Financial Management 1

PART 1

The Company and Its Environment

C H A P T E R 1 An Overview of Financial Management and the Financial Environment 3 C H A P T E R 2 Financial Statements, Cash Flow, and Taxes 57 C H A P T E R 3 Analysis of Financial Statements 101

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C H A P T E R 1

An Overview of Financial Management and the Financial Environment

In a global beauty contest for companies, the winner is … Apple. Or at least Apple is the most admired company in the world, according to Fortune

magazine’s annual survey. The others in the global top ten are Amazon.com, Google, Berkshire Hathaway, Starbucks, Coca-Cola, Walt Disney, FedEx, Southwest Airlines, and General Electric. What do these companies have that separates them from the rest of the pack?

Based on a survey of executives, directors, and security analysts, these companies have very high average scores across nine attributes: (1) innovativeness, (2) quality of management, (3) long-term investment value, (4) social responsibility, (5) people management, (6) quality of products and services, (7) financial soundness, (8) use of corporate assets, and (9) effectiveness in doing business globally. After culling weaker companies, the final rankings are then determined by over 3,900 experts from a wide variety of industries.

What makes these companies special? In a nutshell, they reduce costs by having innovative production processes, they create value for customers by providing high- quality products and services, and they create value for employees by training and fostering an environment that allows employees to utilize all of their skills and talents. As you will see throughout this book, the resulting cash flow and superior return on capital also create value for investors.

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w w w See http://fortune.com/ worlds-most-admired -companies for updates on the rankings.

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This chapter should give you an idea of what financial management is all about, including an overview of the financial markets in which corporations operate. Before going into details, let’s look at the big picture. You’re probably in school because you want an interesting, challenging, and rewarding career. To see where finance fits in, here’s a five-minute MBA.

1-1 The Five-Minute MBA Okay, we realize you can’t get an MBA in five minutes. But just as an artist quickly sketches the outline of a picture before filling in the details, we can sketch the key elements of an MBA education. The primary objective of an MBA program is to provide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies.

First, successful companies have skilled people at all levels inside the company, includ- ing leaders, managers, and a capable workforce. Skilled people enable a company to identify, create, and deliver products or services that are highly valued by customers— so highly valued that customers choose to purchase from them rather than from their competitors.

Second, successful companies have strong relationships with groups outside the com- pany. For example, successful companies develop win–win relationships with suppliers and excel in customer relationship management.

Third, successful companies have enough funding to execute their plans and support their operations. Most companies need cash to purchase land, buildings, equipment, and materials. Companies can reinvest a portion of their earnings, but most growing compa- nies also must raise additional funds externally by some combination of selling stock and/ or borrowing in the financial markets. Therefore, all successful companies sell their products/services at prices that are high enough to cover costs and to compensate owners and creditors for the use of their money and their exposure to risk.

To help your company succeed, you must be able to evaluate any proposal or idea, whether it relates to marketing, supply chains, production, strategy, mergers, or any other area. In addition, you must understand the ways that value-adding proposals can be funded. Therefore, we will show you how to evaluate proposals and fund value-adding ideas, essential financial skills that will help you throughout your career.

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What are three attributes of successful companies?

What two essential financial skills must every successful manager have?

1-2 Finance from 40,000 Feet Above Seeing the big picture of finance from a bird’s-eye view will help you keep track of the individual parts. It all starts with some individuals or organizations that have more cash than they presently want to spend. Other individuals or organizations have less cash than they currently want to spend, but they have opportunities to generate cash in the future.

Let’s call the two groups providers and users: The providers have extra cash today and the users have opportunities to generate cash in the future. For example, a provider might be an individual who is spending less today in order to save for retirement. Another provider might be a bank with more cash on hand than it needs. In either case, the provider is willing to give up cash today for cash in the future.

r e s o u r c e The textbook’s Web site has tools for teaching, learning, and conducting financial research.

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A user might be a student who wants to borrow money for tuition and who plans to pay it back from future earnings after graduating. Another user might be an entrepreneur who has an idea for a new social media application that might generate cash in the future but requires cash today to pay for programmers.

Figure 1-1 shows the relationship between providers and users. As Figure 1-1 shows, providers supply cash now to users in exchange for a claim on

future cash flows. For example, if you took out a student loan, the bank gave you cash, but you signed a document giving the bank a claim on future cash flows to be paid from you to the bank. This claim is risky, because there is some probability (hopefully small) that you will not be able to repay the loan.

Two problems immediately present themselves. First, how do the providers and users identify one another and exchange cash now for claims on risky future cash? Second, how can potential providers evaluate the users’ opportunities? In other words, are the claims on risky future cash flows sufficient to compensate the providers for giving up their cash today? At the risk of oversimplification, financial markets are simply ways of connecting providers with users, and financial analysis is a tool to evaluate risky opportunities.

We cover many topics in this book, and it can be easy to miss the forest for the trees. So as you read about a particular topic, think about how the topic is related to the role played by financial markets in connecting providers with users or how the topic explains a tool for evaluating financial claims on risky future cash flows.

Later in this chapter we provide an overview of financial markets, but first we address an especially important type of user: companies that are incorporated.

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What do providers supply? What do providers receive?

What do users receive? What do users offer?

What two problems are faced by providers and users?

1-3 The Corporate Life Cycle Many major corporations, including Apple and Hewlett-Packard, began life in a garage or basement. How is it possible for such companies to grow into the giants we see today? No two companies develop in exactly the same way, but the following sections describe some typical stages in the corporate life cycle.

FIGURE 1-1 Providers and Users: Cash Now versus Claims on Risky Future Cash

Provider:

Person or organization with cash now

Cash now

Claim on risky future cash

User:

Person or organization with opportunities to convert cash now into cash later

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1-3a Starting Up as a Proprietorship Many companies begin as a proprietorship, which is an unincorporated business owned by one individual. Starting a business as a proprietor is easy—one merely begins business operations after obtaining any required city or state business licenses. The proprietorship has three important advantages: (1) It is easily and inexpensively formed. (2) It is subject to few government regulations. (3) Its income is not subject to corporate taxation but is taxed as part of the proprietor’s personal income.

However, the proprietorship also has three important limitations: (1) It may be difficult for a proprietorship to obtain the funding needed for growth. (2) The proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money invested in the company. (Creditors may even be able to seize a proprietor’s house or other personal property!) (3) The life of a proprietorship is limited to the life of its founder. For these three reasons, sole proprietorships are used primarily for small businesses. In fact, proprietorships account for only about 4% of all sales, based on dollar values, even though about 72% of all companies are proprietorships.

1-3b More Than One Owner: A Partnership Some companies start with more than one owner, and some proprietors decide to add a partner as the business grows. A partnership exists whenever two or more persons or entities associate to conduct a noncorporate business for profit. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agree- ments filed with the secretary of the state in which the partnership was formed. Partnership agreements define the ways any profits and losses are shared between partners. A partner- ship’s advantages and disadvantages are generally similar to those of a proprietorship.

Regarding liability, the partners potentially can lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet his or her pro rata liability then the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary. To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. In a limited partnership, the limited partners can lose only the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control—it rests solely with the general partners—and their returns are likewise limited. Limited partner- ships are common in real estate, oil, equipment-leasing ventures, and venture capital. However, they are not widely used in general business situations, because usually no partner is willing to be the general partner and thus accept the majority of the business’s risk, and no partners are willing to be limited partners and give up all control.

In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in a limited liability partnership (LLP) and a limited liability company (LLC), all partners (or members) enjoy limited liability with regard to the business’s liabilities, and their potential losses are limited to their investment in the LLP. Of course, this arrangement increases the risk faced by an LLP’s lenders, customers, and suppliers.

1-3c Many Owners: A Corporation Most partnerships have difficulty attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, then

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the difficulty in attracting capital becomes a real drawback. Thus, many growth companies, such as Hewlett-Packard and Microsoft, began life as a proprietorship or partnership, and at some point their founders decided to convert to a corporation. On the other hand, some companies, in anticipation of growth, actually begin as corporations. A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers. This separation gives the corporation three major advantages: (1) unlimited life— a corporation can continue after its original owners and managers are deceased; (2) easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and (3) limited liability—losses are limited to the actual funds invested.

To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt and owed $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. On the other hand, if you invested $10,000 in the stock of a corporation that went bankrupt, your potential loss on the investment would be limited to your $10,000 investment. Unlimited life, easy transferability of ownership interest, and limited liability make it much easier for corporations than proprietorships or partnerships to raise money in the financial markets and grow into large companies.

The corporate form offers significant advantages over proprietorships and partner- ships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation involves preparing a charter, writing a set of bylaws, and filing the many required state and federal reports, which is more complex and time-consuming than creating a proprietorship or a partnership.

The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence.1 After the corporation begins operating, quarterly and annual employment, financial, and tax reports must be filed with state and federal authorities.

The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions require it.

There are several different types of corporations. Professionals such as doctors, lawyers, and accountants often form a professional corporation (PC) or a professional association (PA). These types of corporations do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate in order to avoid certain types of unlimited liability yet still be held responsible for professional liability.

Finally, if certain requirements are met, particularly with regard to size and number of stockholders, owners can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such firms, which differ not in organizational form but only in how their owners are taxed, are called S corporations.

1More than 60% of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered, or even to conduct operations, in its state of incorporation, or even in its country of incorporation.

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1-3d Growing a Corporation: Going Public Once a corporation has been established, how does it evolve? When entrepreneurs start a company, they usually provide all the financing from their personal resources, which may include savings, home equity loans, or even credit cards. As the corporation grows, it will need factories, equipment, inventory, and other resources to support its growth. In time, the entrepreneurs usually deplete their own resources and must turn to external financing. Many young companies are too risky for banks, so the founders must sell stock to outsiders, including friends, family, private investors (often called “angels”), or venture capitalists.

Any corporation can raise funds by selling shares of its stock, but government regulations restrict the number and type of investors who can buy the stock. Also, the shareholders cannot subsequently sell their stock to the general public. Therefore, a thriving private corporation may decide to seek approval from the Securities and Exchange Commission (SEC), which regulates stock trading, to sell shares in a public stock market.2 In addition to SEC approval, the company applies to be a listed stock on an SEC-registered stock exchange. For example, the company might list on the New York Stock Exchange (NYSE), which is the oldest registered stock exchange in the United States and is the largest exchange when measured by the market value of its listed stocks. Or perhaps the company might list on the NASDAQ Stock Market, which has the most stock listings, especially among smaller, high-tech companies.

Going public is called an initial public offering (IPO) because it is the first time the company’s shares are sold to the general public. In most cases, an investment bank, such as Goldman Sachs, helps with the IPO by advising the company. In addition, the investment bank’s company usually has a brokerage firm, which employs brokers who are registered with the SEC to buy and sell stocks on behalf of clients.3 These brokers help the investment banker sell the newly issued stock to investors.

Most IPOs raise proceeds in the range of $120 million to $150 million. However, some IPOs are huge, such as the $21.7 billion raised by Alibaba when it went public on the NYSE in 2014. Not only does an IPO raise additional cash to support a company’s growth, but the IPO also makes it possible for the company’s founders and investors to sell some of their own shares, either in the IPO itself or afterward as shares are traded in the stock market. For example, in Facebook’s 2012 IPO, the company raised about $6.4 billion by selling 180 million new shares and the owners received almost $9.2 billion by selling 241 million of their own shares.

Most IPOs are underpriced when they are first sold to the public, based on the initial price paid by IPO investors and the closing price at the end of the first day’s trading. For example, in 2014 the average first-day return was over 15%.

Even if you are able to identify a “hot” issue, it is often difficult to purchase shares in the initial offering. In strong markets, these deals generally are oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors find it hard, if not impossible, to get in on the ground floor. They can buy the stock in the aftermarket, but evidence suggests that if you do not get in on the ground floor, the average IPO underperforms the overall market over the long run.4

2The SEC is a government agency created in 1934 to regulate matters related to investors, including the regulation of stock markets. 3For example, stockbrokers must register with the Financial Industry Regulatory Authority (FINRA), a nongovernment organization that watches over brokerage firms and brokers. FINRA is the biggest, but there are other self-regulatory organizations (SRO). Be aware that not all self-advertised “investment advisors” are actually registered stockbrokers. 4See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, March 1991, pp. 3–27.

w w w For updates on IPO activity, see www .renaissancecapital .com/IPOHome/ MarketWatch.aspx. Also, see Professor Jay Ritter’s Web site for additional IPO data and analysis, http://bear .warrington.ufl.edu/ ritter/ipodata.htm.

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Before you conclude that it isn’t fair to let only the best customers have the stock in an initial offering, think about what it takes to become a best customer. Best customers are usually investors who have done lots of business in the past with the investment banking firm’s brokerage department. In other words, they have paid large sums as commissions in the past, and they are expected to continue doing so in the future. As is so often true, there is no free lunch—most of the investors who get in on the ground floor of an IPO have, in fact, paid for this privilege.

After the IPO, it is easier for a public firm to raise additional funds to support growth than it is for a private company. For example, a public company raises more funds by selling (i.e., issuing) additional shares of stock though a seasoned equity offering, which is much simpler than the original IPO. In addition, publicly traded companies also have better access to the debt markets and can raise additional funds by selling bonds.

1-3e Managing a Corporation’s Value How can managers affect a corporation’s value? To answer this question, we first need to ask, “What determines a corporation’s value?” In a nutshell, it is a company’s ability to generate cash flows now and in the future.

In particular, a company’s value is determined by three properties of its cash flows: (1) The size of the expected future cash flows is important—bigger is better. (2) The timing of cash flows counts—cash received sooner is more valuable than cash that comes later. (3) The risk of the cash flows matters—safer cash flows are worth more than uncertain cash flows. Therefore, managers can increase their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk.

The relevant cash flows are called free cash flows (FCF), not because they are free, but because they are available (or free) for distribution to all of the company’s investors, including creditors and stockholders. You will learn how to calculate free cash flows in Chapter 2, but for now you should know that free cash flow is:

Sales Operating Operating Required investmentsFCF − − −revenues costs taxes in new operating capital

No matter what job you have, your decisions affect free cash flows. For example, brand managers and marketing managers can increase sales (and prices) by truly under- standing their customers and then designing goods and services that customers want. Human resource managers can improve productivity through training and employee retention. Production and logistics managers can improve profit margins, reduce inven- tory, and improve throughput at factories by implementing supply chain management, just-in-time inventory management, and lean manufacturing. All employees, from the CEO down to the night janitor, have an impact on free cash flows.

A company’s value depends on its ability to generate free cash flows, but a company must spend money to make money. For example, cash must be spent on R&D, marketing research, land, buildings, equipment, employee training, and many other activities before the subsequent cash flows become positive. Where do companies get this cash? For start- ups, it comes directly from investors. For mature companies, some of it comes directly from new investors and some comes indirectly from current shareholders when profit is reinvested rather than paid out as dividends. As we stated previously, these cash providers expect a rate of return to compensate them for the timing and risk inherent in their claims on future cash flows. This rate of return from an investor’s perspective is a cost from the company’s point of view. Therefore, the rate of return required by investors is called the weighted average cost of capital (WACC).

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The following equation defines the relationship between a firm’s value, its free cash flows, and its cost of capital:

Value FCF1

1 WACC 1 FCF2

1 WACC 2 FCF3

1 WACC 3 FCF∞

1 WACC ∞ (1-1)

We will explain how to use this equation in later chapters, but for now it is enough to understand that a company’s value is determined by the size, timing, and risk of its expected future free cash flows.

If the expected future free cash flows and the cost of capital incorporate all relevant information, then the value defined in Equation 1-1 is called the intrinsic value; it is also called the fundamental value. If investors have all the relevant information, the market price, which is the price that we observe in the financial markets, should be equal to the intrinsic value. Whether or not investors have the relevant information depends on the quality and transparency of financial reporting for the company and for the financial markets. This is an important issue that we will address throughout the book.

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What are the key differences between proprietorships, partnerships, and corporations? Be sure to describe the advantages and disadvantages of each.

What are charters and bylaws?

Describe some special types of partnerships and corporations, and explain the differences among them.

What are some differences between the NYSE and the NASDAQ Stock Market?

What does it mean for a company to “go public” and “list” its stock?

What roles are played by an investment bank and its brokerage firm during an IPO?

What is IPO underpricing? Why is it often difficult for the average investor to take advantage of underpricing?

Differentiate between an IPO and a seasoned equity offering.

What three properties of future cash flows affect a corporation’s value?

How is a firm’s intrinsic (or fundamental) value related to its free cash flows and its cost of capital? Write out the equation and explain what it means.

What is required for the market price to equal the fundamental value?

1-4 Governing a Corporation For proprietorships, partnerships, and small corporations, the firm’s owners are also its managers. This is usually not true for a large corporation, which often has many different shareholders who each own a small proportion of the total number of shares. These diffuse shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Managers are hired to work on behalf of the shareholders, but what is to prevent managers from acting in their own best interests? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. Agency problems can be addressed by a company’s corporate governance, which is the set of rules that control the company’s behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community. We will have much

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more to say about agency problems and corporate governance throughout the book, especially in Chapters 13, 14, and 15.

It is one thing to say that managers should act on behalf of owners, but how can managers put this into practice?

1-4a The Primary Objective of a Corporation: Maximizing Stockholder Wealth

Managers are entrusted with shareholders’ property and should be good stewards of this property. Good stewardship implies that managers should seek to increase the entrusted property’s value. In other words, the primary goal of the corporation should be to maximize stockholder wealth unless the company’s charter states differently. This does not mean that managers should break laws or violate ethical considerations. This does not mean that managers should be unmindful of employee welfare or community concerns. But it does mean that managers should seek to maximize stockholder wealth.

In fact, maximizing shareholder wealth is a fiduciary duty for most U.S. corpora- tions. If companies fail in this duty, they can be sued by shareholders. For example, suppose several different companies make simultaneous offers to acquire a target company. The target’s board of directors probably will be sued by shareholders if they don’t vote in favor of the highest offer, even if the takeover means that the directors will lose their jobs. Companies can even be sued for maintaining social initiatives (such as purchasing environmentally friendly or locally sourced supplies at higher costs than equivalent imports) if shareholders believe they are too costly to the company.

The situation is different for many non-U.S. companies. For example, many European companies’ boards have directors who specifically represent the interests of employees and not just shareholders. Many other international companies have government repre- sentatives on their boards or are even completely owned by a government. Such compa- nies obviously represent interests other than shareholders.

In a recent development, some U.S. corporations are choosing a new corporate form called a benefit corporation (B-Corp) that expands directors’ fiduciary respon- sibilities to include interests other than shareholders’ interests (see the box “Be Nice with a B-Corp”).

1-4b Intrinsic Stock Value Maximization and Social Welfare

If a firm attempts to maximize its intrinsic stock value, is this good or bad for society? In general, it is good. Aside from such illegal actions as fraudulent accounting, exploiting monopoly power, violating safety codes, and failing to meet environmental standards, the same actions that maximize intrinsic stock values also benefit society.

ORDINARY CITIZENS AND THE STOCK MARKET More than 43% of all U.S. households now own mutual funds, as compared with only 4.6% in 1980. When direct stock ownership and indirect ownership through pension funds are also considered, many members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize intrinsic value, this improves the quality of life for millions of ordinary citizens.

w w w The Investment Company Institute is a great source of information. For updates on mutual fund ownership, see www .ici.org/research#fact _books.

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CONSUMERS AND COMPETITIVE MARKETS Value maximization requires efficient, low-cost businesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efficient and courteous service, adequate stocks of merchandise, and well-located business establishments. Therefore, consumers benefit in competitive markets when companies maximize intrinsic value.

EMPLOYEES AT VALUE-MAXIMIZING COMPANIES In some situations a stock price increases when a company announces plans to lay off employees, but viewed over time this is the exception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus benefiting society. Note, too, that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash flows of recently privatized companies generally improve. Moreover, studies show that newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization.

1-4c Ethics and Intrinsic Stock Value Maximization A firm’s commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and

Be Nice with a B-Corp

In 2010, Maryland became the first state to allow a com- pany, The Big Bad Woof, to be chartered as a benefit corporation (B-Corp). As of early 2015, there were more than 1,000 B-Corps in 27 states, with legislation pending in 14 other states. B-Corps are similar to regular for-profit corporations, but have charters that include mandates to help the environment and society, not just to shareholders. For example, The Big Bad Woof, which sells products for companion pets, seeks to purchase merchandise from small, local, minority-owned businesses even if their prices are a bit higher.

B-Corps are required to report their progress in meet- ing the charters’ objectives. Many self-report, but some choose to be certified by an independent third party, in much the same way that an independent accounting firm certifies a company’s financial statements.

Why would a company become a B-Corp? Patagonia founder Yvon Chouinard said, “Benefit corporation legislation

creates the legal framework to enable mission-driven compa- nies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership, by institution- alizing the values, culture, processes, and high standards put in place by founding entrepreneurs.”a

Will being a B-Corp help or hurt a company’s value? Advocates argue that customers will be more loyal and that employees will be prouder, more motivated, and more productive, which will lead to higher free cash flows and greater value. Critics counter that B-Corps will find it difficult to raise cash from additional investors because maximizing shareholder wealth isn’t a B-Corps only objective.

There isn’t yet enough data to draw a conclusion, but it will be interesting to see whether B-Corps ultimately produce a kinder, gentler form of capitalism.

Notes: aSee www.patagonia.com/us/patagonia.go?assetid=68413.

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selling practices, the use of confidential information for personal gain, community involvement, and illegal payments to obtain business. How does a lack of commitment to ethical behavior affect stock prices?

The intrinsic value of a company ultimately depends on all of its expected future cash flows, and making a substantive change requires hard work to increase sales, cut costs, or reduce capital requirements. There are very few, if any, legal and ethical shortcuts making significant improvements in the stream of future cash flows.

Unfortunately, managers at some companies have taken illegal and unethical actions to make estimated future cash flows appear better than truly warranted, which can drive the market stock price up above its intrinsic value. For example, the former CEO and CFO at ArthroCare Corporation were convicted in 2014 for a fraud that involved artificially inflating revenues via undisclosed special deals with their products’ distributors. The misleading financial reports caused ArthroCare’s stock price to be much higher than its fundamental value. By the time the scheme was brought to light, shareholders had lost $750 million. The perpetrators are being punished, but that doesn’t restore shareholders’ lost value or the company’s tarnished reputation.

Most illegal or unethical schemes are difficult to completely hide from all other employees. But an employee who believes a company is not adhering to a law or regulation might be hesitant to report it for fear of being fired or otherwise punished by the company. To help address this problem, federal and state governments have created a variety of whistleblower protection programs corresponding to different types of corporate misdeeds.

With respect to financial misdeeds, the Sarbanes-Oxley (SOX) Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened protection for whistleblowers who report financial wrongdoing. Under SOX, employees who report corporate financial wrongdoing and subsequently are penalized by the com- pany can ask the Occupational Safety and Health Administration (OSHA) to investigate the situation. If the employee was improperly penalized, the company can be required to reinstate the person, along with back pay and a sizable penalty award. In addition, SOX made it a criminal act for a CEO or CFO to knowingly falsely certify a company’s financial position.

Have these provisions in SOX been successful? The number of SOX-related employee complaints filed each year with OSHA has been falling and is now around 150 per year. Only about one-third of the complaints are deemed worthy of pursuit by OSHA, and the vast majority of these remaining cases are settled out of court. It is hard to determine whether the drop in complaints is due to better corporate behavior or discouraged potential tipsters who have not seen large rewards for whistleblowing. In addition, no executives have been jailed for falsely certifying financial statements, even though a significant number of executives have lost their jobs due to their companies’ financial misreporting.

The Dodd-Frank Act’s establishment of the SEC Office of the Whistleblower has led to dozens of announced awards for reporting wrongdoing by financial firms. These awards can be very large because they are based on a percentage of the amount that the SEC fines the wrongdoing corporation. For example, one whistleblower received a $30 million award in 2014.

Although not a substitute for high individual moral standards, it appears that large and visible rewards to whistleblowers help ethical employees rein in actions being considered by less ethical employees. This leads to less financial misreporting, which in turn helps keep market prices in line with intrinsic value.

w w w For current information from OSHA, see www .osha.gov/index.html and select Data & Statistics.

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S E L F - T E S T

What is an agency problem? What is corporate governance?

What is the fiduciary duty (i.e., the primary goal) for most U.S. corporations?

How does a benefit corporation’s charter differ from that of a typical U.S. corporation?

Explain how individuals, customers, and employees can benefit when a company seeks to maximize its intrinsic value.

What is a whistleblower?

Compare the Sarbanes-Oxley (SOX) Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 with respect to their impact on whistleblowing.

1-5 An Overview of Financial Markets At the risk of oversimplification, we can classify providers and users of cash into four groups: individuals, financial organizations (like banks and insurance companies), non- financial organizations (like Apple, Starbucks, and Ford), and governments. Because providers defer spending money today in the hope of spending more money later, we call them savers. Because users receive cash now with plans to repay in the future, we call them borrowers (even though the cash might be in the form of newly issued stock rather than debt).

Who are the providers of cash? How does the cash get from providers to users? What are the claims that providers receive from users? We answer these questions in the rest of this section and in following sections.

1-5a The Net Providers and Users of Capital In spite of William Shakespeare’s advice, most individuals and firms are both borrowers and lenders. For example, an individual might borrow money with a car loan or a home mortgage but might also lend money through a bank savings account. In the aggregate, however, individuals are net savers and provide most of the funds ultimately used by nonfinancial corporations. In fact, individuals provide a net amount of about $66 trillion to users.

Although most nonfinancial corporations own some financial securities, such as short-term Treasury bills, nonfinancial corporations are net borrowers in the aggregate.

Taxes and Whistleblowing

The Internal Revenue Service (IRS) has a program to reward whistleblowers for information leading to the recovery of unpaid taxes, and sometimes the rewards are huge. The largest reward was $104 million to Bradley C. Birkenfeld, who discov- ered schemes that UBS, a large Swiss bank, was using to help its clients avoid U.S. taxes. UBS settled with the U.S. Depart- ment of Justice in 2009 by paying $780 million in fines and providing account information for over 4,000 U.S. clients to the IRS. This caused thousands of additional U.S. tax payers to fear similar exposure and to enter an IRS amnesty program, leading to over $5 billion in collections of unpaid taxes.

Despite the record-setting payout, Birkenfield and the U.S. government do not have an amicable relationship. The government alleged that Birkenfield learned about the UBS tax evasion schemes while using them to shelter one of his own clients from taxes. Birkenfield refused to divulge information about this client during the investigation, so the United States convicted him of fraud. Birkenfield served 30 months in a medium-security federal prison but still received the $104 million reward.

How much is freedom worth? About $115,000 per day, based on Birkenfield’s reward and prison time served.

w w w For current information, see the Federal Reserve Bank of St. Louis’s FRED® Economic Data. Take the total financial assets of households (and nonprofit organizations serving households), found at http://research .stlouisfed.org/fred2/ series/HNOTFAQ027S. Then subtract the financial liabilities, found at http://research .stlouisfed.org/fred2/ series/HNOTOLQ027S.

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In the United States, federal, state, and local governments are also net borrowers in the aggregate, although many foreign governments, such as those of China and oil-producing countries, are actually net lenders.

Banks and other financial corporations raise money with one hand and invest it with the other. For example, a bank might raise money from individuals in the form of a savings account and then lend most of that money to business customers. In the aggregate, financial corporations are net borrowers by a slight amount.

1-5b Getting Cash from Providers to Users: The Capital Allocation Process

Financial corporations evaluate investment opportunities, connect providers to users, and facilitate the actual exchange of cash for claims on future cash. Because this cash is used for investment purposes, it is called “capital.” Transfers of capital from savers to users take place in three different ways. Direct transfers of money and securities, as shown in Panel 1 of Figure 1-2, occur when a business (or government) sells its securities directly to savers. The business delivers its securities to savers, who in turn provide the firm with the money it needs. For example, a privately held company might sell shares of stock directly to a new shareholder, or the U.S. government might sell a Treasury bond directly to an individual investor.

As shown in Panel 2, indirect transfers may go through an investment bank, which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. Because new securities are involved and the corpora- tion receives the proceeds of the sale, this is a “primary” market transaction.

Transfers also can be made through a financial intermediary such as a bank or mutual fund, as shown in Panel 3. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to purchase and then hold

FIGURE 1-2 Diagram of the Capital Allocation Process

1. Direct Transfers

2. Indirect Transfers through an Investment Bank

3. Indirect Transfers through a Financial Intermediary

Business’s Securities

Dollars

Investment Bank

Financial Intermediary

Business’s Securities

Dollars

Business’s Securities

Dollars

Business’s Securities

Dollars

Intermediary’s Securities

Dollars

Business

Business

Business

Savers

Savers

Savers

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businesses’ securities. For example, a saver might give dollars to a bank and receive a certificate of deposit, and then the bank might lend the money to a small business, receiving in exchange a signed loan. Thus, intermediaries literally create new types of securities.

There are three important features of the capital allocation process. First, new financial securities are created. Second, different types of financial institutions often act as intermediaries between providers and users. Third, the activities occur in a variety of financial markets. The following sections describe each of these topics, beginning with financial securities.

S E L F - T E S T

What are the four major groups of providers and users? For each group, state whether it is a net provider or a net user.

Identify three ways that capital is transferred between savers and borrowers.

Distinguish between the roles played by investment banks and financial intermediaries in exchanging cash now for claims on future cash.

1-6 Claims on Future Cash Flows: Types of Financial Securities

Any claim on a future cash flow is called a financial instrument. Providers exchange cash for a financial instrument only if they expect an acceptable rate of return. We begin with an overview of financial instruments and then discuss expected returns.

1-6a Type of Claim on Future Cash Flows: Debt, Equity, or Derivatives

A financial security is a claim that is standardized and regulated by the government (although the legal definition is a bit longer). The variety of financial securities is limited only by human creativity, ingenuity, and governmental regulations. At the risk of over- simplification, we can classify most financial securities by the type of claim and the time until maturity.

DEBT Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Debt instruments typically have specified payments and a specified maturity. For example, an Alcoa bond might promise to pay 10% interest for 30 years, at which time it promises to make a $1,000 principal payment.

If debt matures in more than a year, it is called a capital market security. Thus, the Alcoa bond in this example is a capital market security. If the debt matures in less than a year, it is a money market security. For example, Google might expect to receive $200,000 in 75 days, but it needs cash now. Google might issue commercial paper, which is essentially an IOU. In this example, Google might agree to pay $200,000 in 75 days in exchange for $199,200 today. Thus, commercial paper is a money market security.

EQUITY Equity instruments are a claim upon a residual value. For example, Alcoa’s stockholders are entitled to the cash flows generated by Alcoa after its bondholders, creditors, and other claimants have been satisfied. Because stock has no maturity date, it is a capital market security.

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DERIVATIVES Notice that debt and equity represent claims upon the cash flows generated by real assets, such as the cash flows generated by Alcoa’s factories and operations. In contrast, deriva- tives are securities whose values depend on, or are derived from, the values of some other traded assets. For example, options and futures are two important types of derivatives, and their values depend on the prices of other assets. An option on Alcoa stock or a futures contract to buy wheat are examples of derivatives. We discuss options in Chapter 8 and in Web Extension 1A, which provides a brief overview of options and other derivatives.

HYBRIDS Some securities are a mix of debt, equity, and derivatives. For example, preferred stock has some features like debt and some like equity, while convertible debt has both debt-like and option-like features. We discuss these in subsequent chapters.

Table 1-1 provides a summary of the major types of financial instrument, including risk and original maturity.

1-6b Type of Claim on Future Cash Flows: Securitized Financial Assets

Some securities are created from packages of other financial assets, a process called securitization. The misuse of securitized assets is one of the primary causes of the most recent global financial crisis, so every manager needs to understand the process of securitization.

THE PROCESS OF SECURITIZATION The details vary for different financial assets (which are expected to generate future cash flows), but the processes are similar. For example, a bank might loan money to an individual for a car purchase. The individual signs a loan contract, which entitles the contract’s owner to receive future payments from the borrower. The bank can put a large number of these individual contracts into a portfolio (called a pool) and transfer the pool into a trust (a separate legal entity). The trust then creates new financial instruments that pay out a prescribed set of cash flows from the pool. The trust registers these new securities and sells them. The bank receives the proceeds from the sale, and the purchasers receive a new financial security that has a claim on the cash flows generated by the pool of auto loan.

Consider the benefits. First, because the bank received cash when it sold the securitized car loans, the bank now has replenished its supply of lendable funds and can make additional loans. Second, the bank no longer bears risk of the borrowers defaulting. Instead, the securities’ purchasers chose to bear that risk in expectation of justifiable returns. Third, the purchaser of a security has greater liquidity than the bank had when it owned the loan contract, because there is an active secondary market for the securities.

Almost any class of financial assets can be securitized, including car loans, student loans, credit card debt, and home mortgages. Because securitization began with home mortgages and played such an important role in the recent global financial crisis, we explain it in more detail.

MORTGAGE-BACKED SECURITIES At one time, most mortgages were made by savings and loan associations (S&Ls), which took in the vast majority of their deposits from individuals who lived in nearby neighbor- hoods. The S&Ls pooled these deposits and then lent money to people in the neighborhood

r e s o u r c e For an overview of derivatives, see Web Extension 1A on the textbook’s Web site.

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in the form of fixed-rate mortgages, which were pieces of paper signed by borrowers promising to make specified payments to the S&L. The new homeowners paid principal and interest to the S&L, which then paid interest to its depositors and reinvested the

TABLE 1-1 Summary of Major Financial Instruments

Instrument Major Participants Risk Original Maturity Rates of Return on

1/23/2015a

U.S. Treasury bills Sold by U.S. Treasury Default-free 91 days to 1 year 0.02%

Bankers’ acceptances A firm’s promise to pay, guaranteed by a bank

Low if strong bank guarantees

Up to 180 days 0.23%

Commercial paper Issued by financially secure firms to large investors

Low default risk Up to 270 days 0.12%

Negotiable certificates of deposit (CDs)

Issued by major banks to large investors

Depends on strength of issuer

Up to 1 year 0.21%

Money market mutual funds

Invest in short-term debt; held by individuals and businesses

Low degree of risk No specific maturity (instant liquidity)

0.08%

Eurodollar market time deposits

Issued by banks outside the United States

Depends on strength of issuer

Up to 1 year 0.37%

Consumer credit loans

Loans by banks/credit unions/finance companies

Risk is variable Variable Variable

Commercial loans Loans by banks to corporations

Depends on borrower Up to 7 years Tied to prime rate (3.25%) or LIBOR

(0.35)b

U.S. Treasury notes and bonds

Issued by U.S. government No default risk, but price falls if interest rates rise

2 to 30 years 1.81%

Mortgages Loans secured by property Risk is variable Up to 30 years 3.63%

Municipal bonds Issued by state and local governments to individuals and institutions

Riskier than U.S. government bonds, but exempt from most taxes

Up to 30 years 3.36%

Corporate bonds Issued by corporations to individuals and institutions

Riskier than U.S. government debt; depends on strength of issuer

Up to 40 years (although a few go up to 100 years)

4.41%

Leases Similar to debt; firms lease assets rather than borrow and then buy them

Risk similar to corporate bonds

Generally 3 to 20 years

Similar to corporate bonds

Preferred stocks Issued by corporations to individuals and institutions

Riskier than corporate bonds

Unlimited 6% to 9%

Common stocksc Issued by corporations to individuals and institutions

Riskier than preferred stocks

Unlimited 9% to 15%

Notes: a Data are from the Federal Reserve Statistical Release (www.federalreserve.gov/releases/H15/update), the Federal Reserve Bank of St. Louis’s FRED®

Economic Data web site at https://research.stlouisfed.org/fred2/, or the Market Data Center from The Wall Street Journal (online.wsj.com). b The prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another. c Common stocks are expected to provide a “return” in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, your

actual return may be considerably higher or lower than your expected return.

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principal repayments in other mortgages. This was clearly better than having individuals lend directly to aspiring homeowners, because a single individual might not have enough money to finance an entire house or the expertise to know if the borrower was cred- itworthy.

Note that S&L assets consisted mainly of long-term, fixed-rate mortgages, but their liabilities were in the form of deposits that could be withdrawn immediately. The combination of long-term assets and short-term liabilities created a problem. If the overall level of interest rates increased, the S&Ls would have to increase the rates they paid on deposits or else savers would take their money elsewhere. However, the S&Ls couldn’t increase the rates on their outstanding mortgages because these mortgages had fixed interest rates, which meant they couldn’t increase the rates they paid on their deposits very much. This problem came to a head in the 1960s, when the Vietnam War led to inflation, which pushed up interest rates. At this point, the “money market fund” industry was born, and it literally sucked money out of the S&Ls, forcing many of them into bankruptcy.

This problem of long-term mortgages financed by short-term and unreliable deposits could be resolved if there were some way for the S&Ls and other mortgage lenders like banks to sell the mortgages to investors who wanted a long-term investment and lend out the resulting money again. The outcome was “mortgage securitization,” a process whereby banks, S&Ls, and specialized mortgage-originating firms would originate mortgages and then sell them to investment banks, which would bundle them into packages and then use these packages as collateral for bonds that could be sold to pension funds, insurance companies, and other institutional investors. Thus, individual mortgages were bundled and then used to back a bond—a “security”—that could be traded in the financial markets.

Congress facilitated this process by creating two stockholder-owned but government- sponsored entities, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae and Freddie Mac were financed by issuing a relatively small amount of stock and a huge amount of debt.

To illustrate the securitization process, suppose an S&L or bank is paying its deposi- tors 5% but is charging its borrowers 8% on their mortgages. The S&L can take hundreds of these mortgages, put them in a pool, and then sell the pool to Fannie Mae. The borrowers can still make their payments to the original S&L, which will then forward the payments (less a small handling fee) to Fannie Mae.

Consider the S&L’s perspective. First, it can use the cash it receives from selling the mortgages to make additional loans to other aspiring homeowners. Second, the S&L is no longer exposed to the risk of owning mortgages. The risk hasn’t disappeared—it has been transferred from the S&L (and its federal deposit insurers) to Fannie Mae. This is clearly a better situation for aspiring homeowners and, perhaps, also for taxpayers.

Fannie Mae can take the mortgages it just bought, put them into a very large pool, and sell bonds backed by the pool to investors. The homeowner will pay the S&L, the S&L will forward the payment to Fannie Mae, and Fannie Mae will use the funds to pay interest on the bonds it issued, to pay dividends on its stock, and to buy additional mortgages from S&Ls, which can then make additional loans to aspiring homeowners. Notice that the mortgage risk has been shifted from Fannie Mae to the investors who now own the mortgage-backed bonds.

How does the situation look from the perspective of the investors who own the bonds? In theory, they own a share in a large pool of mortgages from all over the country, so a problem in a particular region’s real estate market or job market won’t affect the whole pool. Therefore, their expected rate of return should be very close to the 8% rate paid by the home-owning borrowers. (It will be a little less due to handling fees charged by the S&L and Fannie Mae and to the small amount of expected losses from the homeowners

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who could be expected to default on their mortgages.) These investors could have deposited their money at an S&L and earned a virtually risk-free 5%. Instead, they chose to accept more risk in hopes of the higher 8% return. Note, too, that mortgage-backed bonds are more liquid than individual mortgage loans, so the securitization process increases liquidity, which is desirable. The bottom line is that risk has been reduced by the pooling process and then allocated to those who are willing to accept it in return for a higher rate of return.

Thus, in theory it is a win–win–win situation: More money is available for aspiring homeowners, S&Ls (and taxpayers) have less risk, and there are opportunities for inves- tors who are willing to take on more risk to obtain higher potential returns.

Mortgage securitization was a win–win situation in theory, but as practiced in the 2000s, it turned into a lose–lose situation. We will have more to say about securitization and the last great recession of 2007 later in this chapter, but first let’s take a look at the cost of money.

S E L F - T E S T

What is a financial instrument? What is a financial security?

What are some differences among the following types of securities: debt, equity, and derivatives?

Describe the process of securitization as applied to home mortgages.

1-7 Claims on Future Cash Flows: The Required Rate of Return (The Cost of Money)

Providers of cash expect more cash back in the future than they originally supply to users. In other words, providers expect a positive rate of return on their investment. We call this a required rate of return because a prospect of more money in the future is required to induce an investor to give up money today. Keep in mind that a rate of return from an investor’s viewpoint is a cost from that of a user. For debt, we call this cost the interest rate. For equity, we call it the cost of equity, which consists of the dividends and capital gains stockholders expect. Therefore, the required rate of return is also called the cost of money or the price of money.

Notice in Table 1-1 that a financial instrument’s rate of return generally increases as its maturity and risk increase. We will have much more to say about the relationships among an individual security’s features, risk, and required rate of return later in the book, but first we will examine some fundamental factors and economic conditions that affect all financial instruments.

1-7a Fundamental Factors That Affect the Required Rate of Return (The Cost of Money)

The four most fundamental factors affecting the supply and demand of capital and the resulting cost of money are (1) production opportunities, (2) time preferences for con- sumption, (3) risk, and (4) inflation.

PRODUCTION OPPORTUNITIES Production opportunities are activities that require cash now but have the potential to generate cash in the future. For example, a company might sell stock to build a new factory or a student might borrow to attend college. In both cases, there are prospects of

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future cash flows: The company might increase sales and the new graduate might get a high-paying job. Notice that the size and likelihood of the future cash flows put an upper limit on the amount that can be repaid. All else held equal, improvements in production opportunities will increase this upper limit and create more demand for cash now, which will lead to higher interest rates and required returns.

TIME PREFERENCE FOR CONSUMPTION Providers can use their current funds for consumption or saving. By saving, they choose not to consume now, expecting to consume more in the future. If providers strongly prefer consumption now, then it takes high interest rates to induce them to trade current consumption for future consumption. Therefore, the time preference for consumption has a major impact on the cost of money. Notice that the time preference for consumption varies for different individuals, for different age groups, and for different cultures. For example, people in Japan have a lower time preference for consumption than those in the United States, which partially explains why Japanese families tend to save more than U.S. families even though interest rates are lower in Japan.

RISK If an opportunity’s future cash flows are very uncertain and might be much lower than expected, providers require a higher expected return to induce them to take the extra risk.

EXPECTED INFLATION Expected inflation also leads to a higher interest rates and required returns. For example, suppose you earned 10% one year on your investment but inflation caused prices to increase by 20%. This means you can’t consume as much at the end of the year as when you originally invested your money. Obviously, if you had expected 20% inflation, you would have required a much higher rate of return.

1-7b Economic Conditions and Policies That Affect the Required Rate of Return (The Cost of Money)

Economic conditions and policies also affect the required rates of return. These include: (1) Federal Reserve policy, (2) the federal budget deficit or surplus, (3) the level of business activity, and (4) international factors.

FEDERAL RESERVE POLICY If the Federal Reserve Board wants to stimulate the economy, it most often uses open market operations to purchase Treasury securities held by banks. Because banks are selling some of their securities, the banks will have more cash, which increases their supply of loanable funds, which in turn makes banks willing to lend more money at lower interest rates. In addition, the Fed’s purchases represent an increase in the demand for Treasury securities. As with anything for sale, increased demand causes Treasury securities’ prices to go up and interest rates to go down. The net result is a reduction in interest rates, which stimulates the economy by making it less costly for companies to borrow for new projects or for individuals to borrow for major purchases or other expenditures.

Unfortunately, there is a downside to stimulation from the Fed. When banks sell their holdings of Treasury securities to the Fed, the banks’ reserves go up, which increases the money supply. A larger money supply ultimately leads to an increase in expected inflation,

w w w The home page for the Board of Governors of the Federal Reserve System can be found at www.federalreserve .gov. You can access general information about the Federal Reserve, including press releases, speeches, and monetary policy.

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which eventually pushes interest rates up. Thus, the Fed can stimulate the economy in the short term by driving down interest rates and increasing the money supply, but this creates longer-term inflationary pressures. This was exactly the dilemma facing the Fed in early 2015.

On the other hand, if the Fed wishes to slow down the economy and reduce inflation, the Fed reverses the process. Instead of purchasing Treasury securities, the Fed sells Treasury securities to banks, which reduces banking reserves and causes an increase in short-term interest rates but a decrease in long-term inflationary pressures.

FEDERAL BUDGET DEFICITS OR SURPLUSES If the federal government spends more than it takes in from tax revenues, then it runs a deficit, and that deficit must be covered either by borrowing or by printing money (increasing the money supply). The government borrows by issuing new Treasury secu- rities. All else held equal, this creates a greater supply of Treasury securities, which leads to lower security prices and higher interest rates. Federal government actions that increase the money supply also increase expectations for future inflation, which drives up interest rates. Thus, the larger the federal deficit, other things held constant, the higher the level of interest rates. As shown in Figure 1-3, the federal government has run deficits in 18 of the past 22 years. Annual deficits in the mid-1990s were in the $250 billion range, but they ballooned to well over a trillion dollars in the past recession and are now about $500 billion. These huge deficits have contributed to the cumulative federal debt, which in early 2015 stood at more than $18 trillion.

FIGURE 1-3 Federal Budget Surplus/Deficits and Trade Balances (Billions of Dollars)

–1,600

–1,400

–1,200

–1,000

–800

–600

–400

–200

0

200

400

19 93

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

20 10

20 11

20 12

20 13

20 14

Surplus or Deficit

Federal Budget

Surplus/Deficit

Trade Balance

Sources: The raw data are from the Federal Reserve Bank of St. Louis’s FRED® Economic Data: http://research.stlouisfed .org/fred2/series/FYFSD and http://research.stlouisfed.org/fred2/series/BOPGSTB?cid=125.

w w w For today’s cumulative total federal debt (the total public debt), check out the Current Daily Treasury Statement at www.fms.treas.gov/ dts/index.html.

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LEVEL OF BUSINESS ACTIVITY Figure 1-4 shows interest rates, inflation, and recessions. First, notice that interest rates and inflation are presently (early 2015) very low relative to the past 40 years. However, you should never assume that the future always will be like the recent past!

Second, notice that interest rates and inflation typically rise prior to a recession and fall afterward. There are several reasons for this pattern. Consumer demand slows during a recession, keeping companies from increasing prices, which reduces price inflation. Companies also cut back on hiring, which reduces wage inflation. Less disposable income causes consumers to reduce their purchases of homes and automobiles, reducing con- sumer demand for loans. Companies reduce investments in new operations, which reduces their demand for funds. The cumulative effect is downward pressure on inflation and interest rates. The Federal Reserve is also active during recessions, trying to stimulate the economy by driving down interest rates.

FOREIGN TRADE BALANCE: DEFICITS OR SURPLUSES Businesses and individuals in the United States buy from and sell to people and firms in other countries. The foreign trade balance describes the level of imports relative to exports. If we buy more than we sell (that is, if we import more than we export), we are said to be running a foreign trade deficit. When trade deficits occur, they must be

FIGURE 1-4 Business Activity, Interest Rates, and Inflation

–2

0

2

4

6

8

10

12

14

16

19 73

19 75

19 77

19 79

19 81

19 83

19 85

19 87

19 89

19 91

19 93

19 95

19 97

19 99

20 01

20 03

20 05

20 07

20 09

20 11

20 13

20 15

Interest Rate (%)

Inflation

Recession

Interest Rates

Notes: 1. Tick marks represent January 1 of the year.

2. The shaded areas designate business recessions as defined by the National Bureau of Economic Research; see www.nber.org/cycles.

3. Interest rates are for AAA corporate bonds; see the Federal Reserve Bank of St. Louis’s FRED® Economic Data at http://research.stlouisfed .org/fred. These rates reflect the average rate during the month ending on the date shown.

4. Inflation is measured by the annual rate of change for the Consumer Price Index (CPI) for the preceding 12 months; see http://research .stlouisfed.org/fred.

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financed, and the main source of financing is debt. In other words, if we import $200 billion of goods but export only $90 billion, we run a trade deficit of $110 billion, and we will probably borrow the $110 billion.5 Therefore, the larger our trade deficit, the more we must borrow, and the increased borrowing drives up interest rates. Also, international investors are only willing to hold U.S. debt if the risk-adjusted rate paid on this debt is competitive with interest rates in other countries. Therefore, if the Federal Reserve attempts to lower interest rates in the United States, causing our rates to fall below rates abroad (after adjustments for expected changes in the exchange rate), then international investors will sell U.S. bonds, which will depress bond prices and result in higher U.S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it will hinder the Fed’s ability to reduce interest rates and combat a recession.

The United States has been running annual trade deficits since the mid-1970s; see Figure 1-3 for recent years. The cumulative effect of trade deficits and budget deficits is that the United States has become the largest debtor nation of all time. As noted earlier, this federal debt exceeds $18 trillion! As a result, our interest rates are influenced by interest rates in other countries around the world.

International risk factors may increase the cost of money that is invested abroad. These include international changes in tax rates, regulations, currency conversion laws, and currency exchange rates. Foreign investments also include the risk that property will be expropriated by the host government. We discuss these issues in Chapter 17.

Recall that financial markets connect providers and users: Providers supply cash now in exchange for claims on risky future cash. Our discussion has focused on the claims and their required returns, but now we turn our attention to the different ways in which cash is exchanged for claims, beginning with the roles played by financial institutions.

S E L F - T E S T

What is a “required rate of return”? Why is it called the “cost of money” or the “price of money”?

What is debt’s cost of money called?

What two components make up the cost of money for equity?

What four fundamental factors affect required rates of return (i.e., the cost of money)?

How does Federal Reserve policy affect interest rates now and in the future?

What is a federal budget deficit or surplus? How does this affect interest rates?

What is a foreign trade deficit or surplus? How does this affect interest rates?

1-8 The Functions of Financial Institutions Direct transfers of funds from individuals to businesses are relatively uncommon in developed economies. Instead, businesses usually find it more efficient to enlist the services of one or more financial institutions to raise capital. Most financial institutions don’t compete in a single line of business but instead provide a wide variety of services and products, both domestically and globally. The following sections describe the major types of financial institutions and services, but keep in mind that the dividing lines among them are often blurred.

5The deficit could also be financed by selling assets, including gold, corporate stocks, entire companies, and real estate. The United States has financed its massive trade deficits through all of these means in recent years, but the primary method has been by borrowing from foreigners.

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1-8a Investment Banks and Brokerage Activities Investment banks help companies raise capital. Such organizations underwrite security offerings, which means they (1) advise corporations regarding the design and pricing of new securities, (2) buy these securities from the issuing corporation, and (3) resell them to investors. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facilitator to help transfer capital from savers to businesses. An investment bank often is a division or subsidiary of a larger company. For example, JPMorgan Chase & Co. is a very large financial services firm, with over $2.4 trillion in managed assets. One of its holdings is J.P. Morgan, an investment bank.

In addition to security offerings, investment banks also provide consulting and advisory services, such as merger and acquisition (M&A) analysis and investment man- agement for wealthy individuals.

Most investment banks also provide brokerage services for institutions and individuals (called “retail” customers). For example, Merrill Lynch (acquired in 2008 by Bank of America) has a large retail brokerage operation that provides advice and executes trades for its individual clients. Similarly, J.P. Morgan helps execute trades for institutional customers, such as pension funds.

At one time, most investment banks were partnerships, with income generated primarily by fees from their underwriting, M&A consulting, asset management, and brokering activities. When business was good, investment banks generated high fees and paid big bonuses to their partners. When times were tough, investment banks paid no bonuses and often fired employees. In the 1990s, however, most large investment banks were reorganized into publicly traded corporations (or were acquired and then operated as subsidiaries of public companies). For example, in 1994 Lehman Brothers sold some of its own shares of stock to the public via an IPO. Like most corporations, Lehman Brothers was financed by a combination of equity and debt.

A relaxation of regulations in the 2000s allowed investment banks to undertake much riskier activities than at any time since the Great Depression. The new regulations allowed investment banks to use an unprecedented amount of debt to finance their activities— Lehman used roughly $30 of debt for every dollar of equity. In addition to their fee- generating activities, most investment banks also began trading securities for their own accounts. In other words, they took the borrowed money and invested it in financial securities. If you are earning 12% on your investments while paying 8% on your borrowings, then the more money you borrow, the more profit you make. But if you are leveraged 30 to 1 and your investments decline in value by even 3.33%, your business will fail. This is exactly what happened to Bear Stearns, Lehman Brothers, and Merrill Lynch in the fall of 2008. In short, they borrowed money, used it to make risky investments, and then failed when the investments turned out to be worth less than the amount they owed. Note that it was not their traditional investment banking activities that caused the failure, but the fact that they borrowed so much and used those funds to speculate in the market.

1-8b Deposit-Taking Financial Intermediaries Some financial institutions take deposits from savers and then lend most of the deposited money to borrowers. Following is a brief description of such intermediaries.

SAVINGS AND LOAN ASSOCIATIONS (S&LS) As we explained previously, S&Ls originally accepted deposits from many small savers and then loaned this money to home buyers and consumers. Later, they were allowed to

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make riskier investments, such as investing in real estate development. Mutual savings banks (MSBs) are similar to S&Ls, but they operate primarily in the northeastern states. Today, most S&Ls and MSBs have been acquired by banks.

CREDIT UNIONS Credit unions are cooperative associations whose members have a common bond, such as being employees of the same firm or living in the same geographic area. Members’ savings are loaned only to other members, generally for auto purchases, home-improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers.

COMMERCIAL BANKS Commercial banks raise funds from depositors and by issuing stock and bonds to investors. For example, someone might deposit money in a checking account. In return, that person can write checks, use a debit card, and even receive interest on the deposits. Those who buy the banks’ stocks and bonds expect to receive dividends and interest payments. Unlike nonfinancial corporations, most commercial banks are highly leveraged in the sense that they owe much more to their depositors and creditors than they raised from stockholders. For example, a typical bank has about $90 of debt for every $10 of stockholders’ equity. If the bank’s assets are worth $100, we can calculate its equity capital by subtracting the $90 of liabilities from the $100 of assets: Equity capital $100 − $90 $10. But if the assets drop in value by 5% to $95, the equity drops to $5 $95 − $90, a 50% decline.

Banks are vitally important for a well-functioning economy, and their highly leveraged positions make them risky. As a result, banks are more highly regulated than nonfinancial firms. Given the high risk, banks might have a hard time attracting and retaining deposits unless the deposits were insured, so the Federal Deposit Insurance Corporation (FDIC), which is backed by the U.S. government, insures up to $250,000 per depositor. As a result of the great recession of 2007, this insured amount was increased from $100,000 in 2008 to reassure depositors.

Without such insurance, if depositors believed that a bank was in trouble, they would rush to withdraw funds. This is called a “bank run,” which is exactly what happened in the United States during the Great Depression, causing many bank failures and leading to the creation of the FDIC in an effort to prevent future bank runs. Not all countries have their own versions of the FDIC, so international bank runs are still possible. In fact, a bank run occurred in September 2008 at the U.K. bank Northern Rock, leading to its nationaliza- tion by the government.

Most banks are small and locally owned, but the largest banks are parts of giant financial services firms. For example, JPMorgan Chase Bank, commonly called Chase Bank, is owned by JPMorgan Chase & Co., and Citibank is owned by Citicorp.

1-8c Investment Funds At some financial institutions, savers have an ownership interest in a pool of funds rather than owning a deposit account. Examples include mutual funds, hedge funds, and private equity funds.

MUTUAL FUNDS Mutual funds are corporations that accept money from savers and then use these funds to buy financial instruments. These organizations pool funds, which allows them to reduce risks by diversification and achieve economies of scale in analyzing securities, managing portfolios, and buying/selling securities. Different funds are designed to meet the

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objectives of different types of savers. Hence, there are bond funds for those who desire safety and stock funds for savers who are willing to accept risks in the hope of higher returns. There are literally thousands of different mutual funds with dozens of different goals and purposes. Some funds are actively managed, with their managers trying to find undervalued securities, while other funds are passively managed and simply try to minimize expenses by matching the returns on a particular market index.

Money market funds invest in short-term, low-risk securities, such as Treasury bills and commercial paper. Many of these funds offer interest-bearing checking accounts with rates that are greater than those offered by banks, so many people invest in money market funds as an alternative to depositing money in a bank. Note, though, that money market funds are not required to be insured and so are riskier than bank deposits.6

Most traditional mutual funds allow investors to redeem their share of the fund only at the close of business. A special type of mutual fund, the exchange-traded fund (ETF), allows investors to sell their share at any time during normal trading hours. ETFs usually have very low management expenses and are rapidly gaining in popularity.

HEDGE FUNDS Hedge funds raise money from investors and engage in a variety of investment activities. Unlike typical mutual funds, which can have thousands of investors, hedge funds are limited to institutional investors and a relatively small number of high–net-worth indivi- duals. Because these investors are supposed to be sophisticated, hedge funds are much less regulated than mutual funds. The first hedge funds literally tried to hedge their bets by forming portfolios of conventional securities and derivatives in such a way as to limit their potential losses without sacrificing too much of their potential gains. Many hedge funds had spectacular rates of return during the 1990s. This success attracted more investors, and thousands of new hedge funds were created. Much of the low-hanging fruit had already been picked, however, so the hedge funds began pursuing much riskier (and unhedged) strategies, including the use of high leverage in unhedged positions. Perhaps not surprisingly (at least in retrospect), some funds have produced spectacular losses. For example, many hedge fund investors suffered huge losses in 2007 and 2008 when large numbers of sub-prime mortgages defaulted.

PRIVATE EQUITY FUNDS Private equity funds are similar to hedge funds in that they are limited to a relatively small number of large investors. They differ in that they own stock (equity) in other companies and often control those companies, whereas hedge funds usually own many different types of securities. In contrast to a mutual fund, which might own a small percentage of a publicly traded company’s stock, a private equity fund typically owns virtually all of a company’s stock. Because the company’s stock is not traded in the public markets, it is called “private equity.” In fact, private equity funds often take a public company (or subsidiary) and turn it private, such as the 2007 privatization of Chrysler by Cerberus. (Fiat is now the majority owner.) The general partners who manage private equity funds usually sit on the companies’ boards and guide their strategies with the goal of later selling the companies for a profit. For example, The Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch Global Private Equity bought Hertz from Ford on December 22, 2005, and then sold shares of Hertz in an IPO less than a year later.

6The U.S. Treasury sold deposit insurance to eligible money market funds between September 2008 and September 2009 to help stabilize the markets during the height of the financial crisis.

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Many private equity funds experienced high rates of return in the last decade, and those returns attracted enormous sums from investors. A few funds, most notably The Blackstone Group, actually went public themselves through an IPO. Just as with hedge funds, the performance of many private equity funds faltered during the great recession. For example, shortly after its IPO in June 2007, Blackstone’s stock price was over $31 per share. By early 2009, however, it had fallen to about $4 and it’s now (early 2015) up around $34.

1-8d Life Insurance Companies and Pension Funds Life insurance companies take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and then make payments to beneficiaries. Life insurance companies also offer a variety of tax-deferred savings plans designed to provide retirement benefits.

Traditional pension funds are retirement plans funded by corporations or govern- ment agencies. Pension funds invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate. Most companies now offer self-directed retirement plans, such as 401(k) plans, as an addition to or substitute for traditional pension plans. In traditional plans, the plan administrators determine how to invest the funds; in self- directed plans, all individual participants must decide how to invest their own funds. Many companies are switching from traditional plans to self-directed plans, partly because this shifts the risk from the company to the employee.

1-8e Regulation of Financial Institutions In 1933, the Glass-Steagall Act was passed with the intent of preventing another great depression. In addition to creating the FDIC to insure bank deposits, the law imposed constraints on banking activities and separated investment banking from commercial banking. The regulatory environment of the post-Depression era included a prohibition on nationwide branch banking, restrictions on the types of assets the institutions could buy, ceilings on the interest rates they could pay, and limitations on the types of services they could provide. Arguing that these regulations impeded the free flow of capital and hurt the efficiency of our capital markets, policymakers took several steps from the 1970s to the 1990s to deregulate financial services companies, culminating with the Gramm– Leach–Bliley Act of 1999, which “repealed” Glass-Steagall’s separation of commercial and investment banking.

One result of deregulation was the creation of huge financial services corporations, which own commercial banks, S&Ls, mortgage companies, investment-banking houses, insurance companies, pension plan operations, and mutual funds. Many are now global banks with branches and operations across the country and around the world.

For example, Citigroup combined one of the world’s largest commercial banks (Citibank), a huge insurance company (Travelers), and a major investment bank (Smith Barney), along with numerous other subsidiaries that operate throughout the world. Bank of America also made numerous acquisitions of many different financial companies, including Merrill Lynch, with its large brokerage and investment banking operations, and mortgage giant Countrywide Financial.

These conglomerate structures are similar to those of major institutions in China, Europe, Japan, and elsewhere around the globe. Though U.S. banks grew dramatically as a result of recent mergers, they are still relatively small by global standards. The world’s largest bank is the Industrial and Commercial Bank of China. Among the world’s ten largest world banks, based upon total assets, only one (JPMorgan Chase) is headquartered in the United States.

w w w For current bank rankings, go to Global Finance Magazine’s Web site,www.gfmag.com, and use the search for “biggest global banks.”

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The financial crisis of 2008–2009 and the continuing global economic weakness are causing regulators and financial institutions to rethink the wisdom of deregulating con- glomerate financial services corporations. To address some of these concerns, the Dodd- Frank Wall Street Reform and Consumer Protection Act was passed in 2010. We discuss Dodd-Frank and other regulatory changes in Section 1-11, where we explain the events leading up to the great recession of 2007.

S E L F - T E S T

What were the traditional roles of investment banks prior to the 1990s? What types of activities did investment banks add after that?

Describe the different types of deposit-taking institutions.

What are some similarities and differences among mutual funds, hedge funds, and private equity funds?

Describe a life insurance company’s basic activities.

What are traditional pension funds? What are 401(k) plans?

1-9 Financial Markets Financial markets serve to connect providers of funds with users for the purpose of exchanging cash now for claims on future cash (e.g., securities such as stocks or bonds). In addition, they provide a means for trading securities after they have been issued. We describe different types of markets and trading procedures in the following sections.

1-9a Types of Financial Markets There are many different ways to classify financial markets, depending upon the types of instruments, customer, or geographic locations. You should recognize the big differences among types of markets, but keep in mind that the distinctions are often blurred.

PHYSICAL ASSETS VERSUS FINANCIAL ASSETS Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, derivatives, and other financial instruments.

TIME OF DELIVERY: SPOT VERSUS FUTURE Spot markets are markets where assets are being bought or sold for “on-the-spot” delivery (literally, within a few days). Futures markets are for assets whose delivery is at some future date, such as 6 months or a year into the future.

MATURITY OF FINANCIAL ASSET: SHORT VERSUS LONG Money markets are the markets for short-term, highly liquid debt securities, while capital markets are the markets for corporate stocks and debt maturing more than a year in the future. The New York Stock Exchange is an example of a capital market. When describing debt markets, “short term” generally means less than 1 year, “intermediate term” means 1 to 5 years, and “long term” means more than 5 years.

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PURPOSE OF LOANS TO INDIVIDUALS: LONG-TERM ASSET PURCHASES VERSUS SHORTER-TERM SPENDING Mortgage markets deal with loans on residential, agricultural, commercial, and industrial real estate, while consumer credit markets involve loans for autos, appliances, education, vacations, and so on.

PRIVATE VERSUS PUBLIC Private markets are where transactions are worked out directly between two parties. For example, bank loans and private placements of debt with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner that appeals to the two parties.

Public markets are where standardized contracts are traded on organized exchanges. Because securities that are traded in public markets (for example, common stock and futures contracts) are ultimately held by a large number of individuals, they must have fairly standardized contractual features. Private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization.

GEOGRAPHIC EXTENT World, national, regional, and local markets also exist. Thus, depending on an organiza- tion’s size and scope of operations, it may be able to borrow or lend all around the world, or it may be confined to a strictly local, even neighborhood, market.

PRIMARY MARKETS VERSUS SECONDARY MARKETS Primary markets are the markets in which corporations raise new capital. For example, if a private company has an IPO or if a public company sells a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from such a transaction.

Secondary markets are markets in which existing, already-outstanding securities are traded among investors. Thus, if you decided to buy 1,000 shares of Starbucks stock, the purchase would occur in the secondary market. Secondary markets exist for many financial securities, including stock and bonds.

It is important to remember that the company whose securities are being traded is not involved in a secondary market transaction and, thus, does not receive any funds from such a sale. However, secondary markets are vital for a well-functioning economy because they provide liquidity and foster entrepreneurship.

1-9b Why Are Secondary Markets Important? Secondary markets provide liquidity for investors who need cash or who wish to reallocate their investments to potentially more productive opportunities. For example, a parent who owns stock might wish to help pay for a child’s college education. Or consider an investor who owns stock in a coal-mining company but who wishes to invest in a manufacturer of solar panels. Without active secondary markets, investors would be stuck with the securities they purchase.

Secondary markets also foster entrepreneurship. For example, it might take a very long time before an entrepreneur can use a start-up company’s cash flow for personal spending because the cash flow is needed to support the company’s growth. In other words, the company might be successful, but the entrepreneur feels “cash poor.” However, if the company goes public, its stock can be traded in the secondary market. The

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entrepreneur then can sell some personal shares of stock and begin to enjoy the financial rewards of having started a successful company. Without this prospect, entrepreneurs have diminished incentives to start companies.

Secondary markets also provide a measure of value as perceived by buyers and sellers, making it easy to quickly compare different investments.

1-9c Trading Procedures in the Secondary Markets A trading venue is a site (geographical or electronic) where secondary market trading occurs. Although there are many trading venues for a wide variety of securities, we classify their trading procedures along two dimensions: location and method of matching orders.

PHYSICAL LOCATION VERSUS ELECTRONIC NETWORK In a physical location exchange traders actually meet and trade in a specific part of a specific building. For example, the New York Stock Exchange and the London Metal Exchange conduct some trading at physical locations.7

In contrast, traders do not physically meet in a computer/telephone network. For example, the markets for U.S. Treasury bonds and foreign exchange primarily operate via telephone and/or computer networks. Most stock markets, including the NASDAQ Stock Market, do not have face-to-face trading.

MATCHING ORDERS: OPEN OUTCRY AUCTIONS, DEALER MARKETS, AND AUTOMATED TRADING PLATFORMS The second dimension is the way orders from sellers and buyers are matched. This can occur in a face-to-face open outcry auction, through dealers, or by automated matching engines.

Open Outcry Auctions An open outcry auction occurs when traders actually meet face- to-face and communicate with one another through shouts and hand signals. When a seller and buyer agree on the price and quantity, the transaction is finalized and reported to the organization that manages the auction.

Dealer Markets and Market Makers In a dealer market, there are “market makers” who keep an inventory of the stock (or other financial instrument) in much the same way that any merchant keeps an inventory of goods. These dealers list bid quotes and ask quotes, which are the prices at which they are willing to buy or sell. In a traditional dealer market, computerized quotation systems keep track of all bid and ask quotes, but they don’t actually match buyers and sellers. Instead, traders must contact a specific dealer to complete the transaction.

Automated Trading Platforms with Automated Matching Engines An automated matching engine is part of a computer system in which buyers and sellers post their orders and then let the computer automatically determine whether a match exists. If a match exists, the computer automatically executes and reports the trade. The entire system is called an automated trading platform.

For example, suppose Trader B (B is for buyer) places an order to buy 500 shares of GE, but only if the sale occurs within the next hour and at a price of no more $24.99 per share.

7This may change by the time you read this. The London Metals exchange decided in 2014 not to close its face- to-face trading operation even though it is the only one in Europe still trading in this manner. Also, rumors were swirling in early 2015 that the NYSE was going to sell its trading floor and become fully automated.

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The $24.99 is the bid price because the buyer is “bidding” $24.99 for a share of GE. The order itself is a limit order because the buyer specifies limits with respect to the order’s price and duration. The computer will put the information into its order book, which is a record of all outstanding orders. Suppose all other bid prices in the order book are less than $24.99. When the computer ranks bids in the order book from high to low, Trader B’s $24.99 bid will be at the top of the book. In other words, it is the highest bid price of any orders in the book, which is the most anyone currently is willing to pay for GE.

Now suppose Trader S (S is for seller) places a limit order to sell 500 shares of GE at a price of at least $25.15. The $25.15 is the ask price because the seller is asking for $25.15 per share. Let’s suppose that all other ask prices in the computer’s order book are greater than $25.15. When the computer ranks ask prices from low to high, Trader S’s $25.15 ask price will be at the top of the book because it is the lowest ask price of any orders in the book. In other words, it is the lowest at which anyone is willing sell GE.

In this situation, the computer won’t find a match—all sellers want at least $25.15 but no buyers will pay more than $24.99. No transactions will occur until sellers reduce their ask prices or buyers increase their bids. The difference between the ask price and the bid price is called the bid-ask spread. In this example, it is:

Bid-ask spread Ask price − Bid price $25 15 − $24 99 $0 16

The order book is updated each time a new order arrives or a limit order expires. New orders arrive frequently, and many times there will be a match.

For example, suppose Trader S worries that prices will fall and would rather sell at $24.99 than wait and hope that prices will come up to the original ask price of $25.15. In this case, Trader S would send in an order to sell at the market price—this is called a market order because it asks to transact at the current market price. In this case, the computer would automatically match Trader S and Trader B, execute the trade of 500 shares of GE at $24.99, and notify both participants that the trade has occurred.8

Automated trading systems are rapidly replacing face-to-face trading in the secondary stock markets, as we describe in the next section.

S E L F - T E S T

What is the basic function of a financial market?

Distinguish between (1) physical asset markets and financial asset markets, (2) spot and futures markets, (3) money and capital markets, (4) mortgage and consumer credit markets, (5) private and public markets, and (6) primary and secondary markets.

List three reasons why secondary markets are important.

What is a trading venue?

What are the major differences between physical location exchanges and computer/telephone networks?

What are the differences among open outcry auctions, dealer markets, and automated trading platforms with automated matching engines?

What is a limit order? What is an order book? What is a market order?

8There are many more order types than just limit orders and market orders. The NYSE lists 30 order types. NASDAQ lists 17 types with 11 different time-in-force options.

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1-10 Overview of the U.S. Stock Markets Because stock markets are so large and important, all managers should have a basic under- standing of what the stock markets are and how they function. Before 1970, there was just one major U.S. stock exchange, the NYSE, where the vast majority of stocks were listed and traded. Today, however, the situation is much more fragmented both for listing and trading.

Recall that a publicly traded company first registers with the SEC, applies to be listed at a stock exchange, and then has an IPO, after which its stock can be traded in public markets. A company can list its stock only at a single SEC-registered stock exchange. In early 2015, there were about a dozen active registered exchanges for trading stock, but most stocks were listed on just three—the NYSE, the NASDAQ Stock Market (NASDAQ), and the NYSE MKT (formerly called the American Stock Exchange).9 As Table 1-2 shows, these three exchanges have almost 6,000 listings with a total value of around $34 trillion. NASDAQ has the most listings, but the NYSE’s listings have a much bigger market value.

Does it matter where a stock is listed? It certainly did before 2000, when the vast majority of a stock’s secondary market trading occurred where it was listed. The two primary trading venues, the NYSE and NASDAQ, had very different trading procedures: NYSE trading took place face-to-face at a physical location (on Wall Street) and NASDAQ trading was a dealer market with a computerized quotation system. The two exchanges also had very different reputations: Only relatively large companies could list at the NYSE, but smaller companies (many of them high-tech) could list at NASDAQ.

The situation today is very different. Although listings are still concentrated at the NYSE and NASDAQ, a company’s shares can and do trade at many different venues. In fact, less than 11% of the total dollar volume of trading now takes place at the NYSE and less than 19% is through NASDAQ. In addition, very little stock trading is conducted face-to-face, but is instead executed with automated trading platforms, even at the NYSE.

S E L F - T E S T

Which exchange has the most listed stocks? Which exchange’s listed stocks have the greatest market value?

Are shares of a company’s stocks only traded on the exchange where the stock is listed?

TABLE 1-2 Stock Exchange Listings and Total Market Value

Exchange Number of Listings Market Value of Listings (Trillions)

NYSE 2,593 $25.8

NASDAQ 2,827 8.1

NYSE MKT 369 0.2

5,789 $34.1

Source: The data for individual companies are from the NASDAQ Company List and are summarized in this table. See www.nasdaq.com/screening/company-list.aspx.

9NASDAQ originally stood for the National Association of Securities Dealers (NASD) Automated Quotation system. However, the NASD became part of the Financial Industry Regulatory Authority (FINRA) and is no longer affiliated with the automated quotation system even though it is still named NASDAQ.

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1-11 Trading in the Modern Stock Markets10 The NYSE and NASDAQ no longer dominate stock market trading. This section explains how modern stock markets operate.

1-11a Reg NMS: Stock Transactions, Quotes, and the “Market Price”

If an exchange-listed stock is bought or sold at any trading venue, the transaction price and volume (i.e., the number of shares traded) must be reported to the consolidated tape system, which is a computer network.11 The most recent trade often is called “the market price.” Several free sources, including CNBC, report the most recent transaction price. In addition to reporting transactions, registered stock exchanges must also report certain information about limit order bid and ask quotes to a consolidated quote system, as we explain next.

We streamlined the previous example of an automated matching engine by showing quoted limit orders from only one order book. However, there is an order book for each stock at each exchange, and each order book might have different bid and ask prices. To help investors make informed decisions, the SEC adopted Regulation National Market System (Reg NMS) in 2005 and implemented it in 2007. Among its provisions, Reg NMS requires all registered stock exchanges to report their best (highest) bid price and best (lowest) ask price for each stock in their order books. After collecting this information from all the exchanges, a computer system identifies and reports the overall best bid and best ask. These best overall quotes are called the National Best Bid and Offer (NBBO), which is the overall best (highest) bid price and best (lowest) ask price (the price at which an investor offers to sell stock). In other words, the NBBO represents the best prices at which an investor could buy or sell on any of the exchanges.

If an investor places a market order to buy or sell at the market price, Reg NMS’s “order protection rule” requires trading venues to execute the trade at a price that is at least as good as the NBBO quotes. For example, suppose the NBBO quotes for Apple are a bid price of $99.98 and an ask (offer) price of $100.02. If an investor places a market order to sell shares of Apple, the investor must receive at least $99.98, the national best bid price. Or if an investor places a market order to buy Apple stock, the investor must pay no more than $100.02, the national best ask price. As this example illustrates, the NBBO quotes help determine the “market” price in a market order.

What if the investor wants to buy 500 shares of Apple at the market price but the NBBO ask price of $100.02 is for only 100 shares? In this case, 100 shares might be transacted at the current NBBO price of $100.02, after which the computer systems will announce a new NBBO price, which might be for 100 shares at $100.07. The process would be repeated until the market order to buy 500 shares is completed.

Notice that the average price paid by the buyer might be higher than the original NBBO ask price if there were not enough shares offered for sale at the original NBBO ask price. Therefore, the NBBO is supposed to reflect market conditions, but it might not be very representative of the actual market supply and demand if the number of shares in the NBBO quote is very small. We will have more to say about this when we explain high- frequency trading, but let’s first take a look at where stock is traded.

10The material in this section is relatively technical and some instructors may choose to skip with no loss of continuity. 11No tape is involved in the modern consolidated tape system, but the name comes from days in which trades were reported on a thin paper tape that spewed out of a ticker-tape machine.

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1-11b Where Is Stock Traded? As we mentioned previously, almost all trading occurred on the floor of the NYSE before 1970. Even as recently as 2005, almost 80% of trading in NYSE-listed stocks took place at the NYSE, primarily on the trading floor itself.12 However, the markets today are very different, with trading taking place at dozens of different venues. Before tackling the different ways that trades are completed, let’s take a look at how a trade begins.

HOW A STOCK TRADE BEGINS Buyers and sellers must have brokerage accounts through which they place orders. These accounts can be with human stockbrokers (Merrill Lynch has over 15,000 brokers) or with computer systems (such as online trading accounts with TD Ameritrade). Either way, investors must pay to have their orders placed, executed, and recorded.

An investor chooses whether or not to place an order, but unless the investor specifies differently, the broker chooses where to send the order. This is called “order routing” and it determines the trading venue. There are three types of trading venues, each differing with respect to the degree of SEC regulation and reporting requirements: (1) standard broker- dealer networks, (2) alternative trading systems, and (3) registered stock exchanges.

Because an investor initiates a trade by placing an order with a broker, we begin by describing broker-dealer networks.

STANDARD BROKER-DEALER NETWORKS A broker-dealer is a broker that also is registered so that it can buy and sell for itself when it acts as a market maker. Broker-dealers and individual brokers must also follow state and industry licensing and registration requirements.

When broker-dealers execute trades among themselves, it is called an off-exchange transaction because the trades are not executed at a registered stock exchange. Many years ago, brokers actually would pass physical shares of stock over a counter to a buyer, in much the same way that a fast-food employee now hands a bag of burgers to a customer. Although counters are no longer involved, broker-dealer trades are still called over-the- counter (OTC) trades.13

About 20% of all stock market trading (based on dollar values) now takes place in broker-dealer networks, as shown in Table 1-3. Broker-dealer networks are less regulated than registered stock exchanges. For example, broker-dealers must report transactions (the price and number of shares), but are not required to report any information about limit orders that have not yet been filled.

Following is a description of how trading works in a broker-dealer network.

Trading in a Standard Broker-Dealer Network Suppose a broker-dealer receives a market order (buy or sell a certain number of shares in a particular company’s stock at the market price) from one of its clients, from an independent broker, or from another broker- dealer. In many cases, a broker-dealer will attempt to fill the order in-house without sending it to a stock exchange. For example, Morgan Stanley & Co. LLC is a registered broker-dealer

12See page 6 in the SEC’s Concept Release on Equity Market Structure at www.sec.gov/rules/concept/2010/ 34-61358.pdf. 13Today the actual certificates for almost all listed stocks and bonds in the United States are stored in a vault, beneath Manhattan, that is operated by the Depository Trust and Clearing Corporation (DTCC). Most brokerage firms have an account with the DTCC, and most investors leave their stocks with their brokers. Thus, when stocks are sold, the DTCC simply adjusts the accounts of the brokerage firms that are involved, and no stock certificates are actually moved.

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and sometimes facilitates trades for its clients by matching a sell order from one client with a buy order from another client. If no in-house match between clients is available with respect to the company or number of shares, a broker-dealer might act as a dealer and fill the order by selling from or buying for its own inventory. Alternatively, the original broker- dealer might send the order to a “wholesale” broker-dealer who will combine orders from many other brokers-dealers and look for a match.

For example, suppose a broker-dealer has a market order to buy 100 shares of Apple and a market order to sell 100 shares of Apple. Suppose also that the NBBO shows a best bid price of $99.98 and an ask price of $100.02. Reg NMS requires that a client’s order to sell Apple must be transacted at a price of at least $99.98, the national best bid price.

TABLE 1-3 Stock Trading Venues and Trading Activity

Owner of Trading Venue Trading Venue Percentage of Dollar Volumea

BATS Global Markets BATS BYX 2.9%

BATS Global Markets BATS BZX 8.3%

BATS Global Markets EDGA 2.5%

BATS Global Markets EDGX 6.4%

Total BATS: 20.1%

NASDAQ OMX NASDAQ 18.7%

NASDAQ OMX NASDAQ BXb 2.5%

NASDAQ OMX NASDAQ PSXc 0.6%

Total NASDAQ OMX: 21.8%

Intercontinental Exchange NYSE 10.7%

Intercontinental Exchange NYSE Arcad 13.1%

Intercontinental Exchange NYSE MKTe 0.1%

Total Intercontinental Exchange: 23.9%

Chicago Stock Exchange CHX 0.7%

Others Ceased operations during 2014 0.2%

Total trading on all exchanges: 66.7%

Dark Pools (ATS) Over 40 active pools 13.1%

Broker-Dealer Networks Over 250f

Retail trades ≈ 7.7%

Institutional trades ≈ 12.5%

Total Broker-Dealer Trades: 20.2%

Total trading off-exchanges: 33.3%

Notes: a The raw data use to construct the percentages of dollar volumes traded at the exchanges are from BATS Global

Markets at www.batstrading.com/market_data/market_volume_history. The percentages for off-exchange trad- ing are based on the proportions of off-exchange trading for ATSs and non-ATS shown in an SEC report by Laura Tuttle, which can be found at www.sec.gov/marketstructure/research/otc_trading_march_2014.pdf.

b This was formerly the Boston Stock Exchange. c This was formerly the Philadelphia Stock Exchange. d This was formerly the Archipelago electronic communications network. e This was formerly the American Stock Exchange. f About half the trades are executed by only seven broker-dealers.

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Reg NMS also requires that the order to buy cannot be transacted at more than $100.02, the NBBO ask price, as shown here:

NBBO bid $99 98 ≤ Transaction price ≤ $100 02 NBBO ask

The broker-dealer can satisfy Reg NMS, provide better prices to clients, and still profit from the transaction. For example, the broker-dealer can buy 100 shares from the selling client at $99.99, which is better than the NBBO bid of $99.98. The selling client actually gets a higher price than the NBBO bid price.

The broker-dealer can then sell the just-purchased 100 shares to the buying client at $100.01, which is better than the NBBO ask price of $100.02. Therefore, the buying client gets to purchase shares at a lower price than the NBBO ask price. This process is called price improvement because the clients get better deals than the posted NBBO quotes would indicate.

What about the broker dealer’s cash flows? The broker-dealer pays $99.99 per share and then immediately sells for $100.01, pocketing the difference of 2 cents per share: $100 01 − $99 99 $0 02. This spread is the broker-dealer’s compensation for executing the trades.14

This process is called internalization because the broker-dealer is actually the coun- terparty for both clients: The broker-dealer buys from one client and sells to the other. Over 200 broker-dealers participate in this network, but only a handful of wholesale broker-dealers actually execute the trades. Some experts estimate that broker-dealers internalize over 90% of all market orders but send almost all limit orders to trading venues outside their own networks.15

Retail and Institutional Clients in a Broker-Dealer Network Broker-dealers facilitate trading by individual investors (often called “retail trading”) and by institutional investors, such as pension funds. Institutions often trade larger quantities of stock than retail clients, which can create a problem.

For example, suppose a pension fund places an order to sell 10,000 shares of Google (this is called a “block trade” because the quantity is at least 10,000). A large order like this might create a big addition to the number of shares currently being offered for sale by others. This might create a temporary imbalance in supply and demand, causing the price to fall before the institution can sell all 10,000 shares. To avoid depressing the price, the institution might place many small orders rather than a single large order. Alternatively, the institution might engage the services of a broker-dealer to locate a large counterparty to buy the 10,000 shares. This counterparty might be another institution, or it might be another broker-dealer. In either case, this is called an “upstairs” trade even though no stairs are involved.16

14Some broker-dealers actually pay other brokers or dealers for routing orders their way, which is called “payment for order flow.” Dealers do this because the profits from the spread are greater than the payments for flow. Also, the example showed the broker-dealer transacting in prices based on dollars and cents. NBBO quotes must be shown in penny increments, but dealers can actually conduct these transactions using prices that are in increments smaller than pennies as long as the total transaction value (i.e., price multiplied by number of shares) ends up with whole pennies. For example, 1,000 shares could be transacted at $12.00001 because the total value is $12,000 01 1,000 $12 00001 . This means that the client’s price improvement relative to the NBBO can be quite small. 15See a report by the Chartered Financial Analysts Institute, “Dark Pools, Internalization, and Equity Market Quality,” which can be accessed at www.cfapubs.org/doi/pdf/10.2469/ccb.v2012.n5.1. 16The name came from a time when most trading was on the floor of the NYSE. Block trades were not on the “floor,” so they were called “upstairs” trades.

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Although broker-dealers must publicly report price and number of shares for each transaction, they do not have to report the names of the traders, making it impossible to identify exactly how much trading is due to retail clients versus institutions. However, large trades of more than 500 shares comprise about 30% of all dealer-broker trades, and block trades of at least 10,000 shares comprise about 3%.17 These figures suggest that institutional investors are very active in the upstairs market provided by broker-dealers.

ALTERNATIVE TRADING SYSTEMS (ATS): DARK POOLS Recall that internalization in a standard broker-dealer network means that the broker- dealer is a counterparty in all trades—the broker-dealer buys stock from selling clients and sells the stock to buying clients. However, some broker-dealers also provide a different trading venue in which the broker-dealer is no longer a counterparty in all trades. Instead, buyers can trade directly with sellers. This is called an alternative trading system (ATS).

Broker-dealers must register an ATS with the SEC, which imposes more regulatory requirements than it does for standard broker-dealer networks but fewer than for regis- tered stock exchanges. It is costly for the broker-dealer to provide the infrastructure for an ATS, which usually has an automated matching engine. Therefore, the broker-dealer charges a subscription fee, which entitles a subscriber to trade with other subscribers using the ATS’s infrastructure.

Like all trading venues, an ATS must comply with Reg NMS’s order protection rule and report completed transactions to the consolidated tape system. However, an ATS is not required to report quotes from its order book to the consolidated quote system.18 This means that pre-trade information (i.e., bid and ask prices) from an ATS is not available to the general public and is not included when the national best bid and offer (NBBO) prices are reported. Therefore, an ATS is commonly called a dark pool.

There are over 70 registered ATSs, but only 30 to 40 are active. Together, they account for about 13% of total stock market trading (based on dollar value), as shown in Table 1-3.

REGISTERED STOCK EXCHANGES U.S. stock exchanges must register with the SEC and are more regulated than alternative trading systems or dealer-broker networks. In particular, the SEC requires registered stock exchanges to operate in a way that promotes orderly trading and fair dissemination of information, including transactions (price and number of shares) and pre-trade information (i.e., selected quote data from their order books).

As shown in Table 1-2, the NYSE and NASDAQ have the most listed stocks and are probably the most well-known U.S. stock exchanges. Before 2001, neither exchange used automated trading platforms to execute a significant percent of their trading volumes— trading at the NYSE was face-to-face on the floor of the exchange while trading at NASDAQ was through market makers. In response to competition from new exchanges

17See two SEC reports by Laura Tuttle: “OTC Trading: Description of Non-ATS OTC Trading in National Market System Stocks,” March 2014, and “Alternative Trading Systems: Description of ATS Trading in National Market System Stocks,” October 2013. These reports can be accessed at www.sec.gov/divisions/riskfin/ whitepapers/alternative-trading-systems-10-2013.pdf and www.sec.gov/marketstructure/research/otc_trading _march_2014.pdf. 18Before 2005, the term “electronic communications network (ECN)” was commonly used to denote any automated trading platform. After Reg NMS was adopted, the definition of ECN was modified to mean an alternative trading system that used an automated trading platform and that publicly reported order book information in much the same way as registered stock exchange (i.e., reporting of order book quotes); see Reg NMS §242.600(b)(23) and §242.602(b)(5) at www.sec.gov/rules/final/34-51808.pdf. By 2015, all ECNs had been closed or converted into stock exchanges.

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with automated trading platforms, such as BATS Global Markets (BATS), both the NYSE and NASDAQ now execute the majority of their stock trades via automated trading platforms.

Competition has also fragmented trading. From 2005 to 2010, trading on the floor of the NYSE dropped from about 65% of all trading (based on dollar volume) to about 11%. Some of the reduction was due to cannibalization from affiliated exchanges (the NYSE Arca and NYSE MKT), but most was due to gains by other exchanges and by off-exchange trading in dark pools or through broker-dealer internalization.

Table 1-3 shows that about 33% of all trading (based on dollar values) takes place off- exchange, in the less regulated trading venues of dark pools and broker-dealer networks. The combination of technological advances and market fragmentation has led to a phenomenon called “high-frequency trading,” as we explain next.

1-11c High-Frequency Trading (HFT) Investors, broker-dealers, and high-frequency traders buy and sell stocks. Here are some differences among them.

Most investors purchase stock with the intent of owning it until they think it is no longer a good investment or until they need cash for some other purpose. Some investors, like Warren Buffett, buy and hold for decades. Others, like actively managed mutual funds, buy and hold for about a year, on average. Of course, some investors hold stock only for weeks or days at a time.

In contrast, many broker-dealers often hold stock for a very short period. Recall that when a broker-dealer internalizes orders, it buys stock from one investor and sells to another almost immediately at a higher price. The profit is the broker-dealer’s compensation for providing the infrastructure used by the investor to buy or sell shares.

High-frequency trading (HFT) is similar to broker-dealer internalization in that the HF trader buys stock and immediately sells it, profiting if the selling price is higher than the purchase price.19 Unlike broker-dealer networks, HFT does not provide any infra- structure or other direct service for the other buyers and sellers. Because the HFT trader is buying and selling many times a day (or even a second!), the process is called “high- frequency trading.” HFT requires expensive computer systems and highly paid program- mers, so most HFT is done by firms that are created for this purpose rather than by individual investors.

How does high-frequency trading work? HFT firms pay exchanges, like the NYSE, to let them place computers close to the exchanges’ computers, an activity called “co-location.” This reduces the time it takes for information about trading at the exchange to reach the HFT computers. HFT firms usually build or lease dedicated high-speed fiber- optic lines between their co-located computers at the different exchanges. Co-location and dedicated lines allow HFT firms to view information from one exchange, process it, and transmit it to another exchange in the blink of an eye. Actually, even a slow blinker can manage two or three blinks per second, whereas HFT computers can send and receive at least several hundred orders per second.

Recall that brokers send most limit orders to exchanges. If an order is large, there might not be a big enough buyer at a single exchange, so brokers often split large orders into smaller orders and send each one to a different exchange. For example, a broker might split an order to buy 600 shares of FedEx at $175 into 6 orders of 100 shares each.

19High-frequency trading occurs in many different types of financial markets, but this discussion focuses on the stock market.

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However, it might take longer for the order to reach one exchange than another. For example, it might take 1.5 milliseconds to reach the first exchange and 4.2 milliseconds to reach another exchange (there are 1,000 milliseconds in a second) due to slower electronic connections. A person would never notice such a short difference, but this is plenty of time for the HFT computers at the first exchange to observe the order. If the trading algorithm decides that the order is just part of several more to come, then the computer might send a faster order over its fiber-optic connections to the other exchange, arriving before the broker’s order.20 The HFT firm might be able to buy FedEx for $174.99 at the second exchange and then sell it for $175 when the broker’s order finally arrives.21 The net result is that the HFT firm pays $17,499 when it buys the 100 shares at $174.99 and receives $17,500 when it sells 100 shares at $175, for a net profit of $1.

This might look like a lot of effort for a small profit, which could even turn into a loss if the HFT algorithm isn’t correct. However, small profits add up if they occur frequently. HFT accounts for between 40% and 70% of total trading, netting HFT firms about $5 billion total in 2009 and about $1 billion in 2012.22

What is the net impact of HFT on financial markets? Let’s take a look at liquidity, trading costs, and market stability. The total dollar volume of trading has more than doubled since 2005, increasing market liquidity and allowing investors to trade more quickly.23 Much of this increase in volume is due to HFT. However, critics argue that the HFTs provide false liquidity because HFT disappears when markets are falling, which is exactly when the market most needs liquidity.

The average bid-ask spread has shrunk to pennies for many stocks, which reduces costs to investors (and profits to dealers). HFT firms claim this is partially due to their trading, while critics attribute shrinking spreads to more competition and non-HFT advances in technology.

Critics also believe that HFT can destabilize the stock market, pointing to the flash crash of 2010, with the market falling by 9% in a matter of seconds but recovering almost as quickly. The SEC and Commodity Futures Trading Commission concluded that HFT contributed to this disruption, but did not cause it. Critics also claim that HFT makes markets more volatile. Most academic studies show that HFT contributes to market volatility, but by a relatively small amount.

In summary, the empirical evidence does not clearly show that HFT is especially helpful or harmful to well-functioning markets. However, some HFT revenues, such as those from front running, are direct costs to investors. To put those profits into perspective, the total value of stock trades in 2014 was about $65 trillion.24 Therefore, HFT profits represent an extra 0.0015% “fee” to investors, assuming HFT profits in 2014 are close to the 2012 value of $1 billion. While HFT might “feel” unfair to non-HFT traders, there is no definitive evidence as to whether the costs of HFT exceed its possible benefits.

20This is just one example among many HFT strategies and computer algorithms. 21This is sometimes called “front running” because an order by the HFT gets in front of the order from the broker, even though the broker’s order was placed first (albeit at a different exchange). It is illegal for a broker to front run by placing a personal order before submitting a client’s order, but it is not illegal in HFT because the broker’s orders arrive at different exchanges at different times even though they were simultaneously submitted by the broker. 22See www.businessweek.com/articles/2014-04-01/what-michael-lewis-gets-wrong-about-high-frequency-trading. 23See “Select SEC and Market Data” at www.sec.gov/about/secreports.shtml. 24The raw data used to determine this value are from BATS Global Markets at www.batstrading.com/ market_data/market_volume_history.

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1-11d Stock Market Returns As investors trade, stock prices change. When demand is high (lots of bids at high prices and for large quantities), stock prices go up; when demand is low (bids are only at low prices), stock prices go down.

Figure 1-5 shows stock market levels and returns, as measured by the S&P 500 Index (see the box “Measuring the Market” for more on stock indexes). Panel A shows that the market was relatively flat in the 1970s, increased somewhat in the 1980s, and has been a roller coaster ever since. Panel B highlights the year-to-year risk by showing total annual returns. Stocks have had positive returns in most years, but there have been several years with very large losses.

FIGURE 1-5 S&P 500 Stock Index Performance

Panel A: End-of-Month Index Value

Panel B: Total Annual Returns: Dividend Yield + Capital Gain or Loss

0

500

1,000

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Percent

Sources: Returns after 2011 are based on the exchange traded fund SPY, which replicates total S&P 500 returns; previous data are from various issues of The Wall Street Journal; the index level is from finance.yahoo.com.

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S E L F - T E S T

Briefly describe the NBBO and the order protection rule. What regulation implemented them?

What does it mean to say that a trade was internalized at a broker-dealer?

What is an alternative trading system (ATS)? How does a trade at an ATS differ from an internalized trade at a broker-dealer?

How does the information that a registered stock exchange must display and report differ from that of an ATS? Why is an ATS often called a dark pool?

What percentage of stock trading is done off-exchange? On registered exchanges?

What is high-frequency trading? Describe a strategy through which a high-frequency trader makes a profit.

How is high-frequency trading similar to broker-dealer internalization? How is it different?

1-12 Finance and the Great Recession of 2007 Although the great recession of 2007 has many causes, mortgage securitization in the 2000s is certainly one culprit, so we begin with it.

1-12a The Globalization of Mortgage Market Securitization

A national TV program ran a documentary on the travails of Norwegian retirees resulting from defaults on Florida mortgages. Your first reaction might be to wonder how Norwe- gian retirees became financially involved with risky Florida mortgages. We will break the answer to that question into two parts. First, we will identify the different links in the financial chain between the retirees and mortgagees. Second, we will explain why there were so many weak links.

In the movie Jerry Maguire, Tom Cruise said, “Show me the money!” That’s a good way to start identifying the financial links, starting with a single home purchase in Florida.

Measuring the Market

A stock index is designed to show the performance of the stock market. Here we describe some leading indexes.

Dow Jones Industrial Average

Begun in 1896, the Dow Jones Industrial Average (DJIA) now includes 30 widely held stocks that represent almost one-fifth of the market value of all U.S. stocks. See www .dowjones.com for more information.

S&P 500 Index

Created in 1926, the S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stocks’ market performance. It is value-weighted, so the largest companies (in terms of value) have the greatest influence. The S&P 500

Index is used as a comparison benchmark by 97% of all U.S. money managers and pension plan sponsors. See www2 .standardandpoors.com for more information.

NASDAQ Composite Index

The NASDAQ Composite Index measures the performance of all common stocks listed on the NASDAQ Stock Market. Currently, it includes more than 3,200 companies, many of which are in the technology sector. Microsoft, Cisco Systems, and Intel account for a high percentage of the index’s value-weighted market capitalization. For this reason, substantial movements in the same direction by these three companies can move the entire index. See www.NASDAQ.com for more information.

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1. HOME PURCHASE In exchange for cash, a seller in Florida turned over ownership of a house to a buyer.

2. MORTGAGE ORIGINATION To get the cash used to purchase the house, the buyer signed a mortgage loan agreement and gave it to an “originator.” Years ago the originator would probably have been an S&L or a bank, but more recently the originators have been specialized mortgage brokers, as in this case. The broker gathered and examined the borrower’s credit information, arranged for an independent appraisal of the house’s value, handled the paperwork, and received a fee for these services.

3. SECURITIZATION AND RESECURITIZATION In exchange for cash, the originator sold the mortgage to a securitizing firm. For example, Merrill Lynch’s investment banking operation was a major player in securitizing loans. It would bundle large numbers of mortgages into pools and then create new securities that had claims on the pools’ cash flows. Some claims were simple, such as a proportional share of a pool; some were more complex, such as a claim on all interest payments during the first 5 years or a claim on only principal payments. More complicated claims were entitled to a fixed payment, while other claims would receive payments only after the “senior” claimants had been paid. These slices of the pool were called “tranches,” which comes from a French word for slice.

Some of the tranches were themselves recombined and then subdivided into securities called collateralized debt obligations (CDOs), some of which were themselves combined and subdivided into other securities, commonly called CDOs-squared. For example, Lehman Brothers often bought different tranches, split them into CDOs of differing risk, and then had the different CDOs rated by an agency like Moody’s or Standard & Poor’s.

There are three very important points to notice. First, the process didn’t change the total amount of risk embedded in the mortgages, but it did make it possible to create some securities that were less risky than average and some that were more risky. Second, the complexity of the CDOs spread a little bit of each mortgage’s risk to many different investors, making it difficult for investors to determine the aggregate risk of a particular CDO. Third, each time a new security was created or rated, fees were being earned by the investment banks and rating agencies.

NYSE Composite Index

The NYSE Composite Index measures the performance of common stocks listed on the NYSE. It is a value-weighted index and is based on about 2,000 stocks representing over 70% of the total market capitalization of all publicly traded companies in the United States. See www.nyse.com for more information.

Trading the Market

Through the use of exchange traded funds (ETFs), it is now possible to buy and sell the market in much the same way as an individual stock. For example, the Standard & Poor’s depository receipt (SPDR) is a share of a fund that holds the stocks of all the companies in the S&P 500. SPDRs trade during regular market hours, making it possible to buy or sell the S&P 500 any time during the day. There are hundreds of other ETFs,

including ones for the NASDAQ, the Dow Jones Industrial Average, gold stocks, utilities, and so on.

Recent Performance

Go to the Web site finance.yahoo.com. Enter the symbol for any of the indexes (^DJI for the Dow Jones, ^GSPC for the S&P 500, ^IXIC for the NASDAQ, and ^NYA for the NYSE) and then click GO. This will bring up the current value of the index, shown in a table. Click Basic Chart in the panel on the left, which will bring up a chart showing the historical performance of the index. Directly above the chart is a series of buttons that allows you to choose the number of years and to plot the relative performance of several indexes on the same chart. You can even download the historical data in spreadsheet form by clicking Historical Prices in the left panel.

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4. THE INVESTORS In exchange for cash, the securitizing firms sold the newly created securities to individual investors, hedge funds, college endowments, insurance companies, and other financial institutions, including a pension fund in Norway. Keep in mind that financial institutions are funded by individuals, so cash begins with individuals and flows through the system until it is eventually received by the seller of the home. If all goes according to plan, payments on the mortgages eventually return to the individuals who originally provided the cash. But in this case, the chain was broken by a wave of mortgage defaults, resulting in problems for Norwegian retirees.

Students and managers often ask, “What happened to all the money?” The short answer is, “It went from investors to home sellers, with fees being skimmed off all along the way.”

Although the process is complex, in theory there is nothing inherently wrong with it. In fact, it should, in theory, provide more funding for U.S. home purchasers, and it should allow risk to be shifted to those best able to bear it. Unfortunately, this isn’t the end of the story.

1-12b The Dark Side of Securitization: The Sub-Prime Mortgage Meltdown

What caused the financial crisis? Entire books have been written on this subject, but we can identify a few of the culprits.

REGULATORS APPROVED SUB-PRIME STANDARDS In the 1980s and early 1990s, regulations did not permit a non-qualifying mortgage to be securitized, so most originators mandated that borrowers meet certain requirements, including having at least a certain minimum level of income relative to the mortgage payments and a minimum down payment relative to the size of the mortgage. But in the mid-1990s, Washington politicians wanted to extend home ownership to groups that traditionally had difficulty obtaining mortgages. To accomplish this, regulations were relaxed so that non-qualifying mortgages could be securitized. Such loans are commonly called sub-prime or Alt-A mortgages. Thus, riskier mortgages were soon being securitized and sold to investors. Again, there was nothing inherently wrong, provided the two following questions were being answered in the affirmative: One, were home buyers making sound decisions regarding their ability to repay the loans? And two, did the ultimate investors recognize the additional risk? We now know that the answer to both questions is a resounding “no.” Homeowners were signing mortgages that they could not hope to repay, and investors treated these mortgages as if they were much safer than they actually were.

THE FED HELPED FUEL THE REAL ESTATE BUBBLE With more people able to get a mortgage, including people who should not have obtained one, the demand for homes increased. This alone would have driven up house prices. However, the Fed also slashed interest rates to historic lows after the terrorist attacks of 9/11 to prevent a recession, and it kept them low for a long time. These low rates made mortgage payments lower, which made home ownership seem even more affordable, again contributing to an increase in the demand for housing. Figure 1-6 shows that the combination of lower mortgage qualifications and lower interest rates caused house prices to skyrocket. Thus, the Fed contributed to an artificial bubble in real estate.

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HOME BUYERS WANTED MORE FOR LESS Even with low interest rates, how could sub-prime borrowers afford the mortgage payments, especially with house prices rising? First, most sub-prime borrowers chose an adjustable rate mortgage (ARM) with an interest rate based on a short-term rate, such as that on 1-year Treasury bonds, to which the lender added a couple of percentage points. Because the Fed had pushed short-term rates so low, the initial rates on ARMs were very low.

With a traditional fixed-rate mortgage, the payments remain fixed over time. But with an ARM, an increase in market interest rates triggers higher monthly payments, so an ARM is riskier than a fixed-rate mortgage. However, many borrowers chose an even riskier mortgage, the “option ARM,” where the borrower can choose to make such low payments during the first couple of years that they don’t even cover the interest, causing the loan balance to actually increase each month! At a later date, the payments would be reset to reflect both the current market interest rate and the higher loan balance. For example, in some cases a monthly payment of $948 for the first 32 months was reset to $2,454 for the remaining 328 months. (We provide the calculations for this example in Chapter 4 in the box “An Accident Waiting to Happen: Option Reset Adjustable Mortgages.”)

Why would anyone who couldn’t afford to make a $2,454 monthly payment choose an option ARM? Here are three possible reasons. First, some borrowers simply didn’t understand the situation and were victims of predatory lending practices by brokers eager to earn fees regardless of the consequences. Second, some borrowers thought that the home price would go up enough to allow them to sell at a profit or else refinance with

FIGURE 1-6 The Real Estate Boom: Housing Prices and Mortgage Rates

Real Estate Index

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Real Estate Index

Mortgage Rate

Notes: 1. The real estate index is the Case-Shiller composite index for house prices in 10 real estate markets, not

seasonally adjusted, available at the Federal Reserve Bank of St. Louis’s FRED® Economic Data: http://research.stlouisfed.org/fred2/series/SPCS10RSA.

2. Interest rates are for 30-year conventional fixed-rate mortgages: http://research.stlouisfed.org/fred2/ series/MORTG/downloaddata?cid=114.

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another low-payment loan. Third, some people were simply greedy and shortsighted, and they wanted to live in a better home than they could afford.

MORTGAGE BROKERS DIDN’T CARE Years ago, S&Ls and banks had a vested interest in the mortgages they originated because they held them for the life of the loan—up to 30 years. If a mortgage went bad, the bank or S&L would lose money, so they were careful to verify that the borrower would be able to repay the loan. In the bubble years, though, over 80% of mortgages were arranged by independent mortgage brokers who received a commission. Thus, the broker’s incentive was to complete deals even if the borrowers couldn’t make the payments after the soon- to-come reset. So it’s easy to understand (but not to approve!) why brokers pushed deals onto borrowers who were almost certain to default eventually.

REAL ESTATE APPRAISERS WERE LAX The relaxed regulations didn’t require the mortgage broker to verify the borrower’s income, so these loans were called “liar loans” because the borrowers could overstate their income. But even in these cases the broker had to get an appraisal showing that the house’s value was greater than the loan amount. Many real estate appraisers simply assumed that house prices would keep going up, so they were willing to appraise houses at unrealistically high values. Like the mortgage brokers, they were paid at the time of their service. Other than damage to their reputations, they weren’t concerned if the borrower later defaulted and the value of the house turned out to be less than the remaining loan balance, causing a loss for the lender.

ORIGINATORS AND SECURITIZERS WANTED QUANTITY, NOT QUALITY Originating institutions like Countrywide Financial and New Century Mortgage made money when they sold the mortgages, long before any of the mortgages defaulted. The same is true for securitizing firms such as Bear Stearns, Merrill Lynch, and Lehman Brothers. Their incentives were to generate volume through originating loans, not to ensure that the loans were safe investments. This started at the top—CEOs and other top executives received stock options and bonuses based on their firms’ profits, and profits depended on volume. Thus, the top officers pushed their subordinates to generate volume, those subordinates pushed the originators to write more mortgages, and the originators pushed the appraisers to come up with high values.

RATING AGENCIES WERE LAX Investors who purchased the complicated mortgage-backed securities wanted to know how risky they were, so they insisted on seeing the bonds’ “ratings.” The securitizing firms paid rating agencies to investigate the details of each bond and to assign a rating that reflected the security’s risk. For example, Lehman Brothers hired Moody’s to rate some of its CDOs. Indeed, the investment banks would actually pay for advice from the rating agencies as they were designing the securities. The rating and consulting activities were extremely lucrative for the agencies, which ignored the obvious conflict of interest: The investment bank wanted a high rating, the rating agency got paid to help design securities that would qualify for a high rating, and high ratings led to continued business for the raters.

INSURANCE WASN’T INSURANCE To provide a higher rating and make these mortgage-backed securities look even more attractive to investors, the issuers would frequently purchase a type of insurance policy on the security called a credit default swap. For example, suppose you had wanted to

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purchase a CDO from Lehman Brothers but worried about the risk. What if Lehman Brothers had agreed to pay an annual fee to an insurance company such as AIG, which would guarantee the CDO’s payments if the underlying mortgages defaulted? You prob- ably would have felt confident enough to buy the CDO.

But any similarity to a conventional insurance policy ends here. Unlike home insur- ance, where there is a single policyholder and a single insurer, totally uninvolved spec- ulators can also make bets on your CDO by either selling or purchasing credit default swaps on the CDO. For example, a hedge fund could buy a credit default swap on your CDO if it thinks the CDO will default; or an investment bank like Bear Stearns could sell a swap, betting that the CDO won’t default. In fact, the International Swaps and Derivatives Association estimates that in mid-2008 there was about $54 trillion in credit default swaps. This staggering amount was approximately 7 times the value of all U.S. mortgages, was over 4 times the level of the U.S. national debt, and was over twice the value of the entire U.S. stock market.

Another big difference is that home insurance companies are highly regulated, but there was virtually no regulation in the credit default swap market. The players traded directly among themselves, with no central clearinghouse. It was almost impossible to tell how much risk any of the players had taken on, making it impossible to know whether or not counterparties like AIG would be able to fulfill their obligations in the event of a CDO default. And that made it impossible to know the value of CDOs held by many banks, which in turn made it impossible to judge whether or not those banks were de facto bankrupt.

ROCKET SCIENTISTS HAD POOR REARVIEW MIRRORS AND RISK MANAGERS DROVE BLIND Financial engineers are brilliant experts, often trained in physics and hired from rocket science firms, who build elegant models to determine the value of a new security. Unfortunately, a model is only as good as its inputs. The experts looked at the high growth rates of recent real estate prices (see Figure 1-6) and assumed that future growth rates also would be high. These high growth rates caused models to calculate very high CDO prices. Perhaps more surprisingly, many risk managers simply did not insist on seeing scenarios in which housing prices fell.

INVESTORS WANTED MORE FOR LESS In the early 2000s, low-rated debt (including mortgage-backed securities), hedge funds, and private equity funds produced great rates of return. Many investors jumped into this debt to keep up with the Joneses. As shown in Chapter 5 when we discuss bond ratings and bond spreads, investors began lowering the premium they required for taking on extra risk. Thus, investors focused primarily on returns and largely ignored risk. In fairness, some investors assumed the credit ratings were accurate, and they trusted the representatives of the investment banks selling the securities. In retrospect, however, Warren Buffett’s maxim “I only invest in companies I understand” seems wiser than ever.

THE EMPEROR HAS NO CLOTHES In 2006, many of the option ARMs began to reset, borrowers began to default, and home prices first leveled off and then began to fall. Things got worse in 2007 and 2008, and by early 2009, almost 1 out of 10 mortgages was in default or foreclosure, resulting in displaced families and virtual ghost towns of new subdivisions. As homeowners defaulted on their mortgages, so did the CDOs backed by the mortgages. That brought down the counterparties like AIG, who had insured the CDOs via credit default swaps. Virtually

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overnight, investors realized that mortgage-backed security default rates were headed higher and that the houses used as collateral were worth less than the mortgages. Mortgage-backed security prices plummeted, investors quit buying newly securitized mortgages, and liquidity in the secondary market disappeared. Thus, the investors who owned these securities were stuck with pieces of paper worth substantially less than the values reported on their balance sheets.

1-12c From Sub-Prime Meltdown to Liquidity Crisis to Economic Crisis

Like the Andromeda strain, the sub-prime meltdown went viral, and it ended up infecting almost all aspects of the economy. But why did a burst bubble in one market segment, sub-prime mortgages, spread across the globe?

First, securitization allocated the sub-prime risk to many investors and financial institutions. The huge amount of credit default swaps linked to sub-prime–backed securities spread the risk to even more institutions. Unlike previous downturns in a single market, such as the dot-com bubble in 2002, the decline in the sub-prime mortgage values affected many, if not most, financial institutions.

Second, banks were more vulnerable than at any time since the 1929 Depression. Congress had “repealed” the Glass-Steagall Act in 1999, allowing commercial banks and investment banks to be part of a single financial institution. The SEC compounded the problem in 2004 when it allowed large investment banks’ brokerage operations to take on much higher leverage. Some, like Bear Stearns, ended up with $33 of debt for every dollar of its own equity. With such leverage, a small increase in the value of its investments would create enormous gains for the equity holders and large bonuses for the managers; conversely, a small decline would ruin the firm.

When the sub-prime market mortgages began defaulting, mortgage companies were the first to fall. Many originating firms had not sold all of their sub-prime mortgages, and they failed. For example, New Century declared bankruptcy in 2007, IndyMac was placed under FDIC control in 2008, and Countrywide was acquired by Bank of America in 2008 to avoid bankruptcy.

Securitizing firms also crashed, partly because they kept some of the new securities they created. For example, Fannie Mae and Freddie Mac had huge losses on their portfolio assets, causing them to be virtually taken over by the Federal Housing Finance Agency in 2008. In addition to big losses on their own sub-prime portfolios, many investment banks also had losses related to their positions in credit default swaps. Thus, Lehman Brothers was forced into bankruptcy, Bear Stearns was sold to JPMorgan Chase, and Merrill Lynch was sold to Bank of America, with huge losses to stockholders.

Because Lehman Brothers defaulted on some of its commercial paper, investors in the Reserve Primary Fund, a big money market mutual fund, saw the value of its investments “break the buck,” dropping to less than a dollar per share. To avoid panic and a total lockdown in the money markets, the U.S. Treasury agreed to insure some investments in money market funds.

AIG was the largest backer of credit default swaps, and it operated worldwide. In 2008 it became obvious that AIG could not honor its commitments as a counterparty, so the Fed effectively nationalized AIG to avoid a domino effect in which AIG’s failure would topple hundreds of other financial institutions.

In normal times, banks provide liquidity to the economy and funding for creditworthy businesses and individuals. These activities are crucial for a well-functioning economy. However, the financial contagion spread to commercial banks because some owned mortgage-backed securities, some owned commercial paper issued by failing institutions,

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and some had exposure to credit default swaps. As banks worried about their survival in the fall of 2008, they stopped providing credit to other banks and businesses. The market for commercial paper dried up to such an extent that the Fed began buying new commercial paper from issuing companies.

Prior to the sub-prime meltdown, many nonfinancial corporations had been rolling over short-term financing to take advantage of low interest rates on short-term lending. When the meltdown began, banks began calling in loans rather than renewing them. In response, many companies began throttling back their plans. Consumers and small businesses faced a similar situation: With credit harder to obtain, consumers cut back on spending and small businesses cut back on hiring. Plummeting real estate prices caused a major contraction in the construction industry, putting many builders and suppliers out of work.

What began as a slump in housing prices caused enormous distress for commercial banks, not just mortgage companies. Commercial banks cut back on lending, which caused difficulties for nonfinancial business and consumers. Similar scenarios played out all over the world, resulting in the worst recession in the United States since 1929.

1-12d Responding to the Economic Crisis Unlike the beginning of the 1929 Depression, the U.S. government did not take a hands- off approach in the most recent crisis. In late 2008, Congress passed the Troubled Asset Relief Plan (TARP), which authorized the U.S. Treasury to purchase mortgage-related assets from financial institutions. The intent was to simultaneously inject cash into the banking system and get these toxic assets off banks’ balance sheets. The Emergency Economic Stabilization Act of 2008 (EESA) allowed the Treasury to purchase preferred stock in banks (whether they wanted the investment or not). Again, this injected cash into the banking system. Most of the large banks have already paid back the funding they received from the TARP and EESA financing, although it is doubtful whether all reci- pients will be able to do so. Fannie Mae and Freddie Mac have also paid the government more than they received in the bailout.

Although TARP and EESA were originally intended for financial institutions, they were subsequently modified so that the Treasury was able to make loans to GM and Chrysler in 2008 and early 2009 so that they could stave off immediate bankruptcy. Both GM and Chrysler went into bankruptcy in the summer of 2009 despite government loans, but they quickly emerged as stronger companies with the government owning some of the newly issued stock. The U.S. government has since sold all of the shares issued to it by Chrysler and GM.

The government also used traditional measures, such as stimulus spending, tax cuts, and monetary policy: (1) The American Recovery and Reinvestment Act of 2009 provided over $700 billion in direct stimulus spending for a variety of federal projects and aid for state projects. (2) In 2010 the government temporarily cut Social Security taxes from 6.2% to 4.2%. (3) In addition to purchasing mortgage-related assets under the TARP program, the Federal Reserve has purchased around $2 trillion in long-term T-bonds from financial institutions, a process called “quantitative easing.”

Has the response worked? When we wrote this in 2015, real GDP (gross domestic product) was higher than before the crisis and the unemployment rate was down to 5.5%, much lower than its 2009 high of 10% and close to its pre-crisis level of 4.4%. The U.S. recovery has been much stronger than that of Europe, which is only now (2015) beginning its own quantitative easing programs.25

25For a comparison of this crisis with 15 previous banking crises, see Serge Wind, “A Perspective on 2000’s Illiquidity and Capital Crisis: Past Banking Crises and their Relevance to Today’s Credit Crisis,” Review of Business, Vol. 31, No. 1, Fall 2010, pp. 68–83.

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1-12e Preventing the Next Crisis Can the next crisis be prevented? Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 as an attempt to do just that. As we write this in 2015, many provisions have not yet been fully enacted. Following is a brief summary of some major elements in the Act.

PROTECT CONSUMERS FROM PREDATORS AND THEMSELVES Dodd-Frank established the Consumer Financial Protection Bureau, whose objectives include ensuring that borrowers fully understand the terms and risks of the mortgage contracts, that mortgage originators verify borrower’s ability to repay, and that originators maintain an interest in the borrowers by keeping some of the mortgages they originate. The Bureau also watches over other areas in which consumers might have been targets of predatory lending practices, such as credit cards, debit cards, and payday loans.

As of early 2015, the Bureau has fielded over 400,000 consumer complaints and has levied over $4.6 billion in fines on financial institutions to provide monetary compensa- tion for over 15 million wronged consumers.

SEPARATE BANKING FROM SPECULATING The act’s Volcker Rule, named after former Fed chairman Paul Volcker, would greatly limit a bank’s proprietary trading, such as investing the banks’ own funds into hedge funds. The basic idea is to prevent banks from making highly leveraged bets on risky assets. The Volcker Rule has not been implemented as of early 2015 and is not likely to be implemented until 2017 at the earliest. Even so, some large banks, such as Goldman Sachs and Morgan Stanley, have already cut back their proprietary trading operations.

Anatomy of a Toxic Asset

Consider the dismal history of one particular toxic asset named “GSAMP TRUST 2006-NC2.” This toxic asset began life as 3,949 individual mortgages issued by New Century in 2006 with a total principal of about $881 million. Almost all were adjustable rate mortgages, half were concentrated in just two states (California and Florida), and many of the borrowers had previous credit problems. Goldman Sachs bought the mort- gages, pooled them into a trust, and divided the trust into 16 “debt” tranches called mortgage-backed securities (MBS). The tranches had different provisions regarding distribution of payments should there be any defaults, with senior tranches getting paid first and junior tranches getting paid only if funds were available. Despite the mortgages’ poor quality and the pool’s lack of diversification, Moody’s and Standard & Poor’s gave most tranches good ratings, with over 79% rated AAA.

Five years later, in July 2011, about 36% of the under- lying mortgages were behind in payments, defaulted, or even foreclosed. Not surprisingly, the market prices of the mortgage-backed securities had plummeted. These were very toxic assets indeed!

The story doesn’t end here. Fannie Mae and Freddie Mac had purchased some of these toxic assets and taken a beating. In September 2011, the Federal Housing Finance Agency (now the conservator of Fannie Mae and Freddie Mac) sued Gold- man Sachs, alleging that Goldman Sachs had knowingly over- stated the value of the securities in the prospectuses. The FHFA also alleges that at the very same time Goldman Sachs was selling these and other mortgage-backed securities to Fannie and Freddie, Goldman was: (1) trying to get rid of the mortgages by “putting” them back to New Century, and (2) was “betting” against the mortgages in the credit default swap market. Goldman settled the suit in 2014 by agreeing to pay $1.2 billion, but it is safe to say that these toxic assets will continue to poison our economy for years to come.

Sources: Adam B. Ashcraft and Til Schuermann, Understanding the Securitization of Subprime Mortgage Credit, Federal Reserve Bank of New York Staff Reports, no. 318, March 2008; John Cassidy, How Markets Fail (New York: Farrar, Straus and Giroux, 2009), pp. 260–272; and the Federal Housing Finance Agency, www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Settlement -with-Goldman-Sachs.aspx.

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INCREASE TRANSPARENCY AND REDUCE RISK DUE TO DERIVATIVES TRADING Title VII of the Dodd-Frank Act provides for more oversight of hedge funds and credit- rating agencies in an effort to spot potential landmines before they explode. More importantly, it attempts to reduce the financial system’s exposure to risk caused by derivative trading, especially the risk stemming from swaps.

A swap is a contract in which one party swaps something with another party. For example, one party might make payments that fluctuate with interest rates to another party (called the “counterparty”) in exchange for payments that do not fluctuate—the two parties “swap” payments. Because the swaps are traded directly between two parties, the risk that one party defaults was borne by the other party. The market for swaps is huge, with a value of over $350 trillion!26 If there is a series of swaps linking various counter- parties, then the default by one can trigger financial difficulties for all. Title VII in the Dodd-Frank Act directly addresses this situation.

Rather than two parties entering a custom-made swap contract directly between them- selves, Title VII calls for most swaps to be standardized and traded in a public market made by either a designated contract market (DCM), which is like a market maker, or a swap execution facility (SEF), which is an automated trading platform. These markets provide information about trades and market activity, which should provide greater transparency.

In addition, all swap transactions must be sent to a registered derivatives clearing organization (DCO), which “clears” the transaction by agreeing to ensure payments if one of the swap parties defaults. In other words, the risk of default by one party is shifted from the counterparty to the clearinghouse (i.e., the DCO). Of course, the clearinghouse reduces its risk by requiring collateral from each of the swap parties. The SEC and the Commodities Futures Trading Commission also regulate and monitor the clearinghouses.

In late 2012, about 42% of swaps were cleared; by early 2015, about 59% were cleared. There are still too many uncleared swaps, but the Dodd-Frank Act is improving transpar- ency and reducing the financial system’s exposure to swap trading.

Title VII also provides for more oversight of hedge funds and credit-rating agencies in an effort to spot potential landmines before they explode.

HEAD OFF AND REIN IN SYSTEMIC FAILURES AT TOO-BIG-TO-FAIL BANKS When a bank gets extremely large and has business connections with many other compa- nies, it can be very dangerous to the rest of the economy if the institution fails and goes bankrupt, as the 2008 failure of Lehman Brothers illustrates. In other words, a bank or other financial institution can become “too big to fail.” Systemic risk is defined as something that affects most companies. When there are a large number of too-big-to-fail institutions and systemic shock hits, the entire world can be dragged into a recession, as we saw in 2008.

Dodd-Frank gives regulators more oversight of too-big-to-fail institutions, including all banks with $50 billion in assets and any other financial institutions that the Financial Stability Oversight Council deems systemically important. In early 2015, there were 12 nonbank institutions that were designated as systemically important, including insur- ance companies and clearinghouses.

This oversight includes authority to require additional capital or reductions in lever- age if conditions warrant. In addition, these institutions must prepare “transition” plans that would make it easier for regulators to liquidate the institution should it fail. In other words, this provision seeks to reduce the likelihood that a giant financial institution will fail and to minimize the damage if it does fail.

26For updates on the swap markets, see www.cftc.gov/MarketReports/SwapsReports/Archive/index.htm.

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S E L F - T E S T

Briefly describe the process that led from a homeowner purchasing a home to an investor purchasing a collateralized debt obligation.

How is a credit default swap like insurance?

Describe some of the motives and mistakes made by the Fed, home buyers, mortgage brokers, real estate appraisers, mortgage originators, mortgage securitizers, financial engineers, and investors.

What triggered the financial crisis and how did it spread to the rest of the economy?

How did the federal government respond to the crisis?

What provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act are designed to prevent a future financial crisis?

1-13 The Big Picture Finance has vocabulary and tools that might be new to you. To help you avoid getting bogged down in the trenches, Figure 1-7 presents the big picture. A manager’s primary job is to increase the company’s intrinsic value, but how exactly does one go about doing that? The equation in the center of Figure 1-7 shows that intrinsic value is the present value of the firm’s expected free cash flows, discounted at the weighted average cost of capital. Thus, there are two approaches for increasing intrinsic value: improve FCF or reduce the WACC. Observe that several factors affect FCF and several factors affect the WACC. In the rest of the book’s chapters, we will typically focus on only one of these factors, systematically building the vocabulary and tools that you will use after graduation to improve your company’s intrinsic value. It is true that every manager needs to understand financial vocabulary and be able to apply financial tools, but successful managers also understand how their decisions affect the big picture. So as you read this book, keep in mind where each topic fits into the big picture.

FIGURE 1-7 The Determinants of Intrinsic Value: The Big Picture

Required investments in operating capital

Operating costs and taxes

Sales revenues

–

–

= Free cash flow

FCF

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Market interest rates

Market risk aversion

Firm’s debt/equity mix

Firm’s business risk

Value = + … ++ FCF1

(1 + WACC)1

FCF2

(1 + WACC)2 FCF∞

(1 + WACC)∞

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e-Resources The textbook’s Web site contains several types of files that will be helpful to you:

1. It contains Excel files, called Tool Kits, that provide well-documented models for almost all of the text’s calculations. Not only will these Tool Kits help you with this finance course, but they also will serve as tool kits for you in other courses and in your career.

2. There are problems at the end of the chapters that require spreadsheets, and the Web site contains the models you will need to begin work on these problems.

When we think it might be helpful for you to look at resources on the book’s Web site, we’ll show an icon in the margin like the one shown here.

Other resources are also on the Web site, including an electronic library that contains Adobe PDF files for “extensions” to many chapters that cover additional useful material related to the chapter.

S U M M A R Y

• Financial markets are simply ways of connecting providers of cash with users of cash. Providers exchange cash now for claims on uncertain future cash.

• The three main forms of business organization are the proprietorship, the partnership, and the corporation. Although each form of organization offers advantages and disadvantages, corporations conduct much more business than the other forms.

• Going public is called an initial public offering (IPO) because it is the first time the company’s shares are sold to the general public.

• Free cash flows (FCFs) are the cash flows available for distribution to all of a firm’s investors (shareholders and creditors) after the firm has paid all expenses (including taxes) and has made the required investments in operations to support growth.

• The weighted average cost of capital (WACC) is the average return required by all of the firm’s investors. It is determined by the firm’s capital structure (the firm’s relative amounts of debt and equity), interest rates, the firm’s risk, and the market’s attitude toward risk.

• The value of a firm depends on the size of the firm’s free cash flows, the timing of those flows, and their risk. If the expected future free cash flows and the cost of capital incorporate all relevant information, then a firm’s fundamental value (also called intrinsic value), is defined by:

Value FCF1

1 WACC 1 FCF2

1 WACC 2 FCF3

1 WACC 3 FCF∞

1 WACC ∞

• The primary objective of management should be to maximize stockholders’ wealth, and this means maximizing the company’s fundamental value. Legal actions that maximize stock prices usually increase social welfare.

• Transfers of capital between borrowers and savers take place: (1) by direct transfers of money and securities; (2) by transfers through investment banks, which act as go-betweens; and (3) by transfers through financial intermediaries, which create new securities.

• A financial security is a claim on future cash flows that is standardized and regulated. Debt, equity, and derivatives are the primary types of financial securities.

• Derivatives, such as options, are claims on other financial securities. In securitization, new securities are created from claims on packages of other securities.

r e s o u r c e

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• The prospect of more money in the future is required to induce an investor to give up money today. This is a required rate of return from an investor’s perspective and a cost from the user’s point of view.

• Four fundamental factors affect the required rate of return (i.e., the cost of money): (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

• Spot markets and futures markets are terms that refer to whether the assets are bought or sold for “on-the-spot” delivery or for delivery at some future date.

• Money markets are the markets for debt securities with maturities of less than a year. Capital markets are the markets for long-term debt and corporate stocks.

• Primary markets are the markets in which corporations raise new capital. Secondary markets are markets in which existing, already-outstanding securities are traded among investors.

• A trading venue is a site (geographical or electronic) where secondary market trading occurs.

• Orders from buyers and sellers can be matched in one of three ways: (1) in a face-to- face open outcry auction, (2) through a computer network of dealer markets, and (3) through automated trading platforms with computers that match orders and execute trades.

• Registered stock exchanges (like the NYSE or NASDAQ) must display pre-trade quotes. Broker-dealer networks and alterative trading systems (ATS) (which are called dark pools) conduct off-exchange trading and are not required to display pre-trade information.

• The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in an effort to prevent financial crises such as the one that triggered the great recession of 2007.

• Web Extension 1A discusses derivatives.

Q U E S T I O N S

(1-1) Define each of the following terms: a. Proprietorship; partnership; corporation; charter; bylaws b. Limited partnership; limited liability partnership; professional corporation c. Stockholder wealth maximization d. Money market; capital market; primary market; secondary market e. Private markets; public markets; derivatives f. Investment bank; financial services corporation; financial intermediary g. Mutual fund; money market fund h. Physical location exchange; computer/telephone network i. Open outcry auction; dealer market; automated trading platform j. Production opportunities; time preferences for consumption

k. Foreign trade deficit (1-2) What are the three principal forms of business organization? What are the advantages and

disadvantages of each? (1-3) What is a firm’s fundamental value (which is also called its intrinsic value)? What might

cause a firm’s intrinsic value to be different from its actual market value?

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(1-4) Edmund Corporation recently made a large investment to upgrade its technology. Although these improvements won’t have much of an impact on performance in the short run, they are expected to reduce future costs significantly. What impact will this invest- ment have on Edmund’s earnings per share this year? What impact might this investment have on the company’s intrinsic value and stock price?

(1-5) Describe the ways in which capital can be transferred from suppliers of capital to those who are demanding capital.

(1-6) What are financial intermediaries, and what economic functions do they perform? (1-7) Is an initial public offering an example of a primary or a secondary market transaction? (1-8) Contrast and compare trading in face-to-face auctions, dealer markets, and automated

trading platforms. (1-9) Describe some similarities and differences among broker-dealer networks, alternative

trading systems (ATS), and registered stock exchanges. (1-10) What are some similarities and differences between the NYSE and the NASDAQ Stock

Market?

M I N I C A S E

Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.

a. Why is corporate finance important to all managers? b. Describe the organizational forms a company might have as it evolves from a start-

up to a major corporation. List the advantages and disadvantages of each form. c. How do corporations go public and continue to grow? What are agency problems?

What is corporate governance? d. What should be the primary objective of managers?

(1) Do firms have any responsibilities to society at large? (2) Is stock price maximization good or bad for society? (3) Should firms behave ethically?

e. What three aspects of cash flows affect the value of any investment? f. What are free cash flows? g. What is the weighted average cost of capital? h. How do free cash flows and the weighted average cost of capital interact to determine

a firm’s value? i. Who are the providers (savers) and users (borrowers) of capital? How is capital

transferred between savers and borrowers? j. What do we call the cost that a borrower must pay to use debt capital? What two

components make up the cost of using equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

k. What are some economic conditions that affect the cost of money?

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l. What are financial securities? Describe some financial instruments. m. List some financial institutions. n. What are some different types of markets? o. Along what two dimensions can we classify trading procedures? p. What are the differences between market orders and limit orders? q. Explain the differences among dealer-broker networks, alternative trading systems,

and registered stock exchanges. r. Briefly explain mortgage securitization and how it contributed to the global

economic crisis.

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C H A P T E R 2

Financial Statements, Cash Flow, and Taxes

Apple generated almost $58 billion in 2014! The ability to generate cash flow is the lifeblood of a company and the basis for its fundamental value. How did Apple use this cash flow? Apple returned over $55 billion to stockholders by paying $11 billion in dividends and by repurchasing $44 billion of its own stock.

Many other companies also generated large cash flows from operations in 2014, but they used the money differently. For example, Google generated over $22 billion but returned very little to stockholders. Instead, Google spent almost $11 billion on capital expenditures (mostly technology infrastructure) and another $5 billion on acquisitions. Google also put about $5 billion into short-term investments (such as Treasury securities), saving for a rainy day.

Companies other than Google, such as Amazon, also spent heavily on technology infrastructure. Out of the $6.8 billion Amazon generated, it used over $4.8 billion for capital expenditures, much of it on technology infrastructure.

These well-managed companies used their operating cash flows in different ways, including capital expenditures, acquisitions, dividend payments, stock repurchases, and saving for future needs. Which company made the right choices? Only time will tell, but keep these companies and their different cash flow strategies in mind as you read this chapter.

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The stream of cash flows a firm is expected to generate in the future determines its fundamental value (also called intrinsic value). But how does an investor go about estimating future cash flows, and how does a manager decide which actions are most likely to increase cash flows? The first step is to understand the financial statements that publicly traded firms must provide to the public. Thus, we begin with a discussion of financial statements, including how to interpret them and how to use them. Value depends on after-tax cash flows, so we provide an overview of the federal income tax system and highlight differences between accounting income and cash flow.

2-1 Financial Statements and Reports A company’s annual report usually begins with the chairperson’s description of the firm’s operating results during the past year and a discussion of new developments that will affect future operations. The annual report also presents four basic financial statements— the balance sheet, the income statement, the statement of stockholders’ equity, and the statement of cash flows.

Intrinsic Value, Free Cash Flow, and Financial Statements

In Chapter 1, we told you that managers should strive to make their firms more valuable and that a firm’s intrinsic value is determined by the present value of its free cash flows (FCF) discounted at the weighted average cost of

capital (WACC). This chapter focuses on FCF, including its calculation from financial statements and its interpretation when evaluating a company and manager.

Required investments in operating capital

Operating costs and taxes

Sales revenues

–

–

= Free cash flow

FCF

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Market interest rates

Market risk aversion

Firm’s debt/equity mix

Firm’s business risk

Value = + … ++ FCF1

(1 + WACC)1

FCF2

(1 + WACC)2 FCF∞

(1 + WACC)∞

r e s o u r c e The textbook’s Web site contains an Excel file that will guide you through the chapter’s calculations. The file for this chapter is Ch02 Tool Kit.xlsx, and we encourage you to open the file and follow along as you read the chapter.

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The quantitative and qualitative written materials are equally important. The financial statements report what has actually happened to assets, earnings, dividends, and cash flows during the past few years, whereas the written materials attempt to explain why things turned out the way they did.

S E L F - T E S T

What is the annual report, and what two types of information does it present?

What four types of financial statements does the annual report typically include?

2-2 The Balance Sheet For illustrative purposes, we use a hypothetical company, MicroDrive Inc., which pro- duces memory components for computers and smartphones. Figure 2-1 shows Micro- Drive’s most recent balance sheets, which represent “snapshots” of its financial position on the last day of each year. Although most companies report their balance sheets only on the last day of a given period, the “snapshot” actually changes daily as inventories are bought and sold, as fixed assets are added or retired, or as loan balances are increased or paid down. Moreover, a retailer will have larger inventories before Christmas than later in the spring, so balance sheets for the same company can look quite different at different times during the year.

FIGURE 2-1 MicroDrive Inc.: December 31 Balance Sheets (Millions of Dollars)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47

A B C D E F G 2016 2015

Cash and equivalents 50$ 60$ Short‐term investments ‐ 40 Accounts receivable 500 380 Inventor ies 1,000 820

T otal current assets 1,550$ 1,300$ Net plant and equipment 2,000 1,700 T otal assets 3,550$ 3,000$

Accounts payable 200$ 190$ Notes payable 280 130 Accruals 300 280

T otal current liabilities 780$ 600$ L ong‐term bonds 1,200 1,000

T otal liabilities 1,980$ 1,600$ Preferred stock (1,000,000 shares) 100 100 Common stock (50,000,000 shares) 500 500 Retained earnings 970 800

T otal common equity 1,470$ 1,300$ T otal liabilities and equity 3,550$ 3,000$

48 49 50

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

w w w See the Securities and Exchange Commission’s (SEC) Web site for quarterly reports and more detailed annual reports that provide breakdowns for each major division or subsidiary. These reports, called 10-Q and 10-K reports, are available on the SEC’s Web site at www.sec.gov under the heading “EDGAR.”

r e s o u r c e See Ch02 Tool Kit.xlsx for details.

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The balance sheet begins with assets, which are the “things” the company owns. Assets are listed in order of “liquidity,” or length of time it typically takes to convert them to cash at fair market values. The balance sheet also lists the claims that various groups have against the company’s value; these are listed in the order in which they must be paid. For example, suppliers may have claims called “accounts payable” that are due within 30 days, banks may have claims called “notes payable” that are due within 90 days, and bond- holders may have claims that are not due for 20 years or more.

Stockholders’ claims represent ownership (or equity) and need never be “paid off.” These are residual claims in the sense that stockholders may receive payments only if there is value remaining after other claimants have been paid. The nonstockholder claims are liabilities from the stockholders’ perspective. The amounts shown on the balance sheets are called book values because they are based on the amounts recorded by book- keepers when assets are purchased or liabilities are issued. As you will see throughout this textbook, book values may be very different from market values, which are the current values as determined in the marketplace.

The following sections provide more information about specific asset, liability, and equity accounts.

2-2a Assets Cash, short-term investments, accounts receivable, and inventories are listed as current assets because MicroDrive is expected to convert them into cash within a year. All assets are stated in dollars, but only cash represents actual money that can be spent. Some marketable securities mature very soon, and these can be converted quickly into cash at prices close to their book values. Such securities are called “cash equivalents” and are included with cash. Therefore, MicroDrive could write checks for a total of $50 million. Other types of marketable securities have a longer time until maturity (but still less than a year). Their market values are less predictable, so they are not included in cash or cash equivalents.

Because it is helpful in financial analysis, MicroDrive’s accountants are careful to separately identify the cash used in daily operations and the cash that is held for other purposes. For example, MicroDrive continuously deposits checks from customers and writes checks to suppliers, employees, and so on. Because inflows and outflows do not coincide perfectly, MicroDrive must keep some cash in its bank account. In other words, MicroDrive must have some cash on hand to conduct operations, which is the $50 million in cash reported in Figure 2-1.

MicroDrive reports the total of any other cash, cash equivalents, and marketable securities that are not used to support operation in a separate account called short-term investments. For example, Figure 2-1 shows that MicroDrive had $40 million of short- term investments in the previous year and none in the current year.

We will always distinguish between the cash that is used to support operations and the cash, cash equivalents, and marketable securities that are held for other purposes. How- ever, be alert when looking at the financial statements from sources outside our book because they don’t always separately identify the cash used to support operations.

When MicroDrive sells its products to a customer but doesn’t demand immediate payment, the customer then has an obligation to make the payment, which MicroDrive reports as an “account receivable.” The $500 million shown in accounts receivable is the amount of sales for which MicroDrive has not yet been paid.

Figure 2-1 reports inventories of $1,000 million, which is the amount that MicroDrive has tied up in raw materials, work-in-process, and finished goods available for sale. MicroDrive uses the FIFO (first-in, first-out) inventory accounting method to estimate

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production costs and the value of remaining inventory. The FIFO method assumes, for accounting purposes only, that the first items placed in inventory are the first ones used in production. In contrast, the LIFO (last-in, first-out) method assumes that the items most recently placed in inventory are the first ones used in production. (No matter which method a company chooses for accounting purposes, the company actually can use inventory in any order it wishes.) During an inflationary period of rising prices, older purchases of materials have lower costs than newer purchases. This means that FIFO will report lower costs of goods sold on the income statement than LIFO (because FIFO assumes that the older items are used first), but will report higher values for remaining inventory on the balance sheet. Because MicroDrive uses FIFO and because inflation has been occurring: (1) Its balance sheet inventories are higher than they would have been had it used LIFO. (2) Its cost of goods sold is lower than it would have been under LIFO. (3) Its reported profits are therefore higher. Thus, the inventory valuation method can have a significant effect on financial statements, which is important to know when comparing companies that use different methods.

Rather than treat the entire purchase price of a long-term asset (such as a factory, plant, or equipment) as an expense in the purchase year, accountants “spread” the purchase cost over the asset’s useful life.1 The amount they charge each year is called the depreciation expense. Some companies report an amount called “gross plant and equipment,” which is the total cost of the long-term assets they have in place, and another amount called “accumulated depreciation,” which is the total amount of depreciation that has been charged on those assets. Some companies, such as MicroDrive, report only net plant and equipment, which is gross plant and equipment less accumulated depreciation. Chapter 11 provides a more detailed explanation of depreciation methods.

2-2b Liabilities and Equity Accounts payable, notes payable, and accruals are listed as current liabilities because MicroDrive is expected to pay them within a year. When MicroDrive purchases supplies but doesn’t immediately pay for them, it takes on an obligation called an account payable. Similarly, when MicroDrive takes out a loan that must be repaid within a year, it signs an IOU called a note payable. MicroDrive doesn’t pay its taxes or its employees’ wages daily, and the amount it owes on these items at any point in time is called an “accrual” or an “accrued expense.” Long-term bonds are also liabilities because they, too, reflect a claim held by someone other than a stockholder.

Preferred stock is a hybrid, or a cross between common stock and debt. In the event of bankruptcy, preferred stock ranks below debt but above common stock. Also, the pre- ferred dividend is fixed, so preferred stockholders do not benefit if the company’s earnings grow. Most firms do not use much, if any, preferred stock, so “equity” usually means “common equity” unless the words “total” or “preferred” are included.

When a company sells shares of stock, it records the proceeds in the common stock account.2 Retained earnings are the cumulative amount of earnings that have not been paid out as dividends. The sum of common stock and retained earnings is called common equity, or just “equity.” If a company could actually sell its assets at their book value, and

1This is called accrual accounting, which attempts to match revenues to the periods in which they are earned and expenses to the periods in which the effort to generate income occurred. 2Companies sometimes break the total proceeds into two parts, one called “par” and the other called “paid-in capital” or “capital surplus.” For example, if a company sells shares of stock for $10, it might record $1 of par and $9 of paid-in capital. For most purposes, the distinction between par and paid-in capital is not important, and most companies use no-par stock.

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if the liabilities and preferred stock were actually worth their book values, then a company could sell its assets, pay off its liabilities and preferred stock, and the remaining cash would belong to common stockholders. Therefore, common equity is sometimes called the net worth of shareholders—it’s the assets minus (or “net of”) the liabilities and preferred stock.

S E L F - T E S T

What is the balance sheet, and what information does it provide?

What determines the order of the information shown on the balance sheet?

Why might a company’s December 31 balance sheet differ from its June 30 balance sheet?

A firm has $8 million in total assets. It has $3 million in current liabilities, $2 million in long-term debt, and $1 million in preferred stock. What is the reported net worth of shareholders (i.e., the reported common equity)? ($2 million)

2-3 The Income Statement Figure 2-2 shows the income statements and selected additional information for MicroDrive. Income statements can cover any period of time, but they are usually prepared monthly, quarterly, and annually. Unlike the balance sheet, which is a snapshot of a firm at a point in time, the income statement reflects performance during the period.

Net sales are the revenues less any discounts or returns. Depreciation and amortiza- tion reflect the estimated costs of the assets that wear out in producing goods and services. To illustrate depreciation, suppose that in 2015 MicroDrive purchased a $100,000 machine with a life of 5 years and zero expected salvage value. This $100,000 cost is not expensed in the purchase year but is instead spread out over the machine’s 5-year

The Great Recession of 2007

Let’s Play Hide-and-Seek! In a shameful lapse of regulatory accountability, banks and other financial institutions were allowed to use “structured investment vehicles” (SIVs) to hide assets and liabilities and simply not report them on their balance sheets. Here’s how SIVs worked and why they subsequently failed. The SIV was set up as a separate legal entity that the bank owned and managed. The SIV would borrow money in the short-term market (backed by the credit of the bank) and then invest in long-term securities. As you might guess, many SIVs invested in mortgage-backed securities. When the SIV paid only 3% on its borrowings but earned 10% on its investments, the managing bank was able to report fabulous earnings, especially if it also earned fees for creating the mortgage-backed securities that went into the SIV.

But this game of hide-and-seek didn’t have a happy ending. Mortgage-backed securities began defaulting in 2007 and 2008, causing the SIVs to pass losses through to the banks. SunTrust, Citigroup, Bank of America, and Northern Rock are just a few of the many banks that reported enormous losses in the SIV game. Investors, depositors, and the government eventually found the hid- den assets and liabilities, but by then the assets were worth a lot less than the liabilities.

In a case of too little and too late, regulators have closed many of these loopholes, and it doesn’t look like there will be any more hidden SIVs in the near future. But the damage has been done, and the entire financial system was put at risk in large part because of this high-stakes game of hide-and-seek.

r e s o u r c e See Ch02 Tool Kit.xlsx for details.

© Mihai Simonia

NOT FOR SALE

depreciable life. In straight-line depreciation, which we explain in Chapter 11, the deprecia- tion charge for a full year would be $100,000 5 $20,000. The reported depreciation expense on the income statement is the sum of all the assets’ annual depreciation charges. Depreciation applies to tangible assets, such as plant and equipment, whereas amortization applies to intangible assets such as patents, copyrights, trademarks, and goodwill.3

FIGURE 2-2 MicroDrive Inc.: Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data; Millions of Shares)

58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77

A B C D E F G 2016 2015

Net sales 5,000$ 4,760$ Costs of goods sold except depreciation 3,800 3,560 Depreciation and amortizationa 200 170 Other operating expenses 500 480

Earnings before interest and taxes (EBIT ) 500$ 550$ L ess interest 120 100

Pre‐tax earnings 380$ 450$ T axes 152 180

Net Income before preferred dividends 228$ 270$ Preferred dividends 8 8 Net Income available to common stockholders 220$ 262$

Common dividends $50 $48 Addition to retained earnings $170 $214 Number of common shares 50 50 Stock pr ice per share $27 $40

Earnings per share, EPSb $4.40 $5.24

Dividends per share, DPSc $1.00 $0.96

Book value per share, BVPSd $29.40 $26.00

78 79 80

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

Notes: aMicroDrive has no amortization charges.

bEPS Net income available to common stockholders

Common shares outstanding

cDPS Dividends paid to common stockholders

Common shares outstanding

dBVPS Total common equity

Common shares outstanding

3The accounting treatment of goodwill resulting from mergers has changed in recent years. Rather than an annual charge, companies are required to periodically evaluate the value of goodwill and reduce net income only if the goodwill’s value has decreased materially (“become impaired,” in the language of accountants). For example, in 2002 AOL Time Warner wrote off almost $100 billion associated with the AOL merger. It doesn’t take too many $100 billion expenses to really hurt net income!

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The cost of goods sold (COGS) includes labor, raw materials, and other expenses directly related to the production or purchase of the items or services sold in that period. The COGS includes depreciation, but we report depreciation separately so that analysis later in the chapter will be more transparent. Subtracting COGS (including depreciation) and other operating expenses results in earnings before interest and taxes (EBIT).

Many analysts add back depreciation to EBIT to calculate EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Because neither deprecia- tion nor amortization is paid in cash, some analysts claim that EBITDA is a better measure of financial strength than is net income. MicroDrive’s EBITDA is:

EBITDA EBIT Depreciation

$500 $200 $700 million

Alternatively, EBITDA’s calculation can begin with sales:

EBITDA Sales − COGS excluding depreciation − Other expenses

$5,000 − $3,800 − $500 $700 million However, as we show later in the chapter, EBITDA is not as useful to managers and analysts as free cash flow, so we usually focus on free cash flow instead of EBITDA.

The net income available to common shareholders, which equals revenues less expenses, taxes, and preferred dividends (but before paying common dividends), is generally referred to as net income. Net income is also called accounting profit, profit, or earnings, particularly in financial news reports. Dividing net income by the number of shares outstanding gives earnings per share (EPS), often called “the bottom line.” Throughout this book, unless otherwise indicated, net income means net income available to common stockholders.4

S E L F - T E S T

What is an income statement, and what information does it provide?

What is often called “the bottom line”?

What is EBITDA?

How does the income statement differ from the balance sheet with regard to the time period reported?

A firm has the following information: $2 million in earnings before taxes. The firm has an interest expense of $300,000 and depreciation of $200,000; it has no amortization. What is its EBITDA? ($2.5 million)

Now suppose a firm has the following information: $7 million in sales, $4 million of costs of goods sold excluding depreciation and amortization, and $500,000 of other operating expenses. What is its EBITDA? ($2.5 million)

4Companies also report “comprehensive income,” which is the sum of net income and any “comprehensive” income item, such as the change in market value of a financial asset. For example, a decline in a financial asset’s value would be recorded as a loss even though the asset has not been sold. We assume that there are no comprehensive income items in our examples.

Some companies also choose to report “pro forma income.” For example, if a company incurs an expense that it doesn’t expect to recur, such as the closing of a plant, it might calculate pro forma income as though it had not incurred the one-time expense. There are no hard-and-fast rules for calculating pro forma income, so many companies find ingenious ways to make pro forma income higher than traditional income. The SEC and the Public Company Accounting Oversight Board (PCAOB) are taking steps to reduce deceptive uses of pro forma reporting.

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2-4 Statement of Stockholders’ Equity Changes in stockholders’ equity during the accounting period are reported in the state- ment of stockholders’ equity. Figure 2-3 shows that MicroDrive earned $220 million during 2016, paid out $50 million in common dividends, and plowed $170 million back into the business. Thus, the balance sheet item “Retained earnings” increased from $800 million at year-end 2014 to $970 million at year-end 2016.5 The last column shows the beginning stockholders’ equity, any changes, and the end-of-year stockholders’ equity.

Note that “retained earnings” is not a pile of money just waiting to be used; it does not represent assets but is instead a claim against assets. In 2016, MicroDrive’s stockholders allowed it to reinvest $170 million instead of distributing the money as dividends, and management spent this money on new assets. Thus, retained earnings, as reported on the balance sheet, does not represent cash and is not “available” for the payment of dividends or anything else.6

S E L F - T E S T

What is the statement of stockholders’ equity, and what information does it provide?

Why do changes in retained earnings occur?

Explain why the following statement is true: “The retained earnings, as reported on the balance sheet, does not represent cash and is not available for the payment of dividends or anything else.”

A firm had a retained earnings balance of $3 million in the previous year. In the current year, its net income is $2.5 million. If it pays $1 million in common dividends in the current year, what is its resulting retained earnings balance? ($4.5 million)

FIGURE 2-3 MicroDrive Inc.: Statement of Stockholders’ Equity for Years Ending December 31 (Millions of Dollars and Millions of Shares)

101 102 103 104

A B C D E F G H Preferred

Stock Common

Shares Common

Stock Retained Earnings

T otal Equity

Changes dur ing year : Net income Cash dividends Issuance/repurchase of stock

$100 50 $500 $800 $1,400

$220 $220 (50) (50)

0 0 0 $100 50 $500 $970 $1,570

Balances, Dec. 31, 2015

Balances, Dec. 31, 2016

105 106 107

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact. Note: In financial statements, parentheses and red colors denote a negative number.

5A more complicated company might require additional columns and rows to report information regarding new issues of stock, treasury stock acquired or reissued, stock options exercised, and unrealized foreign exchange gains or losses. 6The amount reported in the retained earnings account is not an indication of the amount of cash the firm has. Cash (as of the balance sheet date) is found in the cash account, an asset account. A positive number in the retained earnings account indicates only that the firm earned some income in the past, but its dividends paid were less than its earnings. Even if a company reports record earnings and shows an increase in its retained earnings account, it still may be short of cash.

The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes, and an expensive stereo and hence have a high net worth. But if you have only 23 cents in your pocket plus $5 in your checking account, you will still be short of cash.

r e s o u r c e See Ch02 Tool Kit.xlsx for details.

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2-5 Statement of Cash Flows Even if a company reports a large net income during a year, the amount of cash reported on its year-end balance sheet may be the same or even lower than its beginning cash. The reason is that the company can use its net income in a variety of ways, not just keep it as cash in the bank. For example, the firm may use its net income to pay dividends, to increase inventories, to finance accounts receivable, to invest in fixed assets, to reduce debt, or to buy back common stock. Indeed, many factors affect a company’s cash position as reported on its balance sheet. The statement of cash flows separates a company’s activities into three categories—operating, investing, and financing—and summarizes the resulting cash balance.

2-5a Operating Activities As the name implies, the section for operating activities focuses on the amount of cash generated (or lost) by the firm’s operating activities. The section begins with the reported net income before paying preferred dividends and makes several adjustments, beginning with noncash activities.

NONCASH ADJUSTMENTS Some revenues and expenses reported on the income statement are not received or paid in cash during the year. For example, depreciation and amortization reduce reported net income but are not cash payments.

Reported taxes often differ from the taxes that are paid, resulting in an account called deferred taxes, which is the cumulative difference between the taxes that are reported and those that are paid. Deferred taxes can occur in many ways, including the use of accelerated depreciation for tax purposes but straight-line depreciation for financial reporting. This increases reported taxes relative to actual tax payments in the early years of an asset’s life, causing the resulting net income to be lower than the true cash flow. Therefore, increases in deferred taxes are added to net income when calculating cash flow, and decreases are subtracted from net income.

Another example of noncash reporting occurs if a customer purchases services or products that extend beyond the reporting date, such as a 3-year extended warranty for a computer. Even if the company collects the cash at the time of the purchase, it will spread the reported revenues over the life of the purchase. This causes income to be lower than

Financial Analysis on the Web

A wide range of valuable financial information is available on the Web. With just a couple of clicks, an investor can easily find the key financial statements for most publicly traded companies. Here’s a partial (by no means a com- plete) list of places you can go to get started.

Try Yahoo! Finance’s Web site, http://finance.yahoo .com. Here you will find updated market information along with links to a variety of interesting research sites. Enter a stock’s ticker symbol, click Get Quotes,

and you will see the stock’s current price along with recent news about the company. The panel on the left has links to key statistics and to the company’s income statement, balance sheet, statement of cash flows, and more. The Web site also has a list of insider transac- tions, so you can tell if a company’s CEO and other key insiders are buying or selling their company’s stock. In addition, there is a message board where investors share opinions about the company, and there is a link

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cash flow in the first year and higher in subsequent years, so adjustments must be made when calculating cash flow.

CHANGES IN WORKING CAPITAL Increases in current assets other than cash (such as inventories and accounts receivable) decrease cash, whereas decreases in these accounts increase cash. For example, if inventories are to increase, then the firm must use cash to acquire the additional inventory. Conversely, if inventories decrease, this generally means the firm is selling inventories and not replacing all of them, hence generating cash. Here’s how we keep track of whether a change in assets increases or decreases cash flow: If the amount we own goes up (like getting a new laptop computer), it means we have spent money and our cash goes down. On the other hand, if something we own goes down (like selling a car), our cash goes up.

Now consider a current liability, such as accounts payable. If accounts payable increase, then the firm has received additional credit from its suppliers, which saves cash; however, if payables decrease, this means it has used cash to pay off its suppliers. There- fore, increases in current liabilities such as accounts payable increase cash, whereas decreases in current liabilities decrease cash. To keep track of the cash flow’s direction, think about the impact of getting a student loan. The amount you owe goes up and your cash goes up. Now think about paying off the loan: The amount you owe goes down, but so does your cash.

2-5b Investing Activities Investing activities include transactions involving fixed assets or short-term financial investments. For example, if a company buys new IT infrastructure, its cash goes down at the time of the purchase. On the other hand, if it sells a building or T-bill, its cash goes up.

2-5c Financing Activities Financing activities include raising cash by issuing short-term debt, long-term debt, or stock. Because dividend payments, stock repurchases, and principal payments on debt reduce a company’s cash, such transactions are included here.

to the company’s filings with the SEC. Note that, in most cases, a more complete list of the SEC filings can be found at www.sec.gov. Other sources for up-to-date market information are http:// money.cnn.com and www.zacks.com. These sites also pro- vide financial statements in standardized formats. Both www.bloomberg.com and www.marketwatch.com have areas where you can obtain stock quotes along with company financials, links to Wall Street research, and links to SEC filings. If you are looking for charts of key accounting variables (for example, sales, inventory, depreciation and amortization,

and reported earnings) as well as financial statements, take a look at www.smartmoney.com. Another good place to look is www.reuters.com. Here you can find links to analysts’ research reports along with the key financial statements.

In addition to this information, you may be looking for sites that provide opinions regarding the direction of the overall market and views regarding individual stocks. Two popular sites in this category are The Motley Fool’s Web site, www.fool.com, and the Web site for The Street.com, www.thestreet.com.

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2-5d Putting the Pieces Together The statement of cash flows is used to help answer questions such as these: Is the firm generating enough cash to purchase the additional assets required for growth? Is the firm generating any extra cash it can use to repay debt or to invest in new products? Such information is useful both for managers and investors, so the statement of cash flows is an important part of the annual report.

Figure 2-4 shows MicroDrive’s statement of cash flows as it would appear in the company’s annual report. The top section shows cash generated by and used in operations—for MicroDrive, operations provided net cash flows of $158 million. This subtotal is in many respects the most important figure in any of the financial statements.

FIGURE 2-4 MicroDrive Inc.: Statement of Cash Flows for Year Ending December 31 (Millions of Dollars)

120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142

A B C D E F 2016

Net Income before preferred dividends 228$

Depreciationa 200

Increase in accounts receivableb (120) Increase in inventor ies (180) Increase in accounts payable 10 Increase in accruals 20

Net cash provided (used) by operating activities 158$

Cash used to acquire assetsc (500)$ Sale of short‐term investments 40

Net cash provided (used) by investing activities (460)$

Increase in notes payable 150$ Increase in bonds 200 Payment of common and preferred dividends (58) Net cash provided (used) by activities 292$

Net change in cash and equivalents (10)$ Cash and secur ities at beginning of the year 60

Cash and secur ities at end of the year 50$

143 144 145

fixed

financing

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

Notes: aDepreciation is a noncash expense that was deducted when calculating net income. It must be added back to show cash flow from operations.

bAn increase in a current asset decreases cash. An increase in a current liability increases cash. For example, inventories increased by $180 million and therefore reduced cash by that amount.

cThe net increase in fixed assets is $300 million; however, this net amount is after a deduction for the year’s depreciation expense. Depreciation expense must be added back to find the increase in gross fixed assets. From the company’s income statement, we see that the year’s depreciation expense is $200 million; thus, expenditures on fixed assets were actually $500 million.

r e s o u r c e See Ch02 Tool Kit.xlsx for details.

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Profits as reported on the income statement can be “doctored” by such tactics as depreciating assets too slowly, not recognizing bad debts promptly, and the like. However, it is far more difficult to simultaneously doctor profits and the working capital accounts. Therefore, it is not uncommon for a company to report positive net income right up to the day it declares bankruptcy. In such cases, however, the net cash flow from operations almost always began to deteriorate much earlier, and analysts who kept an eye on cash flow could have predicted trouble. Therefore, if you are ever analyzing a company and are pressed for time, look first at the trend in net cash flow provided by operating activities, because it will tell you more than any other single number.

The second section shows investing activities. MicroDrive purchased fixed assets totaling $500 million and sold $40 million of short-term investments, for a net cash flow from investing activities of minus $460 million.

The third section, financing activities, includes borrowing from banks (notes payable), selling new bonds, and paying dividends on common and preferred stock. MicroDrive raised $350 million by borrowing, but it paid $58 million in preferred and common dividends. Therefore, its net inflow of funds from financing activities was $292 million.

The last section shows the summary. When all of the previous activities are totaled, we see that MicroDrive’s cash outflows exceeded its cash inflows by $10 million during 2016; that is, its net change in cash was a negative $10 million.

MicroDrive’s statement of cash flows should be worrisome to its managers and to outside analysts. The company had $5 billion in sales but generated only $158 million from operations, not nearly enough to cover the $500 million it spent on fixed assets and the $58 million it paid in dividends. It covered these cash outlays by borrowing heavily and by liquidating short-term investments. Obviously, this situation cannot continue year after year, so MicroDrive managers will have to make changes. We will return to MicroDrive throughout the textbook to see what actions its managers are planning.

Filling in the GAAP

While U.S. companies adhere to “generally accepted account- ing principles,” or GAAP, when preparing financial statements, most other developed countries use “International Financial Reporting Standards,” or IFRS. The U.S. GAAP system is rules- based, with thousands of instructions, or “guidances,” for how individual transactions should be reported in financial state- ments. IFRS, on the other hand, is a principles-based system in which detailed instructions are replaced by overall guiding principles.

For example, whereas GAAP provides extensive and detailed rules about when to recognize revenue from any conceivable activity, IFRS provides just four categories of revenue and two overall principles for timing recognition. This means that even the most basic accounting measure, revenue, is different under the two standards—Total Rev- enue, or Sales, under GAAP won’t typically equal Total Revenue under IFRS. Thus, financial statements prepared under GAAP cannot be compared directly to IFRS financial

statements, making comparative financial analysis of U.S. and international companies difficult. Perhaps more proble- matic is that the IFRS principles allow for more company discretion in recording transactions. This means that two companies may treat identical transactions differently when using IFRS, which makes company-to-company comparisons more difficult.

The U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working to merge the two sets of standards since 2002. Some of the joint standards are completed but many important standards, such as revenue recogni- tion, had not been adopted as of early 2015. In fact, it seems likely that adoption of worldwide standards will not happen in the near future.

To keep abreast of developments in IFRS/GAAP con- vergence, visit the IASB Web site at www.iasb.org and the FASB Web site at www.fasb.org.

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S E L F - T E S T

What types of questions does the statement of cash flows answer?

Identify and briefly explain the three categories of activities in the statement of cash flows.

A firm has inventories of $2 million for the previous year and $1.5 million for the current year. What impact does this have on net cash provided by operations? (Increase of $500,000)

2-6 Net Cash Flow In addition to the cash flow from operations as defined in the statement of cash flows, many analysts also calculate net cash flow, which is defined as:

Net cash flow Net income − Noncash revenues Noncash expenses (2-1)

where net income is the net income available for distribution to common shareholders. Depreciation and amortization usually are the largest noncash items, and in many cases the other noncash items roughly net out to zero. For this reason, many analysts assume that net cash flow equals net income plus depreciation and amortization:

Net cash flow Net income Depreciation and amortization (2-2)

We will generally assume that Equation 2-2 holds. However, you should remember that Equation 2-2 will not accurately reflect net cash flow when there are significant noncash items other than depreciation and amortization.

We can illustrate Equation 2-2 with 2016 data for MicroDrive taken from Figure 2-2:

Net cash flow $220 $200 $420 million

You can think of net cash flow as the profit a company would have if it did not have to replace fixed assets as they wear out. This is similar to the net cash flow from operating activities shown on the statement of cash flows, except that the net cash flow from operating activities also includes the impact of working capital. Net income, net cash flow, and net cash flow from operating activities each provide insight into a company’s financial health, but none is as useful as the measures we discuss in the next section.

S E L F - T E S T

Differentiate between net cash flow and accounting profit.

A firm has net income of $5 million. Assuming that depreciation of $1 million is its only noncash expense, what is the firm’s net cash flow? ($6 million)

2-7 Free Cash Flow: The Cash Flow Available for Distribution to Investors

So far in the chapter we have focused on financial statements as presented in the annual report. When you studied income statements in accounting, the emphasis was probably on the firm’s net income. However, the intrinsic value of a company’s operations is determined by the stream of cash flows that the operations will generate now and in the future. To be

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more specific, the value of operations depends on all the future expected free cash flows (FCF), defined as after-tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Therefore, the way for managers to make their companies more valuable is to increase free cash flow now and in the future.

Notice that FCF is the cash flow available for distribution to all the company’s investors after the company has made all investments necessary to sustain ongoing operations. How successful were MicroDrive’s managers in generating FCF? In this section, we will calculate MicroDrive’s FCF and evaluate the performance of MicroDrive’s managers.

Figure 2-5 shows the five steps in calculating free cash flow. As we explain each individual step in the following sections, refer back to Figure 2-5 to keep the big picture in mind.

2-7a Net Operating Profit after Taxes (NOPAT) If two companies have different amounts of debt, thus different amounts of interest charges, they could have identical operating performances but different net incomes— the one with more debt would have a lower net income. Net income is important, but it does not always reflect the true performance of a company’s operations or the effective- ness of its managers. A better measure for comparing managers’ performance is net operating profit after taxes (NOPAT), which is the amount of profit a company would generate if it had no debt and held no financial assets. NOPAT is defined as follows:7

FIGURE 2-5 Calculating Free Cash Flow

Operating current liabilities

Operating current assets

Net operating working capital

Net operating working capital

–

+

–

Operating long-term assets

Total net operating capital

X

Net operating profit a�er taxes

Earnings before interest and taxes

Step 1 Step 2

Step 3

Step 4 Step 5

Net operating profit a�er taxes

Net investment in operating capital

Free cash flow

(1 – Tax rate)

Total net operating capital this year

– Total net operating capital last year

Net investment in operating capital

7For firms with a more complicated tax situation, it is better to define NOPAT as follows: NOPAT Net income before preferred dividends Net interest expense 1 − Tax rate . Also, if a firm is able to defer paying some taxes, perhaps by the use of accelerated depreciation, then it needs to adjust NOPAT to reflect the taxes it actually paid on operating income. See P. Daves, M. Ehrhardt, and R. Shrieves, Corporate Valuation: A Guide for Managers and Investors (Mason, OH: Thomson South-Western, 2004) for a detailed explanation of these and other adjustments.

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NOPAT EBIT 1 − Tax rate (2-3)

Using data from the income statements of Figure 2-2, MicroDrive’s 2016 NOPAT is:

NOPAT $500 1 − 0 4 $500 0 6 $300 million

This means MicroDrive generated an after-tax operating profit of $300 million, less than its previous NOPAT of $550 0 6 $330 million.

2-7b Net Operating Working Capital Most companies need some current assets to support their operating activities. For example, all companies must carry some cash to “grease the wheels” of their operations. Companies continuously receive checks from customers and write checks to suppliers, employees, and so on. Because inflows and outflows do not coincide perfectly, a company must keep some cash in its bank account. In other words, it must have some cash to conduct operations. The same is true for most other current assets, such as inventory and accounts receivable, which are required for normal operations. The short-term assets normally used in a company’s operating activities are called operating current assets.

Not all current assets are operating current assets. For example, holdings of short-term marketable securities generally result from investment decisions made by the treasurer and not as a natural consequence of operating activities. Therefore, short-term invest- ments are nonoperating assets and normally are excluded when calculating operating current assets. A useful rule of thumb is that if an asset pays interest, it should not be classified as an operating asset.

In this textbook we will always distinguish between the cash needed for operations and the marketable securities held as short-term investments. However, many companies don’t make such a clean distinction. For example, Google reported $18 billion in cash at the end of 2014, in addition to $46 billion in short-term investments. Google certainly doesn’t need $18 billion in cash to run its business operations. Therefore, if we were calculating operating current assets for Google, we would classify about $2 billion as cash and the remainder as short-term investments: $18 − $2 $46 $62 billion. The reverse situation is possible, too, where a company reports very little cash but many short-term investments. In such a case we would classify some of the short-term investments as operating cash when calculating operating current assets.

Some current liabilities—especially accounts payable and accruals—arise in the normal course of operations. Such short-term liabilities are called operating current liabilities. Not all current liabilities are operating current liabilities. For example, consider the current liability shown as notes payable to banks. The company could have raised an equivalent amount as long-term debt or could have issued stock, so the choice to borrow from the bank was a financing decision and not a consequence of operations. Again, the rule of thumb is that if a liability charges interest, it is not an operating liability.

If you are ever uncertain about whether an item is an operating asset or operating liability, ask yourself whether the item is a natural consequence of operations or if it is a discretionary choice, such as a particular method of financing or an investment in a particular financial asset. If it is discretionary, then the item is not an operating asset or liability.

Notice that each dollar of operating current liabilities is a dollar that the company does not have to raise from investors in order to conduct its short-term operating activities. Therefore, we define net operating working capital (NOWC) as operating

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current assets minus operating current liabilities. In other words, net operating working capital is the working capital acquired with investor-supplied funds. Here is the definition in equation form:

Net operating working capital

Operating current assets −

Operating current liabilities

(2-4)

We can apply these definitions to MicroDrive, using the balance sheet data given in Figure 2-1. Here is its net operating working capital at year-end 2016:

NOWC Operating current assets − Operating current liabilities Cash Accounts receivable Inventories

− Accounts payable Accruals $50 $500 $1,000 − $200 $300

$1,050 million For the previous year, net operating working capital was:

NOWC $60 $380 $820 − $190 $280 $790 million

2-7c Total Net Operating Capital In addition to working capital, most companies also use long-term assets to support their operations. These include land, buildings, factories, equipment, and the like. Total net operating capital is the sum of NOWC and operating long-term assets such as net plant and equipment:

Total net operating capital NOWC Operating long-term assets (2-5)

Because MicroDrive’s operating long-term assets consist only of net plant and equip- ment, its total net operating capital at year-end 2016 was:

Total net operating capital $1,050 $2,000 $3,050 million

For the previous year, its total net operating capital was:

Total net operating capital $790 $1,700 $2,490 million

Notice that we have defined total net operating capital as the sum of net operating working capital and operating long-term assets. In other words, our definition is in terms of operating assets and liabilities. However, we can also calculate total net operating capital by looking at the sources of funds. Total investor-supplied capital is defined as the total of funds provided by investors, such as notes payable, long-term bonds, preferred stock, and common equity. For most companies, total investor-supplied capital is:

Total investor-supplied capital

Notes payable

Long-term bonds

Preferred stock

Common equity

(2-6)

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For MicroDrive, the total capital provided by investors at year-end 2015 was $130 $1,000 $100 $1,300 $2,530 million. Of this amount, $40 million was tied up in short-term investments, which are not directly related to MicroDrive’s operations. There- fore, we define total investor-supplied operating capital as:

Total investor-supplied operating capital

Total investor-supplied operating capital −

Short-term investments

(2-7)

MicroDrive had $2,530 − $40 $2,490 million of investor-supplied operating capital in 2015. Notice that this is exactly the same value as calculated before. Therefore, we can calculate total net operating capital either from net operating working capital and operating long-term assets or from the investor-supplied funds. We usually base our calculations on operating data because this approach allows us to analyze a division, factory, or work center. In contrast, the approach based on investor-supplied capital is applicable only for the entire company.

The expression “total net operating capital” is a mouthful, so we often call it operating capital or even just capital. Also, unless we specifically say “investor-supplied capital,” we are referring to total net operating capital.

2-7d Net Investment in Operating Capital As calculated previously, MicroDrive had $2,490 million of total net operating capital at the end of 2015 and $3,050 million at the end of 2016. Therefore, during 2016, it made a net investment in operating capital of:

Net investment in operating capital $3,050 − $2,490 $560 million

Much of this investment was made in net operating working capital, which rose from $790 million to $1,050 million, or by $260 million. This 33% increase in net operating working capital, in view of a sales increase of only 5% (to $5 billion from $4.76 billion), should set off warning bells in your head: Why did MicroDrive tie up so much additional cash in working capital? Is the company gearing up for a big increase in sales, or are inventories not moving and receivables not being collected? We will address these questions in detail in Chapter 3, when we cover ratio analysis.

2-7e Calculating Free Cash Flow Free cash flow is defined as:

FCF NOPAT − Net investment in operating capital (2-8)

MicroDrive’s free cash flow in 2016 was:

FCF $300 − $3,050 − $2,490 $300 − $560 − $260 million

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Although we prefer the approach we just explained, sometimes the financial press calculates FCF differently:

FCF EBIT 1−TDepreciation − Gross investment in fixed assets −

Investment NOWC

(2-9)

For MicroDrive, this calculation is:

FCF $300 $200 − $500 − $1,050 − $790 −$260 Notice that the results are the same for either calculation. To see this, substitute

NOPAT into the first bracket of Equation 2-9 and substitute the definition for net investment in fixed assets into the second bracket:

FCF NOPATDepreciation − Net investment in fixed assets

Depreciation − Investmentin NOWC

(2-9a)

Both the first and second brackets have depreciation, so depreciation can be canceled out, leaving:

FCF NOPAT − Net investmentin fixed assets − Investment in NOWC

(2-9b)

The last two bracketed terms are equal to the net investment in operating capital, so Equation 2-9b simplifies to Equation 2-8. We usually use Equation 2-8 because it saves us the step of adding depreciation both to NOPAT and to the net investment in fixed assets and also because frequently only net fixed assets and not gross fixed assets are reported on the firm’s financial statements.

2-7f The Uses of FCF Recall that free cash flow (FCF) is the amount of cash that is available for distribution to all investors, including shareholders and debtholders. There are five good uses for FCF:

1. Pay interest to debtholders, keeping in mind that the net cost to the company is the after-tax interest expense.

2. Repay debtholders; that is, pay off some of the debt. 3. Pay dividends to shareholders. 4. Repurchase stock from shareholders. 5. Buy short-term investments or other nonoperating assets.

Consider MicroDrive, with its FCF of −$260 million in 2016. How did MicroDrive use the FCF?

MicroDrive’s income statement shows an interest expense of $120 million. With a tax rate of 40%, the after-tax interest payment for the year is:

After-tax interest payment $120 1 − 40% $72 million

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The net amount of debt that is repaid is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes notes payable and long-term debt. If the amount of ending debt is less than the beginning debt, the company paid down some of its debt. But if the ending debt is greater than the beginning debt, the company actually borrowed additional funds from creditors. In that case, it would be a negative use of FCF. For MicroDrive, the net debt repayment for 2016 is equal to the amount at the beginning of the year minus the amount at the end of the year:

Net debt repayment $130 $1,000 − $280 $1,200 −$350 million

This is a “negative use” of FCF because it increased the debt balance. This is typical of most companies because growing companies usually add debt each year.

MicroDrive paid $8 million in preferred dividends and $50 in common dividends for a total of:

Dividend payments $8 $50 $58 million

The net amount of stock that is repurchased is equal to the amount at the beginning of the year minus the amount at the end of the year. This includes preferred stock and common stock. If the amount of ending stock is less than the beginning stock, then the company made net repurchases. But if the ending stock is greater than the beginning stock, the company actually made net issuances. In that case, it would be a negative use of FCF.

Sarbanes-Oxley and Financial Fraud

Investors need to be cautious when they review financial statements. Although companies are required to follow generally accepted accounting principles (GAAP), man- agers still use a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legit- imate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings in the current year or more stable earn- ings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances.

Unfortunately, there have also been cases in which managers reported fraudulent statements. Indeed, a num- ber of high-profile executives have faced criminal charges because of their misleading accounting practices. For example, in June 2002 it was discovered that WorldCom (now called MCI, which is a subsidiary of Verizon Communications)

had committed the most massive accounting fraud of all time by recording over $7 billion of ordinary operating costs as capital expenditures, thus overstating net income by the same amount.

WorldCom’s published financial statements fooled most investors, who bid the stock price up to $64.50, and banks and other lenders provided the company with more than $30 billion of loans. Arthur Andersen, the firm’s audi- tor, was faulted for not detecting the fraud. WorldCom’s CFO and CEO were convicted, and Arthur Andersen went bankrupt. But these consequences didn’t help the inves- tors who relied on the published financial statements.

In response to these and other abuses, Congress passed the Sarbanes-Oxley Act of 2002. One of its provi- sions requires both the CEO and the CFO to sign a state- ment certifying that the “financial statements and disclo- sures fairly represent, in all material respects, the operations and financial condition” of the company. In principle, this should make it easier to haul off in handcuffs a CEO or CFO who has been misleading investors. In prac- tice, however, no executives have been sent to jail, although some have lost their jobs.

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Even though MicroDrive neither issued nor repurchased stock during the year, many companies use FCF to repurchase stocks as a replacement for or supplement to dividends, as we discuss in Chapter 14.

The amount of net purchases of short-term investments is equal to the amount at the end of the year minus the amount at the beginning of the year. If the amount of ending investments is greater than the beginning investments, then the company made net purchases. But if the ending investments are less than the beginning investments, the company actually sold investments. In that case, it would be a negative use of FCF. MicroDrive’s net purchases of short-term investments in 2016 are:

Net purchases of short-term investments $0 − $40 −$40 million

Notice that this is a “negative use” because MicroDrive sold short-term investments instead of purchasing them.

We combine these individual uses of FCF to find the total uses:

As it should be, the −$260 total for uses of FCF is identical to the value of FCF from operations that we calculated previously.

Observe that a company does not use FCF to acquire operating assets, because the calculation of FCF already takes into account the purchase of operating assets needed to support growth. Unfortunately, there is evidence to suggest that some companies with high FCF tend to make unnecessary investments that don’t add value, such as paying too much to acquire another company. Thus, high FCF can cause waste if managers fail to act in the best interests of shareholders. As discussed in Chapter 1, this is called an agency cost, because managers are hired as agents to act on behalf of stockholders. We discuss agency costs and ways to control them in Chapter 13 (where we discuss corporate governance) and in Chapter 15 (where we discuss the choice of capital structure).

2-7g FCF and Corporate Value Free cash flow is the amount of cash available for distribution to investors; so the fundamental value of a company to its investors depends on the present value of its expected future FCFs, discounted at the company’s weighted average cost of capital (WACC). Subsequent chapters will develop the tools needed to forecast FCFs and evaluate their risk. Chapter 7 ties all this together with a model used to calculate the value of a company. Even though you do not yet have all the tools to apply the model, you must understand this basic concept: FCF is the cash flow available for distribution to investors. Therefore, a company’s fundamental value depends primarily on its expected future FCF.

1. After-tax interest: $ 72 2. Net debt repayments: −350 3. Dividends: 58 4. Net stock repurchases: 0 5. Net purchases of ST investments: −40

Total uses of FCF: −$260

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S E L F - T E S T

What is net operating working capital? Why does it exclude most short-term investments and notes payable?

What is total net operating capital? Why is it important for managers to calculate a company’s capital requirements?

Why is NOPAT a better performance measure than net income?

What is free cash flow? What are its five uses? Why is FCF important?

Suppose a firm has the following information: Sales $10 million; costs of goods sold excluding depreciation $5 million; depreciation $1 4 million; other operating expenses $2 million; interest expense $1 million. If the tax rate is 25%, what is NOPAT, the net operating profit after taxes? ($1,200,000)

Suppose a firm has the following information: Cash $500,000; short-term investments $2 5 million; accounts receivable $1 2 million; net plant and equipment $7 8 million. How much is tied up in operating current assets? ($2,700,000)

Suppose a firm has the following information: Accounts payable $1 million; notes payable $1 1 million; short-term debt $1 4 million; accruals $500,000; and long-term bonds $3 million. What is the amount arising from operating current liabilities? ($1,500,000)

Suppose a firm has the following information: Operating current assets $2 7 million; operating current liabilities $1 5 million, long-term bonds $3 million, net plant and equipment $7 8 million; and other long-term operating assets $1 million. How much is tied up in net operating working capital (NOWC)? ($1,500,000) How much is tied up in total net operating capital? ($10,000,000)

A firm’s total net operating capital for the previous year was $9.3 million. For the current year, its total net operating capital is $10 million and its NOPAT is $1.2 million. What is its free cash flow for the current year? ($700,000)

2-8 Performance Evaluation Because free cash flow has such a big impact on value, managers and investors can use FCF and its components to measure a company’s performance. The following sections explain three performance measures: return on invested capital, market value added, and economic value added.

2-8a The Return on Invested Capital Even though MicroDrive had a positive NOPAT, its very high investment in operating assets caused a negative FCF. Is a negative free cash flow always bad? The answer is, “Not necessarily; it depends on why the free cash flow is negative.” It’s a bad sign if FCF is negative because NOPAT is negative, which probably means the company is experi- encing operating problems. However, many high-growth companies have positive NOPAT but negative FCF because they are making large investments in operating assets to support growth. For example, Buffalo Wild Wings’s sales grew by 33% in 2012 and its NOPAT was stable compared to 2011 at $60 million; however, its FCF was negative $42 million, due largely to a $100 million investment in operating capital to support its high sales growth.

There is nothing wrong with value-adding growth, even if it causes negative free cash flows in the short term, but it is vital to determine whether growth is actually adding

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value. For this we use the return on invested capital (ROIC), which shows how much NOPAT is generated by each dollar of operating capital:

ROIC NOPAT

Operating capital (2-10)

As shown in Figure 2-6, in 2016 MicroDrive’s ROIC is $300 $3,050 9 84%. To determine whether this ROIC is high enough to add value, compare it to the weighted average cost of capital (WACC). Chapter 9 explains how to calculate the WACC; for now, accept that the WACC considers a company’s individual risk as well as overall market conditions. Figure 2-6 shows that MicroDrive’s 9.84% ROIC is less than its 11% WACC. Thus, MicroDrive did not generate a sufficient rate of return to compensate its investors for the risk they bore in 2016. This is markedly different from the previous year, in which MicroDrive’s 13.25% ROIC was greater than its 10.5% WACC. Not only is the current ROIC too low, but the trend is in the wrong direction.

Is MicroDrive’s ROIC low due to low operating profitability, poor capital utilization, or both? To answer that question, begin with the operating profitability ratio (OP), which measures the percentage operating profit per dollar of sales:

Operating profitability ratio OP NOPAT

Sales (2-11)

MicroDrive’s current operating profitability ratio is:

OP $300

$5,000 6 00% (2-11a)

and its previous operating profitability ratio was 6.93%. The average operating profit- ability ratio for companies in MicroDrive’s industry is 6.92%, so MicroDrive’s operating profitability is trending in the wrong direction and is a bit lower than its industry average. Although troubling, MicroDrive’s operating profitability does not seem to be the primary reason ROIC dropped so much.

Let’s take a look at how effectively MicroDrive uses its capital. The capital requirement ratio (CR) measures how much operating capital is tied up in generating a dollar of sales:

Capital requirement ratio CR Total net operating capital

Sales (2-12)

MicroDrive’s current capital requirement ratio is:

OP $3,050 $5,000

61 0% (2-12a)

and its previous capital requirement ratio was 52.3%. This shows that MicroDrive tied up much more in operating capital needed to generate sales in the current year than it did in

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FIGURE 2-6 Calculating Performance Measures for MicroDrive Inc. (Millions of Dollars and Millions of Shares)

400 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417 418 419 420 421 422 423 424 425 426 427 428 429 430 431 432 433 434 435 436 437 438 439 440 441 442 443

A B C D E F G 2016 2015

$550$500TIBE x (1 Tax rate) 60% 60%

NOPAT = EBIT (1 T ) $330$300

Operating current assets $1,260$1,550 Operating current liabilities $500 $470

$790$1,050NOWC

$790$1,050NOWC + Net plant and equipment $2,000 $1,700

T otal net operating capital $2,490$3,050

$330$300NOPAT ÷ T otal net operating capital $3,050 $2,490

ROIC = NOPAT /T otal net operating capital 13.25%9.84% Weighted average cost of capital (WACC) 10.50%11.00%

$330$300NOPAT ÷ Sales $5,000 $4,760

OP = NOPAT /Sales 6.93%6.00%

T otal net operating capital $2,490$3,050 ÷ Sales $5,000 $4,760

CR = T otal net operating capital/Sales 52.31%61.00%

Price per share $40$27 x Number of shares (millions) 50 50

Market value of equity = P x (# of shares) $2,000$1,350 Book value of equity $1,470 $1,300 MVA = Market value Book value $120 $700

T otal net operating capital $2,490.0$3,050.0 x Weighted average cost of capital (WACC) 11.0% 10.5%

Dollar cost of capital $261.5$335.5

$330.0$300.0NOPAT Dollar cost of capital $335.5 $261.5 EVA = NOPAT – Dollar cost of capital $35.5 $68.6446

445 444

Source: See the file Ch02 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

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the previous year (61.0% versus 52.3%). Even more alarming, MicroDrive’s capital requirement ratio is much worse than the industry average of 46.0%.

To summarize, the decline in MicroDrive’s return on invested capital is primarily due to its poor utilization of capital. We will have much more to say about this in later chapters.

Although not the case for MicroDrive, in many situations a negative FCF is not necessarily bad. For example, Buffalo Wild Wings had a negative FCF in 2012, but its ROIC was about 18.3%. Because its WACC was only 12%, Buffalo Wild Wings’s growth was adding value.8 At some point its growth will slow and it will not require such large capital investments. If it maintains a high ROIC, then its FCF will become positive and very large as growth slows.

Neither traditional accounting data nor return on invested capital incorporates stock prices, even though the primary goal of management should be to maximize the firm’s intrinsic stock price. In contrast, Market Value Added (MVA) and Economic Value Added (EVA) do attempt to compare intrinsic measures with market measures.9

2-8b Market Value Added (MVA) One measure of shareholder wealth is the difference between the market value of the firm’s stock and the cumulative amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA):

MVA Market value of stock − Equity capital supplied by shareholders Shares outstanding Stock price − Total common equity

(2-13)

To illustrate, consider Coca-Cola. In September 2013, its total market equity value, commonly called market capitalization, was $170 billion while its balance sheet showed that stockholders had put up only $33 billion. Thus, Coca-Cola’s MVA was $170 − $33 $137 billion. This $137 billion represents the difference between the money that Coca-Cola’s stockholders have invested in the corporation since its founding— including indirect investment by retaining earnings—and the cash they could get if they sold the business. The higher its MVA, the better the job management is doing for the firm’s shareholders.

Sometimes MVA is defined as the total market value of the company minus the total amount of investor-supplied capital:

MVA Total market value − Total investor-supplied capital Market value of stock Market value of debt − Total investor-supplied capital

(2-13a)

8If g is the growth rate in capital, then with a little (or a lot of!) algebra, free cash flow is:

FCF Capital ROIC − g

1 g

This shows that when the growth rate gets almost as high as ROIC, then FCF will be negative. 9The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of the consulting firm Stern Stewart & Company. Stern Stewart trademarked the term “EVA” so other consulting firms have given other names to this value as they have to MVA. Still, EVA and MVA are the terms most commonly used in practice.

w w w For an updated estimate of Coca-Cola’s MVA, go to http://finance.yahoo .com, enter KO, and click GO. This shows the market value of equity, called Mkt Cap. To get the book value of equity, select Balance Sheet from the left panel.

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For most companies, the total amount of investor-supplied capital is the sum of equity, debt, and preferred stock. We can calculate the total amount of investor-supplied capital directly from their reported values in the financial statements. The total market value of a company is the sum of the market values of common equity, debt, and preferred stock. It is easy to find the market value of equity because stock prices are readily available, but it is not always easy to find the market value of debt. Hence, many analysts use the value of debt reported in the financial statements, which is the debt’s book value, as an estimate of the debt’s market value.

For Coca-Cola, the total amount of reported debt was about $31 billion; Coca-Cola had no preferred stock. Using the debt’s book value as an estimate of the debt’s market value, Coke’s total market value was $170 $31 $201 billion. The total amount of investor-supplied funds was $33 $31 $64 billion. Using these total values, the MVA was $201 − $64 $137 billion. Note that this is the same answer as when we used the previous definition of MVA. Both methods will give the same result if the market value of debt is approximately equal to its book value.

Figure 2-6 shows that MicroDrive has 50 million shares of stock and a stock price of $27, giving it a market value of equity equal to $1,350 million. MicroDrive has $1,470 million in book equity, so its MVA is $1,350 − $1,470 −$120 million. In other words, MicroDrive’s current market value is less than the cumulative amount of equity that its shareholders have invested during the company’s life.

2-8c Economic Value Added (EVA) Whereas MVA measures the effects of managerial actions since the inception of a company, Economic Value Added (EVA) focuses on managerial effectiveness in a given year. The EVA formula is:

EVA Net operating profitafter taxes − After-tax dollar cost of capital

used to support operations

NOPAT − Total net operating capital WACC (2-14)

Economic Value Added is an estimate of a business’s true economic profit for the year, and it differs sharply from accounting profit.10 EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted, whereas accounting profit is determined without imposing a charge for equity capital. As we will discuss in Chapter 9, equity capital has a cost because shareholders give up the opportu- nity to invest and earn returns elsewhere when they provide capital to the firm. This cost is an opportunity cost rather than an accounting cost, but it is real nonetheless.

Note that when calculating EVA we do not add back depreciation. Although it is not a cash expense, depreciation is a cost because worn-out assets must be replaced, and it is therefore deducted when determining both net income and EVA. Our calculation of EVA assumes that the true economic depreciation of the company’s fixed assets exactly equals the depreciation used for accounting and tax purposes. If this were not the case, adjust- ments would have to be made to obtain a more accurate measure of EVA.

10The most important reason EVA differs from accounting profit is that the cost of equity capital is deducted when EVA is calculated. Other factors that could lead to differences include adjustments that might be made to depreciation, to research and development costs, to inventory valuations, and so on. These other adjustments also can affect the calculation of investor-supplied capital, which affects both EVA and MVA. See G. Bennett Stewart, III, The Quest for Value (New York: HarperCollins Publishers, Inc., 1991).

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Economic Value Added measures the extent to which the firm has increased share- holder value. Therefore, if managers focus on EVA, they will more likely operate in a manner consistent with maximizing shareholder wealth. Note too that EVA can be determined for divisions as well as for the company as a whole, so it provides a useful basis for determining managerial performance at all levels. Consequently, many firms include EVA as a component of compensation plans.

We can also calculate EVA in terms of ROIC:

EVA Total net operating capital ROIC − WACC (2-15)

As this equation shows, a firm adds value—that is, has a positive EVA—if its ROIC is greater than its WACC. If WACC exceeds ROIC, then growth can actually reduce a firm’s value.

Using Equation 2-12, Figure 2-6 shows that MicroDrive’s EVA is:

EVA $300 − $3,050 11% $300 − $335 5 − $35 5 million

This negative EVA reinforces our earlier conclusions that MicroDrive lost value in 2015 due to an erosion in its operating performance. In Chapters 7 and 12, we will determine MicroDrive’s intrinsic value and explore ways in which MicroDrive can reverse its downward trend.

2-8d Intrinsic Value, MVA, and EVA We will have more to say about both MVA and EVA later in the book, but we can close this section with two observations. First, there is a relationship between MVA and EVA, but it is not a direct one. If a company has a history of negative EVAs, then its MVA will probably be negative; conversely, its MVA probably will be positive if the company has a history of positive EVAs. However, the stock price, which is the key ingredient in the MVA calculation, depends more on expected future performance than on historical performance. Therefore, a company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future.

The second observation is that when EVAs or MVAs are used to evaluate managerial performance as part of an incentive compensation program, EVA is the measure that is typically used. The reasons are: (1) EVA shows the value added during a given year, whereas MVA reflects performance over the company’s entire life, perhaps even including times before the current managers were born. (2) EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.

S E L F - T E S T

A company has sales of $200 million, NOPAT of $12 million, net income of $8 million, new operating working capital (NOWC) of $10 million, total net operating capital of $100 million, and total assets of $110 million. What is it operating profitability (OP) ratio? (6%) Its capital requirement (CF) ratio? (50%) Its return on invested capital (ROIC)? (12%)

Define Market Value Added (MVA) and Economic Value Added (EVA).

How does EVA differ from accounting profit?

A firm has $100 million in total net operating capital. Its return on invested capital is 14%, and its weighted average cost of capital is 10%. What is its EVA? ($4 million)

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2-9 The Federal Income Tax System The value of any financial asset (including stocks, bonds, and mortgages), as well as most real assets such as plants or even entire firms, depends on the after-tax stream of cash flows produced by the asset. The following sections describe the key features of corporate and individual taxation.

2-9a Corporate Income Taxes The corporate tax structure, shown in Table 2-1, is relatively simple. The marginal tax rate is the rate paid on the last dollar of income, while the average tax rate is the average rate paid on all income. To illustrate, if a firm had $65,000 of taxable income, its tax bill would be:

Taxes $7,500 0 25 $65,000 − $50,000 $7,500 $3,750 $11,250

Its marginal rate would be 25%, and its average tax rate would be $11,250 $65,000 17 3%. Note that corporate income above $18,333,333 has an average and marginal tax rate of 35%.

INTEREST AND DIVIDEND INCOME RECEIVED BY A CORPORATION Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. However, 70% of the dividends received by one corporation from another are excluded from taxable income, while the remaining 30% are taxed at the ordinary tax rate.11 Thus, a corporation earning more than $18,333,333 and paying a 35% marginal tax rate would pay only 0 30 0 35 0 105 10 5% of its dividend

TABLE 2-1 Corporate Tax Rates as of January 2015

If a Corporation’s Taxable Income Is

It Pays This Amount on the Base of the Bracket

Plus This Percentage on the Excess over the Base

Average Tax Rate at Top of Bracket

Up to $50,000 $0 15% 15.0%

$50,000–$75,000 $7,500 25 18.3

$75,000–$100,000 $13,750 34 22.3

$100,000–$335,000 $22,250 39 34.0

$335,000–$10,000,000 $113,900 34 34.0

$10,000,000–$15,000,000 $3,400,000 35 34.3

$15,000,000–$18,333,333 $5,150,000 38 35.0

Over $18,333,333 $6,416,667 35 35.0

Source: See the IRS instructions for Form 1120 at www.irs.gov/pub/irs-pdf/i1120.pdf.

11The size of the dividend exclusion actually depends on the degree of ownership. Corporations that own less than 20% of the stock of the dividend-paying company can exclude 70% of the dividends received; firms that own more than 20% but less than 80% can exclude 80% of the dividends; and firms that own more than 80% can exclude the entire dividend payment. We will, in general, assume a 70% dividend exclusion.

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income as taxes, so its effective tax rate on dividends received would be 10.5%. If this firm had $10,000 in pre-tax dividend income, then its after-tax dividend income would be $8,950:

After-tax income Before-tax income − Taxes Before-tax income − Before-tax income Effective tax rate Before-tax income 1 − Effective tax rate

$10,000 1 − 0 30 0 35 $10,000 1 − 0 105 $10,000 0 895 $8,950

If the corporation pays its own after-tax income out to stockholders as dividends, then the income is ultimately subject to triple taxation: (1) The original corporation is first taxed. (2) The second corporation is then taxed on the dividends it received. (3) The individuals who receive the final dividends are taxed again. This is the reason for the 70% exclusion on intercorporate dividends.

If a corporation has surplus funds that can be invested in marketable securities, the tax treatment favors investment in stocks, which pay dividends, rather than in bonds, which pay interest. For example, suppose Microsoft had $1 million to invest, and suppose it could buy either bonds that paid interest of $80,000 per year or preferred stock that paid dividends of $70,000. Microsoft is in the 35% tax bracket; therefore, its tax on the interest, if it bought bonds, would be 0 35 $80,000 $28,000, and its after-tax income would be $52,000. If it bought preferred (or common) stock, its tax would be 0 35 0 30 $70,000 $7,350, and its after-tax income would be $62,650. Other factors might lead Microsoft to invest in bonds, but the tax treatment certainly favors stock investments when the investor is a corporation.12

INTEREST AND DIVIDENDS PAID BY A CORPORATION A firm’s operations can be financed with either debt or equity capital. If the firm uses debt, then it must pay interest on this debt, but if the firm uses equity, then it is expected to pay dividends to the equity investors (stockholders). The interest paid by a corporation is deducted from its operating income to obtain its taxable income, but dividends paid are not deductible. Therefore, a firm needs $1 of pre-tax income to pay $1 of interest, but if it is in the 40% federal-plus-state tax bracket, it must earn $1.67 of pre-tax income to pay $1 of dividends:

Pre-tax income needed to pay $1 of dividends

$1 1 − Tax rate

$1 0 60

$1 67

Working backward, if a company has $1.67 in pre-tax income, it must pay $0.67 in taxes: 0 4 $1 67 $0 67. This leaves the firm with after-tax income of $1.00.

Of course, it is generally not possible to finance exclusively with debt capital, and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed: Our corporate tax system favors debt financing over equity financing. This point is discussed in more detail in Chapters 15 and 16.

12This illustration demonstrates why corporations favor investing in lower-yielding preferred stocks over higher- yielding bonds. When tax consequences are considered, the yield on the preferred stock, 1 − 0 35 0 30 7 0% 6 265%, is higher than the yield on the bond, 1 − 0 35 8 0% 5 2%. Also, note

that corporations are restricted in their use of borrowed funds to purchase other firms’ preferred or common stocks. Without such restrictions, firms could engage in tax arbitrage, whereby the interest on borrowed funds reduces taxable income on a dollar-for-dollar basis while taxable income is increased by only $0.30 per dollar of dividend income. Thus, current tax laws reduce the 70% dividend exclusion in proportion to the amount of borrowed funds used to purchase the stock.

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CORPORATE CAPITAL GAINS A capital gain occurs when an asset is sold for more than its book value and a capital loss occurs when the reverse happens. Before 1987 long-term corporate capital gains were taxed at lower rates than the regular corporate tax rates shown in Table 2-1. Under current law, however, corporations’ capital gains are taxed at the same rates as their operating income.

CORPORATE LOSS CARRYBACK AND CARRYFORWARD A corporation’s actual payments in a current year depend on its past losses as well as its current profit due to tax loss carryback and carryforward provisions. Ordinary corporate operating losses can be carried back to each of the preceding 2 years and carried forward for the next 20 years and thus be used to offset taxable income in those years. For example, an operating loss in 2016 could be carried back and used to reduce taxable income in 2014 and 2015 as well as carried forward, if necessary, to reduce taxes in 2017, 2018, and so on, to the year 2036. After carrying back 2 years, any remaining loss is typically carried forward, first to the next year, then to the one after that, and so on, until losses have been used up or the 20-year carryforward limit has been reached.

To illustrate, suppose Apex Corporation had $2 million of pre-tax profits (taxable income) in 2014 and 2015, and then, in 2016, Apex lost $12 million. Also, assume that Apex’s federal-plus-state tax rate is 40%. As shown in Table 2-2, the company would use the carryback feature to recalculate its taxes for 2014, using $2 million of the 2016

When It Comes to Taxes, History Repeats and Repeals Itself!

Prior to 1987, many large corporations such as General Electric and Boeing paid no federal income taxes even though they reported profits. How could this happen? Some expenses, especially depreciation, were defined dif- ferently for calculating taxable income than for reporting earnings to stockholders. So some companies reported positive profits to stockholders but losses—hence no taxes—to the Internal Revenue Service. Also, some compa- nies that otherwise would have paid taxes were able to use various tax credits to avoid paying taxes.

The Tax Reform Act of 1986 eliminated many loopholes and tightened up provisions in the corporate Alternative Minimum Tax (AMT) code so that companies would not be able to utilize tax credits and accelerated depreciation to such an extent that their federal taxes fell below a certain minimum level.

Fast-forward to the present. According to a report published in late 2011, General Electric and Boeing paid no federal income taxes in 2008, 2009, or 2010 even though they reported profits in each year. In fact, 30 companies with an average profit of over $1.7 billion per year paid no taxes during the 3-year study period. Of the 280 companies in the study, 97 paid 10% or less of their reported profit as federal income taxes. The average effective rate was less than 19%, much lower than the 35% rate shown in the

corporate tax table. Only 25% of the companies in the study paid more than 30%. How did history repeat itself?

Over the years in response to corporate lobbying efforts Congress gradually repealed many of the 1986 tax reforms and weakened the AMT, adding more and more loopholes and credits. Some of these breaks were for all firms, such as the 2008 acceleration of depreciation intended to stimulate corporate investment in the wake of the global economic crisis. Others were for specific industries, such as tax breaks for ethanol production that might help reduce reliance on imported oil. However, some of the changes appear difficult to justify, such as the 2010 tax breaks given to NASCAR track owners.

The net result is a complicated tax system in which cor- porations with shrewd accountants and well-connected lobby- ists pay substantially less than other companies. As we write this in 2015, President Obama and a few leaders in Congress are calling for corporate tax reform, although Congress as a whole continues to show little interest in rolling back the tax benefits they have granted their well-connected contributors!

Source: Adapted from Robert S. McIntyre, Matthew Gardner, Rebecca J. Wilkins, and Richard Phillips, “Corporate Taxpayers & Corporate Tax Dodgers 2008–10,” Joint Project of Citizens for Tax Justice & the Institute on Taxation and Economic Policy, November 2011; see www.ctj.org/corporatetaxdodgers/Corporate TaxDodgersReport.pdf.

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operating losses to reduce the 2014 pre-tax profit to zero. This would permit it to recover the taxes paid in 2014. Therefore, in 2016 Apex would receive a refund of its 2014 taxes because of the loss experienced in 2016. Because $10 million of the unrecovered losses would still be available, Apex would repeat this procedure for 2015. Thus, in 2016 the company would pay zero taxes for 2016 and also would receive a refund for taxes paid in 2014 and 2015. Apex would still have $8 million of unrecovered losses to carry forward, subject to the 20-year limit. This $8 million could be used to offset future taxable income. The purpose of this loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

IMPROPER ACCUMULATION TO AVOID PAYMENT OF DIVIDENDS Corporations could refrain from paying dividends and thus permit their stockholders to avoid personal income taxes on dividends. To prevent this, the Tax Code contains an improper accumulation provision stating that earnings accumulated by a corporation are subject to penalty rates if the purpose of the accumulation is to enable stockholders to avoid personal income taxes. A cumulative total of $250,000 (the balance sheet item “retained earnings”) is by law exempted from the improper accumulation tax for most corporations. This is a benefit primarily to small corporations.

The improper accumulation penalty applies only if the retained earnings in excess of $250,000 are shown by the IRS to be unnecessary to meet the reasonable needs of the business. A great many companies do indeed have legitimate reasons for retaining more than $250,000 of earnings. For example, firms may retain and use earnings to pay off debt, finance growth, or provide the corporation with a cushion against possible cash drains caused by losses. How much a firm should be allowed to accumulate for uncertain contingencies is a matter of judgment. We shall consider this matter again in Chapter 14, which deals with corporate dividend policy.

CONSOLIDATED CORPORATE TAX RETURNS If a corporation owns 80% or more of another corporation’s stock, then it can aggregate income and file one consolidated tax return; thus, the losses of one company can be used

TABLE 2-2 Apex Corporation: Calculation of $12 Million Loss Carryback and Amount Available for Carryforward

Past Year Past Year Current Year 2014 2015 2016

Original taxable income $2,000,000 $2,000,000 –$12,000,000

Carryback loss 2,000,000 2,000,000

Adjusted profit $ 0 $ 0

Taxes previously paid (40%) 800,000 800,000

Difference Tax refund due $ 800,000 $ 800,000

Total tax refund received $ 1,600,000

Amount of loss carryforward available

Current loss –$12,000,000

Carryback losses used 4,000,000

Carryforward losses still available

−$ 8,000,000

r e s o u r c e See Ch02 Tool Kit.xlsx for details.

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to offset the profits of another. (Similarly, one division’s losses can be used to offset another division’s profits.) No business ever wants to incur losses (you can go broke losing $1 to save 35¢ in taxes), but tax offsets do help make it more feasible for large, multi- divisional corporations to undertake risky new ventures or ventures that will suffer losses during a developmental period.

TAXES ON OVERSEAS INCOME Many U.S. corporations have overseas subsidiaries, and those subsidiaries must pay taxes in the countries where they operate. Often, foreign tax rates are lower than U.S. rates. As long as foreign earnings are reinvested overseas, no U.S. tax is due on those earnings. However, when foreign earnings are repatriated to the U.S. parent, they are taxed at the applicable U.S. rate, less a credit for taxes paid to the foreign country. As a result, U.S. corporations such as IBM, Coca-Cola, and Microsoft have been able to defer billions of dollars of taxes. This procedure has stimulated overseas investments by U.S. multinational firms—they can continue the deferral indefinitely, but only if they reinvest the earnings in their overseas operations.13

2-9b Taxation of Small Businesses: S Corporations The Tax Code provides that small businesses that meet certain restrictions may be set up as corporations and thus receive the benefits of the corporate form of organization—especially limited liability—yet still be taxed as proprietorships or partnerships rather than as corpora- tions. These corporations are called S corporations. (“Regular” corporations are called C corporations.) If a corporation elects S corporation status for tax purposes, then all of the business’s income is reported as personal income by its stockholders, on a pro rata basis, and thus is taxed at the rates that apply to individuals. This is an important benefit to the owners of small corporations in which all or most of the income earned each year will be distributed as dividends, because then the income is taxed only once, at the individual level.

2-9c Personal Taxes Web Extension 2A provides a more detailed treatment of individual taxation, but the key elements are presented here. Ordinary income consists primarily of wages or profits from a proprietorship or partnership, plus investment income. For the 2015 tax year, indivi- duals with less than $9,225 of taxable income are subject to a federal income tax rate of 10%. For those with higher income, tax rates increase and go up to 39.6%, depending on the level of income. This is called a progressive tax, because the higher one’s income, the larger the percentage paid in taxes.

As noted before, individuals are taxed on investment income as well as earned income, but with a few exceptions and modifications. For example, interest received from most municipal bonds issued by state and local government bonds is not subject to federal taxation. However, interest earned on most other bonds or lending is taxed as ordinary income. This means that a lower-yielding muni can provide the same after-tax return as a higher-yielding corporate bond. For a taxpayer in the 35% marginal tax bracket, a muni yielding 5.5% provides the same after-tax return as a corporate bond with a pre-tax yield of 8.46%: 8 46% 1 − 0 35 5 5%.

13This is a contentious political issue. U.S. corporations argue that our tax system is similar to systems in the rest of the world, and if they were taxed immediately on all overseas earnings, then they would be at a competitive disadvantage vis-à-vis their global competitors. Others argue that the tax treatment of foreign profits encourages overseas investments at the expense of domestic investments, contributing to the jobs-outsourcing problem and also to the federal budget deficit.

r e s o u r c e See Web Extension 2A on the textbook’s Web site for details concerning personal taxation.

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Assets such as stocks, bonds, and real estate are defined as capital assets. If you own a capital asset and its price goes up, then your wealth increases, but you are not liable for any taxes on your increased wealth until you sell the asset. If you sell the asset for more than you originally paid, the profit is called a capital gain; if you sell it for less, then you suffer a capital loss. The length of time you owned the asset determines the tax treatment. If held for less than 1 year, then your gain or loss is simply added to your other ordinary income. If held for more than a year, then gains are called long-term capital gains and are taxed at a lower rate. See Web Extension 2A for details, but the long-term capital gains rate is 15% for most situations.

Under the 2003 tax law changes, dividends are now taxed as though they are capital gains. As stated earlier, corporations may deduct interest payments but not dividends when computing their corporate tax liability, which means that dividends are taxed twice, once at the corporate level and again at the personal level. This differential treatment motivates corporations to use debt relatively heavily and to pay small (or even no) dividends. The 2003 tax law did not eliminate the differential treatment of dividends and interest payments from the corporate perspective, but it did make the tax treatment of dividends more similar to that of capital gains from investors’ perspectives. To see this, consider a company that doesn’t pay a dividend but instead reinvests the cash it could have paid. The company’s stock price should increase, leading to a capital gain, which would be taxed at the same rate as the dividend. Of course, the stock price appreciation isn’t actually taxed until the stock is sold, whereas the dividend is taxed in the year it is paid, so dividends will still be more costly than capital gains for many investors.

Finally, note that the income of S corporations and noncorporate businesses is reported as income by the firms’ owners. Because there are far more S corporations, partnerships, and proprietorships than C corporations (which are subject to the corporate tax), individual tax considerations play an important role in business finance.

S E L F - T E S T

Explain what is meant by this statement: “Our tax rates are progressive.”

If a corporation has $85,000 in taxable income, what is its tax liability? ($17,150)

Explain the difference between marginal tax rates and average tax rates.

What are municipal bonds, and how are these bonds taxed?

What are capital gains and losses, and how are they taxed?

How does the federal income tax system treat dividends received by a corporation versus those received by an individual?

What is the difference in the tax treatment of interest and dividends paid by a corporation? Does this factor favor debt or equity financing?

Briefly explain how tax loss carryback and carryforward procedures work.

S U M M A R Y • The four basic statements contained in the annual report are the balance sheet, the income

statement, the statement of stockholders’ equity, and the statement of cash flows. • The balance sheet shows assets and liabilities and equity, or claims against assets. The

balance sheet may be thought of as a snapshot of the firm’s financial position at a particular point in time.

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• The income statement reports the results of operations over a period of time, and it shows earnings per share as its “bottom line.”

• The statement of stockholders’ equity shows the change in stockholders’ equity, including the change in retained earnings, between balance sheet dates. Retained earnings represent a claim against assets, not assets per se.

• The statement of cash flows reports the effect of operating, investing, and financing activities on cash flows over an accounting period.

• Net cash flow differs from accounting profit because some of the revenues and expenses reflected in accounting profits may not have been received or paid out in cash during the year. Depreciation is typically the largest noncash item, so net cash flow is often expressed as net income plus depreciation.

• Operating current assets are the current assets that are used to support operations, such as cash, inventory, and accounts receivable. They do not include short-term investments.

• Operating current liabilities are the current liabilities that occur as a natural consequence of operations, such as accounts payable and accruals. They do not include notes payable or any other short-term debts that charge interest.

• Net operating working capital is the difference between operating current assets and operating current liabilities. Thus, it is the working capital acquired with investor- supplied funds.

• Operating long-term assets are the long-term assets used to support operations, such as net plant and equipment. They do not include any long-term investments that pay interest or dividends.

• Total net operating capital (which means the same as operating capital and net operating assets) is the sum of net operating working capital and operating long-term assets. It is the total amount of capital needed to run the business.

• NOPAT is net operating profit after taxes. It is the after-tax profit a company would have if it had no debt and no investments in nonoperating assets. Because NOPAT excludes the effects of financial decisions, it is a better measure of operating performance than is net income.

• Return on Invested Capital (ROIC) is equal to NOPAT divided by total net operating capital. It measures the rate of return that the operations are generating. It is the best measure of operating performance.

• Free cash flow (FCF) is the amount of cash flow remaining after a company makes the asset investments necessary to support operations. In other words, FCF is the amount of cash flow available for distribution to investors, so the value of a company is directly related to its ability to generate free cash flow. FCF is defined as NOPAT minus the investment in total net operating capital.

• Market Value Added (MVA) represents the difference between the total market value of a firm and the total amount of investor-supplied capital. If the market values of debt and preferred stock equal their values as reported on the financial statements, then MVA is the difference between the market value of a firm’s stock and the amount of equity its shareholders have supplied.

• Economic Value Added (EVA) is the difference between after-tax operating profit and the total dollar cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially from accounting profit because no charge for the use of equity capital is reflected in accounting profit.

• Interest income received by a corporation is taxed as ordinary income; however, 70% of the dividends received by one corporation from another are excluded from taxable income.

• Because interest paid by a corporation is a deductible expense whereas dividends are not, our tax system favors debt over equity financing.

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• Ordinary corporate operating losses can be carried back to each of the preceding 2 years and carried forward for the next 20 years in order to offset taxable income in those years.

• S corporations are small businesses that have the limited-liability benefits of the corporate form of organization yet are taxed as partnerships or proprietorships.

• In the United States, tax rates are progressive—the higher one’s income, the larger the percentage paid in taxes.

• Assets such as stocks, bonds, and real estate are defined as capital assets. If a capital asset is sold for more than its cost, the profit is called a capital gain; if the asset is sold for a loss, it is called a capital loss. Assets held for more than a year provide long-term gains or losses.

• Dividends are taxed as though they were capital gains. • Personal taxes are discussed in more detail in Web Extension 2A.

Q U E S T I O N S

(2-1) Define each of the following terms: a. Annual report; balance sheet; income statement b. Common stockholders’ equity, or net worth; retained earnings c. Statement of stockholders’ equity; statement of cash flows d. Depreciation; amortization; EBITDA e. Operating current assets; operating current liabilities; net operating working capital;

total net operating capital f. Accounting profit; net cash flow; NOPAT; free cash flow; return on invested capital g. Market Value Added; Economic Value Added h. Progressive tax; taxable income; marginal and average tax rates i. Capital gain or loss; tax loss carryback and carryforward j. Improper accumulation; S corporation

(2-2) What four statements are contained in most annual reports? (2-3) If a “typical” firm reports $20 million of retained earnings on its balance sheet, can the

firm definitely pay a $20 million cash dividend? (2-4) Explain the following statement: “Whereas the balance sheet can be thought of as a

snapshot of the firm’s financial position at a point in time, the income statement reports on operations over a period of time.”

(2-5) What is operating capital, and why is it important? (2-6) Explain the difference between NOPAT and net income. Which is a better measure of the

performance of a company’s operations? (2-7) What is free cash flow? Why is it the most important measure of cash flow? (2-8) If you were starting a business, what tax considerations might cause you to prefer to set it

up as a proprietorship or a partnership rather than as a corporation?

S E L F - T E S T P R O B L E M S o l u t i o n S h o w n i n A p p e n d i x A

(ST-1) Last year Cole Furnaces had $5 million in operating income (EBIT). The company had a net depreciation expense of $1 million and an interest expense of $1 million; its corporate tax rate was 40%. The company has $14 million in operating current assets and $4 million in operating current liabilities; it has $15 million in net plant and equipment. It estimates

Net Income, Cash Flow, and EVA

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that it has an after-tax cost of capital of 10%. Assume that Cole’s only noncash item was depreciation.

a. What was the company’s net income for the year? b. What was the company’s net cash flow? c. What was the company’s net operating profit after taxes (NOPAT)? d. Calculate net operating working capital and total net operating capital for the current

year. e. If total net operating capital in the previous year was $24 million, what was the

company’s free cash flow (FCF) for the year? f. What was the return on invested capital? g. What was the company’s Economic Value Added (EVA)?

P R O B L E M S A n s w e r s A r e i n A p p e n d i x B

Note: By the time this book is published, Congress may have changed rates and/or other provisions of current tax law. Work all problems on the assumption that the information in the chapter is applicable.

EASY PROBLEMS 1–6 An investor recently purchased a corporate bond that yields 9%. The investor is in the 36% combined federal and state tax bracket. What is the bond’s after-tax yield?

Corporate bonds issued by Johnson Corporation currently yield 8%. Municipal bonds of equal risk currently yield 6%. At what tax rate would an investor be indifferent between these two bonds?

Molteni Motors Inc. recently reported $6 million of net income. Its EBIT was $13 million, and its tax rate was 40%. What was its interest expense? (Hint: Write out the headings for an income statement and then fill in the known values. Then divide $6 million net income by 1 − T 0 6 to find the pre-tax income. The difference between EBIT and taxable income must be the interest expense. Use this procedure to work some of the other problems.)

Talbot Enterprises recently reported an EBITDA of $8 million and net income of $2.4 million. It had $2.0 million of interest expense, and its corporate tax rate was 40%. What was its charge for depreciation and amortization?

Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $500,000. What was its net cash flow? Assume it had no amortization expense.

In its most recent financial statements, Del-Castillo Inc. reported $70 million of net income and $900 million of retained earnings. The previous retained earnings were $855 million. How much in dividends did the firm pay to shareholders during the year?

INTERMEDIATE PROBLEMS 7–11 The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before: (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. What is the firm’s taxable income? What is it marginal tax rate? What is its tax expense? What is its after-tax income? What is the average tax rate based on taxable income?

(2-1) Personal After-Tax

Yield

(2-2) Personal After-Tax

Yield

(2-3) Income Statement

(2-4) Income Statement

(2-5) Net Cash Flow

(2-6) Statement of

Retained Earnings

(2-7) Corporate Tax

Liability

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The Wendt Corporation had $10.5 million of taxable income. a. What is the company’s federal income tax bill for the year? b. Assume the firm receives an additional $1 million of interest income from some

bonds it owns. What is the additional tax on this interest income? c. Now assume that Wendt does not receive the interest income but does receive an

additional $1 million as dividends on some stock it owns. What is the additional tax on this dividend income?

The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7.5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a dividend yield of 6%. The corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax rates of return on all three securities.

The Moore Corporation has operating income (EBIT) of $750,000. The company’s depreciation expense is $200,000. Moore is 100% equity financed, and it faces a 40% tax rate. What is the company’s net income? What is its net cash flow?

The Berndt Corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Berndt’s federal-plus-state tax rate is 40%. Berndt has no debt.

a. Set up an income statement. What is Berndt’s expected net income? Its expected net cash flow?

b. Suppose Congress changed the tax laws so that Berndt’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?

c. Now suppose that Congress changed the tax laws such that, instead of doubling Berndt’s depreciation, it was reduced by 50%. How would profit and net cash flow be affected?

d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?

CHALLENGING PROBLEMS 12–13 Using Rhodes Corporation’s financial statements (shown after Part f), answer the following questions.

a. What is the net operating profit after taxes (NOPAT) for 2016? b. What are the amounts of net operating working capital for both years? c. What are the amounts of total net operating capital for both years? d. What is the free cash flow for 2016? e. What is the ROIC for 2016? f. How much of the FCF did Rhodes use for each of the following purposes: after-

tax interest, net debt repayments, dividends, net stock repurchases, and net purchases of short-term investments? (Hint: Remember that a net use can be negative.)

(2-8) Corporate Tax

Liability

(2-9) Corporate After-Tax

Yield

(2-10) Net Cash Flows

(2-11) Income and Cash

Flow Analysis

(2-12) Free Cash Flows

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The Bookbinder Company has made $150,000 before taxes during each of the last 15 years, and it expects to make $150,000 a year before taxes in the future. However, in 2016 the firm incurred a loss of $650,000. The firm will claim a tax credit at the time it files its 2016 income tax return, and it will receive a check from the U.S. Treasury. Show how it calculates this credit, and then indicate the firm’s tax liability for each of the next 5 years. Assume a 40% tax rate on all income to ease the calculations.

Rhodes Corporation: Income Statements for Year Ending December 31 (Millions of Dollars)

2016 2015 Sales $11,000 $10,000 Operating costs excluding depreciation 9,360 8,500 Depreciation and amortization 380 360

Earnings before interest and taxes $ 1,260 $ 1,140 Less interest 120 100

Pre-tax income $ 1,140 $ 1,040 Taxes (40%) 456 416 Net income available to common stockholders $ 684 $ 624 Common dividends $ 220 $ 200

Rhodes Corporation: Balance Sheets as of December 31 (Millions of Dollars)

2016 2015 Assets Cash $ 550 $ 500 Short-term investments 110 100 Accounts receivable 2,750 2,500 Inventories 1,650 1,500

Total current assets $5,060 $4,600 Net plant and equipment 3,850 3,500 Total assets $8,910 $8,100

Liabilities and Equity Accounts payable $1,100 $1,000 Accruals 550 500 Notes payable 384 200

Total current liabilities $2,034 $1,700 Long-term debt 1,100 1,000

Total liabilities $3,134 $2,700 Common stock 4,312 4,400 Retained earnings 1,464 1,000

Total common equity $5,776 $5,400 Total liabilities and equity $8,910 $8,100

(2-13) Loss Carryback and

Carryforward

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S P R E A D S H E E T P R O B L E M S

(2-14) Begin with the partial model in the file Ch02 P14 Build a Model.xlsx on the textbook’s Web site.

a. The 2016 sales of Cumberland Industries were $455,000,000; operating costs (excluding depreciation) were equal to 85% of sales; net fixed assets were $67,000,000; depreciation amounted to 10% of net fixed assets; interest expenses were $8,550,000; the state-plus-federal corporate tax rate was 40%; and Cumberland paid 25% of its net income out in dividends. Given this information, construct Cumberland’s 2016 income statement. Also calculate total dividends and the addition to retained earnings. (Hint: Start with the partial model in the file and report all dollar figures in thousands to reduce clutter.)

b. The partial balance sheets of Cumberland Industries are shown here. Cumberland issued $10,000,000 of new common stock in 2016. Using this information and the results from Part a, fill in the missing values for common stock, retained earnings, total common equity, and total liabilities and equity.

Cumberland Industries: Balance Sheets as of December 31 (Thousands of Dollars)

2016 2015 Assets Cash $ 91,450 $ 74,625 Short-term investments 11,400 15,100 Accounts receivable 108,470 85,527 Inventories 38,450 34,982

Total current assets $249,770 $210,234 Net fixed assets 67,000 42,436 Total assets $316,770 $252,670

Liabilities and Equity Accounts payable $ 30,761 $ 23,109 Accruals 30,405 22,656 Notes payable 12,717 14,217

Total current liabilities $ 73,883 $ 59,982 Long-term debt 80,263 63,914

Total liabilities $154,146 $123,896 Common stock ? $ 90,000 Retained earnings ? 38,774

Total common equity ? $128,774 Total liabilities and equity ? $252,670

c. Construct the statement of cash flows for 2016.

Build a Model: Financial State-

ments, EVA, and MVA

r e s o u r c e

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(2-15) Begin with the partial model in the file Ch02 P15 Build a Model.xlsx on the textbook’s Web site. a. Using the financial statements shown here for Lan & Chen Technologies, calculate

net operating working capital, total net operating capital, net operating profit after taxes, free cash flow, and return on invested capital for 2016. (Hint: Start with the partial model in the file and report all dollar figures in thousands to reduce clutter.)

b. Assume there were 15 million shares outstanding at the end of 2016, the year-end closing stock price was $65 per share, and the after-tax cost of capital was 8%. Calculate EVA and MVA for 2016.

Lan & Chen Technologies: Income Statements for Year Ending December 31 (Thousands of Dollars)

2016 2015 Sales $945,000 $900,000 Expenses excluding depreciation and amortization 812,700 774,000

EBITDA $132,300 $126,000 Depreciation and amortization 33,100 31,500

EBIT $ 99,200 $ 94,500 Interest expense 10,470 8,600

Pre-tax earnings $ 88,730 $ 85,900 Taxes (40%) 35,492 34,360

Net income $ 53,238 $ 51,540 Common dividends $ 43,300 $ 41,230 Addition to retained earnings $ 9,938 $ 10,310

Lan & Chen Technologies: December 31 Balance Sheets (Thousands of Dollars)

2016 2015 Assets Cash and cash equivalents $ 47,250 $ 45,000 Short-term investments 3,800 3,600 Accounts receivable 283,500 270,000 Inventories 141,750 135,000

Total current assets $476,300 $453,600 Net fixed assets 330,750 315,000

Total assets $807,050 $768,600

Liabilities and Equity Accounts payable $ 94,500 $ 90,000 Accruals 47,250 45,000 Notes payable 26,262 9,000

Total current liabilities $168,012 $144,000 Long-term debt 94,500 90,000

Total liabilities $262,512 $234,000 Common stock 444,600 444,600 Retained earnings 99,938 90,000

Total common equity $544,538 $534,600 Total liabilities and equity $807,050 $768,600

Build a Model: Free Cash Flows, EVA,

and MVA

r e s o u r c e

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M I N I C A S E

Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components.

During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data. Note: These are available in the file Ch02 Tool Kit.xlsx in the Mini Case tab.

2015 2016 Balance Sheets Assets Cash $ 9,000 $ 7,282 Short-term investments 48,600 20,000 Accounts receivable 351,200 632,160 Inventories 715,200 1,287,360

Total current assets $1,124,000 $1,946,802 Gross fixed assets 491,000 1,202,950 Less: Accumulated depreciation 146,200 263,160

Net fixed assets $ 344,800 $ 939,790 Total assets $1,468,800 $2,886,592 Liabilities and Equity Accounts payable $ 145,600 $ 324,000 Notes payable 200,000 720,000 Accruals 136,000 284,960

Total current liabilities $ 481,600 $1,328,960 Long-term debt 323,432 1,000,000 Common stock (100,000 shares) 460,000 460,000 Retained earnings 203,768 97,632

Total equity $ 663,768 $ 557,632 Total liabilities and equity $1,468,800 $2,886,592

2015 2016 Income Statements Sales $3,432,000 $ 5,834,400 Cost of goods sold (Excluding depreciation and amortization)

2,864,000 4,980,000

Other expenses 340,000 720,000 Depreciation and amortization 18,900 116,960

Total operating costs $3,222,900 $ 5,816,960 EBIT $ 209,100 $ 17,440 Interest expense 62,500 176,000

Pre-tax earnings $ 146,600 ($ 158,560) Taxes (40%) 58,640 (63,424) Net income $ 87,960 ($ 95,136)

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Assume that you are Cochran’s assistant and that you must help her answer the following questions for Meissner:

a. What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity?

b. What do you conclude from the statement of cash flows? c. What is free cash flow? Why is it important? What are the five uses of FCF?

2016 Statement of Cash Flows Operating Activities Net income ($ 95,136) Adjustments:

Noncash adjustments: Depreciation and amortization 116,960

Changes in working capital: Change in accounts receivable (280,960) Change in inventories (572,160)

Change in accounts payable 178,400 Change in accruals 148,960

Net cash provided (used) by operating activities ($ 503,936) Investing Activities

Cash used to acquire fixed assets ($ 711,950) Change in short-term investments 28,600

Net cash provided (used) by investing activities ($ 683,350)

Financing Activities Change in notes payable $ 520,000 Change in long-term debt 676,568 Change in common stock — Payment of cash dividends (11,000)

Net cash provided (used) by financing activities $1,185,568 Summary Net change in cash ($ 1,718) Cash at beginning of year 9,000 Cash at end of year $ 7,282

Other Data 2014 2015 Stock price $ 8.50 $ 6.00 Shares outstanding 100,000 100,000 EPS $ 0.880 ($ 0.951) DPS $ 0.220 $ 0.110 Tax rate 40% 40%

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d. What is Computron’s net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?

e. What is Computron’s free cash flow (FCF)? What are Computron’s “net uses” of its FCF?

f. Calculate Computron’s return on invested capital (ROIC). Computron has a 10% cost of capital (WACC). What caused the decline in the ROIC? Was it due to operating profitability or capital utilization? Do you think Computron’s growth added value?

g. Cochran also has asked you to estimate Computron’s EVA. She estimates that the after-tax cost of capital was 10% in both years.

h. What happened to Computron’s Market Value Added (MVA)? i. Assume that a corporation has $100,000 of taxable income from operations plus $5,000

of interest income and $10,000 of dividend income. What is the company’s federal tax liability?

j. Assume that you are in the 25% marginal tax bracket and that you have $5,000 to invest. You have narrowed your investment choices down to California bonds with a yield of 7% or equally risky ExxonMobil bonds with a yield of 10%. Which one should you choose and why? At what marginal tax rate would you be indifferent to the choice between California and ExxonMobil bonds?

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C H A P T E R 3

Analysis of Financial Statements

Candy Crush is a very popular mobile game, and so is the stock of its maker, King Digital Entertainment. In February 2015, King announced that its most recent quar- ter’s sales were higher than the amount it had forecasted three months previously. In addition, King’s earnings per share crushed Wall Street analysts’ consensus esti- mates. The result? King’s stock jumped 21% after its announcement.

Notice that King had helped analysts by providing estimates of its future revenues. According to a survey by the National Investors Relations Institute, 94% of respon- dents in 2014 provided some form of guidance for analysts and investors. Despite the high proportion of companies that provide guidance, a 2015 survey by Integrated Corporate Relations reports that over half of the responding investment professionals don’t think guidance is vital for determining whether to recommend purchasing a company’s stock. It appears as though many investors rely on other types of informa- tion, including ratio analysis.

Sources: See King’s press releases, announcements from MarketWatch.com, and surveys by NIRI and ICR, which can be found at http://company.king.com/media/36943/q314-release-final.pdf, www.marketwatch.com/ news/markets/earningswatch.asp, http://niri.org/Main-Menu-Category/resource/publications/Executive -Alert/2014-Executive-Alert-Archive/NIRI-Guidance-Practices-Survey–2014-Report-102214.aspx, and http:// icrinc.com/en/pdfs/xchange/XChange_2015_ICR_Survey.pdf.

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Financial statement analysis involves: (1) comparing a firm’s performance with that of other firms in the same industry, and (2) evaluating trends in the firm’s financial position over time. Managers use financial analysis to identify situations needing attention, potential lenders use financial analysis to determine whether a company is creditworthy, and stockholders use financial analysis to help predict future earnings, dividends, and free cash flow. This chapter will explain the similarities and differences among these uses.

3-1 Financial Analysis When we perform a financial analysis, we conduct the following steps.

3-1a Gather Data The first step in financial analysis is to gather data. As discussed in Chapter 2, financial statements can be downloaded from many different Web sites. One of our favorites is Zacks Investment Research, which provides financial statements in a standardized format. If you cut and paste financial statements from Zacks into a spreadsheet and then perform a financial analysis, you can quickly repeat the analysis on a different company by pasting that company’s financial statements into the same cells of the spreadsheet. In other words, you do not need to reinvent the wheel each time you analyze a company.

Intrinsic Value and Analysis of Financial Statements

The intrinsic value of a firm is determined by the present value of the expected future free cash flows (FCF) when discounted at the weighted average cost of capital (WACC).

This chapter explains how to use financial statements to evaluate a company’s profitability, required capital invest- ments, business risk, and mix of debt and equity.

Required investments in operating capital

Net operating profit a�er taxes

–

= Free cash flow

FCF

Weighted average cost of capital (WACC)

Cost of debt Cost of equity

Market interest rates

Market risk aversion

Firm’s debt/equity mix

Firm’s business risk

Value = + … ++ FCF1

(1 + WACC)1

FCF2

(1 + WACC)2 FCF∞

(1 + WACC)∞

r e s o u r c e The textbook’s Web site contains an Excel file that will guide you through the chapter’s calculations. The file for this chapter is Ch03 Tool Kit.xlsx, and we encourage you to open the file and follow along as you read the chapter.

w w w See www.zacks.com for a source of standardized financial statements.

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3-1b Examine the Statement of Cash Flows Some financial analysis can be done with virtually no calculations. For example, we always look to the statement of cash flows first, particularly the net cash provided by operating activities. Downward trends or negative net cash flow from operations almost always indicates problems. The statement of cash flows section on investing activities shows whether the company has made a big acquisition, especially when compared with prior years’ net cash flows from investing activities. A quick look at the section on financing activities also reveals whether a company is issuing debt or buying back stock; in other words, is the company raising capital from investors or returning it to them?

Recall from the previous chapter (Figure 2-4) that MicroDrive generated $158 million from its operating activities but invested $460 million in new fixed assets. To make these purchases, MicroDrive borrowed heavily.

3-1c Calculate and Examine the Return on Invested Capital and Free Cash Flow

After examining the statement of cash flows, we calculate the net operating profit after taxes (NOPAT) and the total net operating capital. We use these measures to calculate the operating profitability ratio (OP), the capital requirement ratio (CR), the return on invested capital (ROIC), and the free cash flow (FCF), as described in Chapter 2.

The ROIC provides a vital measure of a firm’s overall performance. If the ROIC is greater than the company’s weighted average cost of capital (WACC), then the com- pany usually is adding value. If the ROIC is less than the WACC, then the company usually has serious problems. No matter what the ROIC tells us about overall perfor- mance, it is important to examine specific activities, and to do that we use financial ratios.

We calculated these measures for MicroDrive in the previous chapter (see Figure 2-6) and report them here for convenience:

MicroDrive’s operating profitability fell from 6.93% to 6.00% and its capital require- ment ratio increased from 52.31% to 61%, indicating that MicroDrive is not generating enough in sales from its operating capital. The result is a decline in its ROIC from 13.3% to 9.8%. We will use ratio analysis in the following sections to identify the root causes of MicroDrive’s problems.

MicroDrive (Millions of Dollars) 2016 2015 Net operating working capital (NOWC) $1,050 $790

Total net operating capital $3,050 $2,490

Net operating profit after taxes (NOPAT) $300 $330

Operating profitability (OP) ratio = NOPAT/Sales 6.00% 6.93%

Capital requirement (CR) ratio (Total net operating capital/Sales) 61.00% 52.31%

Return on invested capital (ROIC) NOPAT/Total net operating capital 9.8% 13.3%

Free cash flow (FCF) NOPAT Net investment in operating capital $260 N/A

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3-1d Begin Ratio Analysis Financial ratios are designed to extract important information that might not be obvious simply from examining a firm’s financial statements. For example, suppose Firm A owes $5 million in debt while Firm B owes $50 million. Which company is in a stronger financial position? It is impossible to answer this question without first standardizing each firm’s debt relative to total assets, earnings, and interest. Such standardized comparisons are provided through ratio analysis.

We will calculate the 2016 financial ratios for MicroDrive Inc. using data from the balance sheets and income statements given in Figure 3-1. We will also evaluate the ratios in relation to the industry averages. Note that dollar amounts are in millions.

3-2 Liquidity Ratios As shown in Figure 3-1, MicroDrive has current liabilities of $780 million that it must pay off within the coming year. Will it have trouble satisfying those obligations? Liquidity ratios attempt to answer this type of question. We discuss two commonly used liquidity ratios in this section.

3-2a The Current Ratio Calculate the current ratio by dividing current assets by current liabilities:

Current ratio Current assets

Current liabilities

$1,550 $780

2 0

Industry average 2 2

Current assets normally include cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses.

MicroDrive has a slightly lower current ratio than the average for its industry.1 Is this good or bad? Sometimes the answer depends on who is asking the question. For example, suppose a supplier is trying to decide whether to extend credit to MicroDrive. In general, creditors like to see a high current ratio. If a company starts to experience financial difficulty, it will begin paying its bills (accounts payable) more slowly and borrowing more from its bank, so its current liabilities will be increasing. If current liabilities are rising faster than current assets, then the current ratio will fall, and this could spell trouble. Because the current ratio provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly, it is the most commonly used measure of short-term solvency.

Now consider the current ratio from a shareholder’s perspective. A high current ratio could mean that the company has a lot of money tied up in nonproductive assets, such as excess cash or marketable securities. Or perhaps the high current ratio is due to large inventory holdings, which might become obsolete before they can be sold. Thus, share- holders might not want a high current ratio.

1A good source for industry ratios and for S&P 500 ratios is CSIMarket.com: http://csimarket.com/Industry/ industry_Financial_Strength_Ratios.php.

r e s o u r c e See Ch03 Tool Kit.xlsx for all calculations.

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An industry average is not a magic number that all firms should strive to maintain—in fact, some well-managed firms will be above the average, while other good firms will be below it. However, if a firm’s ratios are far from the averages for its industry, this is a red flag, and analysts should be concerned about why the variance occurs. For example, suppose a low current ratio is traced to low inventories. Is this a competitive advantage resulting from the firm’s mastery of just-in-time inventory management, or is it an

FIGURE 3-1 MicroDrive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data)

23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

A B C D E 2016 2015

Cash and equivalents 50$ 60$ Short‐term investments ‐ 40 Accounts receivable 500 380 Inventor ies 1,000 820

T otal current assets 1,550$ 1,300$ Net plant and equipment 2,000 1,700 T otal assets 3,550$ 3,000$

Accounts payable 200$ 190$ Notes payable 280 130 Accruals 300 280

T otal current liabilities 780$ 600$ L ong‐term bonds 1,200 1,000

T otal liabilities 1,980$ 1,600$ Preferred stock (400,000 shares) 100 100 Common stock (50,000,000 shares) 500 500 Retained earnings 970 800

T otal common equity 1,470$ 1,300$ T otal liabilities and equity 3,550$ 3,000$

2016 2015 Net sales 5,000$ 4,760$ Costs of goods sold except depreciation 3,800 3,560 Depreciation 200 170 Other operating expenses 500 480

Earnings before interest and taxes (EBIT ) 500$ 550$ L ess interest 120 100

Pre‐tax earnings 380$ 450$ T axes (40% ) 152 180

Net income before preferred dividends 228$ 270$ Preferred dividends 8 8 Net income available to common stockholders 220$ 262$

Common dividends $50 $48 Addition to retained earnings $170 $214 L ease payments $28 $28 Bonds' required sink ing fund payments $20 $20 Common stock pr ice per share $27 $40

61 62 63

Source: See the file Ch03 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

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Achilles’ heel that is causing the firm to miss shipments and lose sales? Ratio analysis doesn’t answer such questions, but it does point to areas of potential concern.

3-2b The Quick Ratio The quick ratio, also called the acid test ratio, is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities:

Quick ratio Current assets Inventories

Current liabilities

$1,550 $1,000 $780

0 7

Industry average 0 8

A liquid asset is one that trades in an active market, so it can be converted quickly to cash at the going market price. Inventories are typically the least liquid of a firm’s current assets; hence, they are the current assets on which losses are most likely to occur in a bankruptcy. Therefore, a measure of the firm’s ability to pay off short-term obligations without relying on the sale of inventories is important.

MicroDrive’s quick ratio is close to the industry average. However, both are below 1.0, which means that inventories would have to be liquidated in order to pay off current liabilities should the need arise.

How does MicroDrive compare to S&P 500 companies? There has been a steady decline in the average liquidity ratios of S&P 500 companies during the past decade. As we write this in 2015, the average current ratio is about 1.3 and the average quick ratio is about 0.4, so MicroDrive and its industry peers are more liquid than the typical S&P 500 company.

S E L F - T E S T

Identify two ratios to use to analyze a firm’s liquidity position, and write out their equations.

What are the characteristics of a liquid asset? Give some examples.

Which current asset is typically the least liquid?

Morris Corporation has the following information on its balance sheets: Cash $40, accounts receivable $30, inventories $100, net fixed asset $500, accounts payable $20, accruals $10, short-term debt matures in less than a year $25, long-term debt $200, and total common equity $415. What is its current ratio? (3.1) Its quick ratio? (1.3)

A company has current liabilities of $800 million, and its current ratio is 2.5. What is its level of current assets? ($2,000 million) If this firm’s quick ratio is 2, how much inventory does it have? ($400 million)

3-3 Asset Management Ratios Asset management ratios measure how effectively a firm is managing its assets. For this reason, they are also called efficiency ratios. If a company has excessive investments in assets, then its operating capital is unduly high, which reduces its free cash flow and ultimately its stock price. On the other hand, if a company does not have enough assets, then it may lose sales, which would hurt profitability, free cash flow, and the stock price.

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Therefore, it is important to have the right amount invested in assets. Ratios that analyze the different types of assets are described in this section.

3-3a Evaluating Total Assets: The Total Assets Turnover Ratio

The total assets turnover ratio measures the dollars in sales that are generated for each dollar that is tied up in assets:

Total assets turnover ratio Sales

Total assests

$5,000 $3,550

1 4

Industry average 1 8

MicroDrive’s ratio is somewhat below the industry average, indicating that the company is not generating as much business (relative to its peers) given its total asset investment. In other words, MicroDrive uses its assets relatively inefficiently. The follow- ing ratios can be used to identify the specific asset classes that are causing this problem.2

3-3b Evaluating Fixed Assets: The Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of sales to net fixed assets:

Fixed assets turnover ratio Sales

Net fixed assests

$5,000 $2,000

2 5

Industry average 3 0

MicroDrive’s ratio of 2.5 is a little below the industry average, indicating that the firm is not using its fixed assets as intensively as are other firms in its industry.

Inflation can cause problems when interpreting the fixed assets turnover ratio because fixed assets are reported using the historical costs of the assets instead of current replace- ment costs that may be higher due to inflation. Therefore, a mature firm with fixed assets acquired years ago might well have a higher fixed assets turnover ratio than a younger company with newer fixed assets that are reported at inflated prices relative to the historical prices of the older assets. However, this would reflect the difficulty accountants have in dealing with inflation rather than inefficiency on the part of the new firm. You should be alert to this potential problem when evaluating the fixed assets turnover ratio.

2Sales occur throughout the year, but assets are reported at end of the period. For a growing company or a company with seasonal variation, it would be better to use average assets held during the year when calculating turnover ratios. However, we use year-end values for all turnover ratios so that we are more comparable with most reported industry averages.

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3-3c Evaluating Receivables: The Days Sales Outstanding Days sales outstanding (DSO), also called the average collection period (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to find the number of days’ sales that are tied up in receivables. Thus, the DSO represents the average length of time that the firm must wait after making a sale before receiving cash, which is the average collection period. MicroDrive’s DSO is 37, above the 30-day industry average:

DSO Days salesoutstanding Receivables

Average sales per day Receivables

Annual sales 365

$500 $5,000 365

$500 $13 7

36 5 days ≈ 37 days

Industry average 30 days MicroDrive’s sales terms call for payment within 30 days. The fact that 37 days of sales

are outstanding indicates that customers, on average, are not paying their bills on time. As with inventory, high levels of accounts receivable cause high levels of NOWC, which hurts FCF and stock price.

A customer who is paying late may be in financial trouble, which means MicroDrive may have a hard time collecting the receivable. Therefore, if the trend in DSO has been rising unexpectedly, steps should be taken to review credit standards and to expedite the collection of accounts receivable.

3-3d Evaluating Inventories: The Inventory Turnover Ratio

The inventory turnover ratio is defined as costs of goods sold (COGS) divided by inventories.3 The previous ratios use sales instead of COGS. However, sales revenues include costs and profits, whereas inventory usually is reported at cost. Therefore, it is better to compare inventory with costs rather than sales.

The income statement in Figure 3-1 separately reports depreciation and the portion of costs of goods sold that is not comprised of depreciation, which is helpful when calculating cash flows. However, we need the total COGS for calculating the inventory turnover ratio. For MicroDrive, virtually all depreciation is associated with producing its products, so its COGS is:

COGS Costs of goods sold except depreciation Depreciation $3,800 $200 $4,000 million

We can now calculate the inventory turnover:

Inventory turnover ratio COGS

Inventories

$3,800 $200 $1,000

4 0

Industry average 5 0

3Some compilers of financial ratio statistics, such as Dun & Bradstreet, define inventory turnover as the ratio of sales to inventories. However, most sources now report the turnover ratio using COGS, so we have changed our definition to conform to the majority of reporting organizations.

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As a rough approximation, each item of MicroDrive’s inventory is sold out and restocked, or “turned over,” 4 times per year.4

MicroDrive’s turnover of 4 is lower than the industry average of 5. This suggests that MicroDrive is holding too much inventory. High levels of inventory add to net operating working capital (NOWC), which reduces FCF, which leads to lower stock prices. In addition, MicroDrive’s low inventory turnover ratio makes us wonder whether the firm is holding obsolete goods not worth their stated value.

In summary, MicroDrive’s low fixed assets turnover ratio, high DSO, and low inventory turnover ratio each cause MicroDrive’s total assets turnover ratio to be lower than the industry average.

S E L F - T E S T

Identify four ratios that measure how effectively a firm is managing its assets, and write out their equations.

What problem might arise when comparing firms’ fixed assets turnover ratios?

Morris Corporation has the following information on its balance sheets: Cash $40, accounts receivable $30, inventories $100, net fixed asset $500, accounts payable $20, accruals $10, short-term debt matures in less than a year $25, long-term debt $200, and total common equity $415. Its income statement reports: Sales $820, costs of goods sold excluding depreciation $450, depreciation $50, interest expense $20, and tax rate 40%. Calculate the following ratios: total assets turnover (1.2), fixed assets turnover (1.6), days sales outstanding (based on a 365-day year) (13.4), inventory turnover (5.0). Hint: This is the same company used in the previous Self-Test.

A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio? (4.5) What is its DSO based on a 365-day year? (109.5 days)

3-4 Debt Management Ratios The extent to which a firm uses debt financing is called financial leverage. Here are three important implications: (1) Stockholders can control a firm with smaller invest- ments of their own equity if they finance part of the firm with debt. (2) If the firm’s assets generate a higher pre-tax return than the interest rate on debt, then the shareholders’ returns are magnified, or “leveraged.” Conversely, shareholders’ losses are also magnified if assets generate a pre-tax return less than the interest rate. (3) If a company has high leverage, even a small decline in performance might cause the firm’s value to fall below the amount it owes to creditors. Therefore, a creditor’s position becomes riskier as leverage increases. Keep these three points in mind as you read the following sections.

3-4a How the Firm Is Financed: Leverage Ratios MicroDrive’s two primary types of debt are notes payable and long-term bonds, but more complicated companies also might report the portion of long-term debt due within a year,

4“Turnover” is derived from the old Yankee peddler who would load up his wagon with goods and then go off to peddle his wares. If he made 10 trips per year, stocked 100 pans, and made a gross profit of $5 per pan, his annual gross profit would be 100 $5 10 $5 000. If he “turned over” (i.e., sold) his inventory faster and made 20 trips per year, then his gross profit would double, other things held constant. So, his turnover directly affected his profits.

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the value of capitalized leases, and other types of obligations that charge interest. For MicroDrive, total debt is:

Total debt Notes payable Long-term bonds $280 $1,200 $1,480 million

Is this too much debt, not enough, or the right amount? To answer this question, we begin by calculating the percentage of MicroDrive’s assets that are financed by debt. The ratio of total debt to total assets is called the debt-to-assets ratio. It is sometimes shortened to debt ratio.5 Total debt is the sum of all short-term debt and long-term debt; it does not include other liabilities. MicroDrive’s debt ratio is:

Debt-to-assets ratio Debt ratio Total debt

Total assets

$280 $1,200 $3,550

$1,480 $3,550

41 7%

Industry average 25 0%

The Great Recession of 2007

The Price Is Right! (Or Wrong!)

How much is an asset worth if no one is buying or selling? The answer to that question matters because an accounting practice called “mark to market” requires that some assets be adjusted on the balance sheet to reflect their “fair mar- ket value.” The accounting rules are complicated, but the general idea is that if an asset is available for sale, then the balance sheet would be most accurate if it showed the asset’s market value. For example, suppose a company purchased $100 million of Treasury bonds and the value of those bonds later fell to $90 million. With mark to market, the company would report the bonds’ value on the balance sheet as $90 million, not the original purchase price of $100 million. Notice that marking to market can have a significant impact on financial ratios and thus on investors’ perception of a firm’s financial health.

But what if the assets are mortgage-backed securities that were originally purchased for $100 million? As defaults increased during 2008, the value of such secu- rities fell rapidly, and then investors virtually stopped trading them. How should the company report them? At the $100 million original price? At a $60 million price that

was observed before the market largely dried up? At $25 million when a hedge fund in desperate need for cash to avoid a costly default sold a few of these securities? At $0, because there are no current quotes? Or should they be reported at a price generated by a computer model or in some other manner?

The answer to this is especially important during times of economic stress. Congress, the SEC, FASB, and the U.S. Treasury all are working to find the right answers. If they come up with a price that is too low, it could cause investors mistakenly to believe that some companies are worth much less than their intrinsic values, and this could trigger runs on banks and bank- ruptcies for companies that might otherwise survive. But if the price is too high, some “walking dead” or “zombie” companies could linger on and later cause even larger losses for investors, including the U.S. government, which is now the largest investor in many financial institutions. Either way, an error in pricing could perhaps trigger a domino effect that might topple the entire financial sys- tem. So, let’s hope the price is right!

5In previous editions, we defined the debt ratio as total liabilities divided by total assets. For better comparability with Web-based reporting sources, we have changed our definition to total debt divided by total assets.

© Mihai Simonia

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MicroDrive’s debt ratio is 41.7%, which is substantially higher than the 25% industry average.

The debt-to-equity ratio is defined as:6

Debt-to-equity ratio Total debt

Total common equity

$280 $1,200 $1,470

$1,480 $1,470

1 01

Industry average 0 46

The debt-to-equity ratio shows that MicroDrive has $1.01 of debt for every dollar of equity, whereas the debt ratio shows that 41.7% of MicroDrive’s assets are financed by debt. We find it more intuitive to think about the percentage of the firm that is financed with debt, so we usually use the debt ratio. However, the debt-to-equity ratio is also widely used, so you should know how to interpret it as well.

Be sure you know how a ratio is defined before you use it. Some sources define the debt ratio using only long-term debt instead of total debt; others use investor-supplied capital instead of total assets. Some sources make similar changes in the debt-to-equity ratio, so be sure to check your source’s definition.

Sometimes it is useful to express debt ratios in terms of market values. It is easy to calculate the market value of equity, which is equal to the stock price multiplied by the number of shares. MicroDrive’s market value of equity is $27 50 $1 350. Often it is difficult to estimate the market value of debt, so many analysts use the debt reported in the financial statements. The market debt ratio is defined as:

Market debt ratio Total debt

Total debt Market value of equity

$280 $1,200 $280 $1,200 $27 50

$1,480 $1,480 $1,350

52 3% Industry average 20 0%

MicroDrive’s market debt ratio in the previous year was 36.1%. The big increase was due to two major factors: Debt increased and the stock price fell. The stock price reflects a company’s prospects for generating future cash flows, so a decline in stock price indicates a likely decline in future cash flows. Thus, the market debt ratio reflects a source of risk that is not captured by the conventional debt ratio.

6In previous editions we defined the debt-to-equity ratio as total liabilities divided by total common equity. For better comparability with Web-based reporting sources, we have changed our definition to total debt divided by total common equity.

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Finally, the ratio of total liabilities to total assets shows the extent to which a firm’s assets are not supported by equity. The liabilities-to-assets ratio is defined as:

Liabilities-to-assets ratio Total liabilities

Total assets

$1,980 $3,550

55 8%

Industry average 45 0% For all the ratios we examined, MicroDrive has more leverage than its industry peers.

The next section shows how close MicroDrive might be to serious financial distress.

3-4b Ability to Pay Interest: Times-Interest- Earned Ratio

The times-interest-earned (TIE) ratio, also called the interest coverage ratio, is determined by dividing earnings before interest and taxes (EBIT in Figure 3-1) by the interest expense:

Times-interest-earned TIE ratio EBIT

Interest expense

$500 $120

4 2

Industry average 10 0

The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by the firm’s creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes, rather than net income, is used in the numerator. Because interest is paid with pre-tax dollars, the firm’s ability to pay current interest is not affected by taxes.

MicroDrive’s interest is covered 4.2 times, which is well above 1, the point at which EBIT isn’t sufficient to pay interest. The industry average is 10, so even though MicroDrive has enough EBIT to pay interest expenses, it has a relatively low margin of safety compared to its peers. Thus, the TIE ratio reinforces the conclusion from our analysis of the debt ratio that MicroDrive might face difficulties if it attempts to borrow additional funds.

3-4c Ability to Service Debt: EBITDA Coverage Ratio The TIE ratio is useful for assessing a company’s ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the only fixed financial charge— companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments. Failure to repay debt or meet lease payments may force them into bankruptcy. (2) EBIT (earnings before interest and taxes) does not represent all the cash flow available to service debt, especially if a firm has high noncash expenses, like depreciation and/ or amortization charges. A better coverage ratio would take all of the “cash” earnings into account in the numerator and the other financial charges in the denominator.

MicroDrive had $500 million of EBIT and $200 million in depreciation, for an EBITDA (earnings before interest, taxes, depreciation, and amortization) of $700 million. Also, lease payments of $28 million were deducted while calculating EBIT. That $28 million was available to meet financial charges; hence, it must be added back, bringing the total available

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to cover fixed financial charges to $728 million. Fixed financial charges consisted of $120 million of interest, $20 million of sinking fund payments, and $28 million for lease payments, for a total of $168 million.7

MicroDrive’s EBITDA coverage ratio is:8

EBITDA coverage ratio EBITDA Lease payments

Interest Principal payments Lease payments

$500 200 $28 $120 $20 $28

$728 $168

4 3

Industry average 12 0

MicroDrive covered its fixed financial charges by 4.3 times. MicroDrive’s ratio is well below the industry average, so again the company seems to have a relatively high level of debt.

The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than about 5 years. Over a relatively short period, depreciation-generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Therefore, banks and other relatively short-term lenders focus on the EBITDA coverage ratio, whereas long-term bondholders focus on the TIE ratio.

S E L F - T E S T

How does the use of financial leverage affect current stockholders’ control position?

Name six ratios that are used to measure the extent to which a firm uses financial leverage, and write out their equations.

Morris Corporation has the following information on its balance sheets: Cash $40, accounts receivable $30, inventories $100, net fixed asset $500, accounts payable $20, accruals $10, short-term debt matures in less than a year $25, long-term debt $200, and total common equity $415. Its income statement reports: Sales $820, costs of goods sold excluding depreciation $450, depreciation $50, interest expense $20, and tax rate 40%. Calculate the following ratios: Debt-to-assets ratio (33.6%), debt-to-equity ratio (54.2%), liabilities-to-assets ratio (38.1%), and times-interest earned ratio (11.0). Hint: This is the same company used in the previous Self-Test.

Suppose Morris Corporation has 100 shares of stock with a price of $15 per share. What is its market debt ratio (assume the market value of debt is close to the book value)? (13.0%) How does this compare with the previously calculated debt-to-assets ratio? Does the market debt ratio imply that the company is more or less risky than the debt-to-assets ratio indicated?

A company has EBITDA of $600 million, interest payments of $60 million, lease payments of $40 million, and required principal payments (due this year) of $30 million. What is its EBITDA coverage ratio? (4.9)

7A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred stock issue. 8Different analysts define the EBITDA coverage ratio in different ways. For example, some omit the lease payment information; others “gross up” principal payments by dividing them by 1 − T because these payments are not tax deductions and so must be made with after-tax cash flows. We included lease payments because they are quite important for many firms, and failing to make them can lead to bankruptcy as surely as can failure to make payments on “regular” debt. We did not gross up principal payments because, if a company is in financial difficulty, then its tax rate will probably be zero; hence, the gross up is not necessary whenever the ratio is really important.

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3-5 Profitability Ratios Profitability is the net result of a number of policies and decisions. The ratios examined thus far provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios go on to show the combined effects of liquidity, asset management, and debt on operating results.

3-5a Net Profit Margin The net profit margin, also called the profit margin on sales or just the profit margin, is calculated by dividing net income by sales. It gives the profit per dollar of sales:

Net profit margin

Net income available to common stockholders

Sales

$220 $5,000

4 4%

Industry average 6 2%

MicroDrive’s net profit margin is below the industry average of 6.2%, but why is this so? Is it due to inefficient operations, high interest expenses, or both?

Instead of just comparing net income to sales, many analysts also break the income statement into smaller parts to identify the sources of a low net profit margin. For example, the operating profit margin is defined as:

Operating profit margin EBIT Sales

The operating profit margin identifies how a company is performing with respect to its operations before the impact of interest expenses is considered.

Some analysts drill even deeper by breaking operating costs into their components. For example, the gross profit margin is defined as:

Gross profit margin Sales Cost of goods sold including depreciation

Sales

The gross profit margin identifies the gross profit per dollar of sales before any other expenses are deducted.

Rather than calculate each type of profit margin here, later in the chapter we will use common size analysis and percent change analysis to focus on different parts of the income statement. In addition, we will use the DuPont equation to show how the ratios interact with one another.

Sometimes it is confusing to have so many different types of profit margins. To simplify the situation, we will focus primarily on the net profit margin throughout the book and call it the “profit margin.”

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3-5b Basic Earning Power (BEP) Ratio The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets:

Basic earning power BEP ratio EBIT

Total assets

$500 $3,550

14 1%

Industry average 20 2%

This ratio shows the earning power of the firm’s assets before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage. Because of its low turnover ratios and low profit margin on sales, MicroDrive is not getting as high a return on its assets as is the average company in its industry.

3-5c Return on Total Assets The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes. This ratio is also called the return on assets and is defined as follows:

Return on total assets ROA

Net income available to common stockholders

Total assets

$220 $3,550

6 2%

Industry average 11 0%

The World Might Be Flat, but Global Accounting Is Bumpy! The Case of IFRS versus FASB

In a flat world, distance is no barrier. Work flows to where it can be done most efficiently, and capital flows to where it can be invested most profitably. If a radiologist in India is more efficient than one in the United States, then images will be e-mailed to India for diagnosis; if rates of return are higher in Brazil, then investors throughout the world will provide funding for Brazilian projects. One key to “flatten- ing” the world is agreement on common standards. For example, there are common Internet standards so that users throughout the world are able to communicate.

A glaring exception to standardization is in accounting. The Securities and Exchange Commission (SEC) in the Uni- ted States requires firms to comply with standards set by

the Financial Accounting Standards Board (FASB). But the European Union requires all EU-listed companies to com- ply with the International Financial Reporting Standards (IFRS) as defined by the International Accounting Stan- dards Board (IASB).

IFRS tends to rely on general principles, whereas FASB standards are rules-based. As we write this in 2015, some progress toward standardizing accounting rules has been made, but it does not seem likely that the United States and the EU will using the same accounting rules in the near future.

Source: To keep abreast of developments in IFRS/GAAP convergence, visit the IASB Web site at www.iasb.org and the FASB Web site at www.fasb.org.

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MicroDrive’s 6.2% return is well below the 11% average for the industry. This low return is due to: (1) the company’s low basic earning power, and (2) high interest costs resulting from its above-average use of debt. Both of these factors cause MicroDrive’s net income to be relatively low.

3-5d Return on Common Equity The ratio of net income to common equity measures the return on common equity (ROE), which is often called just the return on equity:

Return on common equity ROE

Net income available to common stockholders

common equity

$220 $1,470

15 0%

Industry average 19 0%

Stockholders invest to earn a return on their money, and this ratio tells how well they are doing in an accounting sense. MicroDrive’s 15% return is below the 19% industry average, but not as far below as its return on total assets. This somewhat better result is due to the company’s greater use of debt, a point that we explain in detail later in the chapter.

S E L F - T E S T

Identify and write out the equations for four profitability ratios.

Why is the basic earning power ratio useful?

Why does the use of debt lower ROA?

What does ROE measure?

Morris Corporation has the following information on its balance sheets: Cash $40, accounts receivable $30, inventories $100, net fixed asset $500, accounts payable $20, accruals $10, short-term debt matures in less than a year $25, long-term debt $200, and total common equity $415. Its income statement reports: Sales $820, costs of goods sold excluding depreciation $450, depreciation $50, interest expense $20, and tax rate 40%. Calculate the following ratios: Net profit margin (14.6%), operating profit margin (26.8%), basic earning power ratio (32.8%), return on total assets (17.9%), and return on common equity (28.9%). Hint: This is the same company used in the previous Self-Test.

A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. What is its profit margin? (5%) What is its ROA? (10%) What is its ROE? (20%) Would ROA increase if the firm used less leverage? (Yes) Would ROE increase? (No)

3-6 Market Value Ratios Market value ratios relate a firm’s stock price to its earnings, cash flow, and book value per share. Market value ratios are a way to measure the value of a company’s stock relative to that of another company.

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3-6a Price/Earnings Ratio The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits. MicroDrive has $220 million in net income and 50 million shares, so its earnings per share (EPS) is $4 40 $220 50. MicroDrive’s stock sells for $27, so its P/E ratio is:

Price earnings P E ratio Price per share

Earnings per share

$27 00 $4 40

6 1

Industry average 10 5

Price/earnings ratios are higher for firms with strong growth prospects, other things held constant, but they are lower for riskier firms. Because MicroDrive’s P/E ratio is below the average, this suggests that the company is regarded as being somewhat riskier than most, as having poorer growth prospects, or both. In early 2014, the average P/E ratio for firms in the S&P 500 was 18.98, indicating that investors were willing to pay $18.98 for every dollar of earnings.

3-6b Price/Cash Flow Ratio Stock prices depend on a company’s ability to generate cash flows. Consequently, inves- tors often look at the price/cash flow ratio, where cash flow is defined as net income plus depreciation and amortization:

Price cash flow ratio Price per share

Cash flow per share

$27 00 $220 $200 50

3 2

Industry average 6 8

MicroDrive’s price/cash flow ratio is also below the industry average, once again suggesting that its growth prospects are below average, its risk is above average, or both.

The price/EBITDA ratio is similar to the price/cash flow ratio, except the price/ EBITDA ratio measures performance before the impact of interest expenses and taxes, making it a better measure of operating performance. MicroDrive’s EBITDA per share is $500 $200 50 $14, so its price/EBITDA is $27 $14 1 9. The industry average

price/EBITDA ratio is 4.0, so we see again that MicroDrive is below the industry average. Note that some analysts look at other multiples as well. For example, depending on the

industry, some may look at measures such as price/sales or price/customers. Ultimately, though, value depends on free cash flows, so if these “exotic” ratios do not forecast future free cash flow, they may turn out to be misleading. This was true in the case of the dot-com retailers before they crashed and burned in 2000, costing investors many billions.

3-6c Market/Book Ratio The ratio of a stock’s market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity

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generally sell at higher multiples of book value than those with low returns. First, we find MicroDrive’s book value per share:

Book value per share Total common equity

Shares outstanding

$1,470 50

$29 4

Now we divide the market price per share by the book value per share to get a market/ book (M/B) ratio:

Market book ratio M B Market price per share Book value per share

$27 00 $29 40

0 9

Industry average 1 8

It is also possible to define the market/book ratio as the market value of equity divided by the total common equity reported in the financial statements. The total market value of equity, which is called the market capitalization (or just market cap) is:

Market cap Price per share Total number of shares

$27 00 50 million $1,350 million

Now we divide the market cap by the total common equity:

Market book ratio M B Market cap

Total common equity

$1,350 $1,470

0 9

Both approaches give the same answer, 0.9, which is much lower than the industry average of 1.8. This indicates that investors are willing to pay relatively little for a dollar of MicroDrive’s book value.

The book value is a record of the past, showing the cumulative amount that stock- holders have invested, either directly by purchasing newly issued shares or indirectly through retaining earnings. In contrast, the market price is forward looking, incorporating investors’ expectations of future cash flows. For example, in early 2015, Bank of America had a market/book ratio of less than 0.8, reflecting the financial services industry’s problems, whereas Apple’s market/book ratio was almost 6, indicating that investors expected Apple’s past successes to continue.

Table 3-1 summarizes selected ratios for MicroDrive. As the table indicates, the company has many problems.

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TABLE 3-1 MicroDrive Inc.: Summary of Selected Financial Ratios (Millions of Dollars)

Ratio Formula Calculation Ratio Industry Average Comment

Liquidity

Current Current assets

Current liabilities $1,550 $780

2.0 2.2 Poor

Quick Current assets Inventories

Current liabilities $1,550 $1,000

$780 0.7 0.8 Poor

Asset Management

Total assets turnover Sales

Total assets $5,000 $3,550

1.4 1.8 Poor

Fixed assets turnover Sales

Net fixed assets $5,000 $2,000

2.5 3.0 Poor

Days sales outstanding (DSO)

Receivables Annual sales 365

$500 $13 7

36.5 30.0 Poor

Inventory turnover COGS

Inventories $4,000 $1,000

4.0 5.0 Poor

Debt Management

Debt-to-assets ratio Total debt

Total assets $1,480 $3,550

41.7% 25.0% High (risky)

Times-interest- earned (TIE)

Earnings before interest and taxes EBIT Interest charges

$5,00 $120

4.2 10.0 Low (risky)

Profitability

Profit margin on sales

Net income available to common stockholders Sales

$220 $5,000

4.4% 6.2% Poor

Basic earning power (BEP)

Earnings before interest and taxes EBIT Total assets

$5,00 $3,550

14.1% 20.2% Poor

Return on total assets (ROA)

Net income available to common stockholders Total assets

$220 $3,550

6.2% 11.0% Poor

Return on common equity (ROE)

Net income available to common stockholders Common equity

$220 $1,470

15.0% 19.0% Poor

Market Value

Price/earnings (P/E) Price per share

Earnings per share $27 00 $4 40

6.1 10.5 Low

Market/book (M/B) Market price per share Book value per share

$27 00 $29 40

0.9 1.8 Low

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S E L F - T E S T

Describe three ratios that relate a firm’s stock price to its earnings, cash flow, and book value per share, and write out their equations.

What does the price/earnings (P/E) ratio show? If one firm’s P/E ratio is lower than that of another, what are some factors that might explain the difference?

How is book value per share calculated? Explain why book values often deviate from market values.

A company has $6 billion of net income, $2 billion of depreciation and amortization, $80 billion of common equity, and 1 billion shares of stock. If its stock price is $96 per share, what is its price/earnings ratio? (16) Its price/cash flow ratio? (12) Its market/book ratio? (1.2)

3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis

Trends give clues as to whether a firm’s financial condition is likely to improve or deteriorate. To do a trend analysis, you examine a ratio over time, as shown in Figure 3-2. This graph shows that MicroDrive’s rate of return on common equity has been declining since 2014, in contrast to the industry average. All the other ratios could be analyzed similarly.

In a common size analysis, all income statement items are divided by sales and all balance sheet items are divided by total assets. Thus, a common size income statement shows each item as a percentage of sales, and a common size balance sheet shows each

FIGURE 3-2 MicroDrive, Inc.: Trend Analysis of Rate of Return on Common Equity

Industry

MicroDrive

ROE (%)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

2012 2013 2014 2015 2016

Source: See the file Ch03 Tool Kit.xlsx.

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item as a percentage of total assets.9 The advantage of common size analysis is that it facilitates comparisons of balance sheets and income statements over time and across companies.

Common size statements are easy to generate if the financial statements are in a spreadsheet. In fact, if you obtain your data from a source that uses standardized financial statements, then it is easy to cut and paste the data for a new company over your original company’s data, and all of your spreadsheet formulas will be valid for the new company. We generated Figure 3-3 in the Excel file Ch03 Tool Kit.xlsx. Figure 3-3 shows MicroDrive’s 2015 and 2016 common size income statements, along with the composite statement for the industry. (Note: Rounding may cause addition/subtraction differences in Figures 3-3, 3-4, and 3-5.) MicroDrive’s EBIT is slightly below average, and its interest expenses are slightly above average. The net effect is a relatively low profit margin.

Figure 3-4 shows MicroDrive’s common size balance sheets along with the industry composite. Its accounts receivable are slightly higher than the industry average, its inventories are significantly higher, and it uses much more debt than the average firm.

In percentage change analysis, growth rates are calculated for all income statement items and balance sheet accounts relative to a base year. To illustrate, Figure 3-5 contains MicroDrive’s income statement percentage change analysis for 2016 relative to 2015. Sales increased at a 5% rate during 2016, but EBIT fell by 9.1%. Part of this decline was due to an increase in depreciation, which is a noncash expense, but the cost of goods sold also increased by a little more than the growth in sales. In addition, interest expenses grew by 20%. We apply the same type of analysis to the balance sheets (see the file Ch03 Tool Kit.xlsx), which shows that inventories grew at a whopping 22% rate and accounts receivable grew over 31%. With only a 5% growth in sales, the extreme growth in receivables and inventories should be of great concern to MicroDrive’s managers.

FIGURE 3-3 MicroDrive Inc.: Common Size Income Statement

177 178 179 180 181 182 183 184 185 186 187

A B C D E F

2016 2016 2015 Net sales 100.0% 100.0% 100.0% Costs of goods sold except depreciation 75.5% 76.0% 74.8% Depreciation 3.0% 4.0% 3.6% Other operating expenses 10.0% 10.0% 10.1%

Earnings before interest and taxes (EBIT ) 11.5% 10.0% 11.6% L ess interest 1.2% 2.4% 2.1%

Pre‐tax earnings 10.4% 7.6% 9.5% T axes (40% ) 4.1% 3.0% 3.8%

Net income before preferred dividends 6.2% 4.6% 5.7% Preferred dividends 0.0% 0.2% 0.2% Net income available to common stockholders 6.2% 4.4% 5.5%

Industry Composite MicroDr ive

188 189 190

Source: See the file Ch03 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

9Some sources of industry data, such as Risk Management Associates (formerly known as Robert Morris Associates), are presented exclusively in common size form.

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FIGURE 3-4 MicroDrive Inc.: Common Size Balance Sheet

197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215

A B C D E

2016 2016 2015

Cash and equivalents 1.8% 1.4% 2.0% Short‐term investments 0.0% 0.0% 1.3% Accounts receivable 14.0% 14.1% 12.7% Inventor ies 26.3% 28.2% 27.3%

T otal current assets 42.1% 43.7% 43.3% Net plant and equipment 57.9% 56.3% 56.7% T otal assets 100.0% 100.0% 100.0%

Accounts payable 7.0% 5.6% 6.3% Notes payable 0.0% 7.9% 4.3% Accruals 12.3% 8.5% 9.3%

T otal current liabilities 19.3% 22.0% 20.0% L ong‐term bonds 25.4% 33.8% 33.3%

T otal liabilities 44.7% 55.8% 53.3% Preferred stock 0.0% 2.8% 3.3% T otal common equity 55.3% 41.4% 43.3% T otal liabilities and equity 100.0% 100.0% 100.0%

Industry Composite MicroDr ive

216 217 218

Source: See the file Ch03 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

FIGURE 3-5 MicroDrive Inc.: Income Statement Percentage Change Analysis

227 228 229 230 231 232 233 234 235 236 237

A B C D Base year = 2015

2016 Net sales 5.0% Costs of goods sold except depreciation 6.7%

17.6%Depreciation Other operating expenses 4.2%

Earnings before interest and taxes (EBIT ) L ess interest 20.0%

Pre‐tax earnings (15.6% ) T axes (40% ) (15.6% )

Net income before preferred dividends

(9.1% )

(15.6% ) Preferred dividends 0.0% Net income available to common stockholders (16.0% )

Percent Change in

238 239 240

Source: See the file Ch03 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations using the figure’s rounded values will be inexact.

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S E L F - T E S T

What is a trend analysis, and what information does it provide?

What is common size analysis?

What is percentage change analysis?

3-8 Tying the Ratios Together: The DuPont Equation

In ratio analysis, it is sometimes easy to miss the forest for all the trees. In particular, how do managerial actions affecting a firm’s profitability, asset efficiency, and financial lever- age interact to determine the return on equity, a performance measure that is important for investors? The extended DuPont equation provides just such a framework.

The DuPont equation uses two ratios we covered previously, the profit margin and the total asset turnover ratio, as measures of profitability and asset efficiency, but it uses a new measure of financial leverage, the equity multiplier, which is the ratio of assets to common equity:

Equity multiplier Total assets

Common equity (3-1)

Using this new definition of financial leverage, the extended DuPont equation is:

ROE Net income

Common equity Net income

Sales Sales

Total assets Total assets

Common equity

Profit margin Total assets turnover Equity multiplier

(3-2)

As calculated previously, MicroDrive’s 2016 profit margin is 4.4% and its total assets turnover ratio is 1.41. MicroDrive’s equity multiplier is:

Equity multiplier $3,550 $1,470

2 415

Applying the DuPont equation to MicroDrive, its return on equity is:

ROE 4 4% 1 41 2 415 15%

Sometimes it is useful to focus just on asset profitability and financial leverage. Firms that have a lot of financial leverage (i.e., a lot of liabilities or preferred stock) have a high equity multiplier because the assets are financed with a relatively smaller amount of equity. Therefore, the return on equity (ROE) depends on the ROA and the use of leverage:

ROE ROA Equity multiplier

Net income Total assets

Total assets Common equity

(3-3)

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Using Equation 3-3, we see that MicroDrive’s ROE is 15.0%, the same value given by the DuPont equation:

ROE 6 20% 2 415 15%

The insights provided by the DuPont model are valuable, and the model can be used for “quick and dirty” estimates of the impact that operating changes have on returns. For example, holding all else equal, if MicroDrive can implement lean production techniques and increase to 1.8 its ratio of sales to total assets, then its ROE will improve to 4 4% 1 8 2 415 19 1%.

For a more complete “what if” analysis, most companies use a forecasting model such as the one described in Chapter 12.

S E L F - T E S T

Explain how the extended, or modified, DuPont equation can be used to reveal the basic determinants of ROE.

What is the equity multiplier?

A company has a profit margin of 6%, a total asset turnover ratio of 2, and an equity multiplier of 1.5. What is its ROE? (18%)

3-9 Comparative Ratios and Benchmarking Ratio analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry—that is, with industry average figures. However, like most firms, MicroDrive’s managers go one step further: They also compare their ratios with those of a smaller set of the leading computer companies. This technique is called benchmarking, and the companies used for the comparison are called benchmark companies. For example, MicroDrive benchmarks against five other firms that its man- agement considers to be the best-managed companies with operations similar to its own.

Many companies also benchmark various parts of their overall operation against top companies, whether they are in the same industry or not. For example, MicroDrive has a division that sells hard drives directly to consumers through catalogs and the Internet. This division’s shipping department benchmarks against Amazon, even though they are in different industries, because Amazon’s shipping department is one of the best. MicroDrive wants its own shippers to strive to match Amazon’s record for on-time shipments.

Comparative ratios are available from a number of sources, including Value Line, Dun and Bradstreet (D&B), and the Annual Statement Studies published by Risk Management Associates, which is the national association of bank loan officers. Table 3-2 reports selected ratios from Reuters for Apple and its industry, revealing that Apple has a much higher net profit margin and return on assets than its peers.

Each data-supplying organization uses a somewhat different set of ratios designed for its own purposes. For example, D&B deals mainly with small firms, many of which are proprietorships, and it sells its services primarily to banks and other lenders. Therefore, D&B is concerned largely with the creditor’s viewpoint, and its ratios emphasize current assets and liabilities, not market value ratios. So, when you select a comparative data source, you should be sure that your own emphasis is similar to that of the agency whose ratios you plan to use. Additionally, there are often definitional differences in the ratios presented by different sources, so before using a source, be sure to verify the exact definitions of the ratios to ensure consistency with your own work.

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S E L F - T E S T

Compare and contrast trend analysis and comparative ratio analysis.

Explain benchmarking.

3-10 Uses and Limitations of Ratio Analysis Ratio analysis provides useful information concerning a company’s operations and finan- cial condition, but it has limitations that necessitate care and judgment. Some potential problems include the following.

1. Many large firms operate different divisions in different industries, and for such companies it is difficult to develop a meaningful set of industry averages. Therefore, industry averages are more meaningful for small, narrowly focused firms than for large, multidivisional ones.

2. To set goals for high-level performance, it is best to benchmark on the industry leaders’ ratios rather than the industry average ratios.

3. Inflation may badly distort firms’ balance sheets—reported values are often substantially different from “true” values. Further, because inflation affects depreciation charges and inventory costs, reported profits are also affected. Thus, inflation can distort a ratio analysis for one firm over time or a comparative analysis of firms of different ages.

4. Seasonal effects can distort a ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus the one just after the close of the canning season. This problem can be minimized by using monthly averages for inventory (and receivables) when calculating turnover ratios.

TABLE 3-2 Comparative Ratios for Apple Inc., the Computer Hardware Industry, and the Technology Sector

Ratio Apple Computer Hardware

Industrya Technology Sectorb

P/E ratio 17.1 27.4 18.9

Market to book 6.0 2.9 2.5

Net profit margin 22.3% 7.2% 8.5%

Quick ratio 1.1 1.3 1.8

Current ratio 1.1 1.5 2.3

Total debt-to-equity 29.5% 33.7% 21.7%

Interest coverage (TIE)c NA 15.1 12.8

Return on assets 18.3% 7.1% 10.5%

Return on equity 35.2% 15.5% 11.6%

Inventory turnover 55.1 18.4 51.5

Asset turnover 0.8 1.1 0.9

Notes: a The computer hardware industry includes such firms as IBM, Dell, Apple, and Silicon Graphics. b The technology sector contains 11 industries, including communications equipment, computer hardware, computer networks, semiconductors, and

software and programming. c Apple had more interest income than interest expense.

Source: Adapted from www.reuters.com, February 16, 2015. For updates, Select Market, Stocks, enter the ticker symbol for Apple (AAPL), and select Financials.

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5. Firms can employ window dressing techniques to make their financial statements look stronger. To illustrate, suppose a company takes out a 2-year loan in late December. Because the loan is for more than 1 year, it is not included in current liabilities even though the cash received through the loan is reported as a current asset. This improves the current and quick ratios and makes the year-end balance sheet look stronger. If the company pays the loan back in January, then the transaction was strictly window dressing.

6. Companies’ choices of different accounting practices can distort comparisons. For example, choices of inventory valuation and depreciation methods affect financial statements differently, making comparisons among companies less meaningful. As another example, if one firm leases a substantial amount of its productive equipment, then its assets may appear low relative to sales (because leased assets often do not appear on the balance sheet) and its debt may appear low (because the liability associated with the lease obligation may not be shown as debt).10

In summary, conducting ratio analysis in a mechanical, unthinking manner is dan- gerous. But when ratio analysis is used intelligently and with good judgment, it can provide useful insights into a firm’s operations and identify the right questions to ask.

S E L F - T E S T

List several potential problems with ratio analysis.

3-11 Looking Beyond the Numbers Sound financial analysis involves more than just calculating and comparing ratios— qualitative factors must be considered. Here are some questions suggested by the American Association of Individual Investors (AAII).

1. To what extent are the company’s revenues tied to one key customer or to one key product? To what extent does the company rely on a single supplier? Reliance on single customers, products, or suppliers increases risk.

2. What percentage of the company’s business is generated overseas? Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.

3. What are the probable actions of current competitors and the likelihood of additional new competitors?

4. Do the company’s future prospects depend critically on the success of products currently in the pipeline or on existing products?

5. How do the legal and regulatory environments affect the company?

Ratio Analysis on the Web

A great source for comparative ratios is www.reuters.com. Enter a company’s ticker at the top of the page. This brings up a table with the stock quote, company information, and additional links. Select Financials, which brings up a page

with a detailed ratio analysis for the company and includes comparative ratios for other companies in the same sector and the same industry. (Note: You may have to register to get extra features, but registration is free.)

10This may change when FASB and IASB complete their joint project on leasing. As of early 2015, the estimated project completion date was not certain. For the current status of the project, go to www.fasb.org, and select the tab for Projects.

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What qualitative factors should analysts consider when evaluating a company’s likely future financial performance?

S U M M A R Y

This chapter explained techniques investors and managers use to analyze financial state- ments. The key concepts covered are listed here.

• Liquidity ratios show the relationship of a firm’s current assets to its current liabilities and thus its ability to meet maturing debts. Two commonly used liquidity ratios are the current ratio and the quick ratio (also called the acid test ratio).

• Asset management ratios measure how effectively a firm is managing its assets. These ratios include inventory turnover, days sales outstanding, fixed assets turnover, and total assets turnover.

• Debt management ratios reveal: (1) the extent to which the firm is financed with debt, and (2) its likelihood of defaulting on its debt obligations. They include the debt-to- assets ratio (also called the debt ratio), the debt-to-equity ratio, the times-interest- earned ratio, and the EBITDA coverage ratio.

• Profitability ratios show the combined effects of liquidity, asset management, and debt management policies on operating results. They include the net profit margin (also called the profit margin on sales), the basic earning power ratio, the return on total assets, and the return on common equity.

• Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value per share, thus giving management an indication of what investors think of the company’s past performance and future prospects. These include the price/earnings ratio, the price/cash flow ratio, and the market/book ratio.

• Trend analysis, in which one plots a ratio over time, is important because it reveals whether the firm’s condition has been improving or deteriorating over time.

• The DuPont equation shows how the profit margin on sales, the assets turnover ratio, and the use of debt all interact to determine the rate of return on equity.

• Benchmarking is the process of comparing a particular company with a group of similar successful companies.

Ratio analysis has limitations, but when used with care and judgment, it can be very helpful.

Q U E S T I O N S

(3-1) Define each of the following terms: a. Liquidity ratios: current ratio; quick, or acid test, ratio b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO);

fixed assets turnover ratio; total assets turnover ratio c. Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; coverage ratio d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on

total assets (ROA); return on common equity (ROE) e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/book

(M/B) ratio; book value per share f. Trend analysis; comparative ratio analysis; benchmarking g. DuPont equation; window dressing; seasonal effects on ratios

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(3-2) Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?

(3-3) Over the past year, M. D. Ryngaert & Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?

(3-4) Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between a grocery chain such as Safeway and a steel company? Think particularly about the turnover ratios, the profit margin, and the DuPont equation.

(3-5) How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. How might these problems be alleviated?

(3-6) Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry?

S E L F - T E S T P R O B L E M S S o l u t i o n s S h o w n i n A p p e n d i x A

(ST-1) Argent Corporation has $60 million in current liabilities, $150 million in total liabilities, and $210 million in total common equity; Argent has no preferred stock. Argent’s total debt is $120 million. What is the debt-to-assets ratio? What is the debt-to-equity ratio?

(ST-2) The following data apply to Jacobus and Associates (millions of dollars):

Cash $ 400 Fixed assets $ 4,300 Sales $14,600 Net income $ 730 Quick ratio 2.0 Current ratio 3.0 DSO 40 days ROE 12.5%

Jacobus has no preferred stock—only common equity, current liabilities, and long-term debt. Find Jacobus’s (1) accounts receivable, (2) current liabilities, (3) current assets, (4) total assets, (5) ROA, (6) common equity, (7) long-term debt, (8) equity multiplier, (9) profit margin, and (10) total asset turnover. Substitute your calculated profit margin, total asset turnover, and equity multiplier into the DuPont equation and verify that resulting ROE is 12.5%.

P R O B L E M S A n s w e r s A r e i n A p p e n d i x B

EASY PROBLEMS 1–5

Greene Sisters has a DSO of 20 days. The company’s average daily sales are $20,000. What is the level of its accounts receivable? Assume there are 365 days in a year.

Vigo Vacations has $200 million in total assets, $5 million in notes payable, and $25 million in long-term debt. What is the debt ratio?

Debt Ratio

Ratio Analysis

(3-1) DSO

(3-2) Debt Ratio

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Winston Watch’s stock price is $75 per share. Winston has $10 billion in total assets. Its balance sheet shows $1 billion in current liabilities, $3 billion in long-term debt, and $6 billion in common equity. It has 800 million shares of common stock outstanding. What is Winston’s market/book ratio? Reno Revolvers has an EPS of $1.50, a cash flow per share of $3.00, and a price/cash flow ratio of 8.0. What is its P/E ratio?

Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of 2.0. Its sales are $100 million and it has total assets of $50 million. What is its ROE?

INTERMEDIATE PROBLEMS 6–10

Gardial & Son has an ROA of 12%, a 5% profit margin, and a return on equity equal to 20%. What is the company’s total assets turnover? What is the firm’s equity multiplier? Ace Industries has current assets equal to $3 million. The company’s current ratio is 1.5, and its quick ratio is 1.0. What is the firm’s level of current liabilities? What is the firm’s level of inventories? Assume you are given the following relationships for the Haslam Corporation:

Sales/total assets 1.2 Return on assets (ROA) 4% Return on equity (ROE) 7%

Calculate Haslam’s profit margin and liabilities-to-assets ratio. Suppose half its liabilities are in the form of debt. Calculate the debt-to-assets ratio. The Nelson Company has $1,312,500 in current assets and $525,000 in current liabilities. Its initial inventory level is $375,000, and it will raise funds as additional notes payable and use them to increase inventory. How much can Nelson’s short- term debt (notes payable) increase without pushing its current ratio below 2.0? What will be the firm’s quick ratio after Nelson has raised the maximum amount of short- term funds? The Morrit Corporation has $600,000 of debt outstanding, and it pays an interest rate of 8% annually. Morrit’s annual sales are $3 million, its average tax rate is 40%, and its net profit margin on sales is 3%. If the company does not maintain a TIE ratio of at least 5 to 1, then its bank will refuse to renew the loan and bankruptcy will result. What is Morrit’s TIE ratio?

CHALLENGING PROBLEMS 11–14

Complete the balance sheet and sales information in the table that follows for J. White Industries, using the following financial data:

Total assets turnover: 1.5 Gross profit margin on sales: Sales − Cost of goods sold Sales 25% Total liabilities-to-assets ratio: 40% Quick ratio: 0.80 Days’ sales outstanding (based on 365-day year): 36.5 days Inventory turnover ratio: 3.75

(3-3) Market/Book Ratio

(3-4) Price/Earnings Ratio

(3-5) ROE

(3-6) DuPont Analysis

(3-7) Current and Quick Ratios

(3-8) Profit Margin and

Debt Ratio

(3-9) Current and Quick Ratios

(3-10) Times-Interest-

Earned Ratio

(3-11) Balance Sheet

Analysis

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The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, a days’ sales outstanding of 36.5 days (based on a 365-day year), total current assets of $810,000, and cash and marketable securities of $120,000. What were Kretovich’s annual sales? Data for Lozano Chip Company and its industry averages follow.

a. Calculate the indicated ratios for Lozano. b. Construct the extended DuPont equation for both Lozano and the industry. c. Outline Lozano’s strengths and weaknesses as revealed by your analysis.

Balance Sheet Balance Sheet Information

Cash Accounts payable Accounts receivable Long-term debt 50,000 Inventories Common stock Fixed assets Retained earnings 100,000 Total assets $400,000 Total liabilities and equity

Partial Income Statement

Information Sales Cost of goods sold

Lozano Chip Company: Balance Sheet as of December 31, 2016 (Thousands of Dollars)

Cash $ 225,000 Accounts payable $ 601,866 Receivables 1,575,000 Notes payable 326,634 Inventories 1,125,000 Other current liabilities 525,000

Total current assets $2,925,000 Total current liabilities $1,453,500 Net fixed assets 1,350,000 Long-term debt 1,068,750

Common equity 1,752,750 Total assets $4,275,000 Total liabilities and equity $4,275,000

Lozano Chip Company: Income Statement for Year Ended December 31, 2016 (Thousands of Dollars)

Sales $7,500,000 Cost of goods sold 6,375,000 Selling, general, and administrative expenses 825,000

Earnings before interest and taxes (EBIT) $ 300,000 Interest expense 111,631

Earnings before taxes (EBT) $ 188,369 Federal and state income taxes (40%) 75,348 Net income $ 113,021

(3-12) Comprehensive

Ratio Calculations

(3-13) Comprehensive

Ratio Analysis

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The Jimenez Corporation’s forecasted 2017 financial statements follow, along with some industry average ratios. Calculate Jimenez’s 2017 forecasted ratios, compare them with the industry average data, and comment briefly on Jimenez’s projected strengths and weaknesses.

Ratio Lozano Industry Average Current assets/Current liabilities 2.0 Days sales outstanding (365-day year) 35.0 days COGS/Inventory 6.7 Sales/Fixed assets 12.1 Sales/Total assets 3.0 Net income/Sales 1.2% Net income/Total assets 3.6% Net income/Common equity 9.0% Total debt/Total assets 30.0% Total liabilities/Total assets 60.0%

Jimenez Corporation: Forecasted Balance Sheet as of December 31, 2017

Assets Cash $ 72,000 Accounts receivable 439,000 Inventories 894,000

Total current assets $ 1,405,000 Fixed assets 431,000 Total assets $ 1,836,000 Liabilities and Equity Accounts payable $ 332,000 Notes payable 100,000 Accruals 170,000

Total current liabilities $ 602,000 Long-term debt 404,290 Common stock 575,000 Retained earnings 254,710 Total liabilities and equity $ 1,836,000

Jimenez Corporation: Forecasted Income Statement for 2017

Sales $4,290,000 Cost of goods sold (excluding depreciation) 3,580,000 Selling, general, and administrative expenses 370,320 Depreciation 159,000

Earnings before taxes (EBT) $ 180,680 Taxes (40%) 72,272 Net income $ 108,408

(3-14) Comprehensive

Ratio Analysis

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S P R E A D S H E E T P R O B L E M

(3-15) Start with the partial model in the file Ch03 P15 Build a Model.xlsx from the textbook’s Web site. Joshua & White (J&W) Technology’s financial statements are also shown here. Answer the following questions. (Note: Industry average ratios are provided in Ch03 P15 Build a Model.xlsx.)

a. Has J&W’s liquidity position improved or worsened? Explain. b. Has J&W’s ability to manage its assets improved or worsened? Explain. c. How has J&W’s profitability changed during the last year? d. Perform an extended DuPont analysis for J&W for 2015 and 2016. What do these

results tell you? e. Perform a common size analysis. What has happened to the composition (that is,

percentage in each category) of assets and liabilities? f. Perform a percentage change analysis. What does this tell you about the change in

profitability and asset utilization?

Jimenez Corporation: Per Share Data for 2017

EPS $ 4.71 Cash dividends per share $ 0.95 P/E ratio 5.0 Market price (average) $23.57 Number of shares outstanding 23,000

Industry Ratios Quick ratio 1.0 Current ratio 2.7 Inventory turnovera 7.0 Days sales outstandingb 32.0 days Fixed assets turnovera 13.0 Total assets turnovera 2.6 Return on assets 9.1% Return on equity 18.2% Profit margin on sales 3.5% Debt-to-assets ratio 21.0% Liabilities-to-assets ratio 50.0% P/E ratio 6.0 Price/Cash flow ratio 3.5 Market/Book ratio 3.5

Notes: aBased on year-end balance sheet figures. bCalculation is based on a 365-day year.

Build a Model: Ratio Analysis

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M I N I C A S E

The first part of the case, presented in Chapter 2, discussed the situation of Computron Industries after an expansion program. A large loss occurred in 2016, rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival.

Jenny Cochran was brought in as assistant to Computron’s chairman, who had the task of getting the company back into a sound financial position. Cochran must prepare

Joshua & White Technology: Income Statements for Years Ending December 31 (Thousands of Dollars)

2016 2015 Sales $420,000 $400,000 COGS excluding depr. & amort. 300,000 298,000 Depreciation and amortization 19,660 18,000 Other operating expenses 27,600 22,000

EBIT $ 72,740 $ 62,000 Interest expense 5,740 4,460

EBT $ 67,000 $ 57,540 Taxes (40%) 26,800 23,016

Net income $ 40,200 $ 34,524

Common dividends $ 18,125 $ 17,262

Joshua & White Technology: December 31 Balance Sheets (Thousands of Dollars) Assets 2016 2015 Liabilities & Equity 2016 2015 Cash $ 21,000 $ 20,000 Accounts payable $ 33,600 $ 32,000 Short-term investments 3,759 3,240 Accruals 12,600 12,000 Accounts receivable 52,500 48,000 Notes payable 19,929 6,480 Inventories 84,000 56,000 Total current liabilities $ 66,129 $ 50,480

Total current assets $161,259 $127,240 Long-term debt 67,662 58,320 Net fixed assets 218,400 200,000 Total liabilities $133,791 $108,800

Total assets $379,659 $327,240 Common stock 183,793 178,440 Retained earnings 62,075 40,000

Total common equity $245,868 $218,440 Total liabilities & equity $379,659 $327,240

Other Data 2016 2015 Year-end stock price $ 90.00 $ 96.00 Number of shares (Thousands) 4,052 4,000 Lease payment (Thousands of Dollars) $20,000 $20,000 Sinking fund payment (Thousands of Dollars) $ 5,000 $ 5,000

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an analysis of where the company is now, what it must do to regain its financial health, and what actions to take. Your assignment is to help her answer the following questions, using the recent and projected financial information shown next. Provide clear explana- tions, not yes or no answers.

Balance Sheets 2015 2016 2017E

Assets Cash $ 9,000 $ 7,282 $ 14,000 Short-term investments 48,600 20,000 71,632 Accounts receivable 351,200 632,160 878,000 Inventories 715,200 1,287,360 1,716,480

Total current assets $1,124,000 $1,946,802 $2,680,112 Gross fixed assets 491,000 1,202,950 1,220,000 Less: Accumulated depreciation 146,200 263,160 383,160

Net fixed assets $ 344,800 $ 939,790 $ 836,840 Total assets $1,468,800 $2,886,592 $3,516,952

Liabilities and Equity 2015 2016 2017E Accounts payable $ 145,600 $ 324,000 $ 359,800 Notes payable 200,000 720,000 300,000 Accruals 136,000 284,960 380,000

Total current liabilities $ 481,600 $1,328,960 $1,039,800 Long-term debt 323,432 1,000,000 500,000 Common stock (100,000 shares) 460,000 460,000 1,680,936 Retained earnings 203,768 97,632 296,216

Total equity $ 663,768 $ 557,632 $1,977,152 Total liabilities and equity $1,468,800 $2,886,592 $3,516,952

Note: “E” denotes “estimated”; the 2017 data are forecasts.

Income Statements 2015 2016 2017E

Sales $3,432,000 $5,834,400 $7,035,600 Cost of goods sold except depr. 2,864,000 4,980,000 5,800,000 Depreciation and amortization 18,900 116,960 120,000 Other expenses 340,000 720,000 612,960 Total operating costs $3,222,900 $5,816,960 $6,532,960 EBIT $ 209,100 $ 17,440 $ 502,640 Interest expense 62,500 176,000 80,000 Pre-tax earnings $ 146,600 ($ 158,560) $ 422,640 Taxes (40%) 58,640 (63,424) 169,056 Net income $ 87,960 ($ 95,136) $ 253,584

Note: “E” denotes “estimated”; the 2017 data are forecasts.

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a. Why are ratios useful? What three groups use ratio analysis and for what reasons? b. Calculate the 2017 current and quick ratios based on the projected balance sheet and

income statement data. What can you say about the company’s liquidity position in 2015, 2016, and as projected for 2017? We often think of ratios as being useful: (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the liquidity ratios?

c. Calculate the 2017 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Computron’s utilization of assets stack up against that of other firms in its industry?

d. Calculate the 2017 debt ratio, liabilities-to-assets ratio, times-interest-earned ratio, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?

Other Data 2015 2016 2017E

Stock price $8.50 $6.00 $12.17 Shares outstanding 100,000 100,000 250,000 EPS $0.880 $0.951 $1.014 DPS $0.220 $0.110 $0.220 Tax rate 40% 40% 40% Book value per share $6.638 $5.576 $7.909 Lease payments $40,000 $40,000 $40,000 Note: “E” denotes “estimated”; the 2017 data are forecasts.

Ratio Analysis

2015 2016 2017E Industry Average

Current 2.3 1.5 2.7 Quick 0.8 0.5 1.0 Inventory turnover 4.0 4.0 6.1 Days sales outstanding 37.3 39.6 32.0 Fixed assets turnover 10.0 6.2 7.0 Total assets turnover 2.3 2.0 2.5 Debt ratio 35.6% 59.6% 32.0% Liabilities-to-assets ratio 54.8% 80.7% 50.0% TIE 3.3 0.1 6.2 EBITDA coverage 2.6 0.8 8.0 Profit margin 2.6% −1.6% 3.6% Basic earning power 14.2% 0.6% 17.8% ROA 6.0% −3.3% 9.0% ROE 13.3% −17.1% 17.9% Price/Earnings (P/E) 9.7 −6.3 16.2 Price/Cash flow 8.0 27.5 7.6 Market/Book 1.3 1.1 2.9 Note: “E” denotes “estimated.”

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e. Calculate the 2017 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?

f. Calculate the 2017 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

g. Perform a common size analysis and percentage change analysis. What do these analyses tell you about Computron?

h. Use the extended DuPont equation to provide a summary and overview of Computron’s financial condition as projected for 2017. What are the firm’s major strengths and weaknesses?

i. What are some potential problems and limitations of financial ratio analysis? j. What are some qualitative factors that analysts should consider when evaluating a

company’s likely future financial performance?

S E L E C T E D A D D I T I O N A L C A S E S

The following cases from CengageCompose cover many of the concepts discussed in this chapter and are available at http://compose.cengage.com.

Klein-Brigham Series: Case 35, “Mark X Company (A),” illustrates the use of ratio analysis in the evaluation of a firm’s existing and potential financial positions; Case 36, “Garden State Container Cor- poration,” is similar in content to Case 35; Case 51, “Safe Packaging Corporation,” updates Case 36; Case 68, “Sweet Dreams Inc.,” also updates Case 36; and Case 71, “Swan-Davis, Inc.,” illustrates how financial analysis—based on both historical statements and forecasted statements—is used for internal management and lending decisions.

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