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Financial Analysis,
Flanning & Forecasting
Theory and Application
Third Edition
Cheng F Lee Rutgers University, USA
John Lee Center for PBBEF Research, USA
World Scientific
NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONGKONG • TAIPEI • CHENNAI • TOKYO
Contents
Preface v Acknowlcdgments vii
Chapter 1. Introduction 1
1.1. Introduction 1 1.2. Financial Management: Analysis And Planning 1
1.2.1. Basic Defmitions 1 1.2.2. Objectives of Financial Management 2 1.2.3. Planning Horizon Classification 2
1.3. Objectives and Philosophy of the Book 3 1.4. Structure of the Book 4 Problem Set 8 References for Chapter 1 8
Part I Information and Methodology for Financial Analysis 11
Chapter 2. Accounting Information and Regression Analysis 13
2.1. Introduction 13 2.2. Financial Statements: A Brief Review 14
2.2.1. Balance Sheet 14 2.2.2. Statement of Earnings 16 2.2.3. Statement of Equity 18 2.2.4. Statement of Cash Flows 18 2.2.5. Interrelationship among Four Financial
Statements 26 2.2.6. Annual versus Quarterly Financial Data 26
2.3. Critique of Accounting Information 27
ix
x Financial Analysis, Planning and Forecasting: Theory and Application
2.3.1. Criticism 27 2.3.2. Methods for Improvement 29
2.4. Static Ratio Analysis and its Extension 30 2.4.1. Static Determination of Financial Ratios 31 2.4.2. Dynamic Analysis of Financial Ratios 38 2.4.3. Statistical Distribution of Financial Ratios 43
2.5. CVP Analysis and its Applications 44 2.5.1. Deterministic Analysis 45 2.5.2. Stochastic Analysis 47
2.6. Accounting Income Versus Economic Income 49 2.7. Summary 50 Problem Set 50 Appendix 2.A. Simple and Multiple Regression 57
2.A.I. Introduction 57 2.A.2. Simple Regression 57
Appendix 2.B. Using Indirect Method to Compile Cash Flow Statement 67
2.B.I. Cash Flow from Operating Activities 70 2.B.2. Cash Flow from Investing Activities 71
References for Chapter 2 72
Chapter 3. Discriminant Analysis and Factor Analysis: Theory and Method 75
3.1. Introduction 75 3.2. Important Concepts of Linear Algebra 76
3.2.1. Linear Combination and its Distribution 76 3.2.2. Vectors, Matrices, and Their Operations 77 3.2.3. Linear-Equation System and its Solution 80
3.3. Two-Group Discriminant Analysis 85 3.4. fc-Group Discriminant Analysis 90 3.5. Factor Analysis and Principal-Component Analysis 93
3.5.1. Factor Score 93 3.5.2. Factor Loadings 94
3.6. Summary 94 Notes 95 Problem Set 95 Appendix 3.A. Four Alternative Methods to Solve System
of Linear Equations 95
Contents xi
Appendix 3.B. Relationship between Discriminant Analysis and Dummy Regression Analysis 100
Appendix 3.C. Principal-Component Analysis 105 References for Chapter 3 109
Chapter 4. Application of Discriminant Analysis and Factor Analysis in Financial Management 111
4.1. Introduction 111 4.2. Credit Analysis 111 4.3. Bankruptcy and Financial Distress Analysis 115 4.4. Applications of Factor Analysis to Select Useful
Financial Ratios 120 4.5. Bond Rating Forecasting 124 4.6. Bond Quality Ratings and the Change of Quality Ratings
for the Electric Utility Industry 131 4.7. Other Model for Estimating Default Probability 132
4.7.1. Ohlson's and Shumway's Methods for Estimating Default Probability 132
4.7.2. KMV-Merton Model 135 4.7.3. Empirical Comparison 136
4.8. Summary 136 Notes 137 Problem Set 137 Appendix 4.A. Jackknife Method and its Application
in MDA Analysis 138 Appendix 4.B. Logistic Model and Probit Model 141 Appendix 4.C. SAS Code for Hazard Model
in Bankruptcy Forecasting 142 References for Chapter 4 143
Chapter 5. Determination and Applications of Nominal and Real Rates-of-Return in Financial Analysis 149
5.1. Introduction 149 5.2. Theoretical Justification of Paying Interest 150 5.3. Rate-of-Return Measurements and Types of Averages .... 151
5.3.1. Discrete Rates-of-Return and Continuous Rates-of-Return 151
5.3.2. Types of Averages 152 5.3.3. Power Means 156
xii Financial Analysis, Planning and Forecasting: Theory and Application
5.4. Theories of the Term Structure and Their Application . . . 156 5.5. Interest Rate, Price-Level Changes, and Components
of Risk Premium 162 5.5.1. Imperfect-Foresight Case 163 5.5.2. Perfect-Foresight Case 165
5.6. Three Hypotheses About Inflation and the Value of the Firm: A Review 169 5.6.1. The Debtor-Creditor Hypothesis 169 5.6.2. The Tax-Effects Hypothesis 171 5.6.3. Operating-Income Hypothesis 172 5.6.4. The Relationship araong the Three Hypotheses . . 173
5.7. Summary 174 Notes 174 Problem Set 175 Appendix 5.A. Compounding and Discounting Processes
and Their Applications , . 180 Appendix 5.B. Taylor-Series Expansion and its Applications
to Rates-of-Return Determination 185 References for Chapter 5 189
Project I Analyses of Accounting, Market, and Economic Data 193
Part II Alternative Finance Theories and Their Application 195
Chapter 6. Valuation of Bonds and Stocks 197
6.1. Introduction 197 6.2. Bond Valuation 197
6.2.1. Present Value of Future Cash Flows 198 6.2.2. Interest Rate, YTM, and Bond Price 202 6.2.3. Credit Risk, Interest Rate Risk, and Reinvestment
Rate Risk 204 6.2.4. Zero Coupon Bonds 208
6.3. Stock Valuation 209 6.3.1. Constant Dividend Growth Rate Model 211 6.3.2. Rate-of-Return and Required Rate-of-Return . . . 213 6.3.3. Supernormal Growth Stocks 215
Contents xiii
6.4. Growth Rate Estimation and Its Application 216 6.4.1. Compound-Sum Method 216 6.4.2. Regression Method 218 6.4.3. One-Period Growth Model 218 6.4.4. Two-Period Growth Model 223 6.4.5. Three-Period Growth Model 224
6.5. Preferred Stock Valuation 228 6.6. Risk, Return, and Market Efficiency 230
6.6.1. Historical Returns and Fluctuations 230 6.6.2. Efficient Capital Markets 231 6.6.3. Implications for Financial Managers 233
6.7. Exchange Rates and Investing Overseas 234 6.8. Application Examples 236
6.8.1. Zero Coupon Bond Yield 236 6.8.2. Valuation 236 6.8.3. Stock Valuation 237 6.8.4. Return on Overseas Investment 238
6.9. Summary 238 Problem Set 239 Appendix 6.A. The Relationship between Exchange Rates
and Interest Rates 246 Appendix 6.B. Derivation of Dividend Discount Model 248 Appendix 6.C, Duration Analysis 250 References for Chapter 6 266
Chapter 7. Valuation and Capital Structure: A Review and Integration 269
7.1. Introduction 269 7.1.1. Components of Capital Structure 270 7.1.2. Opportunity Cost, Required Rate-of-Return,
and the Cost of Capital 271 7.2. Bond Valuation 272
7.2.1. Perpetuity 273 7.2.2. Term Bonds 273 7.2.3. Preferred Stock 276
xiv Financial Analysis, Planning and Forecac-'.nuj: Theory and Application
7.3. Common-Stock Valuation 277 7.3.1. Valuation 277
7.4. Financial Leverage and Its Effect on 286 7.4.1. Measurement 286 7.4.2. Effect 286
7.5. Degree of Financial Leverage and Comuiucd Effect 291 7.6. Optimal Capital Structure 292
7.6.1. Overall Discussion 292 7.6.2. Arbitrage Process and the Proof of M&M
Proposition 1 295 7.7. Possible Reasons for Optimal Capital Structure 302
7.7.1. The Traditional Approach of Optimal Capital Structure 303
7.7.2. Bankruptcy Costs 303 7.7.3. Agency Costs 306 7.7.4. Iraperfect Markets 308
7.8. Summary 308 Notes 309 Problem Set 311 Appendix 7.A. Convertible Security Valuation Theory 320 Appendix 7.B. Derivation of DOL, DFL, and CML 326 References for Chapter 7 328
Chapter 8. Risk Estimation and Diversification 331
8.1. Introduction 331 8.2. Risk Classification 331
8.2.1. Business Risk 332 8.2.2. Financial Risk 334 8.2.3. Total Risk 335
8.3. Portfolio Analysis and Application 336 8.3.1. Expected Rate-of-Return on a Portfolio 337 8.3.2. Variance and Standard Deviation
of a Portfolio 337 8.3.3. The Two-asset Case 338 8.3.4. The N-asset Case 340 8.3.5. The Efficient Portfolios 341 8.3.6. Corporate Application of Diversification 344
8.4. The Market Rate-of-Return and Market Risk Premium . . . 345 8.4.1. The Risk Premium 345
Contents xv
8.5. Determination of Commercial Lending Rates 347 8.6. The Dominance Principle and Perfomance Evaluation .... 349 8.7. Summary 352 Problem Set 352 Appendix 8.A. Estimation of Market Risks Premium 358 Appendix 8.B. The Normal Distribution 359 Appendix 8.C. Derivation of Minimum-Variance
Portfolio 363 Appendix 8.D. Sharps Performance Approach to Derive
Optimal Weight 364 References for Chapter 8 368
Chapter 9. Risk and Return Trade-off Analysis 371
9.1. Introduction 371 9.2. CML, EMH and CAPM 371
9.2.1. Lending, Borrowing, and the Market Portfolio . . . 372 9.2.2. The CML 374 9.2.3. EMH 375 9.2.4. Weak-Form EMH 375 9.2.5. Semistrong-Form EMH 375 9.2.6. Strong-Form EMH 376 9.2.7. CAPM 376
9.3. The Market Model and Beta Estimation 378 9.4. Einpirical Evidence for the Risk-Return Relationship .... 381 9.5. Why Beta is Important in Financial Management 384 9.6. Systematic Risk Determination 385
9.6.1. Business Risk and Financial Risk 386 9.6.2. Other Financial Variables 387 9.6.3. Capital Labor Ratio 388 9.6.4. Fixed Costs and Variable Costs 389 9.6.5. Market-Based versus Accounting-Based
Beta Forecasting 389 9.7. Some Applications and Implications of the CAPM 390
9.7.1. Applications 391 9.8. Liquidity and CAPM 393 9.9. APT 394 9.10. Summary 395 Problem Set 395 Appendix 9.A. Mathematical Derivation of the CAPM 401
xvi Financial Analysis, Planning and Forecasting: Theory and Application
Appendix 9.B. Arbitrage Pricing Model 403 References for Chapter 9 406
Chapter 10. Options and Option Strategies 409
10.1. Introduction 409 10.2. The Option Market and Related Definitions 410
10.2.1. What Is an Option? 410 10.2.2. Types of Options and Their Characteristics .... 410 10.2.3. Relationships Between the Option Price
and the Underlying Asset Price 413 10.2.4. Additional Definitions and Distinguishing
Features 417 10.2.5. Types of Underlying Asset 418 10.2.6. Institutional Characteristics 419
10.3. Put-Call Parity 420 10.3.1. European Options 420 10.3.2. American Options 423 10.3.3. Futures Options 424 10.3.4. Market Applications 426
10.4. Risk-Return Characteristics of Options 427 10.4.1. Long Call 427 10.4.2. Short Call 428 10.4.3. Long Put 431 10.4.4. Short Put 433 10.4.5. Long Straddle 434 10.4.6. Short Straddle 437 10.4.7. Long Vertical (Bull) Spread 439 10.4.8. Short Vertical (Bear) Spread 441 10.4.9. Calendar (Time) Spreads 442
10.5. Examples of Alternative Option Strategies 444 10.5.1. Protective Put 444 10.5.2. Covered Call 448 10.5.3. Collar 450 10.5.4. Long Straddle 452 10.5.5. Short Straddle 454 10.5.6. Long Vertical (Bull) Spread 456 10.5.7. Short Vertical (Bear) Spread 457
10.6. Summary 458
Contents xvii
Problem Set 459 References for Chapter 10 464
Chapter 11. Option-Pricing Theory and Firm Valuation 467
11.1. Introduction 467 11.2. Basic Concepts of Options 467
11.2.1. Option Price Information 470 11.3. Factors Affecting Option Value 474
11.3.1. Determining the Value of a Call Option Before the Expiration Date 474
11.4. Determining the Value of Options 483 11.4.1. Expected Value Estimation 483 11.4.2. The Black-Scholes OPM 484 11.4.3. Taxation of Options 489 11.4.4. American Options 490
11.5. Option-Pricing Theory and Capital Structure 491 11.5.1. Proportion of Debt in Capital Structure 494 11.5.2. Riskiness of Business Operations 495
11.6. Warrants and Diluted Earnings Per Share (EPS) 496 11.6.1. Warrants 496 11.6.2. EPS with Warrants and Convertibles 500
11.7. Summary 502 Problem Set 502 Appendix ll.A. Applications of the Binomial Distribution
to Evaluate Call Options 507 Appendix 11.B. Alternative Models for Evaluating Convertible
Bond: Review and Integration 517 References for Chapter 11 529
Project II Application of Useful Finance Theories 531
Part III Capital Budgeting and Leasing Decisions 533
Chapter 12. Alternative Cost of Capital Analysis and Estimation 535
12.1. Introduction 535 12.2. Overview of Cost of Capital 536
xviii Financial Analysis, Planning and. Forecasting: Theory and Application
12.3. Average Earnings Yield Versus Current Earnings Yield Method 537
12.4. DCF Method 538 12.5. Weighted-Average Cost of Capital (WACC) 541
12.5.1. Theoretical Justification of the WACC 546 12.6. The CAPM Method 549 12.7. M&M's Cross-Sectional Method 552
12.7.1. The Cost of Capital 553 12.7.2. Regression Formulation and Empirical Results . . - 555
12.8. Chase Cost of Capital 561 12.9. Summary 566 Problem Set 567 Appendix 12.A. Derivative of the Basic Equilibrium Market
Price of Stock and its Implications 576 References for Chapter 12 578
Chapter 13. Capital Budgeting Under Certainty 581
13.1. Introduction 581 13.2. The Capital Budgeting Process 581
13.2.1. Identification Phase 582 13.2.2. Development Phase 584 13.2.3. Selection Phase 585 13.2.4. Control Phase 586
13.3. Cash-Flow Evaluation of Alternative Investment Projects 588
13.4. Alternative Capital-Budgeting Methods 592 13.4.1. Accounting Rate-of-Return 593 13.4.2. Internal Rate-of-Return 594 13.4.3. Payback Method . 595 13.4.4. Net Present Value Method 596 13.4.5. Profitability Index 597
13.5. Comparison of the NPV and IRR Method 598 13.5.1. Theoretical Criteria 598 13.5.2. Practical Perspective 602
13.6. Different Lives 604
Contents xix
13.6.1. Mutually Exclusive Investment Projects with Different Lives 607
13.6.2. Equivalent Annual Cost 609 13.7. Capital-Rationing Decision 610
13.7.1. Basic Concepts of Linear Programming 610 13.7.2. Capital Rationing 611
13.8. Summary 614 Problem Set 615 Appendix 13.A. NPV and Break-Even Analysis 620 Appendix 13.B. Managers' View on Alternative
Capital-Budgeting Methods 626 Appendix 13.C. Derivation of Crossover Rate 632 References for Chapter 13 634
Chapter 14. Capital Budgeting Under Uncertainty 637
14.1. Introduction 637 14.1.1. Why is Net Present Value (NPV) Positive
(or Negative)? 638 14.1.2. Break-Even Analysis 639 14.1.3. General Break-Even Analysis 640 14.1.4. Cash Break-Even 645 14.1.5. Accounting Break-Even 647 14.1.6. Financial Break-Even 649 14.1.7. A Final Word on Break-Even Analysis 651 14.1.8. Three Alternative Methods of Analyzing
Project Risk 652 14.1.9. Some Final Comments on Evaluating
Uncertainty 660 14.1.10. Evaluating and Controlling Business Risk Through
the Capital Budgeting Process 660 14.1.11. Management Practices 662 14.1.12. Risk Analysis for Research and Development
Projects 663 14.1.13. Summary 664
14.2. Risk-Adjusted Discount-Rate Method 665 14.3. Certainty Equivalent Method 666
xx Financial Analysis, Planning and Forecasting: Theory and Application
14.4. The Relationship of the Risk-Adjusted Discount-Rate Method to the Certainty-Equivalent Method 668
14.5. Three Other Related Stochastic Approaches to Capital Budgeting 671 14.5.1. The Statistical Distribution Method 672 14.5.2. The Decision-TVee Method 678 14.5.3. Simulation Analysis 682 14.5.4. Comparison of the Three Alternative Stochastic
Methods 687 14.6. Inflationary Effects in the Capital-Budgeting Procedura . . . 688 14.7. Multi-period Capital Budgeting 698
14.7.1. Overall Discussion 698 14.7.2. The CAPM and Multi-period Capital-Budgeting
Decision Making 700 14.8. Summary 706 Problem Set 707 Appendix 14.A. Time-state Preference and the Real Option
Approaches for Capital Budgeting Under Uncertainty 718
References for Chapter 14 723
Chapter 15. Leasing: Practices and Theoretical Developments 727
15.1. Introduction 727 15.2. Types of Leasing Arrangements and Accounting
Treatments 728 15.2.1. Three Leasing Forms 728 15.2.2. Accounting for Leases 730
15.3. Cash-Flow Estimation and Valuation Methods 739 15.4. The Modigliani and Miller Propositions and the Theoretical
Considerations of Leasing 743 15.5. Leases-Versus-Buy Decisions Under Uncertainty:
The CAPM Approach 750 15.6. Options to Evaluate Salvage Values in Financial Leases . . . 755 15.7. Summary 755 Problem Set 757 Appendix 15.A. APV Method and Application to Leasing
Decision 761 References for Chapter 15 764
Contents xxi
Project III Capital Budgeting and Leasing Decisions 767
Part IV Corporate Policies and Their Interrelationships 769
Chapter 16. Mergers: Theory and Evidence 771
16.1. Introduction 771 16.2. Overview of Mergers 771 16.3. Classification of Business Combinations 772 16.4. Methods of Business Combination 774 16.5. Merger Accounting and Tax Effects 783
16.5.1. Tax Implications 783 16.5.2. Accounting Treatment of Business
Combinations 784 16.5.3. Legal Considerations 787 16.5.4. Tax and Surplus Funds Motives 789 16.5.5. Undervalued Assets 789 16.5.6. Agency Problems 790
16.6. Economic Theories and Evidence 790 10.6.1. Economic Theories 790 16.6.2. Market Power 791
16.7. Financial Theories and Evidence 793 16.7.1. Diversification and Debt Capacity 793
16.8. Summary 803 Problem Set 806 Appendix 16.A. Effects of Divestiture on Firm Valuation 810 References for Chapter 16 811
Chapter 17. Dividend Policy Theory, Practice, and Empirical Evidence 821
17.1. Introduction 821 17.2. How Firms Pay Dividends 823
17.2.1. Ex-Dividend Date 823 17.2.2. Dividend Reinvestment Plans 825
17.3. The Value of Dividend Policy to the Firm 826 17.3.1. Methods of Determining the Relevance
of Dividends 826 17.4. The Irrelevance of Dividend Policy 834
17.4.1. M&M Dividend Policy 834 17.4.2. Homemade Dividends 836
xxii Financial Analysis, Planning and Forecasting: Theory and Application
17.5. Dividend Payment and Policy Determination 837 17.5.1. Residual Theory 837 17.5.2. Lintner's Model 838 17.5.3. Stahle Dividend Policy 838 17.5.4. Information Content of Dividende —
A Synthesis 840 17.5.5. Double Taxation 841
17.6. Stock Dividends, Stock Splits, and Stock Repurchases .... 843 17.6.1. Stock Dividends and Stock Splits 843 17.6.2, Stock Repurchase 846
17.7. Factors that Influenae Dividend Policy 849 17.7.1. Company Financial Situation 850 17.7.2. Investor Preferences 850
17.8. Issues Marring the Dividend Problem 851 17.8.1. The Classical CAPM 852 17.8.2. Brennan's CAPM with Taxes 853 17.8.3. The Litzenberger and Ramaswarny CAPM
with Taxes 855 17.8.4. Empirical Evidence 858
17.9. Behavioral Considerations of Dividend Policy 868 17.9.1. Partial Adjustment and Information
Content Models 868 17.9.2. An Integration Model 872 17.9.3. Optimal Payout Ratio and Optimal
Growth Rate 874 17.10. Summary 874 Problem Set 875 References for Chapter 17 880
Chapter 18. Interaction of Financing, Investment and Dividend Policies 885
18.1. Introduction 885 18.2. Investment and Dividend Interactions: The Internal-Versus-
External Financing Decision 886 18.2.1. Internal Financing 886 18.2.2. External Financing 887
18.3. Interactions between Dividend and Financing Policies .... 889 18.3.1. Cost of Equity Capital and Dividend Policy .... 890 18.3.2. Default Risk and Dividend Policy 892
Contents xxiii
18.4. Interactions between Financing and Investment Decisions 895 18.4.1. Risk-Free Debt Case 896 18.4.2. Risky Debt Case 899
18.5. Iraplications of Financing and Investment Interactions for Capital Budgeting 900 18.5.1. Equity-Residual Method 901 18.5.2. After-Tax, WACC Method 902 18.5.3. Arditti and Levy Method 902 18.5.4. Myers Adjusted-Present-Value Method 903
18.6. Debt Capacity and Optimal Capital Structure 909 18.7. Implications of DifFerent Policies on the Beta
Coefficient 921 18.7.1. Impact of Financing Policy on Beta Coefficient
Determination 921 18.7.2. Impact of Production Policy on Beta
Coefficient Determination 922 18.7.3. Impact of Dividend Policy on Beta
Coefficient Determination 923 18.8. Summary 924 Problem Set 926 Appendix 18.A. Stochastic Dominance and it's Applications
to Capital Structure Analysis with Default Risk 927
References for Chapter 18 932
Project IV Corporate Policies and Their Interrelationships 937
Part V Short-term Financial Decision 939
Chapter 19. Short-Term Financial Analysis and Flanning 941
19.1. Introduction 941 19.2. The Components of Working-Capital 942 19.3. The Concept of Cash Flow 945 19.4. Cash Flow Versus Funds Flow 946 19.5. Organizing for Short-Term Financial Flanning 949 19.6. The Cash Flow Cycle and its Calculation 950 19.7. Cash Flow Forecasting, Budgeting, and Flanning 956
xxiv Financial Analysis, Planning and Forecasting: Theory and Application
19.8. The Cash Budget 956 19.9. Demand-Driven, Capital-Driven, and Cost-Driven
Cash Budgets 959 19.10. Users of Cash Forecasts and Business Plans 960 19.11. Planning Horizons and Time Intervals of Cash Budgets . . . 961 19.12. From Forecasting to Budgeting to Planning 964 19.13. Summary 969 Problem Set 970 Appendix 19.A. Time-Series Coraponents of Sales 982 References for Chapter 19 987
Chapter 20. Credit, Cash, Marketable Securities, and Inventory Management 989
20.1. Introduction 989 20.2. Trade Credit 990 20.3. The Cost of Trade Credit 994
20.3.1. The Seller's Perspective 994 20.3.2. The Buyer's Perspective 998
20.4. Financial Ratios and Credit Analysis 998 20.4.1. Financial Ratio Analysis 999 20.4.2. Numerical Credit Scoring 999 20.4.3. Benefits of Credit-Scoring Models 1003 20.4.4. Outgide Sources of Credit Information 1004
20.5. Credit Decision and Collection Policies 1006 20.5.1. Collection Policy 1007 20.5.2. Factoring and Credit Insurance 1008
20.6. The Baumol and Miller-Orr Model 1009 20.6.1. Baumol's EOQ Model 1009 20.6.2. Miller-Orr Model 1012
20.7. Cash Management Systems 1016 20.7.1. Float 1016 20.7.2. Cash Collection and Transference Systems 1017 20.7.3. Cash Transference Mechanism and Scheduling . . . 1019
20.8. Credit Lines and Bank Relations 1022 20.8.1. Bank Relations 1024
20.9. Marketable Securities Management 1025 20.9.1. Investment Criteria for Surplus Cash Balances . . . 1025 20.9.2. Types of Marketable Securities 1027 20.9.3. Hedging Considerations 1029
Contents xxv
20.10. Inventory Management 1030 20.10.1. Inventory Loans 1031
20.11. Summary 1032 Problem Set 1033 Appendix 20.A 1040 References for Chapter 20 1040
Chapter 21. Short-Term Financing 1043
21.1. Introduction 1043 21.2. Bank Loans 1044
21.2.1. The Nature of Bank Lending 1044 21.2.2. Self-Liquidating Loans 1045 21.2.3. Lines of Credit 1046 21.2.4. Revolving Credit Agreements 1047 21.2.5. Floor Plan Loans 1048
21.3. Characteristics of Bank Loans 1048 21.3.1. Interest Rates 1049 21.3.2. Security Requirements 1052 21.3.3. Maturity of the Loan 1053
21.4. Short-Term Financing 1054 21.4.1. Stretching Accounts Payable 1054 21.4.2. Offering Liberal Credit to Increase Sales 1056 21.4.3. Trade Credit and Seasonal Business 1056 21.4.4. Who Pays the Cost? 1057 21.4.5. Advantages of Trade Credit 1058
21.5. Turning Receivables into Cash 1058 21.5.1. Pledging 1058 21.5.2. Factoring 1060
21.6. Inventory Financing and Management 1062 21.6.1. Trust Receipts 1062 21.6.2. Warehousing 1063 21.6.3. Selling 1064
21.7. Other Non-bank Sources of Funds 1065 21.7.1. Commercial Paper 1065 21.7.2. Banker's Acceptances 1066 21.7.3. Asset-Backed Debt Securities (ABS) 1067
21.8. Summary 1068 Problem Set 1069 References for Chapter 21 1072
xxvi Financial Analysis, Planning and Forecasting: and Application
Chapter 22. Elementary Applications of Progranjr-üng Techniques in Working-Capital Mau^'-ment 1073
22.1. Introduction 1073 22.2. Linear Programming 1074 22.3. Working-Capital Model and Short-Term
Financial Planning 1076 22.3.1. Questions to be Answered 1077 22.3.2. Model Specification and its Solution 1078 22.3.3. Which Constraints are Causing Botvlenecks? .... 1080 22.3.4. How Much More Profit is Being Lost Because
of Constraints? 1080 22.3.5. How Do the Constraints Affect the Solution? . . . 1081 22.3.6. Duality and Shadow Prices 1082 22.3.7. Short-term Financial Planning 1084
22.4. Goal Programming 1085 22.4.1. Introduction 1085 22.4.2. Application of GP to Working-Capital
Management 1087 22.4.3. Summary and Remarks on Goal Programming . . . 1091
22.5. Programming Approach to Cash Transfer and Concentration 1092 22.5.1. Transfer Mechanisms 1093 22.5.2. Cash-Transfer Scheduling: Contemporary
Practice 1093 22.5.3. Weekend Tuning and Dual Balances 1097 22.5.4. Limitations of the Populär Techniques 1097 22.5.5. Mathematical-Programming Formulation 1098 22.5.6. Relation of Model Formulation to Current
Practice 1105 22.6. Summary 1107 Notes 1107 Problem Set 1108 Appendix 22.A. The Simplex Algorithm for Solving Eq. (22.8) . . . 1109 Appendix 22.B. Mathematical Formulation of Goal
Programming* 1111 References for Chapter 22 1113
Contents xxvii
Part VI Financial Planning and Forecasting 1117
Chapter 23. Long-Range Financial Planning — A Linear-Programming Modeling Approach 1119
23.1. Introduction 1119 23.2. Carleton's Model 1120 23.3. Brief Discussion of Data Inputs 1124 23.4. Objective-Function Development 1127 23.5. The Constraints 1130
23.5.1. Definitional Constraints 1131 23.5.2. Policy Constraints 1140
23.6. Analysis of Overall Results 1151 23.7. Summary and Conclusion 1157 Problem Set 1157 Appendix 23. A. Carleton's Linear-Programming Model:
General Mills as a Case Study 1158 Appendix 23.B. General Mills'Actual Key Financial Data 1160 References for Chapter 23 1161
Chapter 24. Simultaneous Equation Models for Security Valuation 1163
24.1. Introduction 1163 24.2. Warren and Shelton Model 1163
24.2.1. Percentage of Sales Method for Financial Planning and Forecasting 1163
24.2.2. Warren and Shelton Model 1165 24.3. Johnson & Johnson (JNJ) as a Case Study 1179
24.3.1. Data Sources and Parameter Estimations 1179 24.3.2. Procedure for Calculating WS Model 1179
24.4. Francis and Rowell Model 1186 24.4.1. The FR Model Specification 1193 24.4.2. A Brief Discussion of FR'S Empirical Results . . . 1198
24.5. Feltham-Ohlson Model for Determining Equity Value .... 1199 24.6. Combined Forecasting Method to Determine
Equity Value 1202 24.7. Summary 1202 Problem Set 1203
xxviii Financial Analysis, Planning and Forecasting: Theory and Application
Appendix 24.A. Procedure of Using Microsoft Excel to Run FINPLAN Program 1204
Appendix 24.B. Program of FINPLAN with an Example 1205 References for Chapter 24 1213
Chapter 25. Time-Series: Analysis, Model, and Forecasting 1217
25.1. Introduction 1217 25.2. The Classical Time-Series Component Model 1218
25.2.1. The Trend Component 1218 25.2.2. The Seasonal Component 1219 25.2.3. The Cyclical Component and Business Cyclos . . . 1220 25.2.4. The Irregulär Component 1222
25.3. Moving Average and Seasonally Adjusted Time-Series .... 1224 25.3.1. Moving Averages 1224 25.3.2. Seasonal Index and Seasonally Adjusted
Time-Series 1225 25.4. Linear and Log-Linear Time Trend Regressions 1232 25.5. Exponential Smoothing and Forecasting 1235
25.5.1. Simple Exponential Smoothing and Forecasting . . 1235 25.5.2. The Holt-Winters Forecasting Model
for Non-seasonal Series 1240 25.6. Autoregressive Forecasting Model 1244 25.7. Summary 1248 Problem Set 1248 Appendix 25.A. The X-ll Model for Decomposing Time-Series
Components 1263 Appendix 25.B. The Holt-Winters Forecasting Model
for Seasonal Series 1268 References for Chapter 25 1274
Chapter 26. Econometric Approach to Financial Analysis, Planning, and Forecasting 1275
26.1. Introduction 1275 26.2. Simultaneous Nature of Financial Analysis, Planning,
and Forecasting 1276 26.2.1, Basic Concepts of Simultaneous Econometric
Models 1276
Contents xxix
26.2.2. Interrelationship of Accounting Information .... 1276 26.2.3. Interrelationship of Financial Policies 1277
26.3. The Simultaneity and Dynamics of Corporate-Budgeting Decisions 1277 26.3.1. Definitions of Endogenous and Exogenous
Variables 1277 26.3.2. Model Specification and Applications 1278
26.4. Applications of SUR Estimation Method in Financial Analysis and Planning 1292 26.4.1. The Role of Firm-Related Variables
in Capital-Asset Pricing 1292 26.4.2. The Role of Capital Structure in Corporate-
Financing Decisions 1297 26.5. Applications of Structural Econometric Models
in Financial Analysis and Planning 1299 26.5.1. A Brief Review 1299 26.5.2. AT&T's Econometric Planning Model 1299
26.6. Programming versus Simultaneous versus Econometric Financial Models 1300
26.7. Financial Analysis and Business Policy Decisions 1302 26.8. Summary 1305 Problem Set 1305 Appendix 26.A. Instrumental Variables and Two-Stages
Least Squares 1305 Appendix 26.B. Johnson & Johnson as A Case Study 1311 References for Chapter 26 1328
Project V Financial Planning and Forecasting 1331
Author Index 1333 Subject Index 1343