Financial Management: Principles And Applications

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Low

PE~RSON

PRICE

EDITION

~

Education

BR tE,F~e.O,N TEN TS Preface xvii P.ART 1: THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT CHAPTER 1 An Introduction to Financial Management 3 CH~PTER 2 Und,brstanding Financial Statements, Taxes, and Cash Flows 31 I

--

CHAPTER 3 Evaluating a Firm's Financial Performance 71 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107 PART 2: VALUATION OF FINANCIAL ASSETS CHAPTER 5 The Value of Money 137 CHAPTER 6 Risk and Rates of Return 181 CHAPTER 7 Valuation and Characteristics of Bonds 22 3 CHAPTER 8 Stock Valuation 255

PART 3: INVESTMENT IN LONG-TERM ASSETS CHAPTER 9 Capital Budgeting Decision Criteria 289 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 CHAPTER 11 Capital Budgeting and Risk Analysis 371 CHAPTER 12 Cost of Capital 405 CHAPTER 13 Managing for Shareholder Value 435 vii

viii

BRIEF CONTENTS

, PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER

14

Raising Capital in the Financial Markets 469 CHAPTER

15

Analysis and Impact of Leverage 505 CHAPTER

16

Planning the Firm's Financing Mix 551 CHAPTER

17

Dividend Policy and Internal Financing 605 PART 5: WORKING-CAPITAL MANAGEMENT AND SPECIAL TOPICS IN FINANCE CHAPTER

18

Working-Capital Management and Short-Term Financing 645 CHAPTER

19

Cash and Marketable Securities Management 673 CHAPTER

20

Accounts Receivable and Inventory Management 705 PART 6: SPECIAL TOPICS IN FINANCE CHAPTER

21

Risk Management 739 CHAPTER

22

International Business Finance 773 CHAPTER

23

Corporate Restructuring: Combinations and Divestitures* 23-1 CHAPTER

24

Term Loans and Leases* 24-1 Appendixes A-I Glossary G-l Indexes I-I

*Chapters 23 and 24 can be found at www.prenhall.comlkeown

CONTENT:S Preface

.PART

XVii

1: THE SCOPE AND ENVIRONMENT

-

OFFINANCIAL MANAGEMENT

-

CHAPTER

--

- --

1

An Introduction to Financial Management 3

What Is Finance? 4

Goal of the Firm 4

Legal Forms of Business Organization 7

Ten Principles That Form the Basics of Financial Management 12

PRINCIPLE 1: The Risk-Return Trade-Off-We won't take on additional risk unless

we expect to be compensated with additional return 13

PRINCIPLE 2: The Time Value of Money-A dollar received today is worth more

than a dollar received in the future 14

PRINCIPLE 3: Cash-Not Profits-Is King 14

PRINCIPLE 4: Incremental Cash Flows-It's only what changes that counts 15

PRINCIPLE 5: The Curse of Competitive Markets-Why it's hard to find

exceptionally profitable projects 15

PRINCIPLE 6: Efficient Capital Markets-The markets are quick and the prices are

right 16

PRINCIPLE 7: The Agency Problems-Managers won't work for owners unless it's

in their best interest 17

PRiNCIPLE 8: Taxes Bias Business Decisions 18

PRINCIPLE 9: All Risk Is Not Equal-Some risk can be diversified away, and some

cannot 18

PRINCIPLE 10: Ethical behavior is doing the right thing, and ethical dilemmas are

everywhere in finance 20

Overview of the Text 22

Finance and the Multinational Firm: The New Role 24

How Financial Managers Use This Material 25

Summary 25

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--/ CHAPTER

2

Understanding Financial Statements, Taxes, and Cash Flows 31

The Income Statement: Measuring a Company's Profits 32

The Balance Sheet: Measuring a Firm's Book Value 34

Computing a Company's Taxes 41

Measuring Free Cash Flows 44

Financial Statements and International Finance 49


Summary 50

Appendix 2A: Measuring Cash Flows: An Accounting Perspective 66

ix

x

CONTENTS

JCHAPTER 3

Evaluating a Firm's Financial Performance

71

Financial Ratio Analysis 72

The DuPont Analysis: An Integrative Approach to Ratio Analysis 85


Summary 89

CHAPTER 4

Financial Forecasting, Planning, and Budgeting

107

Financial Forecasting 108

Limitations of the Percent of Sales Forecast Method 113

The Sustainable Rate of Growth 115

Financial Planning and Budgeting 117


Summary 120

PART 2: VALUATION OF FINANCIAL ASSETS

.,j CHAPTER 5

The Time Value of Money

137

Compound Interest and Future Value 138

Compound Interest with Nonannual Periods 146

Present Value 147 Annuities-A Level Stream 150

Annuities Due 157

Present Value of Complex Stream 160

Perpetuities and Infinite Annuities 163

Making Interest Rates Comparable 163

The Multinational Firm: The Time Value of Money 164


Summary 165

\,/ CHAPTER 6

Risk and Rates of Return

181

Rates of Return in the Financial Markets 182

The Effects of Inflation on Rates of Return and the Fisher Effect 184

The Term Structure of Interest Rates 185

Expected Return 187

Risk 188

Risk and Diversification 192

Measuring Market Risk 196

Measuring a Portfolio's Beta 201

The Investor's Required Rate of Return 203


Summary 208

\

CONTENTS

j

CHAPTER 7

Valuation and Characteristics of Bonds

223

Types of Bonds 224

Terminology and Characteristics of Bonds 22 7

Definitions of Value 231

Determinants of Value 232

Valuation: The Basic Process 234

Bond Valuation 235

The Bondholder's Expected Rate of Return (Yield to Maturity) 238

Bond Valuation: Five Important Relationships 240


Summary 246

'/ CHAPTER 8

Stock Valuation

255

Features and Types of Preferred Stock 256

Valuing Preferred Stock 259

Characteristics of Common Stock 261

Valuing Common Stock 267

Stockholder's Expected Rate of Return 272


Summary 275

Appendix 8A: The Relationship between Value and Earnings 283

PAR T 3: I' N VE S T MEN TIN LON G - T E R MAS SET S CHAPTER 9

Capital-Budgeting Decision Criteria

289

Finding Profitable Projects 290

Payback Period 292

Net Present Value 295

Profitability Index (Benefit/Cost Ratio) 298

Internal Rate of Return 299

Ethics in Capital Budgeting 312

A Glance at Actual Capital-Budgeting Practices 313


Summary 315

CHAPTER 10

Cash Flows and Other Topics in Capital Budgeting

327

Guidelines for Capital Budgeting 328

An Overview of the Calculations of a Project's Free Cash Flows 332

Complications in Capital Budgeting: Capital Rationing and Mutually Exclusive

Projects 344

I ~

xi

xii

CONTENTS

The Multinational Firm: International Complications in Calculating Expected Free

Cash Flows 353


Summary 354

CHAPTER

11

Capital Budgeting and Risk Analysis

371

Risk and the Investment Decision 372

Methods for Incorporating Riskinto Capital Budgeting 376

Other Approaches to Evaluating Risk in Capital Budgeting 383

The Multinational Firm: Capital Budgeting and Risk 389


Summary 390

CHAPTER

12

Cost of Capital

405

The Cost of Capital: Key Definitions and Concepts 406

Determining Individual Costs of Capital 407

The Weighted Average Cost of Capital 414

Cost of Capital in Practice: Briggs & Stratton 417

Calculating Divisional Costs of Capital: PepsiCo, Inc. 419

Using a Firm's Cost of Capital to Evaluate New Capital Investments 420


Summary 424

CHAPTER

13

Managing for Shareholder Value

435

Who Are the Top Creators of Shareholder Value? 437

Business Valuation-The Key to Creating Shareholder Value 438

Value Drivers 443

Economic Value Added (EVA)® 445

Paying for Performance 448


Summary 457

PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER

14

Raising Capital in the Financial Markets

469

The Financial Manager, Internal and External Funds, and Flexibility 472

The Mix of Corporate Securities Sold in the Capital Market 474

Why Financial Markets Exist 475

Financing of Business: The Movement of Funds Through the Economy 478

Components of the U.S. Financial Market System 481

The Investment Banker 489

More on Private Placements: The Debt Side 493

CONTENTS

xiii

Flotation Costs 494

Regulation 495

The Multinational Firm: Efficient Financial Markets and Intercountry Risk 499


?ummary 501

CHAPTER 15

Analysis and Impact of Leverage

505

Business and Financial Risk 506

Break-Even Analysis 509

Operating Leverage 519

Financial Leverage 524

Combination of Operating and Financial Leverage 527

The Multinational Firm: Business Risk and Global Sales 531


Summary 533

CHAPTER 16

Planning the Firm's Financing Mix

551

Key Terms and Getting Started 552

A Glance at Capital Structure Theory 553

Basic Tools of Capital Structure Management 568

The Multinational Firm: Beware of Currency Risk 580


Summary 587

CHAPTER 17

Dividend Policy and Internal Financing

605

Dividend Payment Versus Profit Retention 607

Does Dividend Policy Affect Stock Price? 608

The Dividend Decision in Practice 621

Dividend Payment Procedures 625

Stock Dividends and Stock Splits 625

Stock Repurchases 628

The Multinational Firm: The Case of Low Dividend Payments-So Where Do We

Invest? 631


Summary 633

PART 5: WORKING-CAPITAL MANAGEMENT AND S P E C I A L TOP I C SIN FIN A N C.E

CHAPTER 18

Working-Capital Management and Short-Term Financing

645

Managing Current Assets and Liabilities 646

Financing Working Capital with Current Liabilities 647

j

xiv

CONTENTS

Appropriate Level of Working Capital 648

Hedging Principles 648

Cash Conversion Cycle 651

Estimation of the Cost of Short-Term Credit 653

Sources of Short-Term Credit 654

Multinational Working-Capital Management 661

How Finance Managers Use This Material 662

Summary 662

CHAPTER 19

Cash and Marketable Securities Management

673

What are Liquid Assets? 674

Why a Company Holds Cash 674

Cash-Management Objectives and Decisions 676

Collection and Disbursement Procedures 678

Composition of Marketable Securities Portfolio 684

The Multinational Firm: The Use of Cash and Marketable Securities 691


Summary 691

CHAPTER 20

Accounts Receivable and Inventory Management

705

Accounts Receivable Management 706

Inventory Management 716

TQM and Inventory-Purchasing Management: The New Supplier

Relationships 724


Summary 728

".

'./ CHAPTER 21

Risk Management

739

Futures 740

Options 746

Currency Swaps 757

The Multinational Firm and Risk Management 758


Summary 759

CHAPTER 22

International Business Finance

773

The Globalization of Product and Financial Markets 774

Exchange Rates 775

Interest-Rate Parity Theory 785

Purchasing-Power Parity 785

Exposure to Exchange Rate Risk 787

Multinational Working-Capital Management 791

CONTENTS

International Financing and Capital-Structure Decisions 793 Direct Foreign Investment 794 How Financial Managers Use This Material 796 Swnmary 796 .1'~ CHAPTER 23 Corporate Restructuring: Combinations and Divestitures

~

Why Mergers Might Create Wealth 23-3 Determination of a Firm's Value 23-6 Divestitures 23-14 How Financial Managers Use This Material 23-17 Summary 23-19

~ CHAPTER 24 - , Term Loans and Leases

24-1

Term Loans 24-3 Loan Payment Calculation 24-5 Leases 24-7 The Economics of Leasing Versus Purchasing 24-16 How Financial Managers Use This Material 24-20 Summary 24-20 Appendixes A-I Glossary G-l Indexes I-I

*Chapters 23 and 24 can be found at www.prenhall.comlkeown

23-1

xv

CHAPTER 1 AN I NTRO DUCTI 0 N TO FINANCIAL MANAGEMENT

CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS

CHAPTER 3 EVALUATI NG A FIRM'S FINANCIAL PERFORMANCE

CHAPTER 4 FI NAN CIAL FORECASTING, PLANNING, AND BUDGETING

CHAPTER 1

An Introd uction to Financial Management

In 1985, Harley-Davidson teetered only hours away from bank

a successful stock offering, and Spring 2003, Harley's stock

ruptcy as one of Harley's largest lenders, Citicorp Industrial

price rose approximately 125-fold. How did Harley-Davidson, a

Credit, was considering bailing out on its loan. Since its begin

company whose name grown men and women have tattooed

ning in 1903, the company survived two world wars, the Great

on their arms and elsewhere, a company that conjures up

Depression, and competition from countless competitors, but

images of burly bad boys and Easy Rider hippies in black leather

by the early 1980s, Harley had become known for questionable

jackets riding down the road, pull off one of the biggest busi

reliability and leaving oil stains on people's driveways. It looked

ness turnarounds of all time? Harley made good decisions.

for a while like the future was set, and Harley wouldn't be

That's what we're going to look at in this book. We'll look at

there. It looked like the future of motorcycles in America would

what it takes to turn Harley or any other company around.

feature only Japanese names like Honda, Yamaha, Kawasaki,

We'll look at how a company goes about making decisions to

and Suzuki. But none of that happened, and today Harley

introduce new product lines. For example, in 2003, Harley

Davidson stands, as President Reagan once proclaimed, as "an

Davidson introduced the Buell Lightning Low XB95, a low-cost,

American success story." For a company in today's world, sur

lightweight bike with a lower seat height aimed at bringing

viving one scare is not enough-Today the business world involves a continuous series of challenges. As for Harley, it was

shorter riders into the sport. How did it make this decision?

a major accomplishment to make it through the 1980s, allow

ining how its experience fits in with the topics we are examin

We'll also follow Harley-Davidson throughout this book, exam

ing it to face another challenge in the 1990s: a market that

ing. In doing so, we will see that there are countless interac

looked like it might disappear within a few years. How did

tions among finance, marketing, management, and accounting.

Harley do against what looked like a shrinking market? It

Because finance deals with decision making, it takes on impor

increased its motorcycle shipments from just over 60,000 in

tance, regardless of your major. Moreover, the tools, techniques,

1990 to over 260,000 in 2002 with expected sales in 2003 of

and understanding you will gain from finance will not only help

around 290,000! How have the shareholders done? Between

you in your business career, but will also help you make edu

1986, when Harley-Davidson returned to public ownership with

cated personal investment decisionsin the future.

~

CHAPTER PREVIEW

In this chapter, we will lay a foundation for the entire book. We will explain what finance is, and then we will explain the key goal that guides financial deci sion making: maximization of shareholder wealth. We will examine the legal environment of financial

~

decisions. Then, we will describe the golden thread that ties everything together: the 10 basic principles of finance. Finally, we will look at the importance of looking beyond our geographic boundaries.

3

4

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

Objective ~

WHAT IS FINANCE? Financial management is concerned with the maintenance and creation of economic value or wealth. Consequently, this course focuses on decision making with an eye toward creating wealth. As such, we will deal with financial decisions such as when to introduce a new product, when to invest in new assets, when to replace existing assets, when to bor row from banks, when to issue stocks or bonds, when to extend credit to a customer, and how much cash to maintain. To illustrate, consider two firms, Merck and General Motors (GM). At the end of 2003, the total market value of Merck, a large pharmaceutical company, was $103 billion. Over the life of the business, Merck's investors had invested about $30 billion in the busi ness. In other words, management created $73 billion in additional wealth for the share holders. GM, on the other hand, was valued at $30 billion at the end of 2003; but over the years, GM's investors had actually invested $85 billion-a loss in value of $55 billion. Therefore, Merck created wealth for its shareholders, while GM lost shareholder wealth. In introducing decision-making techniques,we will emphasize the logic behind those techniques, thereby ensuring that we do not lose sight of the concepts when dealing with the calculations. To the first-time student of finance, this may sound a bit overwhelming. However, as we will see, the techniques and tools introduced in this text are all motivated by 10 underlying principles or axioms that will guide us through the decision-making process.

Objective ~

GOAL OF THE FIRM We believe that the preferable goal of the firm should be maximization of shareholder wealth, by which we mean maximization of the price of the existing common stock. Not only will this goal be in the best interest of the shareholders, but it will also provide the most benefits to society. This will come about as scarce resources are directed to their most productive use by businesses competing to create wealth. To better understand this goal, we will first discuss profit maximization as a possible goal for the firm. Then we will compare it to maximization of shareholder wealth to see why, in financial management, the latter is the more appropriate goal for the firm.

PROFIT MAXIMIZATION In microeconomics courses, profit maximization is frequently given as the goal of the firm. Profit maximization stresses the efficient use of capital resources, but it is not spe cific with respect to the time frame over which profits are to be measured. Do we maxi mize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating research and devel opment expenditures and cutting down on' routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base financial decisions ona goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the.real world. In microeconomics, profit maximization functions largely as a theoretical goal, with economists using it to prove how firms behave rationally to increase profit. Unfortunately, it ignores many real-world complexities that financial managers must address in their deci sions. In the more applied discipline of financial management, firms must deal every day with two major factors not considered by the goal of profit maximization: uncertainty and timing. Microeconomics courses ignore uncertainty and risk to present theory more easily. Projects and investment alternatives are compared by examining their expected values or

CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

weighted average profits. Whether one project is riskier than another does not enter into these calculations; economists do discuss risk, but only tangentially.! In reality, projects differ a great deal with respect to risk characteristics, and to disregard these differences in the practice of financial management can result in incorrect decisions. As we will discover later in this chapter, there is a very definite relationship between risk and expected return-that is, investors demand a higher expected return for taking on added risk-and to ignore this relationship would lead to improper decisions. Another problem with the goal of profit maximization is that it ignores the timing of the project's returns. If this goal is only concerned with this year's profits, we know it inappropriately ignores profit in future years. If we interpret it to maximize the average of future profits, it is also incorrect. Inasmuch as investment opportunities are available for money in hand, we are not indifferent to the timing of the returns. Given equivalent cash flows from profits, we want those cash flows sooner rather than later. Thus the real-world factors of uncertainty and timing force us to look beyond a simple goal of profit maxi mization as a decision criterion. Finally, and possibly most important, accounting profits fail to recognize one of the most important costs of doing business. When we calculate accounting profits, we con sider interest expense as a cost of borrowing money, but we ignore the cost of the funds provided by the firm's shareholders (owners). If a company could earn 8 percent on a new investment, that would surely increase the firm's profits. However, what if the firm's shareholders could earn 12 percent with that same money in another investment of simi lar risk? Should the company's managers accept the investment because it will increase the firm's profits? Not if they want to act in the best interest of the firm's owners (share holders). Now look at what happened with Burlington Northern. Burlington Northern is a perfect example of erroneous thinking. In 1980, Richard Bressler was appointed as Chief Executive Officer (CEO) of the company. Bressler, unlike his predecessor, was not a "railroad man." He was an "outsider" who was hired for the express purpose of improving the value of the shareholders' stock. The reason for the change was that Burlington Northern had been earning about 4 percent on the share holders' equity, when Certificates of Deposit (CDs) with no risk were paying 6 percent. Management was certainly increasing the firm's profits, but they were destroying share holder wealth by investing in railroad lines that were not even earning a rate of return equal to that paid on government securities. We will turn now to an examination of a more robust goal for the firm: maximization of shareholder wealth. -~

MAXIMIZATION OF SHAREHOLDER WEALTH In formulating the goal of maximization of shareholder wealth, we are doing nothing more than modifying the goal of profit maximization to deal with the complexities of the operating environment. We have chosen maximization of shareholder wealth-that is, maximization of the market value of the existing shareholders' common stock-because the effects of all financial decisions are thereby included. Investors react to poor invest ment or dividend decisions by causing the total value of the firm's stock to fall, ano they react to good decisions by pushing up the price of the stock. In effect, under this goal, good decisions are those that create wealth for the shareholder. Obviously, there are some serious practical problems in implementing this goal and in using changes in the firm's stock to evaluate financial decisions. We know the price of a firm's stock fluctuates, often for no apparent r('ason. However, over the long run, price equals value. We will keep this long-run balancing in mind and focus on the effect that

I:

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I See, for example, Robert S. Pindyck and Daniel Rubenfield, MiC7'OecQlwlIIics, 2d ed. (New York: MacmiUan, !992), 244--46.

5

6


FINANCE -

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..... ... "b~' ETHICS

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THE WALL STREET JOURNAL WORKPLACE-ETHICS QUIZ Without question, when you enter the workforce you will be faced with a number of ethical dilemmas that you have never considered. The spread of technology into the workplace has raised a variety of new ethical questions, and many old ones still linger. The following is a quiz dealing with ethical questions that will both give you some questions to think about, and also allow you to compare your answers with those of other Americans surveyed.

Office Technology 1. Is it wrong to use company e-mail for personal reasons? Yes No 2. Is it wrong to play computer games on office equipment during the workday? Yes No 3. Is it unethical to blame an error you made on a technological glitch? Yes No

Gifts and Entertainment 4. Is a $50 gift to a boss unacceptable? Yes No 5. Is a $50 gift from the boss unacceptable? Yes No 6. Of gifts from suppliers: Is it OK to take a $200 pair of football tickets? Yes No 7. Is it OK to take a $100 holiday food basket? Yes No

8. Can you accept a $75 prize won at a raffle at a supplier's conference? Yes No

Truth and Lies 9. Due to on-the-job pressure, have you ever abused or lied about sick days? Yes No 10. Due to on-the-job pressure, have you ever taken credit for someone else's work or idea? Yes No

Ethics-Quiz Answers 1. 34% said personal e-mail on company computers is 2. 3. 4. 5. 6. 7. 8. 9. 10.

wrong 49% said playing computer games at work is wrong 61 % said it's unethical to blame your error on technology 35% said a $50 gift to the boss is unacceptable 12% said a $50 gift from the boss is unacceptable 70% said its unacceptable to take the $200 football tickets 35% said it's unacceptable to take the $100 food basket 40% said it's unacceptable to take the $75 raffle prize 11 % reponed they lie about sick days 4% reported they take credit for the work or ideas of others

Sources: Ethics Officer Association, Belmont, Mass.; Ethical Leadership Group, Vlilmette, Ill.; surveys sampled a cross-section of workers at large companies and natiom\~de; Reprinted by permission of The U7a1J St/'eet J01l17101, Copyright © 1999 Dow Jones & Company, Inc. All Rights Reserved Worldwide. License number 880500341261.

CONCEPT CHECK 1.

According to Principle 1, how do investors decide where to invest their money?

2. 3.

Why is it so hard to find extremely profitable projects? Why is ethics relevant?

I

OVERVIEW OF THE TEXT In this text, we will focus on the maintenance and creation of wealth. Although this will involve attention to decision-making techniques, we will emphasize the logic behind those techniques to ensure that you do not lose sight of the concepts driving finance and the creation of wealth. The text begins by discussing the goal of maximization of shareholder wealth, a goal that is to be used in financial decision making, and presents the legal


~",

AN ENTREPRENEUR'S

P

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7- '

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THE ENTREPRENEUR AND FINANCE Do you ever think about wanting to someday own your own business? Does being an entrepreneur have any appeal to you? Well, it does for a lot of people. During the past decade, starting and growing companies have been the preferred avenue many have chosen for careers. In fact, while many of the large companies are reducing the number of employees, smaller companies are creating new jobs by the thousands. A lot of individuals have thought that there was greater security in working with a big company, only to be disillusioned in the end when they were informed that "Friday is your last day." Defining an entrepreneur is not an easy thing to do. But we can say with some clarity what entrep"meul"Ship is about. Entreprenew'ship has been defined as a relentless pursuit of opportunity for the purpose of creating value, without concern for the resources owned. . 10 be successful, the entrepreneurial process requires that the entrepreneur be able to: • Identify a good opportunity. Oftentimes we may have a "good idea," but it may not be a "good opportunity." Opportunities are market driven. There must be enough customers who want to buy our product or service at a price that covers our expenses and leaves an attractive profit-no matter how much we may like the idea. • Gain access to the resources needed. For any venture, there are critical resources-human, financial, and

r

physical-that must be available. The entrepreneur usually does not have the capital to own all the resources that are needed. So she must have access to resources, but usually cannot afford to own them. It's what we call bootstrapping. The goal is to do more with less. • Launch the venture. All the planning in the world is not enough. The entrepreneur must be action oriented. It requires a "can do" spirit. • Grow the business. A business has to grow if it is to be successful. Frequently, the firm will not break even for several years, which means that we will be burning up cash each month. Being able to survive during the time that cash flows are negative is no easy task. If we grow too slow, we lose, but also if we grow too fast, we may lose as well. During this time, additional capital will be needed, which requires that we know how to value the firm and how to structure financing. • Exit the business. If a venture has been successful, the entrepreneur will have created economic value that is locked up in the business. At some point in time, the entrepreneur will want to capture the value that has been created by the business. It will be time to harvest. To be successful as an entrepreneur requires an understanding of finance. At the appropriate places in Financial Management, we will be presenting how finance relates to the entrepreneurial journey. It is an interesting topic that we think you will enjoy.

and tax environment in which these decisions are to be made. Since this environment sets the ground rules, it is necessary to understand it before decision rules can be formulated. The 10 guiding principles that provide the underpinnings for what is to follow are then presented. Chapters 2 through 4 introduce the basic financial tools the financial manager uses to maintain control over the firm and its operations. These tools enable the financial manager to locate potential problem areas and plan for the future. Chapter 5 explores how the firm and its assets are valued. It begins with an examination of the mathematics of finance and the concept of the time value of money. An understanding of this topic allows us to compare benefits and costs that occur in different time periods. We move on in Chapter 6 to develop an understanding of the meaning and measurement of risk. Valuation of fixed income securities is examined in Chapter 7, and Chapter 8 looks at valuation models that attempt to explain how different financial decisions affect the firm's stock price. Using the valuation principles just developed, Chapter 9 discusses the capitalbudgeting decision, which involves the financial evaluation of investment proposals in fixed assets. We then examine the measurement of cash flows in Chapter 10, andintroduce methods to incorporate risk in the analysis in Chapter 11. In Chapter 12, we will examine the financing of a firm's chosen projects, looking at what costs are associated

23

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with alternative ways of raising new funds. Then, in Chapter 13, we look at managing the finn for shareholder value. Chapter 14 examines the financial markets and the act of raising funds. Chapter 15 examines the fum's capital structure along with the impact of leverage on returns to the enterprise. Once these relationships between leverage and valuation are developed, we move on to the process of planning the firm's financing mix in Chapter 16. This is followed in Chapter 17 with a discussion of the determination of the dividend-retained earnings decision. Chapters 18 through 20 deal with working-capital management, the management of current assets. We will discuss methods for determining the appropriate investment in cash, marketable securities, inventory, and accounts receivable, as well as the risks associated with these investments and the control of these risks. Chapter 21 presents discussion of the use of futures, options, and swaps by financial managers to reduce risk. The final chapter in the text, Chapter 22, deals with international financial management, focusing on how financial decisions are affected by the international environment. In addition, Chapter 23, an introduction to corporate restructuring including mergers, spinoffs, and leveraged buyouts, is provided on the Internet. Similarly, Chapter 24, Loans and Leases, is also provided on the Internet.

Objective ~

FINANCE AND THE MULTINATIONAL FIRM: THE NEW ROLE In the search for profits, U.S. corporations have been forced to look beyond our country's borders. This movement has been spurred on by the collapse of conununism and the acceptance of the free market system in Third World countries. All of this has taken place at a time when information technology has experienced a revolution brought on by the personal computer (PC). Concurrently, the United States went through an unprecedented period of deregulation of industries. These changes resulted in the opening of new international markets, and U.S. firms experienced a period of price competition here at home that made it imperative that businesses look across borders for investment opportunities. The end result is that many U.S. companies, including General Electric, IBM, Walt Disney, American Express, and General Motors, have restructured their operations in order to expand internationally. However, not only do U.S. firms have a freer access to international markets, but also foreign firms have an easier job of entering the U.S. markets and competing with U.S. firms on their own turf. The bottom line is that what you think of as a U.S. firm may be much more of a multinational firm than you would expect. For example, Coca-Cola earns over 80 percent of its profits from overseas sales. Moreover, Coca-Cola earns more money from its sales in Japan than it does from all its domestic sales, and this is not uncommon. In fact, Dow Chemical, Colgate-Palmolive, 3M, Compaq, Hewlett-Packard, and Gillette make over half their sales overseas and earn over half of their profits from international sales. In addition to U.S. firms venturing abroad, foreign firms have also made their mark in the United States. You need only look to the auto industry to see what changes the entrance of Toyota, Honda, Nissan, BMW, and other foreign car manufacturers have made in the auto industry. In addition, foreigners have bought and now own such companies as Brooks Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire & Rubber. Consequently, even if we wanted to, we couldn't keep all our"attention focused on the United States, and even more important, we wouldn't want to ignore the opportunities that are available across international borders.

CHAPTER

25

AN INTRODUCTION TO FINANCIAL MANAGEMENT

CONCEPT CHECK 1.

What has brought on the era of the multinational corporation?

2.

Has looking beyond U.s. borders been a profitable experience for U.s. corporations?

HOW FINANCIAL MANAGERS USE THIS MATERIAL As the chapter title states, this chapter provides you with an introduction to financial management. The principles presented in this chapter provide you with some clues as to the types of questions that will be dealt with by financial managers. As you will find out over the course of your studies, financial questions abound. In the Spring of 2003, headlines in The Willi Street Journal were full of financial decisions, including the giant drug makers Pfizer and Pharmacia winning final approval for their merger, Disney nearing a deal to sell its Anaheim Angels baseball team for $160 to $180 million, and AOL Time Warner Inc. reporting a 2002 net loss of$98.7 billion after taking a fourth-quarter charge of $45.5 billion, mostly to write down the value of its troubled America Online unit while it tried to sell its Atlanta-based teams-baseball's Atlanta Braves, basketball's Atlanta Hawks, and hockey's Atlanta Thrashers. But financial questions and decisions also appeared in the headlines in the sports section when the Washington Redskins signed Lavernues Coles to a $35 million contract and basketball coach Ben Howland took the UCLA coaching job at a salary of $900,000 per year. '¥hat do all of these financial decisions have in common? They are all based on the 10 principles presented in this chapter, and they all deal with decision making. They are all financial decisions, because the focus of finance is how to raise and spend or invest money. Your goal as a financial manager is to manage the firm in such a way that shareholder wealth is maximized. As you will see, there are few, if any, major decisions that a manager makes that don't have financial implications.

[[

II

This chapter outlines a framework for the maintenance and creation of wealth. In introducing decision-making techniques aimed at creating weal til, we will emphasize the logic behind those techniques. This chapter begins with an examination of the goal of the firm. The commonly accepted goal of profit maximization is contrasted with the more complete goal of maximization of shareholder wealth. Because it deals well with uncertainty and time in a real-world environment, the goal of maximization of shareholder wealtll is found to be the proper goal for the firm. The sole proprietorship is a business operation owned and managed by a single individual. Initiating this form of business is Simple and generally does not involve any substantial organizational costs. The proprietor has complete control of the firm, but must be willing to assume full responsibility for its outcomes. The general partnership, which is simply a coming together of two or more individuals, is similar to the sole proprietorship. The limitea partnership is another form of partnership sanctioned by states to permit all but one of the partners to have limited liability if this is agreeable to all partners. The corporation increases the flow of capital from public investors to the business community. Although larger organizational costs and regulations are imposed on this leg'al entity, the corporation is more conducive to raising large amount, of capital. Limited liability, continuity of life, and ease of transfer in ownership, which increase the marketability of the investment, have contributed greatly in attracting large numbers of investors to the corporate environment. The

0 b j e c t i ve

1

I

2

I

3

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e c t I ve

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ve

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26


Objective ~

formal control of the corporation is vested in the parties who own the greatest number of shares. However, day-to-day operations are managed by the corporate officers, who theoretically serve on behalf of the COIlUTIon stockholders. This chapter closes with an examination of the 10 principles on which finance is built that motivate the techniques and tools introduced in this text:

PRINCIPLE

The Risk-Return Trade-Oft-We won't take on additional risk unless we expect to be compensated with additional return

PRINCIPLE

2

The Time Value of Money-A dollar received today is worth more than a dollar received in the future

PRINCIPLE

3

Cash-Not Profits-Is King

PRINCIPLE

Incremental Cash Flows-It's only what changes that counts

PRINCIPLE

The Curse of Competitive Markets-Why it's hard to find exceptionally profitable projects

PRINCIPLE

6

PRINCIPLE

The Agency Problem-Managers won't work for owners unless it's in their best interest

8 PRINCIPLE 9

Taxes Bias Business Decisions

PRINCIPLE

PRINCIPLE

Objective ~

Go To:

www.prenhall.comlkeown for downloads and current events associated with this chapter

Efficient Capital Markets-The markets are quick and the prices are right

All Risk Is Not Equal-Some risk can be diversified away, and some cannot Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance

With the collapse of communism and the acceptance of the free market system in Third World countries, U.S. firms have been spurred on to look beyond our own boundaries for new business. The end result has been that it is not uncommon for major U.S. companies to earn over half their income from sales abroad.

Agency problem, 17 Corporation, 8 Efficient market, 16 lllitialpublicoffering (lPO),11

Limited liability company (LLC), 8 Partnership, 7 Primary market, 11

Seasoned new issue, 11 Secondary market, 11 Sole proprietorship, 7


21

STUDY QUESTIONS 1-1. What are some of the problems involved in the use of profit maximization as the goal of the finn? How does the goal of maximization of shareholder wealth deal with those problems? , 1-2. Compare and contrast the goals of profit maximization and maximization of shareholder wealth. 1-3. Finns often involve themselves in projects that do not result direccly in profits; for example, IBM and Mobil Oil frequently support public television broadcasts. Do these projects contradict the goal of maximization of shareholder wealth? Why or why not? 1-4. What is the relationship between financial decision making and risk and return? Would all financial managers view risk-return trade-offs similarly? 1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation. 1-6. Identify the primary characteristics of each fonn of legal organization. 1-7. Using the following criterl~; specify the legal form of business that is favored: (a) organizational requirements and costs, (b) liability of the owners, (c) continuity of business, (d) transferability of ownership, (e) management control and regulations, (f) ability to raise capital, and (g) income taxes.

I NTEGRAT I. VE'P ROB L EM I

The final.stage in the interview process for an Assistant Financial Analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether or not you are offered a position at Caledonia will depend on the accuracy of your response. To:

Applicants for the position of Financial Analyst

From: Mr. V Morrison, CEO, Caledonia Products Re:

A test of your understanding of basic financial concepts and of the Corporate Tax Code

Please respond to the following questions: 1. What are the differences between the goals of profit maximization and maximization of shareholder wealth? Which goal do you think is more appropriate? 2. What does the risk-return trade-off mean? 3. Why are we interested in cash flows rather than accounting profits in determining the value of an asset? 4. What is an efficient market and what are the implications of efficient markets for us? 5. What is the cause of the agency problem and how do we try to solve it? 6. What do ethics and ethical behavior have to do with finance? 7. Define (a) sole proprietorship, (b) partnership, and (c) corporation.

; CAS E

POL E

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LIVING AND DYING WITH ASBESTOS What happens when you find your most profitable product is dangerous-an ethical dilemma for the financial manager.

Much of what we deal with in financial management centers around the evaluation of projects-when they should be

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ETHie S

accepted and when they should be tenninated. As new information surfaces regarding the future profitability of a project, the firm always has the choice of terminating that project. When this new infonnation raises the question of whether or not it is ethical to produce a profitable project, the decision becomes more difficult. Many times, ethical dilemmas pit

28


profits versus ethics. These decisions become even more difficult when continuing to produce the product is within the law. Asbestos is a fibrous mineral used for fireproofing, electrical insulation, building materials, brake linings, and chemical filters. If you are exposed long enough to asbestos particlesusually 10 or more years-you can develop a chronic lung inflammation called asbestosis, which makes breathing difficult and infection easy. Also linked to asbestos exposure is mesetheJioma, a cancer of the chest lining. This disease sometimes doesn't develop until 40 years after the first exposure. Although the first major scientific conference on the dangers of asbestos was not held until 1964, the asbestos industry knew of the dangers of asbestos 60 years ago. As early as 1932, the British documented the occupational hazards of asbestos dust inhalation." Indeed, on September 25, 1935, the editors of the trade journal Asbestos wrote to Sumner Simpson, president of Raybestos-Manhattan, a leading asbestos company, asking permission to publish an article on the dangers of asbestos. Simpson refused and later praised the magazine for not printing the article. In a letter to Vandivar Brown, secretary of Johns-Manville, another asbestos manufacrurer, Simpson observed: "The less said about asbestos the better off we are." Brown agreed, adding that any article on asbestosis should reflect American, not English, data. In fact, American data were available, and Brown, as one of the editors of the journal, knew it. Working on behalf of Raybestos-Manhattan and Johns-Manville and their insurance carrier, Metropolitan Life Insurance Company, Anthony Lanza had conducted research between 1929 and 1931 on 126 workers with 3 or more years of asbestos exposure. But Brown and others were not pleased with the paper Lanza submitted to them for editorial review. Lanza, said Brown, had failed to portray asbestosis as milder than silicosis, a lung disease caused by longterm inhalation of silica dust and resulting in chronic shortness of breath. Under the then-pending Workmen's Compensation Jaw, silicosis was categorized as a compensable disease. If asbestosis was worse than silicosis or indistinguishable from it, then it too would have to be covered. Apparently Brown didn't want this and thus requested that Lanza depict asbestosis as less serious than silicosis. Lanza complied and also omitted from his published report the fact that more than half the workers examined--D7 of 126--were suffering from asbestosis. Meanwhile, SUl1U1er Simpson was writing F H. Schulter, president ofThermoid Rubber Company, to suggest that several manufacrurers sponsor further asbestos experiments. The sponsors, said Simpson, could exercise oversight prerogatives; they "could determine from time to time after the findings are made whether they wish any publication or not." Added Simpson: "It would be a good idea to distribute the information to the medical fraternity, providing it is of the right type and would not injure our companies." Lest there should be 'See Samuel S. Epstein, "The Asbestos 'Pentagon Papers: .. in Mark Green and Roben Massie, Jr., eds., Tbe Big Business Read.,,: Essays 011 Co,porate America (New York: Pilgrim Press, 1980), 15+-5. This article is the primary source of the facts and quotations reported here.

any question about the arbiter of publication, Brown wrote to officials at the laboratory conducting the tests:

It is our further understanding that the results obtained will be considered the property of those who are advancing the required funds, who will determine whether, to what extent and in what manner they shall be made public. In the event it is deemed desirable that the results be made public, the manuscript of your srudy will be submitted to us for approval prior to publication. Industry officials were concerned with more than controlling information flow. They also sought to deny workers early evidence of their asbestosis. Dr. Kenneth Smith, medical director of a Johns-Manville plant in Canada, explained why seven workers he found to have asbestosis should not be informed of their disease: It must be remembered that although these men have the X-ray evidence of asbestosis, they are working today and definitely are not disabled from asbestosis. They have not been told of this diagnosis, for it is felt that as long as the man feels well, is happy at home and at work, and his physical condition remains good, nothing should be said. When he becomes disabled and sick, then the diagnosis should be made and the claim submitted by the Company. The fibrosis of this disease is irreversible and permanent so that evenrually compensation will be paid to each of these men. But as long as the man is not disabled, it is felt that he should not be told of his condition so that he can live and work in peace and the Company can benefit by his many years of experience. Should the man be told of his condition today there is a very definite possibility that he would become mentally and physically ill, simply through the knowledge that he has asbestosis. \Vhen lawsuits filed by asbestos workers who had developed cancer reached the industIy in the 1950s, Dr. Smith suggested that the industry retain the Industrial Health Foundation to conduct a cancer srudy that would, in effect, squelch the asbestos-cancer connection. The asbestos companies refused, claiming that such a srudy would only bring further unfavorable publicity to the industry, and that there wasn't enough evidence linking asbestos and cancer industry-wide to warrant it. Shortly before his death in 1977, Dr. Smith was asked whether he had ever recommended to Johns-Manville officials that warning labels be placed on insulation products containing asbestos. He provided the following testimony: The reasons why the caution labels were not implemented immediately, it was a business decision as far as I could understand. Here was a recommendation, the corporation is in business to make, to provide jobs for people and make money for stockholders and they had to take into consideration the effects of evelything they did, and if the application of a caution label identifying a product as hazardous would cut out sales, there would be serious financial implications. And the powers that be had to make some effort to judge the necessity of the label vs. the consequences of placing the label on the product. Dr. Smith's testimony and related documents have figured prominently in hundreds of asbestos-related lawsuits, totaling more than $1 billion. In March 1981, a settlement was reached

CHAPTER

in nine separate lawsuits brought by 680 New Jersey asbestos workers at a Raybestos-Manhattan plant. Several asbestos man~facturers, as well as Metropolitan Life Insurance, were named as defendants. Under the terms of the settlement, the workers affected will share in a $9.4 million courtadministered compensation fund. Each worker will be paid compensation according to the length of exposure to asbestos and the severity of the disease contracted. By 1982, an average of 500 new asbestos cases were being filed each month against Manville (as Johns-Manville was now called), and the company was losing more than half the cases that went to trial. In 10 separate cases, juries had also awarded punitive damages, averaging $616,000 a case. By August, 20,000 claims had been filed against the company, and Manville filed for bankruptcy in federal court. This action froze the lawsuits in their place and forced asbestos victims to stand in line with other Manville creditors. After more than 3 years of legal haggling, Manville's reorganization plan was finally approved by the bankruptcy court. The agreement set up a trust fund valued at approximately $2.5 billion to pay Manville's asbestos claimants. To fund the trust, shareholders were required to surrender half the value of their stock, and the company had to give up much of its projected earnings over the next 25 years. b Claims, however, soon overwhelmed the trust, which ran out of money in 1990. With many victims still waiting for payment, federal Judge Jack B. Weinstein ordered the trust to restructure its payments and renegotiate Manville's contributions to the fund. As a result, the most seriously ill victims will now be paid first, but average payments to victims have been lowered significantly, from $145,000 to $43,000. Meanwhile, the trust's stake in Manville has been increased to 80 percent, and Manville has been required to pay $300 million to it in additional dividends. c Questions 1. Should the asbestos companies be held morally responsible in the sense of being capable of making a moral decibSee Robert Mokhiber. COIpornte Crime ond Violeuce (San Francisco: Sierra Club Books, 1988),285-86; and Arthur Sharplin, "Manville Lives on as Victims Continue to Die," Business o7ld Societ)' Review 65 (Spring 1988): 27-28. -

~

Accounts payable represents credit extended by suppliers to a firm when it purchases inventories. The purchasing firm may have 30 or 60 days before paying for L.'1ventory that has been purchased. This fonn of credit extension is also called trade credit. Other payables include interest payable and income taxes payable that are owed and will come due within the year. Accmed expenses are short-term liabilities that pave been incurred in the firm's operations, but not yet paid. For example, emplo~'€lts'Pkrfonn work that may not be paid for until the following week or month, which are recorded as accrued wages. Short-term notes represent amounts borrowed from a bank or other lending source that are due and payable within 12 months.

LON G- TERM DEB T Long-term debt includes loans from banks or other sources that lend money for longer than 12 months. For example, a firm might borrow money for 5 years to buy equipment, or for as long as 25 to 30 years to purchase real estate, such as a warehouse or an office building.

EQUITY Equity includes the shareholders' investment-both preferred stockholders and common stockholders-in L~e firm. OC\"'(,

~

~

Preferred stockholders receive a dividend that is fixed in amount. In the event of liquidation of the firm, these stockholders are paid after the firm's creditors, but before the common stockholders. Conunon stockholders are the residual owners of a business. They receive whatever is left over-good or bad-after the creditors and preferred stockholders are paid. The amount of a firm's common equity as reported in the balance sheet is equal to (1) the net amount the company received from selling stock to investors less stock the firm has repurchased from shareholders plus (2) the firm's retained earnings. The amount the firm receives from selling stock is recorded in the common equity section in the accounts of par value and paid-in capital. These amounts may be offset by any stock that has been repurchased by the company, which is typically shown as treasury stock. Retained earnings is the cumulative total of alJ. t.~e net income over the firm's life Jess the common stock dividends that have been paid over the years. Thus, t.~e common equity capital consists of the following: common equity = common stock issued (less treasury stock repurchased) + cumulative net income over the firm's life - total dividends paid over the firm's life

which is shown in the balance sheet as: common equity = common stock (par value + paid-in capital- treasury stock) + retained earnings

Consists of such sources ~s credit extended by suppliers or

a loan from a bank.

Equity

Stockholders' investr,,,,.lt in the

firm and the cumulative profits

retained in the business up to

the date of the balance sheet.

Debt capital

Funds provided to dle firm by a

creditor.

CUlTent debt

Debt due to be paid within

1 year.

Accounts payable (f (ark Liability of the firm for goods

purchased from suppliers on

credit.

Other payables Interest payable and income taxes payable that are to be paid within 1 year.

Accrued expenses

S;:"J.:; '.

+

'Expenses that havebeen incurred but not yet paid in cash.

Short-term notes

Amounts borrowed from a

creditor that are due within

-- 1 year.

Long-term debt

Loans from banks or other

sources that lend money for

longer than 12 months.'

PrefelTed stockholders

Investors who own the firm's

preferred stock.

Common stockholders

Investors who own the firm's

common stock. Common

stockholders are the residual

owners of the firm.

Par value and pajd-in

capital

The amount the firm receivc~ from selling stock to investors.

DEB TeA PITAL Debt capital is financing provided by a creditor. As shown in Figure 2-1, it is divided into (1) current, or short-tenn, debt and (2) long-term debt. Current debt, or short-tenn liabilities, includes borrowed money that must be repaid within the next 12 months. Sources of current debt include the following:

Debt

We now turn to the right side of the balance sheet in Figure 2-1, labeled "Liabilities (Debt) and Equity," which indicates how the firm finances its assets. Financing comes from two main sources: debt (liabilities) and equity. Debt is money that has been bor rowed and must be repaid at some predetermined date. Equity, however, represents the Shareholders' investment in the company. See the Finance Matters box, "Financial Statements: Fact or Fiction."

Treasurv stock

The firm\ stock that has been

issued and reacquired by the

firm.

Retained earnings

The cumulativ~ earnings that

have been retained and

reinvested in the firm over its

life (cumulative earnings

cumulative dividends).

,: '.'~'b.'

.

38


FINANCIAL STATEM NTS: FACT OR FICTION? A firm's financial statements are the primary source of information used by investors and creditors for making investment decisions. Firm management is obligated to provide accurate information and motivated to provide tlnancial results that meet the expectations of Wall Street participants. Much of the time both results can be obtained simultaneously. However, there are times where the accu rate information will not support the expectations of the investing community. What is management to do? The requirement for management is to accurately report the firm's financial position. However, in the late 1990s and early 2000s there were instances where the desire to meet vVall Street expectations dominated the obligation to pro vide accurate information. Rite Aid executives were charged with overstating the tlrm's income during the period from May 1997 to .May 1999. Correcting this situation required a $1.6 billion restatement of earnings, the largest restatement ever recorded at that time, according to the Securities and Exchange Commission. In the summer of 2000, \\Taste Management and their independent auditors, Arthur Andersen, paid $229 million to shareholders to settle charges related to $3.5 billion in accounting irregularities. In November 2002, Waste Management paid an additional $457 million in fines for violating securities laws. During its 1997 merger with CUC International, Cendant issued false and misleading statements concerning the merger. Additionally, tlrm officers sold Cendant stock prior to making the accounting problems known to investors. For these actions, the firm paid $2.8 billion. Energy trading firm Enron used off-the-book partner ships to conceal $1 billion in debt and to innate the firm's profits. News of these transactions resulted in the firm filing for bankruptcy in December 2002 and criminal charges against former CFO Andy Fastow. Another casualty of the Enron scandal was the accounting finn Arthur Andersen.

Andersen was found guilty of obstruction of justice for shredding documents related to the Enron investigation. 1 his felony conviction resulted in the discontinuation of Andersen's auditing business. Conglomerate Tyco has also seen its share of account ing problems. Former CEO Dennis Kozlowski used mil lions of dollars in company funds inappropriately and without the consent of the board of directors. As a result of the misuse of company funds, Tyco stock lost 75 per cent of its value in 2002. Telecommunications giant Worldcom saw its fortunes dis appear after an internal audit in 2002 revealed the firm had booked operating expenses as capital expenditures in an attempt to report better than actual profits. In July 2002, Worldcom filed Chapter 11 bankruptcy. As of early 2003, approximately $7 billion of accounting discrepancies have been uncovered. In 2002, Xerox announced plans to restate earnings for the period 1997 to 2001 and to pay a $10 million fine to the SEC for engaging in fraudulent accounting practices. The total amount of improperly recorded revenue for the period could be in excess of $6 billion. Do these examples indicate that financial statements are not reliable at all? Hardly! These large firms that have been charged with or convicted of misrepresenting their financial result are but a few of the over 7,2 00 publicly traded firms in the United States. Most firm managers are committed to their obligation to accurately report financial information. Beginning in 2002, the SEC required firm executives to sub mit a signed document attesting the financial results are accurate. Improper reporting of financial statements can lead to severe consequences for management, including loss of job, fines, and jail time. Source: Wall S"·ect]Oll111al. Eastern Edition (Staff produced copy' only) by S:lllllders-Egodigwe, Long, & "'''arfield. CopYTight © 2003 by Dow Jones & Company, Inc. Reproduced with permission of Dow Jones & Company, Inc. in the form:lt Textbook via Copyright Clearance Centcr.

THE HARLEy-DAVIDSON, INC. BALANCE SHEET Balance sheets for Harley-Davidson, Inc. are presented in Table 2-2 for both December.31, 2001 and December 31, 2002, along with the changes in each account during the year. We show the reasons for the change in retained earnings at the bottom of the table. By referring to the two balance sheets, we can see the financial position of the finn both at the beginning and end of2002. Furthermore, by examining the two balance sheets, along with the income statement for 2002, we will have a more complete picture of the finn's operations. We are then able to see what Harley-Davidson looked like at the beginning of 2002 (balance sheet


Il'l'!J!JEJEI

Harley-Davidson Inc. Annual Balance Sheet ($000) 12131101

12131102

ASSETS

CHANGE

Cash Accounts receivable Inventories Other current assets Total current assets . Gross p1an1-2LQperty. ELe.quipJIle!l..!.... Accumulated depreciation Net plant, property, and equipment . Other .~~e.ts __. Total assets

$ 535,449

$ 795,728

$160,279

775,264 181,115

964,465 218,156

189,201

73,436 $1,665,264

88,237 $2,066,586

$1,705.361

$2,006.256

(813,541)

(973,660)

$ 891,820 561,411

$1,032,596

$3,118,49'5

762,035 $3,861,217

37,041 14,801 $401,322

f$300~895 "..., 200,62 $742,722

LIABILITIES AND EQUITY

LIABILITIES Accounts payable Accrued expenses Income taxes payable Short-term notes Other interest bearing current liabilities Total current liabilities Long-term debt Total liabilities

COMMON EQUITY Common stock (par value) Paid in capital Retained earnings Less treasury stock Total common equity Total liabilities and equity

$ 217,051

$165,528

194,683

$ 382,579 226,977

65,875

67,886

2,011

141,191

189,024

47,833

97.310 716,110

123,586

26,276

$ 990,052

646,102 $1,362,212

638,250 $1,628,302

$273.942 (7,852)

$

$

$

3,242 359,165 1,819,422 (425,546)

3,254 386,284 2,325,737 (482,360)

32,294

$266,090

$

12 27,119 506,315 (56,814)

$1,756,283

$2,232,915

$476,632

$ 3,118,495

$3,861,217

$742,722

HARLEY DAVIDSON INC. RECONCILIATION OF RETAINED EARNINGS

Retained earnings, December 31,2001 2002 net income Dividends paid Retained earnings, December 31,2002

$1,819,422 580,217 73,902 $2,325,737

on December 31, 2001), what happened during the year (income statement for 2002), and the final outcome at the end of the year (balance sheet on December 31, 2002). The firm's investment in assets increased $742.7 million over the year, with most of the growth in cash, accounts receivables, and other assets. The increase in the firm's assets in turn required additional financing. Looking at the debt and equity parts of the balance sheet, we see that management used two primary sources of money to finance the growth: 1. A $506.3 million increase in retained earnings, which is the result of retaining a por tion of the firm's net income, rather than paying it out in dividends. 2. Borrowing $273.9 million in addition~l short-term debt (c1Jfrent liabilities).

.Y\'e also observe in the common equity section that the firm's net common stock was redu_ced ~y $29.7 millio_n, Th.is is due to the increases in common par value

-

39

PART 1 THE SCOPE .AND ENVIRONMENT OF FINANCIAL MANAGEMENT

40

Harley-Davidson Balance Sheet as of December 31, 2002

$4 million

~-

Debt and Equity

Total Assets

1

$3 million

+

I I

:

~(,\y~.'t (JS, ' 1 , ' :.. ~ 7., ., except when all or a part of the profits are dismbuted In the forn1 of diVIdends. Because most -J-. C t! '< (: I ",.I , firms of any size are corporations, we will resnict our discussion to corporate taxes.

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) ~~'r)~,:, \(0Ir)~ COMPUTING TAXABLE INCOME

The taxable income for a corporation is based on the gross income from all sources less I

any tax-deductible expenses. Gross income equals the firm's dollar sales from its product G less the cost of producing ~Dacquiring the produrJ) Tax-deductible expenses in

)

de J.v

Cf0) ~

r:-

G\o:.>

$4,000,000

1,500,000

4,500,000

, \

Marketing expenses ~ Total operating expenses Operating income (;a!"nings before interest and taxes) Interest expense .L:L.--_ '_ _ __ Taxable income

(V)

'":.f r )

~"'--..'-

~

(10,000,000) $17,000,000 (1,000,000) $16,000,000

Note: Dividends paid to common stockholders ($1,000,000) are not tax-deductible,

fA Corporate Tax Rates

RATES

15% 25% 34% 39%

~ 35% 38% 35%

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INCOME lEVELS

$0-$50,000 ---- '" I(~').) $50,001-$75,000,,---) {., ->'.J

$75,001-$100,000 - . '- ,-' '-"7>

Ill1l!DI

$100,gOl::.$335,OOO. -= 335,001-$10,000,000 Ii $10,000,001-$15,000,000 $15,000,001-$18,333,333 Over $18,333,333

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finn's conunon stockholders. The taxable income for theJ&S Corporation would be $16 million, as shown in Table 2-3. COMPUTING THE TAXES OWED The taxes to be paid by a corporation on its tax able income are based on the corporate tax rate structure. The specific rates effective for the corporation, as of 2002, are given in Table 2-4. If you wonder about the economic rationale for the rates, don't waste your time. There is none. Politicians, not economists, determine the rates. Based on the tax rates, J&S Corporation's tax liability would be $5,530,000, as com puted in Table 2-5. The tax rates in Table 2-4 are defined as the marginal tax rates, or rates applicable to the next dollar of taxable income. For instance, if a firm has taxable income of $60,000 and is contemplating an investment that would yield $10,000 in additional taxable income, the tax rate to be used in calculating the taxes on this added income is the 25 per cent marginal tax rate. However, if the corporation already expects $20 million without the new investment, the extra $10,000 in taxable income would be taxed at 35 percent, the marginal tax rate at the $20 million level of income. For theJ&S Corporation, with a taxable income of$16 million, its marginal tax rate is 38 percent; that is, any additional income from new investments will be taxed at a rate of 38 percent-at least until taxable income exceeds $18,333,333. Then the marginal tax rate would decline to 35 percent. Note, however, that while J&S Corporation has a 38 percent marginal tax rate, its average tax rate-taxes owed relative to the firm's tax able income-is 34.6 percent ($5,:;30,000 -;- $16,000,000). For financial decision making, it is the marginal tax rate, rather than the average tax rate, that matters because it is the marginal rate that is applied to any additional earnings resulting from a decision. Thus, when making financial decisions involving taxes, always

Marginal tax rate

The tax rate that would be

applied to the ~dollar of

taxable income.

Average tax rate Taxes owed by the firm divided by the firm's taxable income.

44


IZtJ!lED

Tax Calculations for JEtS Corporation

EARNINGS

x

MARGINAL TAX RATE

TAXES

$50,000 $75,000-$50,000 $100,000-$75,000 $335,000-$100,000 $10,000,000-$335,000 $15,000,000-$10,000,000 $16,000,000-$15,000,000 Total tax liability

x x x x x x x

15% 25% 34% 39% 34% 35% 38%

$

7,500 6,250 8,500 91,650 3,286,100 1,750,000 380,000 $5,530,000

use the marginal tax rate in your calculations and not the average tax rate. We cannot overemphasize the importance of remembering the preceding statement, which is a spe cific application of Principle 4-It's Only What Changes That Counts. We should always analyze decisions at the margin. The tax rate structure used in computing the J&S Corporation's taxes assumes that the income occurs in the United States. Given the globalization of the economy, it may well be that some of the income originates in a foreign country. If so, the tax rates, and the method of taxing the firm, frequently vary. International tax rates can vary substantially and the job of the financial manager is to minimize the firm's taxes by reporting as much income as legaily allowed in the low tax-rate countries and as little as legally allowed in the high tax-rate countries. Of course, other factors, such as political risk, may discourage efforts to minimize taxes across national borders.

CONCEPT CHECK

Objective ~

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(1

1.

Distinguish among sole proprietors, partnerships, and corporations in

terms of how th.ey are taxed.

2.

What is the difference between marginal tax rates and average tax rates?

3.

Why do we use marginal tax rates, rather than average tax rates, when

making financial decisions?

4.

What should be the firm's goal when it comes to international taxes?

MEASURING FREE CASH FLOWS While an income statement measures a company's profits, profits are not the same as cash flows; profits are c'l.lculated on an accrual basis rather than a cash basis. Accrual-basis accounting records income when it is earned, whether or not the income has been received in cash, and records expenses when they are incurred, even if money has not actually been paid out. For example, sales reported in the income statement include both cash sales and credit sales. Therefore, sales for a given year do not correspond exactly to the actual cash collected from sales. Similarly, a finn must purchase inventory, but some of the purchases are financed by credit rather than by immediate cash payment. Also, under the accrual system, the purchase of equipment that will last for more than 1 year is not shown as an expense in the income statement. Instead, the amount is recorded as'an asset and then depreciated over its useful life. An annual depreciation expense (this is not a cash flow) is recorded as a way to match the use of the asset with sales generated from its service. We could give more examples to show why profits differ from cash flows, but the point should be clear: Profits and cash flows are not the same thing. Failure to understand and recognize this important fact could cause some real problems.


In measuring cash flows, we could use the conventional accountant's presentation called a statement ofcash flows. However, we are more interested in considering cash flows from the perspective of the firm's investors, rather than from an accounting view. So, what follows is similar to a conventional cash flow statement presented as part of a com pany's financial statements, but "not exactly." (For a presentation of an accountant's state ment of cash flows, see Appendix 2-A.) We can think of a firm as a block of assets that produce cash flow, which can be either positive or negative. Once the firm has paid all its operating expenses and made all its investments, the remaining cash flows are free to distribute to the firm's creditors and shareholders-thus, the term free cash flows. However, if the free cash flows are nega tive, the~reditorS)andl1nvestors)are the ones who make up the shortfall-someone has to do it. Thus, the cash flows that are generated through a firm's assets equal its cash flows paid to-or received from-the company's investors (both creditors and stockholders). They have to be equal; except that if one is positive (negative) the other will be negative G r(positive). That is, el(;'(\ I • 1"(-3 Or' cY \-f'. J.e",r.lI,D \ S +(-) Cash flows from assets = -~+) cash flows from financing

45

Free cash flows Amount of cash available from operations after paying for investments in net operating working capital and fixed assets. This cash is available to distribute to the firm's creditors and owners.

The two calculations simply give us different perspectives about the firm's cash flows. So, let's look at each approach for measuring a company's free cash flows. CALCULATING FREE CASH FLOWS: AN ASSET PERSPECTIVE!

A firm's free cash flows, viewed from an asset perspective, are the after-tax cash flows gen/ erated from operating the business less the firm's investments in assets; that is: / / free cash flows =

after-tax operating investment . cash flows In assets

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~

Financial Management: Principles And Applications

Management Accounting: Principles and Applications

Management accounting: principles and applications

Financial Applications (Applications of Management Science)

Risk and Financial Management

Materials and Financial Management

Risk And Financial Management

Financial Management: Management Extra