Joel G. Siegel Jae K. Shim - Financial Management-Barrons Educational Series (2000) PDF

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Page i
Financial Management
Second Edition
Jae K. Shim
Professor of Finance and Accounting
California State University, Long Beach
Joel G. Siegel
Professor of Finance and Accounting
Queens College of the City University of New York
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Page ii
General editor for the first edition of Financial Management in BARRON'S BUSINESS LIBRARY
Series is George T. Friedlob, professor in the School of Accountancy at Clemson University.
Copyright © 2000, 1991 by Barron's Educational Series, Inc.
All rights reserved.
No part of this book may be reproduced in any form, by photostat, microfilm, xerography, or any
other means, or incorporated into any information retrieval system, electronic or mechanical, without
the written permission of the copyright owner.
All inquiries should be addressed to:
Barron's Educational Series, Inc.
250 Wireless Boulevard
Hauppauge, New York 11788
http://www.barronseduc.com
Library of Congress Catalog Card No. 99-47469
International Standard Book No. 0-7641-1402-6
Library of Congress Cataloging-in-Publication Data
Shim, Jae K.
Financial management / by Jae K. Shim, Joel G. Siegel. 2nd ed.
p. cm. (Barron's business library)
Includes index.
ISBN 0-7641-1402-6
1. Small businessFinance. I. Siegel, Joel G. II. Title. III. Series.
HG4027.7 .S47 2000
658.15'92dc21 99-47469
PRINTED IN THE UNITED STATES OF AMERICA
987654321

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Page iii
Preface
This book is written for the businessperson who must have a basic knowledge of finance to do his or
her job. You may be a newly hired or recently promoted middle manager, or an entrepreneur or sole
proprietor who has brilliant product ideas but no notion about financing. In any case, a knowledge of
basic finance concepts is essential for you to function successfully on the job.
The goal of this book is to provide a working knowledge of the fundamentals of finance that you can
apply in the real world. The financial techniques and approaches we describe can be used by any
financial manager, regardless of his or her primary duties.
In Financial Management, we walk you through "thinking finance" and suggest strategies to help you
make intelligent financial decisions and analyze their results. You will read about what you need to
know, what to ask, what tools are important, what to look for, what to do, how to do it, and what to
watch out for. We have tried to make this book practical, quick reading, and useful. You will learn
how to appraise where you've been, where you are now, and where you're headed. We present
criteria you can use to examine the performance of your operations and activities as well as to
formulate realistic profit goals. Budgeting procedures and cash flow analysis are also discussed.
A basic understanding of financial information is necessary so you can evaluate the performance of
your operationare things getting better or worse? What are the possible reasons? Who is
responsible? What can you do about it?
You also need to be able to analyze your company's financial statements in order to evaluate its
financial health and operating performance. What has been the trend in profitability and return on
investment? Will the business be able to pay its bills? How are receivables and inventory turning
over?
Familiarity with tax planning strategies is essential so the company can legally minimize its taxes.
We discuss sources of tax-exempt income, tax-deductible expenses, and timing income and expenses
among tax years.

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Page iv
Budgeting is another essential topic for you to understand. In order to plan your departmental affairs
properly, you need to know how to prepare a budget showing expected sales volume, sales revenue,
production and manufacturing costs, operating expenses, and cash flow. The budget, which serves as
a road map showing where you are to go and what you are to do, helps you to accomplish financial
and operating objectives.
You also need to know what the break-even sales are to determine if a new product or proposal will
cover its costs, and how to manage your assets properly to achieve the best possible return
consistent with your desired risk level. We discuss ways of managing cash that help you to
accelerate cash receipts and delay cash payments; how to decide whether to offer a discount for
early payment and extend credit to marginal customers; and how to manage inventory.
Understanding the trade-off between risk and return is crucial. As a rule, the greater the desired rate
of return, the greater the risk required to obtain it. This trade-off affects your financing and
investment decisions.
As a financial manager, you will need to recognize the time value of moneythe idea that a dollar is
worth less the longer it takes to receive. Time value of money applications include determining the
present value of receiving future cash flows, computing how much money will be in an account at a
future date, and calculating interest rates, periodic payments on a loan, and the time it will take for
money to grow to a specific value.
You will probably be required to make capital budgeting decisionsto select the optimum alternative
long-term investment opportunity. Should you buy or lease? Should you sell a division or keep it?
Should you manufacture product A or B? Should you expand? Capital budgeting methods that can aid
you in making these decisions include determining the payback period (how long it takes to get your
initial investment back) and using present value techniques that look at the discounted value in
today's dollars of receiving future cash flows.
You may also be required to determine the overall cost of capital for the business. Cost of capital is
basically the cost of financing, determined by taking into account the weighted-average cost of debt
(interest) and cost of stock (dividends). This cost of capital is the basis for determining the discount
rate used to calculate the present value of future cash flows in capital budgeting.
Strategies must be developed to find the best mix of financing for your company. Should you finance
short-term or long-term? If you decide to go long-term, should you finance with debt or equity? The
particular source of financing depends on the particular circumstances

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Page v
at the time. Further, when you merge with or acquire another business, you will need to select the
most advantageous form of financing.
You may need to determine what dividend policy is best for your company, given its overall
corporate objectives. The amount of dividends to be paid out depends upon many factors, such as
earnings, growth rate, cash position, and opportunities for investment.
If the business is doing poorly, you must be able to take steps to improve operations and avoid
business failure. Is reorganization the answer? What are the indicators of potential bankruptcy? If all
else fails, you have to know the steps in liquidation.
If your company operates overseas, you must be cognizant of any special risks you face. How can
you minimize political and economic exposures in foreign lands? What foreign-currency exchange-
rate risk are you willing to assume?
This book includes many practical examples, applications, illustrations, guidelines, measures, rules
of thumb, graphs, diagrams, and tables to aid your comprehension of the subjects discussed.
Keep this book handy in your library for easy reference throughout your professional business
career. While this book does not include "all you ever wanted to know about finance," it provides a
foundation on which to build your knowledge of finance and related business disciplines.
We would like to thank our wives, Chung and Roberta, for their encouragement and patience during
the writing of this book. We also thank Tom Friedlob, general editor of this series, for his very
valuable input and professional advice. Thanks goes to the outside anonymous reviewer for his
constructive comments and suggestions. In addition, we acknowledge the excellent editorial
assistance of the staff of Barron's Educational Series, which made this book possible.
JAE K. SHIM, PH.D.
JOEL G. SIEGEL, PH.D., CPA

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Page vii
Contents
1
Introduction 1
2
Understanding Financial Statements 19
3
Analyzing Financial Statements 41
4
Financial Forecasting and Budgeting 61
5
Analyzing and Improving Management Performance 85
6
Understanding the Concept of Time Value of Money 97
7
Understanding Return and Risk 115
8
Valuing Stocks and Bonds 127
9
Cost of Capital 139
10
How to Make Capital Budgeting Decisions 153
11
Leverage and Capital Structure 173
12
Using Working Capital Management Effectively 185
13
Short-Term and Intermediate-Term Financing 219
14
Long-Term Debt Financing 251
15
Long-Term Equity Financing 263
16
Dividend Policy 283
17
Warrants and Convertibles 293
18
Failure and Reorganization 311
19
International Finance 327
Appendices 339
A
Online Internet Resources 339
B
Excel Financial and Investment Functions 341
Index 345
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Page 1
Chapter 1
Introduction
Introduction and Main Points
Financial management is the process of planning decisions in order to maximize the owners' wealth.
Financial managers have a major role in cash management, in the acquisition of funds, and in all
aspects of raising and allocating financial capital, taking into account the trade-off between risk and
return. Financial managers need accounting and financial information to carry out their
responsibilities.
In this chapter, you will learn:
· The scope and role of finance.
· The language and decision making of finance.
· The responsibilities of financial managers.
· The relationship between accounting and finance.
· The financial and operating environment in which financial managers operate.
· The corporate forms of business organization.
Goals of Corporate Finance

Company goals usually include (1) stockholder wealth maximization, (2) profit maximization, (3)
managerial reward maximization, (4) behavioral goals, and (5) social responsibility. Modern
managerial finance theory operates on the assumption that the primary goal of the business is to
maximize the wealth of its stockholders, which translates into maximizing the price of the firm's
common stock. The other goals mentioned above also influence the company's policy but are less
important than stock price maximization. Note that the traditional goal frequently stressed by
economistsprofit maximizationis not sufficient for most companies today.
Profit Maximization vs. Stockholder Wealth Maximization

Profit maximization is basically a single-period or, at most, a short-term goal, to be achieved within
one year; it is usually interpreted to mean the maximization of profits within a given period of time.
A


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corporation may maximize its short-term profits at the expense of its long-term profitability. In
contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in
future as well as present profits. Wealth maximization is generally preferred because it considers (1)
wealth for the long term, (2) risk or uncertainty, (3) the timing of returns, and (4) the stockholders'
return. Timing of returns is important; the earlier the return is received, the better, since a quick
return reduces the uncertainty about receiving the return, and the money received can be reinvested
sooner. Table 1-1 summarizes the advantages and disadvantages of these two often conflicting goals.
Let us now see how profit maximization may affect wealth maximization.
EXAMPLE 1-1
Profit maximization can be achieved in the short term at the expense of the long-term goal of wealth
maximization. For example, a costly investment may create losses in the short term but yield
substantial profits in the long term; a company that wants to show a short-term profit may postpone
major repairs or replacement even though such postponement is likely to hurt its long-term
profitability.
EXAMPLE 1-2
Profit maximization, unlike wealth maximization, does not consider risk or uncertainty. Consider two
products, A and B, and their projected earnings over the next five years, as shown below.
Year Product A Product B
1 $10,000 $11,000
2 10,000 11,000
3 10,000 11,000
4 10,000 11,000
5 10,000 11,000
$50,000 $55,000
A profit maximization approach favors product B over product A because its total projected earnings
after five years are higher. However, if product B is more risky than product A, then the decision is
not as straightforward as the figures seem to indicate because of the trade-off between risk and
return. Stockholders expect greater returns from investments with higher risk; they will demand a
sufficiently large return to compensate for the comparatively greater level of risk of producing
product B.


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TABLE 1-1
PROFIT MAXIMIZATION VERSUS
STOCKHOLDER WEALTH MAXIMIZATION
Goal Objective Advantages Disadvantages
Profit Large profits 1. Easy to calculate profits. 1. Emphasizes the short term.
maximization 2. Easy to determine the link 2. Ignores risk or uncertainty.
between financial decisions and 3. Ignores the timing of returns.
profits. 4. Requires immediate resources.
Stockholder Highest market 1. Emphasizes the long term.
wealth value of common 2. Recognizes risk or uncertainty. 1. Offers no clear relationship between
maximization stock 3. Recognizes the timing of returns. financial decisions and stock price.
4. Considers stockholders' return. 2. Can lead to management anxiety and
frustration.

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Financial Decisions and Risk-Return Trade-Off

The concept of risk-return trade-off is integral to the theory of finance. Risk refers to the variability
of expected returns (sales, earnings, or cash flow) and is the probability that a financial problem
will affect the company's operational performance or financial position. Typical forms of risk are
economic risk, political uncertainties, and industry problems.
Risk analysis is a process of measuring and analyzing the risk associated with financial and
investment decisions. It is important to consider risk in making capital investment decisions because
of the large amount of capital involved and the long-term nature of the investments. Analysts must
also consider the rate of return in relation to the degree of risk involved. (Return, the reward for
investing, consists of current income, in the form of either periodic cash payments or capital gain (or
loss) from appreciation (or depreciation) in market value.)
Proper assessment and balance of the various risk-return trade-offs available is part of creating a
sound stockholder wealth maximization plan. The risk-return trade-off is discussed in Chapters 7,
10, and 12.
Time Value of Money

Today's dollars are not the same as tomorrow's. A dollar now is worth more than a dollar to be
received later, because you can invest that dollar for a return and have more than a dollar at the
specified later date. Further, receiving a dollar in the future has uncertainty attached to it; inflation
might make the dollar received at a later time worth less in buying power.
Time value of money is a critical consideration in financial and investment decisions. For example,
compound interest calculations can help you determine your eventual return from an investment.
Discounting, or the calculation of present value, which is inversely related to compounding, is used
to evaluate future cash flow associated with long-term projects; the discounted value of receiving
future cash flows from a proposal is an important consideration. Time value of money has many
applications in finance; for example, it can help you determine the periodic payout or interest rate on
a loan or decide between leasing and buying equipment.
The time value of money is fully discussed in Chapter 6.
Let us now see why finance is important to know in order to optimally perform your responsibilities.


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Importance of Finance
It's important for you to have a knowledge of finance and to know how to apply it successfully,
whether you deal with production, marketing, personnel, operations, or any other aspect of corporate
functioning. You should know where to look, what to ask, and where to get the answers to questions
on your department or company operations. Financial knowledge aids in planning, problem solving,
and decision making. Further, you must have financial and accounting knowledge in order to be able
to understand the financial reports prepared by other segments of the organization.
Financial managers spend a good portion of their time planning, setting objectives, and developing
efficient courses of action to achieve their objectives. As a financial manager, you may have to deal
with a wide variety of plans, including production plans, financial plans, marketing plans, and
personnel plans. Each of these is different, and all require some kind of financial knowledge.
Finance allows for better communication among departments. For example, the corporate budget
(financial plan) communicates overall company goals to department managers so they know what is
expected of them and what financial parameters exist for their operations. You must be able to
identify any problems with the proposed budget before it is finalized and to make recommendations
for subsequent budgets. Further, you need to be able to discuss the budget with other members of the
company. Failure to understand the budget may mean failure to achieve corporate goals.
You have to present convincing information to upper management to obtain approval for activities
and projects such as new product lines. Here, a knowledge of forecasting and capital budgeting
(selecting the most profitable project among long-term alternatives) is essential. You must appraise
your monetary and manpower requests before submitting them; if you are ill-prepared, you will
create a negative impression and may well lose the chance to obtain approval of your request.
Financial knowledge is critical in a wide number of areas. You may be involved in a decision
whether to use debt or equity financing and must have the knowledge to weigh the benefits and costs
of each in order to meet or maintain your company's capital goals. You may be called on to analyze
financial information from competitors based on their financial statements and should be able to
understand and analyze such information and make intelligent financial decisions. Or you may have
to plan and analyze project performance if your company invests in capital projects (property, plant,
and equipment) that are tied to plans for product development, marketing, and production.


Page 6
Scope and Role of Finance

In this section, we discuss the language of finance, the responsibilities of financial managers, and the
relationship between accounting and finance.
The Language and Decision Making of Finance
You should master the finance vocabulary in order to comprehend financial information, to know
how to utilize that information effectively, and to communicate clearly about the quantitative aspects
of performance and results. Further, you must be able to express in a clear, well-thought-out manner
what you need in financial terms in order to perform your job effectively.
Accounting provides financial information and includes financial accounting and managerial
accounting. Financial accounting records the financial history of the business and involves the
preparation of reports for use by external parties, such as investors and creditors. Managerial
accounting provides financial information to be used in making decisions about the future of the
company. Financial and managerial accounting are more fully discussed later in this chapter.
Accounting information is used by financial managers to make decisions regarding the receipt and
use of funds to meet corporate objectives and to forecast future financing needs. The finance function
analyzes the accounting information to improve decisions affecting the company's wealth.
Why and What of Finance
Finance involves many interrelated functions, including obtaining funds, using funds, monitoring
performance, and solving current and prospective problems.
Financial managers have to know product pricing, planning, and variance analysis (comparing actual
to budgeted figures). They must know how to manage assets and optimize the rate of return. They
have to be familiar with budgeting, effective handling of productive assets, and the financial
strengths and weaknesses of the business.
What Do Financial Managers Do?
The financial manager plays an important role in the company's goal-setting, policy determination,
and financial success. Unless the business is small, no one individual handles all the financial
decisions; responsibility is dispersed throughout the organization. The financial manager's
responsibilities include:


Page 7
· Financial analysis and planningDetermining the amount of funds the company needs; a large
company seeking a rapid growth rate will require more funds.
· Making investment decisionsAllocating funds to specific assets (things owned by the company).
The financial manager makes decisions regarding the mix and type of assets acquired and the
possible modification or replacement of assets, particularly when assets are inefficient or obsolete.
· Making financing and capital structure decisionsRaising funds on favorable terms, i.e., at a
lower interest rate or with few restrictions. Deciding how to raise funds depends on many factors,
including interest rate, cash position, and existing debt level; for example, a company with a cash-
flow problem may be better off using long-term financing.
· Managing financial resourcesManaging cash, receivables, and inventory to accomplish higher
returns without undue risk.
The financial manager affects stockholder wealth maximization by influencing:
1. Current and future earnings per share (EPS), equal to net income divided by common shares
outstanding.
2. Timing, duration, and risk of earnings.
3. Dividend policy.
4. Manner of financing.
Table 1-2 presents the functions of the financial manager as defined by the Financial Executives
Institute, a national organization of financial managers.
TABLE 1-2
FUNCTIONS OF THE FINANCIAL
MANAGER AS DEFINED BY
THE FINANCIAL EXECUTIVES INSTITUTE
A. Planning
Long- and short-range financial and corporate planning
Budgeting for operations and capital expenditures
Evaluating performance
Pricing policies and sales forecasting
Analyzing economic factors
Appraising acquisitions and divestment
B. Provision of Capital
Short-term sources; cost and arrangements
Long-term sources; cost and arrangements
Internal generation
(table continued on next page)


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(table continued from previous page)

C. Administration of Funds
Cash management
Banking arrangements
Receipt, custody, and disbursement of company's securities
and monies
Credit and collection management
Pension monies management
Investment portfolio management
D. Accounting and Control
Establishing accounting policies
Developing and reporting accounting data
Cost accounting
Internal auditing
System and procedures
Government reporting
Reporting and interpreting results of operations to management
Comparing performance with operating plans and standards
E. Protection of Assets
Providing for insurance
Establishing sound internal controls
F. Tax Administration
Establishing tax policies and procedures
Preparing tax reports
Tax planning
G. Investor Relations
Maintaining liaison with the investment community
Counseling with analystpublic financial information
H. Evaluation and Consulting
Consulting with and advising other corporate executives on
company policies, operations, and objectives and their
effectiveness
I. Management Information Systems
Development and use of computerized facilities
Development and use of management information systems
Development and use of systems and procedures
NOTE: The size of the company and the capabilities of the various
members of management determine how these responsibilities will be
assigned.

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Controller Versus Treasurer

If you are employed by a large company, the financial responsibilities are probably conducted by the
controller, treasurer, and chief financial officer (financial vice-president). The activities of the
controller and treasurer fall under the umbrella of finance.
There is no precise distinction between the job of the controller and treasurer, and the functions may
differ slightly between organizations because of company policy and the personality of the office
holder.
The controller's functions are primarily of an internal nature and include record keeping, tracking,
and controlling the financial effects of prior and current operations. The internal matters of
importance to the controller include financial and managerial accounting, taxes, control, and audit
functions. The controller is the chief accountant and is involved in the preparation of financial
statements, tax returns, the annual report, and Securities and Exchange Commission (SEC) filings.
The controller's function is primarily assuring that funds are used efficiently. He or she is primarily
concerned with collecting and presenting financial information. The controller usually looks at what
has occurred rather than what should or will happen.
Many controllers are involved with management information systems and review previous, current,
and emerging patterns. They report their analysis of the financial implications of decisions to top
management.
The treasurer's function, in contrast, is primarily external. The treasurer obtains and manages the
corporation's capital and is involved with creditors (e.g., bank loan officers), stockholders,
investors, underwriters of equity (stock) and bond issuances, and governmental regulatory bodies
(e.g., the SEC). The treasurer is responsible for managing corporate assets (e.g., accounts
receivable, inventory) and debt, planning the finances and capital expenditures, obtaining funds,
formulating credit policy, and managing the investment portfolio.
The treasurer concentrates on keeping the company afloat by obtaining cash to meet obligations and
buying assets to achieve corporate objectives. While the controller concentrates on profitability, the
treasurer emphasizes cash flow. Even though a company has been profitable, it may have a
significant negative cash flow; for example, there may exist substantial long-term receivables
(receivables having a maturity of greater than one year). Without adequate cash flow, even a
profitable company may fail. By emphasizing cash flow, the treasurer strives to prevent bankruptcy
and achieve corporate goals. The treasurer analyzes the financial statements, formulates additional
data, and makes decisions based on the analysis.


Page 10
The major responsibilities of controllers and treasurers are shown in Table 1-3.
The chief financial officer (financial vice-president) is involved with financial policy making and
planning. He or she has financial and managerial responsibilities, supervises all phases of financial
activity, and serves as the financial adviser to the board of directors.
Figure 1.1 shows an organization chart of the finance structure within a company. Note that the
controller and treasurer report to the vice-president of finance.
Relationship between Accounting and Finance

Accounting and finance have different focuses. The primary distinctions between accounting and
finance involve the treatment of funds and decision making. Accounting is a necessary subfunction of
finance.
The control features of the finance function are referred to as management accounting. Managerial
accounting includes the preparation of reports used by management for internal decision making,
such as budgeting, costing, pricing, capital budgeting, performance evaluation, break-even analysis,
transfer pricing (pricing of goods or services transferred between departments), and rate-of-return
analysis. Managerial accounting depends heavily on historical data obtained as part of the financial
accounting function. But managerial accounting, unlike financial accounting, is future-oriented and
emphasizes making the right decisions today to ensure future performance.
Managerial accounting information is important to the financial manager. For example, the break-
even point analysis is useful in deciding whether to introduce a product line. Variance analysis is
used to compare actual revenue and/or costs to standard revenue and/or costs for performance
evaluation. Managerial accounting can help identify and suggest corrective action. Budgets provide
manufacturing and marketing guidelines.
Financial and Operating Environment

As a financial manager, you operate in the financial environment and are indirectly affected by it. In
this section, we discuss financial institutions, markets, and the basic forms of business organizations.
Financial Institutions and Markets
A healthy economy depends on the efficient transfer of funds from savers to individuals, businesses,
and governments who need capital. Most transfers occur through specialized financial institutions
that serve as intermediaries between suppliers and users of funds.


Page 11
Figure 1.1
Financial Activity Organization


Page 12
TABLE 1-3
RESPONSIBILITIES OF CONTROLLER
AND TREASURER
Controller Treasurer
Accounting Obtain financing
Reporting financial information Maintaining banking relationships
Custody of records Investing funds
Interpreting financial data Investor relations
Budgeting Managing cash
Controlling operations Insuring assets
Appraising results and making Fostering relationships with
recommendations creditors and investors
Preparing taxes
Managing assets Appraising credit and
collecting funds
Internal auditing Deciding on the financing mix
Protecting assets Disbursing dividends
Managing pension funds
Reporting to government bodies
Payroll
A financial transaction results in the simultaneous creation of a financial asset and a financial
liability. Financial assets include money, stock (equity ownership of a company), or debt (evidence
that someone owes you a debt). Financial liabilities are monies you owe someone else, such as loans
payable. The creation and transfer of such assets and liabilities constitute financial markets.
In the financial markets, companies demanding funds are brought together with those having surplus
funds. Financial markets provide a mechanism through which the financial manager obtains funds
from a wide range of sources, including financial institutions in such forms as loans, bonds, and
common stocks. The financial markets are composed of money markets and capital markets. Figure
1.2 depicts the general flow of funds among financial institutions and markets.
Money markets are the markets for short-term debt securities (those with maturities of less than one
year). Examples of money market securities include U.S. Treasury bills, commercial paper, and
negotiable certificates of deposit issued by government, business, and financial institutions. Federal
funds borrowings between banks, bank borrowings from the Federal Reserve Bank, and various
types of repurchase


Page 13
Figure 1.2
General Flow of Funds Among Financial Institutions and
Financial Markets
agreements are also elements of the money market. These instruments have in common safety and
liquidity. The money market, which operates through dealers, money center banks, and the New York
Federal Reserve Bank, represents an outlet for both shortages and surpluses of liquidity, including
those due to fluctuations in business.
Capital markets are the markets for long-term debt (that with a maturity of more than one year) and
corporate stocks. The New York Stock Exchange, which handles the stocks of many large
corporations, is a prime example of a capital market. The American Stock Exchange and the regional
stock exchanges are other examples. In addition, securities are traded by thousands of brokers and
dealers over-the-counter, a term used to denote all buying and selling activities in securities that do
not occur on an organized stock exchange.


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In the capital market, a distinction is made between the primary market, where new issues of
securities are traded, and the secondary market, where previously issued securities are traded. The
primary market is a source of new securities for the secondary market.
In practice, the boundaries between the money markets and capital markets are blurred, because most
financial institutions deal with both kinds of financial instruments, both short and long term. In
addition, revolving short-term loans become long-term loans in practice.
The financial manager has responsibility for obtaining funds and allocating them among alternative
projects and specific uses, such as inventories and equipment. He or she must manage the cash flow
cycle, make payments for expenses and the purchase of capital goods, and sell products and services
to obtain cash inflows. In the management of cash flows, some cash is recycled and some is returned
to financing sources as debt payment.
Financial market issues, including government regulation, are more fully discussed in Chapters 14
and 15.
Basic Forms of Business Organization

Finance is applicable both to economic entities such as business firms and to nonprofit organizations
such as schools, governments, hospitals, churches, and so on. However, this book will focus on
finance for three basic forms of business organizations. These forms are (1) the sole proprietorship,
(2) the partnership, and (3) the corporation.
Sole Proprietorship
The sole proprietorship is a business owned by one individual. Of the three forms of business
organizations, sole proprietorships are the greatest in number. The advantages of this form are
· No formal charter required.
· Less regulation and red tape.
· Significant tax savings.
· Minimal organizational costs.
· Profits and control not shared with others.
The disadvantages of sole proprietorship are
· Limited ability to raise large sums of money.
· Unlimited liability for the owner.
· Limited life, limited to the life of the owner.
· No tax deductions for personal and employees' health, life, or disability insurance.

Page 15
Partnership
The partnership is similar to the sole proprietorship except that the business has more than one
owner. Its advantages are
· Minimal organizational effort and costs.
· Fewer governmental regulations.
Its disadvantages are
· Unlimited liability for the individual partners.
· Limited ability to raise large sums of money.
· Limited life, dissolved upon the death or withdrawal of any of the partners.
There is a special form of partnership, called a limited partnership, where one or more partners, but
not all, have limited liability up to their investment in the event of business failure. In this case,
· The general partner manages the business.
· Limited partners are not involved in daily activities. The return to limited partners is in the form of
income and capital gains.
· Tax benefits are often involved.
Examples of limited partnerships are in real estate and oil and gas exploration.
Corporation
The corporation is a legal entity that exists apart from its owners, which are better known as
stockholders. Ownership is evidenced by possession of shares of stock. In terms of types of
businesses, the corporate form is not the greatest in number, but it is the most important in terms of
total sales, assets, profits, and contribution to national income. Corporations are governed by a
distinct set of state or federal laws and come in two forms: a state C corporation or federal
Subchapter S corporation.
The advantages of a C corporation are
· Unlimited life.
· Limited liability for its owners, as long as there is no personal guarantee on a business-related
obligation such as a bank loan or lease.
· Ease of transfer of ownership through transfer of stock.
· Ability to raise large sums of capital.
Its disadvantages are
· Difficult and costly to establish, as a formal charter is required.
· Subject to double taxation on its earnings and dividends paid to stockholders.
· Bankruptcy, even at the corporate level, does not discharge tax obligations.


Page 16
Figure 1.3
Corporate Structure
There are two special variations of corporation. They are a Subchapter S corporation and a limited-
liability company.
Subchapter S Corporation
The Subchapter S corporation is a form of corporation whose stockholders are taxed as partners. To
qualify as an S corporation, the following requirements are necessary:
· A corporation cannot have more than seventy-five shareholders.
· The owners must be individuals, estates, or certain qualified trusts.
· The shareholders cannot be nonresident foreigners.
· It must have just one class of stock (no preferred and common stock).
· It must properly elect Subchapter S status.
The Subchapter S corporation can distribute its income directly to shareholders and avoid the
corporate income tax while enjoying the other advantages of the corporate form. Note: Not all states
recognize Subchapter S corporations.
Limited-Liability Company
A limited-liability company (LLC) provides limited personal liability, as a corporation does.
Owners, who are called members, can be other corporations. The members run the company unless
they hire an outside management group. The LLC can choose whether to be taxed as a regular
corporation or to pass tax liability through to members. Profits and losses can be split among
members any way they choose. Note: The LLC rules vary by state.
The structure of a corporation is depicted in Figure 1.3.


Page 17
Chapter Perspective
Chapter 1 discussed the functions of finance, the environment in which finance operates, and how
you fit into the corporate structure. The financial functions of the business involve record keeping,
performance evaluation, variance analysis, budgeting, and utilization of resources. The financial
manager must comprehend the goals, procedures, techniques, yardsticks, and functions of finance in
order to perform his or her duties; a lack of knowledge of finance not only leads to incorrect analysis
and decisions but also jeopardizes your future in the organization.
Without a good understanding of finance and accounting, you lack the tools needed for effective
financial decision making. Decisions that make sense in terms of marketing and sales must also make
financial sense; you must have the background to give sound input into the decision-making process.


Page 19
Chapter 2
Understanding Financial Statements
Knowing the financial health of your company is important. Such knowledge can help you allocate
resources and pinpoint areas requiring development and problems needing correction. Do you know
how your company is doing financially? Is it growing or contracting? Will it be around for a long
time? How profitable is your department, and what can be done to improve the profitability picture?
These questions and others can be answered if you understand corporate financial statements. On the
other hand, if you do not know how your company is doing financially, you cannot provide the
needed financial leadership.
While Chapter 1 discussed finance from an internal perspective, this chapter looks at the key
financial statements from an external viewpoint. These financial statements are the only financial
information outsiders are likely to see.
· The basic financial statements: the balance sheet, income statement, and statement of cash flows.
· How the balance sheet portrays a company's financial position.
· How the income statement reveals the entity's operating performance.
· How to determine and assess a company's cash inflows and cash outflows.
· The many types of accounts that may exist in the accounting system.
· What the annual report is and how to read and understand its components, including the financial
statements, footnotes, review of operations, auditor's report, and supplementary schedules.
· How to read a quarterly report.
What and Why of Financial Statements

Financial decisions are typically based on information generated from the accounting system.
Financial management, stockholders, potential


Page 20
investors, and creditors are concerned with how well the company is doing. The three reports
generated by the accounting system and included in the company's annual report are the balance
sheet, income statement, and statement of cash flows. Although the form of these financial
statements may vary among different businesses or other economic units, their basic purposes do not
change.
The balance sheet portrays the financial position of the organization at a particular point in time. It
shows what you own (assets), how much you owe to vendors and lenders (liabilities), and what is
left (assets minus liabilities, known as equity or net worth). A balance sheet freezes the action,
giving the company's financial position as of a certain date. The balance sheet equation is: Assets -
Liabilities = Stockholders' Equity.
The income statement, on the other hand, measures the operating performance for a specified period
of time (e.g., for the year ended December 31, 20X1). If the balance sheet is a snapshot, the income
statement is a motion picture. The income statement serves as the bridge between two consecutive
balance sheets. Simply put, the balance sheet tells how wealthy or poor your company is, but the
income statement tells you how your company did last year.
The balance sheet and the income statement tell you two different things about your company. For
example, the fact the company made a big profit last year does not necessarily mean it is liquid (has
the ability to meet current liabilities with current assets) or solvent (noncurrent assets are enough to
meet noncurrent liabilities). (Liquidity and solvency are discussed in detail in Chapter 3.) A
company may have reported a significant net income but still have a deficient net worth. In other
words, to find out how your organization is doing, you need both statements. The income statement
summarizes your company's operating results for the accounting period; these results are reflected in
the equity (net worth) on the balance sheet. This relationship is shown in Figure 2.1.
The third basic financial statement is the statement of cash flows. This statement provides useful
information about the inflows and outflows of cash that cannot be found in the balance sheet and the
income statement.
More on the Income Statement

The income statement (profit and loss statement) shows the revenue, expenses, and net income (or
net loss) for a period of time. A definition of each element follows.
Revenue is the increase in capital arising from the sale of merchan-


Page 21
Figure 2.1
The Balance Sheet and Income Statement
dise or the performance of services. When revenue is earned, it results in an increase in either cash
(money received) or accounts receivable (amounts owed to you by customers).
Expenses decrease capital and result from performing activities necessary to generate revenue. The
expense is either equal to the cost of the goods sold or the expenditures necessary to conduct
business operations (e.g., rent expense, salary expense, depreciation expense) during the period.
(Depreciation is discussed in Chapter 10.)
Net income is the amount by which total revenue exceeds total expenses. The resulting profit is
added to the retained earnings account (accumulated earnings of a company since its inception less
dividends). If total expenses are greater than total revenue, a net loss results, decreasing retained
earnings.
Revenue does not necessarily mean receipt of cash, and expense does not automatically imply a cash
payment. Net income and net cash flow (cash receipts less cash payments) are different. For
example, taking out a bank loan generates cash, but this cash is not revenue since no merchandise has
been sold and no services have been provided. Further, capital has not been altered by the loan
because the loan represents a liability, rather than a stockholders' investment, and must be repaid.
Each revenue and expense item has its own account. Such a system enables you to evaluate and
control revenue and expense sources better and to examine the relationships among account
categories.


Page 22
Classified Income Statements

Although companies differ in nature and therefore the specific transactions and accounts differ from
business to business, it is useful to classify the entries in financial statements into major categories.
Financial statements organized in such a fashion are called classified financial statements.
In a classified income statement, each major revenue and expense function is listed separately to
facilitate analysis. The entries in an income statement are usually classified into four major
functions: revenue, cost of goods sold (cost of inventory sold), operating expenses, and other
revenue or expenses. The entries in classified income statements covering different time periods are
easily compared; the comparison over time of revenue sources, expense items, and the relationship
between them can reveal areas that require attention and corrective action. For example, if revenue
from services has been sharply declining over the past several months, you will want to know why
and then take action to reverse the trend.
Revenue comprises the gross income generated by selling goods (sales) or performing services
(professional fees, commission income). To determine net sales, gross sales are reduced by sales
returns, allowances (discounts given for defective merchandise), and sales discounts.
Cost of goods sold is the cost of the merchandise or services sold. In a retail business, it is the cost
of buying goods from the manufacturer; in a service business, it is the cost of the employee services
rendered. For a manufacturing company, cost of goods sold is the beginning finished goods inventory
plus the cost of goods manufactured minus the ending finished goods inventory.
Operating expenses are expenses incurred or resources used in generating revenue. Two types of
operating expenses are selling expenses and general and administrative expenses. Selling expenses
are costs incurred in obtaining the sale of goods or services (e.g., advertising, salesperson salaries)
and in distributing the merchandise (e.g., freight paid on shipments); they relate solely to the selling
function. If a sales manager is responsible for generating sales, his or her performance is judged on
the relationship between promotion costs and sales obtained. General and administrative expenses
are the costs of running the business as a whole. The salaries of the office clerical staff,
administrative executive salaries, and depreciation on office equipment are examples of general and
administrative expenses.
Other revenue (expenses) covers incidental sources of revenue and expense that are nonoperating
in nature and that do not relate to the


Page 23
major purpose of the business. Examples are interest income, dividend income, and interest expense.
Figure 2.2 shows a classified income statement.
More on the Balance Sheet

The balance sheet is classified into major groups of assets and liabilities. An asset is something
owned, such as land and automobile; a liability is something owed, such as loans payable and
mortgage payable.
Assets
A classified balance sheet generally breaks down assets into five categories: current assets, long-
term investments, property, plant, and equipment (fixed assets), intangible assets, and deferred
charges. This breakdown aids in analyzing the type and liquidity of the assets held.
Current assets are assets expected to be converted into cash or used up within one year or the
normal operating cycle of the business, whichever is greater. (The operating cycle is the time period
between the purchase of inventory merchandise for resale and the transfer of inventory through sales,
listed as accounts receivable, or receipt of cash. In effect, the operating cycle takes you from paying
cash to receiving it.) Examples of current assets are cash, marketable securities you expect to hold
for one year or less (short-term investments), accounts receivable, inventory, and prepaid expenses
(expenditures that will expire within one year from the balance sheet date and that represent a
prepayment for an expense that has not yet been incurred).
Long-term investments refer to investments in other companies' stocks (common or preferred) or
bonds where the intent is to hold them for a period greater than one year. Securities are reported in
the balance sheet at the lower of cost or current market value. The investment cost includes the
market price of the securities when bought plus any brokerage fees you paid. If the intent is to hold a
security for one year or less, it should be included in the current asset category and listed as a short-
term investment (marketable securities).
Property, plant, and equipment (often called fixed assets) are assets employed in the production of
goods or services that have a life greater than one year. They are tangible, meaning they have
physical substance (you can physically see and touch them) and are actually being used in the course
of business. Examples are land, buildings, machinery, and automobiles. Unlike inventory, these
assets are not held for sale in the normal course of business.
Intangible assets are assets with a long-term life that lack physical substance and that arise from a
right granted by the government, such


Page 24
X Company
Income Statement
for the Year Ended December 31, 20XX
Revenue
$40,000
Gross Sales
$1,000
Less: Sales Returns and Allowances
500 1,500
Sales Discounts
$38,500
Net Sales
Cost of Goods Sold
$ 1,000
Inventory, January 1
15,000
Add: Purchases
$16,000
Cost of Goods Available for Sale
5,000
Less: Inventory, December 31
Cost of Goods Sold 11,000
Gross Profit $27,500
Operating Expenses

Selling Expenses
$3,000
Advertising
2,000
Salespeople's Salaries
1,000
Travel and Entertainment
500 6,500
Depreciation on Delivery Truck
General and Administrative Expenses
$4,000
Officers' Salaries
1,000
Depreciation
2,000
Rent
1,000 8,000
Insurance
Total Operating Expenses 14,500
Operating Income $13,000
Other Expenses (net)
$2,000
Interest Expense
$ 500
Less: Interest Income
1,000 1,500
Dividend Income
Other Expenses (net) 500
Net Income $12,500
Figure 2.2
A Classified Income Statement


Page 25
as patents, copyrights, and trademarks, or by another company, such as a franchise license. An

example of the latter is the right (acquired by paying a fee) to open a fast-food franchise and use the
name of McDonald's.
Deferred charges are certain expenditures that have already been incurred but that are deferred to
the future either because they are expected to benefit future revenues or because they represent an
appropriate allocation of costs to future operations. In other words, deferred charges are costs
charged to an asset because future benefit exists; they are amortized to an expense in the year the
related revenue is recognized and the benefit consumed in conformity with the accounting principle
requiring matching of expense to revenue. Examples are plant rearrangement costs and moving costs.
No cash can be realized from such assets; for example, you cannot sell deferred moving costs to
anyone because no one will buy them.
Liabilities and Stockholders' Equity
Liabilities are classified as either current or noncurrent. Current liabilities (those due in one year or
less) will be satisfied out of current assets. Examples are accounts payable (amounts owed to
creditors), short-term notes payable (written evidence of loans due within one year), and accrued
expense liabilities (e.g., salaries payable).
Examples of long-term liabilities, which have a maturity of greater than one year, are bonds payable
and mortgage payable. The current portion of a long-term liability (that part that is to be paid within
one year) is shown under current liabilities. For example, if $1,000 of a $10,000 mortgage is to be
paid within the year, that $1,000 is listed as a current liability; the remaining $9,000 is shown under
noncurrent liabilities.
The stockholders' equity section of the balance sheet consists of capital stock, paid-in capital,
retained earnings, and total stockholders' equity. These are defined below.
Capital stock describes the ownership of the corporation in terms of the number of shares
outstanding. Each share is assigned a par value when it is first authorized by the state in which the
business is incorporated. Capital stock is presented on the balance sheet at total par value.
Therefore, the capital stock account, which is at par value, agrees with the stock certificates
(imprinted with the par value) held by stockholders. Preferred stock is listed before common stock
because it receives preference should be company be liquidated.


Page 26
Paid-in capital shows the amount received by the company over the par value for the stock issued.
This helps keep track of the par value of issued shares and the excess over par value paid for it.
Retained earnings represent the accumulated earnings of the company since its inception less
dividends declared and paid to stockholders. There is usually a surplus in this account, but a deficit
may occur if the business has been operating at a loss.
Total stockholders' equity is the sum of the above categories. In a corporation, owners' equity is
referred to as stockholders' equity; in a sole proprietorship or partnership, owners' equity is referred
to as capital.
A classified balance sheet is presented in Figure 2.3.
Statement of Cash Flows

It is important to know your cash flow so that you may adequately plan your expenditures. Should
you cut back on payments because of a cash problem? Where are you getting most of your cash?
What products or projects are cash drains or cash cows? Is there enough money to pay bills and buy
needed machinery?
A company is required to prepare a statement of cash flows in its annual report. It contains useful
information for external users, such as lenders and investors, who make economic decisions about
your company. The statement presents the sources and uses of cash and is a basis for cash flow
analysis. In this section, we discuss what the statement of cash flows is, how it looks, and how to
analyze it.
Contents of the Statement of Cash Flows

The statement of cash flows classifies cash receipts and cash payments from investing activities,
financing activities, and operating activities.
Investing Activities
Investing activities include the results of the purchase or sale of debt and equity securities of other
entities and of fixed assets. Cash inflows from investing are comprised of (1) receipts from sales of
equity and debt securities of other companies and (2) amounts received from the sale of fixed assets.
Cash outflows for investing activities include (1) payments to buy equity or debt securities of other
companies and (2) payments to buy fixed assets.
Financing Activities
Financing activities include the issuance of stock and the reacquisition of previously issued shares,
as well as the payment of dividends to


Page 27
X Company
Balance Sheet
December 31, 20XX
ASSETS
Current Assets
$3,000
Cash
1,000
Marketable Securities
6,000
Accounts Receivable
5,000
Inventory
$15,000
Total Current Assets

Long-Term Investments
2,000
Investment in Y Company Stock

Property, Plant, and Equipment
$20,000
Land
30,000
Building (less accumulated depreciation)
7,000
Machinery (less accumulated depreciation)
5,000
Delivery Trucks (less accumulated depreciation)
62,000
Total Property, Plant, and Equipment

Intangible Assets
3,000
Patents (less accumulated amortization)

Deferred Charges
1,000
Deferred Moving Costs
$83,000
Total Assets
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
$8,000
Accounts Payable
4,000
Notes Payable (9 months)
2,000
Accrued Expense Liabilities
$14,000
Total Current Liabilities

Noncurrent Liabilities
30,000
Bonds Payable
$44,000
Total Liabilities

Stockholders' Equity
$20,000
Capital Stock
4,000
Paid-in Capital
15,000
Retained Earnings*
39,000
Total Stockholders' Equity
$83,000
Total Liabilities and Stockholders' Equity
* A schedule of retained earnings follows:
Retained earningsJanuary 1 $10,000
Net income 12,500
Dividends (7,500)
Retained earningsDecember 31 $15,000
Figure 2.3
A Sample Balance Sheet


Page 28
stockholders. Also included are debt financing and repayment. Cash inflows from financing
activities are composed of funds received from the sale of stock and the incurrence of debt. Cash
outflows for financing activities include (1) paying off debt, (2) repurchasing of stock, and (3)
issuing dividend payments.
Operating Activities
Operating activities are connected to the manufacture and sale of goods or the rendering of services.
Cash inflows from operating activities include (1) cash sales or collections on receivables arising
from the initial sale of merchandise or rendering of service and (2) cash receipts from debt
securities (e.g., interest income) or equity securities (e.g., dividend income) of other entities. Cash
outflows for operating activities include (1) cash paid for raw material or merchandise intended for
resale, (2) payments on accounts payable arising from the initial purchase of goods, (3) payments to
suppliers of operating expense items (e.g., office supplies, advertising, insurance), and (4) wages.
Figure 2.4 shows an outline of the statement of cash flows.
Cash Flow Analysis

Along with financial ratio analysis (discussed in Chapter 3), cash flow analysis is a valuable tool.
The cash flow statement provides information on how your company generated and used cash, that is,
why cash flow increased or decreased. An analysis of the statement is helpful in appraising past
performance, projecting the company's future direction, forecasting liquidity trends, and evaluating
your company's ability to satisfy its debts at maturity. Because the statement lists the specific sources
and uses of cash during the period, it can be used to answer the following:
· How was the expansion in plant and equipment financed?
· What use was made of net income?
· Where did you obtain funds?
· How much required capital is generated internally?
· Is the dividend policy in balance with its operating policy?
· How much debt was paid off?
· How much was received from the issuance of stock?
· How much debt financing was taken out?
The cash flow per share equals net cash flow divided by the number of shares. A high ratio is
desirable because it indicates a liquid position, that is, that the company has ample cash on hand.


Page 29
FORMAT OF THE STATEMENT OF

CASH FLOWS
(INDIRECT METHOD)
Net cash flow from operating activities:
$980,000
Net income

Adjustments for noncash expenses, revenues,
losses, and gains included in income:

Depreciation 20,000
Net cash flow from operating activities $1,000,000
Cash flows from investing activities:
$(630,000)
Purchase machinery

Investments in other companies' stocks ( 70,000)
Sale of land
200,000
Net cash flows provided (used) by investing activities
(500,000)
Cash flows from financing activities:
$ 400,000
Issuance of common stock

Issuance of bonds payable 100,000

Payment on long-term mortgage payable (160,000)

Payment of dividends ( 40,000)
Net cash provided (used) by financing activities
300,000
Net increase (decrease) in cash
$800,000
Schedule of noncash investing and financing activities:

Issuance of preferred stock for building $180,000

Conversion of bonds payable to common stock 100,000
Figure 2.4
The Statement of Cash Flows
Operating Section
An analysis of the operating section of the statement of cash flows determines the adequacy of cash
flow from operating activities. For example, an operating cash outlay for refunds given to customers
for deficient goods indicates a quality problem with the merchandise, while payments of penalties,
fines, and lawsuit damages reveal poor management practices that result in nonbeneficial
expenditures.


Page 30
Investing Section
An analysis of the investing section can identify investments in other companies. These investments
may lead to an attempt to assume control of another company for purposes of diversification. The
analysis may also indicate a change in future direction or a change in business philosophy.
An increase in fixed assets indicates capital expansion and future growth. A contraction in business
arising from the sale of fixed assets without adequate replacement is a negative sign.
Financing Section
An evaluation of the financing section reveals the company's ability to obtain financing in the money
and capital markets as well as its ability to meet obligations. The financial mixture of bonds, long-
term loans from banks, and equity instruments affects risk and the cost of financing. Debt financing
carries greater risk because the company must generate adequate funds to pay the interest costs and
to retire the obligation at maturity; thus, a very high percent of debt to equity is generally not
advisable. The problem is acute if earnings and cash flow are declining. On the other hand, reducing
long-term debt is desirable because it points to lowered risk.
The ability to obtain financing through the issuance of common stock at attractive terms (high stock
price) indicates that the investing public is optimistic about the financial well-being of the business.
The issuance of preferred stock may be a negative sign, since it may mean the company is having
difficulty selling its common stock. Perhaps investors view the company as very risky and will
invest only in preferred stock since preferred stock has a preference over common stock in the event
of the company's liquidation.
Evaluate the company's ability to pay dividends. Stockholders who rely on a fixed income, such as a
retired couple, may be unhappy when dividends are cut or eliminated.
Preparing and Analyzing the Statement of Cash Flows

In this section, we do an analysis of a hypothetical statement of cash flows, prepared from sample
balance sheet and income statement figures.


Page 31
EXAMPLE 2-1
X Company provides the following financial statements:
X Company
Comparative Balance Sheets
December 31
(in millions)
ASSETS 20X1 20X0
Cash $ 40 $ 47
Accounts receivable 30 35
Prepaid expenses 4 2
Land 50 35
Building 100 80
Accumulated depreciation (9) (6)
Equipment 50 42
Accumulated depreciation (11) (7)
Total assets $254 $228
Accounts payable $ 20 $ 16
Long-term notes payable
30 20
Common stock 100 100
Retained earnings 104
92
Total liabilities and stockholders' equity $254 $228
X Company
Income Statement
for the Year Ended December 31, 20X1
(in millions)
Revenue $300
$200
Operating expenses (excluding
depreciation)
Depreciation 7 207
Income from operations $
93
Income tax expense 32
Net income $
61

Page 32
Additional information:
1. Cash dividends paid, $49.
2. The company issued long-term notes payable for cash, $10.
3. Land of $15, building of $20, and equipment of $8 were acquired for cash.
We can now prepare the statement of cash flows as follows:
X Company
(in millions)
Operating activities:
$61
Net income

Adjustments to reconcile net income to cash provided by
operating activities:
$
Depreciation 7
Changes in operating assets and liabilities:
5
Decrease in accounts receivable

Increase in prepaid items (2)
4
Increase in accounts payable
75
Cash provided by operating activities
Cash flow from investing activities
($15)
Purchase of land
(
Purchase of building 20)
( (43)
Purchase of equipment 8)
Cash flow from financing activities
$10
Issuance of long-term notes payable
( 49) (39)
Payment of cash dividends
Net decrease in cash $ 7
Assume the company has a policy of paying very high dividends.

Information for 20X0 follows: Net income, $32; cash flow from operations, $20.
A financial analysis of the statement of cash flows reveals that the profitability and operating cash
flow of X Company improved from 20X0 to 20X1. The company's earnings performance was good,
and the $61 earnings resulted in cash inflow from operations of $75. Thus, compared to 20X0, 20X1
showed better results.
The decrease in accounts receivable may reveal better collection efforts. The increase in accounts
payable is a sign that suppliers are confident they will be paid and are willing to give interest-free
financing.


Page 33
The acquisition of land, building, and equipment points to a growing business undertaking capital
expansion. The issuance of long-term notes payable indicates that the company is financing part of its
assets through debt. Stockholders will be happy with the significant dividend payout of 80.3 percent
(dividends divided by net income, or $49/61). Overall, there was a decrease in cash on hand of $7,
but this should not cause alarm because of the company's profitability and the fact that cash was used
for capital expansion and dividend payments. We recommend that the dividend payout be reduced
from its high level and that the funds be reinvested in the business; the reduction of dividends by
more than $7 would result in a positive net cash flow for the year, which is needed for immediate
liquidity.
EXAMPLE 2-2
Y Company presents the following statement of cash flows.
Y Company
Operating activities:
Net income $134,000

Adjustments to reconcile net income to
cash provided by operating activities:
$21,000
Depreciation
Changes in operating assets and liabilities:
10,000
Decrease in accounts receivable
(6,000)
Increase in prepaid items
35,000 60,000
Increase in accounts payable
Cash provided by operating activities $194,000
Cash flows from investing activities
($70,000)
Purchase of land
(200,000)
Purchase of building
(68,000)
Purchase of equipment
Cash used by investing activities (338,000)
Cash flows from financing activities
150,000
Issuance of bonds
(18,000)
Payment of cash dividends
Cash provided by financing activities 132,000
Net decrease in cash $(12,000)

Page 34
An analysis of the statement of cash flows reveals that the company is profitable and that cash flow
from operating activities exceeds net income, which indicates good internal cash generation. The
ratio of cash flow from operating activities to net income is a solid 1.45 ($194,000/$134,000). A
high ratio is desirable because it shows that earnings are backed up by cash. The decline in accounts
receivable may indicate better collection efforts; the increase in accounts payable shows the
company can obtain interest-free financing. The company is definitely in the process of expanding for
future growth, as demonstrated by the purchase of land, building, and equipment. The debt position
of the company has increased, indicating greater risk for investors. The dividend payout was 13.4
percent ($18,000/$134,000), which is good news for stockholders, who look positively on
companies that pay dividends. The decrease of $12,000 in cash flow for the year is a negative sign.
Statement of Cash Flows and Corporate Planning

Current profitability is only one important factor in predicting corporate success; current and future
cash flows are also essential. In fact, it is possible for a profitable company to have a cash crisis; for
example, a company with significant credit sales but a very long collection period may show a profit
without actually having the cash from those sales.
Financial managers are responsible for planning how and when cash will be used and obtained.
When planned expenditures require more cash than planned activities are likely to produce, financial
managers must decide what to do. They may decide to obtain debt or equity funds or to dispose of
some fixed assets or a whole business segment. Alternatively, they may decide to cut back on
planned activities by modifying operational plans, such as ending a special advertising campaign or
delaying new acquisitions, or to revise planned payments to financing sources, such as bondholders
or stockholders. Whatever is decided, the financial manager's goal is to balance the cash available
and the needs for cash over both the short and the long term.
Evaluating the statement of cash flows is essential if you are to appraise accurately an entity's cash
flows from operating, investing, and financing activities and its liquidity and solvency positions.
Inadequacy in cash flow has possible serious implications, including declining profitability, greater
financial risk, and even possible bankruptcy.
Other Sections of the Annual Report

Other sections in the annual report in addition to the financial statements are helpful in understanding
the company's financial health.


Page 35
These sections include the highlights, review of operations, footnotes, supplementary schedules, and
auditor's report.
Highlights
The highlights section provides comparative financial statement information and covers important
points such as profitability, sales, dividends, market price of stock, and asset acquisitions. At a
minimum, the company provides sales, net income, and earnings per share figures for the last two
years.
Review of Operations
The review of operations section discusses the company's products, services, facilities, and future
directions in both numbers and narrative form.
Report of Independent Public Accountants
The independent accountant is a certified public accountant (CPA) in public practice who has no
financial or other interest in the client whose financial statements are being examined In this part of
the annual report, he or she expresses an opinion on the fairness of the financial statement numbers.
CPAs render four types of audit opinions: an unqualified opinion, a qualified opinion, a disclaimer
of opinion, and an adverse opinion. The auditor's opinion is heavily relied on since he or she is
knowledgeable, objective, and independent.
Unqualified Opinion
An unqualified opinion means the CPA is satisfied that the company's financial statements present
fairly its financial position and results of operations and gives the financial manager confidence that
the financial statements are an accurate reflection of the company's financial health and operating
performance.
A typical standard report presenting an unqualified opinion follows.
Independent Auditor's Report
We have audited the accompanying balance sheet of ABC Company as of December 31, 20X2 and the related statements of
income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.


Page 36
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC
Company as of December 31, 20X2, and the results of its operations and its cash flows for the year then ended in conformity
with generally accepted accounting principles.
If the company is facing a situation with an uncertain outcome that may substantially affect its
financial health, such as a lawsuit, the CPA may still give an unqualified opinion. However, there
will probably be an explanatory paragraph describing the material uncertainty; this uncertainty will
undoubtedly affect readers' opinions of the financial statement information. As a financial manager,
you are well advised to note the contingency (potential problem, such as a dispute with the
government) and its possible adverse financial effects on the company.
Qualified Opinion
The CPA may issue a qualified opinion if your company has placed a ''scope limitation" on his or her
work. A scope limitation prevents the independent auditor from doing one or more of the following:
(1) gathering enough evidential matter to permit the expression of an unqualified opinion; (2)
applying a required auditing procedure; or (3) applying one or more auditing procedures considered
necessary under the circumstances.
If the scope limitation is fairly minor, the CPA may issue an "except for" qualified opinion. This may
occur, for example, if the auditor is unable to confirm accounts receivable or observe inventory.
Disclaimer of Opinion
When a severe scope limitation exists, the auditor may decide to offer a disclaimer of opinion. A
disclaimer indicates that the auditor was unable to form an opinion on the fairness of the financial
statements.


Page 37
Adverse Opinion
The auditor may issue an adverse opinion when the financial statements do not present the company's
financial position, results of operations, retained earnings, and cash flows fairly and in conformity
with generally accepted accounting principles. By issuing an adverse opinion, the CPA is stating that
the financial statements may be misleading.
Obviously, the financial manager wants the independent auditor to render an unqualified opinion.
Disclaimers and adverse opinions are viewed very negatively by readers such as investors and
creditors, who then put little if any faith in the company's financial statements.
Footnotes
Financial statements themselves are concise and condensed, and any explanatory information that
cannot readily be abbreviated is added in greater detail in the footnotes. In such cases, the report
contains a statement similar to this: "The accompanying footnotes are an integral part of the financial
statements."
Footnotes provide detailed information on financial statement figures, accounting policies,
explanatory data such as mergers and stock options, and any additional disclosure.
Footnote disclosures usually include accounting methods, estimated figures such as inventory
pricing, pension fund, and profit-sharing arrangements, terms and characteristics of long-term debt,
particulars of lease agreements, contingencies, and tax matters.
The footnotes appear at the end of the financial statements and explain the figures in those statements
both in narrative form and in numbers. It is essential that the financial manager evaluate footnote
information to arrive at an informed opinion about the company's financial stature and earning
potential.
Supplementary Schedules and Tables
Supplementary schedules and tables enhance the financial manager's comprehension of the
company's financial position. Some of the more common schedules are five-year summary of
operations, two-year quarterly data, and segmental information. This summary provides income
statement information for the past five years, including dividends on preferred stock and common
stock. It also reveals operating trends. Some companies provide ten-year comparative data.
Two-Year Quarterly Data
This schedule gives a quarterly breakdown of sales, profit, high and low stock price, and the
common stock dividend. Quarterly operating information is particularly useful for a sea-


Page 38
sonal business, because it helps readers to track the business's highs and lows more accurately. The
quarterly market price reveals fluctuations in the market price of stock, while the dividend quarterly
information reveals how regularly the company pays dividends.
Segmental Disclosure
This important supplementary schedule presents financial figures for the segments of the business,
enabling readers to evaluate each segment's profit potential and risk. Segmental data may be
organized by industry, foreign area, major customer, or government contract.
A segment is reportable if any one of the following conditions exists:
· Revenue is 10 percent or more of total corporate revenue.
· Operating profit is 10 percent or more of total corporate operating profit.
· Identifiable assets are 10 percent or more of total corporate assets.
The company must also disclose if foreign operations, sales to a major customer, or domestic
contract revenue provide 10 percent or more of total sales. The percentage derived and the source of
the sales must be stated.
Useful segment information that may be disclosed includes sales, operating profit, total assets, fixed
assets, intangible assets, inventory, cost of sales, depreciation, and amortization.
History of Market Price
While this information is optional, many companies provide a brief history of the market price of
stock, such as quarterly highs and lows. This information reveals the variability and direction in
market price of stock.
How to Read a Quarterly Report

In addition to the annual report, publicly held companies issue quarterly reports that provide updated
information on sales and earnings and describe any material1 changes that have occurred in the
business or its operations. These quarterly reports may provide unaudited financial statements or
updates on operating highlights, changes in outstanding shares, compliance with debt restrictions,
and pending lawsuits.
At a minimum, quarterly reports must provide data on sales, net income, taxes, nonrecurring revenue
and expenses, accounting changes,
1The Securities and Exchange Commission defines materiality as a change in an account of 10 percent or more relative to the
prior year. However, many CPA firms use 5 percent as a materiality guideline.


Page 39
contingencies (e.g., tax disputes), additions or deletions of business segments, and material changes
in financial position.
The company may provide financial figures for the quarter itself (e.g., the third quarter, from July 1
to September 30) or cumulatively from the beginning of the year (cumulative up to the third quarter,
or January 1 to September 30). Prior-year data must be provided in a form that allows for
comparisons.
The financial manager should read the quarterly report in conjunction with the annual report.
Chapter Perspective
The financial manager should have a good understanding of the financial statements of the company
in order to make an informed judgment on the financial position and operating performance of the
entity. The balance sheet reveals the company's financial status as of a given date, while the income
statement reports the earnings components for the year. The statement of cash flows allows readers
to analyze the company's sources and uses of cash. These financial statements are included in the
annual report, along with other vital information including footnote disclosures, the auditor's report,
management's discussion of operations, and supplementary schedules.


Page 41
Chapter 3
Analyzing Financial Statements
In this chapter, we discuss how to analyze a company's financial statements, comprised of the
balance sheet and income statement. Financial statement analysis attempts to answer the following
basic question:
1. How well is the business doing?
2. What are its strengths?
3. What are its weaknesses?
4. How does it fare in the industry?
5. Is the business improving or deteriorating?
A complete set of financial statements, as explained in Chapter 2, includes the balance sheet, income
statement, and statement of cash flows. The first two are vital in financial statement analysis, which
is accomplished by the use of various tools, such as horizontal, vertical, and ratio analysis.
In this chapter you will learn:
· What financial statement analysis is and why it is important.
· The basic components of ratio analysis.
· Distinguishing between trend analysis and industry comparison.
· How to calculate and interpret various ratios.
· The limitations of ratio analysis.
What Is Financial Statement Analysis?

The analysis of financial statements means different things to different people, depending on their
particular interests. Creditors, current and prospective investors, and the corporation's own
management look at different parts of the analysis to find the answers to the questions that are of
greatest concern to them.
Creditors are primarily interested in the company's debt-paying ability. A short-term creditor, such
as a vendor or supplier, is ultimately concerned with the business's ability to pay its bills and wants
to be assured that the business is liquid. A long-term creditor, such as a bank or bondholder, on the
other hand, is interested in the company's ability to repay interest and principal on borrowed funds.

Page 42
Investors are interested in the current and future level of return (earnings) and risk (liquidity, debt,
and activity). Investors evaluate a stock based on an examination of the company's financial
statements. This evaluation considers overall financial health, economic and political conditions,
industry factors, and future outlook of the company. The analysis attempts to ascertain how the stock
is priced in proportion to its market value. A stock is valuable to you only if you can predict the
future financial performance of the business; financial statement analysis gives you much of the data
to develop predictions.
Management is concerned with all the questions raised by creditors and investors, since both must
be satisfied if the company is to obtain the capital it needs.
Horizontal and Vertical Analysis

Comparison of two or more years' financial data is known as horizontal analysis. Horizontal
analysis concentrates on trends in the accounts in dollar and percentage terms. It is typically
presented in comparative financial statements (see Figures 3.1a and 3.1b). Annual reports usually
present comparative financial data for five years.
Horizontal analysis helps you pinpoint areas of wide divergence that require investigation. For
example, in the income statement shown in Figure 3.1b, the significant rise in sales returns, taken
with the reduction in sales for 20X1-20X2, should cause concern. Compare these results with those
of competitors.
It is essential to present both the dollar amount of change and the percentage of change, since the use
of one without the other may result in erroneous conclusions. In our example, the interest expense
from 20X0-20X1 went up by 100 percent, but the increase in dollars was only $1,000 and may not
need further investigation. Similarly, a large number change may translate into a small percentage
change and not be of any great importance.
Key changes and trends can also be highlighted by the use of common-size statements. A common-
size statement is one that shows each item in percentage terms. Preparation of common-size
statements is known as vertical analysis, in which a material financial statement item is used as a
base value and all other accounts on the financial statement are compared to it. In the balance sheet,
for example, total assets equal 100 percent, and each individual asset is stated as a percentage of
total assets. Similarly, total liabilities and stockholders' equity are assigned a value of 100 percent
and each liability or equity account is then stated as a percentage of total liabilities and stockholders'
equity, respectively. Figure 3.2 shows a common-size income statement based


Page 43
on the data provided in Figure 3.1b.

Placing all assets in common-size form shows the relative importance of current assets compared to
noncurrent assets. It also shows any significant changes that have taken place in the composition of
the current assets over the last year. In Figure 3.2, for example, receivables have increased and cash
has declined in relative importance. The deterioration in the cash position may be a result of the
company's inability to collect from customers. For the income statement, a value of 100 percent is
assigned to net sales, and all other revenue and expense accounts are related to it. It is possible to
see at a glance how each dollar of sales is distributed among the various costs, expenses, and
profits. For example, notice from Figure 3.2 that 64.8 cents of every dollar of sales was needed to
cover cost of goods sold in 20X2, as compared to only 57.3 cents in the prior year; also notice that
only 9.9 cents out of every dollar of sales remained for profits in 20X2, down from 13.6 cents in the
prior year. You should also compare the vertical percentages of the business to those of the
competition and to the industry norms in order to determine how the company is faring within its
industry. Further, in making industry comparisons, size of firms within industries should be
considered.
Working with Financial Ratios

Horizontal and vertical analysis compares one figure to another within the same category. However,
it is also essential to compare figures from different categories. This is accomplished by ratio
analysis. In this section, we discuss how to calculate and interpret the various financial ratios. The
results of the ratio analysis will allow you to:
1. Appraise the position of a business.
2. Identify trouble spots that need attention.
3. Make projections and forecasts about the course of future operations.
Think of ratios as measures of the relative health or sickness of a business. Just as a doctor takes
readings of a patient's temperature, blood pressure, and heart rate, you can take readings of a
business's liquidity, profitability, leverage, efficiency in using assets, and market value. Just as the
doctor compares the readings to generally accepted guidelines, you compare your results to
generally accepted norms.
To obtain useful conclusions from the ratios, you must make two comparisons:
· Industry comparison. This comparison allows you to answer the question, "How does a business
fare in the industry?" You must compare the company's ratios to those of competing companies in the
in-


Page 44
20X220X120X0 Incr. or 20X2- Decr. 20X1- % Incr. 20X2- or Decr. 20X1-

20X1 20X0 20X1 20X0
ASSETS
Current Assets:
$28 $36 $36 -8 0 -22.2%
Cash 0.0%
$22 $15 $7 7 8 46.7% 114.3%
Marketable Securities
$21 $16 $10 5 6 31.3% 60.0%
Accounts Receivable
$53 $46 $49 7 -3 15.2%
Inventory -6.1%
Total Current Assets $124 $113 $102 11 11 10.8%
9.7%
Plant and Equip. $103 $91 $83 12 8 13.2%
9.6%
Total Assets $227 $204 $185 23 19 11.3% 10.3%
LIABILITIES
Current Liabilities $56 $50 $51 6 -1 12.0%
-2.0%
Long-Term Debt $83 $74 $69 9 5 12.2%
7.2%
Total Liabilities $139 $124 $120 15 4 12.1%
3.3%
STOCKHOLDERS' EQUITY
$46 $46 $46 0 0 0.0% 0.0%
Common Stock,
$10 par, 4,600 shares
Retained Earnings $42 $34 $19 8 15 23.5% 78.9%g
Total Stockholders' Equity $88 $80 $65 8 15 10.0% 23.1%
Total Liab. and Stockholders' $227 $204 $185 23 19 11.3% 10.3%
Equity
Figure 3.1a
TLC, Inc., Comparative Balance Sheet (in thousands of dollars), December 31, 20X2, 20X1, 20X0


Page 45
20X2 20X120X0 Incr. or 20X2- Decr. 20X1- % Incr. 20X2- or Decr. 20X1-
20X1 20X0 20X1 20X0
Sales $98.3$120.0$56.6 $63.4 -18.1% 112.0%
-$21.7
Sales Returns & Allowances$18.0 $10.0 $4.0 $6.0 80.0% 150.0%
$8.0
Net Sales $80.3$110.0$52.6 $57.4 -27.0% 109.1%
-$29.7
Cost of Goods Sold $52.0 $63.0$28.0 $35.0 -17.5% 125.0%
-$11.0
Gross Profit $28.3 $47.0$24.6 $22.4 -39.8% 91.1%
-$18.7
Operating Expenses
$12.0 $13.0$11.0 $2.0 18.2%
Selling Expenses -$1.0 -7.7%
$5.0 $8.0 $3.0 $5.0 -37.5% 166.7%
General Expenses $3.0
Total Operating Expenses $17.0 $21.0$14.0 $7.0 -19.0% 50.0%
$4.0
Income from Operations $11.3 $26.0$10.6 $15.4 -56.5% 145.3%
-$14.7
Nonoperating Income $4.0 $1.0 $2.0 -$1.0 300.0% -50.0%
$3.0
Income before Interest & $15.3 $27.0$12.6 $14.4 -43.3% 114.3%
Taxes -$11.7
Interest Expense $2.0 $2.0 $1.0 $1.0 100.0%
$0.0 0.0%
Income before Taxes $13.3 $25.0$11.6 $13.4 -46.8% 115.5%
-$11.7
Income Taxes (40%) $5.3 $10.0 $4.6 $5.4 -46.8% 115.5%
$4.7
Net Income $8.0 $15.0 $7.0 $8.0 -46.8% 115.5%
-$7.0
Figure 3.1b
TLC, Inc., Comparative Income Statement (in thousands of dollars), December 31, 20X2, 20X1, 20X0


Page 46
20X2 % 20X1 %
Amount Amount
Sales $98.3 122.4% $120.0 109.1%
Sales Returns & Allowances $18.0 $10.0
22.4% 9.1%
Net Sales $80.3 100.0% $110.0 100.0%
Cost of Goods Sold $52.0 $63.0
64.8% 57.3%
Gross Profit $28.3 $47.0
35.2% 42.7%
Operating Expenses
Selling Expenses $12.0 $13.0 11.8%
14.9%
General Expenses $5.0
6.2% $8.0 7.3%
Total Operating Expenses $17.0 $21.0
21.2% 19.1%
Income from Operations $11.3 $26.0
14.1% 23.6%
Nonoperating Income $4.0
5.0% $1.0 0.9%
Income before Interest & $15.3 $27.0
Taxes 19.1% 24.5%
Interest Expense $2.0
2.5% $2.0 1.8%
Income before Taxes $13.3 $25.0
16.6% 22.7%
Income Taxes (40%) $5.3 $10.0
6.6% 9.1%
Net Income $8.0 $15.0
9.9% 13.6%
Figure 3.2
TLC, Inc., Income Statement and Common Size Analysis (in thousands of dollars) for the Years Ended December 31, 20X2 & 20X1
dustry or with industry standards (averages). (You can obtain industry norms from financial services
such as Value Line, Dun and Bradstreet, and Standard & Poor's.)
· Trend analysis. To see how the business is doing over time, you can track a given ratio for one
company over several years to determine any trends and see the direction of the company's financial
health or operational performance.
Financial ratios can be grouped into the following types: liquidity, asset utilization (activity),
solvency (leverage and debt service), profitability, and market value.
Liquidity Ratios
Liquidity is a company's ability to satisfy maturing short-term debt. It is crucial to carrying out the
business, especially during periods of adversity. Poor liquidity may increase a company's cost of
financing and can render it unable to pay bills and dividends. However, too much


Page 47
liquidity is not good because excessive cash balances means the company is earning a lower rate of
return. The three basic measures of liquidity are (a) net working capital, (b) the current ratio, and (c)
the quick (acid-test) ratio.
Throughout the discussion that follows, refer to Figures 3.1a and 3.1b to make sure you understand
where the numbers come from.
Net working capital equals current assets minus current liabilities. Net working capital for 20X2 is:
In 20X1, net working capital was $63. The one-year rise is favorable.
The current ratio equals current assets divided by current liabilities. The ratio reflects the
company's ability to satisfy current debt from current assets.
For 20X2, the current ratio is:
In 20X1, the current ratio was 2.26. The ratio's decline over the year points to a slight reduction in
liquidity.
A more stringent liquidity test is the quick (acid-test) ratio. Inventory and prepaid expenses are
excluded from the total of current assets used in this ratio; only the more liquid (or quick) assets are
totaled and divided by current liabilities.
The quick ratio for 20X2 is:
In 20X1, the ratio was 1.34. A small reduction in the ratio over the period points to a lower level of
liquidity.
The overall liquidity trend for TLC shows a slight deterioration, as reflected in the lower current
and quick ratios, although it is better than the industry norms (see Figure 3.3 for industry averages).
But a mitigating factor is the increase in net working capital.


Page 48
Asset Utilization Ratios

Asset utilization (activity, turnover) ratios reflect the way in which a company uses its assets to
obtain revenue and profit. One example is how well receivables are turned into cash. The higher the
ratio, the more efficiently the business manages its assets.
Accounts receivable ratios comprise the accounts receivable turnover and the average collection
period.
Accounts receivable turnover is the number of times accounts receivable are collected in the year. It
is derived by dividing net credit sales by average accounts receivable. You can calculate average
accounts receivable by adding the beginning and ending balances and then dividing by 2.
For 20X2, the average accounts receivable is:
The accounts receivable turnover for 20X2 is:
In 20X1, the turnover was 8.46. There is a sharp reduction in the turnover rate, suggesting a
collection problem.
The average collection period is the length of time it takes to collect receivables; it represents the
number of days receivables are held.
In 20X2, the collection period is:
It takes this firm about 84 days to convert receivables to cash. In 20X1, the collection period was
43.1 days. The significant lengthening of the collection period may be a cause for some concern; it
may result from the presence of many doubtful accounts or from poor credit management.
Inventory ratios are especially useful when a buildup in inventory exists. Inventory ties up cash;
holding large amounts of inventory can result in both lost opportunities for profit and increased
storage costs.


Page 49
Before you extend credit or lend money to a company, you should examine its inventory turnover
and average age of inventory.
The inventory turnover for 20X2 is:
For 20X1, the turnover was 1.33.
In 20X2, the average age is:
In the previous year, the average age was 274.4 days.

The reduction in the turnover and increase in inventory age suggests that inventory is being held onto
for a longer time. You should ask why the inventory is not selling as quickly.
The operating cycle is the number of days it takes to convert inventory and receivables to cash.
In 20X2, the operating cycle is:
In the previous year, the operating cycle was 317.5 days. The increase is unfavorable, because it
means that additional funds are tied up in noncash assets and that cash is being collected more
slowly.
By calculating the total asset turnover, you can find out whether the company is efficiently
employing its total assets to obtain sales revenue. A low ratio may indicate that too many assets are
being held compared to the sales revenue generated.
In 20X2, the ratio is:

Page 50
In 20X1, the ratio was .57 ($110/$194.5). Thus, there has been a sharp reduction in asset utilization.
TLC, Inc., has suffered a sharp deterioration in activity ratios, pointing to a need for improved credit
and inventory management, although the 20X2 ratios are not far out of line with the industry averages
(see Figure 3.3). It appears that problems are inefficient collection and obsolescence of inventory.
Solvency (Leverage and Debt Service) Ratios
Solvency is the company's ability to satisfy long-term debt as it becomes due. You should be
concerned about the long-term financial and operating structure of any company in which you might
be interested. Another important consideration is financial leverage, the size of debt in the
company's capital structure. (Capital structure is the mix of long-term sources of funds used by the
company.)
Solvency also depends on earning power; in the long run a company cannot satisfy its debts unless it
earns a profit. A leveraged capital structure subjects the company to fixed interest charges,
contributing to earnings instability. Excessive debt may also make it difficult for the corporation to
borrow funds at reasonable rates during tight money markets.
The debt ratio reveals the amount of money a company owes to its creditors. Excessive debt means
greater risk to the investor. (Equity holders come after creditors in bankruptcy.)
The debt-equity ratio reveals if the company has a great amount of debt in its capital structure. Large
debts mean that the borrower has to pay significant periodic interest and principal. Also, a heavily
indebted firm takes a greater risk of running out of cash in difficult times. The interpretation of this
ratio depends on several variables, including the ratios of other companies in the industry, the degree
of access to additional debt financing, and the stability of operations.

Page 51
In the previous year, the ratio was 1.55. The situation is therefore relatively static.
Times interest earned (interest coverage ratio) tells you how many times the business's before-tax
earnings would cover interest. It is a safety margin indicator in that it reflects how large a reduction
in earnings a company can tolerate.
For 20X2, the ratio is:
In 20X1, interest was covered 13.5 times. The reduction in coverage during the period is a bad sign;
it means that less earnings are available to satisfy interest charges.
You must also note liabilities that have not yet been accounted for in the balance sheet by closely
examining footnote disclosures. For example, you should find out about pending lawsuits,
noncapitalized leases, and future guarantees.
As revealed in Figure 3.3, the company's overall solvency is poor compared to the industry
averages, although it has remained fairly constant. There has been no significant change in its ability
to satisfy long-term debt. Note, however, that significantly less profit is available to cover interest
payments.
Profitability Ratios
A company's ability to earn good profit and return on investment is an indicator of its financial well-
being and the efficiency with which it is managed. Poor earnings have a detrimental effect on both
the market price of stock and dividends, and total dollar net income has little meaning unless it is
compared to the resources used in getting that profit.
The gross profit margin is the percentage of each dollar remaining once the company has paid for
goods acquired. A high margin reflects good earning potential.

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Pag
Ratios Definitions 20X1 20X2 (a) 20X2 Ind. Evaluation
20X2 Industry Comp Trend 20X1-
Average 20X2
Ov
LIQUIDITY
Net working capital 63 68 56 good good go
Current assets -
current liabilities
Current Ratio Current assets/current liabilities 2.26 2.21 2.05 OK OK
Quick (Acid-test) 1.34 1.27 1.11 OK OK
ratio (Cash + marketable securities + accounts
receivable)/current liabilities
ASSET
UTILIZATION
Accounts receivable 8.46 5.5 OK poor po
turnover Net credit sales/average accounts receivable 4.34
Average collection 66.4 days OK poor po
period 365 days/accounts receivable turnover 43.1 84.1
days days
Inventory turnover 1.2 OK poor po
Cost of goods sold/average inventory 1.33 1.05
Average age of 365 days/inventory turnover N/A N/A poor po
inventory 274.4 347.6
days days
Operating cycle N/A N/A poor po
Average collection period 317.5 431.7
+ average age of inventory days days
Total asset turnover Net sales/average total assets 0.44 OK poor po
0.57 0.37
SOLVENCY
Debt ratio Total liabilities/total assets N/A N/A OK
0.61 0.61
Debt-equity ratio 1.3 poor poor po
Total liabilities/stockholders' equity 1.55 1.58

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< previous page page_53 next pag
Page

Ratios Definitions 20X1 20X2 (a) 20X2 Evaluation Trend (b
20X2 Ind. 20X1-
Industry Comp 20X2
Average Ove
Times interest 13.5 7.65 10 times OK poor poo
earned Income before interest and taxes/interest expense times times
PROFITABILITY
Gross profit margin Gross profit/net sales 0.43 0.35 0.48 poor poor poo
Profit margin Net income/net sales 0.14 0.1 0.15 poor poor poo
Return on total Net income/average total assets 0.077 0.037 0.1 poor poor poo
assets
Return on equity 0.207 0.095 0.27 poor poor poo
(ROE) Earnings available to common stockholders/average
stockholders' equity
MARKET VALUE
Earnings per share 3.26 1.74 4.51 poor poor poo
(EPS) (Net income - preferred dividend)/common shares
outstanding
Price/earnings (P/E)Market price per share/EPS 7.98 6.9 7.12 OK poor poo
ratio
Book value per 17.39 19.13 N/A N/A good goo
share (Total stockholders' equity preferred stock)/common
shares outstanding
Price/book value 1.5 0.63 N/A N/A poor poo
ratio Market price per share/book value per share
Dividend yield
Dividends per share/market price per share
Dividend payout Dividends per share/EPS
(a) Obtained from sources not included in this chapter
(b) Represent subjective evaluation
Figure 3.3
Summary of Financial Ratios: Trend and Industry Comparisons; TLC, Inc., 20X2 and 20X1

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Page 54
The ratio was .43 in 20X1. The reduction shows that the company now receives less profit on each
dollar of sales, perhaps because it is paying more for the merchandise it sells.
Profit margin shows the earnings generated from revenue and is a key indicator of operating
performance. It provides an idea of the firm's pricing, cost structure, and efficiency.
The ratio in 20X2 is:
For the previous year, the profit margin was .14. The decline in the ratio shows a downward trend in
earning power. (Note that these percentages are available in the common-size income statement in
Figure 3.2).
Return on investment is an important indicator because it allows you to evaluate the profit you will
earn if you invest in the business. Two key ratios are the return on total assets and the return on
equity.
The return on total assets shows whether management is efficient in using available resources to get
profit.
In 20X2, the return is:
In 20X1, the return was .077. There has been a deterioration in the productivity of assets in
generating earnings.
The return on equity (ROE) reflects the rate of return earned on the stockholders' investment.
The return in 20X2 is:

Page 55

TABLE 3-1

INDUSTRIES WITH HIGH RETURN
ON EQUITY (ROE) RATES
(IN EXCESS OF 20%)
1998
ROE (%)
Industry
Cars and Trucks
62.4
Personal Care
31.0
Eating Places
22.9
Food Processing
24.8
Beverages
32.0
Business Machines and Services
20.6
Telephone
28.6
Source: Corporate Scorecard, by Business Week, McGraw-Hill, March
1999, pp. 75 91.
In 20X1, the return was .207. There has been a significant drop in return to the owners.
The overall profitability of the company has decreased considerably, causing a decline in both the
return on assets and return on equity. Perhaps the lower earnings resulted from higher costs of short-
term financing caused by the decline in liquidity and activity ratios. Moreover, as turnover rates in
assets go down, profit declines because of reduced sales and higher costs of carrying higher current
asset balances. As indicated in Figure 3.3, industry comparisons reveal that the company is faring
very poorly.
Table 3-1 shows industries with high return on equity (in excess of 20 percent).
Market Value Ratios
Market value ratios and dividend-related ratios relate the company's stock price to its dividends,
earnings, or book value per share.
Earnings per share (EPS) is the ratio most widely watched by investors. EPS shows the net income
per common share owned after reducing net income by the preferred dividends. If preferred stock is
not part of the company's capital structure, EPS is determined by dividing net income by common
shares outstanding. EPS is a gauge of corporate operating performance and of expected future
dividends.

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TABLE 3-2
1998 HIGHLY PROFITABLE COMPANIES
(IN TERMS OF EPS)
Company EPS ($)
Ford 17.76
U.S. Home 4.68
Alcoa 4.84
CIGNA 6.05
IBM 6.57
Washington Post 41.10
Source: Corporate Scorecard, by Business Week, McGraw-Hill,
March 1999, pp. 75 91.
EPS in 20X2 is:
For 20X1, EPS was $3.26. The sharp reduction over the year should cause alarm among investors.
As you can see in Figure 3.3, the industry average EPS in 20X2 ($4.51) is much higher than that of
TLC, Inc. ($1.74).
Table 3-2 provides a list of highly profitable companies, as measured by EPS.
The price/earnings (P/E) ratio, also called the earnings multiple, reflects the company's relationship
to its stockholders. The P/E ratio represents the amount investors are willing to pay for each dollar
of the company's earnings. A high multiple (cost per dollar of earnings) is favored since it shows that
investors view the business positively. On the other hand, investors looking for value prefer a
relatively lower multiple (cost per dollar of earnings) as compared with companies of similar risk
and return, a lower P/E ratio in such a case suggests that the company's stock may be undervalued.
Assume a market price per share of $12 on December 31, 20X2, and $26 on December 31, 20X1.
The P/E ratios are:


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TABLE 3-3
P/E RATIOS, 1998
P/E Ratio
Company Industry
Boeing Aerospace
32
General Motors Cars & Trucks
21
Goodyear Tire & Rubber
13
Gap Retailing
52
Intel Semiconductor
37
Pfizer Drugs & Research
88
Source: Corporate Scorecard, by Business Week, McGraw-Hill, March
1999, pp. 75 91.
From the lower P/E multiple, you can infer that the stock market now has a lower opinion of the
business. However, some investors would argue that the stock is undervalued at $12. Nevertheless,
the 54 percent decline in stock price over the year ($14/$26) should cause deep investor concern.
Table 3-3 shows price-earnings ratios of several companies.
Book value per share equals the net assets available to common stockholders divided by shares
outstanding. By comparing it to market price per share, you can get another view of how investors
feel about the business.
In 20X1, book value per share was $17.39.

The increased book value per share is a favorable sign.
The price/book value ratio shows the market value of the company in comparison to its historical
accounting value. A company with old


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TABLE 3-4
DIVIDEND YIELD RATIOS 1998
Dividend Payout Ratio
Company
General Electric
1.2%
General Motors
2.3
Intel
0.1
Wal-Mart
0.4
Pfizer
0.5
Hewlett Packard
0.9
Source: MSN Money Central Investor (http://investor.msn.com),
April 11, 1999.
assets may have a high ratio, whereas one with new assets may have a low ratio. Hence, you should
note the changes in the ratio as part of your effort to appraise the corporate assets.
In 20X1, the ratio was 1.5. The significant drop in the ratio may indicate that investors now hold a
lower opinion of the company than they did formerly. Market price of the stock may have dropped
because of a deterioration in liquidity, activity, and profitability ratios. The major indicators of a
company's performance are intertwined, and problems in one area may spill over into another. This
appears to have happened to the company in our example.
Dividend ratios help you determine the current income from an investment. Two relevant ratios are:
Table 3-4 shows the dividend payout ratios.

There is no such thing as a ''right" payout ratio. Stockholders look unfavorably upon reduced
dividends because lower payouts are a sign


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of a possible deterioration in a company's financial health. However, companies with ample

opportunities for growth at high rates of return on assets tend to have low payout ratios.
An Overall EvaluationSummary of Financial Ratios

No single ratio or group of ratios is adequate for assessing all aspects of a company's financial
condition. Figure 3.3 summarizes the 20X1 and 20X2 ratios calculated in the previous sections,
along with the industry average ratios for 20X2, and shows the formula used to calculate each ratio.
The last three columns of the figure contain subjective assessments of TLC's financial condition,
based on trend analysis and 20X2 comparisons to the industry norms (as a rule, five-year ratios are
needed for trend analysis to be meaningful).
Appraising the trend in the company's ratios from 20X1 to 20X2, we see from the drop in the current
and quick ratios that there has been a slight detraction in short-term liquidity, although the ratios have
been above the industry averages. But working capital has improved. A material deterioration in the
activity ratio has occurred, indicating that an improvement in credit management and inventory
policies is required. The declines are not terribly alarming, however, because these ratios are not
way out of line with industry averages. Also, total utilization of assets, as indicated by the total asset
turnover, shows a deteriorating trend.
Leverage (amount of debt) has been constant. However, there is less profit available to satisfy
interest charges. TLC's profitability has deteriorated over the year and, in 20X2, is consistently
below the industry average in every measure. Consequently, the return on owner's investment and the
return on total assets has gone down. The earnings decrease may be partly the result of the company's
high cost of short-term financing and partly the result of operating inefficiency. The higher costs may
be due to receivable and inventory difficulties that forced a decline in the liquidity and activity
ratios. Furthermore, as receivables and inventory turn over less, profit falls off from the reduced
sales and the costs of carrying more in current asset balances.
The company's market value, as measured by the price/earnings (P/E) ratio, is respectable compared
with other companies in the industry. But it shows a declining trend.
In summary, it appears that the company is doing satisfactorily in the industry in many categories.
The 20X1 20X2 period, however, seems to indicate that the company is heading for financial trouble
in terms of earnings, activity, and short-term liquidity. The business needs to concentrate on
increasing operating efficiency and asset utilization.


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Limitations of Ratio Analysis

While ratio analysis is an effective tool for assessing a business's financial condition, it's important
to recognize its limitations:
1. Accounting policies vary among companies and can inhibit useful comparisons. For example, the
use of different depreciation methods (straight-line vs. double declining balance) affects profitability
and return ratios. Depreciation methods are discussed in detail in Chapter 10.
2. Management may manipulate the figures in order to make them look more impressive. For
example, it can reduce needed research expense just to bolster net income. This practice, however,
almost always hurts the company in the long run.
3. A ratio is static and does not reveal future flows. For example, it cannot answer questions such as,
"How much cash do you have in your pocket now?" or "Is cash on hand sufficient, considering your
expenses and income over the next month?"
4. A ratio does not indicate the quality of its components. For example, a high quick ratio may be
based partly on receivables that may not be collected.
5. Reported liabilities, such as a lawsuit in which the company may be found liable, may be
undervalued.
6. The company may have multiple lines of business, making it difficult to identify the industry group
of which it is a part.
7. Industry averages cited by financial advisory services are only approximations. Hence, you may
have to compare a company's ratios to those of competing companies in the industry to assess its
standing accurately.
Chapter Perspective
The analysis of financial statements is of interest to creditors, current and prospective investors, and
the company's own management. This chapter has presented various financial statement analysis
tools that are useful in evaluating the company's current and future financial condition. These
techniques include horizontal, vertical, and ratio analysis, which provide relative measures of the
performance and financial health of the company. Two methodstrend analysis and industry
comparisonfor analyzing financial ratios were demonstrated.
While ratio analysis is an effective tool for assessing a company's financial condition, its limitations
must be recognized.


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Chapter 4
Financial Forecasting and Budgeting
Financial forecasting, an essential element of planning, is the basis for budgeting and for estimating
future financing requirements. Financing may derive from either internal or external sources. Internal
financing refers to cash flow generated by the company's normal operating activities; external
financing refers to capital provided by parties outside the company, such as investors and banks.
Companies are able to estimate their need for external financing by forecasting future sales and
related expenses.
After studying the material in this chapter:
· You will be able to apply the percent-of-sales method to determine the amount of external financing
needed.
· You will have an understanding of the corporation's budgetary system, including the cash budget
and the forecasted (pro forma) income statement and balance sheet.
· You will be able to formulate the master budget, step by step.
· You will see how a budget can be developed using an electronic spreadsheet.
The Percent-of-Sales Method of Financial Forecasting

The basic steps in projecting a company's financing needs are:
1. Project the company's sales. The sales forecast is the basis for most other forecasts.
2. Project additional variables, such as expenses.
3. Estimate the level of investment in current and fixed assets the company will need to make to
support the projected sales.
4. Calculate the company's financing needs.
The most widely used method for projecting the company's financing needs is the percent-of-sales
method. This method requires financial planners to estimate future expenses, assets, and liabilities as
a percent of sales for that period. They then use those percentages together with projected sales, to
construct forecasted balance sheets.


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The following example illustrates the process.

EXAMPLE 4-1
Assume that sales for 20X1 are $20, projected sales for 20X2 are $24, net income is 5 percent of
sales, and the dividend payout ratio is 40 percent. Figure 4.1 is a step-by-step illustration of the
method for calculating external financing needs. (All dollar amounts are in millions.)
The steps for the computations are as follows:
Express those balance sheet items that vary directly

with sales as a percentage of sales. Any item such as
Steplong-term debt that does not vary directly with sales
1. is designated "n.a.," or "not applicable."
Multiply these percentages by the 20X2 projected
Stepsales ($24) to obtain the projected amounts (shown in
2. the last column).
StepInsert figures for long-term debt, common stock, and
3. paid-in capital from the 20X1 balance sheet.
StepCompute 20X2 retained earnings as shown in footnote
4. (b).
Sum the asset accounts, obtaining total projected
assets of $7.2. Add to that total the projected
liabilities and equity to obtain $7.12, the total internal
financing provided. Since liabilities and equity must
total $7.2, but only $7.12 is projected, there is a
Stepshortfall of $0.08. This is the external financing
5. needed.
Although you can forecast the additional funds required by setting up a pro forma balance sheet as
described above, it is often easier to use the following formula:
where
A/S
= Assets that increase spontaneously with sales as a
percentage of sales
L/S
= Liabilities that increase spontaneously with sales as
a percentage of sales
DS = Change in sales
PM = Profit margin on sales
PS = Projected sales
d = Dividend payout ratio

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EXAMPLE 4-2
In Example 4-1,
A/S = $6/$20 = 30%

L/S = $2/$20 = 10%
DS = ($24 - $20) = $4
PM = 5% on sales
PS = $24
d = 40%
Plugging these figures into the formula yields:
The amount of external financing needed is $80,000, which can be raised by issuing any combination
of notes payable, bonds, and stocks.
The major advantage of the percent-of-sales method of financial forecasting is that it is simple and
inexpensive to use. It assumes that the company is operating at full capacity and therefore does not
have sufficient productive capacity to absorb a projected increase in sales; thus an additional
investment in assets will be necessary. The method must be used with extreme caution if excess
capacity exists in certain asset accounts.
To obtain a more precise projection of the company's future financing needs, a cash budget
(discussed in the next section) is required.
Types of Budgets
A budget represents a company's annual financial plan. A comprehensive (master) budget is a formal
statement of management's expectation for sales, expenses, volume, and other financial transactions
for the coming period. It consists basically of a pro forma (projected or planned) income statement,
pro forma balance sheet, and cash budget.
A budget is a tool for both planning and control. At the beginning of the period, the budget is a plan
or standard; at the end of the period it serves as a control device by which management can measure
its success in achieving the goals outlined in the budget and plan to improve future performance.
With the aid of computer technology, budgeting can be used to evaluate a variety of "what-if"
scenarios. Such analyses makes it easier for management to find the best course of action among
various

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Present % of Sales Projected

(20X1) (20X1 (20X2
Sales = $20) Sales =
$24)
Assets
2 10 2.4
Current assets
4 20 4.8
Fixed assets
6 7.2
Total assets
2 10 2.4
Current liabilities
2.5 n.a. 2.5
Long-term debt
4.5 4.9
Total liabilities
0.1 n.a. 0.1
Common stock
0.2 n.a. 0.2
Capital surplus
1.2 1.92a
Retained earnings
1.5 2.22
Total equity
6 7.12 Total financing
Total liabilities and provided
0.08b External financing
needed
7.2 Total
a 20X2 retained earnings
= 20X1 retained earnings + projected net income
- cash dividends paid
= $1.2 + 5%($24) - 40%[5%($24)]
= $1.2 + $1.2 - $0.48 = $2.4 - $0.48 = $1.92
b External financing needed = projected total assets - (projected total liabilities
+ projected equity)
= $7.2 - ($4.9 + 2.22) = $7.2 - $7.12 = $0.08
Figure 4.1
Pro Forma Balance Sheet (in Millions of Dollars)


Page 65
alternatives. If management does not like what it sees on the budgeted financial statements, it can
alter its contemplated planning decisions.
The budget is classified into two broad categories:
1. Operating budget.
2. Financial budget.
The operating budget consists of:
· Sales budget
· Production budget
· Direct material budget
· Direct labor budget
· Factory overhead budget
· Selling and administrative expense budget
· Pro forma income statement
The financial budget consists of:
· Cash budget
· Pro forma balance sheet
Preparing the Budget

The major steps in preparing the budget are:
1. Prepare a sales forecast.
2. Determine expected production volume.
3. Estimate manufacturing costs and operating expenses.
4. Determine cash flow and other financial effects.
5. Formulate projected financial statements.
Figure 4.2 shows a simplified diagram of the various parts of the comprehensive (master) budget.
To illustrate how these budgets are put together, we will prepare a sample financial plan for a
manufacturing company called the Johnson Company, which produces and markets a single product.
We assume that the company develops its master budget on a quarterly basis and distinguishes
between variable costs and fixed costs in its planning. (Variable costs are those costs that vary in
proportion to sales or production volume; fixed costs do not vary but remain constant regardless of
volume.)
Sales Forecasts
The sales forecast gives the expected level of sales for the company's goods or services throughout
some future period and is instrumental in the company's planning and budgeting functions. It is the
key to other forecasts and plans. There is a wide range of techniques of sales forecasting which the
company may choose from; however, there are basically two approaches to forecasting: qualitative
and quantitative.


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Figure 4.2
Comprehensive (Master) Budget


Page 67
The qualitative approach, which includes forecasts based on judgment and opinion, includes such
methods as executive opinions, the Delphi technique, sales force polling, and consumer surveys. The
quantitative approach is as follows:
· Forecasts based on historical data
Naive methods
Moving averages
Exponential smoothing
Trend analysis
· Associative (causal) forecasts
Simple regression
Multiple regression
Econometric modeling
The discussion on forecasting methodology is reserved for business forecasting texts.
The Sales Budget
The sales budget is the starting point in preparing the master budget, since estimated sales volume
influences nearly all other items in the master budget. The sales budget ordinarily indicates the
quantity in units of each product the company expects to sell. That number is multiplied by the
expected unit selling price to construct the sales budget. The sales budget also includes a
computation of expected cash collections from credit sales, which will be used later for cash
budgeting.
The Production Budget
After sales are budgeted, the production budget is developed by determining the number of units
expected to be manufactured in order to meet budgeted sales and inventory requirements. The
expected volume of production is determined by subtracting the estimated inventory at the beginning
of the period from the sum of the units expected to be sold and the desired inventory at the end of the
period.

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EXAMPLE 4-3
THE JOHNSON COMPANY
Sales Budget
for the Year Ending December 31, 20X2
Quarter Total

1 2 3 4
Expected sales 800 700 900 800 3,200
in units
Unit sales price ×$80 ×$80 ×$80 ×$80 ×$80
Total sales $64,000 $56,000 $72,000 $64,000 $256,000
SCHEDULE OF EXPECTED CASH COLLECTIONS
9,500* $9,500
Accounts receivable, 12/31/20X1
44,800** $17,920*** 62,720
1st quarter sales ($64,000)
39,200 $15,680 54,880
2d quarter sales ($56,000)
50,400 $20,160 70,560
3d quarter sales ($72,000)
44,800 44,800
4th quarter sales ($64,000)
$54,300 $57,120 $66,080 $64,960 $242,460
Total cash collections
* The entire $9,500 accounts receivable balance is assumed to be collectible in the first quarter.
** 70% of a quarter's sales are collected in the quarter of sale.
*** 28% of a quarter's sales are collected in the quarter following; the remaining 2 are
uncollectible.
Monthly Cash Collections from Customers

Frequently, there are time lags between monthly sales made on account and their related monthly
cash collections. For example, in any month, credit sales are collected as follows: 15 percent in
month of sale, 60


Page 69
percent in the following month, and 25 percent in the month after. The following are given for a
hypothetical company (in thousands):
The budgeted cash receipts for June and July are computed as follows:
For June:
From April sales $320 × 0.25 $ 80
From May sales 200 × 0.6 120
From June sales 300 × 0.15 45
Total budgeted collections in June $245
For July:
From May sales $200 × 0.25 $ 50
From June sales 300 × 0.6 180
From July sales 280 × 0.15 42
Total budgeted collections in June $272
EXAMPLE 4-4
THE JOHNSON COMPANY
Production Budget
Quarter Total
1 2 3 4
800 700 900 800 3,200
Planned sales (Example 4-3)
70 90 80 100** 100
Desired ending inventory*
870 790 980 900 3,300
Total Needs
80 70 90 80 80
Less: Beginning inventory***
790 720 890 820 3,220
Units to be produced
* 10% of the next quarter's sales
** Estimated
*** The same as the previous quarter's ending inventory

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The Direct Material Budget

After the level of production has been computed, a direct material budget should be constructed to
show how much material will be required and how much must be purchased to meet production
requirements. The amount to be purchased depends on the expected usage of materials and existing
inventory levels. The formula for computing the purchase is:
The direct material budget is usually accompanied by a computation of expected cash payments for
materials.
EXAMPLE 4-5
THE JOHNSON COMPANY
Direct Material Budget
Quarter Total
1 2 3 4
790 720 890 820 3,220
Units to be produced
(Ex. 4-4)
× 3 × 3 × 3 × 3 × 3
Material needs per unit (lbs)
2,370 2,160 2,670 2,460 9,660
Material needs for production
216 267 246 250** 250
Desired ending inventory of materials*
2,586 2,427 2,916 2,710 9,910
Total needs
237 216 267 246 237
Less: Beginning inventory of materials***
2,349 2,211 2,649 2,464 9,673
Materials to be purchased
× $2 × $2 × $2 × $2 × $2
Unit price
$4,698 $4,422 $5,298 $4,928 $19,346
Purchase cost


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Quarter Total
1 2 3 4
SCHEDULE OF EXPECTED CASH DISBURSEMENTS
$2,200 $2,200
Accounts payable, 12/31/20X1
2,349 2,349§ 4,698
1st quarter purchases ($4,698)
2,211 2,211 4,422
2d quarter purchases ($4,422)
2,649 2,649 5,298
3d quarter purchases ($5,298)
2,464 2,464
4th quarter purchases ($4,928)
$4,549 $4,560 $4,860 $5,113 $19,082
Total disbursements
* 10% of the next quarter's units needed for production
** Estimated
*** The same as the prior quarter's ending inventory
§ 50% of a quarter's purchases are paid for in the quarter of purchase; the remainder are paid
for in the following quarter.
The Direct Labor Budget

The production requirements in the production budget provide the starting point for the preparation
of the direct labor budget. To compute direct labor requirements, multiply expected production
volume for each period by the number of direct labor hours required to produce a single unit. The
result is then multiplied by the direct labor cost per hour to obtain budgeted total direct labor costs.


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EXAMPLE 4-6
THE JOHNSON COMPANY
Direct Labor Budget
Quarter Total
1 2 3 4
790 720 890 820 3,220
Units to be produced (Ex. 4-4)
× 5 × 5 × 5 × 5 × 5
Direct labor hours per unit
Total hours 3,950 3,600 4,450 4,100 16,100
× $5 × $5 × $5 × $5 × $5
Direct labor cost
per hour
$19,750 $18,000 $22,250 $20,500 $80,500
Total direct labor cost
The Factory Overhead Budget

The factory overhead budget provides a schedule of all manufacturing costs other than direct
materials and direct labor, such as depreciation, property taxes and factory rent. In developing the
cash budget, it is important to remember that depreciation does not entail a cash outlay and therefore
must be deducted from the total factory overhead when you compute cash disbursement for factory
overhead.
EXAMPLE 4-7
In the following illustration of a factory overhead budget, we assume that
· Total factory overhead budgeted = $6,000 fixed (per quarter), plus $2 per hour of direct labor.
· Depreciation expenses are $3,250 each quarter.
· All overhead costs involving cash outlays are paid for in the quarter incurred.


Page 73
THE JOHNSON COMPANY
Factory Overhead Budget
Quarter Total
1 2 3 4
3,950 3,600 4,450 4,100 16,100
Budgeted direct labor hours (Example 4-6)
Variable overhead rate × $2 × $2 × $2 × $2 × $2
Variable overhead budgeted 7,900 7,200 8,900 8,200 32,200
Fixed overhead budgeted 6,000 6,000 6,000 6,000 24,000
Total budgeted overhead 13,900 13,200 14,900 14,200 56,200
Less: Depreciation 3,250 3,250 3,250 3,250 13,000
10,650 9,950 11,650 10,950 43,200
Cash disbursement for overhead
The Ending Inventory Budget

The ending inventory budget provides the information required for the construction of budgeted
financial statements. Specifically, it helps compute the cost of goods sold on the budgeted income
statement and the dollar value of the ending materials and finished goods inventory that appears on
the budgeted balance sheet.
EXAMPLE 4-8
THE JOHNSON COMPANY
Ending Inventory Budget
Ending Inventory
Units Unit Cost Total
250 pounds (Example 4-5) $ 2 $500
Direct materials
100 units (Example 4-4) $41* $4,100
Finished goods
* The unit variable cost of $41 is computed as follows:


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Units Unit Cost Total
Direct materials (Example 4-5) $2 3 pounds $6
Direct labor (Example 4-6) 5 5 hours 25
Variable overhead (Example 4-7) 2 5 hours 10
$41
The Selling and Administrative Expense Budget

The selling and administrative expense budget lists the operating expenses incurred in selling the
products and in managing the business. To complete the budgeted income statement (sales less
variable costs less fixed costs), you must compute variable selling and administrative expense per
unit.
EXAMPLE 4-9
THE JOHNSON COMPANY
Selling and Administrative Expense Budget
Quarter Total
1 2 3 4
800 700 900 800 3,200
Expected sales in units
× $4 × $4 × $4 × $4 × $4
Variable selling
and administrative expense per unit*
$3,200 $2,800 $3,600 $3,200 $12,800
Budgeted variable expense

Fixed selling and administrative
expenses:
1,100 1,100 1,100 1,100 4,400
Advertising
2,800 2,800
Insurance
8,500 8,500 8,500 8,500 34,000
Office salaries
350 350 350 350 1,400
Rent
1,200 1,200
Taxes
$15,950 $12,750 $14,750 $13,150 $56,600
Total budgeted
selling and administrative expenses**
* Assumed; includes sales agents' commissions, shipping, and supplies
** Paid for in the quarter incurred

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The Cash Budget

The cash budget helps managers anticipate the expected cash inflow and outflow for a designated
time period, keep cash balances in reasonable relationship to needs, and avoid both unnecessarily
idle cash and possible cash shortages. The cash budget usually consists of four major sections:
1. The receipts section, including the beginning cash balance, cash in from customers, and other
receipts.
2. The disbursements section, comprising all cash payments that are planned during the budget
period.
3. The cash surplus or deficit section, which shows the difference between the cash receipts section
and the cash disbursements section.
EXAMPLE 4-10
THE JOHNSON COMPANY
Cash Budget
From Quarter Total
Example 1 2 3 4
10,000* 9,401 5,461 9,106 10,000
Cash balance, beginning

Add: Receipts:
4-3 54,300 57,120 66,080 64,960 242,460
Collections from customers
64,300 66,521 71,541 74,066 252,460
Total cash available
Less: Disbursements:
4 5 4,549 4,560 4,860 5,113 19,082
Direct materials
4 6 19,750 18,000 22,250 20,500 80,500
Direct labor
4 7 10,650 9,950 11,650 10,950 43,200
Factory overhead
4 9 15,950 12,750 14,750 13,150 56,600
Selling and Admin.
Given 24,300 24,300
Machinery purchase
Given 4,000 4,000
Income tax
54,899 69,560 53,510 49,713 227,682
Total disbursements
9,401 (3,039) 18,031 24,353 24,778
Cash surplus (deficit)
Financing:
8,500 8,500
Borrowing
(8,500) (8,500)
Repayment
( 425) ** ( 425)
Interest
8,500 (8,925) ( 425)
Total financing
9,401 5,461 9,106 24,353 24,353
Cash balance, ending
* From balance sheet 20X1, page 76.
** $8,500 × 1/2 × 10% = $425

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4. The financing section, which provides a detailed account of the borrowings and repayments
expected during the budgeting period. In this illustration, we assume that:
· The company desires to maintain a $5,000 minimum cash balance at the end of each quarter.
· All borrowing and repayment must be in multiples of $500 at an interest rate of 10 percent per
annum. Interest is computed and paid as the principal is repaid. Borrowing takes place at the
beginning of each quarter, and repayment is at the end of each quarter.
The Budgeted Income Statement
The budgeted income statement summarizes projections for the various components of revenue and
expenses for the budgeting period. The budget can be divided into quarters or even months if the
company wishes to keep tight control over its operations.
EXAMPLE 4-11
THE JOHNSON COMPANY
Budgeted Income Statement
Example
4-3 $256,000
Sales (3,200 units @ $80)

Less: Variable expenses
4-4 $131,200
Variable cost of goods sold
(3,200 units @ $41)
4-9 12,800 144,000
Variable selling &
administrative
112,000
Contribution margin

Less: Fixed expenses
4-7 24,000
Factory overhead
4-9 43,800 67,800
Selling and administrative
44,200
Net operating income
4-10 425
Less: Interest expense
43,775
Income before taxes
20% * 8,755
Less: Income taxes
35,020
Net income
* Assumed.


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The budgeted balance sheet is developed by adjusting the balance sheet for the year just ended, using
all the activities that are expected to take place during the budgeting period. The budgeted balance
sheet must be prepared because:
· It might disclose some unfavorable financial conditions that management will want to avoid.
· It serves as a final check on the mathematical accuracy of all the other schedules.
· It helps management perform a variety of ratio calculations.
· It highlights future resources and obligations.
EXAMPLE 4-12
In this illustration, we use the balance sheet for the year 20X1.
THE JOHNSON COMPANY
Balance Sheet
as of December 31, 20X1
ASSETS
LIABILITIES AND STOCKHOLDERS'
EQUITY
Current Assets: Current Liabilities:
10,000 2,200
Cash Accounts Payable
9,500 4,000
Accounts Receivable Income Tax Payable
474 Total Current Liabilities 6,200
Material Inventory
3,280
Finished Goods Inventory
Total Current Assets 23,254
Fixed Assets: Stockholders' Equity:
50,000 70,000
Land Common Stock, No-Par
100,000 37,054
Building and Equipment Retained Earnings

Accumulated (60,000)
Depreciation
90,000
Total Assets 113,254 Total Liabilities and Stockholders' Equity 113,254

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THE JOHNSON COMPANY
Budgeted Balance Sheet
as of December 31, 20X2
ASSETS LIABILITIES AND STOCKHOLDERS' EQUITY
Current Assets: Current Liabilities:
2,464(i)
Cash 24,353(a) Accounts Payable
8,755(j)
Accounts Receivable 23,040(b) Income Tax Payable
11,219
Material Inventory 500(c) Total Current
Liabilities

Finished Goods 4,100(d)
Inventory
Total Current Assets $51,993
Fixed Assets: Stockholders' Equity:
70,000(k)
Land 50,000(e) Common Stock,
No-Par
124,300(f) 72,074(l)
Building and Retained Earnings
Equipment
(73,000)(g)
Accumulated
Depreciation
101,300(h)
Total Assets 153,293 Total Liabilities and Stockholders' Equity 153,293
Computations:
(a) From Example 4-10 (cash budget).
(b) $9,500 (from balance sheet 20X1) + $256,000 sales (from Example 4-3) - $242,460
receipts (from Example 4-3) = $23,040.
(c) and (d) From Example 4-8 (ending inventory budget).
(e) No change.
(f) $100,000 (from balance sheet 20X1) + $24,300 (from Example 4-10) = $124,300.
(g) $60,000 (from balance sheet 20X1) + $13,000 (from Example 4-7) = $73,000.
(h) $50,000 + $124,300 - $73,000 = $101,300.
(i) $2,200 (from balance sheet 20X1) + $19,346 (from Example 4-5) - $19,082 (Example 4-
5) = $2,464 (all accounts payable relate to material purchases), or 50% of 4th quarter
purchase = 50% ($4,928 = 2,464.
(j) From Example 4-11 (budgeted income statement).
(k) No change.
(l) $37,054 (from balance sheet 20X1) + $35,020 net income (from Example 4-11) =
$72,074.
Some Financial Ratio Calculations

To predict the Johnson Company's financial condition for the budgeting year, you can calculate a
sample of financial ratios. (Assume 20X1 after-tax net income was $15,000.)


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20X1 20X2
Current ratio
(Current assets/ = $23,254/$6,200 = $51,993/$11,219
current liabilities) = 3.75 = 4.63
Return on total assets
(Net income after = $15,000/$113,254 = $35,020/$153,293
taxes/ = 13.24% = 22.85%
total assets)
Sample calculations indicate that the Johnson Company may well improve its liquidity in 20X2, as
measured by the current ratio, and its overall performance as measured by return on total assets will
likely improve. This could be an indication that the company's contemplated plan may work out well.
Computer-Based Models and Spreadsheet Program Models for Budgeting

Examples 4-3 to 4-12 showed a detailed procedure for developing a master budget. However, in
practice computer and software technology allows financial planners and budget analysts to take a
short-cut, computerized approach to budgeting. More and more companies are developing computer-
based models for financial planning and budgeting, using powerful, yet easy-to-use, financial
modeling languages such as Comshare's Interactive Financial Planning System (IFPS) and Up Your
Cash Flow. The models help not only to build a budget for profit planning but also to answer a
variety of ''what-if" scenarios. The resultant calculations provide a basis for choice among
alternatives under conditions of uncertainty. Furthermore, budget modeling can be accomplished
using spreadsheet programs such as Microsoft's Excel.
In this section we will illustrate the use of Excel to develop a financial model. For illustrative
purposes, we will present two examples of projecting an income statement.
EXAMPLE 4-13
JKS Furniture Company, Inc., expects the following for the coming 12 months, 20X2:
· Sales for first month = $60,000.
· Cost of sales = 42 percent of sales, all variable.
· Operating expenses = $10,000 fixed plus 5 percent of sales.
· Taxes = 30 percent of net income.
· Sales increase by 5 percent each month.


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Based on this information, Figure 4.3 presents a spreadsheet for the contribution income statement
for the next 12 months and in total.
Figure 4.4 shows a spreadsheet for the contribution income statement for the next 12 months and in
total, assuming that sales increase by 10 percent and operating expenses = $10,000 plus 10 percent
of sales. This is an example of "what-if" scenarios.
EXAMPLE 4-14
Delta Gamma Company wishes to prepare a 3-year projection of net income using the following
1998 base year information:
Sales revenues
Cost of sales $4,500,000
Selling and administrative 2,900,000
expenses 800,000
Net income before taxes 800,000
The projection uses following assumptions:

· Sales revenues increase by 6 percent in 1999, 7 percent in 2000, and 8 percent in 2001.
· Cost of sales increase by 5 percent each year.
· Selling and administrative expenses increase only 1 percent in 1999 and will remain at the 1999
level thereafter.
· The income tax rate = 46 percent.
Figure 4.5 presents a spreadsheet for the income statement for the next 3 years.
Chapter Perspective
Financial forecasting, an essential element of planning, is a vital function of financial managers.
Forecasts of future sales and their related expenses provide the business with the information needed
to project financing requirements. The chapter discussed two major methods: (1) a short-cut
technique of financial forecasting, referred to as the percent-of-sales method, and (2) the budgetary
system, including the cash budget. Financial forecasting and budgeting are simplified by the use of
electronic spreadsheet software, such as Excel.


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1 2 3 4 5 6 7 8 9 10 11 12 TOTAL
Sales $60,000 $63,000 $66,150 $69,458 $72,930 $76,577 $80,406 $84,426 $88,647 $93,080 $97,734 $102,620 $955,028
$25,200 $26,460 $27,783 $29,172 $30,631 $32,162 $33,770 $35,459 $37,232 $39,093 $41,048 $43,101 $401,112
Less: VC Cost of sales
$3,000 $3,150 $3,308 $3,473 $3,647 $3,829 $4,020 $4,221 $4,432 $4,654 $4,887 $5,131 $47,751
Operating exp.
CM $31,800 $33,390 $35,060 $36,812 $38,653 $40,586 $42,615 $44,746 $46,983 $49,332 $51,799 $54,389 $506,165
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $120,000
Less: FC Operating exp.
$21,800 $23,390 $25,060 $26,812 $28,653 $30,586 $32,615 $34,746 $36,983 $39,332 $41,799 $44,389 $386,165
Net income
Less: Tax $6,540 $7,017 $7,518 $8,044 $8,596 $9,176 $9,785 $10,424 $11,095 $11,800 $12,540 $13,317 $115,849
$15,260 $16,373 $17,542 $18,769 $20,057 $21,410 $22,831 $24,322 $25,888 $27,533 $29,259 $31,072 $270,315
NI after tax
Figure 4.3
Projected Income Statement


1 2 3 4 5 6 7 8 9 10 11 12 TOTAL
Sales $60,000$66,000 $72,600 $79,860 $87,846 $96,631 $106,294 $116,923 $128,615 $141,477 $155,625 $171,187 $1,283,057
$25,200$27,720 $30,492 $33,541 $36,895 $40,585 $44,643 $49,108 $54,018 $59,420 $65,362 $71,899
Less: VC Cost of sales $538,884
$6,000 $6,600 $7,260 $7,986 $8,785 $9,663 $10,629 $11,692 $12,862 $14,148 $15,562 $17,119
Operating exp. $64,153
CM $28,800$31,680 $34,848 $38,333 $42,166 $46,383 $51,021 $56,123 $61,735 $67,909 $74,700 $82,170
$615,867
$10,000$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000
Less: FC Operating exp. $120,000
$18,800$21,680 $24,848 $28,333 $32,166 $36,383 $41,021 $46,123 $51,735 $57,909 $64,700 $72,170
Net income $495,867
Less: Tax $5,640 $6,504 $7,454 $8,500 $9,650$10,915 $12,306 $13,837 $15,521 $17,373 $19,410 $21,651
$148,760
$13,160$15,176 $17,394 $19,833 $22,516 $25,468 $28,715 $32,286 $36,215 $40,536 $45,290 $50,519
NI after tax $347,107
Figure 4.4
Projected Income Statement


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1998 1999 2000 2001

Sales $4,500,000 $4,770,000 $5,103,900 $5,512,212
Cost of sales 2,900,000 3,045,000 3,197,250 3,357,113
Gross margin 1,600,000 1,725,000 1,906,650 2,155,100
Selling & administrative exp.
800,000 808,000 808,000 808,000
1,098,650 1,347,100
Net income 800,000 917,000
before tax
Tax
368,000 421,820 505,379 619,666
$ 432,000 $ 495,180 $ 593,271 $ 727,434
Net income
after tax
Figure 4.5
3-Year Income Projections (1998 2001)


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Chapter 5
Analyzing and Improving Management Performance
Companies must be able to measure managerial performance if they are to control operations and
achieve organizational goals. As companies grow or their activities become more complex, they
often attempt to decentralize decision making as much as possible by restructuring into several
divisions and treating each as an independent business. The managers of these subunits or segments
are evaluated on the basis of the effectiveness with which they use the assets entrusted to them.
Perhaps the most widely used single measure of success of an organization and its subunits is the rate
of return on investment (ROI). A related measure is the return to stockholders, known as the return on
equity (ROE). After studying the material in this chapter:
· You will be able to explain ROI.
· You will be able to identify the components of the Du Pont formula and explain how it can be used
for profit improvement.
· You will see how financial leverage affects the stockholder's return.
· You will have an understanding of the relationship between ROI and ROE.
Return on Investment
ROI, which relates net income to invested capital (total assets), provides a standard for evaluating
how efficiently management employs the average dollar invested in a business's assets. An increase
in ROI can translate directly into a higher return on the stockholders' equity. ROI is calculated as:
EXAMPLE 5-1
Consider the following financial data:
If Total assets = $100,000, and Net profit after taxes = $18,000


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The problem with this formula is that it tells you only how well a company utilized its assets and
how it fared compared to others in its industry. It has very little value from the standpoint of profit
planning, meaning determining ways to increase profits.
Du Pont Formula
ROI can be broken down into two factorsprofit margin and asset turnover. In the past, managers have
tended to focus only on profit margin and have ignored the turnover of assets. However, having
excessive funds tied up in assets can be just as much a drag on profitability as can excessive
expenses. The Du Pont Corporation was the first major company to recognize the importance of
looking at both net profit margin and total asset turnover in assessing the performance of an
organization. The ROI breakdown, known as the Du Pont formula, is expressed as a product of these
two factors, as shown below.
The breakdown of ROI is based on the thesis that company profitability is directly related to
management's ability to manage assets efficiently and to control expenses effectively. Net profit
margin (the percentage of profit earned on sales) is a measure of profitability or operating efficiency.
On the other hand, total asset turnover (the number of times the investment in assets turns over each
year to generate sales) measures how well a company manages its assets.
EXAMPLE 5-2
Assume the same data as in Example 5-1. Also assume sales of $200,000.
Alternatively,


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Therefore,
Financial managers can gain a great deal of insight into how to improve profitability and improve
investment strategy from this breakdown. (Net profit margin and total asset turnover are hereafter
called margin and turnover, respectively.) This breakdown has several advantages for profit
planning over the original formula:
1. It recognizes the importance of turnover as a key to overall return on investment. In fact, turnover
is just as important as profit margin in enhancing overall return.
2. It recognizes the importance of sales.
3. It stresses the possibility of trading margin for turnover in an attempt to improve the overall
performance of a company. In other words, a low turnover can be made up by a high margin, and
vice versa.
EXAMPLE 5-3
The breakdown of ROI into its two components shows that a number of combinations of margin and
turnover can yield the same rate of return, as shown below:
Margin × Turnover = ROI
(1) 9% × 2 times = 18%

(2) 6 × 3 = 18
(3) 3 × 6 = 18
(4) 2 × 9 = 18
The turnover-margin relationship and its resulting ROI are illustrated in Figure 5.1.
Is There an Optimal ROI?

No one ROI is satisfactory for all companies. Sound and successful operation results in an optimum
combination of profits, sales, and capital employed, but the precise combination necessarily varies
with the nature of the business and the characteristics of the product. An industry


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Figure 5.1
The Margin-Turnover Relationship


Page 89
whose products are tailored to customers' specifications will have different margins and turnover
ratios than an industry that mass-produces highly competitive consumer goods. For example, a
supermarket operation inherently works with low margin and high turnover, while a jewelry store
typically has a low turnover and high margin.
Using the Du Pont Formula for Profit Improvement

The breakdown of ROI into margin and turnover gives management insight into planning for profit
improvement by revealing where weaknesses existmargin or turnover, or both. Management can then
take various actions to enhance ROI:
· Improve margin
· Improve turnover
· Improve both
Improving margin, a popular way of improving performance, may be accomplished by reducing
expenses, raising selling prices, or increasing sales faster than expenses. Expenses may be reduced
by:
(a) Using less costly materials (although this can be dangerous in today's quality-oriented
environment).
(b) Automating processes as much as possible to increase labor productivity. (This will probably
increase assets, thereby reducing turnover.)
(c) Bringing discretionary fixed costs under scrutiny and curtailing or eliminating various programs.
Discretionary fixed costs include advertising, research and development, and management
development programs.
Companies that can raise selling prices and retain profitability without losing business even in poor
economic times are said to have pricing power. Pricing power is also the ability to pass on cost
increases to consumers without attracting domestic and import competition, political opposition,
regulation, or threats of product substitution. As a rule, companies that offer unique, high-quality
goods and services (where the service is more important than the cost) are most likely to have
pricing power.
Improved turnover may be achieved by increasing sales while holding the investment in assets
relatively constant or by reducing assets. Some of the strategies to reduce assets are:
(a) Disposing of obsolete and redundant inventory. Computers have made it easy to monitor
inventory continuously, allowing for better control.
(b) Devising methods to speed up the collection of receivables and to evaluate credit terms and
policies.

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(c) Identifying unused fixed assets.

(d) Using the cash obtained by implementing the previous methods to repay outstanding debts,
repurchase outstanding issues of stock, or invest in other profit-producing activities.
Figure 5.2 shows the relationship of ROI to the underlying ratiosmargin and turnoverand their
components.
EXAMPLE 5-4
Assume that management sets a 20 percent ROI as a profit target. It is currently making an 18 percent
return on its investment.
Present situation:
There are several strategies the company can use to achieve its goals.
Alternative 1: Increase the margin while holding turnover constant. Pursuing this strategy requires
maintaining current selling prices and working to increase efficiency in order to reduce expenses.
This strategy can reduce expenses by $2,000 without affecting sales and investment and thus yield a
20 percent target ROI, as follows:
Alternative 2: Increase turnover by reducing investment in assets while holding net profit and sales
constant. The company might reduce working capital or sell some land, reducing investment in assets
by $10,000 without affecting sales and net income and yielding the 20 percent target ROI as follows:
Alternative 3: Increase both margin and turnover by disposing of obsolete and redundant inventories
or by initiating an active advertising campaign. For example, the company could trim $5,000 worth
of inventory, thereby reducing the inventory holding charge by $1,000. This strategy would increase
ROI to 20 percent.

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Figure 5.2
Relationship of Factors Influencing ROI


Page 92
Excessive investment in assets is just as much of a drag on profitability as are excessive expenses. In
this case, cutting unnecessary inventories also helps reduce the costs of carrying those inventories,
thus improving both margin and turnover at the same time. In practice, alternative 3 is much more
common than alternatives 1 or 2.
Improving Return to Stockholders through Financial Leverage

Generally, a high level of management performance, defined as a high or above-average ROI,
produces a high return to equity holders. However, even a poorly managed company that suffers from
a below-average performance can generate an above-average return on the stockholders' equity, or
return on equity (ROE). It can do this through the use of borrowed funds that can magnify the returns
paid out to stockholders.
A variant on the Du Pont formula, called the modified Du Pont formula, reflects this effect. The
formula ties together the company's ROI and its degree of financial leverage, that is, its use of
borrowed funds. Financial leverage is measured by the equity multiplier (the ratio of a company's
total asset base to its equity investment or, stated another way, dollars of assets held per dollar of
stockholders' equity). This ratio, which is calculated by dividing total assets by stockholders' equity,
gives an indication of the extent to which a company's assets are financed by stockholders' equity and
borrowed funds.
The return on equity (ROE) is calculated as:
ROE measures the returns earned on both preferred and common stockholders' investments. The use
of the equity multiplier to convert the ROI to the ROE reflects the impact of the leverage (use of
debt) on the stockholders' return (see Figure 5.3).


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EXAMPLE 5-5
In Example 5-1, assume stockholders' equity of $45,000. Then,
If the company used only equity to fund its operations, ROI and ROE would both be 18 percent.
However 55 percent of the company's capital was supplied by creditors ($45,000/$100,000 = 45
percent is the equity-to-asset ratio; $55,000/$100,000 = 55 percent is the debt ratio). Since the entire
18 percent ROI goes to stockholders, who put up only 45 percent of the capital, the ROE is higher
than 18 percent. This example illustrates a successful use of leverage.
EXAMPLE 5-6
To further demonstrate the interrelationship between a company's financial structure and the return it
generates on its stockholders' investments, we compare two companies that generate $300,000 in
operating income. Both businesses have $800,000 in total assets, but they have different capital
structures. One employs no debt; the other uses $400,000 in borrowed funds. The comparative
capital structures are:
A B
Total assets $800,000 $800,000
Total liabilities
400,000
Stockholders' equity (a)
800,000 400,000
Total liabilities and stockholders' $800,000 $800,000
equity


Page 94
Figure 5.3
ROI, ROE, and Financial Leverage
Firm B pays 10 percent interest for borrowed funds. The comparative income statements and ROEs
for A and B are as follows:
Operating income $300,000 $300,000
Interest expense
(40,000)
Profit before taxes $300,000 $260,000
Taxes (30% assumed) (90,000)
(78,000)
$210,000 $182,000
Net profit
after taxes (b)

ROE [(b)/(a)] 26.25% 45.5%

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Although the absence of debt allows company A to register higher profits after taxes, the owners of
company B enjoy a significantly higher return on their investments. This contrast demonstrates the
benefits that can accrue from using debtup to a limit. Too much debt can increase a company's
financial risk and thus its cost of financing.
If the assets in which the borrowed funds are invested earn a return greater than the interest rate
required by the creditors, the leverage is positive and the common stockholders benefit. The
advantage of the modified Du Pont formula is that the company can break its ROE into a profit
margin portion (net profit margin), an efficiency-of-asset-utilization portion (total asset turnover),
and a use-of-leverage portion (equity multiplier).
Since the added interest costs created by financial leverage affect net profit margin, management
must analyze the parts of the ROE equation to determine how to earn the highest return for
stockholders and to identify the combination of asset return and leverage that will work best in its
competitive environment. Most companies try to keep a level equal to the average for their industry.
A Word of Caution
Unfortunately, leverage is a two-edged sword. If assets do not earn a rate of return high enough to
cover fixed finance charges, then stockholders suffer, since part of the profits generated by the assets
they have provided to the company must go to make up the shortfall to the long-term creditors.
Chapter Perspective
This chapter covered in detail various strategies for increasing the return on investment (ROI). The
breakdown of ROI into margin and turnover, popularly known as the Du Pont formula, provides
insight into: (a) the strengths and weaknesses of a business and its segments, and (b) what needs to
be done in order to improve performance. Another version of the Du Pont formulathe modified Du
Pont formularelates ROI to ROE (stockholders' return) through financial leverage and shows how
leverage can benefit company shareholders.


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Chapter 6
Understanding the Concept of Time Value of Money
Money has a time value; a dollar received now is worth more than a dollar to be received later. The
reasoning behind this principle does not reflect concern that inflation might reduce the buying power
of the dollar received later; it is based on the fact that you can invest the dollar now and have more
than a dollar at a specified later date.
Time value of money is a critical consideration in financial and investment decisions. It is an
element of compound interest calculations used to determine future results of investments and of
discounting, which is inversely related to compounding and is used to evaluate the future cash flow
associated with capital budgeting projects.
· You will understand the concept of future value, with both annual and intrayear compounding.
· You will be able to distinguish between future value and present value concepts.
· You will be able to calculate the future value of a single payment and an annuity.
· You will be able to calculate the present value of a single payment and an annuity.
· You will see how to utilize future value and present value tables.
· You will be able to determine some important financial variables such as a sinking fund amount, the
monthly payment of an amortized loan, and annual percentage rate (APR).
Calculating Future Values

A dollar in hand today is worth more than a dollar to be received tomorrow because of the interest
you can earn by putting it in a savings account or other investment account. Further, over time that
interest will earn interest, a practice known as compounding. For our discussion of the concepts of
compounding and time value, we define the following terms:


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Then,
The future value of an investment compounded annually at rate i for n years is
where T1 (i, n) is the compound amount of $1 (see Table 6-1).

EXAMPLE 6-1
You place $1,000 in a savings account earning 8 percent interest compounded annually. How much
money will you have in the account at the end of 4 years?
From Table 6-1, the T1 for 4 years at 8 percent is 1.361. Therefore,
EXAMPLE 6-2
You invested a large sum of money in the stock of TLC Corporation. The company paid a $3
dividend per share. The dividend is expected to increase by 20 percent per year for the next 3 years.
You wish to project the dividends for years 1 through 3.

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Intrayear Compounding
Interest is often compounded more frequently than once a year. Banks, for example, compound
interest quarterly, daily, and even continuously. If interest is compounded m times a year, then the
general formula for solving the future value becomes
The formula reflects more frequent compounding (n · m) at a smaller interest rate per period (i/m).
For example, in the case of semiannual compounding (m = 2), the above formula becomes
EXAMPLE 6-3
You deposit $10,000 in an account offering an annual interest rate of 20 percent. You will keep the
money on deposit for five years. The interest rate is compounded quarterly. The accumulated amount
at the end of the fifth year is calculated as follows:
where
Therefore,
EXAMPLE 6-4
Assume that P = $1,000, i = 8%, and n = 2 years. Then for annual compounding (m = 1):

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Semiannual compounding (m = 2):
Quarterly compounding (m = 4):
As the example shows, the more frequently interest is compounded, the greater the amount that
accumulates. This is true for any rate of interest over any period of time.
Future Value of an Annuity
An annuity is defined as a series of payments (or receipts) of a fixed amount of money for a specified
number of periods. Each payment is assumed to occur at the end of the period. The future value of an
annuity involves depositing or investing an equal sum of money at the end of each year for a certain
number of years and allowing it to grow.
Let= the future value of an n-year

Snannuity
A= the amount of an annuity
Then we can write

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where T2(i, n) represents the future value of an annuity of $1 for n years compounded at i percent
(see Table 6-2).
EXAMPLE 6-5
You wish to determine the sum of money you will have in a savings account at the end of 6 years
after depositing $1,000 at the end of each year for the next 6 years. The annual interest rate is 8
percent. The T2 (8%, 6 years) is given in Table 6-2 as 7.336. Therefore,
EXAMPLE 6-6
You deposit $30,000 semiannually into a fund for 10 years. The annual interest rate is 8 percent. The
amount accumulated at the end of the tenth year is calculated as follows:
where
Therefore,
Calculating Present Values of Money

Present value, defined as the present worth of future sums of money, is calculated by a process that is
actually the opposite of that for finding the compounded future value. In connection with present
value calculations known as discounting, the interest rate, i, is called the discount rate, more
commonly called the cost of capital, the minimum rate of return required by the investor.
(Determining the cost of capital is discussed in detail in Chapter 9.)
Recall that
Therefore,

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where T3(i, n) represents the present value of $1 (see Table 6-3).

EXAMPLE 6-7
You have been given an opportunity to receive $20,000 six years from now. If you can earn 10
percent on your investments, what is the most you should pay for this opportunity? To answer this
question, you must compute the present value of $20,000 to be received six years from now at a 10
percent rate of discount. F6 is $20,000, i is 10 percent, and n is six years. T3(10%, 6) from Table 6-
3 is 0.565.
Since you can earn 10 percent on your investment, paying $11,300 for the opportunity discussed is
pointless. In either case, you will wind up with $20,000 in six years.
Present Value of Mixed Streams of Cash Flows
The present value of a series of mixed payments (or receipts) is the sum of the present value of each
individual payment. We know that the present value of each individual payment is the payment times
the appropriate T3 value.
You are thinking of starting a new product line that will cost $32,000 up front. Your annual projected
cash inflows are:
year 1
year 2
year 3$10,000
$20,000
$5,000
If you must earn a minimum of 10 percent on your investment, should you undertake this new product
line?
The present value of this series of mixed streams of cash inflows is calculated as follows:
Year Cash Inflows ×T3(10%, n) Present Value
1 $10,000 0.909 $9,090
2 $20,000 0.826 $16,520
3 $5,000 0.751 $3,755
$29,365

Page 103
Since the present value of your projected cash inflows is less than the initial investment required,
you should not undertake this project.
Present Value of an Annuity
Interest received from bonds, pension funds, and insurance obligations all involve annuities. To
compare these financial instruments, we need to know the present value of each. The present value of
an annuity (Pn) can be found by using the following equation:
where T4(i, n) represents the present value of an annuity of $1 discounted at i percent for n years
(see Table 6-4).
EXAMPLE 6-8
Assume that the cash inflows in Example 6-7 form an annuity of $10,000 for 3 years. Then the
present value is
Perpetuities
Some annuities, called perpetuities, go on forever. An example of a perpetuity is preferred stock,
which yields a constant dollar dividend indefinitely. The present value of a perpetuity is found as
follows:
EXAMPLE 6-9
Assume that a perpetual bond has an $80-per-year interest payment and that the discount rate is 10
percent. The present value of this perpetuity


Page 104
is:
Applications of Future Values and Present Values

Future and present values have numerous applications in financial and investment decisions. Six of
the most common applications are presented below.
Calculating Deposits to Accumulate a Future Sum (or Sinking Fund)
To determine the annual deposit (or payment) that is necessary to accumulate a future sum (or sinking
fund), we can use the formula for finding the future value of an annuity.
Solving for A, we obtain:
EXAMPLE 6-10
You wish to determine the equal annual end-of-year deposits required to accumulate $5,000 at the
end of 5 years. The interest rate is 10 percent. The annual deposit is:
In other words, if you deposit $819 at the end of each year for 5 years at 10 percent interest, you will
have accumulated $5,000 at the end of the fifth year.
EXAMPLE 6-11
You need a sinking fund for the retirement of a bond 30 years from now. The interest rate is 10
percent. The annual year-end contribution needed to accumulate $1,000,000 is

Page 105
Amortized Loans
An amortized loan is a loan that is repaid in equal periodic payments. Examples include auto loans,
mortgage loans, and most commercial loans. The periodic payment can be computed as follows:
Solving for A, we obtain
EXAMPLE 6-12
You borrow $200,000 for 5 years at an interest rate of 14 percent. The annual year-end payment on
the loan is calculated as follows:
EXAMPLE 6-13
You take out a 40-month bank loan of $5,000 at a 12 percent annual interest rate. You want to find out
the monthly loan payment.
Therefore,
So, to repay the principal and interest on a $5,000, 12 percent, 40-month loan, you have to pay
$152.28 a month for the next 40 months.
EXAMPLE 6-14
Assume that a company borrows $2,000 to be repaid in three equal installments at the end of each of
the next 3 years. The bank charges 12 percent interest. The amount of each payment is

Page 106
Therefore,
Developing Loan Amortization Schedules

The breakdown of each loan payment into interest and principal is often displayed in a loan
amortization schedule. The interest component of the payment is largest in the first period (because
the principal balance is the highest) and subsequently declines, whereas the principal portion is
smallest in the first period and increases thereafter, as shown in the following example.
EXAMPLE 6-15
Using the same data as in Example 6-14, we set up the following amortization schedule:
Year Payment Interest Repayment of Principal Remaining
Balance
0
$2,000.00
1 $832.64 $240.00(a)
$592.64(b) $1,407.36
2 $832.64 $168.88
$663.76 $ 743.60
3 $832.64 $ 89.23
$743.41(c)
(a) Interest is computed by multiplying the loan balance at the beginning of the year by the
interest rate. Therefore, interest in year 1 is $2,000(0.12) = $240; in year 2, interest is
$1,407.36(0.12) = $168.88; and in year 3, interest is $743.60(0.12) = $89.23. All figures are
rounded.
(b) The reduction in principal equals the payment less the interest portion ($832.64-$240.00 =
$592.64)
(c) Not exact because of accumulated rounding errors.
Calculating Annual Percentage Rates

Different types of investments use different compounding periods. For example, most bonds pay
interest semiannually, whereas banks generally pay interest quarterly. If a financial manager wishes
to compare investments with different compounding periods, he or she needs to put them on a
common basis. The annual percentage rate or effective annual rate, which is used for this purpose, is
computed as follows:
where i = the stated, nominal, or quoted rate and m = the number of compounding periods per year.


Page 107
EXAMPLE 6-16
If the nominal rate is 6 percent, compounded quarterly, the APR is
This means that if one bank offers 6 percent with quarterly compounding, while another offers 6.14
percent with annual compounding, they are both paying the same effective rate of interest.
The annual percentage rate also is a measure of the cost of credit, expressed as a yearly rate. It
includes interest as well as other financial charges, such as loan origination and certain closing fees.
Lenders are required to disclose the APR, which provides a good basis for comparing the cost of
loans, including mortgages.
Calculating Rates of Growth
In finance, it is often necessary to calculate the compound annual rate of growth associated with a
stream of earnings. The compound annual growth rate in earnings per share is computed as follows:
Solving this for T1, we obtain
EXAMPLE 6-17
Assume that your company has earnings per share of $2.50 in 20X1 and that 10 years later the
earnings per share has increased to $3.70. The compound annual rate of growth in earnings per share
is computed as follows:
Therefore,
From Table 6-1, T1 of 1.48 at 10 years is at i = 4%. The compound annual rate of growth is
therefore 4 percent.


Page 108
Calculating Bond Values

Bonds call for the payment of a specific amount of interest, usually semiannually, for a stated number
of years and the repayment of the face value at the maturity date. Thus, a bond represents an annuity
plus a final lump sum payment. Its value is found as the present value of the payment stream.
where I= interest payment per period

= par value, or maturity value, usually
M$1,000
i= investor's required rate of return
n= number of periods
This topic is covered in more detail in Chapter 8.
EXAMPLE 6-18
Assume a 10-year bond with a 10 percent coupon pays interest semiannually and has a face value of
$1,000. Since interest is paid semiannually, the number of periods involved is twenty and the
semiannual cash inflow is $100/2 = $50.
Assume that you have a required rate of return of 12 percent for this type of bond. The present value
(V) of this bond is:
Note that the required rate of return (12 percent) is higher than the coupon rate of interest (10
percent). Therefore, the bond value (the price investors are willing to pay for this particular bond) is
less than its $1,000 face value.
Use of Financial Calculators and Spreadsheet Programs

Many financial calculators contain pre-programmed formulas for performing present-value and
future-value applications. Furthermore, spreadsheet software has built-in financial functions for
performing many such applications.


Page 109
TABLE 6-1
THE FUTURE VALUE OF $1.00
(COMPOUNDED AMOUNT OF $1.00)
(1+i)n = T1(i, n)
PERIODS
4% 6% 8% 10% 12% 14% 20%
1 1.040 1.060 1.080 1.100 1.120 1.140 1.200
2 1.082 1.124 1.166 1.210 1.254 1.300 1.440
3 1.125 1.191 1.260 1.331 1.405 1.482 1.728
4 1.170 1.263 1.361 1.464 1.574 1.689 2.074
5 1.217 1.338 1.469 1.611 1.762 1.925 2.488
6 1.265 1.419 1.587 1.772 1.974 2.195 2.986
7 1.316 1.504 1.714 1.949 2.211 2.502 3.583
8 1.369 1.594 1.851 2.144 2.476 2.853 4.300
9 1.423 1.690 1.999 2.359 2.773 3.252 5.160
10 1.480 1.791 2.159 2.594 3.106 3.707 6.192
11 1.540 1.898 2.332 2.853 3.479 4.226 7.430
12 1.601 2.012 2.518 3.139 3.896 4.818 8.916
13 1.665 2.133 2.720 3.452 4.364 5.492 10.699
14 1.732 2.261 2.937 3.798 4.887 6.261 12.839
15 1.801 2.397 3.172 4.177 5.474 7.138 15.407
16 1.873 2.540 3.426 4.595 6.130 8.137 18.488
17 1.948 2.693 3.700 5.055 6.866 9.277 22.186
18 2.026 2.854 3.996 5.560 7.690 10.575 26.623
19 2.107 3.026 4.316 6.116 8.613 12.056 31.948
20 2.191 3.207 4.661 6.728 9.646 13.743 38.338
30 3.243 5.744 10.063 17.450 29.960 50.950 237.380
40 4.801 10.286 21.725 45.260 93.051 188.880 1469.800

Page 110
TABLE 6-2
THE FUTURE VALUE
OF AN ANNUITY OF $1.00*
(COMPOUNDED AMOUNT
OF AN ANNUITY OF $1.00)

PERIODS
4% 6% 8% 10% 12% 14% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.040 2.060 2.080 2.100 2.120 2.140 2.200
3 3.122 3.184 3.246 3.310 3.374 3.440 3.640
4 4.247 4.375 4.506 4.641 4.779 4.921 5.368
5 5.416 5.637 5.867 6.105 6.353 6.610 7.442
6 6.633 6.975 7.336 7.716 8.115 8.536 9.930
7 7.898 8.394 8.923 9.487 10.089 10.730 12.916
8 9.214 9.898 10.637 11.436 12.300 13.233 16.499
9 10.583 11.491 12.488 13.580 14.776 16.085 20.799
10 12.006 13.181 14.487 15.938 17.549 19.337 25.959
11 13.486 14.972 16.646 18.531 20.655 23.045 32.150
12 15.026 16.870 18.977 21.385 24.133 27.271 39.580
13 16.627 18.882 21.495 24.523 28.029 32.089 48.497
14 18.292 21.015 24.215 27.976 32.393 37.581 59.196
15 20.024 23.276 27.152 31.773 37.280 43.842 72.035
16 21.825 25.673 30.324 35.950 42.753 50.980 87.442
17 23.698 28.213 33.750 40.546 48.884 59.118 105.930
18 25.645 30.906 37.450 45.600 55.750 68.394 128.120
19 27.671 33.760 41.446 51.160 63.440 78.969 154.740
20 29.778 36.778 45.762 57.276 75.052 91.025 186.690
30 56.085 79.058 113.283 164.496 241.330 356.790 1181.900
40 95.026 154.762 259.057 442.597 767.090 1342.000 7343.900
*Payments (or receipts) at the end of each period.

TABLE 6-3
PRESENT VALUE OF $1.00

PERIODS 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28%
1 .962 .943 .926 .909 .893 .877 .862 .847 .833 .820 .806 .794 .781
2 .925 .890 .857 .826 .797 .769 .743 .718 .694 .672 .650 .630 .610
3 .889 .840 .794 .751 .712 .675 .641 .609 .579 .551 .524 .500 .477
4 .855 .792 .735 .683 .636 .592 .552 .516 .482 .451 .423 .397 .373
5 .822 .747 .681 .621 .567 .519 .476 .437 .402 .370 .341 .315 .291
6 .790 .705 .630 .564 .507 .456 .410 .370 .335 .303 .275 .250 .227
7 .760 .665 .583 .513 .452 .400 .354 .314 .279 .249 .222 .198 .178
8 .731 .627 .540 .467 .404 .351 .305 .266 .233 .204 .179 .157 .139
9 .703 .592 .500 .424 .361 .308 .263 .225 .194 .167 .144 .125 .108
10 .676 .558 .463 .386 .322 .270 .227 .191 .162 .137 .116 .099 .085
11 .650 .527 .429 .350 .287 .237 .195 .162 .135 .112 .094 .079 .066
12 .625 .497 .397 .319 .257 .208 .168 .137 .112 .092 .076 .062 .052
13 .601 .469 .368 .290 .229 .182 .145 .116 .093 .075 .061 .050 .040
14 .577 .442 .340 .263 .205 .160 .125 .099 .078 .062 .049 .039 .032
15 .555 .417 .315 .239 .183 .140 .108 .084 .065 .051 .040 .031 .025
16 .534 .394 .292 .218 .163 .123 .093 .071 .054 .042 .032 .025 .019
17 .513 .371 .270 .198 .146 .108 .080 .060 .045 .034 .026 .020 .015
18 .494 .350 .250 .180 .130 .095 .069 .051 .038 .028 .021 .016 .012
19 .475 .331 .232 .164 .116 .083 .060 .043 .031 .023 .017 .012 .009
20 .456 .312 .215 .149 .104 .073 .051 .037 .026 .019 .014 .010 .007
21 .439 .294 .199 .135 .093 .064 .044 .031 .022 .015 .011 .008 .006
22 .422 .278 .184 .123 .083 .056 .038 .026 .018 .013 .009 .006 .004
23 .406 .262 .170 .112 .074 .049 .033 .022 .015 .010 .007 .005 .003
24 .390 .247 .158 .102 .066 .043 .028 .019 .013 .008 .006 .004 .003
25 .375 .233 .146 .092 .059 .038 .024 .016 .010 .007 .005 .003 .002
26 .361 .220 .135 .084 .053 .033 .021 .014 .009 .006 .004 .002 .002
27 .347 .207 .125 .076 .047 .029 .018 .011 .007 .005 .003 .002 .001
28 .333 .196 .116 .069 .042 .026 .016 .010 .006 .004 .002 .002 .001
29 .321 .185 .107 .063 .037 .022 .014 .008 .005 .003 .002 .001 .001
30 .308 .174 .099 .057 .033 .020 .012 .007 .004 .003 .002 .001 .001
40 .208 .097 .046 .022 .011 .005 .003 .001 .001

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TABLE 6-4
PRESENT VALUE OF AN ANNUITY OF $1 FOR N PERIODS

n
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 2.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.352 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.661 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.244 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427
40 32.835 27.356 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779
50 39.197 31.424 25.730 21.482 18.256 15.762 13.801 12.234 10.962 9.915


Page 113

n
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 .901 .893 .885 .877 .870 .862 .855 .847 .840 .833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.487 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.303 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.669 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.585 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 5.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.747 5.451 5.182 4.937
25 8.442 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
50 9.042 8.305 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999


Page 114

n
31% 32% 33% 34% 35% 36% 37% 38% 39% 40%
1 .763 .758 .752 .746 .741 .735 .730 .725 .719 .714
2 1.346 1.331 1.317 1.303 1.289 1.276 1.263 1.250 1.237 1.224
3 1.791 1.766 1.742 1.719 1.696 1.673 1.652 1.630 1.609 1.589
4 2.130 2.096 2.062 2.029 1.997 1.966 1.935 1.906 1.877 1.849
5 2.390 2.345 2.302 2.260 2.220 2.181 2.143 2.106 2.070 2.035
6 2.588 2.534 2.483 2.433 2.385 2.339 2.294 2.251 2.209 2.168
7 2.739 2.677 2.619 2.562 2.508 2.455 2.404 2.355 2.308 2.263
8 2.854 2.786 2.721 2.658 2.598 2.540 2.485 2.432 2.380 2.331
9 2.942 2.868 2.798 2.730 2.665 2.603 2.544 2.487 2.432 2.379
10 3.009 2.930 2.855 2.784 2.715 2.649 2.587 2.527 2.469 2.414
11 3.060 2.978 2.899 2.824 2.752 2.683 2.618 2.555 2.496 2.438
12 3.100 3.013 2.931 2.853 2.779 2.708 2.641 2.576 2.515 2.456
13 3.129 3.040 2.956 2.876 2.799 2.727 2.658 2.592 2.529 2.469
14 3.152 3.061 2.974 2.892 2.814 2.740 2.670 2.603 2.539 2.477
15 3.170 3.076 2.988 2.905 2.825 2.750 2.679 2.611 2.546 2.484
16 3.183 3.088 2.999 2.914 2.834 2.757 2.685 2.616 2.551 2.489
17 3.193 3.097 3.007 2.921 2.840 2.763 2.690 2.621 2.555 2.492
18 3.201 3.104 3.012 2.926 2.844 2.767 2.693 2.624 2.557 2.494
19 3.207 3.109 3.017 2.930 2.848 2.770 2.696 2.626 2.559 2.496
20 3.211 3.113 3.020 2.933 2.850 2.772 2.698 2.627 2.561 2.497
21 3.215 3.116 3.023 2.935 2.852 2.773 2.699 2.629 2.562 2.498
22 3.217 3.118 3.025 2.936 2.853 2.775 2.700 2.629 2.562 2.498
23 3.219 3.120 3.026 2.938 2.854 2.775 2.701 2.630 2.563 2.499
24 3.221 3.121 3.027 2.939 2.855 2.776 2.701 2.630 2.563 2.499
25 3.222 3.122 3.028 2.939 2.856 2.776 2.702 2.631 2.563 2.499
30 3.225 3.124 3.030 2.941 2.857 2.777 2.702 2.631 2.564 2.500
40 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
50 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
Chapter Perspective
Money received in the future is not as valuable as money received today. The time value of money is
a critical factor in many financial and investment applications, such as determining the size of
deposits necessary to accumulate a future sum and the periodic payment of an amortized loan. The
time value of money concept permits comparison of sums of money that are available at different
times. In this chapter, we developed the two basic concepts of future value and present value and
showed how these values are calculated. We also discussed their application to various financial
and investment situations.


Page 115
Chapter 7
Understanding Return and Risk
You can never predict with certainty the outcome of any financial or investment decision. Each
decision presents certain risks and return characteristics.
Because of this reality, all major decisions must be viewed in terms of expected return and expected
risk and their combined impact on the market value of your company. You must also take into account
the trade-off between the return you expect to receive from the decision and the risk you must assume
to earn.
· You will be able to define return and how it is measured.
· You will be able to distinguish between arithmetic return and geometric return.
· You will be able to calculate and understand risk statistics: the variance, standard deviation, and
coefficient of variation.
· You will be able to identify the types of risk.
· You will understand the nature of diversification and how it reduces risk.
· You will be able to calculate a beta value and understand its use in designing a portfolio.
What Is Return?
Return, a key consideration in financial and investment decisions, is simply the reward for investing.
The return on an investment consists of the following sources of income:
(a) Periodic cash payments, called current income.
(b) Appreciation (or depreciation) in market value, called capital gains (or losses).
Current income, which is received on a periodic basis, may take the form of interest, dividends, or
rent. Capital gains or losses represent changes in market value; a capital gain is the amount by which
the proceeds from the sale of an investment exceeds its original purchase


Page 116
price, while a capital loss represents the amount by which the sale price of investment falls short of
its original purchase price.
Measuring Return
How you measure the return on a given investment depends primarily on how you define the relevant
period over which you hold the investment (the holding period). The term holding period return
(HPR) refers to the total return earned from holding an investment for that period of time. It is
computed as follows:
EXAMPLE 7-1
Consider the investment in stocks A and B over a one-year period of ownership:
Stock
A B
$100 $100
Purchase price (beginning of
year)
$ $
Cash dividend received (during 13 18
the year)
$107 $
Sales price 97
(end of year)
The current income from the investment in stocks A and B over the one-year period is $13 and $18,
respectively. For stock A, a capital gain of $7 ($107 sales price - $100 purchase price) is realized
over the period. For stock B, a $3 capital loss ($97 sales price - $100 purchase price) results.
Combining the capital gain return (or loss) with the current income, the total return on each
investment is summarized as follows:
Stock
Return B
A
Cash dividend $13 $18
Capital gain (loss) 7
(3)
Total return $20 $15

Page 117
Thus, the return on investments A and B are:
Arithmetic and Geometric Average Returns

It is one thing to measure the return over a single holding period and quite another to describe a
series of returns over time. When a financial manager holds an investment for more than one period,
it is important to understand how to compute the average of the successive rates of return. Two types
of multi-period average (mean) returnsthe arithmetic average return and geometric average returnare
commonly used.
The arithmetic return is simply the arithmetic average of successive one-period rates of return. It is
defined as:
where n = the number of time periods and rt = the single holding period return in time t. The
arithmetic average return, however, can be quite misleading when it is used for multi-period return
calculations.
A more accurate measure of the actual return generated by an investment over multiple periods is the
geometric average return, commonly called the compounded annual rate of return. The geometric
return over n periods is computed as follows:
The following example illustrates the accuracy of the geometric return as a measure of return for
multiple-period situations.


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EXAMPLE 7-2
Consider the following data, in which the price of a stock doubles in one period and then depreciates
back to the original price. Dividend income (current income) is zero.
Time Periods
t = 0 t = 1 t = 2
Price (end of period) $80 $160 $80
HPR 100% -50%
The arithmetic average return is the average of 100 percent and -50 percent, which is 25 percent, as
shown below:
In reality, though, the stock purchased for $80 and sold for the same price two periods later did not
earn a 25 percent return; it clearly earned zero return. This can be shown by computing the geometric
average return.
Expected Rate of Return

A financial manager is primarily concerned with predicting future returns from an investment in a
security. This outcome is the expected rate of return. Historical (actual) rates of return can provide a
useful basis for formulating these future expectations.
Probabilities may be used to evaluate the expected return. The expected rate of return ( ) is the
weighted average of possible returns from a given investment, weights being probabilities.
Mathematically,
where ri is the ith possible return, pi is the probability of the ith return, and n4 is the number of
possible returns.


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EXAMPLE 7-3
Consider the possible rates of return, depending upon the states of the economy, recession, normal,
and prosperity, that you might earn next year on a $50,000 investment in either stock A or stock B:
Stock A
State of economy Return (ri) Probability (pi)
Recession
-5% .2
Normal
20 .6
Prosperity
40 .2
Stock B
State of economy Return (ri) Probability (pi)
Recession
10% .2
Normal
15 .6
Prosperity
20 .2
The expected rates of return can be calculated as follows:

For stock A,
For stock B,
Risk and the Risk-Return Trade-Off

The concept of a risk-return trade-off is integral to the subject of finance. All financial decisions
involve some sort of risk-return trade-off; the greater the risk, the greater the return expected. Proper
assessment and balance of the various risk-return trade-offs available is part of creating a sound
financial and investment plan. Figure 7.1 depicts the risk-return trade-off (the risk-free rate is the
rate of return commonly required on a risk-free security such as a U.S. Treasury bill).
In the case of investment in stock, you, as an investor, demand higher return from a speculative stock
to compensate for the higher level of risk. In the case of working capital management, the less
inventory you keep, the higher the expected return (since less of your current assets are tied up);
however, there is increased risk of running out of stock and thus losing potential revenue.


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Reducing Risk by Diversifying

Diversificationspreading your investments over a range of investment instruments to minimize the
risk of losing all your assets should one investment go badis one way to minimize risk. In a
diversified portfolio containing stocks, bonds, real estate, and savings accounts, the values of the
investments do not all increase or decrease at the same time or in the same magnitude, and you can
therefore protect yourself against fluctuations. Similarly, your company may diversify into different
lines of businesses that are not subject to the same economic and political influences and thus protect
itself against fluctuations in earnings.
Measuring Risk
Risk refers to variations in earnings and includes the chance you may lose money on an investment.
The standard deviation, a statistical measure of dispersion of the probability distribution of possible
returns, is one measure of risk. The smaller the deviation, the tighter the distribution and thus the
lower the riskiness of the investment. Mathematically,

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To calculate s, proceed as follows:
Step
1. First compute the expected rate of return ( ).
StepSubtract each possible return from to obtain a set of
2. deviations ( ).
Square each deviation, multiply the squared deviation by
Stepthe probability of occurrence for its respective return,
3. and sum these products to obtain the variance (s)2:
StepFinally, take the square root of the variance to obtain the

4. standard deviation (s).
EXAMPLE 7-4
To follow this step-by-step approach, it is convenient to set up a table, as follows:
Stock A
(step 1) (step 2) (step 3)
Return (ri) Probability (pi) ripi
.2 -1% -24% 576 115.2
-5%
.6 12 1 1 .6
20
.2 8 21 441 88.2
40
s2 = 204
(step 4)
s = 14.18%
Stock B
(step 1) (step 2) (step 3)
Return (ri) Probability (pi) ripi
.2 2% -5% 25 5
10%
.6 9 0 0 0
15
.2 4 5 25 5
20
s2 = 10
(step 4)
s = 3.16%
The financial manager must be careful in using the standard deviation to compare risk, since it is
only an absolute measure of dispersion (risk) and does not consider the risk in relationship to an
expected return. To compare securities with differing expected returns, managers


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commonly use the coefficient of variation, computed by dividing the standard deviation for a
security by its expected value:
The higher the coefficient, the more risky the security.

EXAMPLE 7-5
Using the following data, we can compute the coefficient of variation for each stock as follows:
Stock A Stock B
19% 15%
s 14.28% 3.16%
The coefficient of variation is computed as follows:

For stock A,
For stock B,
Although stock A produces a considerably higher return than stock B, stock A is overall more risky
than stock B, based on the computed coefficient of variation.
Types of Risk
While all investments are subject to risk, different types of risk affect various investment alternatives
differently. Among the kinds of risk that financial managers must consider are:
· Business riskthe risk that the company will have general business problems. This kind of risk
depends on changes in demand, input prices, and technological obsolescence.
· Liquidity riskthe possibility that an asset may not be sold on short notice for its market value. If an
investment must be sold at a high discount, it is said to have a substantial amount of liquidity risk.
· Default riskthe risk that the issuing company is unable to make interest payments or principal
repayments on debt. For example, there is a great amount of default risk inherent in the bonds of a
company experiencing financial difficulty.
· Market riskrisk associated with changes in stock price resulting from broad swings in the stock
market as a whole. The prices of many stocks are affected by trends such as bull or bear markets.
· Interest rate riskfluctuations in the value of an asset as the interest rates and conditions of the
money and capital markets change.


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Interest rate risk applies to fixed income securities, such as bonds and real estate. As a rule, for
example, if interest rates rise (fall), bond prices fall (rise).
· Purchasing power riskthe possibility that you will receive a lesser amount of purchasing power
than was originally invested. Bonds are most affected by this risk since the issuer repays them in
cheaper dollars during an inflationary period.
Beta
That portion of a security's risk (called unsystematic risk) that is unique to that security can be
controlled through diversification. Business, liquidity, and default risks fall into this category.
Nondiversifiable risk, more commonly referred to as systematic risk, results from forces outside the
company's control and is therefore not unique to the given security. Purchasing power, interest rate,
and market risks fall into this category. Systematic risk is measured by beta.
Beta (b) measures a security's volatility relative to an average security. A particular stock's beta can
help you predict how much the security will go up or down, provided that you know which way the
market will go, and therefore figure out risk and expected return.
Most of the unsystematic risk affecting a security can be diversified away in an efficiently
constructed portfolio; therefore, this type of risk does not need to be compensated with a higher level
of return. The only relevant risk for which the investor can expect to receive compensation is
systematic risk or beta risk.
Under the capital asset pricing model (CAPM), there is a relationship between a stock's expected
(or required return) and its beta. The following formula is very helpful in determining a stock's
expected return.
In words,
Expected return = Risk-free rate + Beta × (Market risk premium)
where rj = the expected (or required) return on security j; rf = the risk-free rate on a security such as
a T-bill; rm = the expected return on the market portfolio (such as Standard & Poor's 500 Stock
Composite Index or Dow Jones 30 Industrials); and b = beta, an index of systematic
(nondiversifiable, noncontrollable) risk.
The market risk premium (rm - rf), which equals the expected market return (rm) minus the risk-free
rate (rf), is the additional return above that which you could earn on, say, a T-bill, to compensate for
your assuming a given level of risk (as measured by beta). Thus, the


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formula shows that the required (expected) return on a given security is equal to the return required
for securities that have no risk plus a risk premium.
The idea behind the formula is that the relevant measure of risk is the risk of the individual security,
or its beta. The higher the beta for a security, the greater the return expected (or demanded) by the
investor.
EXAMPLE 7-6
Assume that rf = 6 percent and rm = 10 percent. If a stock has a beta of 2.0, its risk premium should
be 14 percent:
This means that you would expect (or demand) an extra 8 percent (risk premium) on this stock on top
of the risk-free return of 6 percent. Therefore, the total expected (required) return on the stock should
be 14 percent:
How to Read Beta

Beta (b) measures a security's volatility relative to an average security; it is a measure of a security's
return over time compared to that of the overall market. For example, if your company's beta is 2.0
and the stock market goes up 10 percent, your company's common stock goes up 20 percent; if the
market goes down 10 percent, your company's stock price goes down 20 percent. There are general
standards for interpreting betas:
Beta What It Means
The security's return is independent of the market. An example is a risk-free
0 security such as a T-bill.
0.5 The security is only half as responsive as the market.
1.0 The security has the same responsive or risk as the market (i.e., average risk).
This is the beta value of the market portfolio such as Standard & Poor's 500 or
Dow Jones 30 Industrials.
2.0 The security is twice as responsive, or risky, as the market.
An investment portfolio with high beta stocks will do poorly in a bear market but offer better returns
in a bull market; Table 7-1 shows betas for selected stocks.


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TABLE 7-1
BETA VALUES FOR SELECTED STOCKS (APRIL
1999)
Company Beta Value
Microsoft 1.4
Pfizer 0.9
Intel 1.4
Wal-Mart 0.9
GTE 0.6
General Motors 1.1
IBM 1.3
AOL 2.5
Source: AOL Personal Finance Channel and MSN
Money Central Investor
(http://investor.msn.com), April 12, 1999.
Chapter Perspective
Risk and return are two of the major factors you should consider in making financial and investment
decisions. Always remember that the higher the return, the higher the risk. Beta can help you estimate
the expected return and risk of a security. In order to reduce the risk, you might want to diversify
your investment holdings.
The chapter covered a wide range of tools and measures associated with return and risk. The need to
understand the different types of risk was emphasized.


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Chapter 8
Valuing Stocks and Bonds
Valuation is the process of determining the worth (or value) of an asset. Just like a company's
investors, the company's financial managers must have a good understanding of how to value its
stocks, bonds, and other securities to judge whether or not they are a good buy. Failure to understand
the concepts and computational procedures used in valuing a security may preclude the managers'
making sound financial decisions that maximize the value of the company's common stock.
In this chapter, we use the concept of the time value of money to analyze the values of bonds and
stocks and discuss basic bond and stock valuation models under varying assumptions. In all cases,
bond and stock values are the present value of the future cash flows expected from the security.
· The key inputs and concepts underlying the security valuation process.
· How to value bonds.
· How to identify and calculate various yields on a bond.
· How to distinguish between preferred stock and common stock.
· The various methods of common stock valuation.
· How to determine the investor's expected rate of return on preferred stock and common stock.
Valuing a Security
The process of determining the value of a security involves finding the present value of the asset's
expected future cash flows using the investor's required rate of return. The basic security valuation
model can be defined mathematically as follows:


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where V= intrinsic value or present value of a security

= expected future cash flows in period t = 1, . . .,
Ctn
r= the investor's required rate of return
Bonds
A bond is a certificate or security certifying that its holder loaned funds to a company in return for
fixed future interest and repayment of principal.
Certain terms and features are commonly used to describe bonds, including:
· Par valuethe face value (maturity value), usually $1,000.
· Coupon ratethe nominal interest rate that determines the actual interest to be received on a bond. It
is an annual interest based on par value. For example, if you own a $1,000 bond having a coupon
rate of 6 percent, you will receive an annual interest payment of $60.
· Maturity datethe final date on which repayment of the bond principal is due.
· Yieldthe effective interest rate you are earning on the bond investment. The yield is different than
the coupon interest rate. If a bond is bought below its face value (i.e., purchased at a discount), the
yield is higher than the coupon rate; if it is acquired above face value (i.e., bought at a premium), the
yield is below the coupon rate.
Valuing Bonds
To value a bond, you need to know three basic elements: (1) the amount of the cash flows to be
received by the investor, equal to the periodic interest to be received and the par value to be paid at
maturity; (2) the maturity date of the loan; and (3) the investor's required rate of return.
The periodic interest can be received annually or semiannually. The value of a bond is simply the
present value of these cash flows. Two versions of the bond valuation model are presented below.
If the interest payments are made annually, then

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where
I= interest payment each year

= coupon interest rate × par value
M= par value, or maturity value, typically $1,000
r= the investor's required rate of return
n= number of years to maturity
T4
= present value interest factor of an annuity of
$1 (which can be found in Table 6-4 in
Chapter 6)
T3
= present value interest factor of $1 (which
can be found in Table 6-3 in Chapter 6)
Both T4 and T3 were discussed in detail in Chapter 6 on the time value of money.
EXAMPLE 8-1
Consider a bond, maturing in 10 years and having a coupon rate of 8 percent. The par value is
$1,000. Investors consider 10 percent to be an appropriate required rate of return in view of the risk
level associated with this bond. The annual interest payment is $80 (8% × $1,000). The present
value is:
If the interest is paid semiannually, then


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EXAMPLE 8-2
Assume the same data as in Example 8-1, except the interest is paid semiannually.
Calculating Yield (Effective Rate of Return) on a Bond

Bonds are evaluated on many different types of returns, including current yield and yield to maturity.
Current Yield
The current yield is the annual interest payment divided by the current price of the bond. This figure
is reported in The Wall Street Journal, among other newspapers.
EXAMPLE 8-3
Assume a 12 percent coupon rate $1,000 par value bond selling for $960. The current yield is:
The problem with this measure of return is that it does not take into account the maturity date of the
bond. A bond with 1 year to run and another with 15 years to run would have the same current yield
quote if interest payments were $120 and the price were $960. Clearly, the 1-year bond would be
preferable under this circumstance because you would get not only $120 in interest but also a gain of
$40 ($1000 $960).
Yield to Maturity
The expected rate of return on a bond, better known as the bond's yield to maturity, is computed by
solving the following equation (the bond valuation model) for r:


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Because the yield to maturity takes into account the maturity date of the bond, it is the real return you
would receive from interest income plus capital gain, assuming you hold the bond to maturity.
Finding the bond's yield r involves trial and error. It is best explained by an example.
EXAMPLE 8-4
Suppose you are offered a 10-year, 8 percent coupon, $1,000 par value bond at a price of $877.60.
What rate of return could you earn if you bought the bond and held it to maturity? Recall that in
Example 8-1 the value of the bond ($877.60) was obtained using the required rate of return of 10
percent. Compute this bond's yield to see if it is 10 percent.
First, set up the bond valuation model:
Since the bond is selling at a discount under the par value ($877.60 versus $1,000), the bond's yield
is above the going coupon rate of 8 percent. Therefore, try a rate of 9 percent. Substituting factors for
9 percent in the equation, we obtain:
The calculated bond value, $935.44, is above the actual market price of $877.60, so the yield is not
9 percent. To lower the calculated value, the rate must be raised. Trying 10 percent, we obtain:
This calculated value is exactly equal to the market price of the bond; thus, 10 percent is the bond's
yield to maturity.


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The formula that can be used to find the approximate yield to maturity on a bond is:
where
I= dollars of interest paid per year
= the par value, typically $1,000 per
Mbond
V= a bond's current value (price)
n= number of years to maturity
This formula can also be used to obtain a starting point for the trial-and-error method discussed in
Example 8-4.
EXAMPLE 8-5
Using the same data as in Example 8-4 and the short-cut method, the rate of return on the bond is:
Since the bond was bought at a discount, the yield (9.8 percent) is actually greater than the coupon
rate of 8 percent.
Preferred Stock
Preferred stock carries a fixed dividend that is paid quarterly and that is stated in dollar terms per
share or as a percentage of par (stated) value of the stock. It is considered a hybrid security because
it possesses features of both common stock and corporate bonds. It resembles common stock in that:
· It represents equity ownership and is issued without stated maturity dates.
· It pays dividends.
However, it is like a corporate bond in that:
· It provides for prior claims on earnings and assets.
· Its dividend is fixed for the life of the issue.
· It can carry call and convertible features and sinking fund provisions.
Since preferred stocks are traded on the basis of the yield offered to investors, they are viewed as
fixed income securities and, as a result,


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compete with bonds in the marketplace. Convertible preferred stock (which can be exchanged for
common stock), however, trades more like common stock, depending on conversion prices.
Valuing Preferred Stock

The value of preferred stock is the present worth of a series of equal cash flow streams (dividends),
continuing indefinitely. Since the dividends in each period are equal for preferred stock, the
valuation model is:
where
V= present value of a preferred stock
D= annual dividend
= the investor's required rate of
rreturn
EXAMPLE 8-6
ABC preferred stock pays an annual dividend of $4.00. You, as an investor, require a 16% return on
your investment. Then the value of the ABC preferred stock can be determined as follows:
Calculating Expected Return on Preferred Stock

To compute the preferred stockholder's expected rate of return, we use the valuation equation for
preferred stock presented in Example 8-6. Solving it for r,
which indicates that the expected rate of return of a preferred stock equals the dividend yield (annual
dividend/market price).
EXAMPLE 8-7
A preferred stock paying $5.00 a year in dividends and having a market price of $25 would have a
current yield of 20%, computed as follows:
Common Stock
Common stock is an equity investment that represents the ownership of a corporation. It is the
equivalent of the capital account for a sole proprietorship or capital contributed by each partner for
a partnership.
The corporation's stockholders have certain rights and privileges including:
· Control of the firm. The stockholders elect the company's directors, who in turn select officers to
manage the business.


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· Preemptive rights. This is the right to purchase new stock. A preemptive right entitles a common
stockholder to maintain his or her proportional ownership through the opportunity to purchase, on a
pro rata basis, any new stock being offered or any securities convertible into common stock.
A distinction should be made between growth and value stocks. A growth stock shows better market
price and profit potential. However, it pays little or no dividends. A value stock is underpriced
and/or has high dividends.
Valuing Common Stock

The value of a common stock is the present value of all future cash inflows expected to be received
by the investor, including dividends and the future price of the stock at the time it is sold.
Single Holding Period
For an investor holding a common stock for only one year, the value of the stock is the present value
of both the expected cash dividend to be received in one year (D1) and the expected market price
per share of the stock at year-end (P1). If r represents an investor's required rate of return, the value
of common stock (P0) is:
EXAMPLE 8-8
Assume an investor is considering the purchase of stock A at the beginning of the year. The dividend
at year-end is expected to be $1.50, and the market price by the end of the year is expected to be
$40. If the investor's required rate of return is 15%, the value of the stock is:
Multiple Holding Period

Since common stock has no maturity date and can be held for many years, a more general, multi-
period model is needed to project its value.


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The common stock valuation model is:
where Dt = dividend in period t.

Dividends may be classified as zero growth or constant growth. In the case of zero growth (i.e., D0
= D1 = . . . = D), then the valuation model is:
This model is most applicable to the valuation of preferred stocks or to the common stocks of very
mature companies, such as large utilities.
EXAMPLE 8-9
Assuming dividend (D) equals $2.50 and r equals 10 percent, then the value of the stock is:
In the case of constant growth, if we assume that dividends grow at a constant rate of g every year
[i.e., Dt = D0(1 + g)t], then the general model is:
In words,
This formula, known as the Gordon's valuation model, is most applicable to the valuation of the
common stock of very large or broadly diversified firms.
EXAMPLE 8-10
Consider a common stock that paid a $3 dividend per share at the end of the last year and is expected
to pay a cash dividend every year at a growth rate of 10 percent. Assume the investor's required rate
of return is 12 percent. The value of the stock is:

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Calculating the Expected Return on Common Stock

The formula for computing the expected rate of return on common stock can be derived easily from
the valuation models.
The single-holding period return formula is derived from:
Solving for r gives:
In words,
This formula is the same as the holding period return (HPR), introduced in Chapter 7.
EXAMPLE 8-11
Consider a stock that sells for $50. The company is expected to pay a $3 cash dividend at the end of
the year, and the stock market price at the end of the year is expected to be $55 a share. Thus the
expected return is:
or:

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Assuming a constant growth in dividends, the formula for the expected rate of return on an investment
in stock is:
Solving for r gives:
EXAMPLE 8-12
Suppose that your company's dividend per share is $4.50 and that it is expected to grow at a constant
rate of 6 percent. The current market price of the stock is $30. Then the expected rate of return is:
Chapter Perspective
In this chapter we have discussed the valuation of bonds, preferred stock, and common stock.
Valuation is a present value concept that involves estimating future cash flows and discounting them
at a required rate of return. The value of a bond is essentially the present value of all future interest
and principal payments; the value of a stock is a function of the expected future dividends and the
rate of return required by investors (the Gordon's market valuation model). The chapter also
discussed how to calculate the expected return from a stock investment and the yield on a bond.


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Chapter 9
Cost of Capital
The cost of capital is defined as the rate of return that a company must offer on its securities in order
to maintain its market value. Financial managers must know the cost of capital in order to (1) make
capital budgeting decisions, (2) help to establish the optimal capital structure, and (3) make
decisions concerning leasing, bond refunding, and working capital management. The cost of capital
is computed as a weighted average of the various capital components, items on the right-hand side of
the balance sheet such as debt, preferred stock, common stock, and retained earnings.
· You will be able to compute individual costs of financing including long-term debt, bonds,
preferred stock, common stock, and retained earnings.
· You will be able to determine the overall cost of capital.
· You will be able to discuss the various weighting schemes.
· You will be able to explain how the weighted marginal cost of capital can be used with the
investment opportunity schedule to find the optimal capital budget.
Computing Individual Costs of Capital

Each element of capital has a component cost that is identified by the following:
ki= before-tax cost of debt

= Ki(1 - t) = after-tax cost of debt, where t = tax
kdrate
kp= cost of preferred stock
ks= cost of retained earnings (or internal equity)
ke
= cost of external equity capital, or cost of issuing
new common stock
ko
= company's overall cost of capital, or a weighted
average cost of capital


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Cost of Debt
You can compute before-tax cost of debt by determining the internal rate of return (or yield to
maturity) on the bond cash flows. However, there is a short-cut formula that may be used for
approximating the yield to maturity on a bond:
where I= annual interest payments in dollars

M= par or face value, usually $1,000 per bond
= market value or net proceeds from the sale of a
Vbond
n= term of the bond n years
Since the interest payments are tax deductible, you must state the cost of debt on an after-tax basis,
which is:
where t is the tax rate.

EXAMPLE 9-1
Assume that the Carter Company issues a $1,000, 8 percent, 20-year bond whose net proceeds are
$940. The tax rate is 40 percent. Then, the before-tax cost of debt, ki, is:
Therefore, the after-tax cost of debt is:
Cost of Preferred Stock

The cost of preferred stock, kp, is found by dividing the annual preferred stock dividend, dp, by the
net proceeds from the sale of the preferred stock, p, as follows:

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Since preferred stock dividends are not tax deductible, no tax adjustment is required.
EXAMPLE 9-2
Suppose that the Carter Company has preferred stock that pays a $13 dividend per share and sells
for $100 per share in the market. The flotation (or underwriting) cost is 3 percent, or $3 per share.
Then the cost of preferred stock is:
Cost of Equity Capital

The cost of common stock, ke, is generally viewed as the rate of return investors require on a
company's common stock. There are two widely used techniques for measuring the cost of common
stock equity capital: the Gordon's growth model and the capital asset pricing model (CAPM)
approach.
The Gordon's Growth Model
The Gordon model is:
where
Po= value (or market price) of common stock
D1= dividend to be received in one year
r= investor's required rate of return
= rate of growth (assumed to be constant
gover time)
Solving the model for r yields the formula for the cost of common stock:
The symbol r is changed to ke to show that it is used for the computation of cost of capital.
EXAMPLE 9-3
Assume that the market price of the Carter Company's stock is $40. The dividend to be paid at the
end of the coming year is $4 per share; it is expected to grow at a constant annual rate of 6 percent.
Then the cost of this common stock is:


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The cost of new common stock, or external equity capital, is higher than the cost of existing common
stock because of the flotation costs involved in selling the new stock. Flotation costs, sometimes
called issuance costs, are the total costs of issuing and selling a security, including printing and
engraving, legal fees, and accounting fees.
If f is flotation cost in percent, the formula for the cost of new common stock is:
EXAMPLE 9-4
Assume the same data as in Example 9-3, except that the corporation is trying to sell new issues of
stock A and its flotation cost is 10 percent. Then:
The Capital Asset Pricing Model Approach

To use this alternative approach to measuring the cost of common stock, you must:
1. Estimate the risk-free rate, rf, generally taken to be the U.S. Treasury bill rate.
2. Estimate the stock's beta coefficient, b, which is an index of systematic (or nondiversifiable
market) risk.
3. Estimate the rate of return on the market portfolio, rm, such as the Standard & Poor's 500 Stock
Composite Index or Dow Jones 30 Industrials.
4. Estimate the required rate of return on the company's stock using the CAPM equation:

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Again, note that the symbol rj is changed to ke.

EXAMPLE 9-5
Assuming that rf is 7%, b is 1.5, and rm is 13%, then:
This 16 percent cost of common stock consists of a 7 percent risk-free rate plus a 9 percent risk
premium, reflecting the fact that the stock price is 1.5 times more vulnerable than the market
portfolio to the factors affecting nondiversifiable, or systematic, risk.
The Arbitrage Pricing Model
The CAPM assumes that required rates of return depend only on one risk factor, the stock's beta. The
Arbitrage Pricing Model (APM) disputes this and includes any number of risk factors:
where
r= the expected return for a given stock or portfolio
rf= the risk-free rate
bi
= the sensitivity (or reaction) of the returns of the
stock to unexpected changes in economic forces i(i
= 1, . . ., n)
RPi
= the market risk premium associated with an
unexpected change in the ith economic force
n= the number of relevant economic forces
The following five economic forces are suggested:
· Changes in expected inflation.
· Unanticipated changes in inflation.
· Unanticipated changes in industrial production.
· Unanticipated changes in the yield differential between low- and high-grade bonds (the default-risk
premium).
· Unanticipated changes in the yield differential between long- and short-term bonds (the term
structure of interest rates).
EXAMPLE 9-6
Suppose returns required in the market by investors are a function of two economic factors according
the following equation, where the risk-free rate is 7 percent:

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ABC stock has the reaction coefficients to the factors, such that b1 = 1.3 and b2 = 0.90. Then the
required rate of return for the ABC stock is
Cost of Retained Earnings

The cost of retained earnings, ks, is closely related to the cost of existing common stock, since the
cost of equity obtained by retained earnings is the same as the rate of return investors require on the
company's common stock. Therefore,
Measuring the Overall Cost of Capital

The firm's overall cost of capital is the average of the individual capital costs, weighted by the
proportion of each type of capital used. If ko is the overall cost of capital:
ko
= Percentage of the total capital structure

supplied by each source of capital

× Cost of capital for each source
= wdkd + wpkp + weke + wsks
where
wd= % of total capital supplied by debts
wp= % of total capital supplied by preferred stock
we= % of total capital supplied by external equity
ws
= % of total capital supplied by retained earnings
(or internal equity)
The weights can be historical, target, or marginal.

Historical Weights
Historical weights are based on a company's existing capital structure and are used if management
believes that the existing capital structure is optimal and therefore should be maintained in the future.
There are two types of historical weightsbook value weights and market value weights.
Book Value Weights
The use of book value weights to calculate a company's weighted cost of capital assumes that new
financing will be raised using the same method the company used for its present capital


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structure. The weights are determined by dividing the book value of each capital component by the
sum of the book values of all the long-term capital sources. A sample computation follows:
EXAMPLE 9-7
Assume the following capital structure and cost of each source of financing for the Carter Company:
Cost
$20,000,000 5.14% (from Example
Mortgage bonds ($1,000 9-1)
par)
5,000,000 13.40% (from Example
Preferred stock ($100 9-2)
par)
20,000,000 17.11% (from Example
Common stock ($40 par) 9-4)
5,000,000 16.00% (from Example
Retained earnings 9-3)
Total 50,000,000
The book value weights and the overall cost of capital are computed as follows:
Source Weights Cost Weighted Cost
Book
Value
Debt $20,000,000 40% (a) 5.14% 2.06% (b)
Preferred stock 5,000,000 10 13.40% 1.34
Common stock 20,000,000 40 17.11% 6.84
Retained earnings 5,000,000 10 16.00% 1.60
Total $50,000,000100% 11.84%
Overall cost of capital = k0 = 11.84%
(a) $20,000,000/$50,000,000 = .40 = 40%
(b) 5.14% × 40% = 2.06%
Market Value Weights

Market value weights are determined by dividing the market value of each source by the sum of the
market values of all sources. This approach for computing a company's weighted average cost of
capital is considered more accurate than the use of book value weights because the market values of
the securities closely approximate the actual dollars to be received from their sale.


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EXAMPLE 9-8
In addition to the data from Example 9-7, assume that the security market prices are as follows:
The number of securities in each category is:
Therefore, the market value weights are:

Source Number of Securities Price Market Value
Debt 20,000 $1,100 $22,000,000
Preferred stock 50,000 $ 90 4,500,000
Common stock 500,000 $ 80 40,000,000
$66,500,000
The $40 million common stock value must be split in the ratio of 4 to 1 ($20 million common stock
and $5 million retained earnings in the original capital structure), since the market value of the
retained earnings has been impounded into the common stock.
The company's cost of capital is as follows:
Source Market Value Weights Cost Weighted Average
Debt $22,000,000 33.08% 5.14%
1.70%
Preferred stock 4,500,000 13.40% 0.91
6.77
Common stock 32,000,000 48.12 17.11% 8.23
Retained earnings 8,000,000 12.03 16.00% 1.92
$66,500,000 100.00% 12.76%

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Target Weights
If the company has a target capital structure (that is, a desired debt-equity mix) that it maintains over
the long term, then the use of that capital structure and associated weights can be used in calculating
the weighted cost of capital.
Marginal Weights
Marginal weights using the actual financial mix proposed for financing investments can also be used
for calculating the weighted cost of capital. This approach, while attractive, presents a problem. The
cost of capital for the individual sources depend on the company's financial risk, which is affected
by its financial mix. If the company alters its present capital structure, the individual costs will
change, making it more difficult to compute the weighted cost of capital. For this method to work,
financial managers must be able to assume that the company's financial mix is relatively stable and
that current weights will closely approximate future financing practice.
EXAMPLE 9-9
The Carter Company is considering raising $8 million for plant expansion. Management estimates
using the following mix for financing this project:
Debt $4,000,000 50%
Common stock 2,000,000 25%
Retained earnings 2,000,000 25%
$8,000,000 100%
The company's cost of capital is computed as follows:

Source Marginal Weights Cost Weighted Cost
Debt 50% 5.14% 2.57%
Common stock 25 17.11% 4.28
Retained earnings 25 16.00% 4.00
100% 10.85%
Level of Financing and the Marginal Cost of Capital

In Example 9-9, the weighted cost of capital was determined with the assumption that no new
common stock was to be issued. If new common stock is in fact to be issued, the weighted cost of
capital


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will increase for each dollar of new financing, in order to allow for the flotation costs associated
with external equity capital. Therefore, companies generally prefer to use the lower-cost capital
sources first.
A schedule or graph relating the company's cost of capital to the level of new financing is called the
weighted marginal cost of capital (MCC). This schedule determines the discount rate to be used in
the capital budgeting process. The steps to be followed in calculating the marginal cost of capital are
summarized below.
1. Determine the cost and the percentage of financing for each source of capital (debt, preferred
stock, common stock equity).
2. Compute the break points on the MCC curve where the weighted cost will increase. The formula
for computing the break points is:
3. Calculate the weighted cost of capital over the range of total financing between break points.
4. Construct a MCC schedule or graph that shows the weighted cost of capital for each level of total
new financing. This schedule will be used in conjunction with the company's available investment
opportunities schedule (IOS) in order to select the investments. As long as a project's internal rate
of return (IRR) is greater than the marginal cost of new financing, the project should be accepted.
The point at which the IRR intersects the MCC gives the optimal capital budget.
EXAMPLE 9-10
A company is contemplating three investment projects, A, B, and C, whose initial cash outlays and
expected IRR are shown below. IOS for these projects is:
Project Cash Outlay IRR
A $2,000,000 13%
B $2,000,000 15%
C $1,000,000 10%
If these projects are accepted, the financing will consist of 50 percent debt and 50 percent common
stock. The company expects to have $1.8 million in earnings available for reinvestment (internally
generated funds). The company will consider only the effects of increases in the cost of common
stock on its marginal cost of capital.


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1. The costs of capital for each source of financing have been computed and are given below:
Source Cost
Debt 5%
Common stock ($1.8 million) 15%
New common stock 19%
If the firm uses only internally generated common stock, the weighted cost of capital is:
In this case, the capital structure is composed of 50 percent debt and 50 percent internally generated
common stock. Thus,
If the company uses only new common stock, the weighted cost of capital is:
Range of Total Type of Capital Proportion Cost Weighted Cost

New Financing
(in millions of dollars)
$0 $3.6 Debt 0.5 5% 2.5%
Internal common 0.5 15% 7.5
10.0%
$3.6 and up Debt 0.5 5% 2.5%
New common 0.5 19% 9.5
12.0%
2. Next compute the break point, the level of financing at which the weighted cost of capital
increases.

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Figure 9.1
MCC Schedule and IOS Graph
3. The company may be able to finance $3.6 million in new investments with internal common stock
and debt without changing the current mix of 50 percent debt and 50 percent common stock.
Therefore, if the total financing is $3.6 million or less, the cost of capital is 10 percent.
4. Construct the MCC schedule on the IOS graph to obtain the discount rate in order to determine
which project to accept and to show the optimal capital budget (see Figure 9.1).
The company should continue to invest up to the point where the IRR equals the MCC. The graph in
Figure 9.1 shows that the company should invest in projects B and A, since each IRR exceeds the
marginal cost of capital. It should reject project C since its cost of capital is greater than the IRR.
The optimal capital budget is $4 million, the sum of the cash outlay required for projects A and B.


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Chapter Perspective
Cost of capital is the rate of return that must be achieved in order for the price of a company's stock
to remain unchanged and is therefore the minimum acceptable rate of return for the company's new
investments. The chapter discussed how to calculate the individual costs of financing sources,
various ways to calculate the overall cost of capital, and how to construct the optimal budget for
capital spending. Financial officers should be thoroughly familiar with the ways to compute the costs
of various sources of financing for financial, capital budgeting, and capital structure decisions.


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Chapter 10
How to Make Capital Budgeting Decisions
Capital budgeting is the process of making long-term investment decisions that further the company's
goals. The stockholders have entrusted the company with their money, and they expect the company
to invest their money wisely. Investments in fixed assets should be consistent with the goal of
maximizing the market value of the firm.
Companies must make many financial decisions in order to grow, including selecting product lines,
disposing of business segments, choosing to lease or buy equipment, and selecting investments. To
make long-term investment decisions in accordance with the company's goals, you must perform
three tasks when evaluating capital budgeting projects: (1) estimate cash flows, (2) estimate the cost
of capital (or required rate of return), and (3) apply a decision rule to determine whether a project
will be good for the company.
· You will know the types and special features of capital budgeting decisions.
· You will be able to calculate, interpret, and evaluate five capital budgeting techniques.
· You will be able to select the best mix of projects to implement with a limited capital spending
budget.
· You will understand how income tax factors affect decisions.
· You will understand different methods of calculating depreciation.
· You will be familiar with the effect of Accelerated Cost Recovery System (ACRS) on capital
budgeting decisions.
Types of Investment Projects

Your company must make two types of long-term investment decisions:
1. Selection decisionsdetermining whether to obtain new facilities or expand existing facilities.
Typically, such decisions involve:
(a) Investments in property, plant, and equipment and other types of assets.


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(b) Resource commitments in the form of new product development, market research, introduction
of a computer, refunding of long-term debt, etc.
(c) Mergers and acquisitions, that is, buying another company to acquire a new product line.
2. Replacement decisionsdeciding to replace existing facilities with new facilities, such as opting to
replace an old machine with a hightech machine.
Features of Investment Projects

Long-term investments have three important characteristics:
1. They typically involve a large initial cash outlay, which usually has a long-term impact on the
company's profitability. Therefore, this initial cash outlay must be justified on a cost-benefit basis.
2. They generate recurring cash inflows (for example, increased revenues or savings in cash
operating expenses). Because much of this income or savings occurs years into the future, managers
must consider the time value of money.
3. Income tax factors may be critical in whether a project is cost-effective. Therefore, they must be
taken into account in every capital budgeting decision.
Measuring Investment Worth

Several methods of evaluating investment projects are used by financial managers. They include:
1. Payback period
2. Accounting rate of return (ARR)
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Profitability index (or cost/benefit ratio)
Payback Period
The payback period is the length of time it will take the company to recover its initial investment. It
is computed by dividing the initial investment by the cash inflows generated by either increased
revenues or cost savings.


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EXAMPLE 10-1
Assume:
Cost of investment
Annual after-tax cash $18,000
savings $3,000
Then, the payback period is:
As a rule, it is wiser to choose the project with the shorter payback period. Such projects are less
risky and have greater liquidity.
EXAMPLE 10-2
Consider two projects with uneven after-tax cash inflows. Assume each project costs $1,000.
Cash Inflow
Year A($) B($)
1 100 500
2 200 400
3 300 300
4 400 100
5 500
6 600
When cash inflows are not even, you must find the payback period by trial and error. The payback
period of project A is ($1,000 = $100+ $200 + $300 + $400), or 4 years. The payback period of
project B is ($1,000 = $500 + $400 + $100):
Project B is the project of choice in this case, since it has the shorter payback period.
The advantages of using the payback period method of evaluating an investment project are that (1) it
is simple to compute and easy to understand, and (2) it handles investment risk effectively. The
shortcomings of this method are that (1) it does not recognize the time value of money, and (2) it
ignores the impact of cash inflows received after the payback period, which determine the project's
profitability.


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Accounting Rate of Return

Accounting rate of return (ARR) measures profitability by relating either the required investment or
the average investment to future annual net income.
As a decision, you should select the project with the higher rate of return.
EXAMPLE 10-3
Consider the following investment:
Initial investment
Estimated life
Cash inflows per year $6,500
Depreciation per year 20 years
(using straight-line $1,000
method) $325
The accounting rate of return for this project is:
If average investment (usually assumed to be one-half the original investment) is used, then:
The advantages of this method are that it is easily understandable and simple to compute and it
recognizes the importance of profitability. Its shortcomings are that it fails to recognize the time
value of money and that it uses accounting data instead of cash flow data.
Net Present Value
Net present value (NPV) is the excess of the present value (PV) of future cash inflows to be
generated by the project over the amount of the initial investment (I):
The present value of future cash flows is computed using the so-called cost of capital (or minimum
required rate of return) as the discount rate. With an annuity, the present value is
where A is the amount of the annuity. The value of T4 is found in Table 6-4 in Chapter 6.


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If NPV is positive, you should accept the project. If it is not, you should reject it.
EXAMPLE 10-4
Consider the following investment:
Initial investment
Estimated life
Annual cash inflows
Cost of capital $12,950
(minimum 10 years
required rate of $3,000
return) 12%
Present value of the cash inflows is:

PV = A · T4(i, n)
= $3,000 · T4(12%, 10 years)
= $3,000(5.650) $16,950
Initial investment (I) 12,950
Net present value (NPV = PV I) $ 4,000
Since the NPV of the investment is positive, the investment should be accepted.
The advantages of the NPV method are that it recognizes the time value of money and it is easy to
compute, whether the cash flows form an annuity or vary from period to period.
Internal Rate of Return
Internal rate of return (IRR) is defined as that rate of interest that equates the initial investment I with
the present value (PV) of future cash inflows. In other words, at IRR,
or
Generally, you should accept the project if the IRR exceeds the cost of capital.
EXAMPLE 10-5
Assume the same data given in Example 10-4, and set the following equality (I = PV):

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which stands somewhere between 18 percent and 20 percent in the 10-year line of Table 6-4. The
interpolation follows:

PV of an Annuity of $1 Factor T4 (i, 10 years)
18% 4.494
4.494
IRR 4.317
20%
4.192
Difference0.177
0.302
Therefore,
Since the IRR of the investment is greater than the cost of capital (12 percent), you should accept the
project.
The advantage of using the IRR method is that it considers the time value of money and therefore is
more exact and realistic than the ARR method. However, it is time-consuming to compute, especially
when the cash inflows are not even (most business calculators have a program to calculate IRR), and
it fails to recognize the different sizes of investment required for competing projects.
When cash inflows are not even, IRR is computed by the trial and error method, which is not
discussed here. Many financial calculators have a key for IRR calculations.
Can a Computer Help?

Spreadsheet programs can be used in making IRR calculations. For example, Excel has a function
IRR(values, guess). Excel considers negative numbers as cash outflows such as the initial
investment and positive numbers as cash inflows. Many financial calculators have similar features.
As in Example 10-5, suppose that you want to calculate the IRR of a $12,950 investment (the value -
12950 entered in year 0 that is followed by 10 monthly cash inflows of $3,000. Using a guess of 12
percent (the value of 0.12), which is in effect the cost of capital), your formula would be
@IRR(values, 0.12) and Excel would return 19.15 percent, as shown here.


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Year 0 1 2 3 4 5 6 7 8 9 10
$ (12,950) 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
IRR = 19.15%
NPV = $4,000.67
Note: The Excel formula for NPV is NPV (discount rate, cash inflow values) + I, where I is
given as a negative number.
Profitability Index
The profitability index is the ratio of the total present value of future cash inflows to the initial
investment, that is, PV/I. This index is used as a means of ranking projects in descending order of
attractiveness. If the profitability index is greater than 1, then you should accept the project.
EXAMPLE 10-6
Using the data in Example 10-4, the profitability index is
Since the project generates $1.31 for each dollar invested (i.e., its profitability index is greater than
1), you should accept the project.
The profitability index has the advantage of putting all projects on the same relative basis regardless
of size.
Selecting the Best Mix of Projects for a Limited Budget

Many companies limit their overall budgets for capital spending. Capital rationing is the process of
selecting that mix of acceptable projects that provides the highest overall net present value (NPV).
The profitability index is widely used in ranking projects competing for limited funds.
EXAMPLE 10-7
A company with a fixed capital spending budget of $250,000 needs to select a mix of acceptable
projects from the following:
Projects I($) PV($) NPV($) Profitability Index Ranking
A 70,000 112,000 42,000 1.6 1
B 100,000 145,000 45,000 1.45 2
C 110,000 126,500 16,500 1.15 5
D 60,000 79,000 19,000 1.32 3
E 40,000 38,000 -2,000 0.95 6
F 80,000 95,000 15,000 1.19 4

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The ranking derived from the profitability index shows that the company should select projects A, B,
and D.
I PV
A $70,000 $112,000
B 100,000 145,000
D 60,000 79,000
$230,000 $336,000
Therefore,
Zero-one programming, a special case of linear programming, is a more general approach to

solving capital rationing problems. Here the objective is to select that mix of projects that maximizes
the net present value (NPV) subject to a budget constraint. Using the data given in Example 10-7, we
can set up the problem as a zero-one programming problem such that
The problem then can be formulated as follows:

Maximize
subject to
Using the zero-one programming solution routine, the solution to the problem is:
and the NPV is $106,000. Thus, projects A, B, and D should be selected.

The strength of the use of zero-one programming is its ability to handle mutually exclusive and
interdependent projects. For further information on this subject, consult an advanced finance
textbook.


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Handling Mutually Exclusive Investments

A mutually exclusive project is one whose acceptance automatically precludes the acceptance of one
or more other projects (for example, choosing between two alternative uses of a single plot of land).
If you must choose between mutually exclusive investments, you may find that the NPV and IRR
methods may result in contradictory indications under certain conditions:
1. If the projects have different life expectancies.
2. If the projects call for different amounts of investment capital.
3. If the projects are expected to yield different cash flows over time-if, for example, the cash flows
of one project will increase over time while those of the other will decrease.
The contradictions between the NPV and the IRR methods result from different assumptions
concerning the reinvestment rate on cash flows from the projects. The NPV method discounts all
cash flows at the cost of capital, thus implicitly assuming that these cash flows can be reinvested at
this rate; on the other hand, the IRR method assumes that cash flows are reinvested at the often
unrealistic rate specified by the project's internal rate of return. Thus, the implied investment rate
differs from project to project.
The relative desirability of mutually exclusive projects depends on the rate of return the subsequent
cash flows can earn. The NPV method generally gives correct ranking, since the cost of capital is the
more realistic reinvestment rate; the cost of capital usually closely approximates the market rate of
return.
EXAMPLE 10-8
Assume the following:
Cash Flows
0 1 2 3 4 5
A (100) 120
B (100) 201.14
Computing IRR and NPV at 10 percent gives the following different rankings:
IRR NPV at 10%
A 20% 9.01
B 15% 24.90
The difference in ranking between the two methods is caused by the methods' reinvestment rate
assumptions. The IRR method assumes


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Figure 10.1
NPV Profiles for Projects A and B
project A's cash inflow of $120 is reinvested at 20 percent for the subsequent four years; the NPV
method assumes $120 is reinvested at 10 percent. The correct decision is to select the project with
the higher NPV (that is, Project B), since the NPV method assumes a more realistic reinvestment rate
(the cost of capital, 10 percent in this example).
The net present value plotted against various discount rates (costs of capital) results in the NPV
profiles for projects A and B (Figure 10.1). An analysis of Figure 10.1 indicates that at a discount
rate larger than 14%, A has a higher NPV than B, and should therefore be selected. At a discount rate
less than 14%, B has a higher NPV than A and thus should be selected.
The Effect of Income Taxes on Investment Decisions

Income taxes make a difference in many capital budgeting decisions; often, projects that appear
attractive on a before-tax basis have to be rejected when income taxes are factored in. Income taxes
typically affect both the amount and the timing of cash flows. Since net income, not cash inflows, is
subject to tax, after-tax cash inflows are usually different from after-tax net income. Let us define:
S = Sales
= Cash operating
E expenses
d = Depreciation
t = Tax rate

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Then, before-tax cash inflows (or before-tax cash savings) = S - E and net income = S - E - d.
By definition,
Rearranging gives the short-cut formula:
Depreciation may be deducted from sales when you are computing net income subject to taxes. This
reduces the company's income tax payments and thus serves as a tax shield.
EXAMPLE 10-9
Assume:
S = $12,000
E= $10,000
= $500 per year using the straight-line
d method
t = 30%
Then,
The higher the depreciation deduction, the higher the tax savings on depreciation. Therefore, using an
accelerated depreciation method (such as double-declining balance) produces higher initial tax
savings than the straight-line method. Accelerated methods produce higher present values for the tax
savings, which may make a given investment more attractive.


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EXAMPLE 10-10
The Shalimar Company estimates that it can save $2,500 a year in cash operating costs for the next
ten years if it buys a special-purpose machine at a cost of $10,000. No salvage value is expected.
Assume that the income tax rate is 30 percent and the after-tax cost of capital (minimum required rate
of return) is 10 percent. Depreciation by straight-line is $10,000/10 = $1,000 per year.
Thus,
To see if this machine should be purchased, the net present value can be calculated.
Thus,
Since NPV is positive, the machine should be bought.
Depreciation Methods
The most commonly used depreciation methods are the straight-line method and two accelerated
methods, sum-of-the-years'-digits (SYD) and the double-declining-balance (DDB).
Straight-Line Method
The easiest and most popular method of calculating depreciation, straight-line depreciation results in
equal periodic depreciation deductions. This method is most appropriate when an asset's use is
uniform from period to period, as is the case with furniture. The annual depreciation expense is
calculated by using the following formula:

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EXAMPLE 10-11
An auto is purchased for $20,000 and has an expected salvage value of $2,000. The auto's estimated
life is eight years. Its annual depreciation is calculated as follows:
An alternative means of computation is to multiply the depreciable cost ($18,000) by the annual
depreciation rate, which is 12.5 percent in this example. The annual rate is calculated by dividing
the number of years of useful life into one (1/8 = 12.5%). The result is the same: $18,000 × 12.5% =
$2,250.
Sum-of-the-Years'-Digits Method
This method uses a ratio in which the numerator is the number of years of life expectancy in reverse
order, and the denominator is the sum of the digits. For example, if the life expectancy of a machine
is eight years, write the numbers in reverse order: 8, 7, 6, 5, 4, 3, 2, 1. The sum of these digits is 36,
or (8 + 7 + 6 + 5 + 4 + 3 + 2 + 1). Thus, the fraction for the first year is 8/36, while the fraction for
the last year is 1/36. The sum of the eight fractions equals 36/36, or 1. Therefore, at the end of eight
years, the machine is written down to its salvage value.
The following formula may be used to find the sum-of-the-years'-digits (S) quickly:
where N represents the number of years of expected life.

EXAMPLE 10-12
In Example 10-11, the depreciable cost is $18,000 ($20,000 - $2,000). Using the SYD method, the
computation for each year's depreciation expense is

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Year Fraction Depreciation Amount ($) Depreciation
× = Expense
1 8/36 $18,000 $4,000
2 7/36 18,000 3,500
3 6/36 18,000 3,000
4 5/36 18,000 2,500
5 4/36 18,000 2,000
6 3/36 18,000 1,500
7 2/36 18,000 1,000
8 1/36 18,000 500
Total $18,000
Double-Declining-Balance Method
In the double-declining-balance method, depreciation expense is highest in the early years of the
asset's life and decreases in the later years. First, you determine a depreciation rate by doubling the
straight-line rate. For example, if an asset has a life of 10 years, the straight-line depreciation rate is
1/10 or 10 percent, whereas the double-declining rate is 20 percent. Second, you calculate
depreciation expense by multiplying the depreciation rate by the book value of the asset at the
beginning of each year. Since book value declines over time, the depreciation expense decreases
each successive period.
This method ignores salvage value. However, the book value of the fixed asset at the end of its useful
life cannot be below its salvage value.
EXAMPLE 10-13
Assume the data in Example 10-11. Since the straight-line rate is 12.5 percent (1/8), the double-
declining-balance rate is 25 percent (2 × 12.5%). The depreciation expense is computed as follows:
Year Book Value at × Rate Depreciation Year-end Book
Beginning of Year (%) = Expense Value
1 $20,000 25% $5,000 $15,000
2 15,000 25 3,750 11,250
3 11,250 25 2,813 8,437
4 8,437 25 2,109 6,328
5 6,328 25 1,582 4,746
6 4,746 25 1,187 3,559
7 3,559 25 890 2,669
8 2,669 25 667 2,002

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If the original estimated salvage value had been $2,100, the depreciation expense for the eighth year
would have been $569 ($2,669 - $2,100) rather than $667, since the asset cannot be depreciated
below its salvage value.
Capital Budgeting Decisions and the Modified Accelerated Cost Recovery System
Although the traditional depreciation methods still can be used for computing depreciation for book
purposes, 1981 saw a new way of computing depreciation deductions for tax purposes. The current
rule is called the Modified Accelerated Cost Recovery System (MACRS) rule, as enacted by
Congress in 1981 and then modified somewhat in 1986 under the Tax Reform Act of 1986. This rule
is characterized as follows:
1. It abandons the concept of useful life and accelerates depreciation deductions by placing all
depreciable assets into one of eight age property classes. It calculates deductions, based on an
allowable percentage of the asset's original cost (see Tables 10-1 and 10-2).
With a shorter asset tax life than useful life, the company would be able to deduct depreciation more
quickly and save more in income taxes in the earlier years, thereby making an investment more
attractive. The rationale behind the system is that this way the government encourages the company to
invest in facilities and increase its productive capacity and efficiency. (Remember that the higher the
d, the larger the tax shield (d)(t).)
2. Since the allowable percentages in Table 10-1 add up to 100 percent, there is no need to consider
the salvage value of an asset when computing depreciation.
3. The company may elect the straight-line method. The straight-line convention must follow what is
called the half-year convention. This means that the company can deduct only half of the regular
straight-line depreciation amount in the first year. The reason for electing to use the MACRS
optional straight-line method is that some firms may prefer to stretch out depreciation deductions
using the straight-line method rather than to accelerate them. Those firms are the ones that just start
out or have little or no income and wish to show more income on their income statements.
EXAMPLE 10-14
Assume that a machine falls under a three-year property class and costs $3,000 initially. The
straight-line option under MACRS differs from the traditional straight-line method in that under this
method the


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company would deduct only $500 depreciation in the first and fourth years ($3,000/3 years =
$1,000; $1,000/2 = $500). The following table compares straight-line with half-year convention
with MACRS.
Year Straight-line (half-year) Cost MACRS MACRS
Depreciation % Deduction
1 $ 500 $3,000 $ 999
× 33.3%
2 1,000 3,000 44.5 1,335
×
3 1,000 3,000 14.8
× 444
4 3,000 7.4
500 × 222
$3,000 $3,000
EXAMPLE 10-15
A machine costs $10,000. Annual cash inflows are expected to be $5,000. The machine will be
depreciated using the MACRS rule and will fall under the 3-year property class. The cost of capital
after taxes is 10%. The estimated life of the machine is 4 years. The salvage value of the machine at
the end of the fourth year is expected to be $1,200. The tax rate is 30%.
The formula for computation of after-tax cash inflows (S - E)(1 - t) + (d)(t) needs to be computed
separately. The NPV analysis can be performed as follows:
Present Value Factor @ Present
10% Value
Initial investment: 1.000 $(10,000.00)
$10,000
3.170* $11,095.00
* T4 (10%, 4 years) = 3.170 (from Table 6-4).
(d)(t): Cost MACRS d (d)(t) Present Value @ Present

Year % 10% Value
1 $10,000 33.3% $3,330 $ .909* 908.09
× 999
2 $10,000 44.5 4,450 1,335 .826* 1,102.71
×
3 $10,000 14.8 1,480 .751* 333.44
× 444
4 $10,000 7.4 .683* 151.63
× 740 222


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Salvage value: Present Value @ Present
10% Value
683* 573.72
$1,200 in year 4: $1,200 (1 - .3) =
840**
Net present value (NPV) $4,164.59
* T3 values obtained from Table 6-3.
** Any salvage value received under the MACRS rules is a taxable
gain (the excess of the selling price over book value, $1,200 in this
example), since the book value will be zero at the end of the life of the
machine.
Since NPV = PV - I = $4,164.59 is positive, the machine should be bought.
Chapter Perspective
In this chapter, we have examined the process of evaluating investment projects. We have discussed
five commonly used criteria for evaluating capital budgeting projects, including the net present value
(NPV) and internal rate of return (IRR) methods. The problems that arise with mutually exclusive
investments and capital rationing were addressed. Since income taxes often make a difference in
whether a project is accepted, we examined the role of factors in financial decisions.
Although the traditional depreciation methods still can be used for computing depreciation for book
purposes, since 1981 a new rule, called the Modified Accelerated Cost Recovery System
(MACRS), has been available to businesses. The use of MACRS and an overview of the traditional
depreciation methods were presented.


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TABLE 10-1
MODIFIED ACCELERATED COST RECOVERY
SYSTEM CLASSIFICATION OF ASSETS
Property class
Year 3-year 5-year 7-year 10-year 15-year 20-year
1 33.3% 20.0% 14.3% 10.0% 5.0% 3.8%
2 44.5 32.0 24.5 18.0 9.5 7.2
3 14.8* 19.2 17.5 14.4 8.6 6.7
4 7.4 11.5* 12.5 11.5 7.7 6.2
5 11.5 8.9* 9.2 6.9 5.7
6 5.8 8.9 7.4 6.2 5.3
7 8.9 6.6* 5.9* 4.9
8 4.5 6.5 5.9 4.5*
9 6.5 5.9 4.5
10 3.3 5.9 4.5
11 5.9 4.5
12 5.9 4.5
13 5.9 4.5
14 5.9 4.5
15 5.9 4.5
16 3.0 4.4
17 4.4
18 4.4
19 4.4
20 4.4
21 2.2
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
* Denotes the year of changeover to straight-line depreciation.

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TABLE 10-2
MACRS TABLES BY PROPERTY CLASS
Property class
MACRS Useful Life Examples of Assets
Property Class (ADR
and Midpoint
Depreciation Life*)
Method
3-year 4 years or Most small tools are included; the law specifically
property 200% less excludes autos and light trucks from this
declining property class.
balance
5-year More than Autos and light trucks, computers, typewriters,
property 200% 4 years to copiers, duplicating equipment, heavy general-
declining less than 10 purpose trucks, and research and experimentation
balance years equipment are included.
7-year 10 years or Office furniture and fixtures and most items of
property 200% more to machinery and equipment used in production are
declining less than 16 included.
balance years
10-year 16 years or Various machinery and equipment, such as that
property 200% more to used in petroleum distilling and refining and in the
declining less than 20 milling of grain, are included.
balance years
15-year 20 years or Sewage treatment plants, telephone and electrical
property 150% more to distribution facilities, and land improvements are
declining less than 25 included.
balance years
20-year 25 years or Service stations and other real property with an
property 150% more ADR midpoint life of less than 27.5 years are
declining included.
balance
27.5-year Not All residential rental property is included.
property applicable
Straight-line
31.5-year Not All nonresidential real property is included.
property applicable
Straight-line
* The term ADR midpoint life means the ''useful life" of an asset in a
business sense; the appropriate ADR midpoint lives for assets are designated
in the tax Regulations.


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Chapter 11
Leverage and Capital Structure
In Chapter 8 we developed an understanding of how securities are valued in the marketplace, and
then, in Chapter 9, we presented various ways to measure the cost of funds to the company. The
concepts to be covered in this chapter relate closely to those discussions of the valuation process
and the cost of capital and extend to the crucial problem of determining the company's optimal
capital structure. First, we discuss the concept of leverage and how it impacts on the company's
profits; we then discuss how to build an appropriate financing mix.
Leverage is that portion of a company's fixed costs that represent a risk to the firm. Operating
leverage, a measure of operating risk, refers to the fixed operating costs found in the income
statement. Financial leverage, a measure of financial risk, refers to a long-term financing with fixed
financing charges, of the company's assets. The higher the financial leverage, the higher the financial
risk and therefore the higher the cost of capital. The optimal capital structure for any company
depends to a great extent on the amount of leverage the company can tolerate and the resultant cost of
capital.
· The basics of break-even analysis and operating leverage and how they relate to each other.
· How to measure operating leverage and financial leverage and distinguish between them.
· How to apply the EBIT-EPS approach to evaluate alternative financing plans.
· How to determine the best capital structure.
Break-Even Analysis, Operating Leverage, and Financial Leverage

Break-even analysis, which is closely related to operating leverage, determines break-even salesthe
financial crossover point at which revenues exactly match costs. Although this analysis does not
show


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up in corporate earnings reports, financial officers find it an extremely useful measurement. Let us
define:
S= Sales ($)
x= Sales volume in units
p= Selling price per unit
v= Unit variable cost
VC= Variable operating costs
FC= Fixed operating costs
We also note the following important concepts.
· Contribution margin (CM)the excess of sales (S) over the variable costs (VC) of the product. It is
the amount of money available to cover fixed costs (FC) and to generate profits. Symbolically, CM =
S - VC.
· Unit CMthe excess of the unit selling price (p) over the unit variable cost (v). Symbolically, unit
CM = p - v.
EXAMPLE 11-1
To illustrate these concepts, consider the following data for company Z:
Total Per Unit Percentage
Sales (1,500 units) $37,500 $25 100%
Less: Variable costs 15,000 10 40
Contribution margin $22,500 $15
60%
Less: Fixed costs 15,000
Net income $7,500
From the data listed above, CM and unit CM are computed as:
Break-Even Point
The break-even point represents the level of sales revenue that equals the total of the variable and
fixed costs for a given volume of output at a particular capacity use rate. Generally, the lower the
break-even point, the higher the profits and the less the operating risk, other things being equal. You
can determine the break-even point by setting sales just equal to the total of the variable costs plus
the fixed costs:


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That is,
EXAMPLE 11-2
Using the data from Example 11-1, in which unit CM = $25 $10 = $15, we get:
Cash Break-Even Point

If a company has a small amount of available cash or if the opportunity cost of holding excess cash is
too high, management may want to know the volume of sales necessary to cover all cash expenses
during a period. This is known as the cash break-even point. Not all fixed operating costs involve
cash payments; for example, depreciation expenses are noncash fixed charges. To find the cash
break-even point, you must subtract noncash charges from fixed costs. As a result, the cash break-
even point is usually lower than the break-even point. The formula is:
EXAMPLE 11-3
Assume from Example 11-1 that the total fixed costs of $15,000 include depreciation of $1,500. The
cash break-even point is:
Company Z has to sell 900 units to cover only its fixed cash costs of $13,500.


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Operating Leverage
Operating leverage, a measure of operating risk, arises from the company's use of fixed operating
costs. A simple indication of operating leverage is the impact of a change in sales on earnings before
interest and taxes (EBIT). The formula is:
EXAMPLE 11-4
The Wayne Company manufactures and sells doors to home builders. The doors are sold for $25
each. Variable costs are $15 per door, and fixed operating costs total $50,000. Assume further that
the Wayne Company is currently selling 6,000 doors per year. Its operating leverage is:
which means if sales increase by 10 percent, the company can expect its net income to increase by
six times that amount, or 60 percent.
It's important to note that all types of leverage are two-edged swords. When sales decrease by some
percentage, the impact on EBIT of that decrease will be an even larger percentage decline.
Financial Leverage
Financial leverage is a measure of financial risk that arises from the presence of debt and/or
preferred stock in the company's capital structure. One way to measure financial leverage is to
determine how earnings per share (EPS) is affected by a change in EBIT. When financial leverage is
used, changes in EBIT translate into larger changes in EPS. If EBIT falls, a financially leveraged
company will experience negative


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changes in EPS that are larger than the relative decline in EBIT. Again, leverage is a two-edged
sword.
where EPS is earnings per share and I is fixed finance charges, such as interest expense or preferred
stock dividends. [Preferred stock dividend must be adjusted for taxes, i.e., preferred stock dividend
divided by (1 - t).]
EXAMPLE 11-5
Using the data in Example 11-4, the Wayne Company has total financial charges of $2,000, half in
interest expense and half in preferred stock dividends. The corporate tax rate is 40 percent. First, the
fixed financial charges are:
Therefore, Wayne's financial leverage is computed as follows:
which means that if EBIT increases by 10 percent, Wayne can expect its EPS to increase by 1.36
times, or by 13.6 percent.
Total Leverage
Total leverage is a measure of total risk. To measure total leverage, determine how EPS is affected
by a change in sales.

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EXAMPLE 11-6
From Examples 11-4 and 11-5, the total leverage for Wayne Company is:
or
Tools of Capital Structure Management

Capital structure management, which is closely related to cost of capital, is the mix of long-term
funding sources used by the company. Its primary objective is to maximize the market value of the
company. This mix, called the optimal capital structure, minimizes the overall cost of capital.
However, not all financial managers believe that an optimal capital structure actually exists.
Disputes over this question center on whether a business can, in reality, affect its valuation and its
cost of capital by varying the mixture of the funds it uses.
The decision to use debt and/or preferred stock in capitalization results in two types of financial
leverage effects. The first effect is an increased risk to earnings per share (EPS) caused by the use of
fixed financial obligations. The second effect relates to the level of EPS at a given EBIT under a
specific capital structure. EBIT-EPS analysis is used to measure this second effect.
EBIT-EPS Approach to Capital Structure Decisions
EBIT-EPS analysis is a practical tool that enables financial managers to evaluate alternative
financing plans by investigating their effect on EPS for a range of EBIT levels. Its primary objective
is to determine the EBIT break-even, or indifference, points at which the EPS will be the same
regardless of the financing plan chosen by the financial manager.
This indifference point has major implications for capital structure decisions. At EBIT amounts in
excess of the EBIT indifference level, a more heavily leveraged financing plan will generate a
higher EPS. At EBIT amounts below the EBIT indifference level, however, the financing plan
involving the least leverage will generate a higher EPS. Therefore, it is of critical importance for the
financial manager to know the EBIT indifference level.


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The indifference points between any two methods of financing can be determined by solving for
EBIT in the following equation:
where
t= tax rate
PD= preferred stock dividends
S1
and
S2
= number of shares of common stock
outstanding after financing for plan 1
and plan 2, respectively.
EXAMPLE 11-7
Assume that ABC Company, with long-term capitalization consisting entirely of $5 million in stock,
wants to raise $2 million for the acquisition of special equipment by (1) selling 40,000 shares of
common stock at $50 each, (2) selling bonds at 10 percent interest, or (3) issuing preferred stock
with an 8 percent dividend. The present EBIT is $800,000, the income tax rate is 50 percent, and
100,000 shares of common stock are now outstanding. To compute the indifference points, begin by
calculating EPS at a projected EBIT level of $1 million.
All All Debt All
Common Preferred
EBIT $1,000,000 $1,000,000 $1,000,000
Interest 200,000
Earnings before taxes
(EBT) $1,000,000 $ $1,000,000
800,000
Taxes 500,000 400,000 500,000
Earnings after taxes
(EAT) $ 500,000 $ $ 500,000
400,000
Preferred stock dividend 160,000
Earnings available to common $ 500,000 $ $ 340,000
stockholders 400,000
Number of shares 140,000 100,000 100,000
EPS $3.57 $4.00 $3.40
Using Figure 11.1 as a model, connect the EPSs at the level of EBIT of $1 million with the EBITs for
each financing alternative on the horizontal axis to obtain the EPS-EBIT graphs. Plot the EBIT
necessary


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Figure 11.1
EPS-EBIT Graph
to cover all fixed financial costs for each financing alternative on the horizontal axis. The common
stock plan has no fixed costs, so the intercept on the horizontal axis is zero. The debt plan calls for
an EBIT of $200,000 to cover interest charges, so the horizontal axis intercept is at that point. The
preferred stock plan requires an EBIT of $320,000 [$160,000/(1 0.5)] to cover $160,000 in
preferred stock dividends at a 50 percent income tax rate; so $320,000 becomes the horizontal axis
intercept. (See Figure 11.1.)
In this example, the indifference point between all common and all debt is:

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Rearranging yields:
Similarly, the indifference point between all common and all preferred would be:
Rearranging yields:
Based on the preceding computations and observing Figure 11.1 we can draw the following
conclusions:
1. At any level of EBIT, debt is better than preferred stock, since it gives a higher EPS.
2. At a level of EBIT above $700,000, debt is better than common stock. If EBIT is below $700,000,
the reverse is true.
3. At a level of EBIT above $1,120,000, preferred stock is better than common. At or below that
point, the reverse is true.
Financial leverage can magnify profits, but it can also increase losses. The EBIT-EPS approach
helps financial managers examine the impact of financial leverage as a financing method.
Analysis of Corporate Cash Flows
A second tool of capital structure management is the analysis of cash flows. When considering the
appropriate capital structure, it is important to analyze the company's cash flow in order to determine
its ability to service fixed charges. The greater the dollar amount of debt and/or preferred stock the
company issues and the shorter their maturity, the greater the fixed charges the company will have to
bear. These charges include principal and interest payments on debt, lease payments, and preferred
stock dividends. Before assuming additional fixed charges that will require cash outlays, the
company should analyze its expected future cash flows, because the inability to meet these future
charges,


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with the exception of preferred stock dividends, may result in insolvency. The greater and more
stable the expected future cash flows of the company, the greater its debt capacity.
Coverage Ratios
A third tool for capital structure management is the calculation of comparative coverage ratios.
Among the ways to gain insight into the debt capacity of a business is through the use of coverage
ratios, which were introduced in Chapter 3. In the computation of these ratios, a corporate financial
officer typically uses EBIT as a rough measure of the cash flow available to cover debt-servicing
obligations. Perhaps the most widely used coverage ratio is times interest earned, which is simply:
Assume that the most recent annual EBIT for a company was $4 million and that interest payments on
all debt obligations were $1 million. Therefore, times interest earned would be four times. This
indicates that even if EBIT drops by as much as 75 percent, the company will still be able to cover
its interest payments out of earnings. However, a coverage of ratio of only 1.0 indicates that earnings
are just sufficient to satisfy the interest burden. While it is difficult to generalize as to what is an
appropriate interest coverage ratio, a financial officer usually is concerned when the ratio gets much
below 3:1. However, the standard for this ratio can vary. In a highly stable industry, a relatively low
times-interest-earned ratio may be acceptable, whereas it is not appropriate in a highly cyclical one.
Unfortunately, the times-interest-earned ratio reveals nothing about the company's ability to meet
principal payments on its debt. The inability to meet a principal payment constitutes the same legal
default as failure to meet an interest payment. Therefore, it is useful to compute the coverage ratio
for the full debt-service burden. This ratio is
Because EBIT represents earnings before taxes, principal payments are adjusted upward to
compensate for the tax effect. Principal payments are not tax deductible; they must be paid out of
after-tax earnings. Therefore, you should adjust principal payments so that they are consistent with
EBIT. If EBIT equals $4 million, interest equals $1 million, principal payments equal $1.5 million,
and the tax rate is 34 percent,


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the debt-service coverage ratio would be
A coverage ratio of 1.22 means that EBIT can fall by only 22% before earnings coverage become
insufficient to service the debt. Obviously, the closer the ratio is to 1.0, the worst things are, all other
things being equal. However, even with a coverage ratio of less than 1.0, a company may still meet
its obligations if it can refinance some of its debt when it comes due.
The financial risk associated with leverage should be analyzed on the basis of the company's ability
to service total fixed charges. While lease financing is not debt per se, it has exactly the same impact
on cash flows as the payment of interest and principal on a debt obligation. Therefore, annual lease
payments should be added to the denominator of the formula in order to reflect the total cash-flow
burden.
Coverage ratios can be used for two types of comparison. First, they can be compared with past and
expected future ratios for the same company in order to determine if there has been an improvement
or a deterioration in coverage over time. A second method for analyzing a company's capital
structure is to evaluate the capital structure of other companies in the same industry. If a company is
contemplating a capital structure that is significantly out of line with that of similar companies,
potential investors will quickly notice the disparity. This is not to say, however, that the company's
decision is wrong; other companies in the industry may be too conservative in their use of debt. The
optimal capital structure for all companies in the industry may allow a higher proportion of debt to
equity than the actual industry average; as a result, the company may well be able to justify more
debt than the industry average. Because investment analysts and creditors tend to evaluate companies
by industry, however, it should be able to justify its position if its capital structure is noticeably out
of line in either direction.
Ultimately, financial officers want to be able to make generalizations about the appropriate amount
of debt (and leases) for a company. Because, over the long run, the source of funds with which to
service debt is earnings, coverage ratios are an important analytical tool. However, they are subject
to certain limitations and consequently cannot be used as the sole means for determining the capital
structure. For one thing, the fact that EBIT falls below the debt-service burden does not spell
immediate doom for the company; often, alternative sources


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of funds, including renewal of a loan, are available, and these sources must be considered.
Making Capital Structure Decisions in Practice

How do companies decide in practice which route to follow in raising capital? The decision is
complex and is related to a company's balance sheet, market conditions, outstanding obligations, and
a host of other factors.
Many financial managers believe that the following factors influence capital structure:
1. Growth rate and stability of future sales
2. Competitive structure in the industry
3. Asset makeup of the individual firm
4. The business risk to which the firm is exposed
5. Control status of owners and management
6. Lenders' attitudes toward the industry and the company
Surveys indicate that the majority of financial managers in large firms believe in the concept of an
optimal capital structure, approximated by target debt ratios. The most frequently mentioned factor
that affects the level of the target debt ratio is the company's ability to service fixed financing costs;
other factors include (1) maintaining a desired bond rating, (2) providing an adequate borrowing
reserve, and (3) exploiting the advantages of financial leverage.
Chapter Perspective
The chapter discussed the process of arriving at an appropriate capital structure for the firm. Tools
that can assist financial officers in this task were examined. We first discussed assessing the
variability in earnings per share induced by operating leverage and financial leverage. This
assessment built upon the principles of break-even analysis.
In deciding upon an appropriate capital structure, financial managers should consider a number of
factors, including the relationship between earnings before interest and taxes and earnings per share
for alternative methods of financing. In addition, the financial manager can learn much from a
comparison of capital structure ratios and coverage ratios (such as times interest earned and debt-
service coverage) for similar companies and over time for the company in question.


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Chapter 12
Using Working Capital Management Effectively
Effective management of working capital (current assets less current liabilities) improves returns
and minimizes the risk that the company will run short of cash. By optimally managing cash,
receivables, and inventory, a company can maximize its rate of return and minimize its liquidity and
business risk. The amount invested in each current asset may change daily and should be monitored
carefully to ensure that funds are used in the most productive way possible. Large account balances
may also indicate risk; for example, inventory may not be salable and/or accounts receivable may
not be collectible. On the other hand, maintaining inadequate current asset levels may be costly;
business may be lost if inventory is too low.
Cash refers to currency and demand deposits; excess funds may be invested in marketable securities.
Cash management involves accelerating cash inflow and delaying cash outflow. Accounts receivable
management involves selecting customers with good credit standing and speeding up customer
collections. Inventory management involves having the optimal order size at the right time.
· How to accelerate cash receipts.
· How to delay cash payments.
· How to determine an optimal cash balance.
· The types of marketable securities.
· How to manage accounts receivable.
· What credit and discount policies may be advisable.
· How to manage inventory.
· Computing the carrying cost and ordering cost of inventory.
· How to determine how much inventory to order each time and when to order it.


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Evaluating Working Capital

Working capital equals current assets less current liabilities. If current assets are $6,500,000 and
current liabilities are $4,000,000, working capital equals $2,500,000. Managing working
capitalregulating the various types of current assets and current liabilitiesrequires making decisions
on how assets should be financed (e.g., by short-term debt, long-term debt, or equity); net working
capital increases when current assets are financed through noncurrent sources.
Managing working capital is also evaluating the trade-off between return and risk. If funds are
transferred from fixed assets to current assets, liquidity risk is reduced, greater ability to obtain
short-term financing is enhanced, and the company has greater flexibility in adjusting current assets
to meet changes in sales volume. However, it also receives reduced return, because the yield on
fixed assets exceeds that of current assets. Financing with noncurrent debt carries less liquidity risk
than financing with current debt because the former is payable over a longer time period. However,
long-term debt often has a higher cost than short-term debt because of its greater uncertainty.
Liquidity risk may be reduced by using the hedging approach to financing, in which assets are
financed by liabilities with similar maturity. When a company needs funds to purchase seasonal or
cyclical inventory, it uses short-term financing, which gives it flexibility to meet its seasonal needs
within its ability to repay the loan. On the other hand, the company's permanent assets should be
financed with long-term debt. Because the assets last longer, the financing can be spread over a
longer time, helping to ensure the availability of adequate funds with which to meet debt payments.
The less time it takes between purchase and delivery of goods, the less working capital is needed.
For example, if the company can receive a raw material in two weeks, it can maintain a lower level
of inventory than if two months' lead time is required. You should purchase material early if by doing
so you can pay significantly lower prices and if the material's cost savings exceed inventory carrying
costs.
Cash Management
The goal of cash management is to invest excess cash for a return and at the same time have adequate
liquidity. A proper cash balance, neither excessive nor deficient, should exist; for example,
companies with many bank accounts may be accumulating excessive balances. Proper cash
forecasting is particularly crucial in a recession and is required to determine (1) the optimal time to
incur and pay back debt and (2) the amount to transfer daily between accounts. A daily computerized


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listing of cash balances and transactions reporting can let you know the up-to-date cash balance so
you can decide how best to use the funds. You should also assess the costs you are paying for
banking services, looking at each account's cost.
When cash receipts and cash payments are highly synchronized and predictable, your company may
keep a smaller cash balance; if quick liquidity is needed, it can invest in marketable securities. Any
additional cash should be invested in income-producing securities with maturities structured to
provide the necessary liquidity.
Financially strong companies that are able to borrow at favorable rates, even in difficult financial
markets, can afford to keep a lower level of cash than companies that are highly leveraged or
considered poor credit risks.
At a minimum, a company should hold in cash the greater of (1) compensating balances (deposits
held by a bank to compensate it for providing services) or (2) precautionary balances (money held
for emergency purposes) plus transaction balances (money to cover checks outstanding). It must also
hold enough cash to meet its daily requirements.
A number of factors go into the decision on how much cash to hold, including the company's liquid
assets, business risk, debt levels and maturity dates, ability to borrow on short notice and on
favorable terms, and rate of return; economic conditions; and the possibility of unexpected problems,
such as customer defaults.
Acceleration of Cash Inflow
To improve cash inflow, you should evaluate the causes of and take corrective action for delays in
having cash receipts deposited. Ascertain the origin of cash receipts, how they are delivered, and
how cash is transferred from outlying accounts to the main corporate account. Also investigate
banking policy regarding availability of funds and the length of time lag between when a check is
received and when it is deposited.
The types of delays in processing checks are: (1) ''mail float," the time required for a check to move
from debtor to creditor; (2) "processing float," the time needed for the creditor to enter the payment;
and (3) "deposit collection float," the time it takes for a check to clear.
Figure 12.1 depicts the total float of a check.
You should try out all possible ways to accelerate cash receipts including the use of lockboxes,
return envelopes, pre-authorized debits (PADs), wire transfers, and depository transfer checks.
· Lockbox. A lockbox represents a way to place the optimum collection point near customers.
Customer payments are mailed to strategic


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Figure 12.1
Float on a Check Issued and Mailed by Payer to Payee
post office boxes geographically situated to reduce mailing and depositing time. Banks make
collections from these boxes several times a day and deposit the funds to the corporate account. They
then prepare a computer listing of payments received by account and a daily total, which is
forwarded to the corporation.
To determine the effectiveness of using a lockbox, you should determine the average face value of
checks received, the cost of operations eliminated, reducible processing overhead, and the reduction
in "mail float" days. Because per-item processing costs for lockboxes is typically significant, it
makes the most sense to use one for low-volume, high-dollar collections. However, businesses with
high-volume, low-dollar receipts are using them more and more as technological advances lower
their per-item cost.
Wholesale lockboxes are used for checks received from other companies. As a rule, the average
dollar cash receipts are large, and the number of cash receipts is small. Many wholesale lockboxes
result in mail time reductions of no more than one business day and check-clearing time reductions of
only a few tenths of one day. They are therefore most useful for companies that have gross revenues
of at least several million dollars and that receive large checks from distant customers.
A retail lockbox is the best choice if the company deals with the public (retail customers as
distinguished from companies). Retail lockboxes typically receive many transactions of nominal
amounts. The


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lockbox reduces float and transfers workload from the company to the bank, resulting in improved
cash flow and reduced expenses.
· Return Envelopes. Providing return envelopes can accelerate customer remissions. On the return
envelope, you can use bar codes, nine-digit code numbers, or post office box numbers. Another
option is Accelerated Reply Mail (ARM), in which a unique "truncating" ZIP code is assigned to
payments such as lockbox receivables. The coded remittances are removed from the postal system
and processed by banks or third parties.
· Pre-Authorized Debits. Cash from customers may be collected faster if you obtain permission from
customers to have pre-authorized debits (PADs) automatically charged to the customers' bank
accounts for repetitive charges. This is a common practice among insurance companies, which
collect monthly premium payments via PADs. These debits may take the form of paper pre-
authorized checks (PACs) or paperless automatic clearing house entries. PADs are cost-effective
because they avoid the process of billing the customer, receiving and processing the payment, and
depositing the check. Using PADs for variable payments is less efficient because the amount of the
PAD must be changed each period and the customer generally must be advised by mail of the amount
of the debit. PADs are most effective when used for constant, relatively nominal periodic payments.
· Wire Transfers. To accelerate cash flow, you may transfer funds between banks by wire transfers
through computer terminal and telephone. Such transfers should be used only for significant dollar
amounts because wire transfer fees are assessed by both the originating and receiving banks. Wire
transfers are best for intraorganization transfers, such as transfers to and from investments, deposits
to an account made the day checks are expected to clear, and deposits made to any other account that
requires immediate availability of funds. They may also be used to fund other types of checking
accounts, such as payroll accounts. In order to avoid unnecessarily large balances in the account, you
may fund it on a staggered basis. However, to prevent an overdraft, you should make sure balances
are maintained in another account at the bank.
There are two types of wire transfers-preformatted (recurring) and free-form (nonrepetitive).
Recurring transfers do not involve extensive authorization and are suitable for ordinary transfers in
which the company designates issuing and receiving banks and provides its account number.
Nonrecurring transfers require greater control, including written confirmations instead of telephone
or computer terminal confirmations.


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· Depository Transfer Checks (DTCs). Paper or paperless depository checks may be used to transfer
funds between the company's bank accounts. They do not require a signature, since the check is
payable to the bank for credit to the company's account. DTCs typically clear in one day. Manual
DTCs are preprinted checks that include all information except the amount and date; automated
DTCs are printed as needed. It is usually best to use the bank's printer since it is not cost-effective
for the company to purchase a printer. Automatic check preparation is advisable only for companies
that must prepare a large number of transfer checks daily.
There are other ways to accelerate cash inflow. You can send bills to customers sooner than is your
practice, perhaps immediately after the order is shipped. You can also require deposits on large or
custom orders or submit progress billings as the work on the order progresses. You can charge
interest on accounts receivable that are past due and offer cash discounts for early payment; you can
also use cash-on-delivery terms. In any event, you should deposit checks immediately.
EXAMPLE 12-1
C Corporation obtains average cash receipts of $200,000 per day. It usually takes five days from the
time a check is mailed until the funds are available for use. The amount tied up by the delay is:
You can also calculate the return earned on the average cash balance.
EXAMPLE 12-2
A company's weekly average cash balances are as follows:
Week Average Cash Balance
1 $12,000
2 17,000
3 10,000
4 15,000
Total $54,000
The monthly average cash balance is:

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If the annual interest rate is approximately 12 percent, the monthly return earned on the average cash
balance is:
If you are thinking of establishing a lockbox to accelerate cash inflow, you will need to determine the
maximum monthly charge you will incur for the service.
EXAMPLE 12-3
It takes Travis Corporation about seven days to receive and deposit payments from customers.
Therefore, it is considering establishing a lockbox system. It expects the system to reduce the float
time to five days. Average daily collections are $500,000. The rate of return is 12 percent.
The reduction in outstanding cash balances arising from implementing the lockbox system is:
The return that could be earned on these funds in a year is:
The maximum monthly charge the company should pay for this lockbox arrangement is therefore:
You should compare the return earned on freed cash to the cost of the lockbox arrangement to
determine if using the lockbox is financially advantageous.
EXAMPLE 12-4
A company's financial officer is determining whether to initiate a lockbox arrangement that will cost
$150,000 annually. The daily average collections are $700,000. Using a lockbox will reduce mailing
and processing time by two days. The rate of return is 14 percent.
$196,000
Annual return on freed cash
(14% × 2 × $700,000)
Annual cost 150,000
Net advantage of lockbox system $46,000

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Sometimes you need to determine whether to switch banks in order to lower the overall costs
associated with a lockbox arrangement.
EXAMPLE 12-5
You now have a lockbox arrangement in which Bank A handles $5 million a day in return for an
$800,000 compensating balance. You are thinking of canceling this arrangement and further dividing
your western region by entering into contracts with two other banks. Bank B will handle $3 million a
day in collections with a compensating balance of $700,000, and Bank C will handle $2 million a
day with a compensating balance of $600,000. Collections will be half a day quicker than they are
now. Your return rate is 12 percent.
$2,500,000
Accelerated cash receipts
($5 million per day × 0.5
day)
Increased compensating
balance 500,000
Improved cash flow $2,000,000
Rate of return × 0.12
Net annual savings $240,000
Delay of Cash Outlay

Delaying cash payments can help your company earn a greater return and have more cash available.
You should evaluate the payees and determine to what extent you can reasonably stretch time limits
without incurring finance charges or impairing your credit rating.
There are many ways to delay cash payments, including centralizing payables, having zero balance
accounts, and paying by draft.
· Centralize Payables. You should centralize your company's payables operationthat is, make one
center responsible for making all paymentsso that debt may be paid at the most profitable time and so
that the amount of disbursement float in the system may be ascertained.
· Zero Balance Account (ZBA). Cash payments may be delayed by maintaining zero balance accounts
in one bank in which you maintain zero balances for all of the company's disbursing units, with funds
being transferred in from a master account as needed. The advantages of ZBAs are that they allow
better control over cash payments and reduced excess cash balances in regional banks. Using ZBAs
is an aggressive strategy that requires the company to put funds into its payroll and payables
checking accounts only when it expects checks to clear. However, watch out for overdrafts and
service charges.
· Drafts. Payment drafts are another strategy for delaying disbursements. With a draft, payment is
made when the draft is presented for


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collection to the bank, which in turn goes to the issuer for acceptance. When the draft is approved,
the company deposits the funds to the payee's account. Because of this delay, you can maintain a
lower checking balance. Banks usually impose a charge for drafts, and you must endure the
inconveniences of formally approving them before payment. Drafts can provide a measure of
protection against fraud and theft because they must be presented for inspection before payment.
· Delay in Mail. You can delay cash payment by drawing checks on remote banks (e.g., a New York
company might use a Texas bank), thus ensuring that checks take longer to clear. You may also mail
checks from post offices that offer limited service or at which mail must go through numerous
handling points. If you utilize the mail float properly, you can maintain higher actual bank balances
than book balances. For instance, if you write checks averaging $200,000 per day and they take three
days to clear, you will have $600,000 ($200,000 × 3) in your checking account for those three days,
even though the money has been deducted in your records.
· Check Clearing. You can use probability analysis to determine the expected date for checks to
clear. Probability is defined as the degree of likelihood that something will happen and is expressed
as a percentage from 0 to 100. For example, it's likely that not all payroll checks are cashed on the
payroll date, so you can deposit some funds later and earn a return until the last minute.
· Delay Payment to Employees. You can reduce the frequency of payments to employees (e.g.,
expense account reimbursements, payrolls); for example, you can institute a monthly payroll rather
than a weekly one. In this way, you have the use of the cash for a greater time period. You can also
disburse commissions on sales when the receivables are collected rather than when sales are made.
Finally, you can utilize noncash compensation and remuneration methods (e.g., distribute stock
instead of bonuses).
Other ways exist to delay cash payments. Instead of making full payment on an invoice, you can make
partial payments. You can also delay payment by requesting additional information about an invoice
from the vendor before paying it. Another strategy is to use a charge account to lengthen the time
between when you buy goods and when you pay for them. In any event, never pay a bill before its
due date.
EXAMPLE 12-6
Every two weeks the company disburses checks that average $500,000 and take three days to clear.
You want to find out how much money can be saved annually if the transfer of funds is delayed from
an interest-


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bearing account that pays 0.0384 percent per day (annual rate of 14 percent) for those three days.
A cash management system is shown in Table 12-1.
Cash Models
A number of mathematical models have been developed to assist the financial manager in
distributing a company's funds so that they provide a maximum return to the company. A model
developed by William Baumol can determine the optimum amount of cash for a company to hold
under conditions of certainty. The objective is to minimize the sum of the fixed costs of transactions
and the opportunity cost (return forgone) of holding cash balances that do not yield a return. These
costs are expressed as
where
F= the fixed cost of a transaction
= the total cash needed for the time period
Tinvolved
i= the interest rate on marketable securities
C= cash balance
C*= optimal level of cash
The optimal level of cash is determined using the following formula:
EXAMPLE 12-7
You estimate a cash need for $4,000,000 over a one-month period during which the cash account is
expected to be disbursed at a constant rate. The opportunity interest rate is 6 percent per annum, or
0.5 percent for a one-month period. The transaction cost each time you borrow or withdraw is $100.
The optimal transaction size (the optimal borrowing or withdrawal lot size) and the number of
transactions you should make during the month follow:
The optimal transaction size is $400,000.

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TABLE 12-1
CASH MANAGEMENT SYSTEM
Acceleration of Cash Delay of Cash Payments
ReceiptsConcentration Banking Pay by Draft
Pre-Authorized Checks Requisition More Frequently
Pre-Addressed Stamp Envelopes Disbursing Float
Obtain Deposits on Large Orders Make Partial Payments
Charge Interest on Overdue Use Charge Accounts
Receivables Delay Frequency of Paying
Employees
Lockbox System
The average cash balance is
The number of transactions required is
There is also a model for cash management when cash payments are uncertain. The Miller-Orr
model places upper and lower limits on cash balances. When the upper limit is reached, a transfer of
cash to marketable securities is made; when the lower limit is reached, a transfer from securities to
cash occurs. No transaction occurs as long as the cash balance stays within the limits.
Factors taken into account in the Miller-Orr model are the fixed costs of a securities transaction (F),
assumed to be the same for buying as well as selling; the daily interest rate on marketable securities
(i); and the variance of daily net cash flows (s2)(s is sigma). The objective is to meet cash
requirements at the lowest possible cost. A major assumption of this model is the randomness of
cash flows. The control limits in the Miller-Orr model are d dollars as an upper limit and zero
dollars at the lower limit. When the cash balance reaches the upper level, d less z dollars (optimal
cash balance) of securities are bought, and the new balance becomes z dollars. When the cash
balance equals zero, z dollars of securities are sold and the new balance again reaches z. Of course,
in practice the minimum cash balance is established at an amount greater than zero because of delays
in transfer; the higher minimum in effect acts as a safety buffer.


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The optimal cash balance z is computed as follows:
The optimal value for d is computed as 3z.
The average cash balance approximates .

EXAMPLE 12-8
You wish to use the Miller-Orr model. The following information is supplied:
Fixed cost of a securities transaction

Variance of daily net cash flows $10
Daily interest rate on securities $50
(10%/360) 0.00030
The optimal cash balance, the upper limit of cash needed, and the average cash balance follow:
The optimal cash balance is $102; the upper limit is $306 (3 × $102); and the average cash balance
is $136 ( ).
When the upper limit of $306 is reached, $204 of securities ($306-$102) will be purchased to bring
the account to the optimal cash balance of $102. When the lower limit of zero dollars is reached,
$102 of securities will be sold to again bring it to the optimal cash balance of $102.
Banking Relationships
Before establishing a relationship with a bank, you should appraise its financial soundness by
checking the ratings compiled by financial advisory services such as Moody's and Standard &
Poor's. Your company may want to limit its total deposits at any one bank to no more than the amount
insured by the Federal Deposit Insurance Corporation, especially if the bank is having difficulties.

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You may also decide to use different banks for different services. In selecting a bank, consider
location (which affects lockboxes and disbursement points), type and cost of services, and
availability of funds.
You may undertake a bank account analysis by comparing the value of the company balance
maintained at the bank to the service charges imposed. Banks will provide such analysis for you, if
you wish, but you should scrutinize the bank's analysis closely to be sure it is accurate.
Most checks clear in one business day; clearing time of three or more business days is rare. Try to
arrange for the financial institution to give same-day credit on deposits received prior to a specified
cutoff time. If the deposit is made over the counter, the funds may not be immediately available; if the
deposit is made early enough, especially through a lockbox, they may be.
Investing in Marketable Securities

Cash management requires knowing the amount of funds the company has available for investment
and the length of time for which they can be invested. Such investments earn a return for the
company. Marketable securities include:
· Time depositssavings accounts that earn daily interest, long-term savings accounts, and certificates
of deposit.
· Money market fundsmanaged portfolios of short-term, high-grade debt instruments such as Treasury
bills and commercial paper.
· Interestpaying demand deposits.
· U.S. Treasury securities.
Automatic short-term money market investments immediately deposit excess cash in money market
securities in order to earn a return on the funds. Holding marketable securities serves as protection
against cash shortages; companies with seasonal operations may purchase marketable securities
when they have excess funds and then sell the securities when cash deficits occur. Companies may
also invest in marketable securities when they are holding funds temporarily in expectation of short-
term capital expansion. In selecting an investment portfolio, you should consider return, default risk,
marketability, and maturity date.
You should monitor coupon and security collection to ensure that the company receives any interest it
is entitled to and that securities that mature or are sold are properly collected and deposited.


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Management of Accounts Receivable

Accounts receivable management directly impacts the profitability of the firm. It includes
determining discount policy and credit policy for marginal customers, investigating ways of speeding
up collections and reducing bad debts, and setting terms of sale to assure ultimate collection.
As part of accounts receivable management, you should appraise order entry, billing, and accounts
receivable activities to be sure that proper procedures are being followed from the time an order is
received until ultimate collection. Among the points to consider is how the average time lag between
completing the sales transaction and invoicing the customer can be reduced. You should also
consider the opportunity cost of holding receivables, that is, the return lost by having funds tied up in
accounts receivable instead of invested elsewhere.
Accounts receivable management involves two types of float-invoicing and mail. Invoicing float is
the number of days between the time goods are shipped to the customer and the time the invoice is
sent out. Obviously, the company should mail invoices on a timely basis. Mail float is the time
between the preparation of an invoice and its receipt by the customer. Mail float may be reduced by
decentralizing invoicing and mailing, coordinating outgoing mail with post office schedules, using
express mail services for large invoices, enforcing due dates, and offering discounts for early
payment.
Credit Policies
A key concern in accounts receivable management is determining credit terms to be given to
customers, which affects sales volume and collections. For example, offering longer credit terms
will probably increase sales. Credit terms have a direct bearing on the costs and revenue generated
from receivables. If credit terms are tight, the company will have a lower investment in accounts
receivable and incur fewer bad-debt losses, but it may also experience lower sales, reduced profits,
and adverse customer reaction. On the other hand, if credit terms are lax, the company may enjoy
higher sales and gross profit, but it risks increased bad debts and a higher opportunity cost of
carrying the investment in accounts receivable because marginal customers take longer to pay.
Receivable terms should be liberalized when you want to get rid of excessive inventory or obsolete
items or if you operate in an industry in which products are sold in advance of retail seasons (e.g.,
swimsuits). If your products are perishable, you should impose short receivable terms and possibly
require payment on delivery.


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In evaluating a potential customer's ability to pay, consider the customer's integrity, financial
soundness, and collateral. A customer's credit soundness may be appraised through quantitative
techniques such as regression analysis, which examines the change in a dependent variable that
occurs as an independent (explanatory) variable changes. Such techniques are particularly useful
when you need to evaluate a large number of small customers. You should be able to estimate bad
debt losses reliably if your company sells to many customers and has not changed its credit policies
for a long time.
Keep in mind that extending credit involves additional expensesthe administrative costs of operating
the credit department; computer services; and fees paid to rating agencies.
You may find it useful to obtain references from retail credit bureaus and professional credit
reference services as part of your customer credit evaluation. Dun and Bradstreet (D&B) reports
contain information about a company's nature of business, product line, management, financial
statements, number of employees, previous payment history as reported by suppliers, current debts,
including any past due, terms of sale, audit opinion, lawsuits, insurance coverage, leases, criminal
proceedings, banking relationships and account information (e.g., current bank loans), location, and
seasonal fluctuations, if applicable.
Monitoring Receivables
There are many ways to maximize profitability from accounts receivable and keep losses to a
minimum. These include proper billing, factoring, and evaluating customers' financial health.
· Billing. Cycle billing, in which customers are billed at different time periods, can smooth out the
billing process. In such a system, customers with last names starting with A may be billed on the first
of the month, those with last names beginning with B on the second day, and so on. Customer
statements should be mailed within twenty-four hours of the close of the billing period.
To speed up collections, you can send invoices to customers when their order is processed at the
warehouse instead of when the merchandise is shipped. You can also bill for services at intervals
when work is performed over a period of time or charge a retainer, rather than receiving payment
when the work is completed. In any event, you should bill large sales immediately.
When business is slow, seasonal datings, in which you offer delayed payment terms to stimulate
demand from customers who are unable to pay until later in the season, can be used.


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· Customer Evaluation Process. Before giving credit, carefully analyze customer financial
statements and obtain ratings from financial advisory services. Try to avoid high-risk receivables,
such as customers who are in a financially troubled industry or region. Be careful of customers who
have been in business less than one year since about 50 percent of businesses fail within the first two
years. As a rule, consumer receivables carry a greater risk of default than do corporate receivables.
You should modify credit limits and accelerate collections based on changes in a customer's
financial health; you may want to withhold products or services until payments are made and ask for
collateral in support of questionable accounts (the collateral value should equal or exceed the
account balance). If necessary, you can use outside collection agencies to try to collect from
recalcitrant customers.
You should age accounts receivable (that is, rank them by the time elapsed since they were billed) to
spot delinquent customers and charge interest on late payments. After you compare current aged
receivables to those of prior years, industry norms, and the competition's, you can prepare a Bad
Debt Loss Report showing cumulative bad debt losses by customer, terms of sale, and size of
account and then summarized by department, product line, and type of customer (e.g., industry). Bad
debt losses are typically higher for smaller companies than for larger ones.
· Insurance Protection. You may want to have credit insurance to guard against unusual bad debt
losses. In deciding whether to acquire this protection, consider expected average bad debt losses,
the company's financial ability to withstand the losses, and the cost of insurance.
· Factoring. Factor (sell) accounts receivable if that results in a net savings. However, you should
realize that confidential information may be disclosed in a factoring transaction. (Factoring is
discussed in Chapter 13.)
Credit Policy
In granting trade credit, you should consider your competition and current economic conditions. In a
recession, you may want to relax your credit policy in order to stimulate additional business. For
example, the company may not rebill customers who take a cash discount even after the discount
period has elapsed. On the other hand, you may decide to tighten credit policy in times of short
supply, because at such times your company as the seller has the upper hand.
In offering a credit card, the seller will generate more sales and high interest income. However,
there will be greater default risk.


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Determining the Investment in Accounts Receivable

To determine the dollar investment tied up in accounts receivable, use a computation that takes into
account the annual credit sales and the length of time receivables are outstanding.
EXAMPLE 12-9
A company sells on terms of net/30, meaning payment is required within 30 days. The accounts are
on average 20 days past due. Annual credit sales are $600,000. The investment in accounts
receivable is:
The investment in accounts receivable represents the cost tied up in those receivables, including
both the cost of the product and the cost of capital.
EXAMPLE 12-10
The cost of a product is 30 percent of selling price, and the cost of capital is 10 percent of selling
price. On average, accounts are paid four months after sale. Average sales are $70,000 per month.
The investment in accounts receivable from this product is:
EXAMPLE 12-11
Accounts receivable are $700,000. The average manufacturing cost is 40% of the selling price. The
before-tax profit margin is 10%. The carrying cost of inventory is 3% of selling price. The sales
commission is 8% of sales. The investment in accounts receivable is:
The average investment in accounts receivable may be computed by multiplying the average accounts
receivable by the cost/selling price ratio.
EXAMPLE 12-12
If a company's credit sales are $120,000, the collection period is 60 days, and the cost is 80 percent
of sales price, what is (a) the average


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accounts receivable balance and (b) the average investment in accounts receivable?
Discount Policy
In order to determine if customers should be offered a discount for the early payment of account
balances, the financial manager has to compare the return on freed cash resulting from customer's
paying sooner to the cost of the discount.
EXAMPLE 12-13
The following data are provided:
Current annual credit

sales $14,000,000
Collection period 3 months
Terms net/30
Minimum rate of return 15%
The company is considering offering a 3/10, net/30 discount (that is, if the customer pays within 10
days of the date of sale, the customer will receive a 3 percent discount. If payment is made after 10
days, no discount is offered. Total payment must be made within 30 days.) The company expects 25
percent of the customers to take advantage of the discount. The collection period will decline to two
months.
The discount should be offered, as indicated in the following calculations:
Advantage of discount
Increased profitability:
Average accounts receivable balance before a change in policy

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Average accounts receivable balance after change in policy
Reduction in average accounts receivable balance $1,116,667

Rate of return × .15
Return $ 175,000
Disadvantage of discount
Cost of the discount 0.30 × 0.25 × $14,000,000 $ 105,000
Net advantage of discount $ 70,000
Changing Credit Policy

To decide whether the company should give credit to marginal customers, you need to compare the
earnings on the additional sales obtained to the added cost of the receivables. If the company has
idle capacity, the additional earnings is the contribution margin on the new sales, since fixed costs
are constant. The additional cost of the receivables results from the likely increase in bad debts and
the opportunity cost of tying up funds in receivables for a longer time period.
EXAMPLE 12-14
Sales price per unit

Variable cost per $120
unit 80
Fixed cost per unit 15
Annual credit sales $600,000
Collection period 1 month
Minimum return 16%
If you liberalize the credit policy, you project that

· Sales will increase by 40%.
· The collection period on total accounts will increase to two months.
· Bad debts on the increased sales will be 5 percent.
Preliminary calculations:

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Advantage of the change in policy

Additional profitability:
2,000units
Incremental sales volume
× Contribution margin per unit
(Selling price - Variable cost) $120 - $80 × $40
Incremental profitability $80,000units
Disadvantage of the change in policy

Incremental bad debts:
Incremental units × Selling price (2,000 × $120) $240,000
Bad debt percentage × 0.05
Additional bad debts $12,000
The first step in determining the opportunity cost of the investment tied up in accounts receivable is
to compute the new average unit cost as follows:
Units × Unit Cost = Total Cost
Current units 5,000 × $95 = $475,000
Additional units 2,000 × $80 = 160,000
Total 7,000 $635,000
Note that at idle capacity, fixed cost remains constant; therefore, the incremental cost is only the
variable cost of $80 per unit. Therefore, the average unit cost will drop.
We now compute the opportunity cost of funds placed in accounts receivable:
Average investment in accounts receivable after change in policy:

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Current average investment in accounts receivable:
Additional investment in accounts receivable $66,245

Minimum return × 0.16
Opportunity cost of funds tied up $10,599
Net advantage of relaxation in credit standards:

Additional earnings $80,000
Less:
$12,000
Additional bad debt losses
10,599 22,599
Opportunity cost
Net savings $57,401
The company may have to decide whether to extend full credit to presently limited credit customers
or no-credit customers. Full credit should be given only if net profitability occurs.
EXAMPLE 12-15
Category Bad Debt Collection Credit Increase in
Percentage Period Policy Annual Sales if
Credit Restrictions Are
Relaxed
X 2% 30 days Unlimited $ 80,000
Y 5% 40 days Restricted 600,000
Z 30% 80 days No Credit 850,000
Gross profit is 25 percent of sales. The minimum return on investment is 12%.


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Category Y Category Z

Gross profit = Incremental sales rate ×
Gross profit rate
$600,000 × .25 $150,000
$850,000 × .25 $212,500

Less bad debts = Incremental sales ×
Bad debt percentage
$600,000 × .05 -(30,000)
$850,000 × .30 -(255,000)

Incremental average investment
in accounts receivable*
40/360 × (0.75 × $600,000) $50,000
80/360 × (0.75 × $850,000) $141,667
×0.12 ×0.12
Opportunity cost of incremental
investment in accounts receivable
(6,000) (17,000)
$114,000
Net earnings
$(59,500)

Credit should be extended to category Y.
As you decide whether credit standards should be loosened, consider the gross profit on increased
sales versus the opportunity cost associated with higher receivable balances and collection
expenses.
EXAMPLE 12-16
You are considering liberalizing the credit policy to encourage more customers to purchase on
credit. Currently, 80 percent of sales are on credit, and there is a gross margin of 30 percent. The
return rate on funds is 10 percent. Other relevant data are:


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Currently Proposal
Sales $300,000 $450,000
Credit sales 240,000 360,000
Collection expenses 4% of credit 5% of credit
sales sales
4.5 3
Accounts receivable
turnover
An analysis of the proposal yields the following results:

Gross profit:
Expected increase in credit sales $360,000 - $240,000 $120,000
Gross profit rate × .30
Increase in gross profit $36,000
Opportunity cost:

Average accounts receivable balance
(credit sales/accounts receivable turnover)
Expected average accounts receivable $360,000/3 $120,000
Current average accounts receivable $240,000/4.5 53,333
Increase in average accounts receivable $66,667
× 10%
× Return rate
Opportunity cost of funds tied up in accounts receivable $6,667
Collection expenses:
$18,000
Expected collection expenses 0.05 × $360,000
9,600
Current collection expenses 0.04 × $240,000
$8,400
Increase in collection expenses
You would profit from a more liberal credit policy as follows:

Increase in gross profit $36,000
Opportunity cost in accounts receivable (6,667)
Increase in collection expenses (8,400)
Net advantage $20,933
To determine whether it is advantageous to engage in a sales campaign, you should consider the
gross margin earned, the sales discount, and the opportunity cost of higher receivable balances.


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EXAMPLE 12-17
The company is planning a sales campaign in which it will offer credit terms of 3/10, net/45. It
expects the collection period to increase from 60 days to 80 days. Relevant data for the
contemplated campaign follow:
Percent of Sales Before Percent of Sales During
Campaign Campaign
Cash sales 40% 30%
Payment from
(in days)
1 10 25
55
11 100 35
15
The proposed sales strategy will probably increase sales from $8 million to $10 million. There is a
gross margin rate of 30 percent. The rate of return is 14 percent. Sales discounts are given on cash
sales.
The company should undertake the sales campaign, because earnings will increase by $413,889
($2,527,222 - $2,113,333).
Inventory Management
The purpose of inventory management is to develop policies that will achieve an optimal inventory
investment. This level varies among industries and among companies in a given industry. Successful
inventory management minimizes inventory, lowers cost, and improves profitability.
As part of this process, you should appraise the adequacy of inventory levels, which depend on many
factors, including sales, liquidity, available inventory financing, production, supplier reliability,
delay in

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receiving new orders, and seasonality. In the event you have slowmoving products, you may wish to
consider discarding them at lower prices to reduce inventory carrying costs and improve cash flow.
You should try to minimize the lead time in your company's acquisition, manufacturing, and
distribution functionsthat is, how long it takes to receive the merchandise from suppliers after an
order is placed. Depending upon lead times, you may need to increase inventory or alter the
purchasing pattern. Calculate the ratio of the value of outstanding orders to average daily purchases
to indicate the lead time for receiving orders from suppliers; this ratio indicates whether you should
increase the inventory balance or change your buying pattern.
You must also consider the obsolescence and spoilage risk of inventory. For example, technological,
perishable, fashionable, flammable, and specialized goods usually have high salability risk, which
should be taken into account in computing desired inventory levels.
Inventory management involves a trade-off between the costs of keeping inventory and the benefits of
holding it. Different inventory items vary in profitability and the amount of space they take up, and
higher inventory levels result in increased costs for storage, casualty and theft insurance, spoilage,
property taxes for larger facilities, increased staffing, and interest on funds borrowed to finance
inventory acquisition. On the other hand, an increase in inventory lowers the possibility of lost sales
from stockouts and the production slowdowns caused by inadequate inventory. Additionally, large
volume purchases result in greater purchase discounts.
Inventory levels are also affected by short-term interest rates. As short-term interest rates increase,
the optimum level of holding inventory is reduced.
You may have to decide whether it is more profitable to sell inventory as is or to sell it after further
processing. For example, assume inventory can be sold as is for $40,000 or for $80,000 if it is put
into further processing costing $20,000. The latter should be selected because the additional
processing yields a $60,000 profit, compared to $40,000 for the current sale.
Quality Discount
You may be entitled to a quantity discount when purchasing large orders. The discount reduces the
cost of materials.


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EXAMPLE 12-18
A company purchases 1,000 units of an item having a list price of $10 each. The quantity discount is
5 percent. The net cost of the item is:
Acquisition cost (1,000 × $10) $10,000
Less: Discount (0.05 × $10,000) 500
Net cost $ 9,500
Investment in Inventory
You should consider the average investment in inventory, which equals the average inventory
balance times the per unit cost.
EXAMPLE 12-19
Savon Company places an order for 5,000 units at the beginning of the year. Each unit costs $10. The
average investment is:
Average inventory(a) 2,500units
Unit cost, $ × $10
Average investment $25,000
To get an average, add the beginning balance and the ending balance and then divide by 2. This gives
the mid-value.
The more frequently a company places an order, the lower the average investment.
Determining Carrying and Ordering Costs
You want to determine the costs for planning, financing, record keeping, and control associated with
inventory. Once inventory costs are known, you can compute the amount of timeliness of financing.
Inventory carrying costs include warehousing, handling, insurance, property taxes, and the
opportunity cost of holding inventory. A provisional cost for spoilage and obsolescence should also
be included in the analysis. The more the inventory held, the greater the carrying cost. Carrying costs
equals:
where Q/2 represents average quantity and C is the carrying cost per unit.


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A knowledge of inventory carrying costs will help you determine which items are worth storing.
Inventory ordering costs are the costs of placing an order and receiving the merchandise. They
include freight and the clerical costs incurred in placing the order. To minimize ordering costs, you
should enter the fewest number of orders possible. In the case of produced items, ordering cost also
includes scheduling cost. Ordering cost equals:
where S = total usage, Q = quantity per order, and P = cost of placing an order.
The total inventory cost is therefore:
A knowledge of ordering costs helps you decide how many orders you should place during the
period to suit your needs.
A tradeoff exists between ordering and carrying costs. A large order quantity increases carrying
costs but lowers ordering costs.
The economic order quantity (EOQ) is the optimum amount of goods to order each time to minimize
total inventory costs. EOQ analysis should be applied to every product that represents a significant
proportion of sales.
The EOQ model assumes:

· Demand is constant and known with certainty.
· Depletion of stock is linear and constant.
· No discount is allowed for quantity purchases.
· Lead time, the time interval between placing an order and receiving delivery, is a constant (that is,
stockout is not possible).
The number of orders for a period is the usage (S) divided by the EOQ.
Figure 12.2 graphically shows the EOQ point.
In the next two examples, we compute for a product the EOQ, the number of orders, and the number
of days that should elapse before the next order is placed.


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Figure 12.2
EOQ Point
EXAMPLE 12-20
You want to know how frequently to place orders to lower your costs. The following information is
provided:
S = 500 units per month

P = $40 per order
C = $4 per unit
The number of orders each month is:
Therefore, an order should be placed about every 6 days (31/5).


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EXAMPLE 12-21
A company is determining its frequency of orders for product X. Each product X costs $15. The
annual carrying cost is $200. The ordering cost is $10. The company anticipates selling 50 product
Xs each month. Its desired average inventory level is 40.
The number of orders per year is:
The company should place an order about every thirty days (365/12).
The Reorder Point
The reorder point (ROP) is a signal that tells you when to place an order. Calculating the reorder
point requires a knowledge of the lead time between order and receipt of merchandise. It may be
influenced by the months of supply or total dollar ceilings on inventory to be held or inventory to be
ordered.
Reorder point is computed as follows:
This reveals the inventory level at which a new order should be placed. If a safety stock is needed,
add to the ROP.
You have to know at what inventory level you should place an order to reduce inventory costs and
have an adequate stock of goods with which to satisfy customer orders.


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EXAMPLE 12-22
A company needs 6,400 units evenly throughout the year. There is a lead time of one week. There are
50 working weeks in the year. The reorder point is:
When the inventory level drops to 128 units, a new order should be placed.
An optimal inventory level can be based on consideration of the incremental profitability resulting
from having more merchandise compared to the opportunity cost of carrying the higher inventory
balances.
EXAMPLE 12-23
The current inventory turnover is 12 times. Variable costs are 60 percent of sales. An increase in
inventory balances is expected to prevent stockouts, thus increasing sales. Minimum rate of return is
18 percent. Relevant data include:
Sales Turnover

$800,000 12
890,000 10
940,000 8
980,000 7
(1) (2) (3) (4) (5) (6)

Sales Turnover [(1)(2)] Opportunity Increased [(5)-
Average Cost of Profitabilityb (4)]
Inventory Carrying Net
Balance Incremental Savings
Inventorya
$800,000 12 $66,667
10 89,000 $4,020 $36,000 $31,980
890,000
8 117,500 5,130 20,000 14,870
940,000
7 140,000 4,050 16,000 11,950
980,000
a Increased inventory from column 3 × 0.18
b Increased sales from column 1 × 0.40
The optimal inventory level is $89,000, because it results in the highest net savings.
Using the ABC Inventory Control Method
ABC analysis focuses on the most critical itemsgross profitability, sensitive price or demand
patterns, and supply excesses or shortages.


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The ABC method requires the classification of inventory into one of four groupsA, B, C, or
Daccording to the potential savings associated with a proper level of inventory control.
Perpetual inventory records should be maintained for Group A items, which require accuracy and
frequent, often daily, attention. A items usually consist of about 70 percent of the dollar value of
inventory. Group B items are less expensive than Group A items but are still important and require
intermediate level control. Group C items include most of the inventory items. Since they are usually
less expensive and less used, they receive less attention. There is usually a high safety stock level
for Group C items. Blanket purchase orders should exist for A items and only ''spot buys" for Bs and
Cs. Group D items are the losers, items that have not been used for an extended time period (e.g., six
months). D items should not be reordered unless special authorization is given. Items may be
reclassified as need be. For instance, a "fragile" item or one that is frequently stolen can be
reclassified from C to A.
To institute the ABC method:
1. Segregate merchandise into components based on dollar value.
2. Compute annual dollar usage by inventory type (anticipated annual usage times unit cost).
3. Rank inventory in terms of dollar usage, ranging from high to low (e.g., As in top 30 percent, Bs in
next 50 percent, and Cs in last 20 percent). Tag inventory with the appropriate classification and
record the classifications in the inventory records.
Figure 12.3 depicts an ABC inventory control system, while Table 12-2 illustrates an ABC
distribution.
Just-in-Time Inventory System

The inventory control problem occurs in almost every type of organization. It exists whenever
products are held to meet some expected future demand. In most industries, cost of inventory
represents the largest liquid asset under the control of management. Therefore, it is very important to
develop a production and inventory planning system that will minimize both purchasing and carrying
costs. In recent years, the Japanese have demonstrated the ability to manage their production systems
effectively. Much of their success has been attributed to what is known as the Just-In-Time (JIT)
approach to production and inventory control, which has generated a great deal of interest among
practitioners. The "Kanban" systemas they call ithas been a focal point of interest, with its dramatic
impact on the inventory performance and productivity of the Japanese auto industry.


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TABLE 12-2
ABC INVENTORY DISTRIBUTION
Inventory Population Dollar Usage
Classification (Percent) (Percent)
A 20 80
B 30 15
C 50 5
The potential benefits of JIT are numerous. First, JIT practice reduces inventory levels, which means
lower investments in inventories. Since the system requires only the smallest quantity of materials
needed immediately, it reduces the overall inventory level substantially. In many Japanese
companies that use the JIT concept, inventory levels have been reduced to the point that makes the
annual working capital turnover ratio much higher than that experienced by U.S. counterparts. For
instance, Toyota reported inventory turnover ratios of 41 to 63, whereas comparable U.S. companies
reported inventory turnover ratios of 5 to 8.
Second, since purchasing under JIT requires a significantly shorter delivery lead time, lead time
reliability is greatly improved. Reduced lead time and increased reliability also contribute to a
significant reduction in safety stock requirements.
Third, reduced lead times and set-up times increase scheduling flexibility. The cumulative lead time,
which includes both purchasing and production lead times, is reduced. Thus, the firm schedule
within the production planning horizon is reduced. This results in a longer "look-ahead" time that can
be used to meet shifts in market demand. The smaller lot size production made possible by reduced
set-up time, adds flexibility.
Other financial benefits include:
· Lower investments in factory space for inventories and production
· Less obsolescence risk in inventories
· Reduction in scrap and rework
· Decline in paperwork
· Reduction in direct material costs through quantity purchases


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Figure 12.3
ABC Inventory Control System


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Chapter Perspective
To maximize cash flow, cash collections should be accelerated and cash payments delayed.
Accounts receivable management requires decisions on whether to give credit and to whom, the
amount to give, and the terms. The proper amount of investment in inventory may change daily and
requires close evaluation. Improper inventory management occurs when funds tied up in inventory
can be used more productively elsewhere. A buildup of inventory may carry risk, such as
obsolescence. On the other hand, an excessively low inventory may result in reduced profit through
lost sales. A JIT inventory system is designed to reduce inventory investment.


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Chapter 13
Short-Term and Intermediate-Term Financing
In this chapter we provide a broad picture of short-term financing (financing that will be repaid in
one year or less). Examples of short-term financing are trade credit, short-term bank loans,
commercial paper, and financing for receivables and inventory.
We also discuss intermediate-term financing, instruments with a maturity in excess of one year, such
as some bank loans and leases. In deciding on a particular source of financing, managers should
consider cost, risk, liquidity, and flexibility.
· The different short-term financing instruments and when each one is most appropriate.
· The advantages of trade credit.
· The types of bank loans and how they work.
· How to compute interest.
· The attributes of commercial paper financing.
· How to finance using receivables and inventory as collateral.
· The differences between short-term and long-term financing.
· The advantages and disadvantages of leasing.
Short-Term Financing
Short-term financing may be used to meet seasonal and temporary fluctuations in funds position as
well as to meet long-term needs. For example, short-term financing may be used to provide
additional working capital, finance current assets (such as receivables and inventory), or provide
interim financing for a long-term project (such as the acquisition of plant and equipment) until long-
term financing is arranged. (Long-term financing may not always be appropriate because of
perceived long-term credit risk or excessively high cost.)
When compared to long-term financing (see Chapter 14), short-term financing has several
advantages. It is usually easier to arrange and less expensive and has more flexibility. The
drawbacks of


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short-term financing are that it is subject to greater fluctuations in interest rates, refinancing is
frequently required, there is greater risk of default because the loan comes due sooner, and any
delinquency may damage the company's credit rating.
The sources of short-term financing include trade credit, bank loans, bankers' acceptances, finance
company loans, commercial paper, receivable financing, and inventory financing. One particular
source may be more appropriate than another in a given circumstance; some are more desirable than
others because of interest rates or collateral requirements.
You should consider the merits of the different sources of short-term financing, focusing on:
· Cost.
· Effect on financial ratios.
· Effect on credit rating (some sources of short-term financing may negatively impact the company's
credit rating, such as factoring accounts receivable).
· Risk (reliability of the source of funds for future borrowing). If your company is materially affected
by outside forces, it will need more stable and reliable financing.
· Restrictions, such as requiring a minimum level of working capital.
· Flexibility.
· Expected money market conditions (e.g., future interest rates) and availability of future financing.
· Inflation rate.
· Company profitability and liquidity positions, both of which must be favorable if the company is to
be able to pay its near-term obligations.
· Stability and maturity of operations.
· Tax rate.
If the company can predict that it will be short of cash during certain times, the financial manager
should arrange for financing (such as a line of credit) in advance instead of waiting for an
emergency.
Using Trade Credit
Trade credit (accounts payable) are balances owed by your company to suppliers. It is a spontaneous
(recurring) financing source for credit-worthy companies since it comes from normal operations.
Trade credit is the least expensive form of financing inventory. Its benefits are that it is readily
available, since suppliers want business; it requires no collateral; there is no interest charge or else
a minimal one; it is convenient; and it is likely to be extended if the company gets into financial
trouble. If the company has liquidity difficulties, it may be able to stretch

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(extend) accounts payable; however, the company will be required to give up any cash discount
offered and accept a lower credit rating. The company should prepare a report analyzing accounts
payable in terms of lost discounts, aged debit balances, aged unpaid invoices, and days to pay.
EXAMPLE 13-1
The company purchases $500 worth of merchandise per day from suppliers. The terms of purchase
are net/60, and the company pays on time. The accounts payable balance is:
The company should typically take advantage of a cash discount offered for early payment because
failing to do so results in a high opportunity cost. The cost of not taking a discount equals:
EXAMPLE 13-2
The company buys $1,000 in merchandise on terms of 2/10, net/30. The company fails to take the
discount and pays the bill on the thirtieth day. The cost of the discount is:
The company would be better off taking the discount even if it needed to borrow the money from the
bank, since the opportunity cost is 36.7 percent. The interest rate on a bank loan would be far less.
Bank Loans
Even though other institutions, such as savings and loan associations and credit unions, provide
banking services, most banking activities are conducted by commercial banks. Commercial banks
allow the company to operate with minimal cash and still be confident of planning activities even in
uncertain conditions.
Commercial banks favor short-term loans since they like to get their money back within one year. If
the company is large, a group of banks may form a consortium to furnish the desired level of capital.


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The prime interest rate is a benchmark for the short-term loan interest rate banks charge creditworthy
corporate borrowers. Good companies with strong financial strength can get terms below prime.
Your company's interest rate may be higher depending upon the risk the bank believes it is taking.
Bank financing may take the following forms:
· Unsecured loans
· Secured loans
· Lines of credit
· Letters of credit
· Revolving credit
· Installment loans
· Unsecured Loans. Most short-term unsecured (uncollateralized) loans are self-liquidating. This
kind of loan is recommended if the company has an excellent credit rating. It is usually used to
finance projects having quick cash flows and is appropriate if the company has immediate cash and
can either repay the loan in the near future or quickly obtain longer-term financing. Seasonal cash
shortfalls and desired inventory buildups are among the reasons to use an unsecured loan. The
disadvantages of this kind of loan are that it carries a higher interest rate than a secured loan since
there is no collateral and that a lump-sum payment is required.
· Secured Loans. If the company's credit rating is deficient, the bank may lend money only on a
secured basis. Collateral can take many forms, including inventory, marketable securities, or fixed
assets. Even if the company is able to obtain an unsecured loan, it may be better off taking a
collateralized loan at a lower interest rate.
· Lines of Credit. Under a line of credit, the bank agrees to lend money up to a specified amount on a
recurring basis. The bank typically charges a commitment fee on the amount of the unused credit line.
Credit lines are typically established for a one-year period and may be renewed annually. You can
determine it the preferred line of credit is adequate for your company's present and immediate future
needs by considering the current and expected cash requirements of the business.
The advantages of a line of credit are that it offers easy and immediate access to funds during tight
money market conditions and it enables the company to borrow only as much as it needs and to repay
immediately when cash is available. You should use a line of credit if the company is working on
large individual projects for a long time period and will obtain minimal or no payments until the job
is completed. The disadvantages of lines of credit relate to the collateral requirements and the
additional financial information that must be presented to the


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bank. Banks also may place restrictions on the company, such as setting a ceiling on capital
expenditures or requiring a minimum level of working capital.
When the company borrows under a line of credit, it may be required to maintain a compensating
balance (a noninterest-bearing account) with the bank. The compensating balance is stated as a
percentage of the loan and effectively increases the cost of the loan. A compensating balance may
also be placed on the unused portion of a line of credit, in which case the interest rate is reduced.
EXAMPLE 13-3
The company borrows $200,000 and is required to keep a 12 percent compensating balance. It also
has an unused line of credit of $100,000, for which a 10 percent compensating balance is required.
The minimum balance that must be maintained is:
A line of credit is typically decided upon prior to the actual borrowing. In the days between the
arrangement for the loan and the actual borrowing, interest rates may change. Therefore, the
agreement will stipulate the loan is at the prime interest rate prevailing when the loan is extended
plus a risk premium. (The prime interest rate will not be known until you actually borrow the money
since market interest rates may change from the time you contract for a loan and the time you receive
the funds.)
The bank may test the company's financial capability by requiring it to "clean up," that is, repay the
loan for a brief time during the year (e.g., for one month). The payment shows the bank that the loan
is actually seasonal rather than permanent. If the company is unable to repay a short-term loan, it
should probably finance with long-term funds.
· Letters of Credit. A letter of credit is a document issued by a bank guaranteeing the payment of a
customer's drafts up to a specified amount for a designated time period. In effect, the bank's credit is
substituted for that of the buyer, minimizing the seller's risk. Payment may be made on submission of
proof of shipment or other performance. Letters of credit are used primarily in international trade.
There are different types of letters of credit. A commercial letter of credit is typically drawn in
favor of a third party. A confirmed letter of credit is provided by a correspondent bank and
guaranteed by the issuing bank.


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The advantages of letters of credit are that the company does not have to pay cash in advance of
shipment, using funds that could be used elsewhere in the business.
· Revolving Credit. A revolving credit is an agreement between the bank and the borrower in which
the bank contracts to make loans up to a specified ceiling within a prescribed time period. With
revolving credit, notes are short term (typically ninety days). When part of the loan is paid, an
amount equal to the repayment may again be borrowed under the terms of the agreement. Advantages
are the readily available credit and few restrictions compared to line-of-credit agreements. A major
disadvantage may be restrictions imposed by the bank.
· Installment Loans. An installment loan requires monthly payments of interest and principal. When
the principal on the loan decreases sufficiently, you may be able to refinance at a lower interest rate.
The advantage of this kind of loan is that it may be tailored to satisfy seasonal financing needs.
Interest
Interest on a loan may be paid either at maturity (ordinary interest) or in advance (discounting the
loan). When interest is paid in advance, the loan proceeds are reduced and the effective (true)
interest rate is increased.
EXAMPLE 13-4
The company borrows $30,000 at 16 percent interest per annum and repays the loan one year later.
The interest is $30,000 × .16 = $4,800. The effective interest rate is 16 percent ($4,800/$30,000).
EXAMPLE 13-5
Assume the same facts as in the prior example, except the note is discounted. The effective interest
rate increases as follows:
A compensating balance will increase the effective interest rate.

EXAMPLE 13-6
The effective interest rate for a one-year, $600,000 loan that has a nominal interest rate of 19 percent
with interest due at maturity and requiring a 15 percent compensating balance is:


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Effective interest rate (with compensating balance) equals:
EXAMPLE 13-7
Assume the same facts as in the prior example, except that the loan is discounted. The effective
interest rate is:
Effective interest rate (with discount) equals:
EXAMPLE 13-8
The company has a credit line of $400,000, but it must maintain a compensating balance of 13
percent on outstanding loans and a compensating balance of 10 percent on the unused credit. The
interest rate on the loan is 18 percent. The company borrows $275,000. The effective interest rate on
the loan is calculated as follows.
The required compensating balance is:
.13 × $275,000 $35,750
.10 × 125,000 12,500
$48,250
Effective interest rate (with line of credit) equals:

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On an installment loan, the effective interest rate computation is illustrated below. Assuming a one-
year loan payable in equal monthly installments, the effective rate is based on the average amount
outstanding for the year. The interest is computed on the face amount of the loan.
EXAMPLE 13-9
The company borrows $40,000 at an interest rate of 10 percent to be paid in 12 monthly installments.
The average loan balance is $40,000/2 = $20,000. Divide by 2 to obtain an average (the beginning
balance is $40,000 and the ending balance is 0, so the average is beginning plus ending divided by
2). The effective interest rate is
EXAMPLE 13-10
Assume the same facts as in the prior example, except that the loan is discounted. The interest of
$4,000 is deducted in advance so the proceeds received are $40,000 - $4,000 = $36,000. The
average loan balance is $36,000/2 = $18,000. The effective interest rate is $4,000/$18,000 = 22.2
percent.
The effective interest cost computation may be more complicated when installment payments vary.
The true interest cost of an installment loan is the internal rate of return of the applicable cash flows
converted on an annual basis (if desired).
EXAMPLE 13-11
The company borrows $100,000 and will repay it in three monthly installments of $25,000, $25,000,
and $50,000. The interest rate is 12 percent.
Amount of borrowing equals:
Installment loan $100,000
Less: Interest on first installment 3,000
($25,000 × .12)
Balance $97,000
We now compute the effective interest cost on the installment loan as follows:


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This shows that the effective annual interest rate on the installment loan is 16.44 percent.
Dealing with the Banker
Banks are eager to lend money to meet self-liquidating, cyclical business needs. A short-term bank
loan is an inexpensive way to obtain funds to satisfy working capital requirements during the
business cycle. But the financial officer must be able to explain what the company's needs are in an
intelligent manner.
Commercial Finance Loans
When credit is unavailable from a bank, the company may have to go to a commercial finance
company, which typically charges a higher interest rate than the bank and requires collateral.
Typically, the value of the collateral is greater than the balance of the loan and may consist of
accounts receivable, inventories, and fixed assets. Commercial finance companies also finance the
installment purchases of industrial equipment. A portion of their financing is sometimes obtained
through commercial bank borrowing at wholesale rates.
Commercial Paper
Commercial paper is a short-term unsecured obligation with a maturity ranging from 2 to 270 days,
issued by companies to investors with temporarily idle cash. Commercial paper can be issued only
if the company possesses a very high credit rating; therefore, the interest rate is less than that of a
bank loan, typically one-half percent below the prime interest rate. Commercial paper is sold at a
discount (below face value), with the interest immediately deducted from the face of the note by the
creditor; however, the company pays the full face value. Commercial paper may be issued through a
dealer or directly placed to an institutional investor (a dealer is a company that buys securities and
then sells them out of its own inventory, while an institutional investor is an entity that buys large
volumes of securities, such as banks and insurance companies).


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The benefits of commercial paper are that no security is required, the interest rate is typically less
than that required by banks or finance companies, and the commercial paper dealer often offers
financial advice. The drawbacks are that commercial paper can be issued only by large, financially
sound companies and that commercial paper dealings are impersonal. Commercial paper is usually
backed by a bank letter of credit.
We now look at an example that determines whether the amount of commercial paper issued by a
company is excessive.
EXAMPLE 13-12
A company's balance sheet appears below.
ASSETS
Current assets $ 540,000
Fixed assets 800,000
Total assets $1,340,000
Current liabilities:
$ 100,000
Notes payable to banks
650,000
Commercial paper
Total current liabilities $ 750,000
Long-term liabilities 260,000
Total liabilities $1,010,000
Stockholders' equity 330,000
Total liabilities and stockholders' equity $1,340,000
The amount of commercial paper issued by the company is a high percentage of both its current
liabilities, 86.7% ($650,000/$750,000), and its total liabilities, 64.4% ($650,000/$1,010,000).
Because bank loans are minimal, the company may want to do more bank borrowing and less
commercial paper financing. In the event of a money market squeeze, the company may find it
advantageous to have a working relationship with a bank.
EXAMPLE 13-13
The company issues $500,000 of commercial paper every two months at a 13 percent rate. There is a
$1,000 placement cost each time. The percentage cost of the commercial paper is:


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Interest ($500,000 × .13) $65,000
Placement cost ($1,000 × 6) 6,000
Cost $71,000
EXAMPLE 13-14
Ajax Corporation issues $300,00 worth of 18 percent, 90-day commercial paper. However, the
funds are needed for only 70 days. The excess funds can be invested in securities earning 17 percent.
The brokerage fee associated with the commercial paper transaction is 1.5 percent. The dollar cost
to the company in issuing the commercial paper is:
Interest expense [0.18 × $300,000 × (90/360)] $13,500
Brokerage fee (0.015 × $300,000) 4,500
Total cost $18,000
2,833
Less: Return on marketable securities
[0.17 × $300,000 × (20/360)]
Net cost $15,167
EXAMPLE 13-15
The company needs $300,000 for the month of November. Its options are:
1. Obtaining a one-year line of credit for $300,000 with a bank. The commitment fee is 0.5 percent,
and the interest charge on the used funds is 12 percent.
2. Issuing two-month commercial paper at 10 percent interest. Because the funds are needed only for
one month, the excess funds ($300,000) can be invested in 8 percent marketable securities for
December. The total transaction fee for the marketable securities is 0.3 percent.
The line of credit costs:


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Commitment fee for unused period $1,375
(0.005) (300,000) (11/12)
Interest for one month (0.12) (300,000) (1/12) 3,000
Total cost $4,375
The commercial paper costs:
Interest charge (0.10) (300,000) (2/12) $5,000
Transaction fee (0.003) (300,000) 900
Less interest earned on marketable securities (2,000)
(0.08) (300,000) (1/12)
Total cost $3,900
Since $3,900 is less than $4,375, the commercial paper arrangement is the better option.
Using Receivables for Financing
In accounts receivable financing, the accounts receivable serve as security for the loan as well as the
source of repayment.
Financing backed by accounts receivable generally takes place when:
· Receivables are at least $25,000.
· Sales are at least $250,000.
· Individual receivables are at least $100.
· Receivables apply to selling merchandise rather than rendering services.
· Customers are financially strong.
· Sales returns are low.
· The buyer receives title to the goods at shipment.
Receivable financing has several advantages. It eliminates the need to issue bonds or stock to obtain
a recurring cash flow. Its drawback is the high administrative costs of monitoring many small
accounts.
Accounts receivable may be financed under either a factoring agreement or an assignment (pledging)
arrangement. Factoring is the outright sale of accounts receivable to a bank or finance company
without recourse; the purchaser takes all credit and collection risks. The proceeds received by the
seller are equal to the face value of the receivables less the commission charge, which is usually 2 to
4 percent higher than the prime interest rate. The cost of the factoring arrangement is the factor's
commission for credit investigation, interest on the unpaid balance of advanced funds, and a discount
from the face value of the receivables if there is high credit risk. Remissions by customers are made
directly to the factor.


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The advantages of factoring are that it offers immediate cash, it reduces overhead because the credit
examination function is no longer needed, it provides financial advice, it allows for receipt of
advances as required on a seasonal basis, and it strengthens the company's balance sheet position.
The disadvantages of factoring include both the high cost and the negative impression left with
customers as a result of the change in ownership of the receivables. Factors may also antagonize
customers by their demanding methods of collecting delinquent accounts.
In an assignment (pledging) arrangement, ownership of the accounts receivable is not transferred.
Instead, receivables are given to a finance company with recourse. The finance company usually
advances between 50 and 85 percent of the face value of the receivables in cash; your company is
responsible for a service charge, interest on the advance, and any resulting bad debt losses, and
continues to receive customer remissions.
The assignment of accounts receivable has the advantages of providing immediate cash, making cash
advances available on a seasonal basis, and avoiding negative customer feelings. The disadvantages
include the high cost, the continuing of administrative costs, and the bearing of all credit risk.
Financial managers must be aware of the impact of a change in accounts receivable policy on the
cost of financing receivables. When accounts receivable are financed, the cost of financing may rise
or fall. For example, when credit standards are relaxed, costs rise; when recourse for defaults is
given to the finance company, costs decrease; and when the minimum invoice amount of a credit sale
is increased, costs decline.
The financial officer should compute the costs of accounts receivable financing and select the least
expensive alternative.
EXAMPLE 13-16
A factor will purchase the company's $120,000 per month accounts receivable. The factor will
advance up to 80 percent of the receivables for an annual charge of 14 percent and a 1.5 percent fee
on receivables purchased. The cost of this factoring arrangement is:
Factor fee [0.015 × ($120,000 × 12)] $21,600
Cost of borrowing [0.14 × ($120,000 × 0.8)] 13,440
Total cost $35,040


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EXAMPLE 13-17
A factor charges a 3 percent fee per month. The factor lends the company up to 75 percent of
receivables purchased for an additional 1 percent per month. Credit sales are $400,000 per month.
As a result of the factoring arrangement, the company saves $6,500 per month in credit costs and a
bad debt expense of 3 percent of credit sales.
XYZ Bank has offered an arrangement to lend the company up to 75 percent of the receivables. The
bank will charge 2 percent per month interest plus a 4 percent processing charge on receivable
lending.
The collection period is 30 days. If the company borrows the maximum per month, should it stay
with the factor or switch to XYZ Bank?
Cost of factor:
$12,000
Purchased receivables (0.03 × $400,000)
3,000
Lending fee (0.01 × .75 × $400,000)
$15,000
Total cost
Cost of bank financing:
$6,000
Interest (0.02 × .75 × $400,000)
12,000
Processing charge (0.04 × $300,000)

Additional cost of not using the factor:
6,500
Credit costs
8,000
Bad debts (0.02 × $400,000)
Total Cost $32,500
Since $15,000 is less than $32,500, the company should stay with the factor.
EXAMPLE 13-18
A company needs $250,000 and is weighing the alternatives of arranging a bank loan or going to a
factor. The bank loan terms are 18 percent interest, discounted, with a compensating balance of 20
percent. The factor will charge a 4 percent commission on invoices purchased monthly; the interest
rate on the purchased invoices is 12 percent, deducted in advance. By using a factor, the company
will save $1,000 monthly credit department costs, and avoid uncollectible accounts estimated at 3
percent of the factored accounts. Which is the better alternative for the company?
The bank loan which will net the company its desired $250,000 is:

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The effective interest rate of the bank loan is:
We must briefly switch to the factor arrangement in order to determine the $8,929 below as a bank
cost.
The amount of accounts receivable that should be factored to net the firm $250,000 is:
The total annual cost of the bank arrangement is:

Interest ($250,000 × 0.29) $72,500
Additional cost of not using a factor:
Credit costs ($1,000 × 12) 12,000
Uncollectible accounts ($297,619 × 0.03) 8,929
Total cost $93,429
The effective interest rate of factoring accounts receivable is:
The total annual cost of the factoring alternative is:

Interest ($250,000 × 0.143) $35,750
Factoring ($297,619 × 0.04) 11,905
Total cost $47,655
Factoring should be used since it will cost almost half as much as the bank loan.
Before looking at the next example on factoring, we should discuss several items that were
mentioned in that example. Reserve on


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accounts receivable is the amount retained by the factor against problem receivables, which reduces
the proceeds received by the company. Average accounts receivable is the average balance held for
the period and is the basis for the factor's commission at the time the receivables are purchased by
the factor.
EXAMPLE 13-19
A company is considering a factoring arrangement. The company's sales are $2,700,000, accounts
receivable turnover is 9 times, and a 17 percent reserve on accounts receivable is required. The
factor's commission charge on average accounts receivable payable at the point of receivable
purchase is 2.0 percent. The factor's interest charge is 16 percent of receivables after subtracting the
commission charge and reserve. The interest charge reduces the advance. The annual effective cost
under the factoring arrangement is computed below.
The company will receive the following amount by factoring its accounts receivable:
Average accounts receivable $300,000
Less: Reserve ($300,000 × 0.17) -51,000
-6,000
Commission ($300,00 × 0.02)
Net prior to interest $243,000
Less: Interest ($243,000 × 16%/9) 4,320
Proceeds received $238,680
The annual cost of the factoring arrangement is:
Commission ($300,000 × 0.02) $6,000
Interest ($243,000 × 16%/9) 4,320
Cost each 40 days (360/9) $10,320
Turnover × 9
Total annual cost $92,880
The annual effective cost under the factoring arrangement based on the amount received is:

Page 235
Using Inventories for Financing

Financing inventory, which typically takes place when the company has completely used its
borrowing capacity on receivables, requires the existence of marketable, nonperishable, and
standardized goods that have quick turnover and that are not subject to rapid obsolescence. Good
collateral inventory can be easily sold. However, you should consider the price stability of the
merchandise and the costs of selling it when deciding on a course of action.
The cash advance for financed inventory is high when there is marketable inventory. In general, the
financing of raw materials and finished goods is about 75 percent of their value; the interest rate is
approximately 3 to 5 points over the prime interest rate.
The drawbacks of inventory financing include the high interest rate and the restrictions it places on
inventory.
Types of inventory financing include floating (blanket) liens, warehouse receipts, and trust receipts.
With a floating lien, the creditor's security lies in the aggregate inventory rather than in its
components. Even though the company sells and restocks, the lender's security interest continues.
With a warehouse receipt, the lender receives an interest in the inventory stored at a public
warehouse; the fixed costs of this arrangement are high. There may be a field warehouse arrangement
in which the warehouser sets up a secured area directly at the company's location; the company has
access to the goods but must continually account for them. With a trust receipt loan, the creditor has
title to the goods but releases them to the company to sell on the creditor's behalf; as goods are sold,
the company remits the funds to the lender. The drawback of the trust receipt arrangement is that a
trust receipt must be given for specific items.
A collateral certificate guaranteeing the existence of pledged inventory may be issued by a third
party to the lender. The advantage of a collateral certificate is its flexibility; merchandise need not
be segregated or possessed by the lender.
EXAMPLE 13-20
The company wants to finance $500,000 of inventory. Funds are required for three months. A
warehouse receipt loan may be taken at 16 percent with a 90 percent advance against the inventory's
value. The warehousing cost is $4,000 for the three-month period. The cost of financing the
inventory is:
Interest [0.16 × 0.90 × $500,000 × (3/12)] $18,000
Warehousing cost 4,000
Total cost $22,000


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EXAMPLE 13-21
The company shows growth in operations but is experiencing liquidity difficulties. Six large
financially sound companies are customers and account for 75 percent of sales. On the basis of the
following financial information for 20X1, should the financial manager borrow on receivables or
inventory?
Balance sheet data follow:
Balance Sheet
ASSETS
Current Assets
$
Cash 27,000
380,000
Receivables
320,000
Inventory (consisting of 55% of work-in-
process)
$727,000
Total Current Assets
Fixed Assets 250,000
Total Assets $977,000
Current Liabilities
$260,000
Accounts Payable
200,000
Loans Payable
35,000
Accrued Expenses
$495,000
Total Current Liabilities
Noncurrent Liabilities
110,000
Bonds Payable
Total Liabilities $605,000
Stockholders' Equity
$250,000
Common stock
122,000
Retained Earnings
Total Stockholders' Equity 372,000
Total Liabilities and Stockholders' Equity $977,000
Selected income statement information follows:
Sales $1,800,000
Net income 130,000
Receivable financing is the expected choice, since a high percentage of sales are made to only six
large and financially strong companies. Receivables thus are highly collectible. It is also easier to
control a few large customer accounts.


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Inventory financing is not likely because of the high percentage of partially completed items. Lenders
are reluctant to finance inventory when a large work-in-process balance exists, since it will be hard
for them to process and sell the goods.
Financing with Other Assets
Assets other than inventory and receivables may be used as security for short-term bank loans.
Possibilities include real estate, plant and equipment, cash surrender value of life insurance policies,
and securities. Lenders are also usually willing to advance a high percentage of the market value of
bonds or to make loans based on a third-party guaranty.
Table 13-1 presents a summary of the major features of short-term financing sources.
Short-term financing is easier to arrange, has lower cost, and is more flexible than long-term
financing. However, short-term financing leaves the borrower more vulnerable to interest rate
swings, requires more frequent refinancing, and requires earlier payment. As a rule, you should use
short-term financing to provide additional working capital, to finance short-lived assets, or to serve
as interim financing on long-term projects. Long-term financing is more appropriate for the financing
of long-term assets or construction projects.
Intermediate-Term Financing:
Term Loans and Leasing
We now consider the use of intermediate-term loans, primarily through banks and leases, to meet
corporate financing needs. Examples are bank loans, insurance company term loans, and equipment
financing.
Purposes of Intermediate-Term Bank Loans
Intermediate-term loans are loans with a maturity of more than one year but less than five years. They
are appropriate when short-term unsecured loans are not, such as when a business is acquired, new
fixed assets are purchased, or long-term debt is retired. If a company wants to float long-term debt or
issue common stock but market conditions are unfavorable, it may seek an intermediate loan to
bridge the gap until conditions improve. A company may use extendable debt when it will have a
continuing financing need, reducing the time and cost required for repeated debt issuance.
The interest rate on intermediate-term loans is typically higher than that for short-term loans because
of the longer maturity period and varies with the amount of the loan and the company's financial
strength. The interest rate may be either fixed or variable.


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TABLE 13-1
SUMMARY OF MAJOR SHORT-TERM
FINANCING SOURCES
Type of Source Cost or Terms Features
Financing
A.Spontaneous sources
Accounts Suppliers No explicit cost but there is an The main source
payable opportunity cost if a cash discount of short-term
for early payment is not taken. financing typically
Companies should take advantage of on term of 0 to
the discount offered. 120 days.
Accrued Employees None Expenses incurred
expenses and tax but not yet paid
agencies (e.g., accrued
wages payable,
accrued taxes
payable
B.Unsecured sources
Bank
loans
CommercialPrime interest rate plus risk A single-payment
1. banks premium. The interest rate may be loan to satisfy a
Single- fixed or variable. Unsecured loans funds shortage to
paymen are less costly than secured loans. last a short time
note period.
CommercialPrime interest rate plus risk An agreed-upon
2. Lines banks premium. The interest rate may be borrowing limit for
of credit fixed or variable. A compensating funds to satisfy
balance is typically required. The seasonal needs.
line of credit must be ''cleaned up"
periodically.


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Financing
CommercialCommercialA little less than the prime Unsecured, short-term
paper banks, interest rate. note of financially strong
insurance companies.
companies,
other
financial
institutions,
and other
companies
C.Secured sources
Accounts
receivable
as collateral
Commercial2% to 5% above prime Qualified accounts
1. banks and plus fees (usually receivable accounts serve
Pledging finance 2% 3%). Low as collateral. Upon
companies administrative costs. collection of the account,
Advances typically the borrower remits to the
ranging from 60% to lender. Customers are not
85%. notified of the
arrangement. With
recourse meaning that the
risk of nonpayment is
borne by the company.
Factors, Typically a 2% 3% Certain accounts
2. commercial discount from the face receivable are sold on a
Factoring banks, and value of factored discount basis without
commercial receivables. Interest on recourse. Customers are
finance advances of almost 3% notified of the
companies over prime. Interest on arrangement. The factor
surplus balances held by provides more services
factor of about 1/2% per than is the case with
month. Costs with pledging.
factoring are higher than
with pledging.


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Financing
Inventory
collateral
CommercialAbout 4% above Collateral is all the inventory.
1. banks and prime. Advance is There should be a stable
Floating commercial about 40% of inventory with many inexpensive
liens finance collateral value. items.
companies
CommercialAbout 3% above Collateral is specific inventory
2. Trust banks and prime. Advances that is typically expensive.
receipts commercial ranging from 80% Borrower retains collateral.
(floor finance to 100% of Borrower remits proceeds to
planning) companies collateral value. lender upon sale of the inventory.
CommercialAbout 4% above Collateralized inventory is
3. Warehouse banks and prime plus about controlled by lender. A
receipts commercial 2% warehouse warehousing company issues a
finance fee. Advance of warehouse receipt held by the
companies about 80% of lender. The warehousing
collateral value. company acts as the lender's
agent.
Ordinary intermediate-term loans are payable in periodic equal installments except for the last
payment, which may be higher (a balloon payment). The schedule of loan payments should be based
on the company's cash flow position to satisfy the debt. The periodic payment in a term loan equals:

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EXAMPLE 13-22
The company contracts to repay a term loan in five equal year-end installments. The amount of the
loan is $150,000 and the interest rate is 10 percent. The payment each year is:
The total interest on the loan is:

Total payments (5 × $39,567.40) $197,837
Principal 150,000
Interest $ 47,847
EXAMPLE 13-23
The company takes out a term loan in twenty year-end annual installments of $2,000 each. The
interest rate is 12 percent. The amount of the loan is:
The amortization schedule for the first two years is:

Year Payment Interest(a) Principal Balance
0 $14,938.00
1 $2,000 $1,792.56 $207.44 14,730.56
2 2,000 1,767.67 232.33 14,498.23
(a) 12 percent times the balance of the loan at the beginning of the
year.
Restrictions may be placed on the company by the lender in an intermediate-term loan agreement in
order to protect the lender's interest. Typical restrictions include:
· Working capital requirements and cash dividend limitations, such as requiring a minimum amount
of working capital or limiting dividend payment to no more than 20 percent of net income.

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· Routine (uniform) provisions employed universally in most agreements, such as the payment of
taxes and the maintenance of proper insurance to assure maximum lender protection.
· Specific provisions tailored to a particular situation, such as limiting future loans and requiring
adequate life insurance for executives.
The advantages of intermediate-term loans are:
· Flexibilityterms may be altered as the company's financing requirements change.
· Confidentialityno public issuance (offering to the investment public after registering with the
Securities and Exchange Commission) is involved, so no information about the company's finances
need be made public.
· Speedthe loan may be arranged quickly, compared to preparing a public offering.
· Securityavoids the possible nonrenewal of a short-term loan.
· Low costeliminates public flotation (issuance) costs. The disadvantages of intermediate-term loans
are these:
· Collateral and restrictive covenants are usually required.
· Budgets and financial statements may have to be submitted periodically to the lender.
· "Kickers" or "sweeteners," such as stock warrants or a share of the profits, are sometimes
requested by the bank.
Insurance Company Term Loans
Insurance companies and other institutional lenders such as commercial finance companies may be
sources of intermediate-term loans. Insurance companies typically accept loan maturity dates
exceeding 10 years, but their rate of interest is often higher than that of bank loans. Insurance
companies do not require compensating balances but usually impose a prepayment penalty, which is
typically not true with a bank loan. A company may opt for an insurance company loan when it
desires a longer maturity range.
Equipment-Backed Financing
Equipment may serve as collateral for a loan, with the advance based on the market value of the
equipment. The more marketable the equipment and the lower the cost of selling it, the higher the
advance will be. The repayment schedule is designed so that the market value of the equipment at
any given time is in excess of the unpaid loan principal.
Equipment financing may be obtained from banks, finance companies, and manufacturers of
equipment and is secured by a chattel mortgage or a conditional sales contract. A chattel mortgage
serves as

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a lien on property, except for real estate. In a conditional sales contract, the seller of the equipment
keeps title to it until the buyer has satisfied the terms; otherwise the seller can repossess the
equipment. Conditional sales contracts are generally used by small companies with low credit
ratings.
Equipment trust certificates may be issued to finance the purchase of readily salable equipment,
preferably equipment that is general purpose and easily movable. A trust is formed by the lessor to
buy the equipment and lease it to the user; the trust issues the certificates to finance 75 to 85 percent
of the purchase price and holds title to the equipment until all the certificates have been fully repaid,
at which time the title passes to the lessee.
Advantages of Leasing
The parties in a lease are the lessor, who legally owns the property, and the lessee, who uses it in
exchange for making rental payments. Of course, your company is the lessee.
There are several types of leases:
1. Operating (service) lease. This type of lease includes both financing and maintenance services.
The company leases property that is owned by the lessor, who may be the manufacturer of the asset
or a leasing company that buys assets from the manufacturer to lease to others. The lease payments
under the contract are typically not adequate to recover the full cost of the property. Operating leases
usually contain a cancellation clause that allows the lessee to return the property prior to the
expiration date of the agreement. The life of the contract is less than the economic life of the
property.
2. Financial (capital) lease. This type of lease usually does not provide for maintenance services. It
is noncancellable, and the rental payments equal the full price of the leased property. The life of the
contract approximates the life of the property.
3. Sale and leaseback. With this lease arrangement, the company sells an asset to another (usually a
financial institution) and then leases it back. This allows the company to obtain cash from the sale
and still have the use of the property.
4. Leveraged lease. In a leveraged lease, a third party serves as the lender. The lessor borrows a
significant portion of the purchase price (usually up to 80 percent) to buy the asset and provides the
balance of the purchase price as his equity investment. The property is then leased to the lessee. As
security for the loan, the lessor grants the long-term lender a mortgage on the asset and assigns the
lease contract to the lender. Leverage leasing is a cost-effective


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alternative to debt financing when the lessee cannot use the full tax benefits of asset ownership.
Leasing has a number of advantages:
· No immediate cash outlay is required.
· It is a satisfactory way to meet temporary equipment needs and provides flexibility in operations.
· Usually there is a purchase option that allows the company to obtain the property at a bargain price
at the expiration of the lease. This allows the flexibility to make a purchase decision based on the
value of the property at the termination date.
· The lessor's expert service is available.
· Leasing typically imposes fewer financing restrictions than are imposed by lenders.
· The company's obligation for future rental payment need not be reported on the balance sheet if the
lease is considered an operating lease. However, capital leases must be stated in financial
statements.
· Leasing allows the company, in effect, to depreciate land, which is not allowed if land is
purchased.
· Lessors may claim a maximum of three years' lease payments in the event of bankruptcy or
reorganization, whereas creditors have a claim for the total amount of the unpaid financing.
· Leasing eliminates equipment disposal.
Leasing may be more attractive than buying when a business cannot use all of the tax deductions and
tax credits associated with purchasing the assets.
Drawbacks to leasing are these:
· It carries a higher cost in the long run than purchasing the asset; the lessee does not build equity.
· The interest cost of leasing is typically higher than the interest cost on debt.
· If the property reverts to the lessor at termination of the lease, the lessee must either sign a new
lease or buy the property at higher current prices. Also, the salvage value of the property is realized
by the lessor.
· The lessee may have to retain property it no longer needs or wants (i.e., obsolete equipment).
· The lessee cannot make improvements to the leased property without the permission of the lessor.
Examples 13-24 to 13-26 require the use of the present value of annuity table (Table 6-4), discussed
in Chapter 6.


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EXAMPLE 13-24
The company enters into a lease for a $100,000 machine. It is to make ten equal annual payments at
year-end. The interest rate on the lease is 14 percent. The periodic payment equals:
EXAMPLE 13-25
Assume the same facts as in Example 13-24, except that now the annual payments are to be made at
the beginning of each year. The periodic payment equals:
Year Factor
0 1.0
1-9 4.9464
5.9464
The interest rate associated with a lease agreement can also be computed by dividing the value of the
leased property by the annual payment to obtain the factor, which is then used to find the interest rate
with the help of a present value of annuity table.
EXAMPLE 13-26
The company leased $300,000 of property and is to make equal annual payments at year-end of
$40,000 for 11 years. The interest rate associated with the lease agreement is:
Going to the present value of annuity table and looking across 11 years to a factor nearest to 7.5, we
find 7.499 at a 7% interest rate. Thus, the interest rate in the lease agreement is 7%.
Lease-Purchase Decision
The lease-purchase decision is one commonly confronting firms considering the acquisition of new
assets. It is a hybrid capital budgeting decision that forces a company to compare the leasing and
purchasing


Page 246
alternatives. To make an intelligent decision, an after-tax, cash outflow, present value comparison is
needed. There are special steps to take when making this comparison. When considering a lease,
take the following steps:
1. Find the annual lease payment. Since the annual lease payment is typically made in advance, the
formula used is:
or
Notice that we use n - 1 rather than n.

2. Find the after-tax cash outflows.
3. Find the present value of the after-tax cash outflows.
When considering a purchase, take the following steps:
1. Find the annual loan amortization by using:
The step may not be necessary since this amount is usually available.
2. Calculate the interest. The interest is segregated from the principal in each of the annual loan
payments because only the interest is tax-deductible.
3. Find the cash outflows by adding interest and depreciation (plus any maintenance costs), and then
compute the after-tax outflows.
4. Find the present value of the after-tax cash outflows, using Table 6-3.
EXAMPLE 13-27
A firm has decided to acquire an asset costing $100,000 that has an expected life of 5 years, after
which the asset is not expected to have any residual value. The asset can be purchased by borrowing,
or it can be leased. If leasing is used, the lessor requires a 12 percent return. As is customary, lease
payments are to be made in advance, that is, at the end of the year prior to each of the 10 years. The
tax rate is 50 percent, and the firm's cost of capital, or after-tax cost of borrowing, is 8 percent.


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To summarize:
Lease Purchase
Proposal Proposal
Cost of machine $ 100,000 $ 100,000
Terms of payment 5 years 5 years
Interest rate 12% 10%
Down payment
$ 23,216
Monthly lease payment at the
end of the year
Monthly loan payment $ 26,381
Depreciation Straight line
Residual purchase price 0% 0%
Corporate tax bracket 50% 50%
After-tax cost of capital 8% 8%
First, compute the present value of the after-tax cash outflows associated with the leasing alternative.
Begin by finding the annual lease payment:
Steps 2 and 3 can be done in the same schedule, as follows:

(1) (2) (3) = (1) - (2) (4) (5) = (3) × (4)
Year Lease Payment ($) Tax Savings ($) After-Tax PV PV of Cash Out-
Cash Outflow ($) at 8% flow ($ rounded)
0 23,216 23,216 23,216
1.000
1 4 23,216 11,608(a) 11,608 38,447
3.3121(b)
5 (11,608) (7,900)
11,608 0.6806(c)
53,763
(a) $23,216 × 50%
(b) From Table 6-4.
(c) From Table 6-3.

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If the asset is purchased, the firm is assumed to finance it entirely with a 10 percent unsecured term
loan. Straight-line depreciation is used with no salvage value. Therefore, the annual depreciation is
$20,000 ($100,000/5 years). In this alternative, first find the annual loan payment by using:
Then, calculate the interest by setting up a loan amortization schedule.

(1) (2) (3) = (2) (4) = (1) - (5) = (2) - (4)
(10%) (3)
Yr Loan Payment Beginning-of-Year Interest ($) Principal ($) End-of-Year
($) Principal ($) Principal ($)
1 26,381 10,000 83,619
100,000 16,381
2 26,381 8,362 65,600
83,619 18,019
3 26,381 6,560 45,779
65,600 19,821
4 26,381 4,578 23,976
45,779 21,803
5 26,381 2,398
23,976(a) 23,983(a)
(a) Because of rounding errors, there is a slight difference between (2) and (4).
Steps 3 (cash outflows) and 4 (present values of those outflows) can be done as shown in Figure
13.1.
The sum of the present values of the cash outflows for leasing and purchasing by borrowing shows
that purchasing is preferable because the PV of borrowing is less than the PV of leasing ($52,008
versus $53,763). The incremental savings is $1,675.


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TABLE 13-2
BUY VERSUS LEASE EVALUATION REPORT
Year Loan Interest Depreciation Net After- Present Value Discounted Cash Flow
Payments Expense Expense Tax Cash Factor Buy
Flow
(1) (2) (3) (4) = (1) - {.5[(2) + (5) (6) = (4) × (5)
(3)]}
1 $26,381 $10,000 $ 20,000 $11,381 0.9259 10,538
2 26,381 8,362 12,200 0.8573 10,459
20,000
3 26,381 6,560 13,101 0.7938 10,400
20,000
4 26,381 4,578 14,092 0.735 10,358
20,000
5 26,381 2,398 15,182 0.6806 10,333
20,000
$131,905 $31,898 $100,000 $65,956 $52,087

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Chapter Perspective
When seeking short-term financing, you should select the best financing vehicle available to meet the
company's objectives. The choice of a particular financing instrument depends on the company's
particular circumstances and such factors as cost, risk, restrictions, stability of operations, and tax
rate. Sources of short-term financing include trade credit, bank loans, bankers' acceptances, finance
company loans, commercial paper, receivable financing, and inventory financing.
Intermediate-term financing has a maturity between one and five years and includes multi-year bank
or insurance company loans and leases. Fixed assets may serve as collateral. Some advantages of
intermediate-term financing are its flexibility and its lower flotation costs.


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Chapter 14
Long-Term Debt Financing
Long-term financing generally refers to financing with a maturity of more than five years. This
chapter discusses the what, why, and how-to of long-term debt financing. Long-term debt financing
consists primarily of bonds. Long-term financing is often used to finance long-lived assets, such as
land or equipment, or construction projects. The more capital-intensive the business, the more it
should rely on long-term debt and equity.
A company's mix of long-term funds is referred to as its capital structure. The ideal capital structure
maximizes the total value of the company and minimizes the overall cost of capital. Managers
charged with formulating an appropriate capital structure should take into account the nature of the
business and industry, the company's strategic business plan, its current and historical capital
structure, and its planned growth rate.
· The types of bonds that can be issued.
· The advantages of using bonds for long-term financing.
· How bond interest is calculated and paid.
· How to decide if a bond issue should be refunded before maturity.
Types of Long-Term Debt

Different types of debt instruments are appropriate in different circumstances. The amount of debt a
company may have depends largely on its available collateral. Sources of long-term debt include
mortgages and bonds.
Mortgages
Mortgages are notes payable that are secured by real assets and that require periodic payments.
Mortgages can be issued to finance the purchase of assets, the construction of plant, or the
modernization of facilities. Banks require that the value of the property exceed the mortgage on that
property and usually lend up to between 70 percent and


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90 percent of the value of the collateral. Mortgages may be obtained from a bank, life insurance
company, or other financial institution. As a rule, it is easier to obtain mortgage loans for multiple-
use real assets than for single-use real assets.
There are two types of mortgages: senior mortgages, which have first claim on assets and earnings,
and junior mortgages, which have subordinate liens.
A mortgage may have a closed-end provision that prevents the company from issuing additional debt
of the same priority against the specific property. If the mortgage is open-ended, the company can
issue additional first-mortgage bonds against the property.
Mortgages have a number of advantages, including favorable interest rates, fewer financing
restrictions than bonds, extended maturity dates for loan repayment, and easy availability.
Bonds
Long-term corporate debt usually takes the form of bonds payable and loans payable. A bond is a
certificate indicating that the company has borrowed money and agrees to repay it. A written
agreement, called an indenture, describes the features of the bond issue (e.g., payment dates, call
prices should the issuer decide to reacquire the bonds, conversion privileges, and any restrictions).
The indenture is a contract between the company, the bondholder, and the trustee, who makes sure
that the company meets the terms of the bond contract (in many instances, the trustee is the trust
department of a commercial bank). Although the trustee is an agent for the bondholder, it is selected
by the issuing company prior to the issuance of the bonds. If a provision of the indenture is violated,
the bonds are in default. (Covenants in the indenture should be flexible enough to allow companies to
respond quickly to changes in the financial world.) The indenture may also have a negative pledge
clause, which precludes the issuance of new debt that takes priority over existing debt in the event of
liquidation. The clause can apply to assets currently held as well as to assets that may be purchased
in the future.
The price of a bond depends on several factors, including its maturity date, interest rate, and
collateral. In selecting a maturity period for long-term debt, you should structure the debt repayment
schedule so that not all of the debt comes due close together. It is best to spread out the payments to
avoid the possibility that the cash flow will be inadequate to meet the debt payment. Also, if you
expect your company's credit rating to improve in the near term, you should issue short-term debt and
then refinance later at a lower interest rate.


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Bond prices and market interest rates are inversely related. As market interest rates increase, the
price of existing bonds falls because investors can invest in new bonds paying higher interest rates.
The price of a bond on the open market depends on several factors such as its maturity value, interest
rate, and collateral.
Interest
Bonds are issued in $1,000 denominations; many have maturities of 10 to 30 years. The interest
payment to the bondholder is called nominal interest, which is the interest on the face of the bond
and which is equal to the coupon (nominal) interest rate times the face value of the bond. Although
the interest rate is stated on an annual basis, interest on a bond is usually paid seminannually. Interest
expense incurred by the issuer is tax deductible.
EXAMPLE 14-1
A company issues a 20 percent, 20-year bond. The tax rate is 46 percent. The annual after-tax cost of
the debt is:
EXAMPLE 14-2
A company issues a $100,000, 12 percent, 10-year bond. The semiannual interest payment is:
Assuming a tax rate of 30 percent, the after-tax semiannual interest is:
A bond sold at face value ($1,000) is said to be sold at 100. If a bond is sold below its face value, it
is being sold at less than 100 and is issued at a discount. If a bond is sold above face value, it is
being sold at more than 100, that is, at a premium. A bond is likely to be sold at a discount when the
interest rate on the bond is below the prevailing market interest rate for that type of security, when
the issuing company is risky, or when it carries a long maturity period. A bond is sold at a premium
when the opposite conditions exist.
Bond issue costs are also tax deductible.
EXAMPLE 14-3
Travis Corporation issues a $100,000, 14 percent, 20-year bond at 94. The maturity value of the
bond is $100,000. The annual interest payment is:

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The proceeds from the issuance of the bond is:
The amount of the discount is:
EXAMPLE 14-4
A bond having a face value of $100,000 with a 25-year life was sold at 102. The tax rate is 40
percent. The bond was sold at a premium since it was issued above face value. The total premium is
$2,000 ($100,000 × 0.02).
Types of Bonds
Companies may issue various types of bonds:
· Debentures. Because debentures are unsecured (have no collateral) debt, they can be issued only
by large, financially strong companies with excellent credit ratings. Note, however, that most ''junk
bonds" are debentures of large companies that do not have good credit ratings.
· Subordinated Debentures. The claims of the holders of these bonds are subordinated to those of
senior creditors. Debt that has a prior claim over the subordinated debentures is set forth in the bond
indenture. Typically, in the event a company is liquidated, subordinated debentures are paid off after
short-term debt.
· Mortgage Bonds. These are bonds secured by real assets. The first-mortgage claim must be met
before a distribution is made to a second-mortgage claim. There may be several mortgages for the
same property.
· Collateral Trust Bonds. The collateral for these bonds is the company's security investments in
other companies (bonds or stocks), which are held by a trustee for safekeeping.
· Convertible Bonds. These bonds may be converted to stock at a later date based on a specified
conversion ratio. Convertible bonds are typically issued in the form of subordinated debentures.
Convertible bonds are more marketable and are typically issued at a lower interest rate than are
regular bonds because they offer the right to conversion to common stock. Of course, if bonds are
converted to stock, the debt is not repaid. A convertible bond is a quasi-equity security because its
market value is tied to its value if converted to stock rather than as a bond. Chapter 17 discusses
convertible bonds in detail.
· Income Bonds. These bonds pay interest only if the company makes a profit. The interest may be
cumulative, in which case it accumulates regardless of earnings and if bypassed must be paid in a
later year when adequate earnings exist, or noncumulative. Income bonds are appropriate for
companies with large fixed capital investments and

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large fluctuations in earnings or for emerging companies that expect low earnings in the early years.
· Guaranteed Bonds. These are debt issued by one party and guaranteed by another.
· Serial Bonds. These bonds are issued with different maturities available. At the time serial bonds
are issued, a schedule is prepared to show the yields, interest rates, and prices for each maturity. The
interest rate on the shorter maturities is lower than the interest rate on the longer maturities because
there is less uncertainty about the near future.
· Deep Discount Bonds. These bonds have very low interest rates and thus are issued at substantial
discounts from face value. The return to the holder comes primarily from appreciation in price rather
than from interest payments. The bonds are volatile in price.
· Zero Coupon Bonds. These bonds do not pay interest; the return to the holder is in the form of
appreciation in price. Lower interest rates may be available for zero coupon bonds (and deep
discount bonds) because they cannot be called.
· Variable-Rate Bonds. The interest rates on the bonds are adjusted periodically to reflect changes in
money market conditions (e.g., prime interest rate). These bonds are popular when future interest
rates and inflation are uncertain.
· Eurobonds. Eurobonds are issued outside the country in whose currency the bonds are
denominated. Dollar-denominated Eurobonds cannot be sold by U.S. issuers to U.S. investors but
may be sold only to foreign investors, because they are not registered with the SEC. The bonds are
typically in bearer form, meaning the securities are not registered on the books of the issuing
corporation and thus are payable to whoever possesses them. A bearer bond has coupons attached,
which the bondholder sends in or presents on the interest date to receive payment. If you are
considering a bond issue, check to see if the Eurodollar market will give the company a lower cost
option than the U.S. market. Eurobonds typically can only be issued by high-quality borrowers.
Small companies with unproven track records may have to issue what is commonly referred to as
"junk bonds" (high-yielding risky bonds rated by Standard & Poor's as B+ or below or by Moody's
Investors Service as B-1 or below). These are considered low-quality bonds.
A summary of the characteristics and priority claims associated with bonds appears in Table 14-1.


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TABLE 14-1
SUMMARY OF CHARACTERISTICS AND
PRIORITY CLAIMS OF BONDS
Bond Type Characteristics Priority of Lender's
Claim
Debentures Available only to financially strong General creditor.
companies. Convertible bonds are typically
debentures.
SubordinatedComes after senior debt holders. General creditor.
Debentures
Mortgage Collateral is real property or buildings. Paid from the
Bonds proceeds from the
sale of the
mortgaged assets. If
any deficiency
exists, general
creditor status
applies.
Collateral Secured by stock and (or) bonds owned by Paid from the
Trust Bonds the issuer. Collateral value is usually 30% proceeds of stock
more than bond value. and (or) bond that is
collateralized. If
there is a deficiency,
general creditor
status applies.
Income Interest is only paid if there is net income. General creditor.
Bonds Often issued when a company is in
reorganization because of financial problems.
Deep Issued at very low or no (zero) coupon rates.Unsecured or
Discount Issued at prices significantly below face secured status may
and Zero value. Usually callable at par value. apply depending on
Coupon the features of the
Bonds issue.
Variable-rateCoupon rate changes within limits based on Unsecured or
Bonds changes in money or capital market rates. secured status may
Appropriate when uncertainty exists apply depending on
regarding inflation and future interest rates. the features of the
Because of the automatic adjustment to issue.
changing market conditions, the bonds sell
near face value.

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Bond Ratings
Financial advisory services, such as Standard & Poor's and Moody's, rate publicly traded bonds
according to their risk of default. An inverse relationship exists between the quality of a bond and its
yield; low-quality bonds have a higher yield than high-quality bonds. Hence, a risk-return trade-off
exists for the bondholder. Bond ratings are important because they influence marketability and the
cost associated with the bond issue.
Advantages and Disadvantages to Debt Refinancing
Among the advantages of long-term debt are these:
· Interest is tax-deductible, while dividends paid to stockholders are not.
· Bondholders do not participate in earnings growth of the company.
· Debt is repaid in cheaper dollars during inflationary periods.
· Company control remains undiluted.
· Financing flexibility can be achieved by including a call provision allowing the company to pay the
debt before the expiration date of the bond in the bond indenture. However, the issuer pays a price
for this advantage in the form of the higher interest rates that callable bonds require.
· It may safeguard the company's future financial stability if used in times of tight money markets
when short-term loans are not available.
The disadvantages of issuing long-term debt are these:
· Interest charges must be met regardless of the company's earnings.
· Debt must be repaid at maturity.
· Higher debt implies greater financial risk, which may increase the cost of financing.
· Indenture provisions may place stringent restrictions on the company.
· Overcommitments may arise from errors in forecasting future cash flow.
To investors, bonds have the following advantages:
· They pay a fixed interest payment each year.
· They are safer than equity securities.
However, investors should consider these disadvantages:
· Bonds carry interest rate risk, the chance that principal will be lost if interest rates rise and the
bond drops in value.
· Bonds do not participate in corporate profitability.
· Bondholders have no voting rights and therefore no say in how the company is run.
The proper mixture of long-term debt and equity depends on company organization, credit
availability, and the after-tax cost of financing.


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If the company already has a high level of debt, it should take steps to minimize other corporate
risks.
Long-term debt financing is appropriate when:
· The interest rate on debt is less than the rate of return that can be earned on the money borrowed.
For example, a company may borrow at 10 percent interest but earn a return of 18 percent by
investing that money in the business. Through the use of other people's money (OPM), the company
can increase its after-tax profit. (Stockholders will have made an extra profit with no extra
investment!)
· The company's revenue and earnings are stable, so that the company will be able to meet interest
and principal in both good and bad years. However, cyclical factors should not scare a company
away from having any debt. The important thing is to accumulate no more interest and principal
repayment obligations that can reasonably be satisfied in bad times as well as good.
· There is a satisfactory profit margin so that earnings are sufficient to meet debt obligations.
· The liquidity and cash flow positions are good.
· The debt/equity ratio is low so the company can handle additional obligations.
· The risk level of the firm is low.
· Stock prices are currently depressed so that it does not pay to issue common stock at the present
time.
· Control considerations are a primary factor (if common stock was issued, greater control might fall
into the hands of a potential corporate raider).
· The firm is mature, meaning it has been in business for a long time.
· The inflation rate is expected to rise, so that debt can be paid back in cheaper dollars.
· There is a lack of competition (e.g., entry barriers exist in the industry, such as stringent
governmental regulations).
· The markets for the company's products are expanding and the company is growing.
· The tax rate is high so that the company will benefit by deducting interest payments from its taxes.
· Bond indenture restrictions are not burdensome.
· Money market trends are favorable and any necessary financing is available.
Project financing is tied to particular projects and may be suitable for large, self-contained
undertakings, perhaps involving joint ventures.

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If your company is experiencing financial difficulties, it may wish to refinance short-term debt on a
long-term basis, perhaps by extending the maturity dates of existing loans. This may alleviate current
liability and cash flow problems. As the default risk of your company becomes higher, so will the
interest rate lenders demand to compensate for the greater risk.
When a high degree of debt (financial leverage) exists, you should try to reduce other risks (e.g.,
product risk) so that total corporate risk is controlled. The threat of financial distress or even
bankruptcy is the ultimate limitation on leverage. If the company's debt is beyond a reasonable limit,
the tax savings on interest expense will be offset by the increased interest rate demanded by
creditors to compensate for the increased risk. Excessive debt also lowers the market price of stock
because of the greater risk associated with the company.
Small companies with thinly traded stocks (little market activity) often issue debt and equity
securities together in the form of units. A company may elect to issue units instead of convertible
debt if it desires to increase its common equity immediately.
Bond Refunding
Companies may refund bonds before maturity by either issuing a serial bond or exercising a call
privilege on a straight bond. The issuance of serial bonds allows the company to refund the debt
over the life of the issue; calling the bond enables the company to retire it before the expiration date.
When future interest rates are expected to drop, it is wise for the company to exercise the call
provision. It can buy back the higher-interest bond and then issue one at lower interest. The timing
for the refunding depends on expected future interest rates. The call price typically exceeds the face
value of the bond; the resulting call premium equals the difference between the call price and the
maturity value. The call premium is usually equal to one year's interest if the bond is called in the
first year; it declines at a constant rate each year thereafter. Also involved in selling a new issue are
flotation costs (e.g., brokerage commissions, printing costs).
A bond with a call provision typically has a lower offering price and is issued at an interest rate
higher than one without the call provision. Investors prefer not to have a situation in which the
company can buy back the bond at its option prior to maturity; they would obviously prefer to hold
onto a high-interest bond when prevailing interest rates are low.


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EXAMPLE 14-5
A $100,000 issue of 8 percent, 10-year bonds is priced at 94 percent. The call price is 103 percent.
Three years after the issue, the bonds are called. The call premium is equal to:
Call price $103,000
Face value of bond 100,000
Call premium $3,000
EXAMPLE 14-6
A company issues $40,000 of callable bonds. The call price is 104. The tax rate is 35 percent. The
after-tax cost of calling the issue is:
EXAMPLE 14-7
Your company has a $20 million, 10 percent bond issue outstanding that has 10 years to maturity. The
call premium is 7 percent of face value. New 10-year bonds in the amount of $20 million can be
issued at an 8 percent interest rate. Flotation costs of the new issue are $600,000.
Refunding of the original bond issue should occur as shown here.
Old interest payments ($20,000,000 × 0.10) $2,000,000
New interest payments ($20,000,000 × 0.08) 1,600,000
Annual Savings $400,000
Call premium ($20,000,000 × 0.07) $1,400,000
Flotation cost 600,000
Total cost $2,000,000
Year Calculation Present Value

0 -$2,000,000× 1 -$2,000,000
1 10 $400,000× 6.71(a)
2,684,000

Net present value $684,000
(a) Present value of annuity factor for i = 8%, n = 10

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Sinking Fund
Bond issues may require a sinking fund, into which the company puts aside money with which to buy
and retire part of a bond issue each year. Usually, a mandatory fixed amount must be retired, but
occasionally the amount is tied to the company's sales or profit for the year. If a sinking fund payment
is not made, the bond issue may be in default.
In many instances, the company can handle the sinking fund in one of the following two ways:
· It can call a given percentage of the bonds at a specified price each year, for instance, 10 percent of
the original amount at a price of $1,070.
· It can buy its own bonds on the open market.
The least costly of these alternatives should be selected. If interest rates have increased, the price of
the bonds will have decreased and the open market option should be employed. If interest rates have
decreased, bond prices will have increased; thus calling the bonds is less costly.
EXAMPLE 14-8
Your company has to reduce bonds payable by $300,000. The call price is 104. The market price of
the bonds is 103. The company will opt to buy back the bonds on the open market because it is less
expensive, as indicated below:
Call price ($300,000 × 104%) $312,000
Purchase on open market ($300,000 × 103%) 309,000
Advantage of purchasing bonds on the open market $3,000
Chapter Perspective
This chapter has discussed the kinds of bonds a company uses in long-term financing. We have
explained when to use bond financing and have discussed the advantages and disadvantages of using
bonds. We have shown how bond interest is calculated and paid and we have showed you how to
decide if bonds should be refunded before maturity. The next chapter covers stockholders' equity, the
other source of long-term capital.


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Chapter 15
Long-Term Equity Financing
All stock issued by a company is either preferred stock or common stock, regardless of what name
the issue of stock may be given. And, although some companies may describe several different types
or classes, there is (except in very rare cases) only one class of common stock. All other classes of
stock, regardless of name, are preferred in some way over the one class of common stock. This
chapter discusses the advantages and disadvantages of the different kinds of stock and other equity
securities a company can issue. We will discuss the role of the investment banker and the difference
between a public and private placement of securities.
· You will understand the advantages and disadvantages of the different kinds of stock and other
equity securities.
· You will understand the characteristics of the different classes of stock.
· You will understand the role of the investment banker.
· You will see the importance of making wise capital structure decisions.
· You will know the difference between a private and public placement of securities.
Issuing Equity Securities

The sources of equity financing are preferred stock and common stock. There are advantages and
disadvantages associated with issuing preferred and common, and each is the issue of choice in
certain circumstances.
Preferred Stock
Preferred stock is a hybrid of bonds and common stock. Preferred stock comes after debt but before
common stock in the event of liquidation and in the distribution of earnings. The optimal time to
issue preferred


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stock is when the company has excessive debt and an issue of common stock might encourage a
corporate raider to try to take control of the company. Issuing preferred stock is a more expensive
way to raise capital than issuing bonds because dividend payments are not tax deductible.
Preferred stock may be cumulative or noncumulative. If any prior year's dividend payments to
holders of cumulative preferred stock have been missed, they must be made up before dividends can
be paid to common stockholders. If preferred dividends are in arrears for a long time, the company
may find it difficult to resume its dividend payments to common stockholders. The company need not
pay missed preferred dividends to holders of noncumulative preferred stock. Most preferred stock is
cumulative; dividends are limited to a specified rate, which is based on the total par value of the
outstanding shares.
EXAMPLE 15-1
As of December 31, 20X6, Ace Company has 6,000 shares of $15 par value, 14 percent, cumulative
preferred stock outstanding. Dividends have not been paid in 20X4 and 20X5. Assuming the
company has been profitable in 20X6, the amount of the dividend to be distributed is:
Dividends in arrears ($90,000 × 14% × 2 years) $25,200

Current year dividend ($90,000 × 14%) 12,600
Total dividend $37,800
If dividends exceed the amount typically given to preferred stockholders and common stockholders,
the preferred and common stockholders will participate in the excess dividends; in such cases, the
preferred stock is referred to as participating preferred stock. Unless stated otherwise, the
distribution of the excess dividends will be based on the relative total par values. Nonparticipating
preferred stock does not participate with common stock in excess dividends. Most preferred stock is
nonparticipating. Dividend policy is discussed further in Chapter 16.
Preferred stock may be callable. This provision is advantageous to the company when interest rates
decline, since the company has the option of discontinuing payment of dividends at a rate that has
become excessive by buying back outstanding preferred stock. Unlike bonds, preferred stock rarely
has a maturity date; however, preferred stock that has a sinking fund associated with it in effect has a
maturity date for repayment.


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There are several forms of preferred stock issues. Limited life preferred stock has a specified
maturity date or can be redeemed at the holder's option. Perpetual preferred stock automatically
converts to common stock at a given date. There is also preferred stock with ''floating rate"
dividends, which keep the preferred stock at par by altering the dividend rate.
In the event of a corporate bankruptcy, preferred stockholders are paid after creditors and before
common stockholders. In such a case, preferred stockholders receive the par value of their shares,
dividends in arrears, and the current year's dividend. Any asset balance then goes to the common
stockholders.
The cost of preferred stock usually follows changes in interest rates and is likely to be low when
interest rates are low. When the cost of common stock is high, preferred stock may be issued at a
lower cost.
A preferred stock issue has the following advantages:
· Preferred dividends do not have to be paid (important during periods of financial distress). Interest
on debt must be paid.
· Preferred stockholders cannot force the company into bankruptcy.
· Preferred shareholders do not share in unusually high profits because the common stockholders are
the real owners of the business.
· A growth company can generate better earnings for its original owners by issuing preferred stock
having a fixed dividend rate than by issuing common stock.
· Preferred stock issuance does not dilute the ownership interest of common stockholders in terms of
earnings participation and voting rights.
· No, sinking fund is required.
· The company does not have to collateralize its assets as it may have to do if bonds are issued.
· The debt to equity ratio is improved.
A preferred stock issue does have some disadvantages:
· Preferred stock must offer a higher yield than corporate bonds because it carries greater risk (since
preferred stock comes after bonds in corporate liquidation).
· Preferred dividends are not tax deductible.
· Preferred stock has higher flotation costs than bonds.
To an investor, a preferred stock offers the following:
· Preferred stock usually provides a constant return in the form of a fixed dividend payment.
· Preferred stockholders come before common stockholders in the event of corporate bankruptcy.
· Preferred dividends are subject to an 80 percent dividend exclusion


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for corporate investors. For example, if a company holds preferred stock in another company and
receives dividends of $10,000, only 20 percent (or $2,000) is taxable. On the other hand, interest
income received on bonds is fully taxable.
The disadvantages of preferred stock to an investor are:
· Return is limited because of the fixed dividend rate.
· Prices of preferred stock fluctuate more than those of bonds because there is no maturity date on the
stock.
· Preferred stockholders cannot require the company to pay dividends if the firm has inadequate
earnings.
Common Stock Issues
Common stock is the residual equity ownership in the business; it does not involve fixed charges,
maturity dates, or sinking fund requirements. Holders of common stock have voting power but come
after preferred stockholders in receiving dividends and in liquidation.
Common stockholders enjoy the following rights:
· The right to receive dividends.
· The right to receive assets if the business dissolves.
· The right to vote.
· The preemptive right to buy new shares of common stock prior to their sale to the general public,
thus allowing them to maintain proportionate percentage ownership in the company.
· The right to a stock certificate which evidences ownership in the firm. The stock certificate may
then be sold by the holder to another investor in the secondary security market, exchanges and over-
the-counter markets in which securities are bought and sold after their original issuance. Proceeds of
secondary market sales go to the dealers or investors, not to the company which originally issued the
securities.
· The right to inspect the company's books.
Companies may occasionally issue different classes of common stock. Class A is stock issued to the
public that has no dividends but does usually have voting rights (although these are insufficient to
obtain control of the company). Class B stock, which is typically kept by the company's organizers,
does not pay dividends until the company has generated adequate earnings; it provides majority
voting rights in order for current management to maintain control. Having two classes of stock
enables the founders or management of the company to keep control by holding majority voting
rights.
Authorized shares represent the maximum amount of stock the company can issue according to the
corporate charter. Issued shares represents the number of authorized shares that have been sold by
the


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firm. Outstanding shares are the issued shares actually being held by the investing public; treasury
stock is stock that has been reacquired by the company. Outstanding shares are therefore equal to the
issued shares less the treasury shares; dividends are based on the outstanding shares.
The par value of a stock is a stated amount of value per share as specified in the corporate charter.
The company usually cannot sell stock at a price below par value since stockholders would then be
liable to creditors for the difference between par value and the amount received if the company were
to fail.
The price of common stock moves in opposition to market interest rates. For example, if market
interest rates increase, stock prices fall as investors transfer funds out of stock into higher-yielding
money market instruments and bank accounts. Further, higher interest rates raise the cost of
borrowing, lowering profits and thus stock prices. Common stock is generally issued in one of the
following ways:
· Broad syndication. In a broad syndication, many investment bankers distribute corporate
securities. This method is most common, because it gives the issuer the greatest control over
distribution and thus probably achieves the highest net price. It also provides the widest public
exposure. Its drawbacks are that it may take longer and has high transaction costs.
· Limited distribution. In a limited distribution, a limited number of underwriters are involved in the
issuance of the company's securities. As a result, the stock receives less public exposure. However,
the issuing company may choose to work with only those investment bankers it believes are best
qualified or who have the widest contacts.
· Sole distribution. In a sole distribution, only one underwriter is used, possibly resulting in unsold
shares. The company has less control in this set up than in a broad syndication, but incurs lower
transaction costs. Sole distribution is also fast.
· Dribble-out. In this method, the company periodically issues stock at different prices depending on
market conditions. This approach is not recommended because of the high associated costs, and
because it depresses stock price because of the constant issuance of shares.
In timing a public issuance of common stock, you should consider the following:
· Do not offer shares near the expiration date for options on the company's shares, since the option-
related transaction may affect share price. (An option is the right to buy stock at a specified price
within a given time period. If the right is not exercised within the specified time period, the option
expires.)


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· Offer higher yielding common stock just before the ex-dividend date to attract investors. Ex-
dividend is a term used to indicate that a stock is selling without a recently declared dividend. The
ex-dividend date is four business days before the date of record.
· Issue common stock when there is little competition from other recent issues in the industry.
· Issue shares in bull markets (a rising stock market) and refrain from issuing them in bear markets
(declining markets).
You may need to determine the number of shares that must be issued to raise funds required to satisfy
your capital budget.
EXAMPLE 15-2
Your company currently has 650,000 shares of common stock outstanding. The capital budget for the
upcoming year is $1.8 million.
Assuming new stock may be issued for $16 a share, the number of shares that must be issued to
provide the necessary funds to meet the capital budget are:
EXAMPLE 15-3
Your company wants to raise $3 million in its first public issue of common stock. After its issuance,
the total market value of stock is expected to be $7 million. Currently, there are 140,000 outstanding
shares that are closely held (that is, held by a few shareholders). The shares held by the controlling
group are not considered likely to be available for purchase.
We want to compute the number of new shares that must be issued to raise the $3 million.
The new shares will constitute 3/7 ($3 million/$7 million) of the outstanding shares after the stock
issuance, and current stockholders will be holding 4/7 of the shares.
After the stock issuance, the expected price per share is:

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A company that is about to make its first public offering of stock is referred to as "going public." The
estimated price per share to sell the securities is equal to:
The anticipated market value of the company is based on a valuation model.

For an established company, the market price per share can be determined as follows:
EXAMPLE 15-4
Your company expected the dividend for the year to be $10 a share. The cost of capital is 13 percent.
The growth rate in dividends is expected to be constant at 8 percent. The price per share is:
Another approach to pricing the share of stock for an existing company is through the use of the
price/earnings (P/E) ratio, which is equal to:
EXAMPLE 15-5
Your company's earnings per share is $7. It is expected that the company's stock should sell at eight
times earnings. (This expectation is usually based on what the stock of similar companies sells for in
the market.)
The market price per share is therefore:

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You may want to determine the market value of your company's stock. There are a number of
different ways to accomplish this.
EXAMPLE 15-6
Assuming an indefinite stream of future dividends of $300,000 and a required return rate of 14
percent, the market value of the stock equals:
If there are 200,000 shares, the market price per share is:
EXAMPLE 15-7
Your company is considering a public issue of its securities. The average price/earnings multiple in
the industry is 15. The company's earnings are $400,000. There will be 100,000 shares outstanding
after the issue. The expected price per share is:
If your company has significant debt, it will be better off financing with an equity issue to lower
overall financial risk.
Financing with common stock has the following advantages:
· The company is not required to pay fixed charges such as interest or dividends.
· There is no repayment date or sinking fund requirement.
· A common stock issue improves the company's credit rating compared to a bond issue. For
example, it improves the debt-equity ratio.


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Financing with common stock has disadvantages:

· Dividends are not tax deductible.
· Ownership interest is diluted. The additional voting rights might vote to remove the current
ownership group from power.
· Earnings and dividends must be spread over more shares out-standing.
· The flotation costs of a common stock issue are higher than those for preferred stock and debt
financing.
It is always cheaper to finance operations from internally generated funds because such financing
involves no flotation costs. Retained earnings may be used as equity funding if the company believes
its stock price is lower than the true value of its assets or if transaction costs for external financing
are high.
The company may make use of dividend reinvestment plans, in which stockholders reinvest their
dividends into the company by buying more shares, and employee stock option plans, which allow
employees to buy company stock at an option price typically below what the market price of the
stock will be when the option is exercised. Such plans allow the company to raise financing and
avoid issuance costs and the market impact of a public offering.
An employee stock ownership plan (ESOP) is a program encouraging employees to invest in the
employer's stock as a motivation tool for workers and a way for the company to raise funds.
A summary comparison of bonds and common stocks is presented in Exhibit 15-1.
Stock Rights
Stock rightsoptions to buy securities at a specified price at a later dateare a good source of common
stock financing. Preemptive rights provide existing stockholders with the first option to buy
additional shares. Exercising this right permits investors to maintain voting control and protects
against dilution in ownership and earnings.
Financial management decides on the life of the right (typically about two months), its price
(typically below the current market price), and the number of rights needed to buy a share.
In a rights offering, a date of record indicates the last day that the receiver of the right must be the
legal owner as reflected in the company's stock ledger. To compensate for bookkeeping lags, stocks
are often sold ex rights (without rights) four business days before the record date; prior to this point,
the stock is sold rights on, which means the purchasers receive the rights and can exercise them, sell
them, or let them expire.


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EXHIBIT 15-1
SUMMARY COMPARISON OF BONDS AND
COMMON STOCK
Bonds Common Stock
Bondholders are creditors. Stockholders are owners.
No voting rights exist. Voting rights exist.
There is a maturity date. There is no maturity date.
Bondholders have prior claims on Stockholders have residual
profits and assets in bankruptcy. claims on profits and
assets in bankruptcy.
Interest payments represent fixed Dividend payments do not
charges. constitute fixed charges.
Interest payments are deductible on There is no tax
the tax return. deductibility for dividend
payments.
The rate of return required by The rate of return required
bondholders is typically lower than by stockholders is typically
that required by stockholders. greater than that required
by bondholders.
Since stock rights are transferable, many are traded on the stock exchange and over-the-counter
markets. They may be exercised for a given period of time at a subscription price, which is set
somewhat below the prevailing market price. After the subscription price has been determined,
financial management must ascertain the number of rights necessary to purchase a share of stock. The
total number of shares that must be sold equals:
The number of rights needed to acquire one share equals:
EXAMPLE 15-8
Your company wants to obtain $800,000 by a rights offering. There are presently 100,000 shares
outstanding. The subscription price is $40 per share. The shares to be sold equal:


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The number of rights to acquire one share equals:
Thus, five rights will buy one new share at $40. Each right enables the holder to buy 1/5 of a share
of stock.
Value of a Right
The value of a right should, theoretically, be the same whether the stock is selling with rights on or
with ex rights.
When stock is selling with rights on, the value of a right equals:
EXAMPLE 15-9
Your company's common stock sells for $55 a share with rights on. Each stockholder is given the
right to buy one new share at $35 for every four shares held. The value of each right is:
When stock is traded ex rights, the market price is expected to decline by the value of the right. The
market value of stock trading ex rights should theoretically equal:
The value of a right with stock is selling ex rights equals:

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EXAMPLE 15-10
Assuming the same information as in Example 15-9, the value of the company's stock trading ex
rights should equal:
or
The value of a right when stock is selling ex rights is:
The theoretical value of the right is identical when the stock is selling rights on or ex rights.
Governmental Regulation
When securities are issued publicly, they must conform to federal and state regulations. The major
federal laws are the Securities Act of 1933 and the Securities Exchange Act of 1934. State rules are
referred to as blue sky laws.
The financial manager must be familiar with these laws for several reasons. First, a violation of the
laws makes the manager subject to personal legal liability. Second, governmental regulation impacts
the availability and costs of financing. Third, regulations apply to the money and capital markets in
which the company's shares are traded. Fourth, the laws serve as safeguards to investors.
The Securities Act of 1933 deals with the regulation of new security issues. Its purpose is to ensure
full disclosure of financial information about the company's affairs and to furnish a record of
representations. The Act applies to interstate offerings to the public in amounts exceeding $1.5
million. Securities must be registered with the Securities and Exchange Commission (SEC) at least
twenty days before they are publicly offered. Prior to the issuance of a new security issue, the
company must prepare a prospectus for investors which contains a condensed version of the
registration statement filed with the SEC, including accounting, financial, and legal information about
the company. The SEC may delay or cease a public offering if information contained in the


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registration statement is erroneous, misleading, or incomplete. If the SEC-approved registration

statement or prospectus is later found to contain misrepresentations, an investor who suffers losses
can sue the issuing company and its officers for damages.
The Securities Exchange Act of 1934 applies to existing securities transactions. It requires full and
accurate disclosure of financial information. Companies whose securities are listed on securities
exchanges must file registration statements and periodic financial reports with both the SEC and the
listing stock exchange. ''Insider transactions" are monitored; officers and major stockholders of the
company must prepare monthly reports of their holdings in the company's stock and changes therein.
(An insider is defined as an officer, director, or stockholder of the company who controls 10 percent
or more of equity shares.) The SEC also monitors trading practices in the stock exchanges and is
empowered to monitor and punish manipulative activities affecting the company's stock. The voting
process for corporate elections, particularly proxy voting (power of attorney by which the holder of
stock transfers the voting right to another party), is also subject to SEC scrutiny; margin requirements
regulating the purchase of securities on credit are regulated by the Federal Reserve System.
State blue sky laws are designed to protect investors from being defrauded. Companies issuing
securities must register their offerings with the state in which they are incorporated, and furnish
relevant financial information.
Selecting a Financing Method

Some companies obtain most of their funds by issuing stock and from earnings retained in the
business. Other companies borrow as much as possible and raise additional money from
stockholders only when they can no longer borrow. Most companies are somewhere in the middle.
Financial managers are concerned with selecting the best possible source of financing based on the
company's situation. They must consider the following:
· The cost and risk of alternative financing strategies.
· Future trends in market conditions and their impact on future fund availability and interest rates.
For example, if interest rates are expected to go up, the company will be better off financing with
long-term debt at the currently lower interest rates. If stock prices are high, equity issuance may be
preferred over debt.
· The current debt-to-equity ratio. A very high ratio, for example, indicates financial risk, so
additional funds should come from equity sources.


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· The maturity dates of present debt instruments. For example, the company should avoid having all
debt come due at the same time; in an economic downturn, it may not have adequate funds to meet
required debt payments.
· The restrictions in loan agreements. For instance, a restriction may place a cap on the allowable
debt-equity ratio.
· The type and amount of collateral required by long-term creditors.
· The company's ability to change financing strategy to adjust to changing economic conditions. For
example, a company subject to large cyclical variations should have less debt because it may not be
able to meet principal and interest at the low point of the cycle. If earnings are unstable and/or there
is a highly competitive environment, more emphasis should be given to equity financing.
· The amount, nature, and stability of internally generated funds. If earnings are stable, the company
will be better able to meet debt obligations.
· The adequacy of present lines of credit to meet current and future needs.
· The inflation rate, since debt is repaid in cheaper dollars.
· The earning power and liquidity position of the company. For example, a liquid company is able to
meet debt payments.
· The nature and risk of assets. High-quality assets in terms of cash realizability allow for greater
debt.
· The nature of the product line. A company, for example, that faces obsolescence risk in its product
line (e.g., computers) should refrain from overusing debt.
· The uncertainty of large expenditures. If huge cash outlays may be required (e.g., for a lawsuit or
the acquisition of another company), additional debt capacity should be available.
· The tax rate. For example, a higher tax rate makes debt more attractive because interest expense is
tax deductible.
You have to select the best possible source of financing based on the facts.
EXAMPLE 15-11
Your company is considering issuing either debt or preferred stock to finance the purchase of a plant
costing $1.3 million. The debt position is currently very high. The interest rate on the debt is 15
percent. The dividend rate on the preferred stock is 10 percent. The tax rate is 34 percent.
The annual interest payment on the debt is:

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The annual dividend on the preferred stock is:
The required earnings before interest and taxes to meet the dividend payment is:
If your company anticipates earning $196,970 or more, it should issue the preferred stock because of
its currently excessive debt position.
EXAMPLE 15-12
Your company has sales of $30 million a year. It needs $6 million in financing for capital expansion.
The debt/equity ratio is 68 percent, which is considered quite high in the industry. Your company is
in a risky industry, and net income is not stable. The common stock is selling at a high P/E ratio
compared to competition. The company is considering either a common stock or a debt issue.
Because your company is in a high-risk industry and has a high debt/equity ratio and unstable
earnings, issuing debt may be costly, restrictive, and potentially dangerous to the company's future
financial health. A common stock issue is recommended.
EXAMPLE 15-13
Your company is a mature one in its industry. It has limited ownership. The company has vacillating
sales and earnings. The debt/equity ratio is 70 percent, compared to the industry standard of 55
percent. The aftertax rate of return is 16 percent. Since your company is in a seasonal business, there
are certain times during the year when its liquidity position is inadequate. Your company is unsure of
the best way to finance.
Preferred stock is one possible means of financing. Debt financing is not recommended because of
the already high debt/equity ratio, the fluctuation in profit, the seasonal nature of the business, and the
deficient liquidity posture. Because of the limited ownership, common stock financing may not be
appropriate because it would dilute the ownership.


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EXAMPLE 15-14
A new company is established and plans to raise $15 million in funds. The company expects to
obtain contracts that will provide $1,200,000 a year in before-tax profits. The company is
considering whether to issue bonds only or an equal amount of bonds and preferred stock. The
interest rate on AA corporate bonds is 12 percent. The tax rate is 50 percent.
The company will probably have difficulty issuing $15 million of AA bonds because the interest cost
of $1,800,000 (13% × $15,000,000) on these bonds is greater than estimated earnings before interest
and taxes. The issuance of debt by a new company is a risky alternative.
Financing with $7.5 million in debt and $7.5 million in preferred stock is also not recommended.
While some debt may be issued, it is not practical to finance the balance with preferred stock. If $7.5
million of AA bonds were issued at the 12 percent rate, the company would be required to pay
$900,000 in interest. A forecasted income statement would look as follows:
Earnings before interest and taxes $1,200,000
Interest 900,000
Taxable income $ 300,000
Taxes 150,000
Net income $ 150,000
The amount available for the payment of preferred dividends is only $150,000. Hence, the maximum
rate of return that could be paid on $7.5 million of preferred stock is .02 ($150,000/$7,500,000), too
low to attract investors.
The company should consider financing with common stock.
EXAMPLE 15-15
Your company wants to construct a plant that will take about 1 1/2 years to construct. The plant will
be used to produce a new product line, for which your company expects a high demand. The new
plant will materially increase corporate size. The following costs are expected:
1. The cost to build the plant, $800,000
2. Funds needed for contingencies, $100,000
3. Annual operating costs, $175,000
The asset, debt, and equity positions of your company are similar to industry standards. The market
price of the company's stock is less than it should be, taking into account the future earning power of
the


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new product line. What would be an appropriate means to finance the construction?
Because the market price of stock is less than it should be and considering the potential of the
product line, convertible bonds and installment bank loans might be appropriate means of financing,
since interest expense is tax deductible. Additionally, issuing convertible bonds might not require
repayment, since the bonds are likely to be converted to common stock because of the company's
profitability. Installment bank loans can be paid off gradually as the new product generates cash
inflow. Funds needed for contingencies can be obtained through open bank lines of credit.
If the market price of the stock were not depressed, financing through equity would be an alternative
financing strategy.
EXAMPLE 15-16
Your company wants to acquire another business but has not determined an optimal means to finance
the acquisition. The current debt/equity position is within the industry guideline. In prior years,
financing has been achieved through the assistance of short-term debt.
Profit has shown vacillation; as a result, the market price of the stock has fluctuated. Currently,
however, the market price of stock is strong.
Your company's tax bracket is low.
The purchase should be financed through the issuance of equity securities for the following reasons:
· The market price of stock is currently at a high level.
· Issuing long-term debt will cause greater instability in earnings, because of high fixed interest
charges. Consequently, the stock price will become even more volatile.
· Issuing debt will result in a higher debt/equity ratio relative to the industry norm, negatively
impacting the company's cost of capital and availability of financing.
· Short-term debt would have to be paid before the company receives a return from the acquired
business and is therefore not advisable.
Investment Banking
Investment banking is the underwriting of a securities issue by a firm that serves as an intermediary
between the issuing company and the investing public.
The direct underwriting responsibilities of the investment banking firm may include preparing the
SEC registration statement, assisting in pricing the issue, forming and managing a group of
underwriters,


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and stabilizing the price of the issue during the offering and distribution period. When a client-
relationship exists, the underwriter provides counseling and may have a seat on the board of
directors of the company.
Investment bankers conduct the following activities:
· Underwriting. The investment banker buys a new security issue, pays the issuer, and markets the
securities. The underwriter's compensation is the difference between the price at which the
securities are sold at to the public and the price paid to the issuing company.
· Distributing. The investment banker markets the company's security issue.
· Advice. The investment banker advises the company on the best way to obtain funds. The
investment banker is knowledgeable about alternative sources of long-term funds, debt and equity
markets, and SEC regulations.
· Providing Funds. The investment banker provides funds to the company during the distribution
period.
A syndicate is a group of several investment bankers who have come together to market a
particularly large or risky issue. One investment banker (originating house) in the group will be
selected to manage the syndicate and underwrite the major amount of the issue. The syndicate makes
one bid for the issue, but the terms and features of the issue are set by the company.
The distribution channels for a new security issue are illustrated in Figure 15.1.
In another approach to investment banking, the investment banker may agree to sell the company's
securities on a best-efforts basis, or to an agent. Here, the investment banker does not act as
underwriter but instead sells the stock and receives a sales commission. Depending on the
agreement, the agent may exercise an option to buy enough shares to cover its sales to the public, or
the agent may cancel the incompletely sold issue altogether. Investment bankers may insist on this
type of arrangement if they have reservations about the likelihood of success of the offering, such as
with speculative securities issued by new and financially weak companies. A best-efforts
arrangement involves risks and delays to the issuing company.
In selecting an investment banker for a new issue of securities, you should look for the following:
· Low spread. Spread is the difference between the price paid to the issuing company by the
investment banker and the resale price to the investor.
· Good references, meaning other issuing companies were satisfied


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Figure 15.1
Distribution Channels for a New Security Issue
with the investment banker's performance.

· Ability to float many shares at a good price.
· Institutional (corporate) and retail (individual) clientele.
· Good after-market performance, meaning securities do well after issuance.
· Wide geographic distribution.
· Attractive secondary markets for resale.
· Knowledge of market, regulations, industry, and company.
Public vs. Private Placement
Equity and debt securities may be issued either publicly or privately. In a public issuance, the shares
are bought by the general public; in a private placement, the company issues securities directly to
either one or a few large investors, usually financial institutions such as insurance companies,
pension plans, and commercial banks.
Private placement has the following advantages compared to public issuance:
· The flotation cost is less. The flotation cost for common stock exceeds that for preferred stock and,
expressed as a percentage of gross proceeds, is higher for smaller issues than for larger ones.


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· It avoids SEC filing requirements.

· It avoids the need for disclosure of information to the public.
· It reduces the time lag for obtaining funds.
· It offers greater flexibility.
· It may be the only avenue available to small companies planning small issues that would not be
sufficiently profitable to attract the interest of investment bankers.
· If the company's credit rating is low, private investors with limited funds may not be interested in
purchasing the securities.
The drawbacks of private placement compared to public issuance are these:
· Private placement often requires a higher interest rate because of a reduced resale market.
· Private placements usually have a shorter maturity period than public issues.
· It is more difficult to obtain significant amounts of money in private placements than in public ones.
· Large private investors typically use stringent credit standards and require the company to be in
strong financial condition. In addition, they impose more restrictive terms.
· Large institutional investors may watch the company's activities more closely than smaller
investors in a public issue.
· Large institutional investors are more capable of obtaining voting control of the company, assuming
they hold a large amount of stock.
Most private placements involve debt securities; in fact, only about 2 percent of common stock is
placed privately. The private market is more receptive to smaller issues (e.g., those up to several
million dollars). Small and medium-sized companies typically find it cheaper to place debt privately
than publicly, especially when the issue is $5 million or less.
Chapter Perspective
Your company may finance long-term with debt or equity (preferred stock and common stock) funds.
Each has its own advantages and disadvantages. The facts of a situation have to be examined to
determine which type is best under the circumstances. For example, a rapidly growing company
needs flexibility in its capital structure. While a high debt position may be needed to sustain growth,
it is important that periodic additions to equity are made.


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Chapter 16
Dividend Policy
Corporate earnings that are distributed to stockholders are referred to as dividends. Dividends are
paid in either cash or stock, usually on a quarterly basis, and may be paid only out of retained
earnings, not from invested capital. Generally, the more stable a company's profitability, the more
regular its issuance of dividends. Types of dividend policies include stable dividends per share,
constant dividend payout ratio, and residual dividends. The factors that determine the amount of
money available for dividends include corporate growth rate, restrictive covenants, profitability,
earnings stability, degree of debt, and tax factors.
· The effect of a company's dividend policy on its cash flow and the market price of its stock.
· The different dividend dates.
· The types of dividend policies, advantages and disadvantages.
· The financial and operating factors that affect the amount of dividends paid.
· The difference between stock dividends and stock splits.
· The reasons a company might reacquire its stock and the financial effects of such an action.
Dividend Policy
Dividend policy is important for the following reasons:
· It influences investor attitudes. Stockholders look negatively on companies that cut dividends, since
they associate such cutbacks with financial difficulties. In establishing a dividend policy, a financial
manager must determine and fulfill the owners' objectives; otherwise, the stockholders may sell their
shares, in turn driving down the market price of the stock. Stockholder dissatisfaction raises the
possibility that control of the company may be seized by an outside group.


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· It impacts the financing program and capital budget of the company.

· It affects the company's cash flow. A company with a poor liquidity position may be forced to
restrict its dividend payments.
· It lowers stockholders' equity, since dividends are paid from retained earnings. This results in a
higher debt to equity ratio.
If a company's cash flow and investment requirements are volatile, the company should not establish
a high regular dividend. It is preferable to establish a low regular dividend that can be met even in
bad years.
Dividend Dates
A number of dividend dates are important to understand:
· Declaration datethe date on which the board of directors declares the dividend. On this date, the
payment of the dividend becomes a legal liability to the corporation.
· Date of recordthe date on which the stockholder is entitled to receive the dividend.
· Ex-dividend datethe date on which the right to the dividend leaves the shares. The right to a
dividend stays with the stock until four days before the date of record; that is, on the fourth day
before the record date, the right to the dividend is no longer with the shares, and the seller, rather
than the buyer, of the stock is the one who will receive the dividend. The market price of the stock
takes into account the fact that it has gone ex-dividend and decreases by approximately the amount of
the dividend.
· Date of paymentthe date on which the company distributes its dividend checks to its stockholders.
Dividends are usually paid in cash and are expressed in dollars and cents per share. However, the
dividend on preferred stock is sometimes expressed as a percentage of par value.
EXAMPLE 16-1
The date of record for the dividend declared by the ABC Company is October 20. Mr. H sells Ms. J
his 100 shares on October 18. Mr. H, not Ms. J, will receive the dividend.
EXAMPLE 16-2
On November 15, 20X1, a cash dividend of $1.50 per share was declared on 10,000 shares of $10
par value common stock. The amount of the dividend paid by the company is $15,000 (10,000 ×
$1.50).


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EXAMPLE 16-3
J Corporation has 20,000 shares of $10 par value, 12 percent preferred stock outstanding. On
October 15, 20X1, a cash dividend was declared to holders of record as of December 15, 20X1.
The amount of dividend to be paid by J Corporation is equal to:
Some companies allow stockholders to reinvest their dividends automatically in corporate shares
rather than receive cash. The advantage to the stockholders is that they avoid the brokerage fees
associated with buying new shares. However, they receive no tax advantage since they must still pay
ordinary income taxes on the dividend received.
Types of Dividend Policies

A financial manager's dividend policy objectives are to maximize owner wealth while providing
adequate financing for the company. An increase in a company's earnings does not automatically
raise the dividend; there is generally a time lag between increased earnings and the payment of a
higher dividend. Only when the financial manager is optimistic that the increased earnings will be
sustained should he or she increase the dividend. Once dividends are increased, they should continue
at the higher rate because stockholders get used to it and react unfavorably to decreased payments.
Different types of dividend policies include:
· Stable dividend-per-share policy. Many companies use a stable dividend-per-share policy, since
such a policy is favored by investors. Dividend stability implies a low-risk company; even in a year
when the company shows a loss, it should maintain its dividend to avoid repercussions among
current and prospective investors, who are then more likely to see the loss as temporary. Some
stockholders rely on the receipt of stable dividends for income. A stable dividend policy is also
necessary for a company to be considered for investment by major financial institutions, such as
pension funds and insurance companies. Being on such a list provides greater marketability for
corporate shares.
· Constant dividend-payout ratio (dividends per share/earnings per share). Companies following
this policy pay out a constant percentage of earnings in dividends. Because net income fluctuates,
dividends also vary. The problem this policy causes is that if the company's earnings fall drastically
or if there is a loss, dividends will be significantly reduced or nonexistent. This policy does not
maximize market price per share, since most stockholders do not want variability in their dividend
receipts.


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· A compromise policy. One compromise between the policies of a stable dollar amount and a
percentage amount of dividends is for a company to pay a stable lower dollar amount per share plus
a percentage increment in good years. While this policy gives flexibility, it also creates uncertainty
in the minds of investors as to the amount of dividends they are likely to receive. Stockholders
typically do not like such uncertainty. However, this policy may be appropriate if earnings vary
considerably over the years. The percentage, or extra, portion of the dividend should not be paid
regularly; otherwise, it becomes meaningless.
· Residual-dividend policy. When a company's investment opportunities are not stable, its financial
managers may wish to consider a vacillating dividend policy. With this type of policy the amount of
earnings retained depends on the availability of investment opportunities in a given year. Dividends
are drawn from the residual earnings after the company's investment needs are met.
EXAMPLE 16-4
Company A and company B are identical in every respect except for their dividend policies.
Company A pays out a constant percentage of its net income (60 percent dividends), while company
B pays out a constant dollar dividend. Company B's market price per share is higher than that of
company A because the stock market looks favorably upon stable dollar dividends. They reflect less
investor uncertainty about the company.
EXAMPLE 16-5
Most Corporation had a net income of $800,000 in 20X1. Earnings have grown at an 8 percent
annual rate. Dividends in 20X1 were $300,000. In 20X2, the net income was $1,100,000. This was
much higher than the typical 8 percent annual growth rate. It is expected that profits will be back to
the 8 percent rate in future years. The investment in 20X2 was $700,000.
Assuming a stable dividend payout ratio of 25 percent, the dividends to be paid in 20X2 will be
$275,000 ($1,100,000 × 25%).
If a stable dollar dividend policy is maintained, the 20X2 dividend payment will be $324,000
($300,000 × 1.08).
Assuming a residual dividend policy is maintained and 40 percent of the 20X2 investment is
financed with debt, the 20X2 dividend will be:

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Because net income exceeds the equity needed, all of the $420,000 of equity investment will be
derived from net income.
If the investment for 20X2 is to be financed with 80 percent debt and 20 percent retained earnings
and any net income not invested is paid out in dividends, then the dividends will be:
Theoretically, a company should retain earnings rather than distribute them when the corporate return
exceeds the return investors can obtain on their money elsewhere. In addition, if the company obtains
a return on its profits that exceeds the cost of capital, the market price of its stock will be maximized.
On the other hand, a company should not keep funds for investment if it earns a lower return than its
investors can earn elsewhere. If the owners have better investment opportunities outside the
company, the company should pay a high dividend.
Although theoretical considerations from a financial perspective should be taken into account when
establishing dividend policy, the practicality of the situation is that investors expect to be paid
dividends. Psychological factors come into play and may adversely impact the market price of a
stock that does not pay dividends.
Factors That Affect Dividend Policy

A company's dividend policy depends on many variables, some of which have been already
mentioned. Other factors to be considered are:
· Company growth rate. A rapidly growing business, even if profitable, may have to restrict
dividends to keep funds within the company to invest for growth.
· Restrictive covenants. Sometimes there is a restriction in a credit agreement that limits the
dividends that may be paid.
· Profitability. Dividend distribution is keyed to the profitability of the company.
· Earnings stability. A company with stable earnings is more likely to distribute a higher percentage
of its earnings than one with unstable earnings.
· Maintenance of control. Financial managers who are reluctant to issue additional common stock
because they fear diluting control of the business will retain a higher percentage of its earnings.
Internal financing enables the company to maintain its control.


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· Degree of financial leverage. A company with a high debt-to-equity ratio is more likely to retain
profits to ensure that it will have the funds to pay interest and principal on debt.
· Ability to finance externally. A company that is capable of entering the capital markets easily can
afford to have a higher dividend payout ratio. If access to external sources of funds is limited, the
company will retain more earnings to meet planned financial needs.
· Uncertainty. Payment of dividends reduces the uncertainty in stockholders' minds about the
company's financial health.
· Age and size. The age and size of the company bear upon its ease of access to capital markets. A
mature, large company is typically deemed to be more secure than a young company.
· Tax penalties. A desire to avoid possible tax penalties for excess accumulation of retained
earnings may result in high dividend payouts.
· Tax position of investors. Under current tax law, dividends are fully taxed to individual investors,
but long-term capital gains are capped at 20 percent. For example, an individual in the 31 percent tax
bracket would have to pay 31 percent in taxes on dividends but only 20 percent on long-term capital
gains.
There is an ongoing controversy about the impact of dividend policy on a company's financial well-
being. A number of authors have taken positions on this issue.
Many believe that cash flows of a company having a low dividend payout will be capitalized at a
lower rate. They argue that investors will consider capital gains resulting from earnings retention to
be more risky than dividends, because there is more uncertainty in depending on appreciation in
market price of stock than in receiving a fixed dividend.
A change in dividends impacts the price of the stock, since investors consider such a change as being
a statement about expected future profits. They believe that investors are generally indifferent to
dividends or capital gains.
The choice of dividend policy varies with the particular characteristics of the company and its
owners, including the tax bracket and income needs of stockholders and corporate investment
opportunities.
Stock Dividends
A stock dividend is an additional share of stock issued to stockholders. Such dividends may be
declared when the cash position of the company is inadequate to support a cash dividend and/or
when the company wishes to prompt increased trading in its stock by reducing its market price. Stock
dividends increase the number of shares held, but the proportion of the company owned by each
stockholder remains the

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same. In other words, if a stockholder has a 2 percent interest in the company prior to a stock
dividend, he or she will continue to have a 2 percent interest after the stock dividend.
EXAMPLE 16-6
Mr. J owns 200 shares of N Corporation. There are 10,000 shares outstanding; therefore, Mr. J holds
a 2 percent interest in the company. The company issues a stock dividend of 10 percent. Mr. J will
then have 220 shares out of 11,000 shares issued. His proportionate interest remains at 2 percent
(220/11,000).
Stock Splits
A stock split is the issuance of a substantial amount of additional shares, thereby reducing the par
value of the stock on a proportionate basis. A stock split is often prompted by a desire to reduce the
market price per share, making it easier for small investors to buy shares.
EXAMPLE 16-7
S Corporation has 1,000 shares of $20 par value common stock outstanding. The total par value is
$20,000. A 4-for-1 stock split is issued. After the split, 4,000 shares at $5 par value will be
outstanding. The total par value thus remains at $20,000. Theoretically, the market price per share of
the stock should drop to one-fourth of what it was before the split.
Stock Dividend Versus Stock Split

The differences between a stock dividend and stock split are as follows:
1. With a stock dividend, a company reduces its retained earnings and distributes shares on a pro
rata basis to stockholders. A stock split increases the shares outstanding but does not lower retained
earnings.
2. The par value of stock remains the same after a stock dividend is paid but is proportionally
reduced in a stock split.
Stock dividends and stock splits are similar in that:
1. Cash is not paid.
2. Shares outstanding increase.
3. Stockholders' equity remains the same.


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Stock Repurchases
Companies may purchase treasury stock as an alternative to paying dividends. Since outstanding
shares will be fewer after such a purchase, earnings per share will increase (assuming net income is
constant). The increase in earnings per share may result in a higher market price per share.
EXAMPLE 16-8
A company earned $2.5 million in 20X1. Of this amount, it decided that 20 percent would be used to
buy treasury stock. Currently, there are 400,000 shares outstanding. Market price per share is $18.
The company can use $500,000 (20% × $2.5 million) to buy back 25,000 shares through a tender
offer to stockholders of $20 per share. The offer price of $20 is higher than the current market price
of $18 because the company feels its buyback will drive up the price of existing shares as a function
of the law of supply and demand.
Current earnings per share is:
The current P/E multiple is:
Earnings per share after treasury stock is acquired becomes:
The expected market price, assuming the P/E ratio (multiple) remains the same, is:
To stockholders, stock repurchases have the advantage of increasing the market price per share,
since fewer shares will be outstanding.
To the company, the benefits of a stock repurchase include the following:
1. It is a way of using excess temporary cash without paying higher dividends that may not be able to
be maintained.
2. Treasury stock can be used for future acquisitions or used as a basis for stock options.


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3. Treasury stock can be resold in the market if additional funds are needed.
To stockholders, the disadvantages of treasury stock acquisitions include the following:
1. The market price of stock may benefit more from a dividend than from a stock repurchase.
2. Treasury stock may be bought at an excessively high price to the detriment of the remaining
stockholders. A higher price may be paid for treasury stock when share activity is limited or when
the company wishes to reacquire a significant number of shares.
To the company, the disadvantages of treasury stock acquisition are these:
1. Market price may drop if investors believe that the company is engaging in a repurchase plan
because its management does not have good alternative investment opportunities. However, this is
not always the case.
2. The company risks an SEC investigation if it appears that the reacquisition of stock is in an effort
to manipulate the company's stock price. Further, if the Internal Revenue Service (IRS) concludes
that the repurchase is designed to avoid paying tax on dividends, tax penalties may be imposed
because of the improper accumulation of earnings.
Chapter Perspective
Companies may declare two types of dividendscash and stock. A company's dividend policy affects
its cash flow and the market price of its stock. Important dividend dates are declaration date, date of
record, and payment date. Companies may select from different dividend policies, including stable
dividends per share and constant dividend payout ratio. A company's dividend policy may be based
on many factors such as growth rate, earnings, liquidity, restrictive convenants, and operating risk. A
company may issue a stock split or reacquire its shares depending on its financial objectives.


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Chapter 17
Warrants and Convertibles
Warrants and convertibles are unique among securities because they may be converted into common
stock. This chapter discusses the valuation of warrants and convertibles, presents their advantages
and disadvantages, and discusses when their issuance is most appropriate.
· What warrants are and how to value them.
· The positive and negative aspects of warrants.
· The features of convertible securities and how to value them.
· The positive and negative aspects of convertible securities.
· The role of warrants and convertibles in a company's financing strategy.
· The difference between warrants and convertibles.
Warrants
A warrant is an option to purchase a given number of shares of stock at a specified price. A warrant
can be either detachable or nondetachable. A detachable warrant may be sold separately from the
bond with which it is associated, allowing the holder to exercise the warrant without redeeming the
bond; a nondetachable warrant is sold with its bond to be exercised by the bondholder
simultaneously with the convertible bond.
A company may sell warrants separately or in combination with other securities.
To obtain common stock, the holder must surrender the warrant and pay a sum called the exercise
price. Although warrants typically expire on a given date, some are perpetual. A holder of a warrant
may exercise it by buying the stock, sell it on the market to other investors, or continue to hold it. An
investor may wish to hold a warrant rather than exercise or sell it because there exists a possibility
of achieving a high rate of return as the market price of the related common stock


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appreciates. But there are several drawbacks to warrants, including a high risk of losing money, the
absence of voting rights, and the lack of dividends.
The company cannot force the exercise of a warrant. However, the company may vary the exercise
price associated with a warrant.
If a stock split or stock dividend is declared before the warrant is exercised, the option price of the
warrant is usually adjusted to reflect the effect of the action.
Warrants can provide additional funds for the issuer. When a bond is issued with a warrant, the
warrant price is typically set between 10 percent and 20 percent above the stock's market price. If
the company's stock price goes above the option price, the warrants will, of course, be exercised at
the option price. The closer the warrants are to their expiration date, the greater the chance that they
will be exercised, assuming the stock has reached the exercise price.
Valuing a Warrant
The theoretical value of a warrant may be computed by a formula; however, the formula value is
usually less than the market price of the warrant. The reason for this difference is that the speculative
appeal of a warrant allows investors to obtain a good degree of personal leverage because, with a
relatively small investment, they have a chance to obtain a significant gain.
EXAMPLE 17-1
A warrant for XYZ company's stock gives the owner the right to buy one share of common stock at
$25 a share. The market price of the common stock is $53. The formula price of the warrant is $28
[($53 - $25) × 1].
If the owner had the right to buy three shares of common stock with one warrant, the theoretical value
of the warrant would be $84 [($53 - $25) × 3].
If the stock is selling for an amount below the option price, the warrant's value will be negative.
Since this is illogical, we use a formula value of zero.
EXAMPLE 17-2
Assume the same facts as in Example 17-1, except that the stock is selling at $21 a share. The
formula amount is -$4 [($21 - $25) × 1]. (However, a value of zero will be assigned.)


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Warrants do not have an investment value because they pay neither interest nor dividends and carry
no voting rights. Hence, the market value of a warrant derives solely from its convertibility value
into common stock. But the market price of a warrant, referred to as the premium on the warrant, is
usually more than its theoretical value. The lowest amount that a warrant will sell for is its
theoretical value.
The value of a warrant depends on the remaining life of the option, dividend payments on the
common stock, the variability in price of the common stock, whether the warrant is listed on the
exchange, and the opportunity cost of funds for the investor. Warrants generally have a high value
when their life is long, the dividend payment on common stock is small, the stock price is volatile,
the warrant is listed on the exchange, and the value of funds to the investor is great (since the warrant
requires a smaller investment).
EXAMPLE 17-3
ABC stock currently has a market value of $50. The exercise price of the warrant is also $50.
Therefore, the theoretical value of the warrant is $0. However, the warrant will sell at a premium
(positive price) provided there is the possibility that the market price of the common stock will
exceed $50 before the expiration of the warrant. The further into the future the expiration date, the
greater the premium, since there is a longer period for possible price appreciation.
Of course, the lower the market price compared to the exercise price, the smaller the premium.
EXAMPLE 17-4
Assume the same facts as in Example 17-3, except that the current market price of the stock is $35.
The warrant's premium in this instance will be much lower, since it would take a long time for the
stock's price to increase to above $50 a share. If investors anticipate that the stock price will not
increase above $50 at any time in the future, the warrants will be valued at $0.
If the market price of ABC stock rises above $50, the market price of the warrant will increase and
the premium will decrease. In other words, when the stock price exceeds the exercise price, the
market price of the warrant approximately equals the theoretical value, causing the premium to
disappear. The reduction in the premium arises because of the reduced value of owning the warrant
relative to exercising it.


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Advantages and Disadvantages of Warrants

The advantages of issuing warrants include the following:
· They permit the issuance of debt at a lower interest rate.
· The company receives additional cash when the warrants are exercised.
The disadvantages of issuing warrants include the following:
· When exercised, warrants dilute common stock, possibly reducing the market price of stock.
· The warrants may be exercised at a time when the business has no need for additional capital.
Warrants vs. Stock Rights
There is a difference between a warrant and a stock right. A stock right is given free to current
stockholders, who may either exercise them by buying new shares or sell them in the market. Stock
rights also have shorter durations than warrants.
Convertible Securities
A convertible security is one that may be exchanged for common stock by the holder or, in some
cases, the issuer, according to agreed-upon terms. Examples are convertible bonds and convertible
preferred stock. A specified number of shares of stock are received by the holder of the convertible
security at the time of the exchange; the number is determined by the conversion ratio, which equals:
The conversion price is the effective price paid by the holder for the common stock when the
conversion is effected. The conversion price and the conversion ratio are set when the convertible
security is issued. The conversion price should be tied to the growth potential of the company; the
greater the company's earnings potential, the higher the conversion price.
A convertible bond is considered a quasi-equity security because its market value is tied to its value
if converted rather than its value as a bond. The convertible bond may be considered a delayed issue
of common stock at a price above the current level.
EXAMPLE 17-5
If the conversion price of stock is $25 per share, a $1,000 convertible bond is convertible into 40
shares ($1,000/$25).


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EXAMPLE 17-6
A $1,000 bond is convertible into thirty shares of stock. The conversion price is $33.33 ($1,000/30
shares).
EXAMPLE 17-7
A share of convertible preferred stock with a par value of $50 is convertible into four shares of
common stock. The conversion price is $12.50 ($50/4).
EXAMPLE 17-8
A $1,000 convertible bond that entitles the holder to convert the bond into 10 shares of common
stock is issued. Hence, the conversion ratio is ten shares for one bond. Since the face value of the
bond is $1,000, the holder tenders this amount upon conversion. The conversion price equals $100
per share ($1,000/10 shares).
EXAMPLE 17-9
An investor holds a $1,000 convertible bond that is convertible into forty shares of common stock.
Assuming the common stock is selling for $35 a share, the bondholder can convert the bond into forty
shares worth $1,400. If the convertible bond is traded as a bond, it would trade at 140, or $1,400.
EXAMPLE 17-10
Y Company issued a $1,000 convertible bond at par. The conversion price is $40. The conversion
ratio is:
The conversion value of a security is computed as follows:
When a convertible security is issued, its percentage conversion premium is computed in the
following manner:

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EXAMPLE 17-11
LA Corporation issued a $1,000 convertible bond at par. The market price of the common stock at
the date of issue was $48. The conversion price is $55.
Conversion value of the bond equals:
The difference between the conversion value of $872 and the issue price of $1,000 constitutes the
conversion premium of $128. The conversion premium may also be expressed as a percentage of the
conversion value. The percent in this case is:
Percentage conversion premium equals:
The conversion terms may not be static but may increase in steps over specified time periods.
Hence, as time passes, fewer common shares will be exchanged for the bond. In some instances, the
conversion option may expire after a certain time period.
Typically, convertible securities contain a clause protecting them from dilution caused by stock
dividends, stock splits, and stock rights. The clause usually prevents the issuance of common stock at
a price lower than the conversion price; in addition, the conversion price is reduced by the
percentage amount of any stock split or stock dividend, enabling the shareholder of common stock to
maintain his or her proportionate interest.
EXAMPLE 17-12
A three-for-one stock split occurs, which requires a tripling of the conversion ratio. A 20 percent
stock dividend requires a 20 percent increase in the conversion ratio.


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EXAMPLE 17-13
Assume the same facts as in Example 17-8 coupled with a four-for-one split. The conversion ratio
now becomes 40, and the conversion price now becomes $25.
The decision whether to convert a security depends on a comparison of the interest on the bond to the
dividend on the stock, the risk preference of the holder (stock has a greater risk than a bond), and the
current and expected market price of the stock.
Valuation of Convertibles
A convertible security is a hybrid security, because it has attributes of both common stock and bonds.
The expectation is that the holder will ultimately receive both interest yield and a capital gain.
Interest yield is the coupon interest compared to the market price of the bond at purchase. The capital
gain yield is the difference between the conversion price and the stock price at the issuance date and
the expected growth rate in stock price.
Conversion value is the value of the stock received at conversion. As the price of the stock
increases, so will its conversion value.
EXAMPLE 17-14
A $1,000 bond is convertible into eighteen shares of common stock with a market value of $52 per
share. The conversion value of the bond equals:
EXAMPLE 17-15
At the date of a $100,000 convertible bond issue, the market price of the stock is $18 a share. Each
$1,000 bond is convertible into fifty shares of stock. The conversion ratio is thus 50. The number of
shares the bond issue is convertible into is:
The conversion value is $90,000 ($18 × 5,000 shares).

If the stock price is expected to grow at 6 percent per year, the conversion value at the end of the
first year is:
Shares 5,000
Stock price ($18 × 1.06) $19.08
Conversion value $95,400


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The conversion value at the end of year 2 is:

Shares 5,000
Stock price ($19.08 × 1.06) $20.22
Conversion value $101,100
Businesses that issue convertible bonds expect the value of common stock to appreciate and the
bonds to be converted. If conversion does occur, the company can then issue another convertible
bond. Such a financial policy is known as ''leapfrog financing." If the market price of the common
stock drops instead of rising, the holder will not convert the debt into equity. In this instance, the
convertible security continues as debt and is termed a "hung" convertible.
A convertible security holder may prefer to hold the security instead of converting it even though the
conversion value exceeds the price paid for it. First, as the price of the common stock increases, so
will the price of the convertible security. Second, the holder receives regular interest payments or
preferred dividends. To force conversion, companies issuing convertibles often have a call price
that is higher than the face value of the bond (usually 10 to 20 percent higher). This practice in effect
forces holders of convertibles to exchange them for stock as long as the stock price exceeds the
conversion price, because the holder naturally prefers having common stock that is worth more than
the call price he or she would receive for the bond.
The issuing company may force conversion of its convertible bond into common stock when such a
move is financially advantageous, such as when the market price of the stock has dropped or when
the interest rate on the convertible debt rises above prevailing market interest rates.
EXAMPLE 17-16
The conversion price on a $1,000 debenture is $40 and the call price is $1,100. Thus, upon
conversion twenty-five shares ($1,000/$40) are received. In order for the conversion value of the
bond to equal the call price, the market price of the stock would have to be $44 ($1,000/25). If the
conversion value of the bond is 15 percent higher than the call price, the approximate market price of
common stock would be $51 (1.15 × $44). At a $51 price, conversion is virtually guaranteed, since
if the investor did not convert he or she would incur a material opportunity loss if the bond is called.
EXAMPLE 17-17
ABC Company's convertible bond has a conversion price of $800. The conversion ratio is 10. The
market price of the stock is $140. The


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call price is $1,100. The bondholder would rather convert to common stock with a market value of
$1,400 ($140 × 10) than have his or her convertible bond redeemed at $1,100. In this instance, the
call provision forces the conversion when the bondholder might be tempted to wait longer.
Advantages and Disadvantages of Convertibles
The advantages of issuing convertible securities are:
· It acts as a "sweetener" in a debt offering by giving the investor a chance to take part in the price
appreciation of common stock.
· The issuance of convertible debt allows for a lower interest rate on the financing compared to
issuing straight debt.
· A convertible security may be issued in a tight money market, when it is difficult for a creditworthy
firm to issue a straight bond or preferred stock.
· Convertibles usually involve fewer financing restrictions than straight debt.
· Convertibles provide a means of issuing equity at prices higher than current market prices.
· The call provision enables the company to force conversion whenever the market price of the stock
exceeds the conversion price.
· If the company were to issue straight debt now and common stock later to meet the debt, it would
incur flotation costs twice; with convertible debt, flotation costs occur only once, at the initial
issuance of the convertible bonds.
To the holder, the advantages of convertible securities are:
· They offer the potential of a significant capital gain due to price appreciation of the common stock.
· They offer the holder protection if corporate performance falls off.
· The margin requirement (the amount an investor deposits when borrowing from the broker to
purchase securities) for convertible bonds is lower than that for common stock. More money can be
borrowed from the broker to invest in convertibles.
The disadvantages of issuing convertible securities are:
· If the company's stock price increases appreciably in value, the company would have been better
off financing through a regular common stock issue at the higher price rather than allowing
conversion at the lower price.
· The company is obligated to pay the convertible debt if the stock price does not rise.


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To the holder, disadvantages of convertible securities are:

· The yield on a convertible security is lower than that on a comparable security that does not have
the conversion option.
· A convertible bond is usually subordinated to other debt obligations and therefore typically has a
lower bond rating.
Corporate Financing Strategy

When a company's stock price is depressed, it should issue convertible debt instead of common
stock if the stock price is expected to rise. Establishing a conversion price above the present market
price of stock will require issuing fewer shares when the bonds are converted compared to selling
the shares at the current lower price. Of course, the conversion will occur only if the price of the
stock rises above the conversion price. The drawback is that if the stock price does not increase and
conversion does not take place, the company must face the debt burden of repaying the principal.
A convertible issuance is not recommended for a company with a modest growth rate, since it would
take a long time to force conversion. During the intervening time, the company will not be able to
secure additional financing easily. A long conversion interval may imply to the investing public that
the stock has not done as well as expected. The company's growth rate is a prime consideration in
determining whether convertibles are the best method of financing.
A company may also issue bonds that may be exchanged for the common stock of other companies.
The issuer may do this if it owns a sizable stake in another company's stock, if it wants to raise cash
currently, and if it intends to sell the shares at a later date because it expects the share price to rise.
In conclusion, convertibility usually allows the company to pay a lower interest rate. Since equity is
the most expensive form of financing, issuing convertibles that never reach conversion might be
viewed as an optimal strategy. A convertible bond is a delayed common equity financing to be used
when the issuer expects its stock price to rise in the future (e.g., over the next two to four years) to
stimulate conversion.
Financial Statement Analysis

When performing financial statement analysis, the creditor should consider a convertible bond with
an attractive conversion feature as equity instead of debt since in all likelihood it will be converted
into common stock and the future payment of interest and principal on the debt will not be required.


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Convertibles Versus Warrants

The differences between convertibles and warrants are:
1. Exercising convertibles does not usually provide additional funds to the company, while the
exercise of warrants does.
2. When conversion occurs, the company's debt ratio is reduced. However, the exercise of warrants
adds to the equity position and debt remains unchanged.
3. Because of the call feature, the company has more control over its capital structure with
convertibles than with warrants.
Derivatives
A derivative is a contract whose value is tied to the value of an underlying asset (e.g., foreign
currency, market index, stock, debt security). Derivative can be used to reduce risk exposure such as
that related to foreign exchange exposure. Speculators can attempt to obtain significant profit from
price level changes or simultaneous price differences in different markets. Further, derivatives may
be used to hedge a position so that an unfavorable price movement in one asset is offset by a
favorable price movement in another asset.
Options
An option is a contract to give the investor the right-but not an obligation-to buy or sell something. It
has three main features. It allows you, as an investor, to "lock in"
· a specified number of shares of stock,
· at a fixed price per share, called strike or exercise price,
· for a limited length of time.
EXAMPLE 17-18
If you have purchased an option on a stock, you have the right to "exercise" the option at any time
during the life of the option. This means that, regardless of the current market price of the stock, you
have the right to buy or sell a specified number of shares of the stock at the strike price (rather than
the current market price).
Calls and puts are types of options. You can buy or sell options in round lots, typically 100 shares.
When you buy a call, you are buying the right to purchase stock at a fixed price. You do this when
you anticipate the price of the stock will go up. In buying a call you have the chance to make a
significant gain from a small investment if the stock price increases, but you also risk the loss of your
entire investment if the stock does not increase

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in price. Calls are in bearer-negotiable form with a life of one to nine months.
The price per share for 100 shares, which the purchaser may buy (call), is referred to as the striking
price (exercise price). For a put, it is the price at which the stock may be sold. The purchase or sale
of the stock is to the writer of the option. The striking price is set for the life of the option on the
options exchange. When stock price changes, new exercise prices are introduced for trading
purposes reflecting the new value.
The option expires on the last day it can be exercised. Conventional options can expire on any
business day, whereas options have a standardized expiration date.
The cost of an option is termed the premium. It is the price the purchaser of the call or put has to pay
the writer.
Premium for a Call Option

The premium depends on the exchange on which the option is listed, prevailing interest rates,
dividend trend of the related security, trading volume, market price of the stock it applies to, amount
of time remaining before the expiration date, variability in the price of the related security, and width
of the spread in price of the stock relative to the option's exercise price (a wider spread means a
higher price).
In-the-Money and Out-of-the-Money

When the market price is greater than the strike price, the call is in-the-money. When the market
price is less than the strike price, the call is out-of-the-money.
A Call at a $50 Strike
Price
In-the-money Over $50
At-the-money $50
Out-of-the- Under $50
money
Call options in-the-money have an intrinsic value equal to the difference between the market price
and the strike price.
The market price of stock is at the current date. Of course, the market price will typically change on
a stock each day. The exercise (strike) price of the call is fixed for its life. For example, the


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exercise (strike) price for a 3-month call is the same for the entire period.
EXAMPLE 17-19
The market price per share of a stock is $45, with a strike price of $40. Remember that one call is
for 100 shares of stock. The value of the call is
Recall that out-of-the-money call options have no intrinsic value.

In effect, the total premium consists of the intrinsic value plus speculative premium (time value)
based on factors such as risk, variability, forecasted future prices, expiration date, leverage, and
dividend.
The call purchaser takes the risk of losing the entire investment price for the option if a price
increase does not take place.
EXAMPLE 17-20
A two-month call option allows you to buy 500 shares of ABC Company at $20 per share. Within
that time period, you exercise the option when the market price is $38. Your gain is $9,000 ($38 -
$20 = $18 × 500 shares). If the market price had declined from $20 you would not have exercised
the call option, and you would have lost your entire investment.
By purchasing a call you can own common stock for a fraction of the cost of purchasing regular
shares. Calls cost significantly less than common stock. Leverage exists because a little change in
common stock price can result in a major change in the call option's price. A part of the percentage
gain in the price of the call is the speculative premium attributable to the remaining life on the call.
EXAMPLE 17-21
A stock has a current market price of $35. A call can be purchased for $300 allowing the acquisition
of 100 shares at $35 each. If the price of the stock increases, the call will be worth more. Assume
that the stock is at $55 at the call's expiration date.
The profit is $20 ($55 - $35) on each of the 100 shares of stock in the call, or a total of $2,000 on an
investment of $300. A return of 667 percent ($2,000/$3,000) is earned.
The Black-Scholes Option Pricing Model

The Black-Scholes option pricing model (OPM) provides the relationship between call option value
and the five factors that determine the


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premium of an option's market value over its expiration value:

· Time to maturityThe longer the option period, the greater the value of the option.
· Stock price volatilityThe greater the volatility of the underlying stock's price, the greater its value.
· Exercise priceThe lower the exercise price, the greater the value.
· Stock priceThe higher the price of the underlying stock, the greater the value.
· Risk-free rateThe higher the risk-free rate, the higher the value. The formula is:
where
V= Current value of a call option
P= current stock price
PV(E)
= present value of exercise or strike price of the
option, E = E/e-rt
r
= risk-free rate of return, continuously compounded
for t time periods
e= 2.71828
t
= number of time periods until the expiration date
(For example, 3 months means
t = 3/12 = 1/4 = 0.25)
n= normal
N(d)
= probability that the normally distributed random
variable Z is less than or equal to d
s
= standard deviation per period of (continuously
compounded) rate of return on the stock
d1=
d2=
The formula requires readily available input data, with the exception of s2, or volatility. P, X, r, and t
are easily obtained. The implications of the option model are as follows:
· The value of the option increases with the level of stock price relative to the exercise price
[P/PV(E)], the time to expiration, and the time to expiration times the stock's variability ( ).
Other properties:
· The option price is always less than the stock price.
· The option price never falls below the payoff to immediate exercise (P - E or zero, whichever is
larger).
· If the stock is worthless, the option is worthless.


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· As the stock price becomes very large, the option price approaches the stock price less the present
value of the exercise price.
EXAMPLE 17-22
The current price of Sigma Corporation's common stock is $59.375 per share. A call option on this
stock has a $55 exercise price. It has 3 months to expiration. If the standard deviation of continuously
compounded rate of return on the stock is 0.2968 and the risk-free rate is 5 percent per year, we
calculate the value of this call option as follows.
First, calculate the time until the option expires in years:
Second, calculate the values of the other variables:
Next, use a table for standard normal distribution (See Table 17-1) to determine N(d1) and N(d2):
Finally, use those values to find the option's value:
This call option is worth $5.05, a little more than its value if it is exercised immediately, $4.375
($59.375 - $55), as one should expect.


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EXAMPLE 17-23
You want to determine the value of another option on the same stock that has an exercise price of $50
and expires in 45 days. The time until the option expires in years is t in years = 45 days/365 days =
0.1233.
The values of the other variables are:
Next, use a table for the standard normal distribution (see Table 17-1) to determine N(d1) and
N(d2):
Finally, use those values to find the option's value:
The call option is worth more than the other option ($9.78 versus $5.05) since it has a lower
exercise price and a longer time until expiration.
Futures
A futures is a contract to purchase or sell a given amount of an item for a given price by a certain
date (in the futurethus the name "futures market"). The seller of a futures contract agrees to deliver
the item to the buyer of the contract, who agrees to purchase the item. The contract specifies the
amount, valuation, method, quality, month and means of delivery, and exchange to be traded in. The
month of delivery is the

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expiration date; in other words, the date on which the commodity or financial instrument must be
delivered.
Commodity contracts are guarantees by a seller to deliver a commodity (e.g., cocoa or cotton).
Financial contracts are a commitment by the seller to deliver a financial instrument (e.g., a Treasury
bill) or a specific amount of foreign currency.
Future markets can be used for both hedging and speculating.
EXAMPLE 17-24
Investors use hedging to protect their position in a commodity. For example, a citrus grower (the
seller) will hedge to get a higher price for his products while a processor (or buyer) of the item will
hedge to obtain a lower price. By hedging an investor minimizes the risk of loss but loses the
prospect of sizable profit.
Chapter Perspective
A warrant and a convertible security give the holder the option to convert the security into common
stock at a later date. They may act as a "sweetener" to a debt issue. A warrant may be detached or
nondetached from the bond it is associated with. The two types of convertible securities are
convertible bonds and convertible preferred stock. A convertible bond is a "hybrid" security
because, while it is debt, it will appreciate in value with an increase in the market price of the
related stock. Financial derivatives are used to hedge risk.


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TABLE 17-1
NORMAL DISTRIBUTION TABLE
Areas under the normal curve
Z 0 1 2 3 4 5 6 7 8 9
.0 .5000 .5040 .5080 .5120 .5160 .5199 .5239 .5279 .5319 .5359
.1 .5398 .5438 .5478 .5517 .5557 .5596 .5636 .5675 .5714 .5753
.2 .5793 .5832 .5871 .5910 .5948 .5987 .6026 .6064 .6103 .6141
.3 .6179 .6217 .6255 .6293 .6331 .6368 .6406 .6443 .6480 .6517
.4 .6554 .6591 .6628 .6664 .6700 .6736 .6772 .6808 .6844 .6879
.5 .6915 .6950 .6985 .7019 .7054 .7088 .7123 .7157 .7190 .7224
.6 .7257 .7291 .7324 .7357 .7389 .7422 .7454 .7486 .7517 .7549
.7 .7580 .7611 .7642 .7673 .7703 .7734 .7764 .7794 .7823 .7852
.8 .7881 .7910 .7939 .7967 .7995 .8023 .8051 .8078 .8106 .8133
.9 .8159 .8186 .8212 .8238 .8264 .8289 .8315 .8340 .8365 .8389
1.0 .8413 .8438 .8461 .8485 .8508 .8531 .8554 .8577 .8599 .8621
1.1 .8643 .8665 .8686 .8708 .8729 .8749 .8770 .8790 .8810 .8830
1.2 .8849 .8869 .8888 .8907 .8925 .8944 .8962 .8980 .8997 .9015
1.3 .9032 .9049 .9066 .9082 .9099 .9115 .9131 .9147 .9162 .9177
1.4 .9192 .9207 .9222 .9236 .9251 .9265 .9278 .9292 .9306 .9319
1.5 .9332 .9345 .9357 .9370 .9382 .9394 .9406 .9418 .9430 .9441
1.6 .9452 .9463 .9474 .9484 .9495 .9505 .9515 .9525 .9535 .9545
1.7 .9554 .9564 .9573 .9582 .9591 .9599 .9608 .9616 .9625 .9633
1.8 .9641 .9648 .9656 .9664 .9671 .9678 .9686 .9693 .9700 .9706
1.9 .9713 .9719 .9726 .9732 .9738 .9744 .9750 .9756 .9762 .9767
2.0 .9772 .9778 .9783 .9788 .9793 .9798 .9803 .9808 .9812 .9817
2.1 .9821 .9826 .9830 .9834 .9838 .9842 .9846 .9850 .9854 .9857
2.2 .9861 .9864 .9868 .9871 .9874 .9878 .9881 .9884 .9887 .9890
2.3 .9893 .9896 .9898 .9901 .9904 .9906 .9909 .9911 .9913 .9916
2.4 .9918 .9920 .9922 .9925 .9927 .9929 .9931 .9932 .9934 .9936
2.5 .9938 .9940 .9941 .9943 .9945 .9946 .9948 .9949 .9951 .9952
2.6 .9953 .9955 .9956 .9957 .9959 .9960 .9961 .9962 .9963 .9964
2.7 .9965 .9966 .9967 .9968 .9969 .9970 .9971 .9972 .9973 .9974
2.8 .9974 .9975 .9976 .9977 .9977 .9978 .9979 .9979 .9980 .9981
2.9 .9981 .9982 .9982 .9983 .9984 .9984 .9985 .9985 .9986 .9986
3.0 .9987 .9990 .9993 .9995 .9997 .9998 .9998 .9999 .9999 1.0000


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Chapter 18
Failure and Reorganization
In this chapter, we present the warning signs of potential bankruptcy. If bankruptcy can be predicted,
the company may be able to do something to prevent it. We discuss the many ways to avoid liquidity
and solvency problems.
When a company fails it can be reorganized or dissolved, depending on the circumstances. Business
failures occur in a number of ways, including technical insolvency and bankruptcy.
· The quantitative and qualitative indicators of potential business failure.
· How the ''Z score" is used.
· How future bankruptcy may be avoided.
· What bankruptcy is about.
· How extensions and compositions work.
· The implications of a Chapter 11 reorganization.
· The priority claims in bankruptcy.
Signs of Bankruptcy
It is vital that you recognize the warning signs for impending bankruptcy and know what can be done
to avoid failure.
Since bankruptcy occurs when the company is unable to meet maturing financial obligations, cash
flow is one major predictor. Financial difficulties affect the P/E ratio, bond ratings, and the effective
interest rate.
Many quantitative factors are used in predicting corporate failure, including:
· Low cash-flow-to-total-liabilities ratio
· High debt-to-equity ratio and high debt-to-total-assets ratio
· Low return on investment
· Low profit margin
· Low retained-earnings-to-total-assets ratio

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· Low working-capital-to-total-assets and low working-capital-to-sales ratios

· Low fixed-assets-to-noncurrent-liabilities ratio
· Inadequate interest-coverage ratio
· Unstable earnings
· Small company size measured in sales and/or total assets
· Sharp decline in stock price, bond price, and earnings
· A significant increase in beta (beta is the variability in the price of the company's stock relative to
market index)
· Large gap between market price per share and book value per share
· Reduction in dividend payments
· A significant rise in the company's weighted-average cost of capital
· High fixed-cost-to-total-cost-structure (also called high operating leverage)
· Failure to maintain capital assets (e.g., a decline in the ratio of repairs to fixed assets)
A comprehensive quantitative indicator used to predict failure is Altman's Z-score, which is based
on a weighted-sum of financial ratios. The Z-score model has three general outcomes: likely
bankruptcy, unlikely bankruptcy, and gray area.
The Z score is about 90 percent accurate in forecasting business failure one year in the future and
about 80 percent accurate in forecasting it two years in the future. For a more detailed discussion of
Z-score, see Edward I. Altman, "Financial Ratios, Discriminant Analysis, and the Prediction of
Corporate Bankruptcy," Journal of Finance, September 1968.
The Z-score equals:
The scores and the probability of failure developed by Altman follow:

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Score Probability of Failure
1.80 or less Very high
1.81 2.7 High
2.8 2.9 Possible
3.0 or greater Not likely
EXAMPLE 18-1
A company presents the following information:
Working capital $280,000

Total assets 875,000
Total liabilities 320,000
Retained earnings 215,000
Sales 950,000
Operating income 130,000
Common stock
220,000
Book value
310,000
Market value
Preferred stock
115,000
Book value
170,000
Market value
The Z-score equals:
The probability of failure is not likely.

The qualitative factors that predict failure include:
· Poor financial reporting system and inability to control costs
· Newness of company
· Declining industry
· High degree of competition
· Inability to obtain adequate financing and significant loan restrictions on any financing obtained
· Inability to meet past-due obligations
· Poor management
· Ventures into areas in which management lacks expertise


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· Failure of the company to keep up-to-date, especially in a technologically oriented business

· High business risk, such as a positive correlation in the product line, meaning that demand for all
the company's products moves up or down together, or susceptibility to strikes
· Inadequate insurance coverage
· Fraudulent actions (e.g., misstating inventories to avoid impending bankruptcy)
· Cyclical business operations
· Inability to adjust production to meet consumption needs
· Susceptibility to stringent governmental regulation (e.g., rent control laws affecting landlords)
· Susceptibility to energy shortages
· Susceptibility to unreliable suppliers
· Renegotiated debt and/or lease agreements
· Deficient accounting and financial reporting systems
If you can predict with reasonable accuracy that the company is developing financial distress, you
can better protect it and recommend corrective action.
Avoiding Business Failure

Companies have many financial and quantitative ways to minimize the potential for failure. Liquidity
and solvency problems may be minimized by:
· Avoiding heavy debt. If liabilities are excessive, finance with equity.
· Disposing of losing divisions and product lines.
· Managing assets for maximum return and minimum risk.
· Staggering and extending the maturity dates of debt.
· Using quantitative techniques such as multiple regression analysis to compute the correlation
between variables and the likelihood of business failure.
· Ensuring that there is a safety buffer between actual status and compliance requirements (e.g.,
working capital) in connection with loan agreements.
· Having a negative correlation in products and investments.
· Lowering dividend payouts.
Nonfinancial factors that minimize the potential for failure include:
· Vertical and horizontal diversification of product lines and operations.
· Financing assets with liabilities of similar maturity (hedging).


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· Diversifying geographically.
· Having adequate insurance.
· Enhancing the marketing effort.
· Engaging in cost-reduction programs.
· Improving productivity (e.g., using timely and detailed variance analysis).
· Minimizing the adverse effect of inflation and recession on the entity (e.g., price on a next-in, first-
out basis).
· Investing in multi-purpose, rather than single-purpose, assets, because of their lower risks.
· Avoiding entering industries that have historically had a high failure rate.
· Having many projects, rather than only a few, that significantly affect operations.
· Introducing product lines that are only slightly affected by the business cycle and that possess
stable demand.
· Avoiding going from a labor-intensive to a capital-intensive business, since the latter has a high
operating leverage.
· Avoiding long-term fixed-fee contracts to customers and instead incorporating inflation adjustment
and energy-cost indices in contracts.
· Avoiding markets that are on the downturn or that are already highly competitive.
· Adjusting to changes in technology.
Business Failure
A technically insolvent or bankrupt company may be considered a business failure.
Technical Insolvency
Technical insolvency means that the company cannot meet current obligations when due even if its
total assets exceed its total liabilities. In this case, one or more creditors can petition to have a
debtor judged insolvent by a court in order to obtain an orderly and equitable settlement of
obligations.
Bankruptcy
In bankruptcy, liabilities exceed the fair market value of assets and the company has a negative real
net worth.
According to law, a company failure can be either a technical insolvency or a bankruptcy. When
credit or claims against a business are in question, the law gives creditors recourse against the
company.


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Some causes of business failure include poor management, an economic downturn that affects the
company and/or industry, overexpansion, the end of the company's life cycle, lawsuit, and
catastrophe.
Voluntary Settlement
A voluntary settlement with creditors allows the company to save many of the costs that would occur
in bankruptcy while enabling it to recover some of its investment. Such a settlement is reached out of
court and permits the company to either continue or be liquidated.
A creditor committee may elect to permit the company to operate if it is anticipated that the company
will recover. Creditors may also keep doing business with the company. To sustain the company's
existence, there may be:
· An extension
· A composition
· Integration of each
Extension
In an extension, creditors receive the balances due thembut over an extended time period. Current
purchases by the company are made with cash. Creditors may agree not only to extend the maturity
date for payment but also to subordinate their claims to current debt for suppliers providing credit in
the extension period. The creditors expect the debtor to be able to work out its problems.
The creditor committee may mandate certain controls, including establishing legal control over the
company's assets or common stock, obtaining a security interest in assets, and obtaining the right to
approve all cash payments.
If some creditors dissent from the extension agreement, they may be paid immediately to prevent
their having the company declared bankrupt.
Composition
In a composition, creditors voluntarily reduce the amount the debtor owes them. The creditor obtains
from the debtor a specified percent of the obligation in full satisfaction of the debt, regardless of
how low the percent is. The agreement permits the debtor to continue to operate. The creditor may
attempt to work with the debtor in handling the company's financial difficulties in hope of eventually
obtaining a stable customer. The benefits of a composition are that it eliminates court costs as well
as the stigma of a bankruptcy.


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For an extension or composition to be practical, it should be reasonable to expect that the debtor
will recover, and present business conditions must be conducive to that recovery.
Integration
In an integrated agreement, the company and creditors negotiate a plan involving a combination of
extension and composition. For example, the agreement may provide for a 10 percent cash payment
of the balance owed plus five future payments of 15 percent each, usually in notes. The total payment
is thus 85 percent.
The benefits of a negotiated settlement are these:
· They cost less, particularly in legal fees.
· They are easier to implement than bankruptcy proceedings.
· They are less formal than bankruptcy.
The following drawbacks to a negotiated settlement exist:
· If the troubled debtor still has control over its business affairs, asset values may decline further.
However, creditor control can provide some protection.
· Unrealistic small creditors may drain the negotiating process.
Bankruptcy Reorganization
If no voluntary settlement is agreed upon, creditors may put the company into bankruptcy, which may
either reorganize or liquidate the company.
Bankruptcy occurs when the company cannot pay its bills or when liabilities exceed the fair market
value of the assets. A company may file for reorganization under which it will formulate a plan for
continued life.
Chapter 11 of the Bankruptcy Reform Act of 1978 describes the steps involved in reorganizing a
failed business. (Chapter 7 of the Bankruptcy Reform Act, which outlines the procedures to be
followed for liquidation, applies when reorganization is not practical.)
The two kinds of reorganization petitions are:
1. VoluntaryIn this petition the company seeks its own reorganization. The company need not be
insolvent to file for voluntary reorganization.
2. InvoluntaryCreditors file for an involuntary reorganization of the company and must establish
either that the debtor firm is not meeting its debts when due or that a creditor or another party has
taken control of the debtor's assets. In general, most of the creditors or claims must support the
petition.

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The five steps in a reorganization are:

1. A reorganization petition is filed under Chapter 11 in court.
2. A judge approves the petition and either appoints a trustee or allows the creditors to elect one to
handle the disposition of the assets.
3. The trustee provides a fair plan of reorganization to the court.
4. The plan is given to the creditors and stockholders of the company for approval.
5. The debtor pays the expenses of the parties performing services in the reorganization proceedings.
The trustee in a reorganization plan is required to:
· Value the company
· Recapitalize the company
· Exchange outstanding debts for new securities
Valuation
In valuing the company, the trustee must estimate its liquidation value versus its value as a going
concern. Liquidation is called for when the liquidation value exceeds the continuity value; if the
company is more valuable when operating, reorganization is the answer. To determine the value of
the reorganized company, the trustee must predict future earnings. The going concern value
represents the present value of future earnings.
EXAMPLE 18-2
A petition for reorganization of a company was filed under Chapter 11. The trustee computed the
firm's liquidation value after deducting expenses as $4.5 million. The trustee estimates that the
reorganized business will generate $530,000 in annual earnings. The cost of capital is 10 percent.
Assuming the earnings continue indefinitely, the value of the business is:
Since the company's value as a going concern ($5.3 million) exceeds its liquidation value ($4.5
million), reorganization is called for.
Recapitalization
If the trustee recommends company reorganization, a plan must be formulated by which it can meet
its debts. This can be done in a number of ways. The obligations may be extended; equity securities
may be issued in place of the debt; or income bonds may be given for the debentures. (Income bonds
pay interest only when there are earnings.) The process of exchanging liabilities for other types of
liabilities or

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equity securities is referred to as recapitalization. The objective of recapitalizing the company is to

have a mixture of debt and equity that will allow the company to meet its debts and furnish a
reasonable profit for the owners.
EXAMPLE 18-3
The current capital structure of Y Corporation is presented below.
Debentures $1,500,000
Collateral bonds 3,000,000
Preferred stock 800,000
Common stock 2,500,000
Total $7,800,000
There exists high financial leverage:
Assuming the company is deemed to be worth $5 million as a going concern, the trustee can develop
a less leveraged capital structure having a total capital of $5 million as follows:
Debentures $1,000,000
Collateral bonds 1,000,000
Income bonds 1,500,000
Preferred stock 500,000
Common stock 1,000,000
Total $5,000,000
It should be noted that this recapitalization has resulted in a significant loss to stockholders.
The income bond of $1.5 million is similar to equity in appraising financial leverage, since interest
is not paid unless there is income. The new debt/equity ratio is safer:

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Exchange of Obligations
In exchanging obligations to arrive at the optimal capital structure, specified priorities must be
followed. Senior claims are paid before junior ones, and holders of senior debt receive a claim on
new capital equal to their prior claims. The lowest priority goes to common stockholders in
receiving new securities. A debtholder typically receives a combination of different securities;
holders of preferred and common stock may receive nothing. Typically, however, they retain some
small ownership. After the exchange, the debtholders may become the company's new owners.
Liquidation Due to Bankruptcy

A company that becomes bankrupt may be liquidated under Chapter 7. The major elements of
liquidation are legal considerations, claim priority, and dissolution.
Legal Considerations
When a company is declared bankrupt by the court, creditors are required to meet between ten and
thirty days after than declaration. A judge or referee takes charge of the meeting in which the
creditors provide their claims, and a trustee is appointed by the creditors to handle the property of
the defaulted firm, liquidate the business, maintain records, appraise the creditors' claims, make
payments, and provide relevant information on the liquidation process.
Claim Priority
Some claims against the company take precedence over others in bankruptcy. The following rank
order exists in meeting claims:
1. Secured claims. Secured creditors receive the value of the secured assets in support of their
claims. If the value of the secured assets is inadequate to meet their claims in full, the balance
reverts to general creditor status.
2. Bankruptcy administrative costs. These costs include any expenses of handling the bankruptcy,
such as legal and trustee expenses.
3. Unsecured salaries and commissions. These claims are limited to a maximum specific amount
per individual and must be incurred within ninety days of the bankruptcy petition.
4. Unsecured customer deposit claims. These claims are limited to a nominal amount each. An
example is a deposit made by a customer for future goods or services.
5. Taxes. Tax claims are unpaid taxes due the government.
6. General creditor claims. These are claims made by general cred-


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itors, who loaned the company money without specific collateral. Included are debentures and
accounts payable.
7. Preferred stockholders.
8. Common stockholders.
Dissolution
After claims have been met in priority order and an accounting made of the proceedings, an
application to discharge the bankrupt business may then be instituted. A discharge occurs when the
court releases the company from legitimate debts in bankruptcy, with the exception of debts that are
immune to discharge. As long as a debtor has not been discharged within the previous six years and
was not bankrupt due to fraud, he or she may then start a new business.
EXAMPLE 18-4
The balance sheet of Ace Corporation for the year ended December 31, 20X4, follows:
Balance Sheet
Current $400,000Current liabilities $475,000
assets
Fixed assets 410,000Long-term liabilities
250,000
Common stock
175,000
Retained earnings
(90,000)
Total assets $810,000 $810,000
Total liabilities and stockholders'
equity
The company's liquidation value is $625,000. Rather than liquidate, the company could be
reorganized with an investment of an additional $320,000. The reorganization is expected to
generate earnings of $115,000 per year. A multiplier of 7.5 is appropriate. If the $320,000 is
obtained, long-term debtholders will receive a negotiated 40 percent of the common stock in the
reorganized business in substitution for their current claims.
If $320,000 of further investment is made, the business's going-concern value is $862,500 (7.5 ×
$115,000). The liquidation value is given at $625,000. Since the reorganization value exceeds the
liquidation value, reorganization is called for.
EXAMPLE 18-5
Fixed assets with a book value of $1.5 million were sold for $1.3 million. There are mortgage bonds
amounting to $1.8 million on the fixed assets. The proceeds from the collateral sale are inadequate to
meet

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the secured claim. The unsatisfied portion of $500,000 ($1,800,000 - $1,300,000) of the claim
becomes a general creditor claim.
EXAMPLE 18-6
Land having a book value of $1.2 million was sold for $800,000. Mortgage bonds on the land are
$600,000. The excess of $200,000 will be returned to the trustee to pay other creditors.
EXAMPLE 18-7
Charles Company is bankrupt. The book and liquidation values follow:
Book Value Liquidation Value
Cash $ 600,000
$ 600,000
Accounts receivable
1,900,000 1,500,000
Inventory
3,700,000 2,100,000
Land
5,000,000 3,200,000
Buildings
7,800,000 5,300,000
Equipment
6,700,000 2,800,000
Total assets $15,500,000
$25,700,000
The liabilities and stockholders' equity at the date of liquidation are:

Current liabilities
$1,800,000
Accounts payable

Notes payable 900,000

Accrued taxes 650,000

Accrued salaries 450,000a
$ 3,800,000
Total current liabilities
Long-term liabilities
$3,200,000
Mortgage on land
2,800,000
First mortgagebuilding
2,500,000
Second mortgagebuilding
4,800,000
Subordinated debentures
13,300,000
Total long-term liabilities
$17,100,000
Total liabilities
a The salary owed each worker is below the specified amount and
was incurred within 90 days of the bankruptcy petition.


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Stockholders' equity
$4,700,000
Preferred stock
6,800,000
Common stock
(2,900,000)
Retained earnings
8,600,000
Total stockholders' equity
$25,700,000
Total liabilities and
Expenses of the liquidation including legal costs were 15 percent of the proceeds. The debentures
are subordinated only with regard to the two first-mortgage bonds.
The distribution of the proceeds follows:
Proceeds $15,500,000
Mortgage on land $3,200,000
First mortgagebuilding 2,800,000
Second mortgagebuilding 2,500,000
2,325,000
Liquidation expenses
(15% × $15,500,000)
Accrued salaries 450,000
Accrued taxes 650,000
11,925,000
Total
Balance $ 3,575,000
The percent to be paid to general creditors is:
The balance due general creditors follows:

General Creditors Owed Paid
Accounts payable $1,800,000 $ 858,000
Notes payable 900,000 429,000
Subordinated debentures 4,800,000 2,288,000
Total $7,500,000 $3,575,000

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EXAMPLE 18-8
The balance sheet of the Oakhurst Company follows:
ASSETS
Current assets

Cash $ 9,000

Marketable securities 6,000

Receivables 1,100,000

Inventory 3,000,000

Prepaid expenses 4,000
$4,119,000
Total current assets
Noncurrent assets

Land $1,800,000

Fixed assets 2,000,000
3,800,000
Total noncurrent assets
$7,919,000
Total assets
Current liabilities

Accounts payable $ 180,000

Bank loan payable 900,000
300,000a
Accrued salaries
70,000b
Employee benefits payable
80,000c
Customer claimsunsecured

Taxes payable 350,000
$1,880,000
Total current liabilities
Noncurrent liabilities

First mortgage payable $1,600,000

Second mortgage payable 1,100,000

Subordinated debentures 700,000
3,400,000
Total noncurrent liabilities
$5,280,000
Total liabilities
Stockholders' equity

Preferred stock (3,500 shares) $ 350,000

Common stock (8,000 shares) 480,000

Paid-in capital 1,600,000

Retained earnings 209,000
2,639,000
Total stockholders' equity
$7,919,000
Total liabilities and
a The salary owed to each worker is below the specified amount and was
incurred within 90 days of the bankruptcy petition.
b Employee benefits payable have the same limitations as unsecured wages and
satisfy for eligibility in bankruptcy distribution.
c No customer claim is greater than the nominal amount.

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Additional data are as follows:

1. The mortgages apply to the company's total noncurrent assets.
2. The subordinated debentures are subordinated to the bank loan payable. Therefore, they come
after the bank loan payable in liquidation.
3. The trustee has sold the company's current assets for $2.1 million and the noncurrent assets for
$1.9 million. Therefore, a total of $4 million was received.
4. The business is bankrupt, since the total liabilities of $5.28 million are greater than the $4 million
of the fair value of the assets.
Assume that the administration expense for handling the bankrupt company is $900,000. This
liability is not reflected in the preceding balance sheet.
The allocation of the $4 million to the creditors follows:
Proceeds $4,000,000
Available to secured creditors
$1,600,000
First mortgagepayable from
$1,900,000 proceeds of
noncurrent assets
300,000 1,900,000
Second mortgagepayable from
balance of proceeds of
noncurrent assets
Balance after secured creditors $2,100,000
Next priority
$ 900,000
Administrative expenses
300,000
Accrued salaries
70,000
Employee benefits payable
80,000
Customer claimsunsecured
350,000 1,700,000
Taxes payable
Proceeds available to general creditors $ 400,000
Now that the claims on the proceeds from liquidation have been met, general creditors receive the
balance on a pro rata basis. The distribution of the $400,000 follows:


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Amount Pro Rata Allocation for Balance to

General Creditor Be Paid*
$124,0311
Second-mortgage balance $ 800,000
($1,100,000 - $300,000)
27,907
Accounts payable 180,000
248,062a
Bank loan payable 900,000
0
Subordinated debentures 700,000

Total $2,580,000 $400,000
*
1
a Since the debentures are subordinated, the bank loan
payable must be satisfied in full before amount can go to the
subordinated debentures. The subordinated debenture
holders therefore receive nothing.
Chapter Perspective
There are signs of potential bankruptcy that must be noted and corrective action must be taken.
Several ways exist to sustain the company's existence, including extension and composition. A
voluntary or involuntary corporate reorganization may also occur. In liquidating the business, a
priority order of claims has to be followed.


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Chapter 19
International Finance
Multinational corporations (MNCs) have significant foreign operations deriving a high percentage of
their sales overseas. Financial managers of MNCs must understand the complexities of international
finance so that they can make sound financial and investment decisions. Multinational finance
involves consideration of managing working capital, financing the business, assessing control of
foreign exchange and political risks, and evaluating foreign direct investments. Most importantly, the
financial manager must consider the value of the U.S. dollar relative to the value of the currency of
the foreign country in which business activities are being conducted.
· Special features of an MNC.
· The foreign exchange market and how it works.
· How to manage foreign currency risk.
· The impact of changes in foreign exchange rates.
· Theorems associated with interest rates, inflation, and exchange rates.
· How to analyze foreign investments.
· International sources of financing.
Special Problems of a Multinational Corporation

· Multiple-currency problem. Sales revenues may be collected in one currency, while assets are
denominated in another, and profits measured in a third.
· Various legal, institutional, and economic constraints. There are variations in such things as tax
laws, labor practices, balance of payment policies, and government controls with respect to the
types and sizes of investments, types and amount of capital raised, and repatriation of profits.
· Internal control problem. When the parent office of an MNC and its affiliates are widely located,
internal organizational difficulties arise.


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Foreign Exchange Market

Except in a few European centers, there is no central marketplace for the foreign exchange market.
Rather, business is carried out over telephone, telex, or the Internet. The major dealers are large
banks. A company that wants to buy or sell currency typically uses a commercial bank. International
transactions and investments involve more than one currency. For example, when a U.S. company
sells merchandise to a Japanese firm, the former wants to be paid in dollars, but the Japanese
company typically expects to receive yen. Because of the foreign exchange market, the buyer may
pay in one currency, but the seller receives payment in another currency.
Spot and Forward Foreign Exchange Rates

An exchange rate is the ratio of one unit of currency to another. An exchange rate is established
between the different currencies. The conversion rate between currencies depends on the
demand/supply relationship. Because of the change in exchange rates, companies are susceptible to
exchange rate fluctuation risks because of a net asset or net liability position in a foreign currency.
Exchange rates may be in terms of dollars per foreign currency unit (called a direct quote) or units
of foreign currency per dollar (called an indirect quote). Therefore, an indirect quote is the
reciprocal of a direct quote and vice versa.
Figure 19.1 presents a sample of indirect and direct quotes for selected currencies.
EXAMPLE 19-1
A rate of 1.617/British pound means each pound costs the U.S. company $0.6184. In other words, the
U.S. company gets 1/1.617 = 0.6184 pounds for each U.S. dollar.
The spot rate is the exchange rate for immediate delivery of currencies exchanged, whereas the
forward rate is the exchange rate for later delivery of currencies exchanged. For example, there may
be a 90-day exchange rate. The forward exchange rate of a currency will be slightly different from
the spot rate at the current date because of future expectations and uncertainties.
Forward rates may be greater than the current spot rate (premium) or less than the current spot rate
(discount).


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Country Contract U.S. Dollar Currency per
Equivalent U.S. $
Britain Spot 1.6170 0.6184
(Pound) 30-day 1.6153 0.6191
future
90-day 1.6130 0.6200
future
180-day 1.6089 0.6215
future
Germany Spot 0.7282 1.3733
(Mark) 30-day 0.7290 1.3716
future
90-day 0.7311 1.3677
future
180-day 0.7342 1.3620
future
Japan Spot
0.011955 83.65
(Yen) 30-day
future 0.012003 83.31
90-day
future 0.012100 82.64
180-day
future 0.012247 81.65
Figure 19.1
Foreign Exchange Rates (October 31, 20X0)
Cross Rates
A cross rate is the indirect calculation of the exchange rate of one currency from the exchange rates
of two other currencies.
EXAMPLE 19-2
The dollar per pound and the yen per dollar rates are given in Figure 19.1. From this information,
you can determine the yen per pound (or pound per yen) exchanges rates. For example, you see that
Thus, the pound per yen exchange rate is:
Figure 19.2 displays the cross rates among key currencies.

EXAMPLE 19-3
On February 1, 20X8, forward rates on the British pound were at a premium in relation to the spot
rate, whereas the forward rates for the Japanese yen were at a discount from the spot rate. This
means that


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Britain Germany Japan U.S.

Britain 0.45032 0.00739 0.61843
Germany 2.2206 0.01642 1.3733
Japan 135.26 60.912
83.65
U.S. 1.6170 0.72817 0.01195
Figure 19.2
Key Currency Cross Rates (March 15, 20X0)
participants in the foreign exchange market anticipated that the British pound would appreciate
relative to the U.S. dollar in the future but the Japanese yen would depreciate against the dollar.
The percentage premium (P) or discount (D) is computed as follows:
where F, S = the forward and spot rates respectively and n = length of the forward contract in
months.
If P > S, the result is the annualized premium in percent; otherwise, it is the annualized discount in
percent.
EXAMPLE 19-4
On May 3, 20X1, a 30-day forward contract in Japanese yen was selling at a 4.8 percent discount:
Currency Risk Management

Foreign exchange rate risk exists when the contract is written in terms of the foreign currency or
denominated in the foreign currency. The exchange rate fluctuations increase the riskiness of the
investment and incur cash losses. The financial manager not only must seek the highest return on
temporary investments but also must be concerned about changing values of the currencies invested.
You do not necessarily eliminate foreign exchange risk. You may only try to contain it. Some
financial strategies follow.
In countries where currency values are likely to drop, financial managers of the subsidiaries should:


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· Avoid paying advances on purchase orders unless the seller pays interest on the advances sufficient
to cover the loss of purchasing power.
· Not have excess idle cash. Excess cash can be used to buy inventory or other real assets.
· Buy materials and supplies on credit in the country in which the foreign subsidiary is operating,
extending the final payment date as long as possible.
· Avoid giving excessive trade credit. If accounts receivable balances are outstanding for an
extended time period, interest should be charged to absorb the loss in purchasing power.
· Borrow local currency funds when the interest rate charged does not exceed U.S. rates after taking
into account expected devaluation in the foreign country.
Types of Foreign Exchange Exposure
Financial managers of MNCs are faced with the dilemma of three different types of foreign exchange
risk. They are:
· Translation exposure, often called accounting exposure, measures the impact of an exchange rate
change on the firm's financial statements. An example would be the impact of a French franc
devaluation on a U.S. firm's reported income statement and balance sheet.
· Transaction exposure measures potential gains or losses on the future settlement of outstanding
obligations that are denominated in a foreign currency. An example would be a U.S. dollar loss after
the franc devalues, on payments received for an export invoiced in francs before that devaluation.
· Operating exposure, often called economic exposure, is the potential for the change in the present
value of future cash flows due to an unexpected change in the exchange rate.
Ways to Neutralize Foreign Exchange Risk
Foreign exchange risk can be neutralized or hedged by a change in the asset and liability position in
the foreign currency. Here are some ways to control exchange risk.
Entering a Money-market Hedge. Here the exposed position in a foreign currency is offset by
borrowing or lending in the money market.
EXAMPLE 19-5
XYZ, an American importer, enters into a contract with a British supplier to buy merchandise for
4,000 pounds. The amount is payable on the delivery of the goods, 30 days from today. The company
knows the exact amount of its pound liability in 30 days. However, it does not


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know the payable in dollars. Assume that the 30-day money-market rates for both lending and
borrowing in the United States and United Kingdom are 0.5% and 1%, respectively. Assume further
that today's foreign exchange rate is $1.50 per pound.
In a money-market hedge, XYZ can take the following steps:
1. Buy a one-month U.K. money market security, worth 4,000/(1 + 0.005) = 3,980 pounds. This
investment will compound to exactly 4,000 pounds in one month.
2. Exchange dollars on today's spot (cash) market to obtain the 3,980 pounds. The dollar amount
needed today is
3. If XYZ does not have this amount, it can borrow it from the U.S. money market at the going rate of
1%. In 30 days, XYZ will need to repay $6,905.30 × (1 + 0.1) = $7,595.83.
Note: XYZ need not wait for the future exchange rate to be available. On today's date, the future
dollar amount of the contract is known with certainty. The British supplier will receive 4,000
pounds, and the cost of XYZ to make the payment is $7,595.83.
Hedging by Purchasing Forward (or Futures) Exchange Contracts. A forward exchange contract is
a commitment to buy or sell, at a specified future date, one currency for a specified amount of
another currency (at a specified exchange rate). This can be a hedge against changes in exchange
rates during a period of contract or exposure to risk from such changes. More specifically, do the
following: (1) Buy foreign exchange forward contracts to cover payables denominated in a foreign
currency and (2) sell foreign exchange forward contracts to cover receivables denominated in a
foreign currency. This way, any gain or loss on the foreign receivables or payables due to changes in
exchange rates is offset by the gain or loss on the forward exchange contract.
EXAMPLE 19-6
In the previous example, assume that the 30-day forward exchange rate is $1.6153. XYZ may take
the following steps to cover its payable.
1. Buy a forward contract today to purchase 4,000 pounds in 30 days.
2. On the 30th day pay the foreign exchange dealer 4,000 pounds × $1.6153 per pound = $6,461.20
and collect 4,000 pounds. Pay this amount to the British supplier. Using the forward contract XYZ
knows the exact worth of the future payment in dollars ($6,461.20).
Note: The basic difference between futures contracts and forward contracts is that futures contracts
are for specified amounts and maturities, whereas forward contracts are for any size and maturity.


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Hedging by Foreign Currency Options. Foreign currency options can be purchased or sold in three
different types of markets: (a) Options on the physical currency, purchased on the over-the- counter
(interbank) market, (b) options on the physical currency, on organized exchanges such as the
Philadelphia Stock Exchange and the Chicago Mercantile Exchange, and (c) options on futures
contracts, purchased on the International Monetary Market (IMM) of the Chicago Mercantile
Exchange.
Repositioning Cash. Financial managers can reposition cash by leading and lagging the time at
which an MNC makes operational or financial payments. Often, money- and forward-market hedges
are not available to eliminate exchange risk. Under such circumstances, leading (accelerating) and
lagging (decelerating) may be used to reduce risk.
Maintaining Balance Between Receivables and Payables. A balance must be maintained between
receivables and payables denominated in a foreign currency. MNCs typically set up ''multilateral
netting centers" as a special department to settle the outstanding balances of affiliates of an MNC
with each other on a net basis. It is the development of a "clearinghouse" for payments by the firm's
affiliates. If there are amounts due among affiliates, they are offset insofar as possible. The net
amount would be paid in the currency of the transaction. The total amounts owed need not be paid in
the currency of the transaction; thus, a much lower quantity of the currency must be acquired.
Positioning of Funds. Transfer pricing can be used to position funds. A transfer price is the price at
which an MNC sells goods and services to its foreign affiliates or, alternatively, the price at which
an affiliate sells to the parent. For example, a parent that wishes to transfer funds from an affiliate in
a depreciating-currency country may charge a higher price on the goods and services sold to this
affiliate by the parent or by affiliates from strong-currency countries. Transfer pricing affects not
only transfer of funds from one entity to another but also the income taxes paid by both entities.
Key Questions to Ask That Help to Identify Foreign Exchange Risk
A systematic approach to identifying an MNC's exposure to foreign exchange risk is to ask a series
of questions regarding the net effects on profits of changes in foreign currency revenues and costs.
The questions are:
· Where is the MNC selling? (domestic vs. foreign sales share)
· Who are the firm's major competitors? (domestic vs. foreign)
· Where is the firm producing? (domestic vs. foreign)
· Where are the firm's inputs coming from? (domestic vs. foreign)


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Currency Weak Currency Strong
(Depreciation) (Appreciation)
Imports More expensive Cheaper
Exports Cheaper More expensive
Payables More expensive Cheaper
ReceivablesCheaper More expensive
Figure 19.3
The Impact of Changes in Foreign Exchange Rates
· How sensitive is quantity demanded to price? (elastic vs. inelastic)

· How are the firm's inputs or outputs priced? (domestic market vs. global market; the currency of
denomination)
Impact of Changes in Foreign Exchange Rates

Figure 19.3 summarizes the impact of changes in foreign exchange rates on the company's products
and financial transactions.
Interest Rates
Interest rates have an important influence on exchange rates. In fact, there is an important economic
relationship between any two nations' spot rates, forward rates, and interest rates. This relationship
is called the interest rate parity theorem (IRPT). The IRPT states that the ratio of the forward and
spot rates is directly related to the two interest rates. Specifically, the premium or discount should
be:
where rf and rd = foreign and domestic interest rates.

When interest rates are relatively low, this equation can be approximated by P (or D) = -(rf - rd).
The IRPT implies that the P (or D) calculated by the equation should be the same as the P (or D)
calculated by:

Page 335
EXAMPLE 19-7
On May 3, 20X1, a 30-day forward contract in Japanese yen was selling at a 4.82 percent premium:
The 30-day U.S. T-bill rate is 8 percent annualized. What is the 30-day Japanese rate?
Using the equation:
The 30-day Japanese rate should be 3.03 percent.
Inflation
Inflation, which is a change in price levels, also affects future exchange rates. The mathematical
relationship that links changes in exchange rates and changes in price level is called the purchasing
power parity theorem (PPPT). The PPPT states that the ratio of the forward and spot rates is
directly related to the two inflation rates:
where= forward exchange rate (e.g., $/foreign

Fcurrency)
= spot exchange rate (e.g., $/foreign
Scurrency)
Pd= domestic inflation rate
Pf= foreign inflation rate


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EXAMPLE 19-8
Assume the following data for the United States and France:
Expected U.S. inflation rate = 5%
Expected French inflation rate = 10%
S = $0.220/franc
Then,
So
Note: If France has the higher inflation rate, then the purchasing power of the franc is declining faster
than that of the dollar. This will lead to a forward discount on the franc relative to the dollar.
Analysis of Foreign Investments

Foreign investment decisions are basically capital budgeting decisions at the international level. The
decision requires three major components:
· The estimation of the relevant future cash flows. Cash flows are the dividends and possible future
sales price of the investment. The estimation depends on the sales forecast, the effects on exchange
rate changes, the risk in cash flows, and the actions of foreign governments.
· The choice of the proper discount rate (cost of capital). The cost of capital in foreign investment
projects is higher due to the increased risks of:
Currency risk (or foreign exchange risk)changes in exchange rates. This risk may adversely affect
sales by making competing imported goods cheaper.
Political risk (or sovereignty risk)possibility of nationalization or other restrictions with net losses
to the parent company.
International Sources of Financing

A company may finance its activities abroad, especially in countries it is operating in. A successful
company in domestic markets is more likely to be able to attract financing for international
expansion.
The most important international sources of funds are the Eurocurrency market and the Eurobond
market. Also, MNCs often have access to national capital markets in which their subsidiaries are
located.
The Eurocurrency market is a largely short-term (usually less than one year of maturity) market for
bank deposits and loans denominated


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in any currency except the currency of the country where the market is located. For example, in
London, the Eurocurrency market is a market for bank deposits and loans denominated in dollars,
yen, francs, marks, and any other currency except British pounds. The main instruments used in this
market are CDs and time deposits, and bank loans.
Note: The term "market" in this context is not a physical marketplace, but a set of bank deposits and
loans.
The Eurobond market is a long-term market for bonds denominated in any currency except the
currency of the country where the market is located. Eurobonds may be of different types such as
straight, convertible, and with warrants. Although most Eurobonds are fixed rate, variable rate bonds
also exist. Maturities vary, but 10 12 years is typical.
Although Eurobonds are issued in many currencies, you wish to select a stable, fully convertible, and
actively traded currency. In some cases, if a Eurobond is denominated in a weak currency, the holder
has the option of requesting payment in another currency.
Sometimes, large MNCs establish wholly owned offshore finance subsidiaries. These subsidiaries
issue Eurobond debt, and the proceeds are given to the parent or to overseas operating subsidiaries.
Debt service goes back to bondholders through the finance subsidiaries.
If the Eurobond was issued by the parent directly, the United States would require a withholding tax
on interest. There may also be an estate tax when the bondholder dies. These tax problems do not
arise when a bond is issued by a finance subsidiary incorporated in a tax haven. Hence, the
subsidiary may borrow at less cost than the parent.
In summary, the Euromarkets offers borrowers and investors in one country the opportunity to deal
with borrowers and investors from many other countries, buying and selling bank deposits, bonds,
and loans denominated in many currencies.
Chapter Perspective
Financial managers of MNCs require an understanding of the complexities of international finance to
make sound financial and investment decisions. Multinational finance involves consideration of
managing working capital, financing the business, assessing control of foreign exchange and political
risks, and evaluating foreign direct investments. Especially, the financial manager has to understand
how changes in foreign exchange rates affect not only receivables and payables but also imports and
exports of the MNC in its multinational operations.


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Appendix A
Online Internet Resources
Government Statistical Data on the Internet
http://www.bls.gov
Department of Labor-Bureau of
Labor Statistics
Government statistics in general http://www.fedstats.gov
Financial and Investment Information
EDGAR SEC
database http://www.sec.gov
Morningstar, Inc. http://www.morningstar.net
http://www.bridge.com/front
Bridge Information
Systems
http://www.aaii.com
American
Association for
Individual
Investors
http://www.amex.com
Amex: American
Stock Exchange
Money Radio http://www.roadtosuccess.com
Bloomberg Online http://www.bloomberg.com/welcome.html
Microsoft Investor http://investor.msn.com
http://www.investors.com
Investor's Business
Daily
Wall Street Journal http://www.wsj.com
The Motley Fool http://www.motleyfool.com
Barron's Magazine http://www.barrons.com
http://www.zacks.com
Zacks Investment
Research
Bank Rate Monitor http://www.bankrate.com/brm/default.asp
Mutual Funds
Interactive http://www.fundsinteractive.com
CBS MarketWatch http://cbs.marketwatch.com
S&P Personal
Wealth http://www.personalwealth.com

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Appendix B
Excel Financial and Investment Functions
ACCRINT
Returns the accrued interest for a security that pays periodic interest
ACCRINTM
Returns the accrued interest for a security that pays interest at maturity
AMORDEGRC
Returns the depreciation for each accounting period
AMORLINC
Returns the depreciation for each accounting period
COUPDAYBS
Returns the number of days from the beginning of the coupon period to the settlement date
COUPDAYS
Returns the number of days in the coupon period that contains the settlement date
COUPDAYSNC
Returns the number of days from the settlement date to the next coupon date
COUPNCD
Returns the next coupon date after the settlement date
COUPNUM
Returns the number of coupons payable between the settlement date and maturity date
COUPPCD
Returns the previous coupon date before the settlement date
CUMIPMT
Returns the cumulative interest paid between two periods
CUMPRINC
Returns the cumulative principal paid on a loan between two periods
DB
Returns the depreciation of an asset for a specified period using the fixed-declining-balance method
DDB
Returns the depreciation of an asset for a specified period using the double-declining-balance
method or some other method you specify
DISC
Returns the discount rate for a security
DOLLARDE
Converts a dollar price, expressed as a fraction, into a dollar price, expressed as a decimal number


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DOLLARFR
Converts a dollar price, expressed as a decimal number, into a dollar price, expressed as a fraction
DURATION
Returns the annual duration of a security with periodic interest payments
EFFECT
Returns the effective annual interest rate
FV
Returns the future value of an investment
FVSCHEDULE
Returns the future value of an initial principal after applying a series of compound interest rates
INTRATE
Returns the interest rate for a fully invested security
IPMT
Returns the interest payment for an investment for a given period
IRR
Returns the internal rate of return for a series of cash flows
MDURATION
Returns the Macauley modified duration for a security with an assumed par value of $100
MIRR
Returns the internal rate of return where positive and negative cash flows are financed at different
rates
NOMINAL
Returns the annual nominal interest rate
NPER
Returns the number of periods for an investment
NPV
Returns the net present value of an investment based on a series of periodic cash flows and a
discount rate
ODDFPRICE
Returns the price per $100 face value of a security with an odd first period
ODDFYIELD
Returns the yield of a security with an odd first period
ODDLPRICE
Returns the price per $100 face value of a security with an odd last period
ODDLYIELD
Returns the yield of a security with an odd last period
PMT
Returns the periodic payment for an annuity
PPMT
Returns the payment on the principal for an investment for a given period
PRICE
Returns the price per $100 face value of a security that pays periodic interest
PRICEDISC
Returns the price per $100 face value of a discounted security
PRICEMAT
Returns the price per $100 face value of a security that pays interest at maturity
PV
Returns the present value of an investment


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RATE
Returns the interest rate per period of an annuity
RECEIVED
Returns the amount received at maturity for a fully invested security
SLN
Returns the straight-line depreciation of an asset for one period
SYD
Returns the sum-of-years' digits depreciation of an asset for a specified period
TBILLEQ
Returns the bond-equivalent yield for a Treasury bill
TBILLPRICE
Returns the price per $100 face value for a Treasury bill
TBILLYIELD
Returns the yield for a Treasury bill
VDB
Returns the depreciation of an asset for a specified or partial period using a declining balance
method
XIRR
Returns the internal rate of return for a schedule of cash flows that is not necessarily periodic
XNPV
Returns the net present value for a schedule of cash flows that is not necessarily periodic
YIELD
Returns the yield on a security that pays periodic interest
YIELDDISC
Returns the annual yield for a discounted security (e.g., a Treasury bill)
YIELDMAT
Returns the annual yield of a security that pays interest at maturity


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Index
A
ABC inventory control method, 214-215, 217
Ability to finance externally, 288
Accounting:
exposure, 331
rates of return, 156
Accounts:
payable, 23, 192, 220-221, 333
receivable, 48, 198-208, 333
Acquisitions, appraisals, 7
Advice, 280
American Stock Exchange, 13
Amortized loans, 105-107
Analysis:
of corporate cash flows, 181-182
horizontal, 42
Annual:
percentage rates, calculating, 106-107
report, 34-38
Annuity, 100-103
Appraisals, 7
Appreciation, 115
Arbitrage pricing model, 143-144
Arithmetic return, 117
Assets, 23
protection, 8
utilization ratios, 48-50
Authorized shares, 266
Average age of inventory, 49
Average collection period, 48
B
Balance sheet, 20-21, 23-27, 77-78, 236
Bank loans, 221-224, 238


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Bankers, 227
Banking, 8
investment, 279-282
relationships, 196-197
Bankruptcy, 311-326
administrative costs, 320
claim priority, 320-321
legal considerations, 320
reorganization, 317-320
signs, 311-314
Beta, 123-125
Billing, 199
Black-Scholes option pricing model, 305-308
Blue sky laws, 274-275
Bonds, 108, 127-137, 252-257, 259-260, 272
Book value:
per share, 57
weight, 144-145
Break even analysis, 174-175
Broad syndication, 267
Budget, 65-79
Budgeted:
balance sheet, 77-78
income statement, 76-77
Budgeting, 61-83
Business:
organization, forms, 14-16
risk, 122
C
C corporation, 15
Call option, premium, 304
Callable, 264
Capital:
asset pricing model, 123, 142-143
budgeting decisions, 153-171
cost of, 139-151, 336
gains, 115
lease, 243
markets, 13-14
rationing, 159
stock, 25


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structure, 7, 176, 184

working, management, 185-217
Carrying costs, 210-213
Cash:
break even point, 175
budget, 75-76
collections, monthly, 68-69
flows, 20, 26, 28-34, 181-182, 336
management, 8, 186-187, 195-197
repositioning, 333
Chattel mortgage, 242
Check clearing, 193
Classified income statements, 22-24
Collateral trust bonds, 254
Collection management, 8
Commercial paper, 227-230, 239
Commissions, 320
Common stock, 133-137, 266-272
stockholders, 321
Common-size statements, 42-43
Company growth rate, 287
Comparative coverage ratios, 182-184
Composition, 316-317
Compounded amount, 109-110
Compounding, 97-100
Compromise policy, 286
Computer assisted budgeting, 79-80
Confirmed letter of credit, 223
Controller, 9-10, 12
Conversion, 296-298
Convertibles, 293, 296-310
Corporate:
cash flows, analysis, 181-182
financing strategy, 302
structure, 16
Corporation, 15-16
Cost:
accounting, 8
of capital, 101, 147-151, 336
of goods sold, 22
Coupon rate, 128
Coverage ratios, 182-184


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Credit:
letters of, 223-224
lines of, 222-223, 238
policies, 198-200
revolving, 224
trade, 220-221
Creditors, 41
Cross rate, 329-330
Currency risk, 330-334, 336
Current:
assets, 23
income, 115
liabilities, 25
yield, 130
Customer:
deposit claims, 320
evaluation process, 200
D
Dates, 128, 284
Debentures, 254
Debit refinancing, 257-259
Debt, 50-51, 140
Declaration date, 284
Default risk, 122
Deferred charges, 25
Deposits, accumulating, 104
Depreciation, 115, 164-169
Derivatives, 303
Detachable warrant, 293
Direct:
labor budget, 71
material budget, 70
quote, exchange rate, 328
Disbursements, 75
Discount rate, 101, 336
Dissolution, 321-326
Distributing, 280
Diversification, 120
Divestment, 7
Dividend, 132
dates, 284
floating rate, 265


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policy, 7, 283-291
ratios, 58-59
stock, 264-266
versus split, 289
Double declining balance method of depreciation, 166-167
Drafts, 192-193
Dribble-out, 267
Du Pont formula, 86-89
E
Earnings:
before interest and taxes, 176-181
earnings per share analysis, 178-181
per share, 7, 55-56, 176, 178-181
retained, 21, 144
stability, 287
EBIT-EPS analysis, 178-181
Economic:
exposure, 331
order quantity, 211-213
Employee payment delay, 193
Ending inventory budget, 73
Equipment, 23, 242-243
Equity:
capital, cost of, 141
multiplier, 93
return, 54-55
securities, issuing, 263-274
Eurobonds, 255
Eurocurrency market, 336-337
Ex rights, 271
Exchange of obligations, 320
Exchange rates, 328-329
Ex-dividend date, 284
Exercise price, 293, 304, 306
Expected rate of return, 118-119
Expenses, 21-22
Extension, 316
F
Factoring, 239
Factory overhead budget, 72-73
Failure, 311-326


Page 350
Federal Reserve Bank, 12-13

Financial:
activity organization, 11
analysis and planning, 7
forecasting, 61-83
institutions, 10-11
leverage, 50, 176-177
markets, 12-13
operating environment, 10-14
ratios, 43, 78-79
statements, 19-39
analyzing, 41-60, 302
annual report, 34-38
Financing:
activities, 26, 28
assets, 237
international sources, 336-337
method, selecting, 275-279
short-term, 219-240
using inventories, 235-237
using receivables, 230-234, 239
Firm, control of, 133
Float, 187-188
Floating:
lien, 235, 240
rate dividends, 265
Forecasting, 61-83
Foreign:
exchange, 328, 331-334, 336
investment, analysis of, 336
Forward exchange contracts, 332
Funds:
general flow, 13
positioning, 333
providing, 280
Future:
sum, 104
value, 97-98, 100-101, 104-110
Futures, 308-309, 332
G
Geometric return, 117
Goods sold, costs of, 22


Page 351
Gordon's Growth Model, 141-142

Governmental regulation, securities, 274-275
Gross profit margin, 51
Growth:
rates, calculating, 107
stocks, 134
Guaranteed bonds, 255
H
Hedging, 186, 331-332
Historical weights, 144
Holding period, 116, 134-135
Horizontal analysis, 42
I
Income:
bonds, 254-255
statement, 20-24
budgeted, 76-77
projected, 81-83
Indenture, 252
Indirect quote, exchange rate, 328
Industry comparison, 43
Inflation, 335-336
Insurance, 8, 200, 242
Intangible assets, 23-24
Integration, 317
Interest, 224-227
bond, 253
compounding, 97-98
coverage ratio, 51
nominal, 253
rates, 334-335
parity theorem, 334
risk, 122-123
Intermediate term financing, 219, 237-250
Internal rate of return, 148, 157-158
International finance, 327-337
In-the-money, 304
Intra year compounding, 99-100
Inventory:
control:
ABC method, 214-215, 217
just-in-time, 215-216


Page 352
management, 208-216
ratios, 48-49
turnover, 49
Investing activities, 26
Investment:
accounts receivable, 201-208
banking, 279-282
decisions, 7, 162-164
long term, 23
mutually exclusive, 161-162
opportunity schedule, 148
portfolio management, 8
projects, 153-154
return on, 54
worth, measuring, 154-155
Investors, 8, 42, 288
Involuntary reorganization, 317
Issued shares, 266-267
J
Just-in-time inventory system, 215-216
K
Kanban system, 215
L
Lease purchase decision, 245-249
Leasing, 243-245
Letters of credit, 223-224
Leverage, 50, 59, 94
and capital structure, 174-184
degree of, 288
ratios, 50-51
Leveraged lease, 243-244
Liabilities, 23, 25-26
Limited:
distribution, 267
liability company, 16
life preferred stock, 265
partnership, 15
Linear programming, 160
Lines of credit, 222-223, 238
Liquidation, due to bankruptcy, 320-321
Liquidity, 20


Page 353
risk, 122, 186

Loans:
amortized, 105-107
bank, 221-224, 238
commercial finance, 227
intermediate term bank, 237-242
secured, 222
unsecured, 222
Lockbox, 187-188
Long term:
debt financing, 251-261
equity financing, 263-282
investments, 23
liabilities, 25
M
Mail:
delay, 193
float, 187
Maintenance of control, 287
Management, 42
information systems, 8
performance, 85-95
Marginal weights, 147
Margin-turnover relationship, 88
Market:
risk, 122
value ratios, 55-59
Markets, 10-12
Maturity:
date, 128
time to, 306
yield to, 130-131
Miller-Orr model, 195-196
Modified Accelerated Cost Recovery System, 167-171
Money:
markets, 12
hedge, 331
time value, 4, 97-114
Monthly cash collections, 68-69
Mortgages, 251-252, 254
Multinational corporations, 327-337


Page 354
Multiple:
currency problem, 327
holding period, 134-135
N
Net income, 21
Net present value, 156-157
New York Stock Exchange, 13
Nominal interest, 253
Nondetachable warrant, 293
Nonoperating expenses, 22-23
Normal distribution table, 310
O
Obligations, exchange of, 320
Operating:
activities, 28
cycle, 49
environment, 10-14
expenses, 22
exposure, 331
lease, 243
leverage, 176
Options, 303-304
Ordering costs, 210-213
Out-of-the money, 304
Outstanding shares, 267
Over-the-counter, 13
P
Paid in capital, 26
Par value, 25, 128, 267
Partnership, 15
Payables:
balance with receivables, 333
centralize, 192
Payback period, 154-155
Payment date, 284
Percent-of-sales method of forecasting, 61-62
Performance management, 85-95
Perpetual preferred stock, 265
Perpetuities, 103
Political risk, 336
Pre-authorized debits, 187, 189
Preemptive rights, 134, 271


Page 355
Preferred stock, 132-133, 263-266

Premium, 304
Present value, 101-108, 111-114
Price:
-book value ratio, 57-58
conversion, 296-297
-earnings ratio, 56-57
exercise, 293, 304, 306
stock, 306
striking, 304
volatility, 306
Primary market, 14
Processing float, 187
Production budget, 67-68
Profit:
improvement, 89-90
margin, 54
maximization, 1-3
Profitability, 287
index, 159
ratios, 51, 54-55
Project mix, selecting, 159-160
Projected income statement, 81-83
Property, 23
Proprietorship, sole, 14
Purchasing power, 123, 335
Q
Quantity discount, 209-210
Quarterly report, reading, 38-39
R
Rate of return:
accounting, 156
effective, bonds, 130-132
internal, 158
Ratio:
accounts receivable, 48
analysis, limitations, 60
utilization, 48-50
calculations, 78-79
conversion, 296-297
debt, 50
-equity, 50
service, 50-51


Page 356
dividend, 58-59
financial, 43
interest coverage, 51
inventory, 48-49
leverage, 50-51
market value, 55-59
price/book value, 57-58
price/earnings, 56-57
profitability, 51, 54-55
solvency, 50-51
Recapitalization, 318-319
Receipts, 75
Receivables:
balance with payables, 333
monitoring, 199-200
Record, date of, 284
Reorder point, 213-214
Reorganization, 311-326
Replacement decisions, 154
Repositioning cash, 333
Residual-dividend policy, 286
Restrictive covenants, 287
Retained earnings, 21, 26, 144
Return, 115-125
arithmetic, 117
envelopes, 189
on equity, 54-55, 85, 92-93
geometric, 117
on investment, 54, 85-95
measuring, 116-117
rate of, 117-119
on total assets, 54
vs. risk, 119-120
Revenue, 20-23
Revolving credit, 224
Rights on, 271
Rights, preemptive, 134
Risk:
analysis, 4
currency, 330-334, 336
-free rate, 306
liquidity, 186


Page 357
measuring, 120-122
political, 336
return trade off, 4, 119-120
sovereignty, 336
types, 122-123
understanding, 115-125
S
Salaries, 320
Sales forecasting, 7, 65-67
Secured:
claims, 320
loans, 222
Securities:
distribution channels, 281
Exchange Commission, 9
governmental regulation, 274-275
private issue, 281-282
public issue, 281-282
Selection decisions, 153-154
Serial bonds, 255
Service lease, 243
Short term financing, 219-240
Single holding period, 134
Sinking fund, 104, 261
Solvency, 20
ratios, 50-51
Sovereignty risk, 336
Spreadsheet programs, 79-80, 108, 158-159
Statement of cash flows, 20
Stock:
common, 133-134, 266-271
dividends, 264-266, 288-289
growth, 134
options, 271, 273-274
preferred, 132-133, 263-266
price, 306
repurchases, 290-291
rights, 271, 273-274
splits, 289
value, 3, 127-137
Stockholders, 1-3, 25-26, 133-134
Straight-line method of depreciation, 164-165
Striking price, 304


Page 358
Structure, corporate, 16
Subchapter S corporation, 15-16
Subordinated debentures, 254
Subscription price, 272
Sum-of-the-years' -digits method of depreciation, 165-166
Syndicate, 280
Systematic risk, 123
T
Tangible assets, 23
Target weights, 147
Taxes:
administration, 8
bankruptcy, 320
effect on investment decisions, 162-164
penalties, 288
of investors, 288
Technical insolvency, 315
Term:
holding period return, 116
loans, 237-242
Time:
to maturity, 306
value of money, 4, 97-114
Times interest earned, 51, 182
Total:
asset turnover, 49
leverage, 177-178
stockholders' equity, 26
Trade credit, 220-221
Transaction exposure, 331
Transfer pricing, 333
Translation exposure, 331
Treasurer, 9-10, 12
Treasury stock, 267
Trust receipt, 235, 240
U
Uncertainty, 288
Underwriting, 280
Unsecured loans, 222


< previous page page_359
Page 359
V
Valuation, 318
securities, 127-137
Value:
conversion, 297-298
par, 25, 128
of a right, 273-274
Values, future, calculating, 97-98
Valuing:
convertibles, 299-301
warrants, 294-295
Variable rate bonds, 255
Voluntary:
reorganization, 317
settlement, 316-317
W
Warehouse receipt, 235, 240
Warrants, 293-310
Weights, 144-145
Wire transfers, 189
Working capital management, 185-217
Y
Yield, 128
calculating, 130-132
current, 130
to maturity, 130-131
Z
Zero:
balance accounts, 192
coupon bonds, 255
-one programming, 160

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What is the purpose and scope of the book?

What is the purpose and scope of the book?

Who is the intended audience of the book?

Who is the intended audience of the book?

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title: Financial ManagementBarron's Business Library

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Goals of Corporate Finance

Profit Maximization vs. Stockholder Wealth Maximization

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Financial Decisions and Risk-Return Trade-Off

Time Value of Money

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Scope and Role of Finance

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(table continued on next page)

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(table continued from previous page)

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Controller Versus Treasurer

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Relationship between Accounting and Finance

Financial and Operating Environment

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Basic Forms of Business Organization

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What and Why of Financial Statements

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More on the Income Statement

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Classified Income Statements

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More on the Balance Sheet

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as patents, copyrights, and trademarks, or by another company, such as a franchise license. An

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Statement of Cash Flows

Contents of the Statement of Cash Flows

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Cash Flow Analysis

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FORMAT OF THE STATEMENT OF