedure is commonly known as Chapter 11, because it is described in the eleventh chapter of the U.S. Bankruptcy Code. In a Chapter 11 case, the court appoints a trustee with the power to operate the business, and the bankrupt firm is given some breathing room to attempt to restructure its loans. Chapter 11 firms can even give priority to new lenders who are willing to step in, temporarily protecting the firm from litigation. Bankruptcy-wise, the alternative to reorganization is liquidation of the firm. In the United States, liquidation is often referred to as Chapter 7, again in reference to the U.S. Bankruptcy Code. In cases of liquidation, there is a priority of claims to any liquidated assets, generally starting with secured creditors (who have lent against assets such as plant, equipment, inventory, and accounts receivable), followed by unsecured creditors (such as suppliers). In most cases, there is no money left for either preferred or common shareholders after a firm’s creditors have been compensated. Bankruptcy laws differ among companies, individuals, and across countries. Bankruptcy and financial distress costs can take two forms: direct and indirect. Direct forms include legal and administrative costs associated with the actual bankruptcy proceedings, as well as the money paid to lawyers, accountants, consultants, and other professionals. Indirect costs occur when a firm faces loss in business due to its circumstances. For example, if it’s been reported that an airline is facing difficulties meeting its credit obligations, potential passengers may avoid booking flights on the airline lest the airline can no longer afford to fly its planes. This decrease in customers subsequently decreases revenue, making the airline’s already bad financial situation worse. Other indirect costs include the time that management spends dealing with the financial distress rather than on productive

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In the News

Largest U.S. Bankruptcy

In September 2008, Lehman Brothers Holdings Inc. filed for bankruptcy. According to MarketWatch, Lehman had $639 billion in total assets, making it the largest U.S. bankruptcy at the time, eclipsing the $104 billion bankruptcy of WorldCom Inc. in July 2002. At the time of declaring bankruptcy, Lehman had over 100,000 creditors and had been in existence for 158 years. See http://www.marketwatch.com/story/lehman-folds-with-record-613-billion-debt?siteid=rss (accessed June 3, 2011)

activities. The business might also lose skeptical suppliers and employees. With an increased chance of bankruptcy comes an increased possibility that management may be forced to gamble what remains of the firm by taking on extremely risky projects in hopes of regaining financial strength, no matter how small the chance of succeeding.

11.3.3 Combining Corporate Taxes and Financial Distress Costs We can now combine the benefits of debt (i.e., the tax shield) and the costs of debt (i.e., the costs of financial distress) in a simple model that represents the impact of capital structure on a firm’s overall value. Specifically, we can think of the value of the firm as follows: Overall market value of the firm = market value of all@equity firm + value of interest tax shield - costs of financial distress This equation is known as the trade-off model of capital structure. We can also represent the value of the firm as in Figure 11.10. In the figure, note that as an all-equity firm begins to take on debt, the firm’s value increases because of the benefits of interest tax deductibility. However, as the firm takes on a larger amount of debt, there is an increased chance that the firm may undergo financial distress and incur the associated bankruptcy-related costs. At the optimal amount of debt, these financial distress costs just offset the firm’s tax-deductibility benefits. We can also interpret the optimal level of Expected financial distress costs

Fig 11.10 Optimal Capital Structure with Corporate Taxes and Financial Distress

Market Value of the Firm

Interest tax shield benefits

trade-off model of capital structure: An idea that managers consider both the value of interest tax shields and the cost of financial distress when choosing the appropriate debt-equity mix

Optimal debt Debt as a Percentage of Firm Value

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debt as the firm’s debt capacity, or the highest amount the firm can borrow before the value of the firm begins to decline. In Chapter 4, we introduced a variety of leverage measures including long-term debt-to-capital—determining the highest amount of such a ratio with which the firm could still function without serious risk of financial distress would be a way of estimating a firm’s debt capacity. Understanding whether a firm is at the optimal level of debt is important for CEOs, because they should always be striving to maximize the value of their firms. Although the benefits of the tax deductibility of interest and the costs of financial distress are the two main drivers of capital structure, firms also face a number of additional considerations when deciding on an optimal capital structure. One factor is the signal a firm can send to investors in terms of its capital structure, as we’ll see in the next section.

11.3.4 Impact of Asymmetric Information

asymmetric information: A situation whereby one party has more or better information than another party, such as managers versus investors

Recall from Section 11.2 that the third M&M assumption was that managers and investors had equal access to the same information about a firm’s prospects. In real life, this is never the case. Rather, managers and investors have asymmetric information. In other words, the two groups have different data available to them, with managers typically having more information than investors. Asymmetric information helps explain why a firm may wish to issue debt, or alternatively, why a firm may be reluctant to issue equity. It also helps explain why a firm might prefer to start with certain methods of raising capital that don’t reveal any information before considering other methods that may reveal information. First, let’s examine why a firm may wish to issue debt. Suppose that you are CEO of ComDev Inc., a firm that makes communication devices. After many long years of research and development, ComDev is nearing completion of the next-generation communication device that will revolutionize your industry. Although you aren’t yet ready to announce the product to the world for fear of copycat competitors, you are concerned that the market is undervaluing your firm and doesn’t appreciate the tremendous opportunity the firm has to increase future cash flows. Of course, as CEO, your primary goal is to maximize the value of your firm. Moreover, if your stock is undervalued, it will be more expensive if you wish to raise capital by issuing equity. What can you do? In this situation, you can use your firm’s capital structure as a signal to existing and potential shareholders. By taking on more debt and committing the firm to higher future interest payments, you signal that the firm’s future prospects look bright, since you are confident you can service the higher amount of debt with increased cash flows. The reason you need to send a signal is because of the asymmetric information issue: You know more about ComDev’s future prospects than your shareholders do. Without revealing any trade secrets, you are telling market participants that you must be expecting greater cash flows in the future to service the higher debt, and that they should view your firm as being more valuable than reflected in ComDev’s current stock price. Assuming more debt allows you to signal the quality of your firm and to distinguish it from lower-quality firms.2 If everyone had the same access to information and acted in a rational manner, then stock prices would always reflect intrinsic values, but if managers have information that investors don’t, stock prices may not reflect intrinsic values. Note that although issuing more debt in this case doesn’t really change the nature of the firm’s underlying value, it does affect perceptions of the firm’s true value. This signal should assist in bringing an undervalued firm value closer to its intrinsic value. 2

Of course, a lower-quality firm might try to fool the market by taking on more debt, but eventually the market would catch on.

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Now, let’s examine why a firm may be reluctant to issue equity. Suppose, for instance, a firm’s stock price has recently increased substantially, doubling from $10 per share to $20 per share. If management believes the $20 market price is above the stock’s intrinsic value, then it might be a good time to issue equity. By issuing a certain number of shares, the company could raise twice as much money at $20, as compared to $10. But if the firm does choose to issue equity, the market might interpret this action negatively by assuming that the firm’s management thinks the stock is overvalued. In other words, the market might think that the firm is looking to cash in on what management believes to be a market error in perception. Simply announcing a planned equity issue could then lead to a drop in the price of the firm’s stock. Indeed, recall from Chapter 9 that we identified as a stylized fact based on research that stock prices do tend to decrease upon the announcement of a seasoned equity offering (SEO). Finally, since a firm has multiple capital-raising alternatives such as using retained earnings, issuing debt, or issuing equity, let’s examine why a company might prefer to start with certain methods of raising capital before considering other methods. Suppose, for example, a firm’s management believes its stock is undervalued, and it is therefore not a good time for the firm to issue equity. To avoid possible misinterpretation, the firm can avoid sending any signal whatsoever by not issuing any debt or equity. This decision reflects the pecking-order model of capital structure, which describes the order in which firms typically raise capital: starting with the form of financing that does not provide any signal to the marketplace (which is through use of retained earnings), followed by issuing debt and then by issuing equity. In other words, if a firm has a net income of $50 million and it needs to spend $50 million in the upcoming year on promising capital projects, then it can retain its current earnings in the firm and reinvest them in the capital projects. Here, we would be able to track the firm’s financing needs by examining the cash flow statement to see whether cash outflows from investments exceed cash inflows from operations. Later, once this year’s retained earnings have been used up, the firm can take on more debt if it has the capacity to do so. The firm can also issue equity as a last resort, because it is more costly and takes more effort for the firm (such as hiring an investment bank to act as an underwriter) to issue equity rather than debt. Concrete evidence on whether firms always act in such a strict manner as a primary factor is mixed, but firms often use the pecking-order as a secondary factor when making capital structure decisions. (Note that there are still other factors a firm should consider when attempting to determine its financing decisions and ultimately what its optimal capital structure should be, as will be described in Chapter 12.)

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pecking-order model of capital structure: An idea that managers prefer retaining earnings, then debt, then equity when choosing a form of financing payout policies: The approach by which a firm determines how to provide cash to its common shareholders, either through dividends or share repurchases

11.4  Understanding Payout Policies If a firm has more cash than it needs for investment purposes, investors may expect to receive a share of the firm’s profits as cash distributions. The term payout policies refers to a company’s policies on when either to pay cash dividends or to repurchase shares. We will see some similarities and differences in the effects between dividend payments and share repurchases as firms seek to utilize the cash generated from their operations.

Objective 11.4

Describe dividend policies and share repurchases, and explain why dividend policies don’t impact the value of a firm under certain conditions.

11.4.1 Paying Dividends Dividends, or the share of a firm’s profits distributed to shareholders, are an important factor in any capital structure discussion, because if a firm chooses to pay out less of its earnings as dividends and instead reinvests those earnings, it is increasing its equity

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Fig 11.11 Average S&P Index Payout Ratio (5-year moving average)

.90 .80 .70 .60 .50 .40 .30 .20 .10

1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

.00

Source: Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm (accessed June 8, 2011)

financing. Dividend policy can be interpreted as either (1) the cash amount of dividends a firm decides to pay to its shareholders or (2) the percentage of earnings the firm decides to pay as dividends, also known as the dividend payout ratio. For example, a firm may have a target payout ratio of 40 percent, implying that, over the long term, it tends to distribute $0.40 of dividends for every dollar of earnings. As we see in Figure 11.11, the average payout ratio in the United States since 1940 has been just over 50 percent. Between late 2008 and late 2009, during the global financial crisis, many firms paid out more in dividends than total earnings, which caused a reversal in the general downward trend in the payout ratio. Of course, averages can mask what happens at the individual firm level. A firm’s dividend policy is very much dependent on what life cycle stage it is in. When a firm is young and growing rapidly, it typically needs a great deal of capital, and its investors expect that any profits will be reinvested in the business to satisfy these capital needs. (Recall our discussion of sustainable growth in Chapter 6 whereby a firm’s ability to grow its sales without having to increase its financial leverage ratio depends on its retention ratio, which is simply the inverse of the dividend payout ratio.) As a firm matures, it may not be growing as fast, and it may have more cash than it needs for investments. Here, the firm would likely establish a policy of distributing the excess cash to its investors in the form of a cash dividend.

dividend policy: The approach by which a firm determines how much it will pay its common shareholders in dividends dividend payout ratio: A ratio of the amount of dividends distributed to shareholders relative to the amount of net earnings share repurchase: The process by which a firm buys back some of its own common shares

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11.4.2 Repurchasing Shares A share repurchase occurs when a firm buys back some of its own common shares. Share repurchases occur most commonly as open market repurchases—meaning the firm buys its shares just like any investor would purchase stocks listed on a particular stock exchange. A firm often announces its intention to repurchase a certain number of its shares, say over the upcoming year, although it is not obligated to repurchase the full amount. In rare cases, a firm may agree to repurchase shares from a major shareholder at a negotiated price. Let’s consider why dividends and share repurchases are related. Suppose a firm has 10 shareholders, each shareholder owns 100 common shares (for a total of 1,000 shares),

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and each share is valued at $1. The firm is currently weighing two alternatives. First, it could pay out a dividend of $0.05 per share, and thus each investor would receive a total of $5. Second, it could buy back 5 percent of the shares or 50 shares (in this example, equally across the 10 shareholders), in which case each shareholder would sell 5 shares and thus receive $5—the same amount as if the firm paid the dividend. Note that with the second option, each shareholder would now have 95 shares out of a total of 950 shares, so each would still own the same 10 percent of outstanding shares as before. As this example shows, dividend payments and share repurchases are conceptually equivalent, thus much of our discussion that focuses on dividend policy also includes any implications related to share repurchases. However, there is one consideration in a firm’s decision to pay dividends or repurchase shares that can potentially make a difference: taxes. From a taxable investor’s perspective, lower taxes are clearly better. Prior to 2003, the tax rate on dividends was higher than the tax on capital gains, so from a tax perspective, share repurchases were more beneficial. More recently, capital gains tax rates have been identical to taxes on dividends, although rates are always subject to change. However we should also note that in an open market repurchase, stock buybacks only impact those shareholders that choose to sell their shares. So while dividends always create a “taxable event” for all shareholders, stock buybacks do not. Those that choose not to sell their shares may reap the rewards of a higher stock price, which is not a taxable event until they choose to sell.

11.4.3  Do Dividend Policies Matter? Is a firm’s dividend policy expected to affect the overall value of the firm? As is often the case, the answer is, “It depends.” The earliest breakthrough examination of this question was addressed by none other than the dynamic duo of Miller and Modigliani.3 Once again, they relied on their M&M world of perfect capital markets with no taxes, no transaction costs, and complete and full information available to both management and investors. Miller and Modigliani showed that, with perfect capital markets, the value of a firm remains the same regardless of its dividend policy. An example based on their argument is presented in the Appendix to this chapter. But is this true in real life? As with our capital structure discussion, we can begin by relaxing the M&M assumption that we live in a world with no taxes. Unlike interest payments, dividends are not tax deductible and hence do not help reduce the tax burden to a firm. However, dividends do matter to individuals who pay taxes. All else being equal, an individual investor would prefer capital gains to dividends even if rates on both are equal, since capital gains can be deferred. However, there are many types of institutional investors, such as pension plans, that are not subject to taxation. As such, firms may attract what are known as clienteles, or different types of investors. Specifically, individual investors in low tax brackets would be attracted to high–dividend-paying firms, and high-tax investors would be attracted to low– (or zero) dividend-paying firms. A similar clientele effect may also arise for nontax reasons: Some individuals may simply prefer to invest in firms that provide them with a reliable stream of dividends. As with our capital structure discussion, we can argue that a firm may use its dividend policy to signal the quality of its expected cash flows. Firms facing financial difficulties may at first consider reducing dividend payments in order to preserve cash but may also be reluctant to reduce dividends (their investors who have become accustomed

clienteles: Types of individuals considered as a group—for example, those who do or don’t prefer to receive cash dividends

3

Merton Miller happened to get top billing for this particular research, but fortunately we can still refer to them as M&M.

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to a steady stream of dividends may not approve); by increasing their dividend payments, firms may be signaling to the marketplace that they expect healthy future cash flows. So, what do we observe in terms of actual payout policies? According to a 2006 global survey by Henri Servaes and Peter Tufano for Deutsche Bank, among firms that had some form of distribution in the previous five years, 93 percent paid regular dividends, whereas 39 percent used share repurchases. In other words, many firms opt to use both types of payouts. A firm’s choice of method is based on a number of factors, including signaling; flexibility in changing the level and type of distribution; tax efficiency (because in most countries, share repurchases are more attractive to taxable investors than dividends); and attractiveness to different investors (clientele effects). In terms of policies, 76 percent of firms in the Deutsche Bank survey had one target dividend payout in mind, whereas less than 32 percent relied on dividend per share targets, the growth of dividends over time, or dividend yields (the amount of dividends divided by the share price). The majority of firms surveyed indicated a reluctance to cut dividends, an action they felt might send a negative signal to the marketplace. When firms were asked how they would respond to a situation in which they did not have enough money to pay dividends, over 40 percent indicated they would cut dividends, but more than a quarter indicated they would either cut deferrable investments or borrow up to the limit of their current credit rating. The results of these surveys suggest that dividend policy does matter and does affect the capital structure of the firm.

11.5 Relevance for Managers Objective 11.5

Explain why financing and payout decisions are relevant for managers.

What does all this information about financing and payout mean for financial and nonfinancial managers? Although managing a firm’s capital structure is generally one of the key duties of CFOs, financing decisions have an impact on a firm’s ability to grow, as well as the amount of cash distributed to investors, and hence affect nonfinancial managers who may be requesting funds to invest in projects. How do managers view many of the issues we have discussed in this chapter? An important survey of American CFOs was conducted by two academics, John Graham and Campbell Harvey.4 This survey found that the corporate tax advantage of debt was one of the most important determinants of capital structure, particularly for types of firms that benefit by having consistent profits, such as larger firms with debt in stable or regulated industries (e.g., utilities). Supporting the trade-off–model notion that firms balance the benefits of tax shields with financial distress costs, over 20 percent of CFOs identified financial distress as an important factor in their debt decisions. Consistent with the pecking-order model, almost half of the CFOs surveyed indicated that having insufficient internal funds was an important factor related to the decision to issue debt. Almost 30 percent said they issued equity because recent profits were insufficient to fund activities, and another 15 percent did so because no other sources of funding were available. Two-thirds of managers were reluctant to issue overvalued equity. This survey provides a solid connection between capital structure theory and how managers actually operate. 4

See Graham, John, and Campbell Harvey. “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (Spring 2002): 8–23.

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Summary

1. Capital structure is the mix of debt and common equity (as well as preferred equity) of a firm. The proportion of debt as a percent of capital varies considerably across industries. 2. In a world with perfect capital markets—meaning there are no taxes, no risk of financial distress, equal information shared by managers and investors, and identical borrowing and lending opportunities by firms and individuals—the value of a firm is not related to its capital structure. 3. The expected return to levered equity investors depends on the expected return to unlevered equity investors plus a risk premium that is proportional to the debt-to-equity ratio.

4. In a world with corporate taxes, financial distress, and information asymmetries, an optimal capital structure exists as a trade-off between the benefits of interest expense tax deductibility and the potential costs of financial distress. This is known as the trade-off model of capital structure. 5. According to the pecking-order model, firms use retained earnings first to finance a project, then debt, then equity as a last resort, since issuing equity may signal that a firm feels its stock is overvalued. 6. Payout policies include decisions of firms to pay cash dividends or repurchase shares. 7. In a world of perfect capital markets, dividend policy doesn’t matter.

Additional Readings and Information

The classic article related to capital structure is the seminal study by Modigliani and Miller: Modigliani, Franco, and Merton Miller. “The Cost of Capital, Corporate Finance and the Theory of Investment.” American Economic Review 48 (June 1958): 261–297. The incorporation of corporate taxes into the capital structure discussion is presented in Modigliani and Miller’s follow-up paper: Modigliani, Franco, and Merton Miller. “Corporate Income Taxes and the Cost of Capital: A Correction.”American Economic Review 5 (June 1963): 433–443. For a discussion of the impact of personal taxes and capital structure, see: Miller, Merton. “Debt and Taxes.” Journal of Finance 32 (May 1977): 261–275. The original signaling argument in corporate finance was made by Stephen Ross: Ross, Stephen. “The Determination of Financial Structure: The Incentive Signalling Approach.” Bell Journal of Economics (1977): 23–40. The capital structure survey described in this chapter is from: Graham, John, and Campbell Harvey. “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (Spring 2002): 8–23. Electronic copy available at http://faculty.fuqua.duke.edu/~jgraham/website/ SurveyJACF.pdf The classic dividend irrelevance argument is presented in: Miller, Merton, and Franco Modigliani. “Dividend Policy, Growth and the Valuation of Shares.” Journal of Business 34 (1961): 411–433. An interesting empirical study of the changing nature of dividend policies is: Fama, Eugene, and Ken French. “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Financial Economics 60 (2001): 3–43.

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The dividend survey described in this chapter is from: Servaes, Henri, and Peter Tufano. “The Theory and Practice of Corporate Dividend and Share Repurchase Policy.” Deutsche Bank Working Paper (February 2006). Electronic copy available at http://faculty.london.edu/hservaes/Corporate%20 Dividend%20Policy%20%20Full%20Paper.pdf Financial information on public firms is available from: http://finance.yahoo.com/

Problems

1. Briefly explain the main differences in the capital structure of a bank in comparison with an automobile manufacturing firm. 2. Which of the following is/are perfect capital markets assumption(s)? a.  Smaller firms are exempt from paying taxes. b.  All market participants act rationally. c. Compared to producers, investors have less access to information. d. All market participants function in a perfectly efficient economy, and all firms operate in an entirely frictionless market. 3. According to Modigliani and Miller (M&M), in a world of perfect capital markets, what will be the expected equity return (or cost of equity) for a firm that has a cost of capital of 10 percent, a cost of debt of 6 percent, debt valued at $1.2 million, and equity valued at $1.0 million? 4. How will your answer in question 3 change if we now relax the M&M perfect capital markets as­sumption and incorporate a corporate tax rate of 35 percent? 5. Suppose a firm has $10 million in debt that it expects to hold in perpetuity. It the interest rate is 7 percent and the corporate tax rate is 35 percent, what is the value of the interest tax shield? 6. How would your answer in question 5 change if the interest rate was 5 percent?

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7. With the help of the trade-off model of capital structure, explain how a firm’s optimal capital structure changes over time. 8. According to the pecking-order model of capital structure, which of the following factor(s) affect(s) the order of raising funds? a.  Issue costs are highest for internal funds. b. Cost of financing increases with asymmetric information. c. After exhausting internal funds, debt is preferred to inviting new shareholders. d.  High interest rates make debt financing attractive. 9. What is the value of an all-equity firm that: a.  has a dividend payout ratio of 100 percent b. is expected to generate net income each year (forever) of $1 million, and c. has a required equity return (also the ROE) of 16 percent? 10. Now suppose the firm in question 9 has a payout ratio of 30 percent. Given the earnings retention, what will be next year’s dividend, at what rate will the firm be able to grow the dividend, and what will be the value of the firm? Compare your answer to this question to your answer for question 9.

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Appendix: Why Dividend Policy Doesn’t Matter: Example

The following example shows that, in a world of perfect capital markets, dividend policy (for instance, the choice to pay out dividends or retain earnings) doesn’t matter in terms of firm value. As with our capital structure discussion, such an example helps us understand why dividend policy does matter in a world that does not have perfect capital markets. Consider an all-equity firm that is expected to generate net income of $2,000 next year and in subsequent years. Investors require a return (or ROE), ke, of 20 percent based on their assessment of the risk associated with the firm’s anticipated ability to generate cash flows. Suppose the firm decides to pay out all of its earnings as dividends (in other words, a payout ratio of 100 percent). What would the value of the firm be? Consider the timeline below:

t = 0

2,000

2,000

2,000

2,000

2,000

t = 1

t = 2

t = 3

t = 4

t = 5

→ ke = 20%

The value of the firm, V, is equal to the present value of the anticipated dividends, DIV, discounted to the present at the rate of ke: v =

DIV3 DIV1 DIV2 DIV4 + + + + g 1 2 3 (1 + ke)4 (1 + ke) (1 + ke) (1 + ke)

Note that because all of the dividends are the same, we have a perpetuity—and if you recall our earlier time value of money discussion, the present value of a perpetuity is simply the projected cash flow divided by the discount rate, or DIV1/ke = $2,000/0.20 = $10,000. Thus, $10,000 is the value of this all-equity firm. Next, consider the case whereby next year’s dividend is cut to 40 percent (DIV1 = $2,000 * 0.40 = $800), and 60 percent of the earnings are retained ($2,000 * 0.60 = $1,200). This amount of retained earnings is like an investment with a 20 percent return (ROE) each year (forever). The dollar growth amount is equal to the dollar amount of earnings’ retention times the ROE ($1,200 * 0.20 = $240 each year), per our earlier discussion of sustainable growth. Assume the firm continues with a 100 percent payout policy in future years. Beyond the first year, dividends will be $2,240 each year (DIV2 = DIV3 = DIV4 = DIV5 = c = $2,000 + 240 = $2,240). Consider the new timeline below:

t = 0

800

2,240

2,240

2,240

2,240

t = 1

t = 2

t = 3

t = 4

t = 5

→ ke = 20%

The value of the firm, V, is equal to the present value of the anticipated dividends, discounted to the present at the rate of ke. There are two components: a single amount representing the dividend in one year and a perpetuity of future cash flows starting one year  from now, discounted to the present. Recall that valuing the perpetuity one year from now at t = 1 implies that the first of the perpetual dividend payments of $2,240 occurs at t = 2: DIV2

3 ke 4 DIV1 + P0 = (1 + ke) (1 + ke)

The resulting value is equal to $800/(1.20) + [$2,240/0.20]/(1.20) = $666.67 + $9,333.33 = $10,000. In other words, the value of the firm is the same.

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Finally, consider the case whereby the dividend payout ratio is set permanently at 40 percent. As in the previous example, DIV1 is equal to $800, and the earnings retention is equal to $1,200. Also as in the previous example, this $1,200 is invested with an ROE of 20 percent, which provides a return of $240 each year, forever ($1,200 * 0.20 = $240). Now with the $240, the firm is able to pay a dividend of 40 percent, or $96 ($240 * 0.40 = $96). Thus, the dividend in the second period is $896 (DIV2 = $800 + $96 = $896). Note that this implies a 12 percent growth in dividends ($800 to $896). Each year there is additional earnings retention of $1,200, so the dividend continues to grow in perpetuity. We can apply our sustainable growth formula: growth of dividends = retention rate * ROE = 0.60 * 20 percent = 12 percent. Thus, our new timeline is as follows: 800 t = 0

t = 1

800 * 1.12 = 896 t = 2

896 * 1.12 = 1,003 → ke = 20% t = 3

All of this simplifies to our classic constant growth dividend discount model (for a growing perpetuity): P0 =

DIV1 (ke - g)

which results in a firm value of $800/(0.20 - 0.12) = $800/0.08 = $10,000, which again is the value of this all-equity firm. Thus, this extended example shows that, given perfect capital markets, dividend policy doesn’t matter.

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Designing an Optimal Capital Structure Learning Objectives Obj 12.1

Explain what key factors help determine an optimal capital structure. Obj 12.2

In the last chapter, we focused on understanding financing and payout decisions and the reasons why a firm’s capital structure matters. We examined the major factors related to the capital structure decision, the benefits of debt, the costs of financial distress, and asymmetrical information. In this chapter, we continue our focus on financing decisions, as indicated in our unifying framework in Figure 12.1, by turning our attention to designing an optimal capital structure. Optimal capital structure is the manager’s determination of debt capacity and debt-equity mix that minimizes the overall cost of capital. The manager’s decisions critically depend on evaluating a number of important trade-offs: the flexibility of future financing, the impact on earnings per share, the risk that lower-than-anticipated profits may strain the ability to make interest payments, the impact on control by existing shareholders, and the overall timing. We first examine each of these factors and then discuss the trade-offs.

Explain how to assess the trade-offs involved in determining an optimal capital structure and describe what a levered beta is. Obj 12.3

Explain why designing an optimal capital structure is relevant for managers and what lessons were learned from the financial crisis of 2007–2009.

12.1  Factors Affecting Financing Decisions: The FIRST Approach A chief financial officer must consider five specific factors when determining how much debt versus equity is appropriate, consistent with the trade-off model discussed in the last chapter. These five factors represent the FIRST approach: Flexibility of future financing, Impact and cost on earnings per share, Risk, Shareholder control, and Timing. In the next section, we will summarize the various trade-offs associated with each of these elements.

Objective 12.1

Explain what key factors help determine an optimal capital structure.

12.1.1  Maximizing Flexibility Growing firms often have ongoing financial needs that exceed internally generated earnings and thus need to rely on external financing. Financial flexibility refers to the ease with which a firm is able to access sources of capital. The decision to issue either debt or equity today often affects future financing decisions. Depending on the firm’s current capital structure, as well as the capital structure following today’s financing decision, the firm may be implicitly deciding on future financing as well.

optimal capital structure: A manager’s determination of debt capacity and debt-equity mix that minimizes the overall cost of capital financial flexibility: The ease at which a firm is able to access sources of capital

259

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Fig 12.1 Unifying Framework

the enterprise

financing Financial Leverage

operating

• Debt financing • New equality • Dividend policy

investing

Managing the risk profile

risk Cost of capital

For example, suppose Noflex Inc., an auto parts manufacturer, currently has a longterm debt-to-capital ratio of 55 percent, above the auto parts industry average of 45 ­percent. If Noflex issues additional debt in order to gain capital, the ratio will increase to 65 percent, whereas issuing equity will decrease the ratio to around the industry average. If Noflex chooses to issue debt today, it will almost certainly need to issue equity the next time it needs to gain capital (unless it is able to retain a substantial amount of earnings). After issuing debt, not only would the proportion of debt be at a much higher level than the industry average, but the debt covenants would likely restrict further borrowing. Alternatively, if Noflex issues equity today, it still has the choice of issuing debt or equity in the future. In other words, by choosing equity, Noflex is maximizing its flexibility related to the future choice of financing. Financial flexibility depends on any excess cash that a firm has above and beyond dayto-day working capital needs, as well as a firm’s capacity to issue more debt while maintaining its current credit rating. There are trade-offs with having excess cash: Although excess cash allows for accessible funding, it does not earn any return for the firm. Credit-rating agencies were discussed in Chapter 9, and credit ratings are an important consideration for many firms as they determine their optimal capital structure. If a firm takes on too much incremental debt it may be downgraded by rating agencies, resulting in higher interest payments. Managers should have a sense of how much more debt the firm can take on without having a downgrade occur, and the rating agencies can provide some guidance. For example, rating agencies may make a debt-to-capital ratio less than or equal to 50 percent for one criteria for maintaining an A credit rating. Thus, if a firm with an A rating wishes to maintain that rating, they should strive for a capital structure with no more than 50 percent in debt.

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Case Study

Ford Motor Company and Financial Flexibility Prior to the Financial Crisis

Late in 2006, the Ford Motor Company took steps to increase its financial flexibility and increase its liquidity. $23.5 billion of new liquidity was obtained in December 2006, including proceeds from a convertible bond offering of $4.95 billion, a secured term loan of $7 billion, and a secured revolving credit facility of $11.5 billion. At year-end it had total liquidity including cash and available credit of about $46.5 billion. In addition, long-term debt was reduced and some noncore assets were sold. According to the 2007 annual report (page 16) management believed this amount “should allow us to fund the restructuring and product development . . . and provide us with a cushion for a recession or other unforeseen events in the near term.” This amount of liquidity was substantial: almost 17 percent of the overall asset base of $280 billion and equivalent to over 30 percent of sales. Preparing for such unforeseen events proved vital to the company’s survival and success. We now know that the financial crisis and worst recession since the Great Depression was about to unfold, forcing Ford’s main U.S. competitors—General Motors and Chrysler—into bankruptcy protection and reliance on huge government bailouts. In such times, financial flexibility and liquidity are of vital importance.

Equity provides more financial flexibility than debt does, but there are elements of flexibility within the debt alternative that are less clear-cut. For example, a firm may issue short-term debt or long-term debt, or a firm may issue debt with fixed interest payments versus floating interest payments. There are trade-offs between short-term versus long-term debts. For instance, issuing long-term debt locks a firm into long-term commitments, which is beneficial because it reduces uncertainty; however, long-term interest rates are typically higher than short-term interest rates, which imply higher costs. Issuing short-term debt is beneficial because it provides more frequent refinancing opportunities; however, if a liquidity crisis occurs (as in the financial crisis of 2008– 2009) and lenders are reluctant to roll over short-term financing, this apparent flexibility could become costly. Issuing fixed versus floating payments also involves trade-offs: Fixed rates provide certainty but may be higher than floating rates at a particular point in time. When evaluating these trade-offs, a firm should attempt to match the nature of the project with the duration of the financing it needs. For example, long-term projects should be financed with long-term debt so interim financing will not be required. In addition, managers should consider the nature of the operating cash flows when deciding between fixed and floating debt: Fixed debt may be more appropriate if the cash flows tend to fluctuate often.

12.1.2  Impact on EPS: Minimizing Cost If a firm were simply concerned with minimizing costs of incremental financing, then the straightforward choice would be debt. As we examined in Chapter 10 and in Figure 11.6, the cost to the firm, on an after-tax basis, is much lower for raising debt than for raising common equity. (Note that in terms of transaction costs, issuing new debt is much cheaper than issuing new equity, which can often cost as much as 6 percent to be paid to underwriters.) It might appear that a firm would always choose “cheap” debt. However, such an approach would be too narrow because it ignores important risk considerations that will be discussed in detail in Section 12.1.3.

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We can examine the capital structure decision directly from the perspective of the common equity shareholder. Again, we need to be careful not to focus too narrowly on equity investors, but such investors are certainly important stakeholders. In order to examine this decision, we need to introduce a preview of a valuation model we will examine in more detail in Chapter 13.

12.1.2.1  A Simple Valuation Model  A simple valuation model is known as the

price-earnings (P/E) valuation model, which values a firm’s equity based on projected earnings. Jennifer is an equity research analyst for an investment bank. One of the stocks she follows is Peco Inc., which is projected to have earnings per share next year (EPS1) of $1 per share. Based on her analysis, Jennifer concludes that the fair price of Peco’s stock should be 16 times the projected earnings. In effect, Jennifer has applied a forwardlooking price-to-earnings or P/E multiple to Peco’s projected earnings to reflect that she feels Peco is worth a price (P0) of $16 per share: P0 = (appropriate forward@looking P>E multiple) * EPS1 = 16 * $1 = $16 Why did Jennifer choose a multiple of 16 times the projected earnings instead of 10 or 20 times? This multiple is often estimated by examining similar firms in the same industry to determine at what price they are trading relative to their earnings—16 happens to be a long-run P/E average in the United States. The multiple also reflects two critical factors: the anticipated rate of growth of earnings (assuming Peco is in a growing industry) and the risk factor or uncertainty associated with the projected earnings. Thus, although higher projected earnings, all else being equal (i.e., with no change in risk), should lead to a higher stock price, if higher earnings are achieved only by substantially increasing risk, then the stock price may not increase. For example, if Peco announces a risky new venture, Jennifer may revise Peco’s projected earnings per share to $1.20, but because of the higher risk, she may deem that a P>E multiple of only 12 times is now warranted, and thus may feel that Peco is only worth 12 * $1.20 = $14.40. We will focus primarily on EPS in this section and will account for risk in the next section.

12.1.2.2  Earnings before Interest and Taxes Breakeven: What Leverage

price-earnings (P/E) valuation model: A model of the intrinsic value of a stock based on projected earnings

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Really Means  Now that we understand the basics of this simple valuation model, let’s examine Peco with two possible capital structures. Suppose Peco is an all-equity firm and needs to increase its capital in order to fund a major new project. We’ll explore its options using two scenarios. In the first scenario, Peco issues an additional $30,000 in equity (3,000 shares at $10 per share). In the second scenario, Peco issues $30,000 in debt at an interest rate of 10 percent. We start with the assumption that the type of financing does not affect the operations of the business. Consequently, the anticipated operating profit, or earnings before interest and taxes (EBIT), will be the same—$10,000—under the all-equity scenario and the debt-and-equity scenario. Figure 12.2 presents each scenario, including the resulting earnings per share and return on equity. The decision between new debt or equity may not be a straightforward one. Issuing debt results in a higher level of anticipated EPS as well as anticipated return on equity (ROE). Do the higher levels of EPS and ROE occur every time or just in this scenario? In order to answer this question, we need to examine what happens if the actual EBIT is different from the anticipated EBIT. We can start by calculating a “breakeven” EBIT, or the point at which the EPS for the debt scenario is the same as the EPS for the all-equity scenario. Note that EPS can be rewritten as: EPS =

(EBIT - interest)(1 - tax rate) number of common shares outstanding

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Debt Firm

Earnings before interest and taxes (EBIT) Interest Earnings before tax Tax @ 35% Earnings after tax

ALL-EQUlTY FIRM

$10,000

$10,000

3,000

0

7,000

10,000

2,450

3,500

$4,550

$6,500

263

Fig 12.2 Debt versus All-Equity Firm

Common shares Previous

$3,000 $3,000

New Total common shares Earnings per share (EPS)

0

3,000

$3,000

$6,000

$1.52

$1.08

Common equity Previous

$30,000 $30,000

New Total common equity Return on equity (ROE)

0

30,000

$30,000

$60,000

15.2%

10.8%

Based on this formulation, calculations for the breakeven EBIT are presented in Figure 12.3. The calculations use the simple principles of algebra and the end result is an EBIT of $6,000. These calculations suggest that if the actual EBIT is $6,000 rather than the anticipated $10,000, then the EPS should be the same under both financing scenarios. This breakeven EPS calculation is confirmed in Figure 12.4. If EBIT is $6,000, then EPS is $0.65 in both scenarios. Note also in the figure that if EBIT is $3,000, then EPS for the debt firm is zero. Finally, note that if EBIT is zero, then EPS for the all-equity firm is zero as well. We can combine the scenarios of different levels of EPS and EBIT for the debt and all equity firms into Figure 12.5, which presents a powerful message. The graph helps us understand what we really mean by the term leverage. Note that the benefits of leverage come from the reduced amount of taxes the firm will pay because it can deduct interest payments as an expense. Note also that if we knew that EBIT was going to be above $6,000, we would issue debt (assuming anticipated EBIT for next year is representative of future year EBITs). Conversely, if we knew EBIT was going to be less than $6,000, we would issue equity.

FIRM with Debt All-Equity firm

Fig 12.3 Breakeven EBIT Calculation

(EBIT – $3,000) (0.65) / 3,000 = (EBIT – 0) (0.65) / 6,000 (EBIT – $3,000) / 3,000 = EBIT / 6,000 (EBIT – $3,000) (6,000) / 3,000 = EBIT (EBIT – $3,000) 2 = EBIT 2EBIT – $6,000 = EBIT 2EBIT – EBIT = $6,000

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EBIT = $6,000

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Fig 12.4 Debt versus All-Equity Firm with Breakeven EBIT



Debt Firm

Earnings before interest and taxes (EBIT) Interest Earnings before tax Tax @ 35% Earnings after tax

ALL-EQUlTY FIRM

$6,000

$6,000

3,000

0

3,000

6,000

1,050

2,100

$1,950

$3,900

Common shares Previous

$3,000 $3,000

New Total common shares Earnings per share (EPS)

0

3,000

$3,000

$6,000

$0.65

$0.65

Common equity Previous

$30,000 $30,000

New Total common equity Return on equity (ROE)

0

30,000

$30,000

$60,000

6.5%

6.5%

Now let’s return to our simple valuation model. Initially it appears that issuing debt is more attractive than issuing equity because, as was shown in Figure 12.2, we anticipate a higher EPS with that scenario. However, we are ignoring the other crucial part of the valuation model we described earlier. Recall that the appropriate forward-looking priceearnings multiple depends on risk: The more risk (for example, through financial leverage), the lower the multiple. Consequently, it is not automatically the case that a firm with a higher anticipated EPS will have a higher stock price. It depends, in part, on our assessment of risk. In other words, how confident are we of the anticipated EBIT, and what is the impact on EPS if we are wrong? Thus, a higher anticipated EPS that results from much more leverage and risk may be associated with an offsetting lower forwardlooking price-earnings multiple. Think of Figure 12.5 as a picture of a seesaw or teeter-totter, commonly found in a children’s playground. If you imagine that the fulcrum (or balancing point) is at the Fig 12.5 Breakeven EBIT: What Leverage Really Means

Debt

EPS

$1.52 All equity $1.08 $0.65

$0

$3,000

$6,000

$10,000 (Anticipated EBIT)

EBIT

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breakeven EBIT level of $6,000, you can visualize what leverage really means. As a firm takes on more debt, it is able to leverage, or increase, the anticipated EPS. However, there is a downside to increased leverage. Thus, the powerful message is that the higher up on the seesaw—or the more leverage—the greater the risk, and the more painfully you will land if you fall off the seesaw. Therefore our discussion leads naturally to risk, the next major consideration in the capital structure decision.

12.1.2.3  Does Issuing Equity Dilute the Value of Existing Shares?  There is a fallacy that issuing equity automatically hurts existing shareholders. After all, the argument goes, the firm’s cash flows must now be divided into more shares outstanding. However, as long as new shares are issued at a fair price, there should not be any negative impact on existing shareholders. In other words, if a firm is issuing equity for a new project and the market incorporates the net present value of that project (we are presuming that the firm will not take on a project with an expected negative NPV), then the money that the firm raises should offset any dilution of shares; the cash flows from the new project should cover the return on those new shares. Let’s look at an example. Consider I-Scream Inc., an all-equity California ice cream retailer that has 10 million shares outstanding, each trading at $10. The current market value of the equity—and the assets—is $100 million. I-Scream recently announced it will be expanding to Florida, requiring a $10 million investment; it will issue equity to finance the expansion. If the firm issues 1 million shares at the current price of $10, it will be able to finance the expansion. Note that the $10 share price already incorporates the news of the expansion and the associated NPV and thus the new shares are issued at this fair price. Note also that as soon as I-Scream gets the $10 million in cash from issuing the new shares, the value of the firm is $110 million. Dividing this amount by the new total shares outstanding of 11 million, we see that the share priced is unchanged at $10. We summarize the situation in Figure 12.6. The key in this example is that the new shares are issued at a fair price. If the shares were undervalued—say, if they were trading for only $9—then I-Scream would need to issue 1,111,111 shares in order to finance the expansion. 12.1.3  Minimizing Risk From the perspective of the firm, risk measures the ability to meet debt and interest payment obligations. As we saw in Figure 12.5, we can think of risk as the possibility of deviating from the expected EBIT and hence not being able to meet obligations. Based solely on risk considerations, an all-equity firm does not have to worry about any financial obligations related to creditors (although managers should be concerned with satisfying equity holders). For an all-equity firm, the cost of equity is equal to the overall cost of capital; when a firm takes on debt, the cost of capital decreases. Even though the cost of capital is greater for an all-equity firm than a firm with debt, it lowers risk from the firm’s perspective. Let’s briefly revisit two types of risk examined earlier—business risk and financial risk—with this balance-based perspective in mind. Business risk, or operating risk, is reflected in the projected variability of the earnings of the firm regardless of how the firm is financed (through equity or debt). Firms in Initial Assets New Cash Total Assets ($ millions) ($ millions) ($ millions) Before equity issue

100

100

Shares (millions)

Value per Share

10

$10.00

business risk: The probability of losses related to the operations of a business Fig 12.6 New Equity Issuance

After equity issue 100 10 110 11 $10.00

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some industries such as technology have higher business risk than firms in other industries such as utilities. For example, Pacific Gas & Electric, a large utility company, has a lower level of business risk (and hence lower projected variability of earnings) than technology firm Hewlett-Packard. Before we discuss the assessment of business risk, let’s revisit our business size-up analysis in Chapter 2. Recall that we examined the key success factors, opportunities, and risk of an industry, then examined the firm to determine its strengths and weaknesses relative to the key success factors. We also relied on historical financial ratios. For the purpose of assessing business risk in this chapter, we can focus on trends in revenue changes as well as the operating margin (EBIT as a percent of revenues) over time. Greater variability in revenues and a declining operating margin mean higher business risk. We can then examine whether these risks might increase in the future. Financial risk is measured by the proportional amount of debt in the firm’s capital structure. As we saw in Chapter 11, financial risk can vary considerably across industries. Regardless of the firm’s business risk, financial risk is an additional consideration. We previously examined a number of financial ratios related to financial risk in Chapter 4: the debt-to-equity ratio; the long-term-debt-to-capital ratio; and the interest coverage ratio, which is the amount of EBIT relative to interest expenses. In Chapter 4, we also examined the debt service coverage, also known as the cash flow coverage measured as follows: Cash flow coverage =

EBITDA (interest payments + before@tax cost of debt repayment)

Instead of EBIT, the numerator captures cash flows (by adding back noncash expenses such as depreciation and amortization to give earnings before interest, taxes, depreciation, and amortization or EBITDA). The denominator includes not only interest but any required principal repayments as well. The before-tax cost of debt repayment is measured as Before@tax cost of debt repayment =

financial risk: The probability of losses related to the financing of a business debt service coverage (cash flow coverage): A ratio of the amount of cash from operations (usually measured as EBITDA) available to pay interest and principal due within a year debt-to-EBITDA: A measure of a firm’s ability to pay its debt: the ratio of a firm’s debt to EBITDA, a measure of cash flow from operations shareholder control: A majority voting equity stake in a firm

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principal repayment (1 - tax rate)

This term captures the fact that the company must earn enough income before tax in order to meet the principal repayment from after-tax earnings. If a company is raising capital and wishes to compare two alternative capital structures, it could calculate the various leverage and coverage ratios under each scenario and assess the financial risk. Invariably the ratios will be weaker in scenarios with more debt and so the key question to be addressed is whether the firm is prepared to accept the additional risks of increased leverage in order to potentially gain the tax-saving benefits. Firms often track their debt-to-EBITDA ratio because lenders often focus on this ratio, with debt usually measured as a firm’s interest-bearing debt such as loans, bonds, and any short-term borrowings. Firms may have a difficult time borrowing above the maximum ratio that lenders allow. For example, depending on current credit conditions, a bank may be unwilling to lend to a firm with a debt-to-EBITDA ratio above 3. Therefore if a firm wants to be conservative, it might aim to have a debt-to-EBITDA ratio below 3. The point to keep in mind is that financial managers should consider taking less financial risk when operating risk is high but may consider taking more financial risk when operating risk is low.

12.1.4  Maintaining Shareholder Control Ultimate shareholder control of a firm depends on who owns the major portion of the common shares and thus controls the direction of the firm through voting power. Small

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businesses often start out with a single owner-manager who has 100 percent control of the firm. As a private business becomes public, the original owner’s equity stake is diminished. As long as the original owner has more than 50 percent of the voting common equity, he or she controls the decision making of the firm by voting for the board of directors, to whom the managers are responsible. In some cases the original owner may also be on the board, or may appoint like-minded individuals and thus will effectively keep control. As a firm grows and needs additional external capital in the form of equity, the firm is owned by a wider base of shareholders besides the original owner-manager CEO.1 In many widely held firms, it is possible to own under half of the common equity and still maintain effective control. For example, suppose the original owner-manager CEO now owns 40 percent of a firm’s 10 million common shares (4 million shares), with the nextlargest shareholder owning only 12 percent of the common shares (1.2 million shares). In such a scenario the original owner-manager CEO would ensure effective control since it is unlikely that over 80 percent of the remaining shareholders would act as a homogeneous group and be able to influence the selection of the board of directors. Consider a different situation. Suppose the original owner-manager CEO owns 40 percent of the outstanding common shares but is planning a new common share issue of 6 million shares that would reduce his stake to 25 percent of the post-issue common shares (4 million of 16 million shares). It may be possible for a new or existing investor to capture a greater stake of the outstanding shares, thereby gaining effective control. In other words, the firm may be taken over by another firm or new investors. Case Study

Maintaining Control: Google Inc. and Dual Class Shares

How can founders of a private company raise a large amount of capital from an IPO in order to take advantage of growth opportunities and still maintain control? Google Inc. cofounders, Larry Page and Sergey Brin, asked themselves this exact question in 2004. Their solution was to create two classes of shares: Class A and Class B shares. Class A shares were owned by the public and were worth one vote each. Class B shares were owned by the two cofounders as well as senior executive Eric Schmidt. Each Class B share had 10 votes per share compared with the one vote per each Class A share. The three executives were able to control the majority of votes while holding only about one-third of the total shares outstanding. Although not widespread in the United States, dual class share structures are more common in some industries such as media, and also more common in other countries such as Canada. The argument in favor of such a dual class structure is that it allows the key manager-owners to focus on long-term plans without being concerned about a potential takeover threat. The disadvantage is that it concentrates ownership power, which may not be in the best interest of minority shareholders if the manager-owners become entrenched and yet are no longer effective managers.2

1

A study by Ronald Anderson and David Reeb found that among 403 nonfinancial, nonutility S&P 500 companies, only 141 had founding-family stakes, and among those the average family holding was less than 18 percent. See “Board Composition: Balancing Family Influence in S&P 500 Firms,” Administrative Science Quarterly 49 (2004): 209–237. 2 For a classic example of entrenched management, see the story of the fight for RJR Nabisco by Bryan

Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York: Harper & Row), 1990.

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The original owner-manager may be in a position where she or he would be required to give up management of the firm. Thus, each new issue of common equity can change the dynamics of the control of the firm and ultimately change the direction of the firm’s business activities. From an owner-manager’s perspective, the choice between debt and equity, based solely on the considerations of shareholder control, is a straightforward one: Issuing debt does not change the control position. The importance of this criterion depends critically on how likely a change of control is.

12.1.5 Optimal Timing If a firm has ongoing external financing needs for issuing debt or equity, it is important to examine both the current and expected outlook in the bond market and the stock market. Recall our discussion in Chapter 7 concerning efficient markets. If bond and stock markets are efficient, then the timing of when to issue debt or equity should not matter. However, if markets are not efficient, there may be an optimal time to issue securities. For example, if a firm perceives the current equity market to be overvalued, then it should consider issuing equity. The intuition is as follows: Suppose the firm is hoping to raise $100 million, the current stock price (or market value) is $25 per share, but the firm feels the intrinsic value of the shares is only $20. (It is important to note two things: [1] we can never really observe the intrinsic value of the shares,3 and [2] if markets are always efficient, the market price should always equal the intrinsic price.) If the firm issues equity today at the $25 price, it will need to issue only four million shares. However, if the price declines to the intrinsic value in the near future, the firm will need to issue a total of five million shares. In addition, if the stock market has been increasing recently, there might be more of an appetite for new shares. In times when markets have declined significantly, there is often little appetite for new shares at any price. In terms of debt or bonds, a firm’s desire to issue either depends on the current and expected outlook for interest rates. If long-term rates are low, then a bond issue may be attractive. However, if rates are currently high, the firm may want to wait until rates decline. When a firm must make a decision about market investment for its current and future financing needs, it must take all market considerations into account.

12.2  Tradeoff Assessment: Evaluating the FIRST Criteria Objective 12.2

Explain how to assess the trade-offs involved in determining an optimal capital structure and describe what a levered beta is.

In the previous section, we examined the five FIRST criteria that a firm should use when considering its optimal capital structure decision (flexibility, impact on EPS [or cost], risk, shareholder control, and timing), summarized in Figure 12.7. As we can see from the chart, determining the optimal capital structure involves assessing trade-offs. If impact on EPS (cost) and shareholder control are the most important criteria, then more debt is better. However, if risk and flexibility are the most important, then more equity is better. Managers need to balance all of these factors. 3

A firm’s management should have the best sense of the anticipated cash flows the firm will generate. Management might consider using one of the valuation models presented in Chapter 13 to estimate intrinsic value.

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Criteria

Debt

Equity

Ideal (✓)

Flexibility

Low

High ✓

High

Impact on EPS (cost)

Low ✓

High

Low

Risk

High

Low ✓

Low

Shareholder control

High ✓

Low

High

Depends

Depends

Timing

Depends

269

Fig 12.7 Summary of Optimal Capital Structure Choice FIRST Criteria

Managers also need to take into account a number of perspectives when assessing these criteria: An investor perspective: From an investor perspective, managers should be asking whether a particular capital structure is maximizing the value of the firm—which also implies maximizing the share price—or alternatively minimizing the cost of capital, as we will see in an upcoming example. The investor perspective focuses primarily on balancing the tax shield benefits with financial distress costs. An internal perspective: From an internal perspective, managers can ask what the vision and strategic direction for the firm are, what the nature and timing of projected cash inflows and outflows are, and how the capital structure might affect the vision and strategy in terms of projected financing needs. A competitive perspective: From a competitive perspective, it is important for a firm to examine the capital structure of peers in its industry. As discussed, certain industries tend to have a greater or lesser proportion of debt, given the nature of the assets and the risks in the industry. If your firm is deviating in a significant manner from the industry average, it could put your firm at either a competitive advantage or disadvantage. For example, if competitors have significantly less debt, then they may be much more flexible if opportunities for investments arise in the future; if revenue and EBIT take an unexpected negative hit, then higher debt firms may suffer. It is often difficult to determine a precise mix of optimal debt and equity, but managers should be able to develop an effective sense of direction, given the existing amount of debt and equity. For example, managers should have the ability to determine whether the firm needs to issue more debt, more equity, or maintain the existing proportions. Keep in mind that factors are constantly changing (recall our size-up discussions from Chapter 2), so the decision is not a one-time decision but rather an ongoing decision. In-Depth

Optimal Amount of Debt at the Firm Level: Six Flags Inc. Example

In two related research papers, three academics, Jules van Binsbergen, John Graham, and Jie Yang, developed a practical model in order to attempt to determine the optimal amount of debt at a firm level. Their model was based on the classic economics argument that the optimal, or equilibrium, state is one in which the margin benefit is precisely equal to the marginal cost. In the case of a firm’s capital structure, the marginal benefit, or the benefit for taking on an additional dollar of debt, is equal to the interest tax shield. Initially, for an all-equity firm, the marginal benefit for the first dollar of interest (and assuming a corporate tax rate of 35 percent) is $0.35. However, the benefit depends on the probability that the firm will be profitable, and hence be able to use the tax shield. Suppose there is only a 5 in 7 chance that the firm will be profitable. In such a case, the marginal benefit will be 0.25 or 0.35 * (5>7) + 0 * (2>7). (continued )

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Eventually the marginal benefit approaches zero, since if a firm takes on an excessive amount of debt with excessive interest payments, it might have a near-zero probability of profitability. Thus, the marginal benefit curve will be downward sloping, as shown below. The second part of the model estimates the marginal cost of each additional dollar of debt, which is less straightforward. Van Binsbergen, Graham, and Yang identified a number of variables that are related to the cost of debt, based on previous research findings. 1.  The cost of debt is higher when a firm has less collateral. 2.  The cost of debt is higher for firms with low book-to-market value of equity ratios since such firms tend to have high-growth opportunities; such firms face a higher cost of debt since debt can restrict a firm’s ability to exercise their growth opportunities (e.g., stricter covenants on capital expenditures). 3.  Other factors that research suggested are related to the cost of debt included the amounts of total assets, intangible assets, and cash flows and whether a firm pays dividends. Thus, the marginal cost curve will be upward sloping as indicated in the graph. Marginal benefit of debt curve

Marginal cost of debt curve

A

B

Optimal Debt

Actual Debt

Van Binsbergen, Graham, and Yang looked at specific firms to determine the net cost of a capital structure that is suboptimal. (Their example for Six Flags Inc. in 2006 is presented in the graph.) Compared to their estimate of the recommended amount of debt for a similar firm that had made optimal capital structure choices (a firm with similar collateral, assets, cash flows, etc.), they found that Six Flags was overlevered. They noted that (1) Six Flags had expanded rapidly in the 1990s and by 2006 had accumulated $6 billion in debt and (2) in 2007 the company had to sell assets in order to reduce the amount of debt. The researchers first estimated the present value of the estimated future net benefit for using debt, as indicated in area A of the graph, to be 6.8 percent of firm value. In other words, if Six Flags did not use any debt, firm value would be reduced by 6.8 percent. However, at the actual level of debt, Six Flags was reducing firm value by 9.6 percent, indicated as area A minus area B. The researchers also noted that the gross benefit of debt was 10.8 percent of firm value, but the cost of debt was much larger, at 20.4 percent of firm value, resulting in a net benefit of –9.6 percent. The bottom line of their analysis was that capital structure does matter and can affect firm value. Although their model is an elegant attempt to quantify the optimal capital structure decision for a firm (some other such spreadsheets have been developed as well), most managers will have an intuitive sense of whether their firm is under- or overlevered and move toward what appears to be optimal based on an assessment of our FIRST criteria.

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12.2.1 Example: Optimal Capital Structure and Minimizing the Cost of Capital

Determining the optimal capital structure is equivalent to minimizing the cost of capital, which in turn is equivalent to maximizing the value of the firm. Determining the optimal capital structure involves both qualitative analysis, which we described with the FIRST approach, as well as quantitative analysis, which will be covered in this section. We will focus on the type of quantitative analysis one might consider in conjunction with the qualitative approach, recognizing that there are limitations to a quantitative approach. Recall that the ultimate goal is to maximize the value of the firm, which can be achieved by increasing projected cash flows. We can also achieve this maximized value by seeking to minimize the cost of financing or the cost of capital, which is the rate used to discount the projected cash flows. The cost of capital, and hence the value of the firm, will be different across different debt-equity scenarios. Thus, the goal is to choose the scenario that is anticipated to lead to the greatest value of the firm. Consider the example presented in Figure 12.8. Stella Tau owns a chain of shoe stores, Heels Inc. She starts with an all-equity firm with $1,000,000 in assets. We assume that regardless of the capital structure, the firm is able to earn a 30 percent operating profit on its assets (EBIT/Assets). Its cost of debt and equity are presented in the figure, along with a fixed tax rate of 35 percent. The cost of debt increases with more debt, particularly as the amount of debt exceeds the amount of equity. The cost of equity also increases as the firm takes on more debt. After subtracting any interest expenses, we can calculate after-tax earnings. We assume that these earnings will remain constant in perpetuity, given the asset base, and we assume that all earnings are paid out as dividends each year. Consequently, the market value of equity is calculated as the after-tax earnings divided by the cost of equity (through a perpetuity Assets

$1,000 $1,400 $1,800 $2,200

Equity (book value)

$1,000 $1,000 $1,000 $1,000

Debt (book and market value)

$0

$400

$800

$1,200

Debt/assets (%)

0% 29% 44% 55%

EBIT/assets (%)

30% 30% 30% 30%

kd (before-tax)

10.00% 10.20% 10.30% 11.70%

kd (after-tax)

6.50% 6.63% 6.70% 7.61%

ke EBIT Interest Earnings before tax Tax @ 35% Earnings after tax Equity (market value) Shares (thousands) Price per share EPS Earnings multiple (times) kc (based on BV weights)

Fig 12.8 Heels Inc. Optimal Capital Structure Example

18.00% 19.00% 20.00% 24.00% $300 $420 $540 $660 $0

41

82

140

300 379 458 520 105

133

160

182

$195 $246 $297 $338 $1,083

$1,297

$1,487 $1,407

100 100 100 100 $10.83 $12.97 $14.87 $14.07 $1.95 $2.46 $2.97 $3.38 5.56 5.26 5.00 4.17 18.00%

15.47%

14.09% 15.06%

*Expressed in $000s unless otherwise noted.

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calculation as described in Chapter 7). For example, in the scenario with $1,400 in assets, the after-tax earnings are $246, the market value of equity is: earnings after tax

$246 = = $1,297 cost of equity 0.19 Given a fixed number of shares (100), we can calculate the price per share (the market value of equity divided by 100 shares), the earnings per share (earnings after tax divided by 100 shares), and the earnings multiple (price per share divided by earnings per share). Finally, we can calculate the cost of capital as described in Chapter 10. (In this example, for simplicity, we use book value weights; one of the end-of-chapter questions asks you to recalculate the cost of capital using market value weights.) As an all-equity firm, the cost of capital of Heels Inc. is simply the cost of equity or 18 percent. Suppose the firm grows its asset base to $1,400,000 and decides to add $400,000 in debt. Notice that both the cost of debt and the cost of equity are assumed to Market value of equity =

Case Study

Changing Capital Structure: The Home Depot Example

The Home Depot, Inc. (Home Depot) operates full-service warehouse-style stores selling home improvement and building supplies primarily throughout North America and is one of the largest retail stores in the United States. At the end of fiscal 2005 (as of January 30, 2006), the firm had a debt-to-equity ratio of 15.2 percent. During 2006, Home Depot increased its net borrowing by $7.6 billion and used the proceeds to repurchase $8.1 billion in equity shares (it had initiated a share repurchase plan in 2002), and during 2007, it sold HD Supply, which distributed products and sold services primarily to professional contractors. By 2007, its debt-toequity ratio had grown dramatically to 75.8 percent, much closer to the industry average. In mid-2007, the firm commented on its decision to change its capital structure. The sale of HD Supply had simplified Home Depot’s business model and created an opportunity for a reevaluation of its optimal capital structure. Between 1996 and 2006, the firm was rapidly growing, increasing sales at an annual rate of 17 percent and earnings per share at a rate of 21 percent. Its value creation strategy had been to invest in new stores. Its financial strategy was to promote growth by having a conservative debt-to-equity ratio, a modest dividend payout, a liquidity buffer, and to use any excess cash for share repurchases. But now it viewed its business as more mature, and since it was projecting much more modest growth—around 5 percent—it was looking for a capital structure that promoted more capital distributions (such as dividends and share repurchases). Its strategy was to create value by substituting expensive equity for much cheaper debt while maintaining a strong investment grade rating and having access to liquidity. The firm identified four key capital structure objectives: (1) liquidity to support its business strategy, (2) strategic flexibility, (3) downturn and credit protection, and (4) cost of capital optimization. The firm planned to work with credit rating agencies to assess the credit rating implications of its new capital structure. It presented a target debt/EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent) ratio of 2.5 times, anchoring its debt levels to the cash generation of the business. The firm estimated that it had reduced its cost of capital from 9.5 percent to 9 percent. The firm described its recapitalization as “transformational.” Did Home Depot make the right decisions? The firm faced some difficult times during the global financial crisis of 2007–2009 but then recovered. Through 2011, Home Depot continued its share repurchase program, which was favorably received by the marketplace. Source: Based on annual reports and documents filed with the Securities and Exchange Commission on July 10, 2007; see http://www.secinfo.com/dsVsf.u6a6.x.htm

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increase, although the cost of debt is lower than the cost of equity. Overall, the cost of capital has declined to 15.47 percent, and the market value of the equity of the firm has increased to $1,297. As we move to $1,800,000 in assets and add more debt, the cost of capital continues to decline, to 14.09 percent, and the market value of the equity correspondingly increases, to $1,487. However, as we move to $2,200,000 in assets and $1,200,000 in debt, the cost of capital increases from the previous level, to 15.06 percent, and the market value of equity decreases to $1,407. We would have to examine other levels of debt, but we can tell that the optimal capital structure is closer to 44 percent debt-to-assets than either 29 percent (not enough debt) or 55 percent (too much debt). The intuition is that as Heels Inc. initially takes on debt, it benefits from the tax deductibility of interest expenses and the value of the firm increases. However, as Heels Inc. takes on a substantial amount of debt, lenders are concerned about financial distress possibilities. As a result, lenders demand a huge risk premium and equity holders require higher returns to compensate for the increased financial risks they face. At the $1,200,000 level of debt, the benefits of interest deductibility for tax purposes are outweighed by the potential cost of financial distress. Consequently, for Heels Inc., it would appear that the optimal capital structure is around 44 percent debt to assets (on a book value basis)—the level at which the benefits and costs of debt are in balance. The key in this quantitative analysis is to project various scenarios and anticipate what the resulting cost of debt and equity would be. In most cases, the cost of debt can be projected by estimating the impact on the firm’s credit rating and by knowing what cost of debt a similarly rated firm might face. Estimating the cost of equity is generally more difficult than projecting the cost of debt. If a manager decided to use a CAPM approach, as discussed in Chapter 10, she or he would need to estimate the impact on beta as a firm takes on more debt. An all-equity firm (with no debt) is also known as an unlevered firm, and the beta of such a firm is an unlevered beta, or bU. As a firm takes on debt, it becomes a levered firm, and the beta of such a firm—the levered beta—is bL. Without going into details, researchers have developed the following relationship between unlevered and levered betas that accounts for the debt-equity ratio of D/E and the corporate tax rate of t: D bL = c 1 + a b (1 - t) d bU E

In other words, as the debt-equity ratio increases, the firm’s beta should increase as well, which makes intuitive sense. Although we have not attempted to incorporate this formula precisely into the example (given the various simplifying assumptions), we capture the spirit of levered firms having higher betas. In-Depth

The Cost of Equity, Levered Betas, and the Target Capital Structure

How do we estimate the cost of equity when a firm is not currently at its target capital structure? Suppose a firm has very little debt—say only 20 percent of its capital structure—­and we estimate its beta to be 0.8. Now imagine the firm has announced that it’s planning to take on a much larger proportion of debt going forward—say a target capital structure of 60 percent debt and 40 percent equity. In this case, we’ve underestimated the riskiness of the firm and hence underestimated the beta. The process for estimating the target beta is as follows. We start with the formula: D bL = c 1 + a b (1 - t) d bU E (continued)

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where we’ll assume the corporate tax rate is equal to 35 percent or 0.35. First, we must “unlever” the beta, in order to estimate what the beta would have been if we were dealing with an all-equity firm. Second, we must “relever” the beta to the target capital structure. We unlever the beta by rearranging the formula in the previous paragraph as follows: bU =

bL D c 1 + a b (1 - t) d E

We then insert our levered beta, debt-to-equity, and tax information to find our unlevered beta: bU =

0.8 = 0.69 0.2 c1 + a b (1 - 0.35) d 0.8

In other words, if the firm had no debt, its beta would have been expected to be 0.69. Next, we relever the beta at the target (D/E)* of (0.6>0.4) or 1.5: D * bL* = c 1 + a b * (1 - t) d bU E

bL* = [1 + 1.5 (1 - 0.35)] * 0.69 = 1.36 In other words, if the firm were at its target capital structure of 60 percent debt and 40 percent equity, we would expect it to have a beta of 1.36. We can then use this relevered beta as part of the CAPM formula to estimate the cost of equity: ke = Rf + bL* MRP.

adjusted present value (APV): A two-part valuation technique whereby the net present value is calculated assuming the project or firm is all-equity, plus the present value of financing benefits such as the tax shield

There is another important application for unlevered betas. Recall that in Chapter 11 we described the value of a levered firm, VL, as being equivalent to the value of an unlevered firm, VU, plus the value of the interest tax shield less the value of financial distress. The last component is somewhat difficult to estimate in practice, but we presented the other components as VL = VU + Dt where D is the amount of debt and t is the corporate tax rate. This approach to valuation is also known as the adjusted present value (APV) formula. We will discuss techniques for valuing a firm in Chapter 13; suffice it to say for now that we can use the unlevered beta to determine the unlevered cost of equity, which in turn is used as a discount rate to find the present value of expected cash flows in order to compute the value of an unlevered firm. The benefit of the APV approach is that it allows us to segregate the value of a firm if it is all-equity, and the value of the tax benefits of debt.

12.3  Relevance for Managers Objective 12.3

Explain why designing an optimal capital structure is relevant for managers and what lessons were learned from the financial crisis of 2007–2009.

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What do all our discussions of capital structure mean for nonfinancial managers? Managing your firm’s capital structure is generally one of the key duties of CFOs, but capital structure does matter to all managers as well as investors. Chief financial officers face crucial trade-offs in assessing capital structure. If your CFO is doing his or her job, then he or she has been able to find that sweet spot that balances the benefits and costs of increased debt as a proportion of capital, resulting in a lower cost of capital, and thus making projects more attractive. If projects are more attractive, then the value of the firm increases. If you work for a publically traded firm and own stock in the firm, then CFOs have helped to enhance the value of your shares.

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How do managers view capital structure issues? Two important surveys asked managers their views on capital structure. In the first survey, two academics who consulted for Deutsche Bank, Henri Servaes and Peter Tufano, conducted a global survey of chief financial officers and found that just over two-thirds of firms claimed to have a target capital structure, although the number was higher in North America at 85 percent. The top three measures used to determine the target capital structure were the EBITDA/ interest ratio, the debt/EBITDA ratio, and the debt-to-book value of equity ratio. Creditrating targets were also very important. In determining the appropriate level of debt, the most significant factors were the credit rating, the ability to continue to make investments, the tax shield, and the ability to maintain dividends. Firms were also asked why they did not use more equity as part of their capital structure. The three most important factors (as indicated by approximately half of the CFOs) were EPS dilution, concern that equity was not the cheapest form of financing, and concern that the share price might decline. Although issuing more shares has the immediate impact of reducing EPS, it should not necessarily reduce the value of the firm if the new equity raised is invested in positive NPV projects. However, firms are concerned that investors may not recognize the long-term benefits and might focus only on the mechanical, immediate reduction in EPS. Almost 40 percent of CFOs indicated control or the ownership stake of key shareholders was a major consideration for not issuing more equity. Another important survey of CFOs in the United States was conducted by two other academics, John Graham and Campbell Harvey. The survey found that 60 percent indicated the importance of flexibility and credit ratings (the two most important factors mentioned) as determinants of capital structure. Over 80 percent of firms had some kind of target capital structure, with a range of strict to flexible targets. Larger firms and those with better credit ratings tended to have stricter targets. Over two-thirds of CFOs were concerned that issuing equity would dilute earnings per share. Graham and Harvey interpreted this as either indicating that CFOs focus too much on EPS management rather than economic value or that CFOs felt that their stock was undervalued and thus if equity were issued it would truly lead to earnings dilution. The global financial crisis, or the Great Recession, is generally recognized as the most significant financial crisis since the Great Depression of the 1930s and it provided some important lessons for capital structure design. The United States entered into a recession in December 2007 and did not emerge until June 2009. The fundamental cause is generally recognized as being related to the collapse of the U.S. housing market. In 2006, huge price increases coincided with a trend of lower interest rates in general and mortgage rates in particular. The United States was not alone; many other countries experienced housing bubbles as well. The subprime mortgage business, in which U.S. banks gave high-risk loans to customers with less-than-stellar credit histories, triggered the collapse of the housing bubble. The high-risk and other loans or forms of credit were often bundled and sold to investors globally who were looking for higher–interest-paying investments in a low-interest rate environment. As homeowners defaulted on their mortgages and housing prices plummeted, credit markets froze as banks were reluctant to lend to each other, resulting in a liquidity crisis. Ultimately a global recession occurred. The financial landscape changed dramatically, as indicated in Figure 12.9. One of the biggest lessons from the Great Recession related to our current discussion is that capital structure does matter. Both individuals and institutions that took on too much debt suffered dramatically. Firms found that the world is not made up of the perfect capital markets assumed in M&M models. For example, many firms relied on short-term financing such as commercial paper and expected a ready and liquid market to be able to roll over the debt every few months but were unable to do so.

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Fig 12.9 Key Events in 2008

March 17:

Investment bank Bear Stearns was acquired at a fire-sale price by JPMorgan Chase.

September 7:

The U.S. government rescued Fannie Mae and Freddie Mac, governmentsponsored enterprises that were originally created to provide mortgages to low income families.

September 15: Investment bank Lehman Brothers collapsed. September 15: Another major investment bank, Merrill Lynch, negotiated its own emergency sale to Bank of America. September 16: The U.S. Federal Reserve took a major stake in AIG, the country’s biggest insurance company, to save it from bankruptcy.

moral hazard: A situation whereby a person or firm takes on undue risk when it feels it will not bear the cost from the risk exposure.

Another lesson relates to the notion of moral hazard, which refers to how a firm behaves when it feels it is protected from risk compared with how it would behave if it was fully exposed to risk. Moral hazard arises when there is asymmetric information between managers and investors. In the global financial crisis, many large financial institutions were exposed to huge risks related to subprime mortgage investments—much larger than investors knew. If house prices had continued to rise, then the financial institutions would have continued to profit. However, if the investments went sour, which is what happened, then the financial institutions may have expected that they were deemed “too big to fail” and that the Federal Reserve would bail them out, which also happened. Calls for reform to reduce the moral hazard in any future crises have centered on how to ensure that no institution feels it is deemed too big to fail. The threat of bankruptcy should ensure that these firms don’t take excessive risk in the future, but reforms will take time to implement.

Summary

1. Optimal capital structure, or debt capacity, is the debt-equity mix that maximizes the value of the firm’s common equity. 2. The five key criteria for evaluating optimal capital are represented by the FIRST approach, which considers Flexibility, Impact on EPS (cost), Risk, Shareholder control, and Timing. There are trade-offs that must be considered with each of these criteria.

3. EBIT breakeven analysis indicates the projected EBIT level such that EPS is identical under two different debt-equity mix scenarios. This type of analysis helps us understand what leverage really means and under what circumstances debt may or may not be preferable to equity once we account for risk.

Additional Readings and Information

The survey of how Chief Financial Officers view finance can be found in: Servaes, Henri, and Peter Tufano. “CFO Views on the Importance and Execution of the Finance Function.” Deutsche Bank Working Paper (January 2006). Electronic copy available at http://faculty.london.edu/hservaes/CFO%20Views% 20-%20Full%20Paper.pdf

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The two research papers that focus on determining optimal capital structure at the firm level are: van Binsbergen, Jules H., John Graham, and Jie Yang. “The Cost of Debt.” Journal of Finance 65 (December 2010): 2089–2136. van Binsbergen, Jules H., John Graham, and Jie Yang. “An Empirical Model of Optimal Capital Structure.” Journal of Applied Corporate Finance 23 (Fall 2011): 34–60. A discussion of factors to consider when determining a capital structure is in: Shivdassani, Anil, and Marc Zenner. “How to Choose a Capital Structure: Navigating the Debt-Equity Decision.” Journal of Applied Corporate Finance 17 (Winter 2005): 18–36. The capital structure surveys described in this chapter are from: Servaes, Henri, and Peter Tufano. “The Theory and Practice of Corporate Capital Structure.” Deutsche Bank Working Paper (January 2006). Electronic copy available at http://faculty.london.edu/hservaes/Corporate%20 Capital%20Structure%20-%20Full%20Paper.pdf Graham, John, and Campbell Harvey. “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (Spring 2002): 8–23. Electronic copy available at http://faculty.fuqua.duke.edu/~jgraham/website/ SurveyJACF.pdf A good discussion of factors to consider when structuring a financial policy, including the various perspectives one should consider, is in the Darden note: Bruner, Robert. Structuring Corporate Financial Policy: Diagnosis of Problems and Evaluation of Strategies. University of Virginia: Darden Business Publishing, 1993 (revised December 2005). UVA-F-1054, Version 1.6. An optimal capital structure spreadsheet and accompanying video instruction are available from: Professor Aswath Damodaran’s website (New York University, Stern School of Business) http://pages.stern.nyu.edu/~adamodar/New_Home_ Page/spreadsh.htm#cf To estimate the before-tax cost of debt for U.S. firms (that have issued publicly traded debt), see: http://cxa.marketwatch.com/finra/BondCenter/Default.aspx

Problems

1. Assume that a firm’s earnings per share (EPS) are expected to be $2.00 next year and that analysts have determined that an appropriate forward-looking multiple is 15 times the projected earnings. What should the stock price be? 2. Suppose that a firm generates $1.5 million in operating income and pays $250,000 in interest expenses. If the firm receives a tax exemption, calculate its EPS if it has 100,000 shares. As the firm alters its capital structure to include more debt, operating income rises to $2 million. Calculate the new EPS. Explain the expected change in its stock price.

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3. Calculate an EBIT breakeven between a debt firm (DF) and an all-equity firm (EF) based on the following information: DF interest 5 $40,000; DF number common shares 5 6,000; EF number of common shares 5 10,000; and tax rate 5 35 percent. Check your answer by calculating the EPS for both DF and EF at the breakeven EBIT. 4. Calculate the cash flow coverage ratio based on the following information: EBIT 5 $540,000; depreciation and amortization 5 $65,000; interest payments 5 $180,000; principal repayment 5 $75,000; and tax rate 5 35 percent.

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5. Suppose a firm has an EBIT of $5 million, interest expenses of $2 million, depreciation expenses of $1 million, and a tax rate of 35 percent. Its bank agrees to lend up to 4 times its EBITDA. How much debt can the firm borrow from the bank? 6. Suppose an all-equity firm has a beta estimated to be 1.2. If the firm changes its capital structure such that its debt-to-equity ratio is now 0.4, what should be the revised beta estimate if it also faces a tax rate of 35 percent? 7. Repeat the cost of capital calculations in Figure 12.8, assuming market value weights instead of book value weights. 8. Suppose that StartRite Co. has a debt-to-equity ratio of two-thirds and a corporate tax rate of 20 percent. Calculate the unlevered beta of StartRite Co. if its levered beta is equal to 1.13.

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9. StartRite Co. aims to reduce its debt-to-equity ratio to 0.6. With the help of calculations explain the effect on its re-levered beta. 10. As a firm alters its capital structure to include a higher debt ratio, the costs of financial distress tend to increase because: a.  The equity tax shield is depleted. b.  The probability of default increases. c.  It can increase its fixed assets. d.  It is expected to earn higher return on assets.

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Part 4    Creating Value

Measuring and Creating Value

13

Learning Objectives

A business valuer was asked what two plus two was. “That depends,” he replied, “on whether you’re buying or selling.”1 —quoted Julien Barry

In Chapter 7, we examined the time value of money; in Chapter 8, we discussed the capital budgeting decisions managers face and looked at capital budgeting techniques. These techniques—such as net present value analysis—help managers determine whether a project will add value to a firm. In Chapter 13, we’ll take another look at investment decisions, this time in a much broader context. We’ll focus specifically on the measurement and creation of value for the firm as a whole (as opposed to an individual project). In doing so, we’ll integrate many of the concepts discussed throughout this book. As you read this chapter, keep in mind that a firm is really just a portfolio of projects. We begin the chapter with an overview of valuation measurement and creation. Then, we describe several well-known firm valuation techniques, including discounted cash flow analysis, price-earnings analysis, and enterprise value-to-EBITDA analysis. This presentation is intended to show that valuation measurement is both a science and an art. Next, we address the concept of value-based management and the measurement of economic value added (EVA®). These approaches attempt to measure management’s ability to increase value for common shareholders. Managers often attempt to increase this value through mergers and acquisitions, which we examine as well; it is important to note, however, that other methods of corporate restructuring are available. Figure 13.1 shows that we are nearing the culmination of our financial journey together. As you look at the figure, recall that external factors related to the economy and industry affect a firm’s growth prospects and risk—as do internal decisions in the areas of operations, investing, and financing. In this chapter, we’ll see how growth (of cash flows in particular) and risk (encapsulated in the cost of capital) both impact a firm’s valuation.

Obj 13.1

Describe four basic valuation principles. Obj 13.2

Explain the book value plus adjustments valuation method. Obj 13.3

Explain the discounted cash flow valuation method. Obj 13.4

Explain the price-earnings and enterprise value-toEBITDA valuation methods. Obj 13.5

Explain economic value added measurement and process. Obj 13.6

Describe reasons for acquisitions and explain comparable transactions valuation methods. Obj 13.7

Explain why valuation measurement and creation is relevant for managers.

1

Cited by Julien Barry as “an old joke,” http://www.4networking.biz/Forum/ViewTopic/75292 (accessed September 20, 2012)

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FIG 13.1 Financial Management Framework: Value Creation

external environment economy

industry

the enterprise

financing

operating

investing

Growing profits, dividends, cash flow

Managing the risk profile

growth

risk

Return on equity

Cost of capital

value creation

13.1 An Overview of Measuring and Creating Value Objective 13.1

Describe four basic valuation principles.

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Because valuation issues arise in numerous business settings, it’s important to understand how a firm’s value is measured. For example, a private firm may be considering whether to go public through the IPO process. Here, the firm will need to work with its investment bankers to determine an appropriate issuing share price, which in turn will determine the initial market value of the firm as a whole. Alternatively, management of an existing public company may be considering taking the firm private through a management buyout (MBO) or a leveraged buyout (LBO)—which means a fair price for the firm must be determined. A firm might also be weighing whether to divest itself or spin off one of its divisions, or perhaps whether to acquire or merge with another firm. In each of these cases, the value of the firm (or part of the firm) must be measured in order for managers to establish a fair price at which to buy or sell. How, then, do we measure a firm’s value? If a firm is publicly traded, it can be argued that its value (or specifically, its market value of equity) is simply its current stock price multiplied by the number of outstanding shares. Although this is clearly an important and straightforward measure of value, the appropriateness of this measure depends

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on your belief in the efficiency of markets. Also, this approach presents a challenge for private firms because they have no such market price and they lack the liquidity associated with shares in public firms—which in turn implies they are worth less than publicly traded shares. So, for a private firm, we may need to measure value as we would with a public firm but adjust for the increased risk of owning private shares and the inability to trade them. In fact, some simple rules of thumb suggest that private firms should be discounted by 20 to 30 percent or more compared to similar publicly traded firms. Measuring a firm’s value is only part of the story, however. Once we have a handle on the worth of an existing business, we are in a better position to assess how additional value can be created. For example, suppose a firm’s CFO determines that the firm can take on much more debt than it currently has. Because debt is cheaper than equity, the firm can reduce its cost of capital by borrowing more rather than issuing equity. In turn, a lower cost of capital means previously considered projects are now more attractive. Thus, by changing its capital structure to a more optimal one, the firm may create value for its stakeholders. Alternatively, the firm might pursue increased efficiencies or partnerships that reduce costs, thereby increasing cash flows and overall firm value. Also, in the case of a potential acquisition, hidden value may be unlocked if a firm’s new owner utilizes existing assets in a manner different from their current use that leads to increased cash flows. For example, a new owner might add a night shift in a manufacturing plant in order to increase output. As we move through the chapter and examine the measurement and creation of value in more detail, it’s important to keep four basic valuation principles in mind: First, we must clearly recognize what is being valued: Is it the firm as a whole, or just the equity portion? We can think of the value of a firm as equal to the combined value of its equity portion and its debt portion (assuming the firm has borrowed). Thus, you may hear of an acquisition in which a firm’s overall value was, say, $3 billion, but for which the buyer only actually paid $2 billion to acquire the firm’s equity, while at the same time inheriting debt of $1 billion. In this chapter, much of our focus will be on trying to measure the value of equity. However, some techniques— for example, the discounted free cash flow to the firm approach—start by determining the value of the firm as a whole, then subtracting the value of firm’s debt in order to arrive at a value for the equity portion. Second, we can create value by taking on positive net present value (NPV) projects. If market participants—including potential equity investors—anticipate that a firm’s managers have taken on a positive net present value project, then the firm’s stock price should increase. Accordingly, we can think of the value of equity as the amount of equity capital initially provided—by the original owner/investor, as well as additional capital raised through an initial public offering or secondary equity offering—plus the net present value of anticipated future projects. Third, value is ultimately what someone is willing to pay for a company or its assets. Thus, perceptions are important, which is why valuation is as much an art as it is a science. The motives of the buyer are also important. In particular, we can view valuation differently if a buyer is planning to liquidate a firm’s assets and shut down the business than if the buyer is treating the purchase as an ongoing business, which is typically the case. Fourth and finally, shareholder control matters. In other words, there is value to having voter control of a firm. For example, if you are the majority shareholder, then you control the firm’s direction—meaning you can hire and fire its managers. In this situation, if a potential acquirer wishes to own your shares, he or she may need to pay you a premium compared to what the shares are currently trading for in the market.

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13.2 Measuring Value: The Book Value Plus Adjustments Method Objective 13.2

Explain the book value plus adjustments valuation method.

book value of equity plus adjustments approach: An approach to estimating the equity value of a firm based on the book value of the firm’s equity

FIG 13.2 Top Traps Inc. Balance Sheet

Suppose you have a great idea—how to build a better mousetrap—and you decide to start a new business called Top Traps Inc. On the day you incorporate, you deposit your savings of $250,000 (plus some money you’ve set aside for the cost of incorporation) in the firm’s bank account. What is the value of your firm? One approach is to examine the book value of equity of Top Traps (recall our discussion in Chapter 3). You own just one asset ($250,000 in cash) and you owe no money (i.e., you have zero liabilities), so the firm’s book value of equity is simply the book value of assets ($250,000) less the book value of liabilities ($0), or $250,000. Another approach is to examine the market value of equity or the fair price someone would pay for the equity of Top Traps. Again, the value is $250,000 representing the cash in the bank account (ignoring the minor cost for incorporating). The moral of our story (so far) is that on day 1 of any start-up firm, the book value of the firm’s equity is equal to the market value of its equity. Now, consider Top Traps’ balance sheet several years after incorporation, as shown in Figure 13.2. We see that the book value of equity is now $280,000, but does that represent a fair price if you were to sell Top Traps? Let’s consider some possible hidden assets—or assets whose actual values are either not represented or are underestimated on the balance sheet—as well as some possible overvalued assets. Suppose you lucked out on the timing of your property investment and the firm’s property is now worth $200,000. There is hidden value of $80,000 (i.e., the difference between the $200,000 current value and the $120,000 cost value). You might also argue that the Top Traps “brand” you created is worth much more than the cost of the patent. For example, an investor might offer you $50,000 for the patent. On the other hand, some of the firm’s inventory may have become obsolete because you’ve refined and updated the product and may only be worth $60,000. As these scenarios suggest, the book value of equity plus adjustments approach starts with a firm’s book value of equity (in our example, $280,000). Next, we add the value of any hidden assets (such as the difference between the firm’s actual property value and the cost on the books, as well as the difference between the patent’s cost and current selling price). Then we make any other appropriate adjustments (in our example, subtracting the difference between the cost of inventory and the true value of the inventory due to obsolescence). Thus, the general equation for the book value of equity plus adjustments approach can be written as: Value of equity (VE) = book value of equity + adjustments

Assets



Cash

$5,000

Inventory

80,000

Liabilities Accounts payable

$20,000

Patent 15,000 Property (at cost) Plant and equipment (net) Total Assets

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120,000

Equity

$280,000

80,000 $300,000 Total Liabilities and Equity $300,000

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For Top Traps, we would calculate the value of the firm’s equity as follows: VE = $280,000 (book value of equity) + $80,000 (hidden value of land)    + $35,000 (excess value of patent) - $20,000 (obsolete inventory) VE = $375,000

13.2.1 Pros and Cons of the Book Value of Equity Plus Adjustments Method

The advantage of the book value of equity plus adjustments approach is self-evident: It is simple to use, in part because we can immediately “plug in” the starting point of the book value of equity without having to do any calculations. The main disadvantage of this approach is that it implicitly assumes that a firm is going to be shut down and its assets are going to be sold to cover its liabilities, with any remaining funds representing the equity value. In other words, it doesn’t consider Top Traps as an ongoing concern. There can be a tangible benefit associated with a business that has a well-established client base that will lead to future revenue, but that benefit isn’t reflected in the liquidation value of the assets. Despite the clear disadvantages of this method, we often see it used as a starting point for valuation. For example, in the financial services industry, acquisition prices are often quoted as a simple multiple of a firm’s book value of equity, such as “two times book.” This particular approach uses the firm’s book value of equity as a starting point, then attaches a multiple to capture both hidden value and future prospects of profitable projects. Fortunately, our next valuation method is much more sound and grounded in reality.

13.3 Measuring Value: The Discounted Cash Flow Analysis Method The discounted cash flow (DCF) method—also known more descriptively as the discounted free cash flow method—is a valuation method that extends the time value concepts introduced in Chapter 7. There are two versions of the DCF approach, both of which involve projecting cash flows, estimating the present value of those cash flows, then adding the present values together in order to estimate value. We highlight the two approaches in Figure 13.3. One version, the free cash flow to equity method, directly estimates the value of the cash flows available to a firm’s shareholders—or the value of equity, VE.2 We’ll focus on the indirect but generally more popular approach known as the free cash flow to the firm method, which focuses initially on estimating the overall value of the firm, VF , then subtracting the value of debt, VD, as well as the value of other claims, VO, to arrive at the value of the firm’s equity. With this approach, we conceptualize the value of a firm’s equity as the value of the entire business less any claims by other investors, such as creditors and preferred shareholders. To better understand the free cash flow to the firm method, let’s begin with an overview of the method and outline the five steps involved in our value calculation, as shown in Figure 13.4. Then, as we further explain each step (including some new terms

Objective 13.3

Explain the discounted cash flow valuation method.

discounted cash flow (DCF) method: An approach to estimating the equity value of a firm based on a projection of cash flows free cash flow to the firm method: An approach of estimating the equity value of a firm based on a projection of free cash flows

2

A description of this approach and a comparison with the free cash flow to the firm method is available at MyFinanceLab.

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FIG 13.3 Direct and Indirect Measures of the Value of Equity

Value of debt VD

Indirect Method: VE = VF − VD − VO

Value of the firm VF

Value of other claims (e.g., preferreds) VO Value of equity VE

Direct Method: VE

such as free cash flows and terminal value), we’ll work through a numerical example. The basic premise of this method is that a firm should be worth the present value of anticipated cash flows. The value of equity should be the difference between the value of the firm as a whole and the value of debt and any other claims on the assets of the firm. To better understand how the free cash flow to the firm process works, let’s consider an example. Suppose you started another company, Even Better Traps Inc., and you anticipate earnings before interest and taxes (EBIT) of $40,000, $50,000, and $60,000 in each of the next three years. Over the same period, depreciation is estimated to be $4,000, $5,000, and $6,000; capital expenditures are estimated to be $6,000, $7,000, and $8,000; and incremental increases in working capital requirements are estimated to be $2,000, $3,000, and $4,000. The estimated tax rate is 35 percent, and the cost of capital is assumed to be 10 percent. Free cash flows (defined in the next section) beyond year 3 are assumed to grow at a constant annual rate of 3 percent. Finally, the current value of the firm’s existing debt, VD, is assumed to be $100,000. How can we estimate the value of the firm’s equity, VE?

13.3.1 Estimating Free Cash Flows free cash flow: The cash flow available to a firm after providing for investments: after-tax operating income plus noncash items (such as depreciation) less capital expenditures and working capital increases FIG 13.4 Free Cash Flow to the Firm Method of Valuation

To answer this question, let’s start with the concept of free cash flows (FCF) (also referred to more specifically here as free cash flows to the firm, or FCFF), which are the cash flows available (or free) to all stakeholders (including bondholders, preferred shareholders, and common shareholders) after accounting for operating expenses, taxes, provisions for capital expenditures, and provisions for changes in working capital requirements. Later in the section, we’ll estimate a firm’s free cash flows for a number of years into the future, but for now, let’s simply consider next year’s estimate. The general formula for each year’s FCFF is presented in Figure 13.5 and described in more detail after the figure. 1. Estimate annual free cash flows for the next number of years (what we will value). 2. E  stimate the cost of capital (to be used as a discount rate for present value calculations). 3. C  alculate the present value of the free cash flows for the next number of years (from step 1) using the discount rate from step 2. 4. E  stimate a terminal value (the value of cash flows beyond the initial forecasting period) and a present value of the terminal value and add the latter to the other cash flow present values in step 3 (to determine the overall value of the firm). 5. S ubtract from step 4 the value of any interest-bearing debt and other non-common equity sources of capital (to determine the value of equity).

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FIG 13.5 Estimating Free Cash Flows Using the Free Cash Flow to the Firm Approach

FCFF = EBIT × (1 − tax rate) + noncash expenses − capex* − net increases in working capital

*Capex refers to capital expenditures.

Let’s consider each component of the FCFF formula in Figure 13.5. First, EBIT is what we referred to earlier as earnings before interest and taxes. This is calculated as revenue less costs associated with producing a good or providing a service—but it does not account for taxes or financing charges, such as the interest on any money borrowed. To account for the taxes on these operating earnings or profits, we must multiply EBIT by (1 - tax rate). For example, if the tax rate is 35 percent (or 0.35), then a firm’s aftertax earnings will be equal to 65 percent of its pretax earnings. For simplicity, we can think of this amount as the net earnings for the firm if it didn’t have any debt. We’ll account for debt financing in the next step when we estimate the cost of capital.

In-Depth

Why Do We Add Back Noncash Items?

Let’s more closely examine what we mean by “adding back noncash items,” whereby we adjust accounting profits to actual cash flows. In the figure here, we compare a “standard” accounting approach with an alternative “cash-basis” approach to show that adding back noncash items is the process by which we reconcile the two approaches. In this example, we focus on the most common noncash item: depreciation.  

Standard Cash Basis

Notes

Net sales

$70,000

$70,000

assume all cash

Cost of sales

$46,000

$46,000

assume all cash

Gross profit

$24,000

$24,000

 

Operating expenses: selling, general, and administrative

  $16,000

  $16,000

  assume all cash

Depreciation Total operating expenses

$2,000 $18,000

    $16,000

 

EBIT

$6,000 $8,000  

Taxes (at 35%)

$2,100

$2,100

Net earnings

$3,900

$5,900

EBIT * (1 - tax rate) + depreciation

$5,900

 

cash tax (actual paid)   same as cash basis

In this example, we have an all-cash business that generates a gross profit of $24,000. In our “standard” accounting method, we subtract all operating expenses— including our noncash item of depreciation—to estimate EBIT, which forms the basis for our tax calculation. (Note that in our simple example, the firm doesn’t have any interestbearing debt, so there are no interest expenses to subtract.) Depreciation is a “good” expense because it doesn’t represent any out-of-pocket expense, yet it helps reduce the amount of taxes we would otherwise have paid. As shown, our standard accounting approach indicates net earnings of $3,900, while in fact we have $5,900 on a cash basis. We can reconcile the two columns by simply adding back our noncash expense, depreciation. So, to recap, to estimate our after-tax earnings on a cash basis, we take EBIT * (1 - tax rate) and then add back noncash expenses: $6,000 * (1 - 0.35) + $2,000 = $5,900.

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Now, let’s move on to the “ + noncash expenses” component of the FCFF formula. Because our focus is on cash flows (the CF part of DCF), we need to adjust the after-tax operating profits for any noncash items (such as depreciation and amortization) by adding them back to the EBIT * (1 - t) amount. Returning to Figure 13.5, the next portion of the FCFF formula is the “- capex” component—which is finance lingo for “capital expenditures.” In most situations, we assume a firm is growing over time. If this is the case, most firms will need to invest to grow—­meaning they’ll need to set aside cash for these investments. For example, if a firm has depreciating assets such as plant and equipment, then at a minimum the firm will need to set aside cash to replace these depreciating assets. If the firm is not growing, we would expect its capital expenditures to approximately offset the amount of depreciation. However, if the firm is growing over time, then we would expect its capital expenditures to exceed its depreciation. Here, because we are setting aside cash to grow, we subtract the amount of capex as part of the FCFF calculation. For many firms, particularly those in manufacturing or resource development, management would have a long-term plan for both major capital expenditures and maintenance capital expenditures and would thus be readily able to project capex. Finally let’s examine the “ - net increases in working capital” component of the FCFF calculation. Recall our examination of working capital needs in Chapter 5. If a firm is growing, it may be experiencing an increasing working capital or cash conversion gap (in dollar terms) between its current assets (such as accounts receivable and inventory) and current liabilities (such as accounts payable). Just as a growing firm must be prepared to set aside money for increased capital expenditures, it must also be prepared to set aside money for increased working capital needs. (If a firm’s revenue was shrinking then it might actually be freeing up working capital and so we might be adding the net decrease in working capital. Since this is not usually the case, we will represent this in the usual manner with the minus sign, recognizing that in rare cases it might be positive.) Note that we are considering only incremental or changing working capital needs. For example, it’s not the amount of money we have tied up in inventory that matters, but rather how much more we need to set aside next year. To estimate the change in working capital, we might look at the historical relationship between the firm’s change in net sales and change in working capital. We might find, for instance, that for every $100 increase in sales, the firm’s working capital increases by $4, or 4 percent of incremental sales. Now that we’re familiar with each portion of the general FCFF formula, let’s estimate the FCFF for Even Better Traps for each of the next three years, using the tax rate, depreciation, capex, and working capital values given earlier in the chapter. FCFF = EBIT 

* (1 - t) 

 

+ noncash expenses - capex - net increases in working capital

FCFF1 = $40,000 * (1 - 0.35) + $4,000    

- $6,000 - $2,000      = $22,000

FCFF2 = $50,000 * (1 - 0.35) + $5,000    

- $7,000 - $3,000      = $27,500

FCFF3 = $60,000 * (1 - 0.35) + $6,000    

- $8,000 - $4,000      = $33,000

13.3.2 Estimating the Cost of Capital Now that we’ve estimated Even Better Traps’ FCFF for the next three years, let’s consider step 2 of the free cash flow to the firm valuation process described in Figure 13.4. Note that when we find a firm’s free cash flows, we appear to be ignoring any financing costs, such as the interest expense on borrowing. In reality, we’re not ignoring such financing issues but rather incorporating them into the discount rate we’ll employ to discount any future cash flows. In other words, we’re discounting them in order to find the present value. The discount rate is equivalent to the cost of capital we discussed extensively in Chapter 10, which incorporates the cost of the various forms of financing, including debt, preferred shares, and common equity.

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Recall that the weighted average cost of capital is estimated as kc = wdkd + wpkp + weke, where the w’s represent the weights (adding to one) and the k’s represent the cost of debt, preferred shares, and common equity. The cost of debt, kd, is estimated as the after-tax cost of issuing new debt (such as bonds) today. The cost of preferred shares, kp, is estimated as the current dividend yield on any existing preferred shares or shares of similar firms. The cost of equity, ke, is commonly estimated by the capital asset pricing model (CAPM) as the risk-free rate or long-term government bond yield plus beta multiplied by a market risk premium. The weights represent targets—in other words, the proportions in which we anticipate the firm will issue debt and equity. The resulting cost of capital, kc, is used as the discount rate for calculating the present value of the future free cash flows to the firm, FCFF, as described in step 1. Recall that for Even Better Traps, we’ve assumed a cost of capital of 10 percent.

13.3.3 Estimating the Present Value of Free Cash Flows Now that we have estimated free cash flows and determined the discount rate, let’s consider the third step in our free cash flow to the firm valuation process. As outlined in Figure 13.4, this step involves calculating the present value of the firm’s anticipated free cash flows for the initial forecasting period (often the next 5 to 10 years) using the cost of capital as the discount rate. Recall that the discounting process involves dividing each of the anticipated free cash flows (or future values) by one plus the cost of capital, to the power of the number of years in the future, as described in Chapter 7: PV of FCFFt =

FCFFt (1 + kc)t

Here, we’re assuming that the cost of capital will remain the same throughout the entire estimation period. It’s always worthwhile to draw a timeline (see Figure 13.6) to visualize the task at hand. Note that our timeline implicitly assumes any cash flows occur at the end of each year. We’ll refer to this timeline as part 1, since we’ve not yet dealt with cash flows beyond the initial forecasting period of explicit free cash flow estimates (or three years, in our Even Better Traps example). Although this step in the process involves estimating free cash flows for a number of years, there is no set rule as to how many years. Still, common practice suggests 5 to 10 years is an appropriate amount of time because most firms have a reasonable idea of projected revenues and any major capital expenditures in the next 5 to 10 years. One guiding principle is to project the number of years until you’re willing to assume that a firm’s free cash flows will grow at a constant rate. (We will utilize this key assumption in the next subsection.) Using a formula from Chapter 7 and the values identified earlier in this chapter, the present value of each of the three projected free cash flows for Even Better Traps, as well

FCFF1

FCFF2

FCFF3

FCFF4

FCFF5

…

FIG 13.6 Free Cash Flows Timeline, Initial Cash Flows

r = kc 0

1

2

3

4

5

…∞

PV = ?

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as the sum of the three present values, can be calculated as follows (note that some of the numbers in this example may be off slightly due to rounding): PV of FCFFt =

FCFFt (1 + kc)t

PV of FCFF1 =

$22,000 $27,500 $33,000 ; PV of FCFF2 = ; PV of FCFF3 = (1.10)1 (1.10)2 (1.10)3

= $20,000

= $22,727

= $24,793

Sum of PVs of FCFF1, FCFF2, and FCFF3 = $67,521

13.3.4 Estimating the Terminal Value

terminal value: The value of assets either at the end of their economic life or at an arbitrary time in the future

As described in Figure 13.4, step 4 in our free cash flow to the firm valuation process involves estimating a terminal value (TV), calculating its present value, and then adding this present value amount to the present values from the earlier period free cash flows. The terminal value represents the value, as of the last year of annual forecasts, of all free cash flows beyond that point in time. In other words, the terminal value represents the value of a perpetuity of cash flows. There are a number of approaches to estimating terminal value. One method is simply to estimate what the firm might be worth at some future time (say in five years). Another method is to apply a multiple to projected EBITDA, as described later in the chapter. Yet another method is to make an assumption that free cash flows will grow at a constant rate beyond the period of our last estimated free cash flow and apply a growing perpetuity formula, as introduced in Chapter 7. In this section, we’ll focus on the last approach. Suppose we’ve specified five years of projected free cash flows and have calculated the present value of those free cash flows as shown in Figure 13.6. Now, let’s consider an extended timeline that starts at t = 5 instead of the usual t = 0. The reason we’re doing this is because we wish to determine the value, at time t = 5, of all cash flows beyond t = 5. In other words, we want to consider free cash flows at t = 6, t = 7, and so on. Recall our assumption that these flows will grow at a constant rate in perpetuity starting at this point. Our new extended timeline is presented in Figure 13.7. We know from Chapter 7 that the value of the firm’s future cash flows as of t = 5 (or TV5) can be estimated using the growing perpetuity formula, as shown in Figure 13.8.

FIG 13.7 Free Cash Flows Timeline, Beyond Initial Cash Flows

FCFF5(1 + g)2

FCFF5(1 + g)

FCFF5(1 + g)3 …

r = Kc 5

6

7

8

…∞

TV5 = ? FIG 13.8 Terminal Value Calculation (as of t = 5 example)

TV5 = where

TV5

FCFF5 (1 + g) (kc − g)

= terminal value of free cash flows as of t = 5

FCFF5 = estimated free cash flow as of t = 5

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g

= anticipated constant growth rate of free cash flows beyond t = 5

kc

= cost of capital

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In-Depth

The Most Common DCF Estimation Mistakes

I’ve often considered making the following announcement to a class just before an exam with valuation problems on it: “If everyone estimates the terminal value correctly, I’ll buy pizza for the entire class!” Although I haven’t actually tried this approach, perhaps your finance professor will—but don’t expect any free pizza! There are two common mistakes related to the terminal value calculation. The first is mis-specifying the free cash flow (FCF) in the growing perpetuity calculation as the current period’s FCF rather than the next period’s FCF. For example, if the terminal value is being estimated at year 5, then we need to estimate FCF6 and use it in the growing perpetuity formula—not FCF5. The second common mistake is discounting (i.e., determining the exponent in the denominator of the PV equation) using next period’s discounting period rather than the same discounting period as the last estimated FCF period. For example, if we have estimated five FCFs—with the last in year 5—then the terminal value is also estimated in year 5 with five discounting periods, and not in year 6 with six discounting periods. In my experience, the odds of no terminal value mistakes in a class of over 50 students are less than 2 percent. Could yours be the rare free pizza class?

Once we’ve estimated a terminal value (TV), the second part of step 4 involves calculating the present value (PV) of that terminal value discounted at the cost of capital (kc). This is a straightforward calculation. PV of TV5 =

TV5 (1 + kc)5

Finally, the last part of step 4 involves adding the present value of the terminal value to the present value of the earlier period free cash flows. We can now combine our two free cash flow timelines from Figures 13.6 and 13.7, as shown in Figure 13.9. Because we’ve estimated the present value of the free cash flows up to the terminal period (part 1) as well as beyond the terminal period (part 2), we’ve now estimated the overall value of the firm, VF, or the value of the firm’s assets. We’ll also refer to the value of the firm’s assets as the enterprise value (EV)—but more on that later. So, for Even Better Traps, the terminal value estimation, present value of the terminal value, and summation of the present value estimates are as follows (keeping in mind the assumed cost of capital of 10 percent and terminal growth rate of 3 percent): TVt = PV of TVt = TV3 =

FCFFt(1 + g) (kc - g) TVt (1 + kc)t $33,000(1.03) $485,571 = $485,571; PV of TV3 = = $364,817 (0.10 - 0.03) (1.10)3

VF = sum of all FCFFs = $67,521 + $364,817 = $432,338

13.3.5 Estimating the Value of Equity We’ve now calculated the value of our firm’s free cash flows, but recall from Figure 13.3 that our overall goal is to estimate the value of the firm’s common equity. As such, we

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FIG 13.9 Free Cash Flow Timeline, Combined

FCFF2

FCFF1

FCFF3

FCFF4

(FCFF5 + TV5)

r = kc 0

1

2

3

4

5

…∞

VF = ?

need to subtract the value of any of the firm’s debt and other claims (for example, preferred equity) from the value of the firm. Thus, step 5 from our free cash flow to the firm valuation process (as outlined in Figure 13.4) involves simply subtracting any interestbearing debt, VD, and other related obligations in order to arrive at the value of the firm’s equity, VE—which is our ultimate goal. VE = VF - VD So, for Even Better Traps, our value of equity calculation is as follows: VE = VF - VD VE = $432,338 - $100,000 = $332,338 We summarize all of the calculations in Figure 13.10.

FIG 13.10 Even Better Traps Inc. DCF Valuation

Tax rate (t) = 35.0% Cost of capital (kc) =

10.0%

Terminal growth rate (g) = 3.0% FCFF Method 0 1 2 3 4 Notes EBIT 40,000 50,000 60,000 given - Taxes

14,000

17,500

21,000 EBIT × t

EBIT * (1 - t) 26,000 32,500 39,000 EBIT – taxes + Depreciation 4,000 5,000 6,000 given - Capex 6,000 7,000 8,000 given - WC change

2,000

3,000

4,000 given

FCFF 22,000 27,500 33,000 33,990 FCFFF4 = FCFF3 (1 + g) Terminal Value (TV)

485,571 FCFF4/(kc - g)

FCFF + TV 22,000 27,500 518,571 PV of FCFF (and TV) Value of firm (VF) =

20,000

22,727

389,610

432,338

discounted at kc sum of PV of future FCFFs

100,000 given Value of debt (VD) = VE = VF - VD Value of equity (VE) = 332,338

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13.3.6  Pros and Cons of the Free Cash Flow to the Firm Approach The major advantage of the free cash flow to the firm method (and DCF methods in general) is that it is based on sound time value of money principles, so it is theoretically sound. This method is also transparent in showing the key drivers of value: growth and risk. For example, the more Even Better Traps Inc. can grow its free cash flows, the greater the value of the firm—but the higher the perceived riskiness of the firm (with a resulting higher beta, higher cost of equity, and higher cost of capital), the lesser the value of the firm. The major disadvantages of the free cash flow to the firm method are that it can be more time consuming and difficult to use than other methods. This method also requires a number of assumptions that are often challenging to estimate in practice. For example, in a merger or acquisition situation, one must carefully assess the resulting business risk to determine an appropriate cost of capital. If the capital structure is changing, then the cost of capital won’t be constant. Making reasonable assumptions about the value of projected capital expenditures and working capital changes is often difficult. Making assumptions about the appropriate tax rate may also be difficult because it is not necessarily based on the previous year’s tax rate (particularly if the year was not a typical one in terms of tax payments), but rather based on the anticipated tax rate. Finally, when estimating the terminal value, we need to estimate the point at which cash flows are anticipated to grow at a constant rate if we are using the growing perpetuity assumption.

13.4 Measuring Value: Relative Valuations and Comparable Analysis Now that we’ve seen the rigor of the discounted cash flow approach to valuation, you may be wondering if there is a less time-consuming approach. The answer is yes—but as with any shortcut, there are benefits and costs. These relative valuation methods offer the benefit of simplicity by comparing a firm’s valuation relative to that of a group of competitors in order to estimate equity value. Although these methods are faster than the DCF methods, their major cost is the decreased precision of the resulting estimate.

Objective 13.4

Explain the price-earnings and enterprise value-toEBITDA valuation methods.

13.4.1 The Price-Earnings Method Let’s start with one relative valuation method that we’ve already previewed. Recall that in Chapter 12, we briefly introduced the price-earnings valuation model. According to this model, the amount common share investors should be willing to pay today for a share, P0, is based on two components. One component is the firm’s projected earnings per share next year, EPS1. The other component, which we refer to as the appropriate forward-looking P/E multiple, is based on a consensus in the marketplace as to how many times those projected earnings a stock is worth, often utilizing comparable analysis of other similar companies in the same industry. Once we’ve estimated the intrinsic value of the common share price, P0, the overall value of the firm’s common equity is estimated by multiplying the value of common share, P0, by the number of common shares outstanding. Unlike the free cash flow to the firm method, this method directly values a firm’s common equity. The price-earnings valuation model is formalized in Figure 13.11. Let’s explore the EPS component and the P/E multiple component in more detail. The forecasted earnings per share estimate, EPS1, used in the P/E valuation model is usually based on the subsequent year, provided that year has “normal” earnings—in other words, there are no

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relative valuation methods: An approach to estimating the equity value of a firm based on a comparison of valuations assigned to comparable firms

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FIG 13.11 Price-Earnings Valuation Model

P0 = (appropriate forward-looking P/E multiple) × EPS1 where

P0 = estimated price per share today appropriate forward-looking P/E multiple is based on “comparables” assessment EPS1 = projected earnings per share next year

extraordinary gains or losses or any unusual impacts on revenues. For publicly traded companies, this information has become more readily available through consensus forecasts by analysts and various financial information services. In some cases, a firm’s management team provides guidance to the public regarding what earnings to expect. If such information is not available, or if the firm is private, then we can simply project earnings ourselves using the forecasted income statement analysis presented in Chapter 6. Determining an appropriate forward-looking price-earnings multiple is more challenging. This process often involves comparable analysis of similar companies in the same industry—in other words, examining similar firms and estimating their average price-earnings multiple (or more precisely, the ratio of their current price to expected earnings per share). An ideal comparable firm is one that: Is in a similar industry Is of similar size Is experiencing similar growth of cash flow prospects Has similar risk as measured by beta Has a similar capital structure or financial leverage Has a similar dividend payout

comparable analysis: Comparison of the assets or businesses of selected firms, often for the purpose of establishing a fair market value

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Because the price-earnings multiple reflects the growth prospects and riskiness of a firm, a related approach estimates a simple industry-wide price-earnings average, then adjusts that amount either upward or downward depending on the perceived growth prospects and riskiness of the firm of interest. For example, if the firm is deemed to have greater growth prospects than the industry average, then (all else equal) it should be assigned a higher multiple. (Recall “Growth is good.”) Alternatively, if the firm is deemed to have more risk than the industry average, then (all else equal) it should be assigned a lower multiple. (“Risk is rotten.”) In many situations, assigning a multiple becomes as much an art as a science in attempting to balance growth and risk considerations. It’s also important to note that at any time, we would expect to see average industry multiples vary considerably. Similarly, even within an industry, we would expect to see average multiples vary over time as overall industry and market conditions change. As a rough guideline, market-wide price-earnings multiples have historically averaged around 16 to 17, as shown in Figure 13.12. Let’s return to our Even Better Traps example to apply the price-earnings valuation approach, then compare our result to the discounted cash flow analysis. Recall from Figure 13.10 that our year 1 EBIT was estimated to be $40,000. Let’s also assume that interest payments are $8,000 (i.e., 8 percent of $100,000 in interest-bearing debt), and assume Even Better Traps has 20,000 common shares outstanding. Projected earnings per share are estimated in Figure 13.13 as $1.04. Now let’s suppose that, based on a comparable analysis, we determine that an appropriate forward-looking price-earnings multiple is 16 times, which reflects our assessment of the growth prospects and risk of Even Better Traps compared to peer firms within the same industry. Consequently, the firm’s intrinsic share price, P0, is estimated to be 16 times $1.04, or $16.64. If we multiply this share price by the number of common

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293

FIG 13.12 Historical Price-Earnings Multiples, Based on Average U.S. Stock Market Prices and Rolling 10-Year Historical Earnings, 1881–2011

45 40 35 30 25

Average = 16.4x

20 15 10

0

1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

5

Source: Robert Shiller’s website, http://www.econ.yale.edu/~shiller/data.htm (accessed March 1, 2012)

EBIT – Interest

$40,000

FIG 13.13 Price-Earnings Valuation

8,000

EBT 32,000 – Taxes

11,200

EAT $20,800 Shares outstanding (000s)

20,000

EPS1 $1.04 Appropriate forward-looking P/E multiple

16.00

P0 $16.64 Value of equity (VE) $332,800

shares (20,000), we arrive at an estimated equity value of $332,800, which is similar to the estimates derived from our discounted cash flow approach.

13.4.2  Pros and Cons of the Price-Earnings Approach In terms of pros, this method is simple to apply, is based on relative market measures, and is forward-looking. In terms of cons, one important drawback is that if we consider comparable firms, we are implicitly assuming they are already fairly priced in the marketplace. This can be a dubious assumption—consider, for instance, the overvaluation of technology stocks in the late 1990s. Another con is that this approach focuses on earnings rather than cash flows, and earnings may be affected by accounting conventions such as the choice of depreciation. The P/E model can’t be used in the case of negative earnings, and it’s difficult to employ if a firm has numerous divisions in different industry sectors. In addition, it is difficult to use this method if comparable firms have very

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In-Depth

The Price-Earnings Model and the Constant Growth Dividend Discount Model

Although very different looking, the price-earnings model is actually strongly connected to the constant growth dividend discount model presented in Chapter 8. If we assume a constant payout K of dividends from earnings, we can replace DIV1 and rewrite the formula to incorporate earnings per share, as shown here: P0 =

K * EPS1 (r - g)

Then, by rearranging the equation, we can solve for the price-earnings multiple: P0 EPS1

=

K (r - g)

We see that, all else equal, the forward-looking price-earnings multiple is directly related to growth—because a higher g is associated with a higher P0/EPS1—and inversely related to risk—because a higher r (the expected or required return by common share investors) is associated with a lower P0/EPS1.

different capital structures. Finally, with this method it is difficult to explore value creation— for example, how the value might change if the firm improves its working capital management.

13.4.3 The Enterprise Value-to-EBITDA Method

enterprise value-to-EBITDA model: A model of the intrinsic value of a firm based on projected EBITDA

FIG 13.14 The EV/EBITDA Valuation Model

One of the disadvantages of the price-earnings valuation model—its focus on earnings— is overcome by the enterprise value-to-EBITDA model (or simply the EV/EBITDA model), which values an overall firm (or enterprise) as a multiple of its projected EBITDA. Like the price-earnings method, the EV/EBITDA model is a relative valuation approach. The EV/EBITDA model involves a two-step process: first estimating firm value, or EV, then subtracting other claims (such as debt) in order to isolate the value of equity— similar to the last step in the free cash flow to the firm model. The steps are formalized in Figure 13.14. Recall that EBITDA represents earnings before interest, taxes, depreciation, and amortization. Because the noncash items—depreciation and amortization—are added back to the firm’s EBIT or operating profits, EBITDA represents a simple proxy for cash flows from operations. Forecasts of EBITDA can be arrived at through consensus

Step 1 EV0 = (appropriate forward-looking EV/EBITDA multiple) x EBITDA1 where

EV0

= estimated enterprise value today appropriate forward-looking EV/EBITDA multiple is based on “comparables” assessment

EBITDA1 = projected EBITDA next year Step 2 VE = EV0 − VD − value of other claims

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EBIT + Depreciation

$40,000

295

FIG 13.15 EV/EBITDA Valuation

4,000

EBITDA $44,000 Appropriate forward-looking EV/EBITDA multiple

10.00

Enterprise value (EV ) = $440,000 Value of debt (VD) =

100,000

Value of equity (VE) = $340,000

forecasts, management guidance, or our own projections. Determining the appropriate forward-looking EV/EBITDA multiple involves similar comparable analysis as in the price-earnings valuation approach—estimating appropriate multiples based on similar firms, adjusted for growth prospects and risk. Once we multiply the forward-looking EV/EBITDA multiple by a firm’s projected EBITDA1, we arrive at our estimate of the overall enterprise value, EV0, or firm value— step 1 in Figure 13.14. Then, as indicated in step 2, to estimate the value of the firm’s equity, VE, we subtract our estimate of the value of debt, VD, as well as any other claims on the firm’s assets—for example, the value of preferred shares. Let’s return to our Even Better Traps example. A summary of our calculations is presented in Figure 13.15. Recall that year 1 EBIT was estimated to be $40,000 and depreciation was estimated to be $4,000. Now let’s suppose that, based on a comparable analysis, we determine that an appropriate forward-looking EV/EBITDA multiple is 10 times, which reflects our assessment of the growth prospects and risk of Even Better Traps in comparison with peer firms within the same industry. Consequently, the estimated enterprise value, EV0, is estimated to be 10 times $44,000, or $440,000. If we then subtract the value of debt, VD, we arrive at an estimated equity value, VE, of $340,000—which is similar to the estimate derived from our discounted cash flow approaches.

13.4.4  Pros and Cons of the EV/EBITDA Approach The EV/EBITDA approach has several advantages compared to the price-earnings approach. Because EBITDA is measured before interest and depreciation expenses are deducted, this method minimizes potential distortions from capital structure differences, as well as from fixed asset differences across firms when performing comparable analysis. For example, if two firms named Alpha and Bravo are of similar size but Alpha relies much more heavily on debt than Bravo, Alpha may have lower earnings because of interest expenses. Alternatively, if Bravo has more fixed assets than Alpha, it might have a higher level of depreciation and hence lower earnings. Also, because the EV/EBITDA approach is more of a cash flow-oriented method, there is less room for accounting discretions. Of course, this approach does suffer the disadvantages of all other relative valuation models because it’s based only on a one-year snapshot of a firm’s prospects. Thus, while the EV/EBITDA model offers the benefit of relative simplicity, it lacks the richness of the discounted cash flow models. Although other relative valuation models exist—for example, those based on sales or cash flow multiples—we must recognize that any valuation model is only as good as its underlying assumptions, regardless of the simplicity of its calculations or the complexity of its spreadsheets.

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In-Depth

Comparing P/B, P/E, and EV/EBITDA across Industries

How do various relative value metrics—price-to-book, price-earnings, and enterprise value-to-EBITDA—compare across selected industries? Aswath Damodaran, a finance professor and expert on valuation, has compiled a large database, available free online. Here is a summary of selected ratios across various industries. Industry

Price/BV Price/EPS1 EV/EBITDA

Advertising

2.0 18.2 7.8

Aerospace/Defense 3.1 15.5

7.4

Apparel

3.4 17.7 11.7

Automotive

1.3 10.0 7.5

Bank

1.0 14.4 4.9

Beverage

4.5 17.1 12.7

Biotechnology

4.6 47.4 22.5

Building Materials

1.7

67.3

14.5

Computer Software

3.9

37.6

9.7

Drug

3.0 22.2 8.9

Electronics

1.9 15.9 6.6

Entertainment

2.4 12.3 9.5

Funeral Services

2.1

Homebuilding

2.5 83.5 21.1

Hotel/Gaming

3.1 23.0 10.7

Household Products

3.8

14.8

Industrial Services

2.3

17.7

8.9

Information Services

3.9

39.9

10.9

IT Services

4.4

25.4

12.2

15.0

9.7

11.1

Machinery

2.8 16.4 9.9

Medical Services

2.0

20.8

6.0

Metals & Mining

2.3

16.3

5.3

Natural Gas Utility

2.0

21.1

9.9

Newspaper

2.7 11.8 8.7

Office Equip/Supplies

1.1

15.5

4.8

Oil/Gas Distribution

3.6

27.8

12.0

Paper/Forest Products

1.9

19.2

7.2

Precious Metals

1.6

18.0

7.2

Property Management

1.7

18.3

16.0

Publishing

3.4 11.7 8.8

Railroad

3.0 14.6 9.1

Restaurant

6.7 19.5 11.5

Retail Store

2.9

14.8

8.4

Retail/Wholesale Food

3.2

14.0

8.3

Securities Brokerage

0.9

13.7

8.8

Semiconductor

2.7 30.2 7.0

Steel

0.9 15.7 5.6

Toiletries/Cosmetics 6.0 15.9 10.1 Total Market

2.1

23.8

7.4

Source: http://pages.stern.nyu.edu/~adamodar/ (accessed February 27, 2013)

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297

13.5  Creating Value and Value-Based Management Up to this point, we’ve focused on measuring the value of a firm. With the preceding information in mind, we now turn our focus to the ways in which management can create value for a firm. Many corporations have attempted to fulfill their primary mandate to maximize shareholder value by implementing value-based management programs, which are strategic management approaches that aim to develop a culture focused on value creation. Probably the best-known program is the economic value added (EVA) approach instituted by the Stern Stewart consulting group. Economic value added is both a measure of value creation as well as a process for attempting to create value. The notion behind EVA is that managers cannot add value until they know where and how value can be created. Thus, EVA is often viewed as both a measurement tool and a management process. If a firm generates positive EVA in a particular year, then it’s adding shareholder value; conversely, if it generates negative EVA, it’s destroying shareholder value. If a firm’s EVA is zero, then the firm is just compensating investors for the risk they’ve taken on and is neither creating nor destroying value. Accordingly, the EVA process looks for ways to create positive EVA. The EVA concept is fairly simple. It suggests that in order to make relevant business decisions, we must consider all costs associated with those decisions. Typical financial statements have shortcomings related to business decision making. They don’t present all relevant information related to the economic costs associated with generating revenues. In particular, the cost of raising equity—the return required by equity shareholders— doesn’t appear on a firm’s income statement, yet we know that equity is not free. The EVA approach attempts to measure “true” economic profit by incorporating the cost of all forms of capital used to generate the profit. As such, proponents of EVA claim that the EVA measure is more closely related to changes in shareholder value (i.e., changes in stock prices) than to changes in accounting measures such as earnings per share. Like the DCF approach, EVA assumes a business is worth the present value of anticipated net cash flows discounted by the cost of capital, less the amount invested in order to generate future cash flows. Thus, there are three key value drivers:

Objective 13.5

Explain economic value added measurement and process.

Net operating profits after tax (NOPAT), which are similar to part of the free cash flow concept, EBIT * (1 - t) The investment in capital The cost of capital The EVA approach helps define the first two value drivers by starting with accounting statements and making adjustments where appropriate to reflect true profits and investments. It then incorporates the third value driver, the cost of capital, by accounting for all forms of financing, including equity financing. Economic value added is a one-period measure of true economic performance, just as after-tax earnings are a one-period measure of accounting profit. As with earnings, EVA is defined for a particular period, such as a year. There are two methods by which EVA is calculated. The first formulation is presented in Figure 13.16. We can interpret EVA as a firm’s net operating profit less an opportunity cost for all invested capital. This notion that profits (or NOPAT) should satisfy capital investors (as indicated by the capital charge term) was first introduced in Chapter 10. Traditional financial statements include only interest costs associated with any debt and not the return required or expected by equity holders, which is included in the EVA approach. Economic value added can also be interpreted as the amount by which profits exceed (or fall short of) the required minimum rate of return investors could receive by investing in other securities of comparable risk.

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value-based management: A strategic management approach that assists firms in developing a culture that focuses on value creation economic value added (EVA): A firm’s or business unit’s after-tax operating profit less a charge for the capital employed

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FIG 13.16 Economic Value Added Method 1

EVA = EBIT × (1 − t) − invested capital × kc = NOPAT − invested capital × kc = NOPAT − capital charge where EVA

= economic value added

EBIT

= earnings before interest and taxes

t

= tax rate

invested capital = amount of permanent financing (debt and equity)

FIG 13.17 Economic Value Added Method 2

kc

= cost of capital

NOPAT

= net operating profit after taxes = EBIT × (1 − t)

EVA = NOPAT − invested capital × kc = ROCE × (invested capital) − (invested capital × kc) = (ROCE − kc) × invested capital where EVA

= economic value added

NOPAT

= net operating profit after taxes

invested capital = amount of permanent financing (debt and equity)

return on capital employed (ROCE): A measure of the effectiveness of the utilization of a firm’s invested capital: the ratio of net operating profits after tax, to invested capital return on assets (ROA): A measure of the effectiveness of the utilization of a firm’s assets: the ratio of net earnings less preferred dividends, to total assets market value added (MVA): The difference between the market value of common equity and the book value

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kc

= cost of capital

ROCE

= return on capital employed = NOPAT/invested capital

We can also represent EVA in a slightly different (but equivalent) manner, as in ­ igure 13.17. In this second formulation, we reinterpret NOPAT as the return on F ­capital employed (ROCE) multiplied by the amount of capital invested or employed. The ROCE is measured as NOPAT divided by invested capital and is also referred to as return on net assets (RONA). We can clearly see that EVA depends on both the amount of capital employed and the spread between ROCE and kc. Thus, one key to creating value is to identify opportunities or market segments where a firm has a competitive advantage and is able to earn a positive spread—that is, where the firm earns a return in excess of its cost of capital—or the overall sector is a profitable one. Identifying such opportunities or markets relates back to our discussion of business size-up in Chapter 2. Let’s consider Home Depot and estimate its EVA for the year ending January 29, 2012, as shown in Figure 13.18. Home Depot is creating value by providing its equity shareholders with a return that exceeds the required return of the shareholders. For simplicity, we’ve assumed that the accounting measures employed by Home Depot truly reflect the firm’s economic realities. In some situations, however, this may not be the case. As such we may need to make adjustments to both NOPAT and capital. Nevertheless, it is often common practice to simply report a first-pass EVA as shown in Figure 13.18. One criticism of EVA is that it is simply a one-period historical performance measure. In response to this criticism, Stern Stewart created a related measure known as market value added (MVA), defined as the difference between the market value of the firm and the invested capital. The MVA for Home Depot is estimated in Figure 13.19. The market value of the firm is defined as the market value of the firm’s debt plus common equity plus preferred shares (or other claims, if any). Because the market value of debt

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Operating profit (EBIT)

6,661

Tax rate (t) 36.01%

299

FIG 13.18 Home Depot Economic Value Added (EVA)*

EBIT * (1 - t) = NOPAT 4,262 Invested capital

30,832

Cost of (kc) 6.19% Capital charge = invested capital * kc 1,908 EVA = NOPAT – capital charge ROCE = NOPAT/invested capital

2,355 13.82%

ROCE - kc 7.64% Invested capital EVA = (ROCE - kc) * invested capital

30,832 2,355

*Amounts in $ millions, except percentages.

Market value of equity

69,931

Value of debt

12,934

Market value of the firm

82,865

Invested capital

30,832

MVA = market value of the firm - invested capital

52,033

FIG 13.19 Home Depot Market Value Added*

*Amounts in $ millions.

is often difficult to estimate in practice, the book value of interest-bearing debt is used as a proxy for the market value of debt. Invested capital is the total amount invested initially by the various stakeholders. A positive MVA indicates that the market believes the firm has created value for its stakeholders. An alternative interpretation of MVA is that it represents the present value of anticipated EVAs, discounted at the appropriate cost of capital. Thus, a firm might have had a negative EVA last year, but it still might have a positive MVA if the market anticipates future EVAs to be positive. In this example, not only did Home Depot have a positive EVA in the previous year, but it also has a substantially positive MVA, suggesting that the market expects Home Depot to continue to invest in positive NPV projects and hence continue to create positive EVA in the future. So how can a firm create value? One way is to improve the rate of return on the existing capital base, or increase the NOPAT relative to the current amount of capital employed. This could be the result of either increased revenues or decreased costs. Another method is for the firm to invest more capital in attractive projects with positive spreads or with returns that exceed the cost of capital. And yet another method is for the firm to stop investing in projects that have returns less than the appropriate cost of capital. Economic value added can be used to set goals and gauge performance against competitors. It can be used for capital budgeting decisions—meaning that a company chooses only to invest in projects that are expected to provide positive EVAs. It can also be used as a measure for developing compensation incentives. The EVA measure has the benefit of being conceptually simple, applicable to business units (in addition to the firm as a whole), and (as suggested in some studies) correlated with stock price performance. There are, however, a number of limitations to EVA. Much training and education is required at all levels of an organization to use it effectively, and commitment to an EVA process is

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required from top management. An appropriate cost measurement system is also required. In addition, compensation plans may need to be amended. For example, to avoid a shortterm focus on increasing EVA in just one year, a “bonus bank” may need to be created whereby bonuses are not strictly cash payouts but have a banked portion that depends on the sustainability of EVA improvements. Finally, employees need to be encouraged to maintain a forward-looking outlook despite the backward-looking nature of the measure.

13.6  Valuing Mergers and Acquisitions Objective 13.6

Describe reasons for acquisitions and explain comparable transactions valuation methods.

merger: The combination of two entities, typically of similar sizes, into one acquisition: The combination of two entities, typically of different sizes, into one synergies: The additional value created by the combination of two entities into one, through increased revenues or reduced costs

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Mergers and acquisitions, commonly referred to as M&As, as well as other corporate restructurings such as spin-offs, are often undertaken when firms attempt to add shareholder value. Mergers and acquisitions have long played an important role in the growth of firms. Companies can grow either internally through retained earnings or externally through additional financing or M&As. A merger involves the formation of a new economic unit from two or more units. Mergers usually imply the melding of firms of similar size. An acquisition has a similar outcome but usually involves a much larger firm acquiring control of a smaller firm. It is my observation that virtually all M&As actually involve one larger firm acquiring a smaller firm, but in order to soothe bruised egos among the acquired firm’s management team, it helps for them to think they are simply merging rather than being acquired! One reason for an acquisition is the possibility of lowering costs—for example, through stronger purchasing power or greater management efficiency, known as synergies. Through these synergies, the combined entity should be worth more than the value of the individual firms as separate entities. This is known as the “two plus two equals five” argument for an acquisition. In addition to creating pure synergies such as economies of scale or the ability to increase profits through cross-selling, acquisitions may occur because one firm’s management team perceives the current management of another firm to be inefficient and feels it could do a better job. “Agency problems” occur when agents, such as managers, must be motivated to act on behalf of principals, such as shareholders. For example, an agency problem occurs when managers incur costs to satisfy their own personal needs—like fancy offices and corporate cars—rather than creating shareholder value. If management is more concerned with its own well-being or perks, then shareholders ultimately suffer. An acquisition can alleviate agency problems by removing such managers. Often, M&A activity occurs in cycles and is concentrated in certain industries at various times. Figure 13.20 shows merger waves (number of deals) over more than a century. In order to be successful, a firm’s corporate strategy must be appropriate, funding must be available, new value must be identified, and the economic environment must be positive. If success is defined from the perspective of shareholder returns before and after the merger, not all mergers are successful. Sometimes, firms overpay relative to the actual value of the acquired firm due to overoptimistic assumptions. For example, forecasted economic conditions and synergistic gains may not be reasonable. Post-integration may be more problematic than anticipated. Also, in the heat of the battle to acquire a firm, the bidding firm may simply overpay. In many ways, valuation in an M&A situation is similar to other valuation situations. For example, discounted cash flows can be estimated and comparable analysis can be performed. However, there are some unique considerations. For example, the value placed on a target firm by a potential buyer may differ from the value placed on the firm by the potential seller. The potential seller looks at the business from the perspective of running it as is, whereas the potential buyer looks at it from the perspective of any value added through synergies as well as increased management efficiencies.

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FIG 13.20 Merger Waves

8,000 Approximate Number of Deals

301

7,000 6,000 5,000 4,000 3,000 2,000 1,000

00

95

20

90

19

85

19

80

19

75

19

70

19

65

19

60

19

55

19

50

19

45

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40

19

35

19

30

19

25

19

20

19

15

19

10

19

05

19

19

19

00

0

Year

Source: Adapted from Marina Martynova and Luc Renneboog. “A Century of Corporate Takeovers: What Have We Learned and Where Do We Stand?” Journal of Banking & Finance 32,10 (2008): 2148–2177. Maximum value of target firm to buyer = value to seller + value added by buyer

FIG 13.21 Acquisition Valuation Model

The framework in Figure 13.21 addresses the issue of how much a target buyer should be willing to pay. The first element, value to (potential) seller, represents the current value of the firm to the present owners. This is the value the current owners derive on the basis of the existing or planned operations of the business. This amount can be estimated by the discounted cash flow (DCF) process or the relative valuation methods previously described. The second element, value added by (potential) buyer, consists of several components: (1) the present value of any estimated synergies; (2) the value added by the potential buyer through a new strategy after the acquisition, such as taking advantage of new market opportunities that are not available to the existing owners; (3) the value of any sale of redundant assets after the acquisition, such as the sale of property or buildings that are not required to run the combined entity; and (4) the present value of any financial benefits resulting from a revised credit rating or the availability of funds. By combining the two elements—value to seller and value added by buyer—we have an estimate of the maximum value the buyer should be willing to pay. Quite clearly, this amount will be more than the current value to the seller. This difference demonstrates why a premium of 20 to 30 percent above the current target share price is often offered in acquisition situations.

13.6.1  Valuing Comparable M&A Transactions In addition to DCF and relative valuation methods for valuing M&As, we can rely on comparable transactions, or similar M&As that have occurred recently in a similar industry, as a guide for the prices target firms may find acceptable. For example, we can compile a list of recent acquisitions and determine what the average EV/EBITDA was for those acquisitions, assuming a new acquisition can be completed at a similar EV level. Another approach is to examine the average premium paid for similar transactions above the prices at which those firms were trading before they became takeover targets, again assuming a new acquisition can be completed at a similar premium. This comparable transaction

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comparable transactions: Similar transactions that have occurred recently in a similar industry, used as a guide for what prices target firms may find acceptable

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analysis is certainly not rigorous, and no two acquisitions are identical—for example, growth prospects and assessed risk may vary considerably—but the analysis can provide some simple and rough guidelines for the prices the target firm may expect.

13.7 Relevance for Managers Objective 13.7

Explain why valuation measurement and creation is relevant for managers.

Valuation measurement and creation matters for financial and nonfinancial managers alike. Understanding value is also critical for private firms as well as public firms. Chief financial officers need to measure the value of assets involved in both potential acquisitions and potential dispositions in order to determine a fair price at which to buy or sell. Similarly, if you work for (or aspire to work for) a publicly traded firm, you need to understand why your stock is selling for the price that it is. By estimating its intrinsic value, you can determine whether your stock appears overvalued or undervalued. Any time a project is being considered—for example, buying a piece of equipment, expanding a plant, providing a new service, entering a new market, or acquiring another firm—a firm’s managers need to determine whether the investment is worthwhile. To do so, they must understand the critical components of valuation measurement. For instance, they need to understand the cash flows that will be created, the cost of capital, the expected growth of cash flows, and the future value of certain assets. A firm’s managers must also know how their firm is viewed in the marketplace relative to its competitors. For instance, if you work for a publicly traded firm, you might wonder why investors are rewarding the firm with a higher EV/EBITDA multiple compared to its peers or why the firm is being punished with a lower multiple. Answers to such questions are related to the two key value drivers: growth and risk. Perceptions are important. If the firm can convince market participants that it has promising growth prospects or that it has the ability to generate future cash flows without undue risk, then it will be rewarded with higher multiples and hence higher stock prices. Regardless of whether you are with a public or private firm, your primary goal should be value creation—making your firm more valuable. Value creation can involve increasing revenue, decreasing costs, improving working capital management, and investing more effectively—for example, by maintaining revenue with fewer assets. Your compensation, including any bonuses, may depend on value creation within your firm. Investing in positive net present value projects creates value. Anything you do that positively impacts growth prospects or mitigates risk helps create value.

Summary

1. Investing in positive net present value projects creates value. 2. The book value plus adjustments approach starts with a firm’s book value of equity and adjusts for any “hidden value” such as property that may be worth more than its book value. The method is simple, but the approach does not take into account the ongoing nature of a business.

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3. With the discounted cash flow (DCF) method, free cash flows are estimated by anticipating operating profits, capital expenditures, and working capital needs. Present values are estimated and the value of debt and related obligations are subtracted to obtain an estimate of the value of the firm’s equity.

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4. The price-earnings (P/E) approach estimates the value of equity directly by forecasted expected earnings per share, then multiplies that amount by an appropriate forward-looking P/E multiple. The multiple is usually based on an analysis of comparable firms and should reflect both the growth prospects and the perceived riskiness of the firm relative to other firms in the industry. 5. The enterprise value-to-EBITDA method estimates the overall value of the firm or enterprise by forecasting expected EBITDA, then multiplying that amount by an appropriate forward-looking EV/EBITDA multiple. 6. Economic value added (EVA) is a value-based management tool and process that attempts to measure value added and enhance the value creation process. Economic value added is a measure of true economic profit and reflects the amount by which a firm’s profits exceed the required minimum rate of return investors could receive by investing in other securities of comparable risk. Market value added (MVA) is the difference between the market value of a firm and the invested capital.

303

7. Valuation is important in a mergers and acquisition (M&A) context whereby one firm acquires the assets of another firm. During this process, value is often created through synergies between the two firms. Comparable M&A transactions provide guidance on relative valuation multiples of previous transactions in the same industry as well as price premiums paid.

Additional Readings and Information

Thorough books on valuation are: Copeland, Tom, Tim Koller, and Jack Murrin. Valuation: Measuring and Managing the Value of Companies, 5th ed. New York: Wiley, 2010. Damodaran, Aswath. Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, 2nd ed. New York: Wiley, 2006. A classic book on valuing private firms is: Pratt, Shannon, and Alina Niculita. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. New York: McGraw-Hill, 2007. Stern Stewart’s Economic Value Added approach is described in: Stewart, G. Bennett III. The Quest for Value: The EVATM Management Guide. New York: HarperCollins, 1991. Ehrbar, Al. Stern Stewart’s EVA: The Real Key to Creating Wealth. New York: Wiley, 1998. Lessons from merger and acquisition activities are described in: Bruner, Robert. Deals from Hell: M&A Lessons That Rise Above the Ashes. New York: Wiley, 2005.

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Problems

1. PrivCo Inc. is a small private firm with a book value of assets of $550,000 and liabilities of $250,000. Its assets include property listed at a cost of $80,000 but with a recently assessed market value of $125,000. In addition, PrivCo has $60,000 of inventory that is entirely obsolete and has no liquidation value. Other assets are deemed to have liquidation values close to book values. Estimate the value of PrivCo’s equity based on the “book value of equity plus adjustments” method. 2. Free Cash Inc. is anticipated to make earnings before interest and taxes (EBIT) of $30,000, $40,000, and $50,000 in each of the next three years. Depreciation is estimated to be $3,000, $3,500, and $4,000 in each of the next three years. Capital expenditures are estimated to be $8,000, $9,000, and $10,000 in each of the next three years. Incremental increases in working capital requirements are estimated to be $2,500, $3,000, and $3,500 in each of the next three years. Free Cash Inc.’s tax rate is 35 percent. Estimate the free cash flows to the firm for Free Cash Inc. for each of the next three years. 3. Free Cash Inc.’s cost of capital is estimated to be 9 percent. Free cash flows beyond year 3 are estimated to grow at an annual rate of 4 percent. Using this information and that provided in question #2, apply the growing perpetuity formula to estimate the terminal value of Free Cash Inc. as of year 3. 4. On the basis of the following information, estimate the free cash flow for Avondale Inc.: EBIT 5 $120,000; tax rate (t) 5 30 percent; noncash expenses 5 $12,000; capital expenditure 5 $16,000; and net increases in working capital 5 $8,000. 5. Using the FCFF in question 4, calculate the terminal value (TV) if the cost of capital is 15 percent and the growth rate is 5 percent.

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6. Relever Inc. has a debt-to-equity (D/E) ratio of 0.3; its target D/E is 1.6. Relever currently has an estimated beta of 1.1. Relever’s estimated tax rate is 35 percent. What is the estimate of Relever’s beta at its target D/E? 7. Pepper Inc. is expected to have before-tax earnings of $2.5 million next year. The tax rate is 35 percent. There are 2 million common shares outstanding. Comparable firms in the same industry are estimated to have price-earnings multiples of 10 to 16. Estimate the intrinsic value of Pepper’s share price based on the price-earnings method. 8. Extra Value Inc. is expected to generate EBIT of $20 million next year, with anticipated depreciation and amortization of $3 million. Extra Value has debt of $40 million. Comparable firms are trading at average forward-looking EV/EBITDA ratios of five times. Based on the EV/EBITDA method, estimate the value of Extra Value’s equity. 9. If the EBIT is $120,000, calculate the EVA based on the following information: tax rate (t) 5 40 percent; invested capital 5 50,000; and cost of capital 5 16 percent. 10. Calculate the market value added (MVA) on the basis of the following information: market value of equity 5 70,000; value of debt 5 15,000; and invested capital 5 35,000. 11. Bigco Inc. is considering acquiring Smallco Inc., a publically traded firm in the same industry. Smallco is currently trading at $12 per share and has 20 million shares; it is believed to be trading at its fair value. Bigco feels that the present value of potential synergies is $50 million. What is the highest bid price that Bigco should consider paying for Smallco shares?

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14

Comprehensive Case Study: Wal-Mart Stores, Inc. Learning Objectives Obj 14.1

We now near the end of our long journey through the wonderful world of finance. We can now bring together all the parts of our financial management framework, reproduced in Figure 14.1. As we reflect on Figure 14.1, let’s take a moment to briefly review how each chapter in this book fit within the larger framework: We began with Chapter 1, which introduced the financial management framework and provided an overview of finance and financial management. After that, Chapter 2 focused on the external environment, examining how general economic conditions and key industry factors affect a firm’s financial health. The next four chapters looked inward, concentrating on a firm’s operating activities and growth prospects. More specifically, Chapter 3 explored financial statements; Chapter 4 examined performance measures; Chapter 5 focused on working capital management; and Chapter 6 presented a method for projecting a firm’s future profits and financial requirements. In Chapters 7 and 8, we concentrated on investment activities. In particular, Chapter 7 introduced time value of money concepts, and Chapter 8 examined how we can assess a firm’s investment decisions. Over the next four chapters, we turned our focus to financing activities and risk. To that end, Chapter 9 presented an overview of capital markets; Chapter 10 examined how we measure a firm’s cost of capital; Chapter 11 investigated financing and payout decisions; and Chapter 12 focused on designing an optimal capital structure. Finally, Chapter 13 completed our framework with a look at how to measure a firm’s value. It also explored some ways in which value can be created. We’re now in a position to apply the frameworks and techniques introduced in Chapters 1 through 13 through a comprehensive case study of the world’s largest retailer (as measured by revenues), Wal-Mart Stores, Inc. (Walmart). Based in Arkansas and founded by the legendary Sam Walton, Walmart has over 10,000 retail units worldwide, including stores in all 50 states and Puerto Rico, as well as in 26 other countries. The firm has more than 2 million employees and 200 million customers. Walmart is best known for its discount stores (Walmart Stores), but it also runs combined discount and grocery stores

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Describe economic conditions, the retail industry, and Walmart’s strengths and weaknesses in operations, marketing, management, and strategy, and assess Walmart’s financial health. Obj 14.2

Describe the process for projecting Walmart’s income statement and balance sheet. Obj 14.3

Describe the process for estimating Walmart’s cost of capital. Obj 14.4

Describe the process for estimating Walmart’s economic value added and intrinsic value based on the discounted cash flow method and comparable analysis, and explain how Walmart can attempt to create value. Obj 14.5

Explain the tools acquired through reading this book.

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FIG 14.1  Financial Management Framework

external environment economy

industry

the enterprise

financing

• Expansion/recession • Interest rates • Credit conditions • Financial markets

• Operations/ suppliers • Marketing/ customers • Working capital • People

Financial Leverage

operating

• Debt financing • New equality • Dividend policy

Profit Margin

• Competition • Technology • Regulation • Key success factors

investing Asset Turnover

•C  apital expenditures • Long-term projects

Managing the risk profile

Growing profits, dividends, cash flow

growth

risk Cost of capital

Return on equity

value creation (Walmart Supercenters), membership-only warehouse stores (Sam’s Club), and smaller grocery stores (Neighborhood Markets). Walmart’s motto is “Helping customers save money and live better.” The firm is organized into three business segments: Walmart U.S. includes the firm’s U.S. discount and grocery operations, as well as its online retail operation, walmart.com. As of the fiscal year ending January 31, 2012, Walmart U.S. accounted for 60 percent of the firm’s net sales. Walmart International consists of retail operations in numerous formats, including retail stores, restaurants, Sam’s Clubs, and online retail operations outside the United States. As of January 2012, it made up 28 percent of the firm’s overall sales. Finally, Sam’s Club consists of membership warehouse operations in 47 states and Puerto Rico, as well as the online operations of samsclub.com. As of January 2012, it accounted for 12 percent of Walmart’s net sales. In the spring of 2012, Walmart had just released its results for the fiscal year ending January 31, on which date its shares were selling for $61.36. Let’s see how we can use the frameworks and techniques described in previous chapters to do the following: Assess current economic conditions. Understand Walmart’s position in its industry and identify industry key success factors.

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Assess Walmart’s strengths and weaknesses in terms of operations, marketing, and management, as well as the firm’s strategic focus. Assess Walmart’s recent financial performance and overall financial health in terms of liquidity, resource management, capacity to issue debt, and profitability. Determine Walmart’s profitability outlook and financing needs over the next year. Assess the extent to which Walmart has been able to generate economic value added over the past year. Assess the intrinsic value of Walmart’s shares relative to the current market value. Identify possible ways by which Walmart can attempt to create value for its shareholders Our first step, as discussed in Chapter 2, is to gather information. Then, once we’ve compiled the appropriate information, our second step is to perform an analysis of the gathered data, as we’ll do in the following sections.

14.1 Sizing-Up Walmart Let’s begin our analysis by assessing Walmart’s current business environment (as of the spring of 2012) through a size-up (or SWOT analysis) of external factors, including the larger industry and the economy as a whole. We’ll then continue our size-up by looking at Walmart’s internal strengths and weaknesses in the areas of operations, marketing, and management. Through this process, we’ll identify various opportunities and risks facing Walmart and the financial implications of each. Finally, we’ll assess the financial health of the firm through an analysis of financial ratios. Through these steps, we’ll put ourselves in a better position to meaningfully interpret Walmart’s financial information and performance.

Objective 14.1

Describe economic conditions, the retail industry, and Walmart’s strengths and weaknesses in operations, marketing, management, and strategy, and assess Walmart’s financial health.

14.1.1 Analyzing the Economy As previously mentioned, one of the most important elements of our business size-up is an examination of external factors, including the overall economy in which Walmart operates. Of course, to better understand economic conditions in early 2012, we must first look back a few years. In doing so, we see that the United States suffered a major recession between December 2007 and June 2009. Then, from June 2009 until the spring of 2012, the nation’s economy entered a mild recovery stage, with 2010 real GDP growth of 3.0 percent and 2011 real GDP growth of 1.7 percent. This overall growth in GDP was fueled primarily by increases in personal consumption and exports. Still, decreased federal spending meant that the growth rate in 2011 was lower than that in 2010. According to the International Monetary Fund’s World Economic Outlook for the United States in the spring of 2012, there were signs of expansion in employment, but there was also continuing weakness in the housing market and potential negative spillover from economic problems in Europe. Inflation had been muted, but there was the possibility of an increase in inflation due to higher oil prices. Real GDP growth for the United States in 2012 and 2013 was forecast at 2.0 percent and 2.5 percent, respectively, indicating average expected growth relative to historical growth rates. Globally, real GDP growth in 2012 and 2013 was expected to be similar to that in 2010, around 4 percent. Early 2012 was also a period of political uncertainty, due to both the upcoming presidential election in November and the perceived gridlock in Congress as Republicans and Democrats disagreed on major fiscal issues. In the area of fiscal policy,

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long-term government bond yields had dropped by around one-and-a-half percentage points since the beginning of 2011. Borrowers were benefitting from lower rates, and the yield curve was strongly upward sloping. Despite low long-term rates, short-term trea­ sury bill rates were also near historic lows. Here, the Federal Reserve had aggressively pursued lower short-term rates in hopes of spurring economic growth, which in turn would lead to higher employment. Consumer confidence had improved substantially over the past several years. According to the Thomson Reuters/University of Michigan Index of Consumer Sentiment released in February 2012,1 although consumer confidence was still well below historical averages, a marked improvement had occurred in the prior twelve months.

Key Economic Take-Aways

The key take-away from our size-up of overall economic conditions in early 2012 is that the U.S. economy was expected to grow at a moderate rate, with moderate inflation. Continued low interest rates would help drive consumption and keep firms’ borrowing costs low. Given the importance of the consumer sector to overall GDP, the retail sector, and firms like Walmart in particular, any potential strengthening in consumer confidence would have a positive impact on the economic outlook and on retail businesses. In fact, world-wide economic outlook was cautiously optimistic—which was positive news for global firms such as Walmart.

14.1.2 Analyzing the Industry Now that we have a basic understanding of general economic conditions in the spring of 2012, let’s consider the other major external factor affecting Walmart: industry conditions. Walmart is in the retail industry and considered a general merchandise store, but it also competes against grocery stores and has an increasing Internet retail presence. What sorts of trends did experts observe in these industries, and what was their forecast for the coming year? To begin to answer these questions, let’s consider a 2012 report in which the consulting firm KPMG surveyed top retail industry executives about current business conditions, growth opportunities, and barriers to growth. The title of this report summarized the overall results: “Retail Industry Outlook Survey: Modest Gains Keep Cautious Optimism in Style.”2 According to the report, the executives were not expecting a substantial U.S. recovery until 2014, although two-thirds were expecting improved business conditions in 2013. Adding customers was anticipated to be the largest driver of revenue growth, followed by retaining customers and market expansion. One of the biggest concerns expressed by the executives was a possible decrease in consumer confidence. Increases in merchandise costs and discounting were seen as the biggest threats to profits, whereas decreases in selling, general, and administrative (SG&A) expenses 1

See Richard Curtin, “Job Growth Maintains Consumer Confidence,” Survey of Consumers, Thomson Reuters University of Michigan, February 24, 2012, http://thomsonreuters.com/content/financial/ pdf/i_and_a/438965/2012_2_24_job_growth_maintains_consumer_confidence.pdf (accessed May 30, 2013). 2 See http://www.kpmg.com/US/en/IssuesAndInsights/ArticlesPublications/Documents/retail-industry-

outlook-survey.pdf (accessed May 30, 2013).

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FIG 14.2  Porter’s Five Forces for the Retail Industry

Low Threat of new entrants

Medium/high Low

Bargaining power of suppliers

Intensity of rivalries

Bargaining power of customers

Low

Threat of substitutes

Low

were viewed as the best strategy to combat those threats. Retail firms included in the survey tended to have significant amounts of cash on their balance sheets, and most planned to increase spending on information technology (including data analytics), new products and services, and geographic expansion. Finally, online shopping trends were clearly on the executives’ radars. As part of our size-up, we can also consider the retail industry from a life-cycle perspective. If we consider revenue growth since 2002, we can make a strong case that the overall retail industry was in a phase of stabilization/maturity in early 2012, while the Internet retail industry was experiencing rapid growth. Based on this assessment, we can anticipate that any long-term growth in retail revenue will tend to occur at a similar rate as growth in the overall economy—with traditional retail revenue expected to grow slightly below the rate of the overall economy and the Internet retail revenue expected to grow at a higher rate than the overall economy. The next step in our industry analysis is to consider Walmart’s competitive position. Although each country in which Walmart does business has unique economic, political, and social factors, the general competitive environment is similar. Recall Porter’s Five Forces model from Chapter 2, which identified five key contributors to the intensity of competition: the threat of new entrants, the threat of substitutes, the bargaining power of suppliers, the bargaining power of customers, and the intensity of rivalries among current competitors. These forces determine the overall profitability of an industry—but how do they affect the retail industry in general and thus relate to Walmart in particular? Let’s summarize in Figure 14.2. Figure 14.2 shows that there is little threat of new entrants to the retail industry, largely because of barriers such as large capital expenditures in plant and equipment as well as investments in distribution channels. There is also steady demand for both groceries and nonfood retail products, with no likely emergence of major substitute

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products. Suppliers appear to be numerous, so the bargaining power of suppliers does not appear to be a threat to profitability. Similarly, customers are individual consumers who do not wield major power, so the bargaining power of customers presents little threat. Rather, the largest potential impact on Walmart’s profit margins relates to the intensity of existing rivalries. Walmart faces myriad competitors in a variety of segments in which it competes. In the general merchandise area, Walmart’s main competitors include Sears, Target, and Kmart, as well as specialty apparel retailers like Gap and Limited. Department store competitors include Macy’s and J. C. Penney. Grocery store competitors include Kroger and Safeway. The major membership-only warehouse competitor is Costco Wholesale; the major drug retailing competitor is Walgreens; and a prominent online competitor is Amazon. Although many of these competitors are formidable, Walmart dominates due to its ability to achieve many of the key industry success factors described in the “takeaway” feature for this section, but it probably faces the largest threat in its online business segment.

Key Industry Take-Aways

Given the mature nature of most of the retail segments in which Walmart competes, long-term growth expectations for the industry as a whole should be similar to expectations for the overall economy (except the online retail segment, which is expected to grow at a greater rate). Thus, the overall industry outlook can be described as neutral. In other words, retail isn’t a growth industry, but it’s not expected to be in decline in the near future either. As a whole, the industry is anticipated to remain profitable. However, given the intense nature of existing traditional competition and the increasing threat of online competition, individual firms (including Walmart) may be challenged to grow their profits at the overall economic growth rate over the long term. Based on our general knowledge of the retail industry and comments by research analysts, we can compile a list of key success factors. To succeed in the retail industry, firms such as Walmart need to strive to be the lowest cost producer, or they must somehow differentiate their products. In terms of groceries, given the commodity-based nature of the industry, product differentiation is difficult. In other retail areas, product differentiation may be possible, but price (and hence low costs) is a key success factor. Another key success factor is the ability of firms to deliver quality products. Both price and quality can be combined into value. Service is another important factor, including availability of products and post-purchase satisfaction. Developing a strong brand through marketing is also crucial. All of these key success factors have important financial implications. For example, a firm’s pricing strategy affects its profitability, and its management of cash flows is crucial to efficient operations. In addition, capital expenditures are required to maintain facilities and provide growth, and marketing expenditures must be maintained.

14.1.3 Analyzing Walmart’s Strengths and Weaknesses in Operations, Marketing, Management, and Strategy

Next, an internal analysis of Walmart’s strengths and weaknesses in the areas of operations, marketing, management, and strategy will help us examine the firm’s ability to

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achieve industry key success factors. It will also help us better understand the financial analysis to follow.

14.1.3.1  Analyzing Walmart’s Operations  In terms of operations, Walmart

has a clear strategy of being the lowest-cost, lowest-priced competitor in the industry. By reducing costs, Walmart can maintain its profit margin even with lower prices, thereby increasing market share and increasing overall profitability. In fact, Walmart is renowned for its efficiency of centralized distribution and inventory control. The firm strives to maximize sales volume and inventory turnover while minimizing expenses. Walmart relies on its suppliers to provide quality goods. However, between 2010 and 2012, it was involved in a number of product and food recalls.

14.1.3.2  Analyzing Walmart’s Marketing  Walmart dominates most of its markets and offers a strong assortment of brands and products. The company attempts to have a special relationship with its customers, from the time they walk through the doors until they make their purchases. However, early in 2012, Walmart eliminated its famous smiley-faced “Welcome to Walmart!” greeters from night shifts and moved them from its lobbies to nearer its cash registers—a hotly debated action that was interpreted by some as a cost-saving measure that deemphasized the importance of service and by others as a modernization of an outdated concept. Walmart relies heavily on advertising to create a strong and recognizable brand. It spent $2.5 billion, or 0.5 percent of net sales, on advertising in the fiscal year ending January 31, 2012. During a similar period, Target, in comparison, spent 2.0 percent of its net sales on ads. Walmart’s marketing efforts emphasize the firm’s everyday low prices and attempt to capture a local connection with customers in particular communities while providing one-stop shopping. To meet competitive pressures, Walmart employs many programs, including “Everyday Low Prices” and “Price Rollbacks,” which pass along cost savings to customers. 14.1.3.3  Analyzing Walmart’s Management and Strategy Although Walmart’s founder Sam Walton died in 1992, his family still has a strong presence in the firm. Together, members of the Walton family own or control just under 50 percent of Walmart’s outstanding shares. In addition, Walton’s son S. Robson Walton currently serves as chairman of the board. With the chairman of the board representing family interests in particular, there is a clear alignment between management oversight and shareholder control. One of Walmart’s major strengths has long been its corporate culture, inspired by Sam Walton’s mission of saving people money so they could live better. Walmart’s management team works hard to achieve this mission and is often recognized for its efforts. For example, in Fortune magazine’s 2012 list of “most admired companies,” Walmart ranked twentyfourth out of 1,400 firms, due in part to the perceived quality of its management.3 According to the firm’s 2012 annual report, Walmart’s strategy for improving shareholder value emphasizes three priorities: growth, leverage, and return. Growth involves increasing sales through higher volumes at each “comparable” (i.e., same-size) store relative to the previous year, as well as increasing volume through greater square footage. Leverage refers to increasing operating income at a faster rate than growth in sales by increasing the firm’s operating, selling, and administrative expenses at a slower rate than the 3

See list at http://money.cnn.com/magazines/fortune/most-admired/2012/full_list/ (accessed May 30, 2013).

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growth in net sales—in other words, by reducing operating expenses as a percentage of net sales. In fact, Walmart’s stated goal is to reduce operating expenses as a percentage of net sales (currently 19.2 percent) by at least a full point over the next five years. And last, Walmart defines return as efficient use of the firm’s assets. Walmart’s internal return on investment (ROI) measure is EBITDAR (the usual EBITDA measure, but with the additional R that represents rent) relative to invested capital. Management attempts to improve the firm’s ROI by both better managing free cash flow (thus increasing EBITDAR) and better managing working capital (thus decreasing the amount of invested capital). Of course, a firm’s value isn’t solely driven by growth—it’s also driven by risk. But what sort of risks does Walmart face? Like other firms in the retail industry, Walmart could be negatively affected by any number of general economic factors, including inflation, consumer debt levels, currency exchange rates, trade restrictions, unemployment, and interest rates. The firm’s 10-K form lists several other common threats that could materially affect financial performance, including changes in the cost of goods; increased expenses (such as greater transportation, fuel, electricity, and labor costs); and competitive pressures that might force Walmart to sacrifice margin. In addition, management identifies a number of company-specific risks, including impediments to expansion (such as problems converting discount stores to supercenters); failure to retain qualified employees; competition from Internet-based retailers; supply risks and issues of product safety; regulatory, political, and economic risks that might affect the firm’s international operations; and failure to identify or effectively respond to consumer trends. Walmart is also involved in a variety of legal proceedings related to a compensation class action and a gender discrimination class action, as well as an internal investigation pertaining to potential violations of the Foreign Corrupt Practices Act.

Key Operating, Marketing, Management, and Strategy Take-Aways

Based on our reading of Walmart’s annual reports and 10-K filings, as well as comments by research analysts, we can reach several conclusions about the firm’s strengths. In terms of overall opportunities, Walmart’s size and dominant position give it tremendous clout relative to its competitors and allow it to pursue its successful low-cost, low-price strategy. In the United States, Walmart has the opportunity to increase its market share relative to its competitors in some of its key segments. Internationally, Walmart has made great inroads in many global locations, but it has room to grow. Still, Walmart faces several significant threats. For one, the firm’s ongoing legal proceedings introduce the possibility of monetary fines or settlements, although the cost of these is relatively low. A far greater threat is the reputational damage these lawsuits may bring, with potential customer loss that could hamper future revenue growth. Yet another potential risk is that Walmart’s online retail efforts might cannibalize its regular store sales.

14.1.4 Analyzing Walmart’s Financial Health Now, let’s begin our assessment of Walmart’s financial health by examining the firm’s 2011 and 2012 consolidated financial statements, presented in the figures on the next few pages. Walmart’s consolidated statements of income are presented in Figure 14.3, its consolidated balance sheets are presented in Figure 14.4, and its consolidated statements of cash flows are presented in Figure 14.5.

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Upon examining the consolidated statements of income (Figure 14.3), we see that Walmart’s net sales in the fiscal year ending January 31, 2012, grew by almost 6 percent relative to the previous fiscal year, slightly better than nominal U.S. GDP growth. Income from continuous operations grew modestly by about 3 percent. However, due to losses associated with discontinuous operations, consolidated net income shrunk by over 4 percent. Earnings per share grew modestly at just over 1 percent due to Walmart’s share repurchase program, which reduced the number of outstanding shares. In fact, in fiscal year 2012, Walmart spent $6.3 billion buying back over 115 million shares. Turning to Walmart’s consolidated balance sheets (Figure 14.4), we see that the firm’s assets grew by almost 7 percent. More specifically, its current assets increased by almost 6 percent, and its net property and equipment grew by about 4 percent. Also, the firm’s current liabilities and equity both grew by just over 6 percent, while its long-term debt grew by over 7 percent. Next, as we examine Walmart’s consolidated statement of cash flows (Figure 14.5), we see that the firm’s cash provided by operating activities grew modestly by 2.6 percent. Walmart continued to invest heavily in capital expenditures (i.e., property, plant, and equipment) as well as in acquisitions. Consequently, Walmart’s net cash used in investing activities increased by 36 percent. Because Walmart’s cash provided by operating activities exceeded its cash requirements for investing, it could use this extra cash to pay



Fiscal years ending January 31



2012 2011

FIG 14.3  Walmart Consolidated Statements of Income*

Revenues Net sales

$443,854

$418,952

3,096

2,897

446,950

421,849

335,127

314,946

85,265

81,361

Membership and other income Total revenues Costs and expenses Cost of sales Operating, selling, and general and administrative expenses Operating income Interest (net)

26,558 25,542 2,160

2,004

Income from continuing operations before income taxes 24,398 23,538 Provision for income taxes Income from continuing operations Income (loss) from discontinued operations, net of tax Consolidated net income Less consol. net income attributed to noncontrolling interest

7,944

7,579

16,454 15,959 (67) 1,034 16,387 16,993 (688)

(604)

Consolidated net income attributable to Walmart

$15,699 $16,389

Weighted average common shares outstanding

3,460 3,656

Basic net income per common share

$4.54 $4.48

*Amounts in $millions, except per share data. Source: Adapted from 2012 Walmart Annual Report.

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FIG 14.4 Walmart Consolidated Balance Sheets*



As of January 31



2012 2011

Assets Current assets Cash and cash equivalents Receivables, net Inventories Prepaid expenses and other Current assets of discontinued operations

$6,550

$7,395

5,937

5,089

40,714 36,437 1,685

2,960

89

131

54,975

52,012

Property and equipment

160,938

154,489

Less accumulated amortization

(48,614)

(46,611)

Property and equipment, net

112,324

107,878

Total current assets Property and equipment

Goodwill Other assets and deferred charges Total assets

20,651 16,763 5,456

4,129

$193,406 $180,782

Liabilities and Equity Current liabilities Short-term borrowings

$4,047

$1,031

Accounts payable

36,608

33,676

Accured liabilities and income tax

19,318

18,858

2,301

4,991

Long-term debt due within one year Current liabilities of discontinued operations Total current liabilities Long-term debt Deferred income tax and other Redeemable noncontrolling interest

26

47

62,300

58,603

47,079

43,842

7,862

6,682

404

408

71,315

68,542

4,446

2,705

75,761

71,247

Equity Walmart shareholders’ equity Noncontrolling interest Total equity Total liabilities and equity

$193,406 $180,782

*Amounts in $millions. Source: Adapted from 2012 Walmart Annual Report.

dividends and also buy back some shares—spending a collective amount of over $11 billion on these two activities. Also, since Walmart’s net cash used for investing and financing exceeded its net cash from operating activities by just under $1 billion, the firm’s cash on hand decreased by that amount between 2011 and 2012. Now that we have an overview of Walmart’s three major financial statements, let’s examine its financial health through ratio analysis. A summary of important performance measures in the four categories of profitability, resource management, liquidity, and capacity is

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Fiscal years ending January 31



2012 2011

315

FIG 14.5  Walmart Consolidated Statements of Cash Flows*

Cash flows from operating activities Consolidated net income Loss (income) from discontinued operations, net of tax Income from continuing operations Adjustments to reconcile to net cash provided by operating activities:

$16,387

$16,993

67

(1,034)

16,454

15,959

---

---

Depreciation and amortization

8,130

7,641

Deferred income taxes

1,050

651

398

1,087

(1,777)

(1,695)

24,255

23,643

(13,510)

(12,699)

580

489

(3,548)

(202)

(131)

219

(16,609)

(12,193)

3,019

503

Other operating activities Changes in certain assets and liabilities Net cash provided by operating activities Cash flows from investing activities Payments for property and equipment Proceeds from disposal of property and equipment Investments and business acquisitions, net of cash required Other investing activities Net cash used in investing activities Cash flows from financing activities Net change in short-term borrowing

5,050

11,396

Payments of long-term debt

Proceeds from issuance of long-term debt

(4,939)

(4,443)

Dividends paid

(5,048)

(4,437)

Purchase of company stock

(6,298)

(14,776)

Other financing activities Net cash used in financing activities Effect of exchange rate changes on cash and cash equivalents

(242)

(271)

(8,458)

(12,028)

(33)

66

Net increase (decrease) in cash and cash equivalents

(845)

(512)

Cash and cash equivalents at beginning of year

7,395

7,907

$6,550

$7,395

Cash and cash equivalents at end of year *Amounts in $millions. Source: Adapted from 2012 Walmart Annual Report.

presented in Figure 14.6. After that, Walmart’s financial ratios for 2012 and 2011 are presented in Figure 14.7 (some numbers may appear to be off slightly due to rounding). As shown in Figure 14.7, Walmart’s return on equity in 2012 was 22.0 percent, only slightly off 2011’s pace of 23.9 percent. Examining other profitability measures, we see that the firm’s gross margin was only slightly below that of the previous year, at 24.5 percent, and its EBIT margin was also only slightly lower at 6.0 percent. Its operating expense ratio was also slightly lower at 19.2 percent (compared to 19.4 percent the previous year), reflecting part of Walmart’s key “leverage” strategy described earlier. The firm’s net sales grew by 5.9 percent (from $418,952 million to $443,854 million), but its

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FIG 14.6  Performance Measures Summary

Performance Measure

Numerator

Denominator

Return on equity

Net income

Equity

Gross margin

Gross profit

Revenues

EBIT margin

EBIT

Revenues

Operating expense ratio

Operating expenses

Revenues

Return on invested capital

EBIT × (1 – tax rate)

Interest-bearing debt + equity

Fixed asset turnover

Revenues

Net property and equipment

Age of inventory

Inventory

Average daily cost of goods

Age of receivables

Accounts receivable

Average daily sales

Age of payables

Accounts payable

Average daily purchases

Current ratio

Current assets

Current liabilities

Quick ratio

Cash + accounts receivable

Current liabilities

Debt-to-assets

Total liabilities

Total assets

Debt-to-equity

Total liabilities

Equity

Long-term debt to capital

Long-term debt

Long-term debt + equity

Interest coverage

EBIT

Interest expenses

Debt service coverage

EBITDA

Interest + “grossed-up” principal

Profitability

Resource management

Liquidity

Capacity/leverage

operating, selling, and administrative expenses increased by just 4.8 percent (from $81,361 million to $85,265 million). Looking at the figure, we also see that even though Walmart’s after-tax EBIT improved, its invested capital increased, resulting in a slightly lower return on invested capital measure. Examining resource management ratios, we see a marginal improvement in Walmart’s fixed asset turnover, with revenue growth slightly greater than growth in net property and equipment. Inventory turnover was slower—reflected in an increase in the age of inventory. There was also a slight increase in the age of receivables. Although Walmart was able to marginally stretch its payments to suppliers, the overall gap— measured as the age of inventory plus the age of receivables less the age of payables— increased slightly. Consequently, Walmart was investing more in its working capital and needed to finance this investment. We now turn our attention to Walmart’s liquidity ratios. Examining these figures, we see that both the current ratio and the quick ratio remained almost the same as the previous year, suggesting a steady position. The one concern is that these ratios are below 1, which means that in a forced liquidation situation, Walmart would have difficulty converting its current assets into cash in order to cover its current liabilities. However, given the extreme remoteness of liquidity issues at Walmart, we shouldn’t be too concerned. In fact, the ratios might suggest that Walmart is attempting to minimize any excess cash. Finally, as we examine Walmart’s capacity or leverage ratios, we see little change over the past year. The firm’s debt-to-assets ratio remained the same, while its debt-to-equity ratio

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FIG 14.7  Walmart Financial Ratios*



2012

2011

Numerator Denominator Measure Numerator Denominator Measure Performance measure Return on equity

15,699

71,315

22.0%

16,389

68,542

23.9%

Profitability Gross margin1 EBIT

margin1

108,727 443,854 24.5% 104,006 418,952 24.8% 26,558 443,854 6.0% 25,542 418,952 6.1%

Operating expense ratio1

85,265 443,854 19.2% 81,361 418,952 19.4%

Return on invested capital2

17,911 124,742 14.4% 17,318 118,406 14.6%

Resource management Fixed asset turnover Age of inventory (days) Age of receivables (days)1 Age of payables (days)3

446,950

112,324

4.0

421,849

107,878

3.9

40,714

918

44.3

36,437

863

42.2

5,937 1,216 4.9

5,089 1,148 4.4

36,608 918 39.9 33,676 863 39.0

Gap = age of inv. + rec. – pay. 9.4 7.6 Liquidity Current ratio

54,975 62,300 0.88 52,012 58,603 0.89

Quick ratio

12,487 62,300 0.20 12,484 58,603 0.21

Capacity/leverage Debt-to-assets4

109,379 193,406 0.57 102,445 180,782 0.57

Debt-to-equity4

109,379 71,315 1.53 102,445 68,542 1.49

Long-term debt to capital5

53,427 124,742 0.43 49,864 118,406 0.42

Interest coverage

26,558 2,160 12.30 25,542 2,004 12.75

Debt service coverage6

34,688 5,572 6.23 33,183 9,365 3.54

**Numerator and denominator amounts are in $millions. 1 based on net sales  2 tax rate based on provision for income taxes/income from continuing operations before taxes; interest-bearing debt includes short-term borrowings plus long-term debt (including due within year)  3 based on cost of goods sold  4 debt based on current liabilities plus long-term debt  5 includes all interesting-bearing debt: short-term borrowings+ long-term debt due within one year  6 principal based on long-term debt due within one year

increased slightly. The long-term debt to capital ratio also increased slightly—from 42 percent to 43 percent—due in part to share repurchases but also due to an increase in both shortterm and long-term borrowing as Walmart took advantage of favorable low interest rates. The management discussion presented in Walmart’s 2012 annual report notes that the debtto-capital ratio is one particular ratio that management monitors because it can impact the company’s credit rating as well as its long-term financial decisions. Interest coverage decreased slightly but remained strong, whereas the firm’s debt service coverage—which also took principal repayments into account—improved substantially. A decomposition of Walmart’s ROE explains the slight decrease from 23.9 percent to 22.0 percent. As shown in Figure 14.8, Walmart’s profit margin slipped; its asset turnover or ability to “sweat its assets” remained stable; and its financial leverage increased slightly as the firm took on more debt while repurchasing shares. Because the profit margin decline was most prominent, the resulting ROE declined. Nonetheless, at 22 percent, the overall measure was still quite strong, indicating that Walmart created profits for its shareholders.

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In-Depth

Target Corporation: ROIC

Throughout this chapter, we provide an opportunity to compare Walmart with Target Corporation, one of its main competitors, albeit much smaller in size. Target describes itself as “an upscale discounter that provides high-quality, on-trend merchandise at attractive prices in clean, spacious and guest-friendly stores.” Target has over 350,000 employees and operates over 1,700 stores in the United States. The firm recently opened stores in Canada, and—like Walmart—it has an online business component. Target also offers branded proprietary credit and debit cards. For the fiscal year ending January 31, 2012, Target’s EBIT was $5,322,* and its tax rate was 34.3 percent. Its short-term borrowings were $3,786, and its long-term debt was $13,697. In addition, the firm’s book value of equity was $15,821. Estimate Target’s return on invested capital or ROIC, then compare it with Walmart’s. Are you surprised at the difference?

* All amounts related to Target in this chapter are in millions of dollars, unless otherwise noted.

FIG 14.8  Walmart ROE Decomposition*



2012 2011

Consolidated net income attributable to Walmart

$15,699

$16,389

$446,950

$421,849

3.5%

3.9%

Total revenues

$446,950

$421,849

Total assets

$193,406

$180,782

Total revenues Profit margin (PM) = net income/revenue

Asset turnover (AT) = revenue/assets Total assets

2.31 2.33 $193,406

$180,782

$71,315

$68,542

Walmart shareholders’ equity Financial leverage (FL) = asset/equity Return on equity = ROE = PM * AT * FL

2.71 2.64 22.0% 23.9%

*All dollar amounts are in millions.

Key Financial Health Take-Aways

Overall, Walmart is in a strong financial position. Although its profitability ratios— gross margin, EBIT margin, and ROIC—were down slightly, the company was able to decrease its operating expenses and was still very profitable. Also, even though the firm’s financing gap increased slightly despite an increase in the age of payables, this gap was still very low, suggesting effective management of resources. Our review also shows that Walmart’s liquidity position (as captured in the current and quick ratios) is steady, its financial capacity is strong (with room for an increase in the long-term debt to capital ratio), and the firm is in a good position to service debt (with a very high interest coverage ratio).

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In-Depth

Target Corporation: ROE

For the fiscal year ending January 31, 2012 (2011), Target had total revenues of (in millions) $69,865 ($67,390) and net earnings of $2,929 ($2,920). Its total assets were $46,630 ($43,705) and its equity was $15,821 ($15,487). Estimate Target’s return on equity (ROE) for each of these two years, using the DuPont decomposition to indicate the profit margin, the asset turnover, and the firm’s financial leverage. Why has the ROE changed? How would you compare the ROE drivers for Walmart and Target?

14.2 Projecting Walmart’s Future Performance Now that we better understand overall economic conditions, the industries in which Walmart competes, Walmart’s competitive position, and the firm’s strengths and weaknesses, we can examine Walmart’s future financing requirements through pro forma financial statements or projections. As we learned in Chapter 6, understanding a company’s current financial position is a springboard to projecting its future financial position. According to Walmart’s 2012 annual report, the management team feels that it will be able to generate sufficient cash flows from operations and will be able to borrow short term in order to cover any seasonal increase in inventories as well as any other requirements for cash. In the unlikely event that such cash flows from operations aren’t also able to pay for dividends or planned capital expenditures, then management is confident it can rely on short-term borrowings and long-term debt. Let’s perform our own pro forma analysis to determine Walmart’s anticipated profits, as well as its anticipated borrowing needs.

Objective 14.2

Describe the process for projecting Walmart’s income statement and balance sheet.

14.2.1 Projecting Walmart’s Income Statement We’ll start our projections with Walmart’s income statement. The firm’s pro forma income statement for the fiscal year ending January 31, 2013, is presented in Figure 14.9, along with the relevant assumptions. Given the previous year’s revenue growth of 6 percent, and considering what we learned through our industry and firm size-up analysis, Walmart’s revenues are anticipated to grow by a similar but slightly lower rate of 5 percent for net sales, as well as for membership and other income. Using this information, we can estimate costs and expenses in the coming year to arrive at Walmart’s projected operating income. Here, we assume a gross margin similar to the previous year at 24.5 percent of net sales, implying cost of sales at a 0.755 fraction of net sales. We also assume operating, selling, general, and administrative expenses similar to the previous year at a 0.192 fraction of net sales. Now that we’ve estimated Walmart’s operating income, or EBIT, let’s consider interest and taxes. Based on information presented in the firm’s 2012 annual report, interest expenses are anticipated to be around 4.5 percent of beginning interest-bearing debt (i.e., short-term borrowings and long-term debt, including any long-term debt due within one year). Taxes are anticipated to remain at a similar percent as last year, at 32.6 percent of income before taxes. We assume there will not be any discontinued operations. We also assume net income attributed to noncontrolling interest is 4 percent of consolidated net income, a similar percentage to the previous year. Consequently, once

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FIG 14.9  Walmart Pro Forma Consolidated Statement of Income*



Fiscal year ending January 31



Assumption 2013

Revenues Net sales

5.0% growth similar to previous year

$466,047

Membership and other income

5.0% growth similar to previous year

3,251

Total revenues

469,298

Costs and expenses Cost of sales

0.755 fraction of net sales (previous year)

351,883

Operating, selling, and general and administrative expenses

0.192 fraction of net sales (previous year)

89,528

Operating income

27,886

Interest (net)

4.5% of beginning interest-bearing debt

Income from continuing operations before income taxes Provision for income taxes

32.6% based on previous year’s tax rate

Income from continuing operations Income (loss) from discontinued operations, net of tax

2,404 25,482 8,297 17,185 0

Consolidated net income 17,185 Less consol. net income attributed to noncontrolling interest

4.0% of net income similar to previous year

Consolidated net income attributable to Walmart

pro forma net income

Dividends

$1.59 per share * previous year’s shares

Change in retained earnings

pro forma net income less pro forma dividends

Basic net income per common share

(687) $16,497 5,501 $10,996 $4.77

*Amounts in $millions, except per share data.

we subtract the noncontrolling interest amount from the consolidated net income, we arrive at consolidated net income attributable to Walmart of $16,497 million. Finally, we want to estimate how Walmart’s retained earnings will change, since we need that information for our balance sheet projection. Dividends reflect management’s announced $1.59 per share for fiscal year 2013. If we multiply this amount by the 2012 weighted average common shares outstanding of 3,460 million, we get anticipated dividends of $5,501 million. Subtracting this amount from the consolidated net income attributable to Walmart results in an anticipated increase in retained earnings (after common share dividends) of $10,996 million. On the basis of shares currently outstanding, Walmart is anticipated to have earnings per share of $4.77. Given all of these assumptions, we are anticipating an increase in consolidated net income attributable to Walmart of 5.1 percent.

Key Pro Forma Income Statement Take-Aways

The major conclusion from our pro forma income statement analysis is that we anticipate Walmart to continue to be profitable, with a growth in profits in line with revenue growth, assuming the firm is able to maintain many of the same financial ratios as in the previous year.

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14.2.2 Projecting Walmart’s Balance Sheet Now, let’s examine Walmart’s projected balance sheet. The firm’s pro forma balance sheet as of January 31, 2013, is presented in Figure 14.10. As shown in the figure, we anticipate that cash will be at a similar level as that of the previous year. We also

FIG 14.10  Walmart Pro Forma Balance Sheet*



As of January 31



Assumption 2013

Assets Current assets Cash and cash equivalents

same as previous year

Receivables, net

4.9 days of accounts receivable (as in previous year)

Inventories

44.3 days of cost of sales (as in previous year)

Prepaid expenses and other

same as previous year

Current assets of discontinued operations

assumed zero

Total current assets

$6,550 6,234 42,750 1,685 0 57,219

Property and equipment Property and equipment

13,500 new assets (before depreciation)

Less accumulated amortization

8,537 (assume 5% increase in depreciation)

Property and equipment, net Goodwill

same as previous year (since not amortized)

Other assets and deferred charges

same as previous year

Total assets

174,438 (57, 151) 117,288 20,651 5,456 $200,613

LIABILITIES AND EQUITY Current liabilities Short-term borrowings

balancing amount

Accounts payable

39.9 days of payables (as in previous year)

38,438

Accrued liabilities and income tax

same as previous year

19,318

Long-term debt due within one year

same as previous year

2,301

Current liabilities of discontinued operations

assume zero

Total current liabilities

$755

0

subtract equity and three liability-related items below from “total liabilities and equity’’

60,812

Long-term debt

last year less due within year

44,778

Deferred income taxes and other

same as previous year

Redeemable noncontrolling interest

same as previous year (since not amortized)

7,862 404

Equity Walmart shareholders’ equity

beginning equity + change in retained earnings

Noncontrolling interest

same as previous year

Total equity Total liabilities and equity

same as total assets

82,311 4,446 86,757 $200,613

*Amounts in $millions, except as noted.

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anticipate that Walmart’s age of accounts receivable will be at a similar level as that of the previous year at 4.9 days of net sales, and its age of inventory will remain at 44.3 days of cost of sales. Additionally, we assume prepaid expenses will be at a similar level as the previous year and current assets of discontinued operations will be zero. Property and equipment reflect management’s anticipated increase in capital expenditures of around $13,500 million (as indicated in the 2012 annual report), to a total of $174,438 million. To estimate accumulated amortization, we start with the previous year’s accumulated amortization of $48,614 million, then add our estimate of next year’s amortization. We see that last year’s depreciation and amortization amount was $8,130 million (from the cash flow statement). Let’s assume that next year’s will be 5 percent higher, or $8,537 million. So the expected accumulated amortization is $57,151 million ($48,614 million plus $8,537 million). Consequently, we project Walmart’s net property and equipment to be $117,288 million and its total assets to be $200,613 million. We can now proceed to the liabilities and equity portion of the balance sheet. Because we know that all balance sheets must balance, we note that the bottom-line total liabilities and equity amount must equal the total assets amount of $200,613 million. Recall that our goal is to identify what Walmart’s borrowing needs will be. As such, we will use the “short-term borrowings” item as the balancing item, after we’ve projected all the other balance sheet items. Let’s proceed “up” the balance sheet with the remaining items before looking more closely at Walmart’s short-term borrowing needs. We begin our way up the balance sheet by assuming Walmart’s noncontrolling interest is the same as that of the previous year at $4,446 million. We then calculate shareholders’ equity as the beginning amount of $71,315 million plus our anticipated increase in retained earnings of $10,996 million, for a total of $82,311 million. Adding this amount to the noncontrolling interest (which is also considered equity, since it represents Walmart’s minority stake in other firms) gives us total equity of $86,757 million. Because we know the firm’s total liabilities and equity is $200,613 million and its equity is $86,757 million, the difference between these two amounts represents total liabilities of $113,856 million. Our next objective is to continue proceeding “up” the balance sheet to arrive at total current liabilities. To do this, we first subtract from the total liabilities amount $404 million in redeemable noncontrolling interest (Walmart’s minority stake in other firms that it can redeem from the other firms at a fixed price), which we assume to be the same as that of the previous year. We then subtract $7,862 million of deferred income taxes, which we again assume to be the same as that of the previous year. Finally, we subtract $44,778 million of long-term debt (representing the previous year’s long-term debt of $47,079 million less the amount of $2,301 million that was previously due within one year). We are then left with projected current liabilities of $60,812 million. Next, we estimate four of the five current liabilities items—saving short-term borrowings as our balancing item. We first assume Walmart’s current liabilities of discontinued operations is zero. We then assume that the firm’s long-term debt due within one year amount of $2,301 million is the same as that of last year. We also assume that the accrued liabilities and income tax amount of $19,318 million is the same as that of last year. Accounts payable days are anticipated to be the same as that shown for the previous year at 39.9 days, resulting in an accounts payable amount of $38,438 million. Subtracting these four amounts from the total current liabilities amount gives us our final balancing amount for short-term borrowings: $755 million. And we are done estimating next year’s balance sheet!

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Key Pro Forma Balance Sheet Take-Aways

Our major conclusion from our pro forma balance sheet analysis is that we anticipate Walmart will require less in short-term borrowings than the current amount of $4,047 million, which is good news. We’ve projected that, if it chooses to do so, Walmart will have the ability to pay down both short-term borrowings and longterm debt. Of course, Walmart’s leadership could decide to increase dividends beyond the amount we’ve forecast; could continue to repurchase shares; or could decide to make acquisitions. The point is that Walmart is anticipated to be in a strong financial position next year—if our assumptions hold true. Accordingly, there isn’t any urgency to renegotiate larger loans or find additional sources of financing.

14.2.3 Examining Alternate Scenarios We can now consider some alternate scenarios by performing sensitivity analysis on some of the key variables in Walmart’s financial statements. Let’s start by examining the impact of net sales on net income and short-term borrowings. Suppose, for example, that Walmart’s net sales increase by 10 percent over the previous year, instead of the 5 percent we’ve used in our analysis. Because of the higher forecasted sales, the consolidated net income attributable to Walmart increases by 5.2 percent over our base-case pro forma, going from $16,497 million to $17,357 million. Then, after we deduct anticipated dividends, the resulting increase in retained earnings leads to a decrease in required short-term borrowings, which drop from $755 million to just $397 million. Conversely, if Walmart’s net sales show no increase (rather than the 5 percent increase we used previously), then the consolidated net income attributable to Walmart decreases by 5.2 percent over our base-case pro forma, moving from $16,497 million to $15,638 million. In turn, the lower increase in retained earnings leads to an increase in required short-term borrowings, which rise from $755 million to $1,112 million. However, it appears that Walmart would have ample capacity to increase its borrowing. Next, suppose Walmart is able to reduce its operating expenses by 0.2 percent, to 19.0 percent of net sales from the base-case 19.2 percent. Note that such a decrease in one year is consistent with Walmart’s five-year plan to reduce operating expenses as a percent of net sales by a full percentage point. The result of such a seemingly small change is substantial. Specifically, the consolidated net income attributable to Walmart increases by 3.8 percent over our base-case pro forma, from $16,497 million to $17,132 million. The increase in retained earnings also leads to a decrease in required short-term borrowings, which drop from $755 million to just $121 million. Finally, suppose Walmart is able to improve its inventory management, thereby reducing its age of inventory slightly to 42.2 days—the same level as that shown in 2011—instead of 44.3 days. This change has no direct impact on the income statement. Rather, its only effect is on the short-term borrowings required, which are not only eliminated but result in an excess of available funds of $1,312 million, which could be used for purposes such as reducing long-term debt. The results of each of these individual changes are summarized in Figure 14.11. Of course, there are many other possible scenarios we could consider in our sensitivity analysis. The likelihood of each of these outcomes and the particular variables on which to focus should relate back to our size-up analysis. For example, if we are not confident in our revenue projection—perhaps because of general economic uncertainty—then revenue is one key variable we might adjust. Similarly, since Walmart has a stated goal of reducing operating expenses, then operating expenses is another key variable on which we might focus.

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FIG 14.11  Pro Forma Sensitivity Analysis*   Item

Assumption

Net income attributable to Walmart

Short-term borrowings

Base

Revised

Base

Revised

Difference

Base

Revenue growth

5%

10%

$16,497

$17,357

$860

$755

$397

–$358

Revenue growth

5%

0%

$16,497

$15,638

–$859

$755

$1,112

$357

Operating expenses

0.192

0.190

$16,497

$17,132

$635

$755

$121

–$634

Inventory days

44.3

42.2

$16,497

$16,497

$0

$755

–$1,312

–$2,067

Revised

Difference

*Dollar amounts are in $millions.

14.3 Assessing Walmart’s Long-Term Investing and Financing Objective 14.3

Describe the process for estimating Walmart’s cost of capital.

We now examine issues related to Walmart’s need to raise long-term capital. As the company’s management notes in the discussion portion of the 2012 annual report, Walmart expected to be able to finance its international expansion through a combination of operating cash flows and borrowing. It is clear that Walmart will need to continually invest in the business through both capital expenditures and acquisitions. If our assumptions are reasonable (note that generating reasonable assumptions is one of the most critical aspects of pro forma analysis), we anticipate that Walmart will generate substantial earnings next fiscal year, two-thirds of which will be retained in the business, but it will also need to rely on external funding. As Walmart looks beyond the coming year, it will most certainly need to continue to invest and tap into capital markets on a regular basis. As such, we need to assess the magnitude of Walmart’s anticipated investments, as well as the firm’s ability to raise capital.

14.3.1 Assessing Walmart’s Investments Currently, Walmart makes investments in a number of areas related to property and equipment, including new stores, expansions and relocations, remodels, information systems, and distribution. The firm also invests through acquisitions. In terms of numbers, Walmart made property and equipment investments of $12,200 million in fiscal year 2010, $12,700 million in fiscal year 2011, and $13,500 million in fiscal year 2012, with a similar level expected for fiscal year 2013. Acquisitions in fiscal year 2012 amounted to $3,500 million but were only $200 million in fiscal year 2011. Investments in property and equipment are more predictable than investments in acquisitions, which tend to be more opportunistic. As such, it is important for Walmart to plan to continue to invest in plant and equipment in order to replace depreciating assets, but also to invest for growth. For example, the investments planned for fiscal year 2013 were expected to add over 45 million square feet of retail space. Such investments are reasonably predictable. On the other hand, given the opportunistic nature of acquisitions, it is important for Walmart to maintain financial flexibility to issue debt if and when such opportunities arise.

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14.3.2 Assessing Walmart’s Capital Raising and the Cost of Capital Given the vast amount of investments that Walmart must make each year, we need to examine the way in which the firm finances these investments and the cost of that financing—from both internal and external sources. Let’s examine these costs by estimating Walmart’s cost of capital. Recall from Chapter 10 that the cost of capital reflects the minimum return investors (and lenders) require, and it is a key driver of the overall value of a firm. Also recall that in order to estimate the overall cost of capital, we need to estimate Walmart’s cost of debt, its cost of equity, and the appropriate weights of each. Based on information presented in Walmart’s 2012 annual report, the company’s borrowing costs are anticipated to be around 4.50 percent, reflective of the low interest rate environment. Taxes are anticipated to remain at a similar percent as last year: 32.56 percent of income before income taxes. Using this information, we can estimate Walmart’s after-tax cost of debt (kd) in the usual manner: kd = kd before@tax * (1 - tax rate) = 4.50% * (1 - 0.3256) = 3.03% Here, we should note that Walmart’s future borrowing costs depend on a number of factors. If economic conditions change—in particular, if the rate of inflation changes— then we can expect borrowing costs to change accordingly (for example, higher inflation will lead to higher interest rates). Federal Reserve monetary policy will also have a large effect on interest rates, with tighter monetary policy resulting in higher rates. Beyond these external factors, Walmart’s borrowing costs also depend on the credit rating it receives on its publicly traded debt, as discussed in Chapter 9. In Walmart’s 2012 annual report, its chief financial officer stated that Walmart was pleased with its AA credit rating, which was the highest in the retail industry. The rating was interpreted as an indication of Walmart’s strong cash flows, its efficient working capital utilization and general sound financial practices. Later, the report noted that Walmart’s credit rating would impact on its ability to continue to issue commercial paper and borrow longer term at reasonable interest rates and terms. Our own assessment of the risks facing Walmart were discussed as part of our size-up process—but keep in mind that the credit-rating agencies use a similar process. Although there are a variety of methods for estimating Walmart’s cost of equity (ke), including the capital asset pricing model (CAPM) approach, we’ll take a direct shortcut and utilize an estimate from one research firm that covers Walmart. According to this firm, Walmart’s cost of equity is 9.70 percent. Keep in mind how we should interpret this number. The cost of equity from an investor’s perspective reflects his or her expected return—both dividends and capital gains—from investing in Walmart’s stock. Recall from Chapter 9 that over the long term (since 1926), average stock returns have been around 10 percent. Of course, going forward, our expected stock returns will also depend on expected risk-free government bond returns at the time of our investment, plus whatever premium we would require for investing in riskier stocks. Now that we’ve estimated Walmart’s cost of debt and cost of equity, we need to determine the appropriate weight of each component, which is meant to reflect how Walmart plans to raise capital in the future. Here, we’ll take the same approach as we did with Home Depot in Chapter 10 by estimating Walmart’s assumed target capital structure based on its spring 2012 market value weights. From Walmart’s balance sheet, we know the firm’s total interest-bearing debt (short-term borrowings plus long-term debt, including amounts due within one year) is $53,427 million. (Although this is actually a book value amount, we will assume it is similar to the market value of debt as well.) Given Walmart’s stock price in the spring of 2012 of $61.36 and the 3,460 million shares outstanding, the market value of its equity is $212,306 million. If we add the value of debt and equity, the estimated market value of the firm as a whole is $265,733 million.

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In-Depth

Target Corporation: Cost of Capital

According to its annual report, as of January 31, 2012, Target’s borrowing costs averaged 4.6 percent, and its tax rate was 34.27 percent. A research report estimated Target’s cost of capital at 10.5 percent. The firm had interest-bearing debt of $17,483. Moreover, Target’s stock was trading at $50.81 per share, and there were 679.1 million shares outstanding. Now, let’s assume Target’s amount of debt is also a market value estimate of the debt. Let’s also assume the current debt and equity values are at Target’s optimal capital structure. Based on market value estimates, what is Target’s cost of capital? How does it compare to Walmart’s, and what explains the difference?

Given the relative amount of debt and equity, we arrive at our estimate of the weight of debt (wd) of 0.20 (or $53,427/$265,753) and the weight of equity (we) of 0.80 (or $212,306/$265,753). Finally, we estimate the overall weighted-average cost of capital (kc), or WACC, for Walmart as follows: WACC = kc = wd * kd + we * ke = 0.20 * 3.03% + 0.80 * 9.70% = 8.36%

14.4 Valuing Walmart Objective 14.4

Describe the process for estimating Walmart’s economic value added and intrinsic value based on the discounted cash flow method and comparable analysis, and explain how Walmart can attempt to create value.

With the preceding information in mind, we can now estimate what we think Walmart is really worth, and we can also examine Walmart’s ability to add value for its shareholders. For our assessment of value added, we can measure Walmart’s most recent year EVA. For an overall assessment of value, including our expectation for the future, we rely on the discounted cash flow analysis approach presented in Chapter 13, supplemented with relative value measures and comparable analysis.

14.4.1 Measuring Walmart’s Economic Value Added Recall that EVA is a period measure that attempts to capture a firm’s ability to add value for shareholders, after accounting for the requirements of other stakeholders. We can use the EVA approach to examine Walmart’s true economic profit in 2012. Specifically, we can estimate Walmart’s net operating profit after-tax (NOPAT) as EBIT * (1 - tax rate). Note that we have implicitly assumed that the “accounting” costs from the financial statements are reflective of true “economic” costs. For 2012, Walmart’s EBIT was $26,558 million. Based on a 32.56 percent tax rate, Walmart’s NOPAT is $17,911 million. Economic value added is calculated as the difference between NOPAT and the capital charge. Thus, we need to estimate invested capital (i.e., book value of debt plus equity) and multiply it by the cost of capital to get the capital charge. (For simplicity, we measure capital and cost of capital as of the end of the period, although an alternative measure could examine an average.) Walmart’s total interest-bearing debt (as calculated in Section 14.3.2) is $53,427 million. The book value of equity is $75,761 million, for a total invested capital of $129,188 million. The capital charge, estimated as the product of the invested capital and the cost of capital of 8.36 percent, is $10,800 million. Finally, EVA is calculated as the difference between NOPAT and the capital charge, or $7,111

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Figure 14.12  Walmart EVA and MVA*

Fiscal year ending January 31, 2012 Operating profit (EBIT)

327

26,558

Tax rate (t) 32.56% EBIT × (1 – t) = NOPAT Invested capital

17,911 129,188

Cost of capital (kc) 8.36% Capital charge = invested capital × kc 10,800 EVA = NOPAT – capital charge ROCE = NOPAT/invested capital

7,111 13.86%

ROCE – kc 5.50% Invested capital

129,188

EVA = (ROCE – kc × invested capital Market value of equity

7,111 212,306

Value of debt

53,427

Market value of the firm

265,733

Invested capital

129,188

MVA = market value of the firm – invested capital

136,545

*Amounts in $millions, except percentages

million. Thus, for the fiscal year ending January 31, 2012, Walmart added considerable value for shareholders, far in excess of required or expected returns. Our calculations are summarized in Figure 14.12, which also presents the alternative EVA estimation approach discussed in Chapter 13. We additionally show the estimated market value added, or MVA, as the market value of the firm of $265,733 million less the invested capital of $129,188 million. The resulting estimated MVA of $136,545 million suggests that market participants feel Walmart is worth a substantial amount greater than the capital invested. One interpretation is that investors expect Walmart to continue to invest in positive net present value projects and continue to create value.

In-Depth

Target Corporation: EVA

Earlier, you were provided with the information necessary to estimate Target’s operating profit (EBIT) after-tax, also known as NOPAT; invested capital (the book value of equity plus interest-bearing debt); cost of capital; and market value of equity. Based on this information, estimate Target’s EVA for the year that ended on January 31, 2012. Was ­ arget adding value? Did Target have a positive market value added or MVA? How did T Target’s EVA and MVA compare with Walmart’s EVA and MVA?

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14.4.2 Estimating Walmart’s Intrinsic Value: The DCF Approach Given the firm’s positive MVA, which suggests market participants feel that Walmart is adding value by investing in value-enhancing projects, we can determine whether the current stock price reflects our estimated intrinsic value of Walmart’s stock. Specifically, we can apply the discounted cash flow analysis free-cash-flow-to-the-firm approach, described in Chapter 13, to determine the per share value of Walmart stock based on our assumptions. Note that if our valuation assumptions are identical to the implicit prevailing market assumptions, then our estimate of the intrinsic value of Walmart shares should be identical to the prevailing market value. If the resulting intrinsic value estimate is greater than the market value, then we can conclude that the shares are undervalued. Our analysis is presented in Figure 14.13. We start with the previously estimated cost of capital, which will be used as the discount rate for estimating the present value of anticipated cash flows. We next estimate annual cash flows for the next five years, using similar assumptions to our one-year pro forma financial statement analysis. We assume annual total revenue growth of 5 percent; an EBIT margin of 6 percent (similar to that of the previous year); 5 percent growth in depreciation (a reasonable assumption); working capital increases at a rate of 2 percent of the change in revenues (similar to changes over the past five years); a tax rate of 32.6 percent (same as that of the previous year); and $13,500 million in capital expenditures in fiscal year 2013 (as indicated by Walmart management); followed by a conservative 3 percent growth in capital expenditures. It is worth noting that we have intentionally assumed that in each year, capital expenditures are greater than depreciation, which is a critical assumption if a firm is growing. For our final assumption, after five years, we assume a constant growth in free cash flows of 3 percent, used to calculate a terminal value (representing the value of all free cash flows beyond the fifth year). This terminal value growth estimate is meant to be conservative relative to the five-year growth estimate and relative to the long-term nominal GDP growth in the United States. We apply the growing perpetuity formula that incorporates the anticipated free cash flow in 2018 (labeled as FCF18 and estimated as the 2017 free cash flow multiplied by 1 plus the terminal growth rate of 3 percent), the cost of capital, and the terminal growth rate. Next, we take the present value of each of the anticipated free cash flows—including the terminal value. Our resulting analysis estimates the present value of Walmart’s assets of $287.9 billion, which is our estimate of the intrinsic value of the firm as a whole. Given the current interest-bearing debt of $53.4 billion, the resulting estimate of the value of the equity is $234.5 billion. Given 3.46 billion shares outstanding, our estimated intrinsic value per share is $67.77, which is slightly greater than the spring 2012 price of $61.36, suggesting the shares are undervalued, based on our assumptions. Of course, as new information arrives in the marketplace causing a reassessment of our assumptions, we can expect the value of Walmart shares to fluctuate as well. The real value in this exercise of estimating intrinsic value is to enhance our understanding of what key factors might have a material impact on value.

14.4.3 Estimating Walmart’s Intrinsic Value: Comparable Analysis As a check to our discounted cash flow (DCF) analysis, we can also estimate the intrinsic value of Walmart shares based on comparable analysis. In Chapter 13, we examined a number of alternative relative value approaches. Here, we focus our analysis on the enterprise value (EV)-to-EBITDA model, which involved two steps. First, we estimated the intrinsic value of the firm as a whole (EV0) as: EV0 = (appropriate forward@looking EV/EBITDA multiple) * EBITDA1

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Fig 14.13  Walmart Discounted Cash Flow Analysis

1. Discount rate or WACC (kc) 8.36% 2.  Cash flow assumptions Explanation Revenue1

5.0% growth/yr over 2012 of ($b): 447.0

EBIT margin % of revenue

6.0% same as in 2012

Depreciation (Dep)

5.0% increase/yr over 2012 of ($b): 8.13

Working capital change (WCchg) as a % change in revenue

2.0% based on previous 5 years

Capital expenditures (Capex)

3.0% increase/yr over 2013 management guidance of ($b): 13.5

Tax rate (t)

32.6% based on 2012 percentage

3. Terminal value (TV) assumptions: Free cash flow (FCF) terminal growth

3.0% assumed

Cash Flows ($ billions) Year2 Time

Revenue

EBIT

FCF + TV

PV

2013

1

469.3

28.1

18.9

8.5

13.5

0.4

13.5

13.5

12.5

2014

2

492.8

29.5

19.9

9.0

13.9

0.5

14.5

14.5

12.3

2015

3

517.4

31.0

20.9

9.4

14.3

0.5

15.5

15.5

12.2

2016

4

543.3

32.5

21.9

9.9

14.8

0.5

16.5

2017

5

570.4

34.1

23.0

10.4

15.2

0.5

17.7

EBIT(1 – t) + Dep

FCF

– Cap Ex – WCchg

TV*

339.3

16.5

12.0

357.0

238.9

Present Value (PV) of assets = PV of assets

287.9

Less: debt3

53.4

PV of equity Shares o/s (b)

234.5 3.46

Price/share $67.77 1 3

287.9

*TV: Growing perpetuity calculation assumptions WACC

kc = 8.36%

FCF terminal growth

g = 3.0%

FCF2018 = FCF2017(1 + g) FCF2018 = 18.2 ➞TV = FCF2018/(kc – g)

revenue = net sales + other income  2 fiscal year ending January 31 as of January 31, 2012; includes short-term borrowings and all long-term debt

where the appropriate forward-looking EV/EBITDA multiple is based on an assessment of “comparable” firms in the same industry with similar growth prospects and risk, and EBITDA1 is the projected EBITDA next year. Second, we estimate the value of equity (VE) as: VE = EV0 - VD - value of other claims where VD is the value of interest-bearing debt. We can then divide our estimated value of equity by the number of shares outstanding to arrive at our estimated intrinsic value. We present our analysis in Figure 14.14. We start with projected EBITDA from our DCF analysis projection in Figure 14.12: We add our 2013 projected EBIT of $28.1 billion and add projected depreciation and amortization of $8.5 billion. We then estimate an appropriate forward-looking EV/ EBITDA multiple, which involves a bit of art and science. We obtained a number of investment research reports written on Walmart and examined reported forward-looking

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Fig 14.14  Walmart EV/EBITDA Valuation*

EBITDA1 Appropriate forward-looking EV/EBITDA multiple

$36.6 7.6

Enterprise value (EV) = $278.3 Less: Value of debt (VD) =

$53.4

Value of equity (VE) = $224.9 Shares outstanding Intrinsic value/share

3.46 $64.99

*Amounts are in $billions, except share price, shares (in billions) and multiple.

EV/EBITDA multiples for comparable firms, then averaged these across a number of reports, giving us 7.3. (If you don’t have access to such reports, then you can “do-ityourself ” by choosing a few key competitors to Walmart and projecting their EBITDA, then finding the EV/EBITDA1 ratio based on their current equity value and value of debt.) We then adjusted this average upward to 7.6, to reflect our size-up analysis that indicated Walmart would be deserving of an above-industry-average multiple given its strong market position, which translates into better growth prospects and less perceived riskiness relative to its competition. Note that the magnitude of this adjustment is more art than science. The value of debt and number of shares are the same as in our DCF analysis. The resulting intrinsic value share estimate of $64.99 confirms our DCF analysis that the shares may currently be modestly undervalued. We don’t expect our EV/ EBITDA method intrinsic value estimate to be identical to our DCF estimate, but we do expect it to be in the same ballpark—otherwise, we need to question the consistency of our assumptions between the two models.

14.4.4 Creating Value and an Overall Assessment of Walmart Now that we have built our DCF and relative value models, we can complete our final task—identifying possible ways by which Walmart can attempt to create value for its shareholders. To do this, we can return to our DCF model. Let’s focus on the one particular target that Walmart highlighted in its 2012 annual report: reducing operating expenses as a percentage of net sales by 0.2 percent in each of the next four years. As a simplified estimate of the impact on our intrinsic value estimate, we reestimate our DCF valuation in Figure 14.13 by replacing our assumed EBIT margin of 6.0 percent in all five years with year-by-year EBIT margins as follows: 6.2 percent in 2013, 6.4 percent in 2014, 6.6 percent In-Depth

Target Corporation: EV/EBITDA Analysis

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Let’s suppose you forecast Target’s EBIT for the year ending January 31, 2013, to be $5,352, and you forecast Target’s depreciation and amortization to be $2,361. A research analyst determines that an appropriate forward-looking EV/EBITDA multiple for Target is 6.9 times. Based on this information, estimate Target’s enterprise value, or EV. Next, incorporating the value of Target’s debt, estimate the firm’s value of equity. Finally, based on 679.1 million shares outstanding, estimate the intrinsic value per share and compare it with Target’s stock price on January 31, 2012, of $50.81. Based on this analysis, is Target’s stock overvalued or undervalued?

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in 2015, and 6.8 percent in both 2016 and 2017. The resulting share price is $81.69—a substantial increase from our initial estimate of $67.77. We can see the dramatic impact of the change since Walmart competes in such a low-margin industry—meaning a small margin increase can have a huge effect. We can also appreciate why Walmart stresses the importance of cost efficiency and why it is such a key success factor. Besides controlling costs, we know from our underlying theme throughout the book that there are two other ways by which Walmart and any other firm can create value. Recall our mantra that “Growth is good!” and “Risk is rotten!” Anything that will increase a firm’s projected free cash flows—both in the short term (in the next five years) and in the long term—will create value. This implies any combination of increasing revenues and decreasing costs. Thus, a reduction in the perceived riskiness of Walmart’s business should result in a lower cost of capital—investors will be satisfied with a lower return, which reduces the cost of equity, and lenders will also be satisfied with lower rates, resulting in a lower cost of debt.

14.5 Relevance for Managers and Final Comments Our journey through the wonderful world of finance is now complete. You are now equipped with tools that will allow you to:

Objective 14.5

Explain the tools acquired through reading this book.

Assess current economic conditions. Identify key industry success factors. Assess a firm’s strengths and weaknesses in the areas of operations, marketing, and management. Assess a firm’s overall financial health in terms of liquidity, resource management, capacity to issue debt, and profitability. Determine a firm’s financial outlook for profitability and financing needs. Measure economic value added. Assess a firm’s intrinsic value. Identify ways to create value. You now have a better appreciation for the workings of a business from a financial perspective. Even if you have a nonfinancial position with a firm, your increased understanding will allow you to better communicate with financial managers as well as assist in creating value. I hope you have enjoyed the journey! Additional Readings and Information

Economic information is available from the Bureau of Economic Analysis, the Federal Reserve, and the International Monetary Fund websites: http://www .bea.gov/national/ http://www.federalreserve.gov/econresdata/statisticsdata.htm http://www.imf.org/external/ The Thomson Reuters/University of Michigan Index of Consumer Sentiment is available at: http://www.sca.isr.umich.edu/ The KPMG retail industry publication is available at: http://www.kpmg.com/us/en/ issuesandinsights/articlespublications/pages/retail-outlook-survey.aspx Securities and Exchange Commission 10-K filings are available through the EDGAR system at: http://www.sec.gov/edgar.shtml

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Part 4  Creating Value

Problems

1. Discuss the three internal factors that create value for an enterprise. 2. Industry analysis is important to determine a company’s competitive position in the long run. Describe a tool used for this kind of analysis. 3. What are the strengths and weaknesses of your chosen firm in the areas of operations, marketing, and human resource management? Assess the firm’s strategy. 4. How would Wal-Mart best define its competitors in terms of their positioning in the industry? 5. Project an income statement for next year for the firm based on your assessment of revenue growth, key projected financial ratios, and any other key assumptions, making sure to justify any assumptions. What is your projection for net income and how does it compare with the previous year? Based on your assessment of anticipated dividends, what is your projection for a change in retained earnings? 6. Project a balance sheet for next year for the firm based on your assessment of the change in retained earnings, key projected financial ratios, and any other key assumptions, making sure to justify any assumptions. Use external borrowing as your balancing “plug.” What is your assessment of the firm’s financial needs? 7. Analyze Wal-Mart’s cash flow position in 2011 and 2012.

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8. Examine the firm’s current capital structure (i.e., mix of debt and equity). Does it appear to be close to the optimal capital structure or should it take on proportionately more debt or equity? 9. Estimate the firm’s cost of capital. 10. Estimate the economic value added for the firm for the most recent fiscal year, interpreting the resulting amount. In addition, estimate and interpret the market value added. 11. Estimate the intrinsic value of the firm based on some key relative value measures and a comparable analysis of similar firms. For example, apply the price-earnings model you will need to project the firms earnings (based on your pro forma income statement) and determine an appropriate forwardlooking multiple. Describe how the firm’s growth prospects and risk impact on your assessment of an appropriate forward-looking multiple. 12. Estimate the intrinsic value of the firm based on the discounted cash flow approach. Compare your estimate with the current market value. Explain any differences. 13. Based on your analysis, would you recommend an investment in this firm’s stock? Summarize your main supporting reasons. 14. What three key recommendations would you make to the firm’s senior management to create value for shareholders?

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Glossary A

bondholders: Owners of bonds.

accounts payable (payables): Money owed to suppliers and trade creditors.

book value: The value of an item as recorded on financial statements.

accounts receivable (receivables): Money owed by customers.

book value of equity plus adjustments approach: An approach to estimating the equity value of a firm based on the book value of the firm’s equity.

accrual accounting method: A method of accounting that recognizes revenues when earned and expenses when incurred, regardless of the time of cash flows. acid test: See quick ratio.

bridge loan: Short-term financing often to bridge to a long-term financing arrangement or another source of raising capital.

acquisition: The combination of two entities, typically of different sizes, into one.

business cycle: Changes in countrywide economic activity reflecting expansions, or increases in real (inflation-adjusted) output versus contractions, or decreases in economic real output.

adjusted present value (APV): A two-part valuation technique whereby the net present value is calculated assuming the project or firm is all-equity, plus the present value of financing benefits such as the tax shield.

business risk: The probability of losses related to the operations of a business.

age of accounts payable (payable period): A measure of the average number of days over which accounts payable are outstanding.

C

age of accounts receivable (collection period): A measure of the average number of days over which accounts receivable are outstanding.

C corp (corporation): A business structure in the United States that has a legal and tax structure separate from its owners with a board of directors that appoints management to run the operations.

age of inventory (inventory period): A measure of the average number of days over which inventory is in stock.

call provisions: A description of terms under which a firm may redeem all or part of a bond or preferred share issue.

American Depositary Receipt (ADR): Negotiable certificates issued by certain U.S. commercial banks that represent an equivalent amount of the foreign securities.

callable (redeemable): A type of bond whereby the firm can choose to pay back the lender at a prespecified date prior to the maturity date.

amortization: The periodic decline in the value of a (typically intangible) asset, recognized for accounting or tax purposes.

capital budgeting: The process of selecting investment projects.

angel investor: An investor who buy stakes in small private firms. annuity: A stream of equal regular payments over a specified period of time. arithmetic return: A return measure that takes a simple average of returns, summing returns and dividing by the number of observations. asset turnover: A measure of the firm’s ability to generate revenue from its asset base; the ratio of revenues or sales to total assets.

capital assets: See fixed assets.

capital markets (securities markets): Markets for long-term financing such as issuing bonds or equity. capital rationing: The act of placing restrictions on the amount of money available for investments, forcing firms to choose among worthwhile projects. capital structure: The mix of debt and equity that a firm uses to finance its operations.

assets: Tangible or intangible items of value to a firm.

cash budget: A plan or projection of cash inflows and outflows over a specified time period.

asymmetric information: A situation whereby one party has more or better information than another party, such as managers versus investors.

cash conversion cycle: See cash flow cycle.

B balance sheet: A financial statement reflecting the value of a firm’s assets, liabilities, and net worth at a particular time. banker’s acceptance (BA): A security issued by a firm as a form of borrowing with a promised repayment accepted or backed by a financial institution. bankruptcy: A legal process of disposing of the assets or the reorganization of a firm to satisfy creditor claims and protecting the firm from further legal actions. beta (B): A measure of the riskiness of a firm’s common equity relative to the risk of the overall stock market. bond: A financial instrument issued by a firm representing long-term debt.

cash equivalents: Short-term, liquid investments (usually maturing in less than 3-months) that can readily be converted to cash, such as treasury bills. cash flow coverage: See debt service coverage. cash flow cycle (cash conversion cycle): The pattern and timing of where cash comes from and where it goes in a firm. cash flow statement: A financial statement reflecting a firm’s cash inflows and outflows categorized into cash related to operating, investing, and financing. clienteles: Types of individuals considered as a group—for example, those who do or don’t prefer to receive cash dividends. collection period: See age of accounts receivable. commercial paper: Unsecured short-term debt issued by a firm, usually with a repayment term of up to nine months.

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Glossary

common equity (common stock): Securities representing the direct ownership of a firm, or the residual claims on the assets.

debt-to-equity: A measure of financial leverage: the ratio of a firm’s debt to shareholders’ equity.

common shareholders: Owners of common shares, or common equity.

default: Failure to make debt obligation payments.

common-size ratios: Standardized financial statement measures, between various balance sheet items as a percentage of assets, and between various income statement items as a percentage of revenue.

deferred income taxes: A provision for future income taxes arising from timing differences between the recognition of tax liabilities for tax purposes versus a firm’s accounting system.

common stock: See common equity.

deflation: The rate of decrease in prices in a country, typically measured relative to a representative basket of goods and services.

comparable analysis: Comparison of the assets or businesses of selected firms, often for the purpose of establishing a fair market value. comparable transactions: Similar transactions that have occurred recently in a similar industry, used as a guide for what prices target firms may find acceptable. compounding: Generating interest on both principal and accrued interest. convertible shares: Securities such as bonds or preferred shares that allow the holder to convert to a fixed number of common shares if the stock prices rises above at a predetermined threshold. corporation: See C corp. cost of capital (weighted-average cost of capital or WACC): The weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shares, and common shares. cost of goods sold: See cost of sales. costs of sales (cost of goods sold): The total of all costs, excluding selling and administrative expenses, required to acquire or prepare goods or services for sale.

demand risk: The possibility that actual demand for a product or service will fall short of anticipated demand. depreciation: The periodic decline in the value of a (typically tangible) asset, recognized for accounting or tax purposes. diluted earnings per share (EPS): A measure of the claim on earnings for each common share: earnings after tax, less any preferred dividends, divided by the number of common shares including potential shares associated with the exercise of stock options and convertibles. discount rate: An interest rate used in the calculation of present values. discounted cash flow (DCF) method: An approach to estimating the equity value of a firm based on a projection of cash flows. diversification: The process or strategy of combining assets or investments in order to reduce risk. dividend discount model: A model of the intrinsic value of a dividendpaying stock based on the present value of anticipated dividends. dividend payout: The amount of dividends distributed to shareholders.

coupon rate: The specified rate of interest on coupons attached to bonds, expressed as a percentage of the face value.

dividend payout ratio: A ratio of the amount of dividends distributed to shareholders relative to the amount of net earnings.

covenants: Provisions in a bond or debt agreement specifying restrictions or requirements on the borrower.

dividend policy: The approach by which a firm determines how much it will pay its common shareholders in dividends.

coverage ratios: Measures of a firm’s ability to meet its debt obligations.

dividends: A share of the profits of the firm distributed to shareholders.

cross-listing: The process by which a firm lists its shares on a foreign stock exchange.

double entry bookkeeping (dual entry accounting): A financial recording system whereby each entry impacts at least two accounts (debits and credits) while preserving the relationship: assets = liabilities + equity.

cumulative feature: A feature of preferred shares whereby any missed dividend payments by the firm are cumulated and paid to preferred shareholders before common shareholders receive dividends. current assets: Assets such as accounts receivables and inventory that are expected to be converted into cash within one year. current ratio: A measure of a firm’s liquidity: the ratio of current assets to current liabilities.

D debt service coverage (cash flow coverage ratio): A ratio of the amount of cash from operations (usually measured as EBITDA) available to pay interest and principal due within a year. debt-to-assets: A measure of financial leverage: the ratio of a firm’s debt to assets. debt-to-capital: A measure of financial leverage: the ratio of a firm’s interest-bearing debt to capital. Capital is measured as interest-bearing debt plus equity. debt-to-EBITDA: A measure of a firm’s ability to pay its debt: the ratio of a firm’s debt to EBITDA, a measure of cash flow from operations.

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Dual-entry accounting: See double-entry bookkeeping.

E earnings: See net earnings. earnings before interest and taxes (EBIT) (operating income): A measure of profitability calculated as the difference between gross profit and operating expenses. earnings before interest, taxes, depreciation, and amortization (EBITDA): A measure of profitability calculated as the difference between gross profit and operating expenses excluding depreciation and amortization. Also measured as EBIT plus depreciation and amortization. earnings per share (EPS): A measure of the claim on earnings for each common share: earnings after tax, less any preferred dividends, divided by the number of outstanding common shares. EBIT margin percentage: A profitability measure: the ratio of operating profits to revenues. EBITDA margin percentage: A profitability measure: the ratio of operating profits, plus depreciation and amortization, to revenues.

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economic value added (EVA): A firm’s or business unit’s after-tax operating profit less a charge for the capital employed. efficient market hypothesis (EMH), weak form, semistrong form, strong form: An investment theory that states that prices fully and immediately reflect all relevant information. The weak form defines relevant information as all historical price information; the semistrong form defines relevant information as all public information; and the strong form defines relevant information as all forms of information including private information. enterprise value: An estimate of the value of a firm as a whole, or the value of the firm’s assets. enterprise value-to-EBITDA model: A model of the intrinsic value of a firm based on projected EBITDA. equity (shareholders’ equity, net worth): The ownership interest of preferred and common shareholders. Also the difference between a firm’s assets and liabilities. equivalent annual cost: The annual cost related to a project over the lifetime of that project.

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Glossary



free cash flow: The cash flow available to a firm after providing for investments: after-tax operating income plus noncash items (such as depreciation) less capital expenditures and working capital increases. free cash flow to the firm method: An approach of estimating the equity value of a firm based on a projection of free cash flows. fundamental analysis: A method of evaluating the worth of securities based on publicly available information such as news stories and annual reports. future value: The value of an asset at a specified time in the future that is equivalent to a specified amount today; the value that an investment today will grow to at a specified time in the future given an interest rate.

G general partnership: A business structure with two or more individuals as joint owners and whereby each partner is liable for any business debts. geometric return: A return measure comparing initial wealth and ending wealth and the rate at which it grows.

event study: A research methodology for analyzing the impact of certain types of events, such as the announcement of dividend increases on security prices.

goodwill: The value of a business paid by a purchaser above its fair market value.

expense ratio: A cost measure: the ratio of expenses to revenues.

gross domestic product (GDP): The total value of the output of goods and services produced or offered by a country over a period of time.

expenses: Costs, such as those related to selling as well as financing, associated with doing business.

gross margin: See gross profit.

F face value: The principal amount due to an investor in securities upon the maturity of the security, such as a bond. factoring: A process by which a firm sells accounts receivable to a lender at a discount. financial assets: See financial instruments. financial distress: Difficulties experienced by a firm in attempting to meet commitments to its creditors. financial flexibility: The ease at which a firm is able to access sources of capital. financial instruments (financial assets): Securities such as bonds and stocks that represent claims on the assets of a firm. financial intermediaries: Stock exchanges, investment banks, or investment dealers that attempt to facilitate the buying and selling of securities, first between firms and investors and second among investors. financial leverage: The use of debt in order to increase the firm’s return on equity while increasing risk exposure. Also the ratio of a firm’s assets to equity. financial ratios: See ratio analysis. financial risk: The probability of losses related to the financing of a business. financing: The process of obtaining funds to pay for real assets. fixed asset turnover: A measure of a firm’s ability to generate revenues relative to the amount of net property and equipment. fixed assets (capital assets, long-term assets): Long-term tangible assets that a firm owns such as land, property, buildings, or plant and equipment. fixed costs: Costs that do not vary over a period with changes in the volume of operations.

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gross margin percentage: The difference between revenues and costs of sales, divided by revenues. gross profit (gross margin): The difference between revenues and costs of sales. growing perpetuity: A stream of regular payments that grows at a steady rate forever.

H hurdle rates: The minimum acceptable rate of return for investments, depending on the nature and risk of the investment.

I income statement: A financial statement indicating a firm’s revenues, expenses, and resulting income over a period of time. inflation: The rate of increase in prices in a country, typically measured relative to a representative basket of goods and services. initial public offering (IPO): The initial sale of stock of a firm to the public. interest coverage: A measure of a firm’s ability to meet its debt obligations: the ratio of operating income before tax to interest expenses. interest rates: The yields on various financial instruments, such as bonds, that effectively represent the price of money: a borrowing or lending rate. interest tax shield: The value of tax savings resulting from the tax deductibility of interest payments. internal rate of return (IRR): The discount rate at which a project’s net present value is exactly equal to zero. internal rate of return rule: A method for evaluating investment projects that states that a firm should accept any project with an internal rate of return greater than or equal to a prespecified hurdle rate.

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336

Glossary

inventory: Goods or materials available to be sold or to be used to manufacture products.

moral hazard: A situation whereby a person or firm takes on undue risk when it feels it will not bear the cost from the risk exposure.

inventory turnover: A measurement of a firm’s control of its investment in inventory: the ratio of cost of sales to (ending or average) inventory.

mutually exclusive projects: Projects that are similar—however, if one is chosen the other cannot be.

investing: The process of committing funds for the purpose of obtaining a return over a particular period of time.

N

L

net earnings (net income, profits, net profits): The difference between revenue and all associated expenses over a particular time period.

leveraged buyout (LBO): The process by which a publically traded firm is acquired by investors (often the management of the company) and is financed primarily through borrowing.

net income: See net earnings.

levered firm: A firm that has some interest-bearing debt as part of its capital structure.

net present value rule: A method for evaluating investment projects that states that a firm should accept any project with a net present value greater than or equal to zero.

liabilities: Obligations to pay a specified amount or perform a particular service. LIBOR (London Inter-Bank Offered Rate): The rate at which banks offer to lend in the London inter-bank market; often used as the basis for floatingrate loans. lien: The right or claim by a creditor to sell an asset assigned by a debtor who fails to meet contractual obligations. limited liability company (LLC): A business structure whereby the owners or members are not personally liable for the firm’s debts. long-term assets: See fixed assets. long-term debt-to-capital: A measure of financial leverage: the ratio of a firm’s long-term debt (or interest-bearing debt) to long-term debt plus shareholders’ equity.

net present value (NPV): The difference between the present value of cash inflows and cash outflows from investments or projects.

net profits: See net earnings. net worth: See equity. notes payable: Short-term obligations, such as a written promise to repay short-term bank loans or promissory notes.

O operating expenses: Costs, such as selling, administrative, depreciation, and research and development, associated with the operations of a business. operating income: See earnings before interest and taxes (EBIT). opportunity cost: The cost of the next best forgone alternative activity.

line of credit: An agreement between a lender and a firm in which the firm can borrow up to a maximum amount at any time during a specified period.

optimal capital structure: A manager’s determination of debt capacity and debt-equity mix that minimizes the overall cost of capital.

M

other current assets: Current assets not included in other main categories such as cash, accounts receivable, or inventory.

market efficiency: The degree to which a security market is deemed to reflect all relevant information.

over-the-counter: A market for stocks that is decentralized and not a formal exchange.

market risk premium: The difference between the expected return on a stock investment in the market and the expected return on a risk-free investment.

P

market value: The value at which an asset can actually be sold or is worth. market value added (MVA): The difference between the market value of common equity and the book value. marketable securities: Short-term investments, usually with maturities of less than one year, that are available for sale. maturity date: The date at which an obligation or claim is to be paid. merger: The combination of two entities, typically of similar sizes, into one. modified internal rate of return (MIRR): A modification of IRR that assumes cash flows are reinvested at the financing rate, such as the cost of capital, rather than at the IRR. money market: A financial market in which very liquid, safe, short-term investments are traded. money market funds: A type of mutual fund that holds very liquid, safe, short-term investments.

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par value: An arbitrary amount set as the face value of a security. payable period: See age of accounts payable. payables: See accounts payable. payback method: A method for evaluating investment projects that measures the time it takes for an investor to recover his or her initial investment. payback period: A payback method measure that assumes smooth cash flows: the initial investment divided by the average annual net cash inflow. payout policies: The approach by which a firm determines how to provide cash to its common shareholders, either through dividends or share repurchases. pecking-order model of capital structure: An idea that managers prefer retaining earnings, then debt, then equity when choosing a form of financing. perfect capital markets: Assumptions or conditions under which markets might operate, with full information available to all, and no frictions such as taxes or bankruptcy costs.

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permanent capital: The amount of interest-bearing debt plus preferred and common equity. perpetuity: A stream of equal and regular payments forever. preferred shares (preferred stock): A class of stock, typically dividend bearing, that has preference over common stock in terms of both dividend payments as well as claim on assets. preferred stock: See preferred shares. prepaid expenses: Short-term expense expected to yield benefits in the near term. present value: The current value of the value of an asset at a specified time in the future; the current value of an investment today that will grow to a specified amount by a specified time in the future given an interest rate. present value factor: The value today of a dollar received at a particular time in the future, discounted at a specified discount or interest rate. present value of annuity factor: The value today of a stream of dollars received at particular times in the future, discounted at a specified discount or interest rate. price-earnings (P/E) valuation model: A model of the intrinsic value of a stock based on projected earnings. prime rate: The rate offered by lending institutions, such as banks, to their most creditworthy customers. principal: The original or face amount of a loan on which interest is paid. private equity firm: An investment firm that invests shareholders’ money in private firms, including those with high growth potential, leveraged buyouts, and distressed firms. private placement: The sale of securities to a selected group of wellinformed investors. pro forma financial statements: The presentation of financial statements, such as income statements and balance sheets, typically used as forecasts, on an “as if” basis. profit margin: The ratio of net earnings to revenue. profitability index: A method for evaluating investment projects that takes the ratio of present value of net cash flows to the initial investment. profits: See net earnings.

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Glossary



R ratio analysis (financial ratios): The use of financial statement-related ratios to analyze the performance of the firm. real assets: Assets used to produce goods and services. real option: The alternative or choice, but not obligation, to make a particular business investment decision, often related to timing. receivables: See accounts receivable. recession: A downturn in a country’s economic activity, typically measured as two consecutive quarters of decline in real (or inflation-adjusted) gross domestic product. redeemable: See callable. relative valuation methods: An approach to estimating the equity value of a firm based on a comparison of valuations assigned to comparable firms. retained earnings: The cumulative amount of earnings retained or reinvested in the firm and not paid out as dividends. retention ratio: The proportion of earnings reinvested in the firm and not paid out as dividends. return on assets (ROA): A measure of the effectiveness of the utilization of a firm’s assets: the ratio of net earnings less preferred dividends, to total assets. return on capital employed (ROCE): A measure of the effectiveness of the utilization of a firm’s invested capital: the ratio of net operating profits after tax, to invested capital. return on equity (ROE): A measure of the effectiveness of the utilization of common shareholders’ equity: the ratio of net earnings less preferred dividends, to common shareholders’ equity. return on invested capital (ROIC): A measure of the effectiveness of the utilization of a firm’s capital: the ratio of after-tax operating profits, to capital employed. Capital employed is measured as net working capital plus fixed assets, or alternatively as interest-bearing debt plus equity. return on net assets (RONA): See return on invested capital. revenues (sales): The resource inflow to a firm through the sale of goods or the provision of services.

promissory notes: Promises by a firm to repay the lender, such as a bank, a certain amount of money by a specified date at a specified interest rate.

rights offer: A type of seasoned equity offering whereby shares are offered only to existing shareholders.

prospectus: A regulatory document filed with authorities, such as the SEC, that describes the details of a security offering in order to help investors make informed decisions.

S

public issue: See public offering. public offering (public issue): The sale of newly issued securities to the public. pure risk: The chance of a loss but no chance of a gain.

Q quick ratio (acid test): A measure of a firm’s liquidity: the ratio of current assets, excluding inventories, to current liabilities.

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S corporation: A business structure in the United States whereby income, losses, and deductions pass through to its shareholders for federal tax purposes. sales: See revenues. scenario analysis: A process similar to sensitivity analysis whereby several variables are changed simultaneously. seasoned equity offering (SEO): The additional sale of equity securities to the public by an already-public firm. secured loans: Loans backed by assets of a firm as collateral. securities markets: See capital markets.

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Glossary

sensitivity analysis: A process that involves investigating a firm’s pro forma statements and quantifying the effects of changing an assumption on a key variable such as net earnings or required financing. share repurchase: The process by which a firm buys back some of its own common shares. shareholder control: A majority voting equity stake in a firm. shareholders’ equity: See equity.

timeline: The representation of the amount and timing of cash inflows or outflows. trade credit: The practice of extending credit to customers, allowing for deferred payment. trade-off model of capital structure: An idea that managers consider both the value of interest tax shields and the cost of financial distress when choosing the appropriate debt-equity mix.

shelf offering: A regulatory provision that allows a firm to issue more shares at a future date without issuing a new prospectus.

U

sinking fund: A cash fund set aside by the firm in order to meet future debt obligations.

underwriting: The process, initiated by investment banks, of marketing new security issues to the public.

size-up: A process for assessing external and internal factors and strengths and weaknesses pertaining to a firm.

unlevered firm: A firm that does not have any interest-bearing debt as part of its capital structure; an all-equity firm.

sole proprietorship: A business structure with one owner and manager. sources and uses statement (statement of change in financial position): A financial statement that documents all fund inflows and outflows over a period of time, based on changes in balance sheet item amounts. speculative risk: The chance of a loss or gain. standard deviation: A statistical measure that captures the extent to which actual outcomes deviate from average or expected outcomes. statement of change in financial position: See sources and uses statement. stock options: Often provided to managers as a form of compensation, giving the holder the right to purchase shares at a particular price for a particular time. supply risk: The chance that the firm may suffer supply-related losses by not being able to meet demand. sustainable growth rate: The rate of growth in revenue that a firm can sustain without negatively impacting its financial resources such as needing to issue new equity, changing its payout of dividends, or changing its debt policy. SWOT analysis: A process for assessing the strengths, weaknesses, opportunities, and threats pertaining to a firm. synergies: The additional value created by the combination of two entities into one, through increased revenues or reduced costs.

T technical analysis: A method of evaluating the worth of securities based on examining patterns and trends in historical prices. terminal value: The value of assets either at the end of their economic life or at an arbitrary time in the future. time value of money: The idea that one dollar today is worth more than one dollar tomorrow because of its earning potential.

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V value-based management: A strategic management approach that assists firms in developing a culture that focuses on value creation. variable costs: Costs that vary over a period with changes in the volume of operations. variable rate: A floating or nonfixed loan rate, often tied to changes in the prime rate or LIBOR. venture capital firm: An investment firm that invests shareholders’ money in private start-up firms with high growth potential.

W weighted average cost of capital (WACC): See cost of capital. working capital: The difference between current assets and current liabilities on the balance sheet. working capital gap: The difference (measured in days) between the time payment to suppliers is required and payment from customers is received. working capital management: The process of managing short-term decisions pertaining to current assets and current liabilities.

Y yield curve: A plot at a particular time of the different (typically government) borrowing rates, with differing times to maturity. yield to maturity (YTM): The internal rate of return (IRR) of a bond when held to maturity.

Z zero coupon bond: A type of bond with no coupon payments.

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Index A Abandonment option, 182 Accounting financial management and, 33–34 international accounting presentation, 86 United States methods, 86 Accounts payable, 73–74. See also Working capital management age of, 98–99 discounts on, 118 management of, 118 Accounts receivable, 72. See also Working capital management age of accounts receivable, 98 aging schedules, 117 management of, 117–118 Accrual accounting method, 82 Acid test, 100–101 Acquisitions. See Mergers and acquisitions Adding back noncash items, 285 Adjusted present value (APV) formula, 274 Adjustment for foreign currency translation, 77 Advanced Micro Devices (AMD), 26 Age of accounts payable, 98–99 of accounts receivable, 98 of inventory, 97–98 Aging schedules, 117 All-equity firms, 243–244 debt vs., 263–264 Alternatives and decision-making, 176–177 American Depositary Receipts (ADRs), 209 Amortization, 72–73 as operating expense, 79 Anderson, Ronald, 267n Angel investors, 203 Annual reports, 107–108 Annuities, 159–160 bonds, annuity stream for, 164 Arithmetic returns on common shares, 200 The Art of War (Sun Tzu), 42 Asset-backed commercial paper (ABCP), 125 Assets, 29 on balance sheets, 71–73 goodwill as, 73

pro forma balance sheets, establishing for, 134–135 real assets, 25 useful life of, 73 Asset turnover (AT) return on equity (ROE) and, 92 sustainable growth rate and, 144 in Walmart case study, 317 Asymmetric information, 250–251 Auction process IPOs, 206 Audits under Sarbanes-Oxley Act (SOX), 205

B Bad debt, 117 Balance sheets, 33, 69–71. See also Pro forma balance sheets assets on, 71–73 equity on, 75–77 income statements, connecting, 81–82 liabilities on, 73–75 in Walmart case study, 313–314, 321–323 Banker’s acceptance (BA), 124–125 Bank of America, 209 Bankruptcy. See also Financial distress cost of indirect bankruptcy/financial distress, 248–249 defined, 248 largest U.S. bankruptcy, 249 relaxing assumption about, 247–249 Banks. See Interest and interest rates; Loans Barbarians at the Gate: The Fall of RJR Nabisco (Burrough & Helyar), 267n Barclays, 194 Bargaining power of customers, 55 of suppliers, 55 Barry, Julien, 279, 279n Best efforts IPOs, 206 Beta (ß), 217, 230 capital asset pricing model (CAPM) and, 230, 231–232 levered/unlevered betas (ß), 273–274 Target capital structure example and cost of equity, 273–274 Black, Fisher, 181

Black-Scholes model, 181–182 Blake, Frank, 65 Bloomberg beta (ß) of companies, 232 quarterly earnings information, 217 stock information, 215 Bondholders, 192 Bonds, 28, 192–197 callable bonds, 195 convertible shares, 80 covenants, 195 face value of, 164 features of, 193–195 financial calculator for present value of, 165 Home Depot example, 167 as long-term liabilities, 74 optimal timing for issuing, 268 private placement and, 202–203 ratings, 195–197 sinking fun features, 194 timeline for valuation of, 165 time value of money and, 163–167 understanding bond information, 215 variable rate bonds, 194 yields, changes in, 192–193 Book value of assets, 72 component weights and, 232 of equity, 76–77 of equity plus adjustments approach, 282–283 Bottom line, determining, 80 Bridge loans, 124 British Bankers Association, 194 Budgeting. See Capital budgeting; Cash budgets Buffett, Warren, 175, 218 Bureau of Economic Analysis website, 44 Burrough, Bryan, 267n Business cycle, 45 sector-related fluctuations in, 47–48 yield curve and, 50–51 Business risk, 265–266 credit analysis and, 196

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340

Index

C Callable bonds, 195 Call provision for bonds, 195 Capacity/leverage 100 Capacity trend, 45 Capital expenditures (Capex), 286 defined, 285 Capital asset pricing model (CAPM) beta (ß) and, 230, 231–232 cost of equity, estimating, 229–230 in Home Depot example, 234 market risk premium (MRP) and, 229–230, 231 risk-free rate and, 229–230, 231 in Walmart case study, 325 Capital assets, 72 Capital budgeting, 29, 177–185. See also Internal rate of return (IRR) capital rationing, 187–188 CFOs, survey of, 189 defined, 175 equivalent annual cost method, 186–187 modified internal rate of return (MIRR), 184–185 mutually exclusive projects and, 187–188 net present value (NPV) method, 179–181 payback method, 178–179 profitability index and, 185–186 project lengths and, 186–187 relevance for managers, 188–189 Capital gains tax and share repurchase, 253 Capital markets, 51–52, 191. See also IPOs (initial public offerings) for bonds, 192 cross-listing of shares, 209 financial intermediaries and, 209–210 market efficiency and, 210–212 over-the-counter (OTC) markets, 209 overview of, 201–202 private equity and, 202–203 private placement process, 202 private vs. public markets, 201–202 public offerings, 202 relevance for managers, 212–213 rights offers, 208 seasoned equity offerings (SEOs), 208 seasoned offerings, 208 shelf offerings, 208 venture capital and, 202–203 Capital rationing, 187–188

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Capital structure, 29, 240–242. See also Dividend policy; Financial distress; FIRST approach asymmetric information and, 250–251 corporate taxes, impact of, 246–247 Home Depot example of changing, 272 Modigliani-Miller argument, 239, 242–245 optimal capital structure, 259 pecking-order model of, 251 relaxing assumptions about, 245–251 relevance for managers, 254 Target capital structure example and cost of equity, 273–274 trade-off model of, 249–250 CAPM (capital asset pricing model). See Capital asset pricing model (CAPM) Cash equivalents, 72 sources and uses of, 115 Cash budgets, 137–139 cash inflows, establishing, 137 cash outflows, establishing, 137–138 net cash flows, establishing, 138–139 Cash conversion cycles, 111 Cash flow cycle, 25–28 defined, 27 Orange Computers example, 119–120 Cash flow cycles, 111–115 Cash flows. See also Cash budgets; Cash flow statements; Free cash flows (FCF); Net cash flows annuities and, 159–160 attributable to exchange rate movements, 87 coverage, 266 from financing activities, 85–87 from investing activities, 85 operating activities and, 83–85 payback method and, 178–179 perpetuities, 160–163 relevance for managers, 125–126 Cash flow statements, 33, 82–87 in Walmart case study, 313–314, 315 Cash inflows cash budgets, establishing for, 137 timelines representing, 156–157 Cash outflows cash budgets, establishing for, 137–138 timelines representing, 156–157 C corporations, 34–36 Center for Research in Security Prices (CRSP), 200–201 CEOs component weights and, 233 shareholder control and, 267

CFOs capital structure policy, survey on, 254 component weights and, 233 finance function, survey on importance of, 241–242 “CFO Views on the Importance and execution of the Finance Function” (Servaes & Tufano), 241–242 Chapter 31 bankruptcy, 248 Chapter 35 bankruptcy, 248 Character of managers, 63 Chief financial officers (CFOs), 42 Citigroup, 209 Clienteles, 253 Colchester, M., 194 Collection period, 98 Columns and rows in spreadsheets, 150 Commercial paper, 124 and financial crisis of 2007-2009, 125 Common dividends, 81 Common equity, 28, 70, 77 Common shareholders, 28 equity and, 75–77 net earnings available to, 81 Common shares, 75, 198–201 arithmetic returns, 200 dividends for, 171, 198–199 formulas for valuation of, 170–171 geometric returns, 200 historical returns on, 199–201 in seasoned equity offerings (SEOs), 208 share repurchase, 252–253 size of stocks, 200 timeline for valuation of, 170 time value of money and, 170–172 Common-size ratios, 104–105 Comparable analysis, 292–293 in Walmart case study, 328–330 Competition FIRST approach and, 269 Five Forces of, 54–56 profitability of industry and, 56 Walmart case study and, 310 Competitive environment, 54–55 Component weights estimating, 232–233 in Home Depot example, 234 in Walmart case study, 325–326 Compounded interest, 155–156 Constant growth dividend discount model, 294 Consumer price index (CPI) and inflation, 49

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Index



net present value (NPV) method, 179–180

Coupon rate, 164 for bonds, 194 setting of, 166 Covenants in bonds, 195 Coverage ratios, 101 CPI (consumer price index) and inflation, 49 Credit-rating agencies for bonds, 195, 196 optimal capital structure, determining, 260 Crosby, Tim, 116 Crossan, Mary, 63n “The Cross-Enterprise Leader” (Crossan, Gandz & Seijts), 63n Cross-listing of shares, 209 Cumulative dividends for preferred shares, 198 Current assets, 72 pro forma balance sheets, establishing for, 134–135 Current business, assessment of, 32 Current liabilities, 73–74 Current ratio, 100 Curtin, Richard, 308n Cyclical industries, 57

optimal capital structure and minimizing cost of capital, example of, 271–274

D

relevance for managers, 236–237

Damodaran, Aswath, 76, 91, 241 Debt. See also Capital structure; Cost of capital; Cost of debt all-equity firm vs., 263–264 financial flexibility and, 261 market value of debt, 298–299 Modigliani-Miller argument and, 242–245 optimal level of, 269–270 optimal timing for acquiring, 268 as percentage of capital across industries, 241 sustainable growth rate and, 144 Debt service coverage ratio, 102, 266 Debt-to-assets ratio, 100–101 Debt-to-capital ratio, 101 Debt-to-EBITDA ratio, 266 Debt-to-equity ratio, 100–101 Decision-making. See also Capital budgeting alternatives, generating, 176–177 analysis and assessment in, 177 evaluation criteria and, 176 preferred alternative, choosing, 177 process for, 175–177 real options and, 181–182 relevance for managers, 188–189 short and long term concerns and, 175–176 Defaults on bonds, 195

Contracts with shareholders, 30–31 Convertible shares, 80 Corporate bonds. See Bonds Corporate commercial paper, 125 Corporate social responsibility (CSR) policies, 30–31 Corporate taxes capital structure, impact on, 246–247 and financial distress costs, 249–250 in international markets, 247 Corporations, 34–35 government borrowing and, 50 Sarbanes-Oxley Act (SOX) and, 205 Cost accounting, 33 Cost of capital, 179, 191–217 component weights, estimating, 232–233 example, 219–221 free cash flow to the firm method and, 286–287 Home Depot example, 233–234 hurdle rates and, 235–236 implications of, 221–222

of Target Corporation, 326 Walmart case study, assessment in, 325–326 Cost of debt estimating, 225–226 in Modigliani-Miller argument, 242–244 optimal level of debt and, 270 permanent capital and, 226 in Walmart case study, 325 Cost of equity capital asset pricing model (CAPM) for estimating, 229–230 dividend model approach to estimating, 228–229 estimating, 228–232 for levered firm, 244–245 in Modigliani-Miller argument, 242–244 Target capital structure example, 273–274 in Walmart case study, 325 Cost of goods sold, establishing, 130–131 Cost of sales defined, 78 on income statements, 77–81 Costs equivalent annual cost method, 186–187 opportunity costs, 154–155 of reducing inventory, 123

Z02_FOER6644_01_SE_IND.indd 341

341

Greece, default on debt by, 50 Russia, default on debt by, 50 Deferred tax liabilities, 74–75 Deflation, 49 Demand risk, sizing-up, 60–62 Depreciation, 72–73 deferred income tax and, 74–75 as operating expense, 79 pro forma income statements, establishing expenses for, 132 straight-line depreciation, 73 tax liabilities and, 74–75 Depressions. See Great Depression Diamond, Neil, 203 Diamond, Robert, 194 Diluted earnings per share, 80–81 Ding, Yuan, 86 Discounted cash flow (DCF) method, 283–291 common mistakes with, 289 enterprise value (EV), 289–290 free cash flow to the firm method, 283–286 in Walmart case study, 328, 329 Discount rate, 48, 157–158 for bonds, 164 internal rate of return (IRR) and, 182–183 net present value (NPV) method and, 179–180 Discounts on accounts payable, 118 for quick payments, 123 Dispersion of expected returns, 223–224 Diversification and risk, 224 Dividend discount model, 170 cost of equity, estimating, 228–229 multistage dividend discount model, 172 Dividend payout ratio, 143, 252 Dividend policy, 81, 239, 251–252 for common shares, 171, 198–199 importance of, 253–254 perfect capital markets and, 257–258 share repurchase and, 252–253 Dividends, 28–29, 81 for common shares, 171, 198–199 cost of equity estimates and, 228–229 information on, 217 for preferred shares, 168, 197–198 sustainable growth rate and, 144 Double-entry bookkeeping, 112–113 Dow Jones Industrial Average, 51 beta (ß) of companies, 232 Dual class shares, 199 Google and, 267

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342

Index

Dual-entry bookkeeping, 112–113 Duke, Mike, 32 Duke Energy Corporation, 48 Dun & Bradstreet, 103 DuPont method, 92, 143 Dylan, Bob, 203

E Earnings before interest, taxes, depreciation, and amortization (EBITDA). See EBITDA (earnings before interest, taxes, depreciation, and amortization) Earnings before interest and taxes (EBIT). See EBIT (earnings before interest and taxes) Earnings before taxes (EBT) for pro forma income statements, 133 Earnings per share (EPS). See EPS (earnings per share) EBITDA (earnings before interest, taxes, depreciation, and amortization), 79. See also EV/EBITDA model cash flow coverage and, 266 debt service coverage ratio and, 102 debt-to-EBITDA ratio, 266 enterprise value-to-EBITDA model, 294–295 margin percentage, 94 EBITDAR in Walmart case study, 312 EBIT (earnings before interest and taxes), 79–80 actual vs. anticipated EBIT, 262–263 breakeven EBIT calculations, 263–264 debt service coverage ratio and, 102 FIRST approach and, 262–265 margin percentage, 94 for pro forma income statements, 133 EBT (earnings before taxes) for pro forma income statements, 133 Economic value added (EVA) approach, 297–300 Target Corporation and, 327 in Walmart case study, 326–327 Economy opportunities and risks and, 56–57 size-up of, 44–52 Walmart case study, analyzing for, 307–308 yield curve and, 50 Edelman, Benjamin, 206 Efficient market hypothesis (EMH), 210 event study sample testing, 211 semistrong form, 211–212 strong form, 212 weak form, 211 Eisenmann, Thomas R., 206 Electronic Data Gathering, Analysis, and Retrieval system (EDGAR), 44

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Enrich, D., 194 Enron scandal, 30 Sarbanes-Oxley Act (SOX) and, 205 Enterprise value (EV), 289–290. See also EV/ EBITDA model enterprise value-to-EBITDA model, 294–295 of firm, 217 EPS (earnings per share), 80 EBIT (earnings before interest and taxes) and, 262–265 FIRST approach and, 261–262 Equity. See also Cost of equity; Return on equity (ROE) on balance sheets, 75–77 book value of, 76–77 common equity, 28, 70, 77 existing shares and, 265 financial flexibility and, 261 market value of, 76–77 optimal timing for issuing, 268 pro forma balance sheets, establishing for, 135–137 sustainable growth rate and, 144 Equity and debt structure, 243–244 Equivalent annual cost method, 186–187 Ethics and maximizing shareholder value, 30–31 Euronext N.V., 209 EVA (economic value added (EVA) approach). See Economic value added (EVA) approach Evaluation criteria and decision-making, 176 EV/EBITDA model, 294–295 advantages/disadvantages of, 295 cross-industry comparisons, 296 mergers and acquisitions, valuing, 201–202 for stocks, 217 and Target Corporation, 330 in Walmart case study, 328–329 Event studies and semistrong form of efficient market hypothesis (EMH), 211–212 Evolution Petroleum Corp., long-term debt of, 243n Excel spreadsheets. See Spreadsheet analysis Exchange traded funds (ETFs), 230 Expected inflation, 49–50 Expected return capital asset pricing model (CAPM) and, 229–230 cost of equity and, 229 dispersion of, 223–224 hurdle rates and, 235–236 trade-offs with risk, 223 Expense ratios, 94–95 Expenses gross profits and, 79

on income statements, 77–81 operating expenses, 79 pro forma income statements, establishing for, 132 External environment financial management and, 36–40 operating decisions and, 43 External funding required, 128

F Facebook, IPO of, 206 Face value of bonds, 164 Facilities, operating systems and, 57–60 Factoring of receivables, 124 Farna, Eugene, 210n Federal Reserve System (The Fed), 48–49 too big to fail institutions, bailout of, 276 website, 44 Financial accounting, 33 Financial assets, 28 Financial calculators annuity, determining present value of, 160 bonds, finding present value of, 165 tips for using, 161 Financial crisis, 261 Financial distress, 239 corporate taxes and, 249–250 impact of, 247–249 indirect bankruptcy/financial distress, 248–249 Financial flexibility, 259–260 Financial Forecasting Spreadsheet, 130 Financial health of Walmart, analyzing, 312–319 Financial instruments, 28 Financial intermediaries, 209–210 Financial leverage, 239 return on equity (ROE) and, 92 Financial management, 25–28 accounting and, 33–34 framework for, 36–40 nonfinancial perspective of, 31–32 role of, 29–31 Financial ratios, 90 Financial risk, 266 credit analysis and, 196 Financial statements. See also Pro forma financial statements annual reports and, 107 demand risk assessment and, 62 international financial statements, 86

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Index



relevance to managers, 87 United States methods, 86 Financing, 239–258. See also Interest and interest rates cash flows from, 85–87 decisions, 43 defined, 29 short-term financing, 123–125 sustainable growth rate and, 143 Firm commitment IPOs, 206 Firms, types of, 34–36 FIRST approach, 259–268 earnings per share (EPS) and, 261–262 EBIT (earnings before interest and taxes) and, 262–265 evaluating, 268–274 financial flexibility, 259–260 price-earnings (P/E) valuation model and, 262 Fitch bond ratings, 195, 196 Five Forces, 54–56 in Home Depot example, 65 Walmart case study and, 309 Fixed assets, 72 pro forma balance sheets, establishing for, 135 return on invested capital (ROIC) and, 96 Fixed asset turnover, 97 Fixed rate loans, 123 Ford Motor Company, financial flexibility of, 261 Foreign currency translation, adjustment for, 77 Foreign markets. See International markets Formulas, 149–152 annuity, formula for present value of, 160 for common share valuation, 170–171 growing perpetuity, formula for present value of, 163 for modified internal rate of return (MIRR), 184–185 perpetuity, formula for present value of, 162 preferred shares, estimating cost of, 227 terminal value, estimating, 288 Four Ps of Marketing, 61–62 Free cash flows (FCF) enterprise value (EV) and, 289–290 estimating, 284–286, 287–288 terminal value, estimating, 288–289 timeline for, 290 Free cash flow to the firm method, 283–286 advantages/disadvantages of, 291 cost of capital and, 286–287 terminal value, estimating, 288–289 Fundamental analysis and semistrong form of efficient market hypothesis (EMH), 211

Z02_FOER6644_01_SE_IND.indd 343

Future financing needs, assessment of, 32 Future taxes, 74–75 Future value (FV), 155–157 of bonds, 164 timeline and, 157

G Gandz, Jeffrey, 63n GDP (gross domestic product), 44–45 business cycle and, 45 components of, 45–47 in Home Depot example, 64 sector-related fluctuations in, 47–48 U.S. real GDP annual change percentage, 46 Generally accepted accounting principles (GAAP), 33, 86 General Motors, 30 General partnerships, 34–35 Geometric returns on common shares, 200 Global Industry Classification Standard (GICS), 53n Going public. See IPOs (initial public offerings) Goldman Sachs, 209 Goodwill as asset, 73 Google IPO of, 206 long-term debt of, 243n OpenIPO and, 210 shareholder control and, 267 Government. See also Bonds yield curve and, 50 Graham, Ben, 175 Graham, John, 189, 237, 254, 254n, 269–270, 275 Great Depression inflation and, 49 stock prices and, 51 Great Recession, 275 Walmart case study and, 307–308 Greece, default on debt by, 50 Gross domestic product (GDP). See GDP (gross domestic product) Gross margin percentage, 94 Gross profits, 79 for pro forma income statements, 130–131, 133 Growing perpetuities, 162–163

H Harris, Ford W., 116 Harvey, Campbell, 189, 237, 254, 254n, 275 Helyar John, 267n High-yield bonds, 196–197

343

Home Depot balance sheet example, 70–71 bond features example, 195 bond prices and yields example, 167 capital structure, example of changing, 272 cash flow statement example, 84 common-size income statements, 104–105 consolidated statements of earnings, 78 cost of capital example, 233–234 economic value added (EVA) and, 298–299 performance measures, 102–107 pro forma statements, 145–147 size-up process example, 64–66 stock information, 216–217 sustainable growth rate and, 145–147 working capital gap example, 120–123 working capital management example, 118 Housing crisis, 275 Human resources, 34 in Home Depot example, 65 sizing-up management of, 62–64 Hurdle rate, 179–180 capital rationing and, 188 cost of capital and, 235–236 internal rate of return (IRR) and, 182–183

I Imports and exports. See also International markets banker’s acceptance (BA), 124–125 net importing/exporting countries, 46, 47 Income statements, 33, 77–82 balance sheets, connecting, 81–82 cost of sales on, 77–81 expenses on, 77–81 profits on, 77–81 pro forma income statements, generating, 129–133 revenues on, 77–81 Income taxes. See Taxes Indirect bankruptcy/financial distress, 248–249 Industries cyclical industries, 57 life cycles, 53–54 Inflation, 48–49 CPI (consumer price index) and, 49 interest rates and, 49–50 Information gathering for size-up, 44 Information technology (IT), 34 Initial public offerings (IPOs). See IPOs (initial public offerings) INSEAD, 30–31

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344

Index

Intensity of rivalries, 55 Interest and interest rates, 48–49. See also Bonds; Discount rate; Libor (London Interbank Offered Rate); Prime rate compounded interest, 155–156 inflation and, 49–50 modified internal rate of return (MIRR) and, 184 pro forma income statements, establishing expenses for, 132 sensitivity analysis and, 141 yield curve, 50 Interest coverage ratios, 101 Interest tax shield, 246–247 Internal rate of return (IRR), 182–185 modified internal rate of return (MIRR), 184–185 mutually exclusive projects and, 187–188 spreadsheet for, 183 strengths/weakness of, 183–184 International accounting presentation, 86 International Accounting Standards Board (IASB), 86 International markets common shares in, 199 corporate taxes across, 247 foreign currency translation, adjustment for, 77 IPOs, first-day returns of, 208 International Monetary Fund’s World Economic Outlook for the United States, 307 Internet financial intermediaries and, 210 stock information on, 215–217 Inventory. See also Working capital management age of inventory, 97–98 on balance sheets, 72 costs of reducing, 123 just-in-time inventory system, 119 management of, 116–117 operating systems and, 58–60 Inventory period, 97–98 Inventory turnover, 97–98 Investing, 28, 29. See also Capital budgeting annuities and, 159–160 cash flows from, 85 decisions, 43 hurdle rate and, 179–180 issues related to, 32 real options for, 181–182 sustainable growth rate and, 143 Walmart case study, assessing investments in, 324 Investment banks, 209–210

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Investment grade bonds, 196 Investors clienteles, 253 FIRST approach and, 269 IPOs (initial public offerings), 54, 203–209 advantages/disadvantages of, 205 cost of, 206 Facebook IPO, 206 first-day returns of international IPOs, 208 first-day returns of U.S. IPOs, 207 Google IPO, 206 number of U.S. IPOs, 207 OpenIPO, 210 prospectus in, 205 IRR (internal rate of return). See Internal rate of return (IRR) Iteration method, 151

Lines of credit, 120 Liquidation of firm, 248 Liquidity measures, 99–100 Liquidity preference, 50 Loans as liability, 28 as long-term liabilities, 74 as short-term financing, 123–124 London Interbank Offered Rate (Libor). See Libor (London Interbank Offered Rate) Long-term assets, 72 Long-term debt-to capital ratio, 101 Long-term financing decisions, 32 Long-term liabilities, 74 Lowe’s Companies, 103–104 common-size income statements, 104–105 performance ratios for, 104

J

M

Jeanjean, Thomas, 86 JP Morgan Chase, 209 Junk bonds, 196–197 Just-in-time inventory system, 119

Management. See also Decision-making; Financial management character of managers, 63 human resource management, sizing-up, 62–64 value, creation of, 40 Walmart case study analyzing, 311–312 Management buyout (MBO), 280 Marketable securities, 72 Market capitalization (market cap), 217 Market efficiency, 210–212. See also Efficient market hypothesis (EMH) Marketing financial managers and, 33 sizing-up management of, 60–62 Walmart case study analyzing, 311 Market risk, 224 Market risk premium (MRP) and capital asset pricing model (CAPM) and, 229–230, 231 Market value component weights and, 233 of debt, 298–299 of equity, 76–77 Market value added (MVA) approach, 298–299 Target Corporation and, 327 in Walmart case study, 327 MarketWatch on Lehman Brothers Holdings, Inc. bankruptcy, 249 Markowitz, Harry, 229 Mergers and acquisitions comparable transactions, valuing, 301–302 defined, 300 valuing, 300–302

K Kansas City Railroad preferred shares example, 169 Key success factors, 53 Kravis, Henry, 259 Kroger Co., return on equity (ROE) and, 93

L Large stocks, 200 Lehman Brothers Holdings, Inc., bankruptcy of, 249 Leveraged buyout (LBO), 241, 280 Leverage measures, 100–102 Levered firms cost of equity for, 244–245 value of, 243 Liabilities, 28 on balance sheets, 73–75 deferred income taxes as, 74–75 pro forma balance sheets, establishing for, 135–137 Libor (London Interbank Offered Rate), 124 bonds and, 194 scandal, 194 Liens, 124 Life cycles of industries, 53–54 Limited liability companies (LLCs), 34–35

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Index



Merton, Bob, 181 Miller, Merton, 242, 253, 253n Modified internal rate of return (MIRR), 184–185 example of, 185 Modigliani, Franco, 242, 253 Modigliani-Miller argument, 239, 242–245 Money markets, 191 Money supply and inflation, 48–49 Moody’s bond ratings, 195, 196 Moral hazard, 276 Morgan Stanley, 209 Morningstar.com OpenIPO and, 210 stock information on, 215 Mortgages, subprime, 275 Moyer, L., 203 Multistage dividend discount model, 172 Mutually exclusive projects, 187–188 MVA (market value added (MVA) approach). See Market value added (MVA) approach

N NASDAQ dual class shares and, 199 OMX, 209 Neighborhood Markets, 306 Net cash flows cash budgets, establishing for, 138–139 payback method and, 178–179 Net earnings, 28, 80 and net earnings available to common shareholders, 81 retained earnings and, 82 Net exporting countries, 46 Net importing countries, 46 United States as, 47 Net income, 28 Net operating profits after tax (NOPAT). See NOPAT (net operating profits after tax) Net present value (NPV) method, 179–181 creating projects with NPV, 281 multi-period example, 180 profitability index and, 185–186 spreadsheets for calculating, 181 strengths/weaknesses of, 181 Net present value rule, 181 Net profits, 28 Net worth, 75 New entrants, threat of, 55 New York Stock Exchange (NYSE). See NYSE (New York Stock Exchange) Noncash items, adding back, 285

Z02_FOER6644_01_SE_IND.indd 345

NOPAT (net operating profits after tax), 297 return on capital employed (ROCE) and, 297 in Walmart case study, 326 Notes payable, 73–74 NPV (net present value) method. See Net present value (NPV) method NYSE Euronext, 194, 209 NYSE (New York Stock Exchange), 36, 209 as source of stock information, 215

O OMX, 209 OpenIPO, 210 Operating expenses, 79 Operating margins for stock, 217 Operations, 28 cash, generation of, 25 cash flows relating to, 83–85 decision-making and, 43 financial managers and, 33 Six Ps of Operations, 57–60 sizing-up management of, 57–60 sustainable growth rate and, 143 Walmart case study analyzing, 300 Opportunities and PEST (political, economic, social, and technological) factors, 56–57 Opportunity costs, 154–155 Optimal capital structure, 259 cost of capital, example on minimizing, 271–274 relevance for managers, 274–276 summary of FIRST criteria, 269 Optimal timing, 268 Other assets, 72, 73 Other current assets, 72 Other long-term liabilities, 75 Over-the-counter (OTC) markets, 209

P Pacific Gas & Electric Company’s preferred share price, 226–228 Page, Larry, 267 Paid-in capital, 75 Partners and partnerships general partnerships, 34–35 operating systems and, 58–60 Parts and operating systems, 58–60 Par value of bonds, 164 Patents as assets, 73 Payable period, 99 Payback method, 178–179 strengths/weaknesses of, 179

345

Payout policy. See Dividend policy Pecking-order model of capital structure, 251 People. See also Human resources operating systems and, 58–60 Perfect capital markets assumptions, 243 dividend policy and, 257–258 Performance measures, 89–107 common-size ratios, 104–105 Home Depot example, 102–107 leverage measures, 100–102 liquidity measures, 99–100 profitability measures, 93–96 relevance for managers, 108–109 resource management measures, 96–99 return on equity (ROE), 90–93 in Walmart case study, 316–317 Performance ratios, summary of, 103 Permanent capital, 123, 226 Perpetual preferred shares, 197 Perpetuities, 160–163 growing perpetuities, 162–163 PEST (political, economic, social, and technological) factors, 56–57 Place in marketing mix, 61 Plant, operating systems and, 57–60 Political factors, opportunities and risks and, 56–57 Porter, Michael, 54–56. See also Five Forces Preferred shares, 197–198 convertible shares, 80 dividends for, 168, 197–198 as equity on balance sheet, 75 estimating cost of, 226–228 Kansas City Railroad example, 169 as perpetuities, 161 timeline for valuation of, 168 time value of money and, 167–169 Premium cost of debt and, 225 market risk premium (MRP), 230 Prepaid expenses, 72 Present value (PV), 157–159. See also Net present value (NPV) method adjusted present value (APV) formula, 274 of annuities, 160 of bonds, 163–164 of common shares, 170 discount rate and, 157–158 net present value (NPV) method, 179–181 of perpetuities, 160–163 of preferred shares, 168 timeline for, 159

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346

Index

Price in marketing mix, 61–62 stock price information, 215–217 Price-earnings (P/E) valuation model, 262, 291–294 advantages/disadvantages of, 293–294 comparable analysis and, 292–293 and constant growth dividend discount model, 294 cross-industry comparisons, 296 historical price-earnings multiples, 293 for stocks, 217 Price-to-book (P/B) ratio cross-industry comparisons, 296 for stocks, 217 Price-to-cash flow (P/CF) ratio for stocks, 217 Price-to-sales (P/S) ratio for stocks, 217 Prime rate for bonds, 194 loans, 123–124 Principal of bonds, 192 Private equity, 202–203 Private equity firms, 203 Private placement process, 202 Sesac Inc. example, 203 Process, operating systems and, 57–60 Product in marketing mix, 61–62 operating systems and, 57–60 Profitability index, 185–186 measures, 93–96 in Walmart case study, 317 Profit margin (PM) return on equity (ROE) and, 92 sustainable growth rate and, 144 Profits, 28. See also Gross profit on income statements, 77–81 Pro forma balance sheets, 134–137 assets, establishing, 25–135 equity, establishing, 135–137 liabilities, establishing, 135–137 in Walmart case study, 321–323 Pro forma financial statements, 128. See also Sensitivity analysis income statements, generating, 129–133 relevance for managers, 147–148 Pro forma income statements cost of goods sold, establishing, 130–131 expenses, establishing, 132 gross profit, establishing, 130–131 Walmart case study, projecting in, 319–320

Z02_FOER6644_01_SE_IND.indd 346

Project lengths and capital budgeting, 186–187 Promissory notes, 123 Promotion in marketing mix, 61–62 Prospectus in IPO process, 205 Public offerings, 202. See also IPOs (initial public offerings) Pure risk, 222–223

Q Quick ratio, 100–101

R Ratings for bonds, 195–197 Ratio analysis, 90 Real assets, 25, 27 Real options, 181–182 Recessions, 45. See also Great Recession sector performance and, 48 Redeemable bonds, 195 Reeb, David, 267n Regression analysis, 231–232 Relative valuation methods, 291–296 price-earnings valuation model, 291–294 Research and development (R&D) as operating expense, 79 Residual claimants, 28, 198 Resource management, 96–99 in Walmart case study, 317 “Retail Industry Outlook Survey: Modest Gains Keep Cautious Optimism in Style” (KMPG), 308 Retained earnings, 29, 77, 81 net earnings and, 82 for pro forma income statements, 133 Retention ratio (RR), sustainable growth rate and, 143–144 Return on assets (ROA), 93 for stocks, 217 Return on capital employed (ROCE), 298 Return on equity (ROE), 90–93. See also DuPont method resource management measures and, 96–97 by sector, 91 for stocks, 217 sustainable growth rate and, 143 of Target Corporation, 319 in Walmart case study, 317–318 Return on invested capital (ROIC), 95–96, 126 of Target Corporation, 318 in Walmart case study, 318 Return on investment (ROI) in Walmart case study, 312 Return on net assets (RONA), 298

Revenues defined, 78 on income statements, 77–81 and industry life cycles, 54 sustainable growth rate and, 142–143 Rights offers, 208 Risk. See also Business risk; Financial risk defining, 222–225 dispersion of expected returns, 223–224 diversification and, 224 expected returns and, 223 minimizing, 265–266 PEST (political, economic, social, and technological) factors, 56–57 preferred shares, estimating cost of, 226–228 pure risk, 222–223 speculative risk, 223 supply risk, sizing-up, 57–60 unsystematic risk, 224 in Walmart case study, 312 Risk-free rate, capital asset pricing model (CAPM) and, 229–230, 231 Ritter, Jay, 207–208 Rivalries, intensity of, 55 ROA (return on assets). See Return on assets (ROA) ROCE (return on capital employed), 298 Rockefeller, John D., 239 ROE (return on equity). See Return on equity (ROE) ROIC (return on invested capital). See Return on invested capital (ROIC) ROI (return on investment) in Walmart case study, 312 RONA (return on net assets), 298 Royal Bank of Scotland, 194 Rule 144a private placement, 203 Rush, 203 Russia, default on debt by, 50

S Sales. See also Cost of sales sensitivity analysis and, 140 Sam’s Club, 306 Sarbanes-Oxley Act (SOX), 205 Scenario analysis, 139–140 Scholes, Myron, 181 Scorecards, accountant providing, 33 S corporations, 34–35 Seasoned equity offerings (SEOs), 208 stock prices and, 251 Seasoned offerings, 208

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Index



SEC (Securities and Exchange Commission). See Securities and Exchange Commission (SEC) Sector performance case study of, 48

Size-ups, 42 capital markets and, 51–52 checklist for, 52

Stock options, 80 Stocks. See also Common shares; Preferred shares; Shares and shareholders diversification, portfolios and, 224

of demand risk, 60–62 external environment and, 43

Stolowy, Harve, 86

Secured loans, 124

gathering information for, 44

Straight-line depreciation, 73

Securities. See also Beta (ß); Bonds; Capital markets; Common shares; Preferred shares

Home Depot example, 64–66

Strong form of efficient market hypothesis (EMH), 212

fluctuations in, 47–48

bid price, 217 Internet, stock information on, 215–217 price, information on, 215–217 Securities and Exchange Commission (SEC), 44 generally accepted accounting principles (GAAP) and, 86 Rule 144a private placement, 203 Securities markets. See Capital markets Seijts, Gerard, 63n Selling, general, and administrative (SG&A) expenses, 79 pro forma income statements, establishing expenses for, 132 and Walmart case study, 308–309 Semiannual yield to maturity for bonds, 164 Sensitivity analysis, 139–142 interest rate sensitivity, 141 sales sensitivity, 140 in Walmart case study, 323–324 working capital sensitivity, 141–142 Sergey, Brin, 267 Servaes, Henri, 241, 254, 275 Sesac Inc. example of private placement, 203 SG&A expenses. See Selling, general, and administrative (SG&A) expenses Share repurchase, 252–253 Shares and shareholders, 266–268 convertible shares, 80 dividend policy, 81 earnings per share (EPS), 80 equity, 70 maximizing shareholder value, 30–31

of human resource management, 62–64 of marketing management, 60–62 of operations management, 57–60 of overall economy, 44–52 questions during, 52 relevance for managers, 66–67 of supply risk, 57–60 in Walmart case study, 307–319 Small stocks, 200 Social trends, opportunities and risks and, 56–57 Sole proprietorships, 34–35

Subprime mortgage business, 275 Substitutes, threat of, 55 Succession, planning for, 62 Sun Tzu, 42 Supply risk, 57–60 Sustainable growth rate, 142–147 SWOT analysis, 42 Synergies, 300 Systematic risk, 224

Sources and uses statements, 82, 114–115

T

Sozzi, Brian, 32

Target Corporation

Speculative bonds, 196–197 Speculative risk, 223 Spreadsheet analysis, 149–152 iteration method, using, 151 what if? questions and, 152 Spreadsheets annuities, determining present value of, 160 bonds, finding present value of, 165

cost of capital of, 326 economic value added (EVA) of, 327 EV/EBITDA analysis of, 330 market value added (MVA) approach and, 327 return on equity (ROE) of, 2925 return on invested capital (ROIC) of, 318

for equivalent annual cost method, 186–187

Taxes. See also Cost of capital; Cost of debt

for internal rate of return (IRR) example, 183

deferred income taxes, 74–75

net present value (NPV), calculating, 181–182

pro forma earnings before tax, estimating, 133

tips for using, 161 S&P (Standard & Poor’s) index. See Standard & Poor’s (S&P) index

share repurchase and, 253 T-bills. See U.S. Treasury bonds Technology

Standard deviation, 224

information technology (IT), 34

Standard & Poor’s (S&P) index, 51–52

opportunities and risks and, 56–57

bond ratings, 195, 196

role of, 34

dividend payout ratio, average of, 252

weak from of efficient market hypothesis (EMH) and technical analysis, 211

stock options, 80

Global Industry Classification Standard (GICS), 53n

value and, 281

Temporary working capital, 123

summary of opinions of, 197

34-K documents, 107–108

Sharpe, Bill, 229

Terminal value, 288–289

Shelf offerings, 208

Statement of change in financial position, 82, 114–115

Shiller, Robert, 52

Stock certificates, 28 Stock exchanges, 209

Thomson One, 54

Short-term financing, 123–125 banker’s acceptance (BA), 124–125

Stockholder’s equity, 75

commercial paper, 124

Stock markets

Text in spreadsheets, entering, 150 Thomson Reuters/University of Michigan Index of Consumer Sentiment, February 2012, 308

Sinking funds, 194

average U.S stock prices, 51–52

Threat of new entrants, 55

Six Flags example of optimal level of debt, 269–270

business cycle and, 47

Threat of substitutes, 55

capital asset pricing model (CAPM) and, 230

Tiffany & Co., 48

Six Ps of Operations, 57–60

efficiency of U.S. stock market, 212

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return on equity (ROE) and, 93

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Index

Timelines, 156–157 for common share valuation, 170 free cash flows (FCF), estimating, 287–288 for free cash flows (FCF), 290 growing perpetuity, depiction of present value of, 163 perpetuity, depiction of present value of, 162 for preferred share valuation, 168 for present values, 159 Time value of money, 153–163 annuities and, 159–160 bonds, application to, 163–167 common shares, 170–172 future values and, 155–157 opportunity costs and, 154–155 perpetuities, 160–163 preferred shares, 167–169 present values, 157–159 relevance for managers, 172–173 Trade credit, 117–118 Trademarks as assets, 73 Trade-off model of capital structure, 249–250 Treasury stock, 77 Tufano, Peter, 241, 254, 275 Twain, Mark, 191 Tyco scandal, 30, 205

U UBS (Switzerland), 194 Unbiased expectations, 50 Underwriting and financial intermediaries, 210 Unlevered firms, value of, 243 Unsystematic risk, 224 US. stock returns, 199 U.S. Treasury bonds, 200–201 returns, 199 yields, 193

V Value, 279–304. See also Book value; Market value comparable analysis for, 292 cost of capital and, 221 creating value, 297–300

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economic value added (EVA) approach, 297–300 EV/EBITDA model, 294–295 free cash flow to the firm method, 283–286 maximizing shareholder value, 30–31 mergers and acquisitions, valuing, 300–302 overview of, 280–281 price-earnings valuation model, 291–294 relative valuation methods, 291–296 relevance for managers, 302 Walmart case study, valuation in, 326–331 Value-based management, 297–300 Value Line on beta (ß) of companies, 232 Value proposition, 61 Van Binsbergen, Jules, 269–270 Vandenbosch, Mark, 60n Variable costs, 94 Variable rate bonds, 194 Variable rate loans, 123 Venture capital, 202–203 amount invested in U.S., 204 number of deals in U.S., 204 Venture capital firms, 203 Vermaelen, Theo, 30–31

W W. R. Hambrecht and Company, 210 Walmart case study, 31–32, 305–332 alternate scenarios, examining, 323–324 balance sheets, analyzing, 313–314 capital raising, assessing, 325–326 cash flow statements in, 313–314, 315 comparable analysis in, 328–330 competition and, 309–310 consolidated statements of income, 313 cost of capital, assessing, 325–326 creating value in, 330–331 discounted cash flow (DCF) method and, 328, 329 economy, analysis of, 307–308 financial health, analyzing, 312–319 industry, analysis of, 308–310 investments, assessing, 324 management, analyzing, 311–312

marketing, analyzing, 311 operations, analyzing, 311 performance measure summary, 316–317 pro forma balance sheets in, 321–323 pro forma income statements, projecting, 319–320 relevance for managers, 331 strengths/weaknesses, analyzing, 310–319 valuation in, 326–331 Walton, Sam, 305 Weighted-average cost of capital (WACC). See Cost of capital Working capital, 25, 27 free cash flow to the firm method and, 286 permanent working capital, 123 resource management measures and, 97 return on invested capital (ROIC) and, 96 sensitivity analysis and, 141–142 spreadsheets relating to, 152 temporary working capital, 123 Working capital gap, 120 Home Depot example, 120–123 ratios across industries, 122 Working capital management, 29, 116–123 Home Depot example, 118 Orange Computers example, 119–120 ratios across industries, 122 WorldCom Inc. bankruptcy of, 249 Sarbanes-Oxley Act (SOX) and, 205

Y Yahoo!Finance, 215 quarterly earnings information, 217 Yang, Jie, 269–270 Yield curve, 50–51 Yield to maturity (YTM) for bonds, 164 and cost of debt, 225 setting of, 166 Yoon, A., 203

Z Zero coupon bonds, 164

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