P ART I
The Foundation
Financial Management and the Financial Manager
As Figure 1.2 shows, the company's long-term investment decisions concern the left side of the balance sheet and result in fixed assets. The company's long-term financing decisions concern the right side of the balance sheet.
Corporate Form of Business Organization
As a firm grows in size, the advantages of the corporate form generally outweigh its disadvantages. In theory, managers should direct the affairs of the corporation in the best interest of its shareholders.
The Goal of Financial Management
The financial goal of the company is thus to maximize shareholder wealth as reflected in the stock's market price. The market price of the company's shares is a measure of the financial well-being of the owners.
Accounting Profit versus Economic Profit
Increasing shareholder wealth also assumes that managers do not engage in actions to mislead financial markets in order to increase the company's stock price. 3 Is accounting profit or economic profit more important to achieving the financial goal of maximizing shareholder wealth.
The Agency Relationship
Investors, especially institutions that hold a large number of shares, can intervene in corporate matters through their voting rights and by nominating and electing members to the board of directors to represent their interests.
Organization of the Book
The financial manager determines the appropriate risk-return trade-off to maximize the value of the firm's stock. 5 The main financial goal of the firm is to maximize the wealth of its shareholders.
Basics of Annual Reports and Financial Statements
But we may have left out one of the most important users of financial statements – the firm's management. Our aim in this chapter is to show how to interpret the content and to understand the limitations of the following financial statements – balance sheet, income statement, statement of cash flows and statement of retained earnings.
Balance Sheet
The total value of shareholders' equity reported on a firm's balance sheet can also differ significantly from the actual market value of the firm's equity. Analysts must also recognize that stockholders' equity on a firm's balance sheet does not represent current market value.
Income Statement
Analysts and investors pay close attention to earnings per share. share that is reported on a company's income statement. Home Depot reports an income tax expense of $2,208 million on its fiscal year 2002 income statement.
Statement of Cash Flows
The resulting cash flow provided to the operations of Home Depot is $4,802 million for fiscal year 2002. Thus, the net income figure of $3,664 million understates the actual cash flow from company operations.
Statement of Retained Earnings
Common-size Statements
We can construct a vertical common size income statement by dividing all components of the income statement by net sales. The full-size vertical income statement reveals these underlying trends more clearly than the (unscaled) income statement.
Notes to Financial Statements
However, such an affirmative statement should not lull stakeholders into a false sense of security, as perhaps millions of Enron Corporation shareholders, lenders, suppliers, customers and employees discovered in the late summer of 2001.
Quality of Earnings
Analysts typically look for information to assess the quality of a firm's earnings in the Notes to Financial Statements. 2 What are some of the common methods used by managers that can increase actual reported earnings and thereby decrease the quality of a firm's earnings.
Other Issues
Differences in international accounting standards can significantly complicate the analysis and comparison of companies from different countries. The continued integration of the world's capital markets has provided significant impetus for the adoption of a set of uniform international accounting standards.
Financial Ratio Analysis
1 What are the different motivations that lenders, investors and managers have when interpreting financial reports. A financial analyst must consider important indicators of financial ratios in an attempt to discover the truth about a firm's financial condition.
Liquidity Ratios
The current ratio is calculated by dividing the company's current assets by its current liabilities. The quick ratio is similar to the current ratio except that inventory is excluded from the current assets in the numerator.1.
Debt Management Ratios
The debt ratio, debt-to-equity ratio, equity multiplier and long-term debt ratio for Home Depot for the fiscal year ended February 2, 2003 are as follows. The interest coverage and cash flow coverage ratios for Home Depot for fiscal year 2002 are shown below.
Asset Management Ratios
The accounts turnover ratio is calculated by dividing the cost of goods sold by the average accounts payable for the firm. The accounts payable payment period can be calculated by dividing 365 by the accounts payable turnover ratio.
Profitability Ratios
The return on assets (ROA) ratio measures the net income generated by each dollar invested in total assets, and is usually calculated as: Since Home Depot has no preferred stock, return on total equity and return on common equity are the same.
Market Value Ratios
A company's market-to-book ratio is calculated by dividing the market value of the company's equity by the book value of its equity. Dividend yield is calculated by dividing a company's dividends per share by the market price of its common stock.
Uses of Financial Ratios
3 Many investment analysts define growth stocks as those belonging to companies with high P/E and market-to-book value ratios. 4 Many investment analysts define value stocks as those belonging to companies with low P/E and market capitalization ratios and high dividend payouts.
Limitations of Financial Ratio Analysis
Thus, the value of money depends on the time it is paid or received. In both cases, financial managers need to understand how the value of the cash flows changes at different points in time.
Central Concepts in Finance
1 What is the meaning of the terms risk-return trade-off and time value of money.
Future Value of a Present Amount
It is sometimes helpful to write the future value equation (Equation 4.1) with subscripts on the FV and PV terms. If the amounts of the present value are equal and periodic, they form a so-called annuity and the calculation of the future value is simplified.
Present Value of a Future Amount
At an interest rate of 8 percent, what is the present value of these future value payment amounts. A net present value subtracts the cash flow in year 0 from the present value of future cash flows.
Future Value of an Annuity
Two rules or conventions must be observed when solving for the future value of an annuity. When using the future value of an annuity formula, the future value is obtained at the time of the last annuity payment.
Present Value of an Annuity
We can also work out the present value of an ordinary pension using the BA II PLUS® calculator. We can also work out the present value of a given annuity using the BA II PLUS® calculator.
Present Value of a Perpetuity
Compounding Frequencies
What will the future value be 5 years from today if the interest rate is increased semi-annually quarterly and monthly. What steps are involved in calculating the future value of a current amount when interest is continuously compounded.
Nominal and Effective Interest Rates
Since most bonds pay interest semi-annually, the effective annual return on a bond will exceed the quoted nominal return. 2 Will the difference between the effective annual interest rate and the nominal interest rate increase or decrease as the compounding rate (m) increases.
Solving for an Unknown Interest Rate
What is the annual interest rate that the supplier's financing of the equipment purchase entails. Using a financial calculator, we find the implicit interest rate on the loan to be 9.19 per cent.
Other Time Value Applications
Basic time value of money principles can be used to determine the periodic lease payment over the lease term. We focus on discounted cash flow models to estimate the value of bonds, preferred stocks, and common stocks.
Valuation Fundamentals
3 Calculate the present value of the estimated cash flows using the required rate of return as the discount rate. The required rate of return, also known as the discount rate, reflects the riskiness of the estimated cash flows.
Bond Characteristics and Features
At maturity, the bondholder receives the final coupon interest payment and the face value of the bond from the issuer. A call premium is an additional amount that the issuer is willing to pay above the face value of the bond to repurchase the bond.
Bond Valuation
This means that the intrinsic value of a bond with a semi-annual payment would be less than the value of an equivalent bond with an annual payment. If investors demand a 9% rate of return, what is the value of this zero-coupon bond.
Bond Pricing Relationships
Another property of bond pricing is that if the required rate of return increases, the bond price decreases. Another feature of bond pricing is that if the required return falls, the bond price will rise.
Interest Rate Risk
To illustrate how the remaining term affects a bond's interest rate risk, let's look at two bonds: Bond S(hort) and Bond L(ong). To illustrate how the coupon rate affects a bond's interest rate risk, consider two semi-annual bonds.
Bond Yields
If the market prices the bond correctly, net asset value and market value (price) are the same, and the discount rate is the bond's YTM. 3 Investors will reinvest all coupons to maturity at a return equal to the bond's YTM.
Bond Trading and Price Reporting
The “Last Yield” column reports the yield to maturity for the bond, which is 8.816 percent for the Ford bond. 9 Small differences in yield to maturity may result because the term to maturity of the bond is not exactly 28 years.
Preferred Stock Features and Valuation
Suppose the current market price of Potomac Corporation's preferred stock is $85, what would be the expected rate of return. If an investor's required rate of return is 8 percent, the investor should consider buying the preferred stock.
Common Stock Characteristics and Features
Common shareholders are only entitled to cash dividends if the company's board of directors declares them. If the company distributes dividends, the common shareholders are entitled to the dividends only after the preferred shareholders receive their dividends.
Common Stock Valuation
If investors demand a 12 percent return, what is the intrinsic value of United Industries' common stock. 2 Find the present value of the terminal price at the end of the supernormal growth period (year 4).
P ART II
Working Capital
Management Decisions
Introduction to Working Capital Management
Thus, determining the firm's optimal investment in working capital involves a trade-off between liquidity and profitability. 2 What is the trade-off between profitability and liquidity and profitability and risk in working capital management.
Approaches to Working Capital Management
Under this approach, the firm finances long-term assets (fixed assets and permanent current assets) with long-term financing sources (long-term debt and equity). Thus, the firm uses short-term financing for only some of the temporary current assets.
Operating and Cash Conversion Cycles
A firm's cash conversion cycle is the length of time a firm has tied up cash in its business operations. Managers can reduce their firm's cash conversion cycle and free up cash for other activities by collecting receivables faster, reducing inventory processing time, or extending the time it takes to pay suppliers.
Cash Management
We examine two models available to determine the firm's optimal cash balances—the Baumol and the Miller-Orr cash management models. Net float represents cash available to the firm that is not reported in the firm's ledger.
Accounts Receivable Management
Using this method, the average age of receivables from the aging chart above would be 22.17 days. Another way to monitor receivables is to calculate the loss ratio, which is the proportion of total receivables that are not paid.
