Introduction to Corporate Finance Compensation 01 corporate executives in the United Slates continues 10 be a hOI-button issue. It is widely viewed thai CEO pay has grown to exorbitant levels (at least in some cases). In response, in Apri l 2007, the U.S. House of Representatives passed the -Say on Pay" bill. The bill requires corporations to allow a nonbinding shareholder vole on executive pay. (Note that because the bill applies to corporations. il does not give voters a ~say on pay" for U.S. Representatives.)

Specifically, the measure allows shareholders to approve or disapprove a company's executive compensation plan. Because the vote is nonbinding. it does nol permit share-holders to velo a compensation package and does nol place limits on executive pay. Some companies had actually already begun iniliatives to allow shareholders a sayan pay before Congress got involved. On May 5. 2008. Aflac, the insurance company with the wellknown ~spokesduck.~ held the first shareholder vote on executive pay in the United States.

Understanding how a corporation sets executive pay, and the role of shareholders in that process, takes us into issues Involving the corporate form of organization, corporate goals, and corporate control, all 01 which we cover in this chapter.

1.1 What Is Corporate Finance? Suppose you decide to start a firm to make tennis ba lls. To do this you hire managers to buy mw materials. and you assemble a workforce that will produce and sell finished tennis balls. In the language of finance, you make an investment in assets such as inventory. machinery, land, and labor. The amount of cash you invest in assets must be matched by a n equa l amount of cash mised by fimll1cing. When you begin to sell ten nis balls. your firm will generate cash. This is the basis of value creation. The purpose of the firm is to create value for you, the owner. The va lue is renected in the framework of the simple balance sheet. model of the firm .

The Balance Sheet Model of the Firm suppose we take a financial snapshot of the firm and its activities at a single point in lime. figure 1.1 sbows a grapbic conceptualization of the balance sheet. and il will help inlroduce you to corporate finance.

The assets o f the rtrm are on the left side of the balance s.beet. These assets can be thought of as current and fixed . Fixed assets are those that will last a long time. such as buildings. Some fixed assets are tangible. such as machinery and equipment. Olher fixcd assets are imangible, sucb as patents and Irademarks. The other category of assets. cllrre", assets. comprises those that have short lives, such as inventory. The

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,

Figure 1.1 The Balance Sheet Model or the FIrm

Pari I Ovcrvieo.v

Current assets

T0'I81 Value of Assets

..... ".

Total Value 01 the Firm to InveSlors

(cnnis balls tbat your firm has made, but has not yel sold, are part of its inventory. Unless you have overproduced, they will leave the firm shortly.

Before a com pany can invest in an asset, il must oblnin linanci ng, which means that it must raise the money to pay for the investment. Tbe forms of financing are repre-sen ted o n the right side of the balance sheet. A firm will issue (scll ) pieces of paper called debt (loan agreements) or equity shares (stock cert ificales). Just as assets are classified as long-lived or short-lived. so too are liabilities. A short-term debt is called a curremliabilit),. SborHerm debt represent s loans and olher obligations that must be repaid within one year. Long-term debt is debt that docs not have 10 be repaid within one year. Shareholders' equity represents the difference between the value of the assets and the debt of the finn. In this sense. it is a resid ual claim on the firm 's assets.

From the bal ance sheet model o f the firm. it is easy to see why finance can be thought of as the study of the following three questions:

I. In wbat lo ng-lived assets should the firm invest? This question eOJ1c;ems tbe left side of the balance sheet. Of course the types and proportions of assets the fi rm veeds lend to be set by the nature of the business. We use the term capital budgeting to describe the process of making and managing expenditures on Jong-lived assets.

2. How can the finn raise cash for requ ired capital expenditures? This question con-cems the right side of the balance sheet. The answer to this question involves the firm's capital structure, which represents the proportions of the firm 's linancing from current and long-term debt and equity.

3. How should shorl-term operating cash flows be managed? This question concerns the upper portion of the balance sheet. There is often a mismatch between the timing of cash inflows and cash o utnows during operating activi-ties. Furthermore, the amount and timing of operati ng cash flows are not known with certainty. Financial managers must attempt to manage the gaps in cash n ow. From a bala nce sheet perspective, sbort-term maoagement of cash now is

For currenl lssue'S I lacing CFOs, S&fJ www.c1p !!OlD.

Figure 1.2 Hypothetical Organization Chart

Chapter I lnl roctvc\iol'l loCorpora\l: Fin:.m;e

associated with a firm's net working capila!. Net working capital is defined as cur-rent assets minus current liabilities. From a financial perspective, short -term cash now problems come from the mismatching of cash inflows and outflows. This is the suhje

,

1.2

For more about small business

organization. see tile "Business and Human Resources" section at

WWW.nolocom

Part J Overview

The Corporate Firm llle firm is a way o f organizing the economic activity o f Illa ny individuals. A basic problem of the firm is how 10 raise cash. The corporate fo rm of busi ness- that i ~ orga-nizing the firm as a corporation- is the standard method fo r solving problems encoun-tered in raising large amounts of cash. However, businesses can take other forms. In Ihis sectio n we consider tbe three basic legal forms of orga nizing fi rms.. and we see how rirms go about the task o f ra ising large amounts of money under each form.

The Sole Proprietorship A sole proprietorship is a business owned by one person. Suppose you decide to sta n a business to produce mousetraps. Going into business is simple: You announce to a ll wbo will listen. Today. I am going to build a better mousetrap."

Most la rge cities require that you obtain a business license. Afterwa rd . you ca n begin to hire as many people as you need and borrow whatever money you need. At yea r-end all the profits and the losses wi ll be yours.

Here are some factors that are impon ant in considering

,

shareho lders. the directors. and the top ma nagement. However. in larger corporations, the shareho lders, directors, and the lo p management are likely to be dislinct groups.

The potential separation of ownership from management gives the corpo ratio n sev-eral advantages over proprietorships and partnerships:

I. Because ownership in a corporal ion is represented by shares of stock. ownership can be readily transferred to new owners. Because the corporation exists indepen -dent ly of those who own its sha res, there is 0 0 limit to the transferabili ty o f sha res as there is in pannerships.

2. The corporation has unlimi ted life. Because the corporation is separate from its owners, tbe death or withdrawal o f an owner does not affect the corporation's legal exis tence. The corporation can continue on arter the original owners have withdrawn.

3. The shareholders' liability is limited 10 the a mount invested in the ownership shares. For example. ir a shareho lder purchased $ 1.000 in sha res o f a corpora-tion, Ihe pOlential loss would be $ 1.000. In a partnership, a general partner with a $1,000 cont ribut ion could lose the S I ,000 plus any other indebtedness of the partnership.

Limited liability. e

In Their Own \'\'ords SKILLS NEEDED FOR THE CHIEF FINANCIAL OFFICERS OF eFINANCE.COM

Chj~f risk officer: Limiting risk will be even more important as ma rkets become mort global and hedg-ing iostruments become more complex.

Ch;efs'raugi.~': CFOs will need to use real- time finan-cial information to make crucial decisions fast.

Ch;~1 communicator: Gaining the confidence of Wall Street and the media will be essential.

Chief dea/maker: CFOs must beadep! at venture capital, mergers and acquisitions, and strategic pannen;hips.

Figure 1.3 Cash Flows between the Arm and ttle FinancIal Markets

8

Thus, the firm must creale more cash now tnan it useS. The cash nows paid to bond-holders and stockholders of the firm shou ld be greater than the casb nows put into the firm by the bondholders and stockholders. To sec how Ihis is done, we can trace Ihe cash nows from the firm to the fi nancial markets and back again.

The interplay of tbe firm 's activities with the financial markets is illustrated in Fig-ure J .3. The arrows in Figure 1.3 trace cash flow from the firm to the fina ncia l markets a nd back again . Suppose we begin with the firm's financing activit ies. To raise money, the fi rm sells debt and equity shares to investors in the financial markets. This results in cash flows from the financial markets to the firm (A). Tbis eash is invested in the investment activities (assets) of the firm (8) by the firm's management. The cash gen-erated by the firm (q is paid to shareholders and bondholders (F) . The shareholders receive cash in the form of d iv idends; the bondholders who lent funds to the tlrm receive interest and , when the initial loan is repaid, principal. Not all of the firm's cash is paid out. Some is retained (E), a nd some is paid to the government as tal(CS (D).

Over time. if the cash paid to shareholders and bondholders (I) is greater than the cash raised in the financial markets (A) , val ue will be created.

Finn invests in assets

(81 Current assets Fixed assets

Tolal Value of Assets Total Value olthe Finn to Investors in

rile Financial Markets

EXAMPLE 1.1

Chapl",r I Introduct ion 10 Corpor..l le Finance ,

Identification of Cash Flows Unforlunately. il is sometimes not easy to o bserve cash flows directly. Much of the information we obta in is in the form of accounting statements, and much of the work of financial analysis is to ex tract cash flow informa-tion from accountiog statemen ts. The following e.xample illustrates how this is done.

Accounting Profit versus Cash Ftows The Midland Company r~fines and trades gold. At the end of the Ye

10

EXAMPLE 1.2

EXAMPLE 1.3

1.4

Pan I Overview

Cash Flow Timing The Mldlaoo Com~ny is attempting to choose between twO proposals for new products. Both proposals will provide additional cash flows over a fouf'-year period and will i.,ioally cost $10,000_ Thoe cash nows from the propc$~ls are as follows:

Year New Product A New Product B

I $ 0 S4,OOO 2 0 ' .000 3 0 '.000 20,000 ' .000

Total $20,000 $16,000

Al first it appears that new product A would be ben. Howcv!t. the cash flows from proposal B come earlier than those of A. Without more information. we cannot decide which set of cash flows would create the most value (or the bondholden and shareholders. It depends on whether the value of geulng cash 'rom B up front outweighs the extra total cash from A. Bond and stock prices reflect this preference for earlier cash. and we will see how to use them to decide between A and 8.

Risk of Cash Flows The firm must consider risk. The amount and timing of cash nows are not usua lly known with certainty. Most investors have an aversion to risk .

Risk Th~ Midland Company is considering expanding operations (Wef"seas. It is evaluating Europe atld J1Pl1"1 15 pouible sites.. Europe is considered to be relatively safe, whereas operating in Jlpa.r1 is seen as very risky. In both cases the company would dose down operations after one year.

After doing

12

Business elllies are considered at

www.busll!fU=lthics ...."

Plrt I Overview

1 r \VC ass lUTIe that stock ho lders buy stock bee .. usc they seck to ga in financihart of Ih(' e:l:isling stock.

The goal o f maximizing the value of the s tock avoids the problems associated wit h the dilTe rent goa ls we listed ea rlier. T here is no a mbiguit y in Ihe c rite rion. and there is no shari-run versus long-run issue. We explicitly mean Ihut our goal is to maximize the curr('/U stock vnlue.

If this goa l seems a little strong or one-diOlcnsional to you. kee p in mind that the stockholders in a firm are residual owners. By th is we mC31l1l1al they are entitled only to what is len aner employees, suppliers, and creditors (and everyone else with legiti-mate cla ims) a re paid their due. If any of these groups go unpaid. the stockholders get nothing. So if the stockholders are winni ng in the sense that Ihe leftover. residual portion is growing, il must be true that e\'eryone else is wi nning also.

Beca use the goal of financial managemenl is to maximize the va lue o f the stock, we oeed to learn how to identify investmen ts and financing arrangements Ihat f,l\'oritbly impact the val ue of the Slock. This is preci sely what we will be study-ing . In the previous section we emphasized the importance of cash flows in va lue crea tion. In fact . we could have deli ned corpor(lfe j'ilUlI/et' as the study of the rela -tionsh ip between business decisions. cash nows. and the value of the stock in the business.

A More General Goal If our goal is as slated in the preceding secti on (to maximize the: va lue of the stock). an ob\,jous question comes up: What is the appropriate goal when the finn has no traded stock? Corporations are cert~inly not the only type of business: and the stock in many co rporati ons rarely changes hands. so it's d ifficult to say what the value per share is at any particular time.

As long as we are considering fo r-profit businesses. only a slight modifiC'ltion is needed. The total value of the stock in a corporation is sim ply equal 10 the value of the owners' equity. Therefore. a more genera l way of stating our goal is as fo llows: Maximize the value of the existing owners' equ ity .

With Ihis in mind. we don't care whether the business is a proprietorship. a part-nership. or a co rporation. For each of these, good fina ncia l decisions increase the market va lue of the owners' equity, and poor financia l decisions decrease it. In fact, although we choose to focus on corporations in the chapters ahead, the principles we develop apply 10 a ll fo rms of business. Many of them even apply to thc not-for-profit sector.

Finally. our goal does not imply that the financia l manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial ma nager besl serves the owners of the busi ness by identify-ing goods and services tbat add value to the firm because they are desired and vd lued in the free marketplace.

Oapoler I Introduction to (orporutc Finll""'\:'

1.5 The Agency Problem and Control of the Corporation

13

We've seen that the linancial manager acts in the best interests of the stockholders by taking actions that increase the V'd lue of the stock. However. in I:nge corpora tions o\\'Ilership can be spread over a huge number of stockholders.' This disper-sion of ownership arguably means Ihat management effecti vely cont rols the firm . In this case. will managemen t necessarily act in the best interests of the stockholders? Put another way, migh t not mamtgement pursue it s own goa ls at the stock.holders expense? In the fo llowing puges we briefly consider some o f the arguments relating to this question.

Agency Relationships The relationsh ip between stockholders and management is called an agel/(\' I'(' /(l/ ioll-ship. Such a relationship exists whenever someone (the principa.l) hires another (the agent) to represent his or her interests. For example. yOll might hire someone (an agent) to sell a car that you own while you a re aWdy at school. In all such relationships there is a possibi lity of a eonniet of in tcrest be tween the principal and the agent. Such a connict is ca ned an agency problem.

Suppose you hire someone to sell your car and you agree to pay that person anal fce when he or she sells the car. The agent 's incentive in this case is 10 make the Sl"tle. not necessa rily to get you the best price. If you o ITer a commission of, say. 10 percent of the sales price instead of a flat fec, then this problem migh t not exist. T his cX

14 Pari I Overview

Management Goals To see how management a nd stockholder interests might differ. imagine that a firm is considering a new investment. The new investment is e:o;peclcd 10 favorably impact the share value. but it is a lso a relatively risky venture. The owners of the firm will wish to take Ihe investment (because the stock value will rise), bm management may nOI because there is the possibility that things will !Urn out badly and mamlgcmenl jobs will be lost. ff management does not lake the investment. then the stockholders may lose a valuable opportunity. This is o ne example of an ageflcr cost

More generally. the term agency ('ost::; refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indi-rect agency cost is a lost opponunity, such as the one we have just described.

Direct agency costs come in two forms. The li rst type is a corporate expenditure tllll! benefits management but costs the stock holders.. Perhaps the purchase of a lu xu-rious and unneeded corporate jet would fall under this heading. The second Iype of direct agency cost is an expense that arises from the need to monitor management aclions. Paying outside auditors to assess Ihe accuracy of financial statement informa-tion could be o ne example.

II is sometimes argued that, left to themselves. managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. Thi s goa l cou ld lead to an overemphasis OJ) corporate size or growth. For example. cases in which management is ae

16 Pan I Overview

Taken toget her. these va rio us groups are called stakeholders in the firm . In gcnenll , a stakeholder i:i someone other than a stockholder or creditor who potentia lly has a claim on the cash flows of the firm . Such groups will also aHem pli O exert contro l over the fi rm. perhaps to the detriment of the owners.

1.6 Regulation Until now, we have talked mostly about the act ions that shareholders and boards of directors can take to reduce the conniets of interest between themselves and manage-ment. We have not talked about regulation. ) Unt; l recently the ma in thrust of fed-era l regulation has been to require that compan ies disclose all relev".:I.nl info rmation 10 investors and potemiai investors. Disclosure o f relevant information by corporat ions is intended to put all investors on a level information playing field and. thereby to reduce connicts of interest. Of course, regulation imposes costs on corporatio ns aDd any a nalysis of regulation must include both benefits and costs.

The Securities Act of 1933 and the Securities Exchange Act of 1934 The Securities Act of 1933 (the 1933 Act) and the Securili~s Exchange Act of 1934 (the 1934 Act) provide the basic regulatory framework in tbe United States for the public tmding of securities.

The 1933 Act focuses on the iss uing of new securities. Basically. (he 1933 Act requires a corporation to file a registration statement with the Securities and Exchange Comnlission (SEC) that must be made available to every buyer of a new security. The intent of the registration statement is to provide potential stockholders with all the necessary informatio n to ma ke a reasonable decision. The 1934 Act extends the disclosure requirements of the 1933 Act to securities trading in markets Clner th ey have been issued. The 1934 Act establishes thc SEC a nd covcrs a large number of issues includ ing corporate reporting. tender offers, and insider trading. The 1934 Act requires corporations to file repons to the SEC on an annua l basis (Fo rm 10K). on a quarterly basis (Form IOQ), and on a mo nthly basis (Form SK).

As mentioned, the 1934 Act deals with the important issue of insider trading. Illegal insider trading occurs when any person who has acquired nonpublic. special informa-lion (i.e .. inside information) buys or sells securi ties based upon that information , One section of the 1934 Act deals with insiders such as directors. officers, and large share-holders. wh ile another ueals wilh any person who has acquireu inside inComation. The intent of these sections of the 1934 Act is to prevent insiders or persons witb inside infor-mation from takiog unfair advantage of tbis information when trading witb outsiders.

To illustrate, suppose you learned that ABC firm was about to publicly a nno unce that it had agreed to be acquired by another finn al a price significantly greater than its current price. This is an example of inside info rmation. The 1934 Act prohibits you from buying ABC stock from shareholders who do not bave this informa.t ion. This

'At th is stage in our book, we focus on th~ regulation or corporate governancc. We do not ta lk about mom}' other regUlators in fin ancia l marke ts such as the Foocral Reserve Board. In Chapte r 8. we discuss the nationally re

18

Summary and Conclusions

Concept Questions

Part I Ol'erv;cw

the accurdcy of the financial statements. so the savings can be huge. or course, there are costs. Stock prices Iypically fall when a company announces it is going dark . Fur-ther. such companies will typica lly have limited access 10 capital markets and usually will have a higher interest cost on bank loans.

Sarbox has also probably affected the number of companies choosing to go public in the United Slates. For example, when Peach Holdings, based in Boynto n Beach, Florida, decided to go public in 2006. il shunned the U.S. stock markets. instead choosing the London Stock Exchange's Alternative Investment Market (AIM), To go public in the United States, the firm would have paid a $100,000 fee, plus about $2 million !O comply with Sarbox. Instead. the company spenl on ly $500,000 on its AIM slock offering. Overall. the European exchanges had a record year in 2006, with 65 1 companies going public. while the US. exchanges had a lackluster year, with 224 companies going public.

This chapler introduced you 10 some of the basie ideas in corporate finance: I. Corporate finance has three main areas of concern:

a. Capilallmdgetillg: Whiliiong-term invest ments should the firm take'! b. Capital SlruCflm': Where will the firm get Ihe long-Ierm financing to pay for its invest-

ments? Also. what mixlUre of debt and equi ty should it usc to fund operations'! e. Working capiwl m(l1wgemellf: How should the fi rm roanage il.:) evcryday fimtnc ial

activities? 2. The goal of financial management in a for-profi t business is 10 make decisions tbat

increase the value of the stock , or. more gCll crall}~ increase the market value of the eq u i t }~

3. TIle corporate form of organization is superior to other forms when il comes 10 raising money aod tr .Illsferring ownership interests. but it has the significant disadqllltage of double w.xali on.

4. There is the possibility of connie!s between stockholders and management in a large corporation. We called these connicts (lgcllq prob/elm" and discussed how they might be controlled and reduced.

5. The advantages of the corporale form ilre enhanced by tbc c:.xislence of financial markets.

Of the topics we've discussed thus fin, the most imponant is the goa! of financial manage-ment: maximizing Ihe va lue of the stock. Througiloulthc lext we will be analyzing many different financial decisions. but \.\C wi ll always ask the same question: How does the deci-sion undcr consjderation atlect the vnlue of tbe stock?

I . Agency Problems Who owns a corporation"? Describe the process whereby the own-ers control the firm's management. What is the main reason thai an agency relat ion-ship exists in the corporate form of orgll11izillion? In this context. what kinds of problems can arise?

2. Not-fur-Profit Firm Goals Suppose you were Ihe financial manager of a not-for-profit business (a fl ot-for-p rofit hospital. perhaps). Wbat kinds of goals do you think would be appropriate"!

S&P Problems STANDARD & POOR'S

(.'bllptcr I Introduc tion to Corpor.ille Finance 19

3. Goal of the Firm Eval uate the following statement: Managers should not focus 011 the current slock value because doing so wjllicad 10 an ovcremphasis on shon-term profits at Ihe expeose of long-term profits. ~. Ethics and Firm Goals elm the goal of maximizing the va luc of the stock COflnicl

with other goals. such as avoiding unelhical or iIleg:11 behavior? In panicular, do you think subj(''Cls like customer and employee safety, the ellvironment . and the gcncml good of society fit in this framework. or arc they cssen tia lly ignored? Think of wme specific scenarios to il lustrate your answer.

5. International Firm Goal Would Ihe goal of maximiziog tbe value of the stock differ for finaIKi:l1 management in a foreign country? Why or why fl a t?

6. Agency Problems Suppose you own slock in a company. The culTCl1t price per share is 525. Another company hasjusl illlllOt11lccd thilt it W,.lIlIS 10 buy your company and will pay $35 persharc 10 acqu ire all the olHstanding stock. Your comp.lllYS manage-ment immediately begins fighting off this hostile bid. Is management aCling in the shareholders' best interests? Why or why nOI'!

7. Ag(>l1c~' Problems and Corporate Ownership Corporate ownership varies around the world. HislOrically. individuals have owned thc majority or sh ares in public cor-porations in Ibe Un ited Stales. In Germany and Japan . however. banks, olher large financial inslitulions. and other companies; own most or the siock in public corpora-lioos. Do you think ,Igency problems are likely to be more or less severe in Germany and Japan than in the Uilitcd States?

8. AgcnQ- Problems and Corporate OtHICrship In recent years, large financial institu-tions such as mUluill funds and pension funds have become the dominant owners of stock in the United Slates, and these inSlilUtiofls arc lx"'Coming more aClive in cOT) oratc affairs. What arc the implicat ions of this trend for agency problems and corporate control?

9. Exccutire Compensation Critics have charged that compensation to top managers in the Uni ted States is simply too hi gh and should be cuI back. For e.umple. focusing on large corporations. Larry Ellison of Oracle has been one or the bcst-compensated CEOs in the Un itt.-d Slates. earning

20

Financial Statements and Cash Flow A write-off frequently means that the value of the company's assets has declined. For exam pie, in the first quarter of 2009, luxury homebuilder Toll Brothers said il was writing down $157 million in assets, much of which was a reflection of the reduced value of land the company owned . Of course, Toll Brothers was not the only homebuilder suffering. Hovnanian Enterprises announced it would lake a $132 million write-oH, and Genlax Corp. announced a $590 million writeoff. At the same lime, O. A. Horton, Inc., the largest homebuilder by volume, had a much smaller write-off of only $56 million. However, D. R. Horton had already written off $1.15 billion In the fourth quarter of 2008.

So did stockholders in these homebuilders lose hundreds 01 millions of dollars (or more) because 01 the write-offs? The answer is probably nol. Understanding why ulti-mately leads us to the main subject 01 this chapter: that all-important substance known as cash flow.

2.1 The Balance Sheet

Two excellent scuces tor ~y IINndat

WormatiOn are fi!\i!lC8.ohoo com

"'" II'lODIJ CM&9R'.

The b21aoce shet't is an accou nta nt 's snapshot of a finn's accounting va lue on a partic-ular date. as though the fi rm stood momentarily sti.ll . The balance sheet has two sides: On the left are the assets and on lhe right are the liabilities a nd slock/Jo/ders' I!quity. The balance sheet states what the firm owns and how it is financed . The accounting definition that underlies the balance sheet and describes the balance is:

Assets !!!!! Liabilities + Stockholders' equity

We have put a three-line eq uality in Ihe balance equation to indicate that it must always hold . by definition. In fact. the stockholders' equity is dejiJll'd to be the difference between the assets and the liabilities of the flnl1 . In principle. equity is wha t the stockholders would have rcmaining afler tbe rum discharged its obligations.

Table 2.1 gives the 2010 and 2009 balance shee t for the fictitious U.S. Compos-ite Corporation . The assets in the balance sheet are li sted in order by the length of lime it nonnally would lake an ongoing finn to convert tbem into cash. The asset side depends on the nature of the busi ness and how management chooses to conduct il. Management must make decisions about cash versus marketable securities, credit versus cash saJes, whether to make or buy commodities.. whether 10 lease or pu rchase ilems, the types of business in which 10 engage, and so on. The liabilities and the stock holders' equity are listed in the o rder in which they would typically be paid over time.

Chapll"f 2 Finar.("iul Sta l,'menu ynu Cash Flow 21

Table 2.1 The Ba lanee Sheet 01 the U.S. Compostte Corporaotlon

U .S. COMPOSITE CORPORATION Balance Shee t 20 I 0 and 2009 ($ in millions)

Liabilities (Debt) and Assets 2010 2009 Stockholders' Equity 2010 2009

Current asseu: Current liabilities: C.lSh and equivalenu $ 140 $ 10' Accounts payable $ 2IJ $ 19' Accounu receivable 294 270 Notes payable SO 53 Inventories 26' 280 A

22

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Pari I O\>( rview

and ~quipment. These assets do nOI convert to cash from normal business activity, and they are nOl usually us_cd 10 pay expenses such as pHyrol1.

Some fixed assets are not tangible. Intangible assets have no physical existence but can be very valuable. Exa mples of imangible assets are the value of a trademark or the vil lue of a patent. The more liquid a lirm's assets. lhe less likely the firm is 10 experience problems meeting short-term obligations. Thus. the probabi lity that a firm \ \ 'i11 avoid financial distress can be linked to the firm 's liquidity. Unfo rlunatcly.liquid assets frequently have lower rales o f relUrn than fixed assets; for example, cash gener-ates no investment income. To the extent a firm invests in liquid assets, it sacrifices an opponunity to invest in more profitable in .... estment vehicles.

Debt versus Equity Liubili,;"s are obligations of the firm that requi re a payout of cash within a stipulated period. Many liabil ities involve contractual obligations to repay a stated amount and interest ovcr a period. Thus., lirinucely $600 would be rulized if all the current accounts were liquidated. Cooney has $500 in long- term debt. both book value and market value. What is the book value 01 the equity~What is the market value/

We can COllstruct two simplified balance Sheil;u.one in aceouming (book value) term~ and one in economic (market YO/Itue) terms:

COONEY CORPORATION Balance Sheets

Milrket VaJue venus Book Value

Assets Liabihties and Shareholders' Equity

Book Market Book Marke t Net working capital $

24

Table 2.2 The Income Statement of the U.S. Composite Corporation

U.S. COMPOSITE CORPORATION Income Statement

2010 ($ in millions)

Total operating revenues COSt of goods sold Selling,general. and administrative expenses Depreciation Opeli'lting income Other income Earnings before interest and taxes (EBIT) Interest expense Pretax income Taxes

Current:: $71 Deferred: I]

Net income Addition to retained earnings; Dividends:

$2.262 1.655

327 .0

S '90 29

$ 219 ..

$ 170 4

$ .,

~ 43

NOTE: ThU'l! ~ .... l'l ""Uion o/Qrt \ O

26

2.3

Table 2.3 Corpora .. Tax Rates

Part I Overy~

ma nufacturing overbead- and are repon ed on the income statement as cost of goods so ld. Both va riable and fixed costs arc included in product cOStS, Period costs are costs Ihat a re allocated \0 a time period : they are called selling. general. aDd " t/muliSIrOlil'e expen.\'('s . One period cost would be the company president 's sn lary.

Taxes Taxes ca n be o ne of the la rgest cash outnows a firm experieoces. In 2007. according to the Department of Commerce. total corporate profit s before taxes in the United Slates were about SJ.6 trillion. and taxes on corporate profits were about $450 billion or about 28 percen t of pretax profits. The size of the firm 's lax bill is determined by the tax code. an often amended set of rules. fn Ibis section. we examine corporate tax rates and how taxes arc calculated .

If the various rules of taxation seem a l.iule biza rre or convolUied to you, keep in mind that the tax code is the resuh of political. 001 economic. forces. As a result. there is no reason why it bas to make economic sense. To put the complexity of corporate taxation into perspective, General Electric's 2006 tax retum requ ired 24,000 pages, far 100 much to print. The electronically filed retu rn ran 237 megabytes.

Corporate Tax Rates Corporate tax rates in effect for 2008 are shown in Table 2.3. A peculiar feat ure of taxa tion instituted by the Tax Reform Act of 1986 and expanded in the 1993 Omnibus Bud-get Reconciliation Act is that corporate tax rdtcs art nOt strictly iocreasing. As shown. corpomte tax rates rise from 15 percent to 39 percent. butlheydrop back to 34 percent on income over 5335.000. They then rise to 38 percent and subsequently fall to 35 percent.

According to the originators of the current tax rules. there a re only four corporate r.ues: 15 percen t, 25 percenl. 34 percent. and 35 percent. The 38 and 39 percent brack-ets arise beca use of "surcharges" applied on top of the 34 and 35 percent rates. A tax is a tax. however, so there arc really six corporate tax brackets. as we have shown.

Average versus Marginal Tax Rates In making financial decisions, it is freq uently important to distinguish between average and ma rginal tax rates. Your average fax n.te is your tax bill d ivided by yoW" taxable income- in other words., the percentage of you r income that goes to pay taxes. Your marginal tax rate is the lax you wou ld pay (in percent) if you ea rned one more dollar.

Taxable Income Tax Rate

$ 0- 50.000 15% 50.001 - 75.000 lS 7S,OOI- 100.000 H

100.001- 335.000 " 335,001-10,000.000 H

10.000.001 - 15.000,000 3S 15.000.00 1- IB.333.333 38 18,333.33

28 P3rl I Q\'crview

average lax rate never goes down. even though the marginal lax rdle docs. As illustrated, for corporations.. average tax rates begin at 15 percent and fi se to a maximum of 35 percent.

Normally, the marginal tax rate will be relevant for financia l decision making. The reason is th at any new cash nows wil ] be taxed at Ibat ml.lrginal rate. Beca use fin ancia l decisions usually involve new cash !lows or changes in existing ones. th is rale will teU us the ma rgi nal effect o f a decision on our lall hill.

There is one last thing to notice aboUilhe lax code as it affects corporations. It's easy 10 verify that the corporate tax bi ll is just a l1at 3S percent of la xable income if our tax-able income is morc than S 18.33 million. Also. for the many midsize corporations with taxable incomes in the range of $335,000 to SIO.OOO.OOO. the tax rate is a nat 34 per-cent. Beca use we will usua lly be talking about large corpor

PHI l Ove rview

We can also calculate capital spending simp ly as: Capital spending = Ending net fixed assets - Beginning net fi xed assets

+ Depreciation = $ 1, 11 8 - 1,035 + 90 = $173

Cash nows are also used for making investments in net working capital. In U.S. Composite Corporation in 2010, additions fO net working capital are :

Additions to net working capial $23

N ote that this $23 million is the change in net working capital we previously calculated. Total cash flows generdted by the firm 's assets are then equal to :

Operating Glsh now Capital spending Additions to net working Glpical

Total cash flow of the firm

$21B - 173 - 23 $ 42

T he total outgoing cash flow of the firm can be separated int? cash no~ paid to creditors and cash now paid to slockholders. Tt.e cash flow paId to. credlt~rs rep-resents a regroupi ng of the data iT) Table 2.5 and an expliCit recordmg of mterest expense. Creditors are paid aD amount general~y r:eferred to. as d~bt serl'ice. Debt ser-vicc is interest payments plus repayments of pnnclpal (that IS, re ti rement of.de.bt).

An important source of cash now is the sale o f new debt. U:S: C~mPOslle s long-term debt increased by $ 13 ilu \1ion (the difference between $86 Imlhon III new.debt and $73 million in retirement of old debt). s Thus. an increase in long-ten:n debt IS the net effect of new borrowing and repayment of maturing obligations plus mterest expense:

Cash Flow Paid to Cr-editol"S ($ in millions)

Interest $ 49 Retirement of debt 73

Debt service 122 Proceeds from long-term debt sates - 86

Total $ 36

Cash flow paid to creditors can also be calculated as: Cash flow paid to creditors = Interest paid - Net new borrowing

= Interest paid - (Ending long-term debt - Beginning long-term debt)

= $49 - (471 - 458) = $36

' New deb! and 11K retirement of old debt nre usuaH~ found in Ihe "notl:s" 10 the balance shec-I.

Chapter 2 Fjn a l\cj~1 SUltemems and Cash FJ.ow "

Cash now of the firm also is paid to thestockhoiders. It is the net effect o f paying divi-dends plus repurchasing outstanding shares of stock and issuing new shares of stock:

Cash Flow to Stockholders ($ in millions)

Dividends Repurchase of stock

Cash to Stockholders Proceeds from new stock Issue

Total

In general. cash flow to stockholders can be determined as:

$43 6

4. - 43 $ 6

Cash flow 10 stockholders = Dividends paid - Net new equity raised = Dividends paid - (Stock sold

- Stock repurchased) To determine stock sold, fi rst not ice that the common stock and capital surplus accounts went up by a combined S23 + 20 = $43 , which implies tbat the company sold $43 millio n worth o f stock. Second , treasury stock went up by $6, indicating that the company bougbt back $6 million worth of Siock. Net new equity is thus $43 - 6 = $37. Dividends paid were $43 million. so the cash now to stockholders was:

Casb now to siockhoiders = $43 - (43 - 6) = $,6, which is what we previously calculated .

Some important observations can be drawn from ou r discussion of cash now:

[. Several types of cash now are relevant to understanding the financia l situat ion of the firm. OpenniDg cash flow, derUled as earnings before interesl p lus depreciation minus taxes, measures the cash generaled from operations not counting capital spending or working capital requirements. It is usuaJly positive: a firm is in Irouble if operating cash flm\' is negative for a long lime because the firm is not generating enough cash to pay operating costs. Total cash flow of tbe film includes adjust-ments for capital spending and additions to net working capital . It will frequently be negative, When a fi rm is growing at a rapid rate, spending o n inventory and fi xed assets can be higher than operating cash flow.

2. Net income is not cash now. The net income of the U.S. Composite Corporation in 2010 was $86 million,' whereas cash now was 542 million . The two numbers are not usually the same. In determining the economic and financial coodition of a firm, cash flow is more revealing.

A firm 's tot

32 PUt I Ovc:rview

2.6 The Accounting Statement of Cash Flows As previously mentioned. there is an official acco unting statement called the s/aremel1f of clIslljlows. This stalemenl helps explain the change in accounting cash. which for U.S. Composite is $33 million in 2010. It is very useful in underslanding financial cash now,

The fi rst step in determining the change in cash is to ligure out cash now from operating activi ties. This is the cash flow that results from the fi rm's normal activities in producing and selling goods aod services. The second step is to make a n adjustment for cash flow from investing acliviries. The final step is to make an adjustment for cash now from fi nancing activities. Financing activities are the nel payments to creditors and owners (exclud ing interest expense) made during the year.

The three components of the statement o f cash flows are determined next.

Cash Flow from Operating Activities To calculate cash flow from operating activities we start with net income. Nel income ca n be found on the income statement and is equal to $86 million. We now need 10 add back noncash expenses a nd adjust for changes in current assets and liabilities (other than cash and notes payable). The result is casb now from operating activities. Notes payable wi ll be included in the fina ncing activities section.

U.S. COMPOSITE CORPORATION Cash Flow from Operating Activities

2010 ($ in millions)

Net income $ 86 Depreciation 90 Deferred taxes 13 Change in assets and liabilities

Accounts receivable - 24 Inventories Accounts payable Accrued expense Other

" " 18 -8

Cash flow from operating activities $202

Cash Flow from Investing Activities Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures). The result for U. S. Composite is shown here:

U.S. COMPOSITE CORPORATION Cash Flow from Investing Activities

2010 ($ in millions)

Acquisition of fixed assets Sales of fixed assets

Cash flow from In .... esting acti .... ities

- $198 25

- $ 173

Table 2.6 Statement of Consolidated Cash Flows of the U.S. Compos ite Corporation

Chapter 1 Financial SI:llerncnlS .md Cash Flow

Cash Flow from Financing Activities Cash nows to and from credilOrs a Dd owneTS inc lude changes in eq uity and debt:

U .S. COMPOSITE CORPORATION Cash Flow from FinancingActivities

2010 ($ in millions)

Retirement of long-term debt Proceeds from long-term debt sales

Cha~ in notes payable Dividends Repurchase of stock Proceeds from new stock issue

Cash now from financing activities

- $73 86 - 3

- 43 - 6 43

$ 4

The statemen t of cash nows is tbe addition of cash flows from operations. cash flows ~rom invest ing activities. and cash nows from financing activities. and is pro-duced In Table 2.6. When we add all the cash flows togetber, we get the change in cash on the balance sheet of $33 million.

U.S. COMPOSITE CORPORATION State m ent of Cash Flows

2010

Operations Net income Depreciation Deferred taxes

($ in millions)

Changes in usets and liabilities Accounts receivable Inventories Accounts payable Accrued expenses Other

Total cash now (rom operations Investing actl .... ities

Acquisition of fixed assets Sales of fixed a.ssets

Total cash now from investing activities Financing activities

Retirement of long-term debt Proceeds (rom long-term debt sales Change in notes payable Dividends Repurchase of stock Proceeds from new stock issue

Total cash flow from financing activities Change in cash (on the balance sheet)

$ 86 90 13

- 24

" 16 18

- 8 $202

- $198 25

- $173

- $ 73 86 - 3

- 43 - 6 43

$ 4 $33

Pan I Overview

There is a close relationship between Ihe offic ial accounting statement called the statement of cash flows aod the totaJ cash now of the firm used in finance. Going back to the previous section, you should note a slight conceptual problem here. Interest paid should really go under financing ac tivities, but unfort unately that is not how the accounting is handled. The reason is tbat inieresl is deductcd as an expense when net income is computed. As a consequence, a primary difference between the accounting cash now and the financial cash flow of the firm (see Table 2.5) is interest expense.

2.7 Cash Flow Management One of the reasons why casb now a nalysis is popular is the difficulty in man ipulating, or spinning,

3. Market Va lues and Book Values Kl ingon Cnliscn,. Inc .. purchased new cloilk -ing machi nery three years ago for 59.5 million. The machinery can be sold to the Romulans !Od ay for 56.3 million. Klingon's current ba.lance sheet shows net fixed :lSSets of 55 million. current li;Jbiiilics of 52.1 million. and net working capital of $800.000. If all tbe current assets were liquidated today. the eOl1lp;J ny would receive S2.8 million cash. Whlll is the book value of Klingon's assets today? What is the market "alue?

4. Calculating Taxes The Herrer:! Co. had 5246.000 in tax;lblc income. Using the rates from Table 2.3 in Ihechapter. calculate the compilny's income taxes. Whilt is the aver-age tax rate? What is the marginal lax rate?

5. CalcuJaling OCF Ranney. Inc .. has sales of 514.900. cOSts of 55.800. depreciation expense of SI.300. and interest expense of 5780. If the tax rme is40 percent , what is the operating cash now. o r OCF?

6. Calculating Net Ca pital Spending Gordon Driving School's 2009 balance sheet showed net fixed assets of 51.65 million. and the 2010 balance sheet showed net fixed asscls of $ 1.73 mil lion. Thecompany's 2010 income slatement sJlOwed a deprecialion expense of S284.000. \\'ha t was Gordon's net capital spending for 201Q?

7. Ruilding a Balance Sheet The following table presents the long-term liabilities and stockholders' equity of Information Control Corp, one year ago:

8.

9.

Long-term debt Preferred stock Common stock ($1 par 'I1lue) Accumulated fet1.ined urnings Capital surplus

572.000.000 9.000.000

20.000.000 97.000.000 "').000.000

During the past year. hlformation Control issued 10 million shares of new stock :It a total price of 543 million. and issued SJO million in new long-term dcbt. The company generated 59 million in net income and paid 52 million in d ividends. Con-struct the curren t balance sheet rencr:t1ng the chClnges that occurred al Informalion Control Corp. during the year. Cash Flow to Creditors Thc 2009 balanceshcet of Aou:t's Tennis Shop. I nc .. showed long-term debt of 51.34 l1)i1lion . md the 20 10 balance sheet showed long-Ierm debt of S 1.39 million. The 20 I 0 income sl

ParI I O"l'rvic\\'

13. Building an Income S tatemenl During the year. the Scnbet Discount Tire Compa ny had gross sales of $1.2 million . The firm's COSt of goods sold and seJliug e .... pcnscs were S450.000 and S225.000. rcs)X."Clh'cly. Scn bct a lso had notes payable o f S900.OOO. These notes carried an interest rate of9 percent. Depredation was $ 110.000. Scnbct's tax n ile was 35 percent. a. What was Scnbc(s net income? b. What was Senbct's openll;ng c;lsh fl ow?

14. CaJculaling Total Casb Flows Schwcrt Corp. shows tbe following info nnation 00 its 2010 income statement: sales :: S I67.000; costs:: 591.000: olherexpenses :: $5.400: depreciation expense :: S8.000: interest e .... pcnsc :: S II.(X)(): taxes = $18.060: divi-dends :: $9.500. In addition. you're lo ld that the firm issued S7.250 in new eq ui ty during 2010 aud redeemed S7.100 in outstanding long-term debt. a. " 'hat is the 2010 oper.ttingcash fl ow? b. What is the 2010 cash flow to credito rs? c. What is the 2010 cash flow to stockholders? d. If net lixcd assets increased by $22.400 during tJle yeur. what was the addition 10

net working capital (NWC)? IS. Using Income Statements Given the fo llowing info rmation for O' Hara J\'larine Co. ,

clIJcu latc th t: depreciation expense: suks - $43,000; C(;Ists ... $27.500: addition 10 rctaioed ea rnings:: S5 ,300; dividends paid ., $1.530: interest expense = $1.900; tax rate = 35 pcn.:ent.

16. Prtparing a Balance S heet Prepare a 2010 balance sheet for Jarrow Corp. based on Ihe following information: cash = $183.(X)(): pillelllS and (.:opyright s = S695.000: accounts paya ble = 5465,000; accounts receiv'abk "" S 138,000; tangible net fL>::ed asselS = 53,200.000; inventory:: $297.(X)(): notes payable "" SI45.000: accumulated retained earnings = SI.960.000: long-ternl debt ,. S I.550.000.

17. Residual Oaims Huang. Inc .. is obligated to pay its credjlo rs 59.700 vcry soon. a. What is the market value of the shareholders' equ ity if assets have a ma rket val ue

of SIO.500? b. What if assets equal S6,800'!

18. Margioal n~rsus A"eragc Tax Ra te!l (Refer to Table 2.3.) Corporation Growth has S78.(X)() in ta;table income, and Corporation Income has S7.800.000 in taxable income. a. What is the tax bill for each firm? b. Suppose both fi rms have identified a new projC'Ct th"t will increase taxable income

by $ 10.000. How much in additiona l t3XCS will each firm pay? Why is this amount Ihe same'!

19. Net Incomc and OCF During 2010. R.1i ncs Umbrella Corp. had sales of S740.000. Cost of goods sold, administ rativc and sell ing eltpcnses, and depreciati.on expenses wcre S61O,000. $ 105.000. ,md SI40.000. respect ively. In addit iol.l. the company had an inlcrest cxpense of $70.000 lind i l ta.>:: ra te of 35 percent. (Ignore any tax loss car ryback or C'.lrryforward provisions.) a. What is Raines 's net income fo r 20107 b. What is its operating cash now? e. Explain your results in (a) and (b).

20. Accounting Values "ersus Cash .' Iows In Problcm 19. suppose Ra ines Umbrella Coq ). pllid out 530.000 in cash dividends. Is this possible? If spending on net fL-..;ed assets ~lI1d net working capital was 7.ero. and if no new stock was issued during Ihe year, \\hat was the change in (he firm 's long-term debt account?

21. Calculating Cash Flows Cusic Industries had the following operating results fo r 2010: saJes = SI5.300: cost of goods sold = $10.900: depreciation expense :: S2. 100; interest expense = S520; di\'idends pa id '" 5500. At the beginn ing of tbe year. net

Chapll'r 2 Financi:1l Stl!.lemi:l1ls and Cash Flow 39

n .

fi xed assets were S I1.800. current assets were $3.400. and current liabilities were 51.900. At the end of the yeOl r. net fixed assets \\-"erC $12.900. curnnt assets were S3.95O. a nd curren t liabili ties were S1.95O. The tax Tate fo r 2010 \\laS 40 percen t. H. What is net income for 20 I O? b. What is the oper'dting cash flow for 20 I O? c. Wha t is thc cash fl ow from assets fo r 20ID? Is Ihis possible? Explain. d. If no new debt WllS issued during tbe year. what is Ihe cash flow to creditors'? What

;s the cash flow to stockholders? Explain and interpret the posilhe and negati\'e signs of your answers io (a) through (d).

Calculating Cash Flows Consider the following abbreviated financial statements for Weston Enterprises:

WESTON ENTERPRISES WESTON ENTERPRISES 2010 Income Statement 2009 and 20 I 0 Partial Balance Sheets

Assets liabilities iU1d Owners' Eq uity Sales $10.320 2009

Cur,..nt assets , 780 Net fixed users 3.480

2010 2009 2010 COSts 4.980 , ... Curnnt li.abllitlM $ 118 348

Depreciation 960 ' .080 long-term debt 1.800 2. ... Interest paid 259

a. What is owners' eq uity fo r 2009 and 20101 h. What is the change in oct work ing capital fo r 20 I O? c. In 2010. Weston Enterprises purchased S1.800 in new fi.-..;ed asset s. Ho ..... much in

fixed assets d id Weston Enterprises sell'? What is the cash now from assets for the year? (The tax rate is 35 percellt.)

d. During 20 10. Weston Enterprises raised S360 in new long-term debt. How much long-ternl debt must WeSlon EllIerprises have paid all' during the yea r'.' \\'hat is thc cash flow to creditors?

Use the following info rmat ion lor Ingersoll. Inc .. fo r Problems 23 and 24 (assume the tax rate is 34 percent):

2009 2010

S,IK $ 5.223 $ ' .606 Depre

4\1

CHALLENGE (QuesUons 25-27)

23. Financial Statements Dmw up:tn income statement and txllance sheet for this COIn-pany for 2009 and 2010.

24. Calcul:lting Cash Flow For 2010. c:tlculate the cash Ilow from assets. C'ash ilow (0 creditors. lind cash flow to stockholders.

25. Cash F1o .... -s You are researching Time Manufacturing and have found the following accounting statement of cash flows for the most n"Ccot year. You also know that the compa ny paid S82 millioo in current taxes and had an interest expense of 543 mil-lion. Use the accounting statemen t of cHsh flows to construct the linancial statement of cash nowS.

26.

Operations Net Income Depreciation Defer'Ted taxel

TIME MANUFACTURING Statement of Cash Flows

($ In millions)

Changes In assets and liabilities Accounu r~lvable Inventories Accounu payable Accl'\.led expenses Other

Total cash flow from operations

Investing activities Acquisition of fixed assets Sale of fixt!d ;useu

Total cash flow (rom investing activities Financing activities

Reti rement of long-term debt Proceeds from Io.-.gterm debt ules Change in notes payable Dividends Repurchase of stock Proceeds from new stock issue

Total cash now from financing activities Change In cash (on balance sheet)

$I" 7. "

-IS I. 14

- 7 2

$250 =

- $ 118 ,.

-$129 =

-$135 97 ,

-12 - II

37 -$ 79

$12

Net fixed Assets and Depredation On the balance sheet. the net li;-.;ed assets (N FA) account is equal 10 the gross lixed assets (FA) a\.'Couni . which records the acquisi-tion cost of fi.'(ed assets. minus the accumulated depreciation (AD) account. which records Ihe total depreciation taken by the firm against its lixcd assets.. Using the fac t that NFA = FA - AD. show that the e1tprcssion given in we chapter for net capital spending. NFA....,. - NF.I\ .... + D (where D is the depreciation e.xpcnS( during the year). is equivalent 10 FAted - FAlooi

S&P Problems

STANDARD & POOR'S

Ch9pl~ 2 Fin:lndal Statcrn

Ihe financial statements provided by Nick. Here lire the balancc shcet for the 1\\"0 mOSI recent years and the mosl recent income statemen1 :

Cur~flt assets Cuh and equivale(lt:S Accounts receivable Inventories

0""' TotAl CUrTti\l assets

Fixed ass-ets Property. plant, ~nd

equipment Len accumulued

depnaciilt ion Net property, plant, and

equipment Inu"lible useu and Others

Toul fixed useu

Total asseu

WARF COMPUTERS Balance Sheet

($ in thousands)

2010 2009 Curreot liabilltiH

$ 290 $ 251 Accounts ~ble

44

Financia l Statements Ana lysis and Financial Models The price 01 a share of common stock in Aeroposlale, the trendy clothing retailer. closed at about $28 on Apri l 2. 2009. At that price. Aeropostale had a price-earnings (PE) ratio of 12.7. That is, investors were willing to pay $12.7 for every dollar in income earned by AeropostaJe. At the same time, investors were willing to pay $6.0, $18.2, and $27.2 lor each dollar earned by Chevron. Coca-Cola, and Google, respectively. At the other extreme was the lumber company. Weyerhauser, which had negative earnings for the previous year, yet the stock was priced at about $30 per share. Because il had negative earnings. the PE ratio would have been negative, so it was not reported. At the same time, the typical stock in the S&P 500 Index of large company stocks was trading at a PE of about 12.4, or about 12.4 times earnings, as they sayan Wall Street.

Price-to-earnings comparisons are exampl es of the use of financial rat ios. As we will see in this chapter, there are a wide variety of financial ratios, all designed to summarize spe-cific aspects of a firm's financial position. In addition to discussing how to analyze financial statements and compute financial ratios, we will have quite a bit to say about who uses this information and why.

3.1 Financial Statements Analysis In Chapter 2, we discussed some of the essent ial concepts of financial statements and cash flows. This chapter continues where o ur ea rlier d isc ussion left 01T. Our goal bere is to expand your understanding of the uses (and abuses) of financial statement information.

;\ good working knowledge of financial statement s is desirable simply because such statements, and numbers derived from those statement s. are the primary means of communicating financial information both within the firm and outside the firm. In short., much of the language of business finance is rooted in the ideas we discuss in this chapter.

Clearly, one important goal of the accountant is to report financial information to the user in a form useful fo r decision making. Iro nica lly. the information frequemly docs 001 come to the user in such a fo rm . ]n o the r wo rds., financia l statements don't come with a user's guide. This chapter is a lirst step in filli ng this gap.

Standardizing Statements One obvious thing we might want to do wilh a company's fin

46

Table 3.2

Pllrt I Q"crview

PRUFROCK CORPORATION CommonSize Balance Sheers December] I, 1009 and 20 I 0

"'~" 1009 2010 Chan .. CUl"I"entuseu Cuh 2.5% 2.'" + .n< Accounts receivable 5.2 + .3 1_'"'1 11.7 11.8 + .1

To'" 19. 1 19.7 + .6 fixed assets

Net pbnt Vld equipment 80.' 80.3 - .6 Total ;lSSets 100.0% 100.0% ....

Liabilities and Owners' Equity Current liabilities

Actounu pa~le 9.2% 9.6% + . % Notes ~ble 6 . 5.5 - 1.3

Total 16.0 15. 1 - ..

long-term debt 15.7 \2.7 - 3.0 Owners' equity

Common stock al'ld paid-in wrylus 1".8 15.3 + .5 Retained earnings 53.) 56.9 + 3.6

Tou] 681 72.2 + " .1 Totall~bil~ md owners' equity 100.0% '00.0% ....

= =

declined from 16.0 percenllO 15. 1 percen t o f tOlal liabili(ies and equity over thal same lime. Simila rly. to tal equity rose from 68.1 percent of total liabilities and equity to 72.2 percent .

Overall , Prufrod (s liquidity. as measured by current assets compared to current liabililics, increased over the year. Simultaneously, Prufrock's indebtedness d iminished as a percentage of total assets. We might be tempted to cooclude thai Ihe balance sheet has grown 'stronger."'

Common-Size Income Statements Table 3.3 describes some commonly used measures of ea rnings.. A useful way of Stan-dardizing the income statement shown in Table 3.4 is to express eaeh item as a percent-age of total sa les. as iUustrated for Prufrock in Table 3.5.

This income statement tells us what happens to each do lla r in sa les. For Prufrock, interest expense eats up $.06 1 out of every sa les do llar, a nd laxes take another S.08 1. When all is said and dOlle, $.157 of each do llar nows th rough ro the bottom line (net income), and that amount is split into S.105 retained in the business and S.052 paid out in d ividends.

These percentages a re useful in comparisons. Fo r exam ple, a relevant figure is the cost percentage. For Prufrock. $.582 of each $ 1.00 in sales goes to pay for goods sold . I! would be interesting to compute the same percentage for Prufrock's main competi-tors to see bow Prufrock stacks up in terms of cOSt con lrol.

Table 3.3 Measures of Eamlngs

Table 3.4

Qapler.) Fim:Hlcial S(atcrncntJ; Analysis and Financial Mooels 47

Investors and analy5u look closely at the Income natemeflt for clues on how well a comp:any has performed during a ~rticular year. Here are some commonly used measures of earnings (numbers in millions). N et Income

.PS

' EBIT

The lO-Cailed bottom line, defined as total rew:nue minus total expenses. Net income for Prufrock In the latest period is $363 million. Net income reflew differences in a firm's capital structure and taxes as well as open-ting income. Interest expense and taxes are subtracted from operating income in computing net Income. Shareholders look closely at net. income because dividend payout and retained earnings are closely linked co net income. Net income divided by the number of shares ouutanding. lt expresses net income o n a per sh:are basis. For Prufrock. the EPS = (Net Income)l{Shares outstanding) - $363/33 = $11. Earnings before interest expense and taXes. EBIT is usually called " income from operations" on the Income statement and is income before unusual Items, discontinued operating or extraordinary icems. To calculate EBIT. operating expenses are subtracted from total operations revenues. Analysu like EBIT because It abstracu from differences in earnings from a firm 's capital structure (interest expense) and taXes. For Prufrock, EBIT is $691 million.

EBITDA Earnings before interest expense. QXes, depredation, and amortization. E8ITOA "" EBIT + depreciation and amortization. Here amortization refers to a noncash expense simil:ar to depreciation except It applies to an intangible asset (such as a ~tent), rather than a tangible asset (such as a machine).The word :amortization here does not refer to the plyment of debt. There Is no amortization in Prufroc k's income statement. For Prufrock. E8ITOA - $691 + $276 = $967 million. Ana~u like to use EBITOA because it adds back two noncash items (depredation and amortization) to EBIT and thus is a bener measure of before-u.x operating cash flow.

Sometimes these measures of e.arnlnp are preceded by the letters LTM, meaning the lut twelve months. For example, LTM EPS is the last twelve months 0( EPS :and LTM EBlTDA is the last twelve months 0( EBITOA At other times, the letters TTM are used, meaning trailing twelve months. Needless to say, LTM is the same as TIM.

PRUFROCK CORPORATION 20 I 0 Inco m e Statement

Sales 4 COst 0( ioocts sold Deprec:ation

($ in millions)

Earnings before intereu and taXes Interest paid Taxable income Taxes (3-4X) Net income

Divi~ $121 Addition to retained earnings 2-42

$2,3 tl 1,]-44

276 $ 691

'41 SSO

'.7 $ 363 =

Table 3.5

3.2

Go to www revtltl'S com!

flnao""sMcts al'ld lind the ratios link

10 examine comparative ratios for a ttuge

IlUmber of companies.

Part I Overview

PRUFROCK CORPORATION CommonSize Income Statement 2010

Sales Cost of goods sold Depreciation Earnings berore interest and taXes Interest ~id Taxable Income Taxes (304%) Net Income

Dividends Addition to retained earnings

Ratio Analysis

5.2% 10.5

100.0% 58.2 11.9 29.9

6.1 23.8 8.1

15.7%

Another way of avoiding the problems involved in comparing compan ies of differenl siLes is to calculate and compare financial ratios. Such ralrOS a re ways of comparing and investigating the relatioaships between different pieces of financial infonnation. We cover some of the more commOQ ratios oexi (I here a re many o thers we don't dis-cuss here).

One problem wj,h ralios is Ihat different people and d ifferent sources rrequenlly don't compute them in exactly the same way, and this leads to much con rusion. The specific defin itions we use here mayor may not be the same as o nes you have seen or will see elsewhere. Ir you a re using ratios as tools ror analysis, you should be carerul 10 document how you calculate each one; and, ir you are comparing your numbers 10 Ihose or another source, be sure you know how theiT numbers are computed.

We will derer much or our discussio n of how rati os are used and some problems that come IIp with using them until later in the chapter. For now, fo r cach ratio we discuss, several questions COme to lDind:

1. How is it computed? 2. What is it intended 10 measure, and why might we be interested? 3. What is the unil or measurement? 4 . What might a high or low value be telling us? How might such values be misleading? 5. How could this measure be improved?

Financial raLios are traditionally grouped into the following categories:

1. Sbor(-(enn solvency, or liquidity. rati os. 2. Long-term solvency, or financial leverage, ratios. 3. Asset management, or turnover, ratios. 4. Profitability ratios.. 5. Market value ratios.

We \vill consider each or these in turn. In calculating these numbers ror Prufrock, we will use the ending balance sheet (2010) figures unless we explicitly say ot herwise.

EXAMPLE 3.1

Cbaptff J Finr.n

Part 1 Ovt:rvicw

If we ~ene the original siwation to $2 ill current ,n$ets and $-1 In current liabilities. the (hange will QUSt. the current rilcio to filii to 1/3 (rom In.

The st.(ood Gilse is IlOt quite iI.S tricky. Nothing happens to the current riltio because cash goes down while inventory goes up--total currellt ilUeu are umffea:ed.

In the third case. the current r.atio would usually rise because inventory is normally shown at COst and the sale would normally be at somethi"l greater than cost (the difference is the markup). The Increase ill either cash or receivables is therefore grener than the decrease in inventory. This incruses cu~( asseu.and the current ratio rises.

FinaJly, note that an apparently low current ralio may oat be a bad sign for a com-pany with a large reserve of untapped borrowing power.

Quick (or Acid-Test) Ratio Inventory is often tbe least liquid current asset. It's also the ooe for which the book values are least reliable as measures of market value because the quality of the inventory isn't considered. Some of the inventory may later tum out to be damaged, obsolete, or losl.

More to the point. relatively large inventories are often a sign of short-term trouble. The lirm may have overestimated sales and overbought or overproduced as a result. In this case, Ihe firm may have a substantial portion of its liquidity tied up in slow-moving inventory.

To further evaluate liquidity, the quick, or acid-lest, Talia is computed just like the current ratio. except inventory is omitted :

. . Current assets - Inventory QUick ratiO = Current liabilities (3.2)

Notice that using cash to buy inventory does not afTC(:t the current ratio, but it reduces Ihe quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash.

For Prufrock, this ratio in 2010 was:

Quick ratio S708 - 422 . SS40 = .53 times

The quick ratio here teUs a somewhat different story than the cu rrent ratio be

Pur I Overview

and amortization, noncash expenses.. have been deducted out. Because interest is most dcflJlitelya cash outflow (to creditors), one way to define the cash corerage ratio is:

. EBlT + (Depreciation and amortizati on) Cash coverage rauo = Interest (3.8)

$69 1 + 276 5967 . = $1 41 - $141 = 6.9 limes

The numerator here, EBIT plus depreciat ion and amortization, ~ s o~ten ab~reviate.d EBITOA (earnings before interest, taxes. depreciation, and amortl7..atlon) . It IS a busle measure of the firm's ability to generate cash from operations. and it is frequently used as a measure o r cash flow available to meet financial obligations. .

More recently another long-term solvency measure is increasi:ngly seen in 0nancla l statement analysis and in debt covena nts. It uses EBlTOA and mterest beanng debt. Specifically, for Prufrock:

Interest bearing debt EB ITDA

5196 million +. 4.57 rniJlian = .68 limes $967 millton

Here we include nOles payable (most likely nOles payable is bank debt) and 10n:B-ter~ debt in the l1umerdtor and EBITDA in the denominator. Values below 1 on thiS rallO are considered very strong and values below 5 arc considered weak. .. HO\vever a ca~ful comparison with other comparable fir ms is necessary to properly Interpret the rallo.

Asset Management or Turnover Measures . We nex t turn our attention to tbe emciency with wbich Prufrock uses Its assets.. The measures in this section are sometimes called asset managemelll o r utilization ratius. The specific ratios we discuss can all be interpreted as measures of turnov~r. What they are intended to describe is how efficiently, or intensively, ~ firm uses lis assets to generate sales. We first look at two important current asse ts: Inventory and receivables..

Inventory Turnover and Days' Sales in Inventory During the year, Prufrock had a cost of goods sold of $ 1,344. Inventory at the end or the year was $422. Wit h these numbers. im'entury tUrIlOI'er can be calculated as:

Cost of good s sold Inventory turnover = Inventory

$1,344 32' = $422 = . tImes

(3.9)

In a sense we sold ofT o r turned over, the ent ire inventory 3.2 times during the year. As long a; we are not ~unlling out of stock and thereby fo rgoing sa les, the higher this ratio is, the more eOiciently we are managing inventory.

Ir we know that we turned our inventory over 3.2 times during the year, we can immediately figure oul how long it took us to turn it over on average. The result is the avera ge days' soles ill iJ1\'emory:

365 days Days' sa les in inventory = Inventory turnove r

= ~~i = 114days (3.10)

EXAMPLE 3.2

Chapter 3 Financial Stlltements Analysis and Financial Models "

Tbis tells us that. roughly speaking. inventory sits 114 days on average berore it is sold . Alternatively, assuming we used (he mOst recent inventory and cost figu res, it wilJ take about 114 days to work otT our curren I inventory.

For example, in September 2007. sales of Genera l Motors (GM) pickup trucks could have used a pick.up. At that time., tbe company had a l20-day supply of the G MC Sierra and a 114-day supply of the Chevrolet Silverado. These numbers mean that at the then-current rale of sa les., it would take GM 120 days to deplete the avail-able supply of Sierras whereas a 6O-day supply is considered normal in the industry. Of course, the days in inventory are lower for better-selling models, and. fort unately for GM . its crossover vehicles were a hit. The company had only a 22-day supply or Buick Enclaves and a 32-day supply of GMC Acadias.

Receivables Turnover and Days' Sales in Receivables Our im-enlOry measures give some indication of how fast we can sell products. We now look at how fast we collect o n those sa les. The receivables /Urllover is defined in the same way as invento ry turnover:

Receivables turnover = Aecoun~: I!sceivable _$2,3 11_ 1'3' - $188 - _. times

(3.11)

Loosely spea king. \ve collected our outstanding cred it accouotS and lent the money again 12.3 times during the year.~

This ratio makes more sense if we conven it to days., so the days' ${lIes ill receimbleJ is:

D ' at . b 365 days ays s es 10 recelVa les = Receivables turnover

= 365 = 30 days 12.3 (3. 12)

Therefore, on average., we collect on our cred it sales in 30 days. For obvious reasons., this ratio is frequently caUed the average collectioll period (ACP). Also note that if we are using the most recent figures. we can also say Ibat we have 30 days' worth of sales currently uncollected.

Payables Turnover Her~ is a variat ion on the receivables collection period. How long. on aver age, does it take for Prufrock Corporation to pay its bill s ~ To answtr. we need to calculate the a("counts payable turnover rat~ using COst of goods sold. We willl.$$ume th

EXAMPLE 3.3

PII1 I Overview

To tal Asset Turnover Moving away from specific accounts like inventory or receiv-ables, we can co nsider an important "big picture" ratio, the total asset IImuwer rat io. As the name suggests. total asset turnover is:

Total asset turnover z:: Tot~f~e;sets $2,311 64 .

= S3.588 =. times (3.13)

In other words, fo r e"ery dollar in assels, we geoeratw $.64 in sa les.

More TlImover Suppose you find that a parJcolar (ornp3ny gtncrues $.40 in annual SAles for wvery donar in total assets. How often does this Compilny tum over itS toa.1 asseu!

The total uset turnoyer here is AO times per year. It takes 11.40 = 2.S years to turn usets over completely,

Profitability Measures The three types of measures we discuss in this section a re probably the best-known and most widely used of all financial ratios. In o ne fonn or another. they are intended 10 measure how efficiently the firm uses it s assets and how efficiently the firm maoages its operations.

Profit Margin Companies pay a greal deal of aneOlion to their profit murgil1: . Net income

Profit ma rg.m = Sa les $363

-= $2 .311 = 15,7% (3.14)

This te ll s us that Prufrock. in a n accounting sense, generates a linle less than 16 cents in net inco me for every do llar in sa les.

EBITOA Margin Another commonly used measure of profit.'\bility is Ibe EBITDA margin . As menlioned, EBITDA is a measure o f before-tax operating cash now. It adds back noncash expenses and does not include laxes or interest expense. As a consequence., EBITDA margin looks more directly at operating cash flows tban does net income and does not include Ibe effect of capital structure or taxes. For Prufrock, EBITDA margin is:

EBITDA S967 million Sales - S2,3 11 million 41.8%

AU other things being equal, a relatively high margin is obviously desirable. This situ ation corresponds to low expense ratios relative to sa les. However, we hasten to add that 01 her things are often nOI equal.

For example. lowering our sales price will usually increase unit volume but wiU nor-mally cause margins 10 shrink. Tota l profit (or, more importantly. operating cash now) may go up or down, so the fact that margins are smaller isn't necessa rily bad . After all, iso'l it possible that. as the saying goes, "Our prices a re so low Ihat we lose money on everything we sell , but we make it up in volume"?'

INo. i("s 00(.

Cha.pter 3 fio3neiaJ SUteml'fl tS Analysis and Financial Modth 55

Margins are very difTerent for d ifferent industries. Grocery sto res have a nmori-au sty low profit margin , generally around 2 percent. In contrast , the profit margin for the pharmaceutica l industry is about 18 percent. So, for example, it is nol surpris-ing that. recent profit margins fo r Albertson's and Pfizer were about 1.2 percent a nd 15.6 percent. respectively.

Return on Assets Retllrn on assets (ROA) is a measure of profil per doUar of assets. It ca n be defined severa l ways, 4 bUllhe mos t common is;

N . Return o n assets = et Income

To tal assets _ S363_ 0 - $3,588 - IO.12Yn

(3.15)

Return on Equity Return 011 equity (RO E) is a measure of how the stockholders fared during the year. Beca use benefiting shareholders is o ur goal, ROE is. in a n accounting scnse. the true bottom-line measure o f performance. ROE is usually measured as:

Return 0 11 equilY = Net incol:!le To tal eqUIty

_ 5363_ 0 - S2,591 - 14 Yn

(3.16)

Therefo re, for every dollar in equity, Prufrock generated 14 cents in profit ; but, again, this is correct only in accounting terms.

Because ROA and ROE are such commo nly cited numbers, we stress that it is importa nt to remember Ihey are accounting rates of return. For thi s reason , Ihese measures should properly be called relll". on book asscu' and Teturn on bock eqllilY. In addition, ROE is sometimes cal led Tellim on net \fOTlh. Whalever iI's called, il wo uld be inappropriate to compare the result to, for e:a:ample, an interest rate observed in the fina ncial markets.

The fact that RO E exceeds ROA rcOcclS Pnlfrock 's use of financial leverage. We will exa mine the relationship between these two measures in the next section .

Market Value Measures Our final group o f measures is based, in part, on information not necessarily con-tained in financial statcments- the ma rket price per share of the stock , Obviously, Ihese measures can be calculated directly only for publicly lraded companies.

We assume that Prufrock has 33 million sbares outstanding and tbe stock sold fo r S88 per share at the end of Ihe year, If we recall that Prufrock 's oet income was $363 mill ion. then we can ~alculate that its earnings pe r share were :

PS Net income $363 E = Shares o utsta nding - 33 = $11 (3.17)

'For example. we might want a relurn on am l.$ measure thai i5 ne\JlraJ wit h rcspccltocapil31 su ucture (i flte~( expense) and lales. Such a measure for P(urrock ",,-ouid be:

EBIT S691 TOlal a.ssel.$ .. 53,588 .. t9.3Y.

This measure has a very natural interpretation. If 19.3 percenl eJl:c.eeds Prurrock's borrowina rale, Prufrock .... iII earn more money on its investments Ihan il will payout 10 in cn:dhors. The surplus will be a.vailable 10 prurrocks shareholders after adjusting fo r taxe$.

56 Part 1 O\'~niew

Price-Earnings Ratio The first of our markcl value measures, the price-e(lrIlings or PE ralio (or muhiple), is defined as:

. Price per share PE rallO = ",=~. ::::=::":1::'::: Earm ngs per share

SS8 8' = ill = tlmc.s

(3.18)

In Ibe vernacul ar. we would say Ihal Prufrock shares sell for eighllimes earoings. or we might say that Prurrock shares have. or "carry,'- a PE multiple of 8.

Because the PE ralio measures how much investors are willing \ 0 pay per dollar of current earnings, higher PEs are oflen taken to mean that Jhc firm has significam prospects for futu re growth. or course. if a finn had no o r almost no earnings. its PE would probably be quite large; so, as always, care is needed in interpreting thi s ralio.

Market-ta-Book Ratio A second commonly quoted measure is the murkeHo-book ratio:

. Market va lue per share Market-tobool\: rallO = Book value per sha re

$88 $88 . $2,59 1/33 =- $78 .5 = I.! 2 urnes

(3.19)

Notice that book value per share is to tAl equity (not just common stock) divided by the number of shares outstanding.

Book value per sha re is ao accounting number that rcnects historical costs. In a loose sense. the market-to-book ratio therefore compares the market va lue of the firm's invest ments to their cost. A value less than I could mean that the firm has not been successful overall in creating value for its stockholders.

Market Capitalization The market capitalization of a public firm is equal to the firm 's stock market price per share multiplied by the number of shares out standing. For Prufrock, this is:

Price per share x Shares o Ulstanding = $88 x 33 million = S2,904 million This is a useful number for potential buyers of Prufrock. A prospective buyer of aU of the outstand ing shares of Prurrock (in a merger or acquisition) would need to come up wi th at least S2 ,904 million plus a premium.

Enterprise Value Enterprise value is a measure of firm value that is very closely related to market capitalization. Inslead of focusing on only the market value of out standing shares of stock, it measures !.he market value of DlllStanding shares of stock plus the market value of outstanding interest bearing debt Jess cash on hand . We know the market capi talization o f Prufrock but we do not know the market va lue of its outstanding interest bearing debt. III this situation, the common practice is 10 use the book va lue of outstandi ng interest bearing debt less cash on hand as an approxima-tion . For Prufrock , enterprise value is (in millions):

EV = Market capitalization + Markel value of in terest bearing debt - cash = $2,904 + ($196 + 457) - $98 = $3.459 million (3.20)

Chapter 3 Finan .. :;"l Sta~ C"ments Analysis and FiTl3nciaJ Models "

The purpose of th~ EV measure is to better estimate how much it would take to buy all Of. the o.utstandlllg stock of a firm and also to payoff the debt. The adjustment for cash IS to recognize t.h~ t if we were a buyer the cilsh could be used immediately to buy back debt or pay a dIVId end.

Ent~rprise V~lue Multiples Financial analysts use valuation multiples based upon a finn s enterpnse value when the goal is to estimate the value of [he firm 's lolal business rather I.han just ,foc~~jng on the va lue of its equity. To form an appropriate multiple, enterpnse value IS diVided by EBJTDA. For Prufrock, the enterprise value multiple is:

EV 53,459 million . EBITDA $967 million = 3.6 hmes

The multiple is especially useful because it allows comparison of one firm with another when .there are dif!"ercl~ces in .capital structure (inlereSt expense), taxes, or ca pita l spend mg. The multiple IS not directly affected by these differences .

. Similar to ~E ratios. we would expect a firm with high growth opportunities to have high EV muluplcs.

This completes our definition of some common ratios. We could tell you about more o f them, b.ut these are enougb for now. We'll leave it here and go onto discuss som~ ways of usmg these ratios instead of j ust how to calculate them. Table 3.6 sum-manzes some of the ralios wcve discllssed.

Table 3.6 Common financial Ratios

I, Short Term Sol..,ency, or Liquidity, Ratios

Current ratio = Current assetS Current liabilities

Q . k . Current assetS - Inventory UIC ratio = Current liabilities

Ch- Cash as ratio'" Current liabilities

II. Long.Tenn Solvency, or Financial Leverage, Ratios

11 I db Total assetS - Total equity Ota e t ratio '" Total assets

Debt~quity ratio :: Total debtITotal equity EqUity multiplier = Total assetsITotal equity

Times interest earned ratio = , EBIT nterest

Cash coverage ratio = EBITDA Interest

III, Asset Utilization,orTumover, Ratios

Cost of goods sold Inventory turnover := ==,,='=="''''

nvemory

Days' sales in inventory "" , 365 days nventory turnover

Receivables turnover = At Sales counts receivable

<

Days' sales in receivables '" R _ 3:15 days ecelva es turnover

Total asset turnover Total assets

Capital intensity = Total assets

"'" IV, Profitability Ratios

Profit margin = Net income Sales

Return on assets (ROA) = Net income Total assets

Return on equity (ROE) = Net inco~ Total eqUity

ROE = Net income X Sales x Assets Sales AssetS EqUity

V. MaricetValue Ratios

. . _ Prke per share Pnce-earnmgs ratio = ,,;;;c.. ;;;;~O':~"

amlngs per share

M ".- bo k . ,M~'~rl

58

EXAMPLE 3.4

Part J Overvjcw

Consider the following 2008 data for lowe's Companies and Home Depot (billions except (or price per share):

Lowe's Companies, Inc. The H om e Depot,lnc.

Sal" $48.3 $77.3 ESrT $ 4.8 $ 7.3 Net income $ 2.8 $ ..... Cuh $ .S $ .5 Depredation $ 1.5 $ 1.9 Interest bearing debt $ 6.7 $13.4 Total usea $]0.9 $-4'1.] Price per sh,tre $24 $27 Shares outstanding 1.5 1.7 SNreholder equity $ 16.1 $17.7

I. Determine the profit margin. RO E. market Cilplta IUt/O . . I' . n enterprise value, PE multiple. 3nd EY multiple for both lowe's and Home Depot.

Lowe's C ompanies. Inc. The H ome Depot, Inc.

Equity multiplier

AuK turnover

-....... RO' Market opIQliDtion Enterprise "alue PE multiple 'BirnA EV multiple

30.9116. 1 -48.3130.9

1.8148.3 1.8116.1 !.5 X 2

..

We can check this relationship for Prufrock by noting that the profit margin was t S. 7 percent :md the total asset turnove r was .64. ROE should thus be:

ROE = Profi t mare.in x Total aSSCllumover X Equity muhiplie r = 15.7% x .64 x 1.39 = 14%

Tllis 14 pe rcent ROE is exactly what we had before. The Du Po nt idcnlity tells us that ROE is a ffected by three things:

I. Operating efficiency (as measured by profit margin). 2. Asset useefl'ic iency (as meas ured by 10lal asscllurno\,er). 3. Financial leverage (as measured by Ihe eq uity Illuiliplier). Weakness in either opera ting or asset use efficiency (or both) will show up in tI dimin ished return o n assets.. wh ich will translute into a lower RO E.

Considering tbe Du Pont identit y. il appears Ihallbe RO E could be levemged up by increasing the amounl o r debt in the firm. However, notice that increasi ng debt also increases interest expense, which reduces profit margins. which acts to reduce ROE. So. ROE could go up or dowe , depending. More imponant. the use or debt financing has a number of other e lTect 5. a nd , as we discuss a t some length in later chapters. the am ount of leverage a finn uses is governed by ilS capilill structure policy.

T he decomposition of ROE we'vc discussed in this section is a convenient way o r sys-lematically approaching finaocia l statement ana lysis. If ROE is unsatisfactory by some measure, then the Du Pont identity tells you where to start looking for the reasons. j

Ya hoo! a nd Google are among the most importan t Interne t companies in the world . In spring 2008, Yahoo! was being urged by a group of dissiden t investors to sell the comp

"

3.4

Pan I O .. ervitw

during the year. FinaJly, for a ny particular fi rm, unusual o r transient events, such as a o ne-rime profit from an asset sale, may atTect financial pe rformance. Such events can giye misleading signals as we compare fi rms.

Financial Models r r. . I tatemenl

Table 3.8

Table 3.9

f'lI,f1 I Ovcroicw

ROSENGARTEN CORPORATION Income Statement

"' .. Cosu Taxable income Taxes (H%) Net income

Dividends Addition to reulned earnings

$4< 88

ROSENGARTEN CORPORATION Pro Forma Income St;atement

Sales (projected) Cosu (80% of sales) Taxable Income T;ues (3~%) Net income

51.250 1.000

5 250 8S

$ 165 =

51 ,000 BOO

$ 200 68

5 132 =

Rosengarten has projected a 25 percent increase in sales fo r the coming ~ear, so we are a nticipating sales of $ 1.000 x 1.25 = $ 1,250. To generate a pro forma mcome statement. we assume that total costs will continue to run at $800/ 1,000 = .80 percent of sa les. With this assumption. Rosenga rten's pro forma income statement IS as shown in Table 3.9. T he effcct here of assumlng Ihat costs are a constant percentage of sales is 10 asswne th at the pro fit margin is constant. To check this., notice thai the pro~t margin was S I321 1.000 == 13.2 percent. In o ur pro forma slatemenl. (he profit margm is $ 165/1 ,250 = 13.2 percent ; so it is unchanged.

Next, we need to proje

66 PlIr1 1 Overview

Table 3.11

ROSENGARTEN CORPORATION

Assets Lill:~ilities and Owners~ Equity --- -

Change Change (rom (rom

Next Current Next Current Year Year Year Year

CUrTeflt assets CUrTeOt liabilities c..h $ 200 $

68 Part I Overview

We bave used a combination of shon- and long-term debt as Ih~ plug here. but we emphasize that this is just one possible strategy; it is not o~nly the ~t one ,by any means. We could (and should) investigate many other scenanos. Th: vanous ra~lOs we discussed earlier come in handy here. For example, with, the scenario we have Ju.st c:\amined . we would surely want to exa mine the current ratio and the total debt ratto to see if we were comfortable with the new projected debt levels.

3.5 External Financing and Growth

Table 3.13

Currentuseu Net fixed U$eu

Totalusets

External financing oeeded and growth are obviously related. All oth.er things Slaying the same. the higher the rate of growth in sales or assets. the greater w~n be the need for external financing. In the p