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EDITIONNinth

Fundamentals of

Corporate Finance

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Financial Management

Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Ninth Edition

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition

Cornett, Adair, and Nofsinger M: Finance Third Edition

DeMello Cases in Finance Third Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition

Shefrin Behavioral Corporate Finance: Decisions That Create Value Second Edition

Investments

Bodie, Kane, and Marcus Essentials of Investments Tenth Edition

Bodie, Kane, and Marcus Investments Tenth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Eighth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

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Financial Institutions and Markets

Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

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Eun and Resnick International Financial Management Eighth Edition

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Brueggeman and Fisher Real Estate Finance and Investments Fifteenth Edition

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THE McGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Stephen A. Ross, Franco Modigliani Professor of Financial Economics Sloan School of Management, Massachusetts Institute of Technology Consulting Editor

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Richard A. Brealey London Business School

Stewart C. Myers Sloan School of Management, Massachusetts Institute of Technology

Alan J. Marcus Carroll School of Management, Boston College

Fundamentals of

Corporate Finance

EDITIONNinth

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mheducation.com/highered

FUNDAMENTALS OF CORPORATE FINANCE, NINTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2018 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2015, 2012, 2009, 2007, 2004, 2001, 1999, and 1995. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Library of Congress Cataloging-in-Publication Data

Names: Brealey, Richard A., author. | Myers, Stewart C., author. | Marcus, Alan J., author. Title: Fundamentals of corporate finance / Richard A. Brealey, London Business School, Stewart C. Myers, Sloan School of Management, Massachusetts Institute of Technology, Alan J. Marcus, Carroll School of Management, Boston College. Description: Ninth edition. | New York, NY : McGraw-Hill, [2017] Identifiers: LCCN 2016031933 | ISBN 9781259722615 (alk. paper) Subjects: LCSH: Corporations--Finance. Classification: LCC HG4026 .B6668 2017 | DDC 658.15--dc23 LC record available at https://lccn.loc. gov/2016031933

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

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To Our FamiliesDedication

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Alan J. Marcus Mario Gabelli Professor of Finance in the Carroll School of Management at Boston College Professor Marcus’s main research interests are in derivatives and securities mar- kets. He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and Essentials of Investments (McGraw-Hill Education). Professor Marcus has served as a research fellow at the National Bureau of Economic Research. Professor Marcus also spent two years at Freddie Mac, where he helped to develop mortgage pricing and credit risk models. He currently serves on the Research Foundation Advisory Board of the CFA Institute.

Stewart C. Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management Dr. Myers is past president of the American Finance Association and a research asso- ciate of the National Bureau of Economic Research. His research has focused on financing decisions, valuation methods, the cost of capital, and financial aspects of government regulation of business. Dr. Myers is a director of The Brattle Group, Inc. and is active as a financial consultant. He is also the author (with Professor Brealey and Franklin Allen) of this book’s sister text, Principles of Corporate Finance (McGraw- Hill Education).

Richard A. Brealey Professor of Finance at the London Business School Professor Brealey is the former president of the European Finance Association and a former director of the American Finance Association. He is a fellow of the British Academy and has served as Special Adviser to the Governor of the Bank of England and as director of a number of financial institutions. Professor Brealey is also the author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles of Corporate Finance (McGraw-Hill Education).

The AuthorsAbout

Courtesy of Richard A. Brealey

Courtesy of Stewart C. Myers

Courtesy of Alan J. Marcus

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This book is an introduction to corporate finance. It focuses on how companies invest in real assets, how they raise the money to pay for the investments, and how those assets ultimately affect the value of the firm. It also provides a broad overview of the financial landscape, discussing, for example, the major players in financial markets, the role of financial institutions in the economy, and how securities are traded and valued by investors. The book offers a framework for systematically thinking about most of the important financial problems that both firms and individuals are likely to confront.

Financial management is important, interesting, and challenging. It is important because today’s capital investment decisions may determine the businesses that the firm is in 10, 20, or more years ahead. Needless to say, a firm’s success or failure depends, in large part, on its ability to find the capital that it requires.

Finance is interesting for several reasons. Financial decisions often involve huge sums of money. Large investment projects or acquisitions may involve billions of dol- lars. Also, the financial community is international and fast-moving, with colorful heroes and a sprinkling of unpleasant villains.

Finance is challenging. Financial decisions are rarely cut and dried, and the finan- cial markets in which companies operate are changing rapidly. Good managers can cope with routine problems, but only the best managers can respond to change. To handle new problems, you need more than rules of thumb; you need to understand why companies and financial markets behave as they do and when common practice may not be best practice. Once you have a consistent framework for making financial decisions, complex problems become more manageable.

This book provides that framework. It is not an encyclopedia of finance. It focuses instead on setting out the basic principles of financial management and applying them to the main decisions faced by the financial manager. It explains why the firm’s own- ers would like the manager to increase firm value and shows how managers make choices between investments that may pay off at different points of time or have dif- ferent degrees of risk. It also describes the main features of financial markets and discusses why companies may prefer a particular source of finance.

We organize the book around the key concepts of modern finance. These concepts, properly explained, simplify the subject. They are also practical. The tools of financial management are easier to grasp and use effectively when presented in a consistent conceptual framework. This text provides that framework.

Modern financial management is not “rocket science.” It is a set of ideas that can be made clear by words, graphs, and numerical examples. The ideas provide the “why” behind the tools that good financial managers use to make investment and financing decisions.

We wrote this book to make financial management clear, useful, and fun for the beginning student. We set out to show that modern finance and good financial practice go together, even for the financial novice.

Fundamentals and Principles of Corporate Finance

This book is derived in part from its sister text Principles of Corporate Finance. The spirit of the two books is similar. Both apply modern finance to give students a working ability to make financial decisions. However, there are also substantial differ- ences between the two books.

Preface

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First, we provide in Fundamentals much more detailed discussion of the princi- ples and mechanics of the time value of money. This material underlies almost all of this text, and we spend a lengthy chapter providing extensive practice with this key concept.

Second, we use numerical examples in this text to a greater degree than in Principles. Each chapter presents several detailed numerical examples to help the reader become familiar and comfortable with the material.

Third, we have streamlined the treatment of most topics. Whereas Principles has 34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals neces- sitates a broader-brush coverage of some topics, but we feel that this is an advantage for a beginning audience.

Fourth, we assume little in the way of background knowledge. While most users will have had an introductory accounting course, we review the concepts of account- ing that are important to the financial manager in Chapter 3.

Principles is known for its relaxed and informal writing style, and we continue this tradition in Fundamentals. In addition, we use as little mathematical notation as possible. Even when we present an equation, we usually write it in words rather than symbols. This approach has two advantages. It is less intimidating, and it focuses attention on the underlying concept rather than the formula.

Organizational Design Fundamentals is organized in eight parts.

Part 1 (Introduction)  provides essential background material. In the first chapter, we discuss how businesses are organized, the role of the financial manager, and the financial markets in which the manager operates. We explain how shareholders want managers to take actions that increase the value of their investment, and we introduce the concept of the opportunity cost of capital and the trade-off that the firm needs to make when assessing investment proposals. We also describe some of the mecha- nisms that help to align the interests of managers and shareholders. Of course, the task of increasing shareholder value does not justify corrupt and unscrupulous behavior. We, therefore, discuss some of the ethical issues that confront managers.

Chapter 2 surveys and sets out the functions of financial markets and institutions. This chapter also reviews the crisis of 2007–2009. The events of those years illustrate clearly why and how financial markets and institutions matter.

A large corporation is a team effort, so the firm produces financial statements to help the players monitor its progress.  Chapter 3 provides a brief overview of these financial statements and introduces two key distinctions—between market and book values and between cash flows and profits. This chapter also discusses some of the shortcomings in accounting practice. The chapter concludes with a summary of federal taxes.

Chapter 4 provides an overview of financial statement analysis. In contrast to most introductions to this topic, our discussion is motivated by considerations of valuation and the insight that financial ratios can provide about how management has added to the firm’s value.

Part 2 (Value) is concerned with valuation. In Chapter 5, we introduce the concept of the time value of money, and because most readers will be more familiar with their own financial affairs than with the big leagues of finance, we motivate our discussion by looking first at some personal financial decisions. We show how to value long-lived streams of cash flows and work through the valuation of perpetuities and annuities. Chapter 5 also contains a short concluding section on inflation and the distinction between real and nominal returns.

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Chapters 6 and 7 introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter 5 to the valuation of these securities. We show how to find the value of a bond given its yield, and we show how prices of bonds fluctuate as interest rates change. We look at what determines stock prices and how stock valuation formulas can be used to infer the return that investors expect. Finally, we see how investment opportunities are reflected in the stock price and why analysts focus on the price-earnings multiple. Chapter 7 also introduces the concept of market efficiency. This concept is crucial to interpreting a stock’s valuation; it also provides a framework for the later treatment of the issues that arise when firms issue securities or make decisions concerning dividends or capital structure.

The remaining chapters of Part 2 are concerned with the company’s investment decision. In Chapter 8, we introduce the concept of net present value and show how to calculate the NPV of a simple investment project. We then consider more complex investment proposals, including choices between alternative projects, machine replace- ment decisions, and decisions of when to invest. We also look at other measures of an investment’s attractiveness—its internal rate of return, profitability index, and payback period. We show how the profitability index can be used to choose between invest- ment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep some of the pitfalls of the IRR rule.

The first step in any NPV calculation is to decide what to discount. Therefore, in Chapter 9, we work through a realistic example of a capital budgeting analysis, showing how the manager needs to recognize the investment in working capital and how taxes and depreciation affect cash flows.

We start Chapter 10 by looking at how companies organize the investment process and ensure everyone works toward a common goal. We then go on to look at various techniques to help managers identify the key assumptions in their estimates, such as sensitivity analysis, scenario analysis, and break-even analysis. We explain the distinc- tion between accounting break-even and NPV break-even. We conclude the chapter by describing how managers try to build future flexibility into projects so that they can capitalize on good luck and mitigate the consequences of bad luck.

Part 3 (Risk) is concerned with the cost of capital. Chapter 11 starts with a historical survey of returns on bonds and stocks and goes on to distinguish between the specific risk and market risk of individual stocks. Chapter 12 shows how to measure mar- ket risk and discusses the relationship between risk and expected return. Chapter 13 introduces the weighted-average cost of capital and provides a practical illustra- tion of how to estimate it.

Part 4 (Financing) begins our discussion of the financing decision. Chapter 14 pro- vides an overview of the securities that firms issue and their relative importance as sources of finance. In Chapter 15, we look at how firms issue securities, and we follow a firm from its first need for venture capital, through its initial public offering, to its continuing need to raise debt or equity.

Part 5 (Debt and Payout Policy)  focuses on the two classic long-term financ- ing decisions. In Chapter 16, we ask how much the firm should borrow, and we summarize bankruptcy procedures that occur when firms can’t pay their debts. In Chapter 17, we study how firms should set dividend and payout policy. In each case, we start with Modigliani and Miller’s (MM’s) observation that in well- functioning markets, the decision should not matter, but we use this initial observation to help the reader understand why financial managers in practice do pay attention to these decisions.

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Part 6 (Financial Analysis and Planning) starts with long-term financial planning in Chapter 18, where we look at how the financial manager considers the com- bined effects of investment and financing decisions on the firm as a whole. We also show how measures of internal and sustainable growth help managers check that the firm’s planned growth is consistent with its financing plans. Chapter 19 is an introduction to short-term financial planning. It shows how managers ensure that the firm will have enough cash to pay its bills over the coming year. Chapter 20 addresses working capital management. It describes the basic steps of credit man- agement, the principles of inventory management, and how firms handle payments efficiently and put cash to work as quickly as possible. It also describes how firms invest temporary surpluses of cash and how they can borrow to offset any temporary deficiency. Chapter 20 is conceptually straightforward, but it contains a large dollop of institutional material.

Part 7 (Special Topics)  covers several important but somewhat more advanced topics—mergers (Chapter 21), international financial management (Chapter 22), options (Chapter 23), and risk management (Chapter 24). Some of these topics are touched on in earlier chapters. For example, we introduce the idea of options in Chapter 10, when we show how companies build flexibility into capital projects. However, Chapter 23 generalizes this material, explains at an elementary level how options are valued, and provides some examples of why the financial manager needs to be concerned about options. International finance is also not confined to Chapter 22. As one might expect from a book that is written by an international group of authors, examples from different countries and financial systems are scattered throughout the book. However, Chapter 22 tackles the specific problems that arise when a corporation is confronted by different currencies.

Part 8 (Conclusion)  contains a concluding chapter (Chapter 25), in which we review the most important ideas covered in the text. We also introduce some interesting questions that either were unanswered in the text or are still puzzles to the finance profession. Thus, the last chapter is an introduction to future finance courses as well as a conclusion to this one.

Routes through the Book There are about as many effective ways to organize a course in corporate finance as there are teachers. For this reason, we have ensured that the text is modular so that topics can be introduced in different sequences.

We like to discuss the principles of valuation before plunging into financial planning. Nevertheless, we recognize that many instructors will prefer to move directly from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long- Term Financial Planning) in order to provide a gentler transition from the typical prerequisite accounting course. We have made sure that Part 6 (Financial Analysis and Planning) can easily follow Part 1.

Similarly, we like to discuss working capital after the student is familiar with the basic principles of valuation and financing, but we recognize that here also many instructors prefer to reverse our order. There should be no difficulty in taking Chapter 20 out of order.

When we discuss project valuation in Part 2, we stress that the opportunity cost of capital depends on project risk. But we do not discuss how to measure risk or how return and risk are linked until Part 3. This ordering can easily be modified. For example, the chapters on risk and return can be introduced before, after, or midway through the material on project valuation.

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Changes in the Ninth Edition

Users of previous editions of this book will not find dramatic changes in either the material or the ordering of topics. But, throughout, we have made the book more up to date and easier to read. Here are some of the ways that we have done this.

Beyond the Page  The biggest change in the last edition was the introduction of Beyond the Page digital extensions and applications. These digital extensions are not, as they may sound, artificial fingernails; they are additional examples, anecdotes, spreadsheet programs, and more thoroughgoing explanations of some topics. This material is very easily accessed on the web. In this edition, we have added a number of additional applications and made them easier to access. For example, the applica- tions are seamlessly available with a click on the e-version of the book, but they are also readily accessible in the traditional hard copy of the text using the shortcut URLs provided in the margins of relevant pages.

Improving the Flow  A major part of our effort in revising this text was spent on improving the flow. Often this has meant a word change here or a redrawn diagram there, but sometimes we have made more substantial changes. One example is the discussion of WACC in  Chapter 13. Rather than chop and change between our two illustrative companies, Geothermal and Big Oil, we now follow through the Geothermal example to the end. By then, the reader should understand when one can and can’t use WACC and can move on to tackling the practical problems of estimating Big Oil’s capital structure and expected returns. The material is substan- tially unchanged, but we think that the flow is much improved.

Updating  Of course, in each new edition we try to ensure that any statistics are as up to date as possible. For example, since the previous edition, we have available an extra 3 years of data on security returns. These show up in the figures in Chapter 11 of the long-run returns on stocks, bonds, and bills. Measures of EVA, data on security ownership, dividend payments, and stock repurchases are just a few of the other cases where data have been brought up to date.

Recent Events  We discussed the financial crisis of 2007–2009 in the previous edition, but we have now been able to revise our discussion to include the spill- over to the crisis in the eurozone and to draw some general lessons. The euro- zone crisis was also a reminder that government debt is not risk free. We come back to that issue in Chapter 6 when we discuss default risk.

Concepts  There are several places where we have introduced new conceptual material. For example, students who have learned about the dividend discount model are often confused about how to value the many companies that also repurchase their stock. We introduce the issue in Chapters 7 and 13, and in Chapter 17, we explain how to value stocks of companies that both pay dividends and repurchase stock. 

New Illustrative Boxes  The text contains a number of boxes with illustrative real- world examples. Many of these are new. Look, for example, at the box in Chapter 2 that describes prediction markets and what they had to say about the 2016 primaries. Or look at the box in  Chapter 15  that shows how HUDWAY used crowdfunding to finance its Head-Up Display project.

More Worked Examples We have added more worked examples in the text, many of them taken from real companies. 

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Specific Chapter Changes in the Ninth Edition Here are a few of the additions to chapter material:

Chapter 1 contains a discussion of the ethical implications of Volkswagen’s suppression of emissions data for its diesel cars.

Chapter 2 includes a new box on mortgage-backed securities and their role in the financial crisis.

Chapter 3 includes updated discussions of accounting malfeasance and of the ebb and flow of attempts to harmonize GAAP and IFRS accounting standards.

Chapter 5 has a reorganized and integrated discussion of calculators and spreadsheets.

Chapter 6 includes a new Finance in Practice box to show how to find bond information on the web.

Chapter 7 contains a new section on using discounted cash flow to value entire businesses. The section on the efficient market theory has also been substan- tially revised and given a more up-to-date feel.

Chapter 9 now includes a short section that looks ahead to the techniques of project analysis in Chapter 10.

Chapter 10 has been substantially rewritten and better integrated with Chapter 9. It continues with the Blooper example from the earlier chapter to show how capital budgeting practices and project analysis techniques combine to ensure that investment decisions truly add value.  

Chapter 14 now includes a discussion of shareholder votes on management compensation.

Chapter 16 now includes a section warning of the effects of hidden debt and a summary section that discusses how a thoughtful financial manager should set the company’s debt strategy.

Chapter 17 contains a quick overview of trends in taxation and payout policy. Chapter 18 has been considerably revised with a new example. It takes the

example of Dynamic Mattress and sets out the three steps needed to derive a financial plan for the company.

Chapter 19 now offers a more focused look at short-term planning models. Discussions of working capital and the sources of short-term finance have been deferred until the next chapter.

Chapter 20 introduces the components of working capital and the determinants of the cash cycle. It then looks briefly at each of the components including short-term debt. Chapter 20 is longer than in the previous edition, but we think that it stands much better on its own.

Chapter 21 features numerous updates to reflect merger news of recent years, including the Allergan/Valeant battle.

Assurance of Learning Assurance of learning is an important element of many accreditation standards. Fundamentals of Corporate Finance, Ninth Edition, is designed specifically to sup- port your assurance-of-learning initiatives. Each chapter in the book begins with a list of numbered learning objectives, which are referred to in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these objectives, in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s easy-to-use test bank software, can search the test bank by these and other categories, providing an engine for targeted assurance-of-learning analysis and assessment.

AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Fundamentals of

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Corporate Finance, Ninth Edition, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the test bank to the general knowledge and skill guidelines found in the AACSB standards.

The statements contained in Fundamentals of Corporate Finance, Ninth Edition, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Fundamentals of Corporate Finance, Ninth Edition, and the teaching package make no claim of any specific AACSB qualification or evalu- ation, we have, within the test bank, labeled selected questions according to the six general knowledge and skills areas.

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values (column C) therefore appear as positive numbers. Column E shows an alterna- tive to the use of the PV function, where we calculate present values directly. This allows us to see exactly what we are doing.

The Beyond the Page icon will take you to an application that shows how each of the examples in this chapter can be solved using a spreadsheet.

Level Cash Flows: Perpetuities and Annuities

Frequently, you may need to value a stream of equal cash flows. For example, a home mortgage might require the homeowner to make equal monthly payments for the life of the loan. For a 30-year loan, this would result in 360 equal payments. A 4-year car loan might require 48 equal monthly payments. Any such sequence of equally spaced, level cash flows is called an annuity. If the payment stream lasts forever, it is called a perpetuity.

How to Value Perpetuities Some time ago, the British government borrowed by issuing loans known as consols. Consols are perpetuities. In other words, instead of repaying these loans, the British government pays the investors a fixed annual payment in perpetuity (forever).

How might we value such a security? Suppose that you could invest $100 at an interest rate of 10%. You would earn annual interest of .10 × $100 = $10 per year and could withdraw this amount from your investment account each year without ever running down your balance. In other words, a $100 investment could provide a perpe- tuity of $10 per year. In general,

Cash payment from perpetuity = interest rate × present value C = r × PV

We can rearrange this relationship to derive the present value of a perpetuity, given the interest rate r and the cash payment C:

PV of perpetuity =  C

__ r  = 

cash payment ____________

interest rate (5.3)

Suppose some worthy person wishes to endow a chair in finance at your university. If the rate of interest is 10% and the aim is to provide $100,000 a year forever, the amount that must be set aside today is

Present value of perpetuity =  C

__ r  = 

$100,000 ________

.10  = $1,000,000

5.5 annuity Level stream of cash flows at regular intervals with a finite maturity.

perpetuity Stream of level cash payments that never ends.

SPREADSHEET 5.3 Using a spreadsheet to find the present value of multiple cash flows

A B C D E 1 Finding the present value of multiple cash flows using a spreadsheet 2 3 Time until CF Cash flow Present value Formula in Col C Alternative formula for Col C 4 0 8000 $8,000.00 =PV($B$10, A4,0, −B4) =B4/(1 + $B$10)^A4 5 1 4000 $3,703.70 =PV($B$10, A5,0, −B5) =B5/(1 + $B$10)^A5 6 2 4000 $3,429.36 =PV($B$10, A6,0, −B6) =B6/(1 + $B$10)^A6 7 8 SUM $15,133.06 =SUM(C4:C6) =SUM(C4:C6) 9

10 Discount rate: 0.08 11 12 Notice that the time until each payment is found in column A. 13 Once we enter the formula for present value in cell C4, we can copy it to cells C5 and C6. 14 The present value for other interest rates can be found by changing the entry in cell B10.

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The value of the bond assuming annual coupon payments is 100.164% of face value, or $1,001.64. If we wanted to assume semiannual coupon payments, as in Example 6.1, we would simply change the entry in cell B10 to 2 (see column D), and the bond value would change to 100.165% of face value, as we found in that example.

We have also assumed that the first coupon payment comes in exactly one period (either a year or a half-year). In other words, the settlement date is precisely at the beginning of the period. However, the PRICE function will make the necessary adjustments for intraperiod purchase dates.

Suppose now that you wish to find the price of a 30-year maturity bond with a coupon rate of 6% (paid annually) selling at a yield to maturity of 7%. You are not given a specific settle- ment or maturity date. You can still use the PRICE function to value the bond. Simply choose an arbitrary settlement date (January 1, 2000, is convenient) and let the maturity date be 30 years hence. The appropriate inputs appear in column F of the preceding spreadsheet, with the resulting price, 87.591% of face value, appearing in cell F13.

Excel also provides a function for yield to maturity. It is:

=YIELD(settlement date, maturity date, annual coupon rate, bond price, redemption value as percent of face value, number of coupon payments per year)

For example, to find the yield to maturity of our 1.25% bond, we would use column B of the following spreadsheet if the coupons were paid annually. If the coupons were paid semiannually, we would change the entry for payments per year to 2 (see cell D8), and the yield would increase slightly.

Excel and most other spreadsheet programs provide built-in functions to compute bond values and yields. They typically ask you to input both the date you buy the bond (called the settlement date) and the maturity date of the bond.

The Excel function for bond value is:

= PRICE(settlement date, maturity date, annual coupon rate, yield to maturity, redemption value as percent of face value, number of coupon payments per year)

(If you can’t remember the formula, just remember that you can go to the Formulas tab in Excel, and from the Financial tab pull down the PRICE function, which will prompt you for the necessary inputs.) For our 1.25% coupon bond, we would enter the values shown in the spreadsheet below. Alternatively, we could simply enter the following function in Excel:

=PRICE(DATE(2015,11,15), DATE(2018,11,15),.0125, .01194,100,1)

The DATE function in Excel, which we use for both the set- tlement and maturity dates, uses the format DATE(year, month, day).

Notice that the coupon rate and yield to maturity are expressed as decimals, not percentages. In most cases, redemption value will be 100 (i.e., 100% of face value), and the resulting price will be expressed as a percent of face value. Occasionally, however, you may encounter bonds that pay off at a premium or discount to face value. One example would be callable bonds, which give the company the right to buy back the bonds at a premium before maturity.

Spreadsheet Solutions Bond Valuation

A B C D E F

1 1.25% annual 1.25% semiannual 6% annual 2 coupon bond, coupon bond, coupon bond, 3 maturing May 2018 Formula in column B maturing May 2018 30-year maturity 4

5 Settlement date 11/15/2015 =DATE(2015,11,15) 11/15/2015 1/1/2000 6 Maturity date 11/15/2018 =DATE(2018,11,15) 11/15/2018 1/1/2030 7 Annual coupon rate 0.0125 0.0125 0.06

8 Yield to maturity 0.01194 0.01194 0.07

9 Redemption value (% of face value)

100 100 100

10 Coupon payments per year

1 2 1

11

12

13 Bond price (% of par) 100.164 =PRICE(B5,B6,B7,B8,B9,B10) 100.165 87.591

178

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138 Part Two Value

Remembering formulas is about as difficult as remembering other people’s birth- days. But as long as you bear in mind that an annuity is equivalent to the difference between an immediate and a delayed perpetuity, you shouldn’t have any difficulty.

You can use a calculator or spreadsheet to work out annuity factors (we show you how momentarily), or you can use a set of annuity tables. Table 5.4 is an abridged annuity table (an extended version is shown in Table A.3 at the end of the book). Check that you can find the 3-year annuity factor for an interest rate of 10%.

Compare Table 5.4 with Table 5.3, which presented the present value of a single cash flow. In both tables, present values fall as we move across the rows to higher discount rates. But in contrast to those in Table 5.3, present values in Table 5.4 increase as we move down the columns, reflecting the greater number of payments made by longer annuities.

Number of Years

Interest Rate per Year

5% 6% 7% 8% 9% 10%

 1 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091  2 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355  3 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869  4 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699  5 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908

10 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 20 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 30 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269

TABLE 5.4 An example of an annuity table, showing the present value today of $1 a year received for each of t years

If the interest rate is 8%, what is the 4-year discount factor? What is the 4-year annuity factor? What is the relationship between these two numbers? Explain.

Self-Test5.6

Winning Big at the Lottery

In September 2015, a 50-year-old Michigan woman bought a Powerball lottery ticket and won $310.5 million. We suspect that she received unsolicited congratulations, good wishes, and requests for money from dozens of more or less worthy charities, relations, and newly devoted friends. In response, she could fairly point out that the prize wasn’t really worth $310.5 million. That sum was to be paid in 30 equal annual installments of $10.35 million each. Assuming that the first payment occurred at the end of 1 year, what was the present value of the prize? The interest rate at the time was about 3.2%.

The present value of these payments is simply the sum of the present values of each annual payment. But rather than valuing the payments separately, it is much easier to treat them as a 30-year annuity. To value this annuity, we multiply $10.35 million by the 30-year annuity factor:

PV = 10.35 × 30-year annuity factor

= 10.35 × [ 1

__ r  − 

1 _______

r(1 + r)30 ]

At an interest rate of 3.2%, the annuity factor is

[ 1 ____

.032  − 

1 ___________

.032(1.032)30 ] = 19.1033

Example 5.8 ⊲

Unique Features

Integrated Examples Numbered and titled examples are integrated in each chapter. Students can learn how to solve specific prob- lems step-by-step as well as gain insight into general principles by see- ing how they are applied to answer concrete questions and scenarios.

Spreadsheet Solutions Boxes These boxes provide the student with detailed examples of how to use Excel spreadsheets when applying financial concepts. The boxes include questions that apply to the spreadsheet, and their solutions are given at the end of the applicable chapter. These spreadsheets are available for download in Connect.

Excel Exhibits Selected exhibits are set as Excel spreadsheets. The accompanying files are available for instructors and stu- dents in Connect.

What makes Fundamentals of Corporate Finance such a powerful learning tool?

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Finance in Practice Boxes These are excerpts that appear in most chapters, often from the financial press, providing real-life illustrations of the chapter’s topics, such as ethi- cal choices in finance, disputes about stock valuation, financial planning, and credit analysis.

Financial Calculator Boxes and Exercises In a continued effort to help students grasp the critical concept of the time value of money, many pedagogical tools have been added throughout the first section of the text. Financial Calculator boxes provide examples for solving a variety of problems, with directions for the most popular finan- cial calculators.

Self-Test Questions Provided in each chapter, these help- ful questions enable students to check their understanding as they read. Answers are worked out at the end of each chapter.

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Interest Rate Risk We have just seen that bond prices fluctuate as interest rates change. In other words, bonds are subject to interest rate risk. Bond investors cross their fingers that market interest rates will fall, so that the price of their bond will rise. If they are unlucky and the market interest rate rises, the value of their investment falls.

A change in interest rates has only a modest impact on the present value of near- term cash flows but a much greater impact on the value of distant cash flows. There- fore, any change has a greater impact on the price of long-term bonds than the price of short-term bonds. For example, compare the two curves in Figure 6.5. The blue line shows how the value of the 3-year, 1.25% coupon bond varies with the interest rate. The green line shows how the price of a 30-year, 1.25% bond varies. You can see that the 30-year bond is more sensitive to interest rate fluctuations than the 3-year bond. This should not surprise you. If you buy a 3-year bond and rates then rise, you will be stuck with a bad deal—you could have got a better interest rate if you had waited. However, think how much worse it would be if the loan had been for 30 years rather than 3 years. The longer the loan, the more income you have lost by accepting what turns out to be a low interest rate. This shows up in a bigger decline in the price of the longer-term bond. Of course, there is a flip side to this effect, which you can also see from Figure 6.5. When interest rates fall, the longer-term bond responds with a greater increase in price.

interest rate risk The risk in bond prices due to fluctuations in interest rates.

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How changes in interest rates affect long- and short-term bonds

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Which is the longer-term bond?

FIGURE 6.5 Plot of bond prices as a function of the interest rate. The price of long- term bonds is more sensitive to changes in the interest rate than is the price of short-term bonds.

0

200

400

600

800

1,000

1,200

1,400

1,600

0 2 4 6 8 10 12 14

Interest rate (%)

B o

n d

p ri

ce (

$ )

30-year bond

3-year bond

When the interest rate equals the 1.25% coupon rate, both bonds sell for face value

Yield to Maturity

Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10%. Your investment adviser quotes a price for the bond. How do you calculate the rate of return the bond offers?

6.3

Suppose that the market interest rate is 4% and then drops overnight to 2%. Calculate the present values of the 1.25%, 3-year bond and of the 1.25%, 30-year bond both before and after this change in interest rates. Assume annual coupon payments. Confirm that your answers correspond with Figure 6.5. Use your financial calculator or a spreadsheet. You can find a box on bond pricing using Excel later in this chapter.

Self-Test6.4

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Treasury bonds, their prices soared. By mid-December, the price of the 4.375s of 2038 had reached 138.05% of face value and the yield had fallen to 2.5%. Anyone fortunate enough to have bought the bond at the issue price would have made a capital gain of $1,380.50 − $963.80 = $416.70. In addition, on August 15 the bond made its first coupon payment of $21.875 (this is the semiannual payment on the 4.375% coupon bond with a face value of $1,000). Our lucky investor would therefore have earned a 7-month rate of return of 45.5%:

Rate of return =  coupon income + price change

_________________________ investment

(6.2)

=  $21.875 + $416.70

________________ $963.80

 = .455 = 45.5%

Suddenly, government bonds did not seem quite so boring as before. ■

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Bond pricing using financial calculators

rate of return Total income per period per dollar invested.

payments of $6.25. Therefore, we can find the semiannual yield as follows:

n i PV PMT FV

Inputs 6 –1001.64 6.25 1000 Compute .5971

This yield to maturity, of course, is a 6-month yield, not an annual one. Bond dealers would typically annualize the semi- annual rate by doubling it, so the yield to maturity would be quoted as .5971 × 2 = 1.1942%.

You can use a financial calculator to calculate the yield to maturity on our 1.25% Treasury bond. The inputs are:

n i PV PMT FV

Inputs 3 –1001.64 12.5 1000 Compute 1.194

Now compute i and you should get an answer of 1.194%. Let’s now redo this calculation but recognize that the cou-

pons are paid semiannually. Instead of three annual coupon payments of $12.50, the bond makes six semiannual

Financial Calculator Using a Financial Calculator to Compute Bond Yield

Is there any connection between the yield to maturity and the rate of return during a particular period? Yes: If the bond’s yield to maturity remains unchanged during the period, the bond price changes with time so that the total return on the bond is equal to the yield to maturity. The rate of return will be less than the yield to maturity if interest rates rise, and it will be greater than the yield to maturity if interest rates fall.

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Bond prices and approaching maturity

Suppose that you purchased 8% coupon, 10-year bonds for $1,324.4 when they were yielding 4% (we assume annual coupon payments). One year later, you receive the annual coupon payment of $80, but the yield to maturity has risen to 6%. Confirm that the rate of return on your bond over the year is less than the original 4% yield to maturity.

Self-Test6.6

Suppose that you buy 8%, 2-year bonds for $1,036.67 when they yield 6%. At the end of the year, they still yield 6%. Show that if you continue to hold the bond until maturity, your return in each of the two years will also be 6%.

Self-Test6.7

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But sometimes raids can enhance shareholder value. For example, in 2012 and 2013, Relational Investors teamed up with the California State Teachers’ Retirement System (CSTRS, a pension fund) to try to force Timken Co. to split into two separate companies, one for its steel business and one for its industrial bearings business. Relational and CSTRS believed that Timken’s combination of unrelated businesses was unfo- cused and inefficient. Timken management responded that breakup would “deprive our shareholders of long-run value— all in an attempt to create illusory short-term gains through financial engineering.” But Timken’s stock price rose at the prospect of a breakup, and a nonbinding shareholder vote on Relational’s proposal attracted a 53% majority. Finally in 2014 Timken spun off its steel business in a new corporation, Timken Steel.

How do you draw the ethical line in such examples? Was Relational Investors a “raider” (sounds bad) or an “activist investor” (sounds good)? Breaking up a portfolio of busi- nesses can create difficult adjustments and job losses. Some stakeholders lose. But shareholders and the overall economy can gain if businesses are managed more efficiently.

Tax Avoidance In 2012 it was revealed that during the 14 years that Starbucks had operated in the United Kingdom, it paid hardly any taxes. Public outrage led to a boycott of Starbucks shops, and the company responded by promising that it would voluntarily pay to the taxman about $16 million more than it was required to pay by law. Several months later, a U.S. Senate committee investigating tax avoidance by U.S. technology firms reported that Apple had used a “highly questionable” web of offshore entities to avoid billions of dollars of U.S. taxes.

Multinational companies, such as Starbucks and Apple, could reduce their tax bills using legal techniques with exotic names such as the “Dutch Sandwich,” “Double Irish,” and “Check-the-Box.” But the public outcry over the revelations suggested that many believed that use of these techniques, though legal, was unethical. If they were unethical, that leaves an awkward question: How do companies decide which tax schemes are ethical and which are not? Can a company act in shareholders’ interest if it voluntarily pays more taxes than it is legally obligated to pay? * We need not go into the mechanics of short sales here, but note that the seller is obligated to buy back the security, even if its price skyrockets far above what he or she sold it for. As the saying goes, “He who sells what isn’t his’n, buys it back or goes to prison.”

† The story of Paulson’s trade is told in G. Zuckerman, The Greatest Trade Ever (Broadway Business, 2009). The trade was controversial for reasons beyond short-selling. Scan the nearby Beyond the Page icon “Goldman Sachs causes a ruckus” to learn more.

Short-Selling Investors who take short positions are betting that securities will fall in price. Usually they do this by borrowing the security, selling it for cash, and then waiting in the hope that they will be able to buy it back cheaply.* In 2007, hedge fund manager John Paulson took a huge short position in mortgage-backed securities. The bet paid off, and that year Paulson’s trade made a profit of $1 billion for his fund.†

Was Paulson’s trade unethical? Some believe not only that he was profiting from the misery that resulted from the crash in mortgage-backed securities, but that his short trades accentuated the collapse. It is certainly true that short-sellers have never been popular. For example, following the crash of 1929, one commentator compared short-selling to the ghoul- ishness of “creatures who, at all great earthquakes and fires, spring up to rob broken homes and injured and dead humans.”

Short-selling in the stock market is the Wall Street Walk on steroids. Not only do short-sellers sell all the shares they may have previously owned, but they borrow more shares and sell them too, hoping to buy them back for less when the stock price falls. Poorly performing companies are natural targets for short-sellers, and the companies’ incumbent managers naturally complain, often bitterly. Governments sometimes listen to such complaints. For example, in 2008 the U.S. government temporarily banned short sales of financial stocks in an attempt to halt their decline.

But defendants of short-selling argue that selling securi- ties that one believes are overpriced is no less legitimate than buying those that appear underpriced. The object of a well-functioning market is to set the correct stock prices, not always higher prices. Why impede short-selling if it conveys truly bad news, puts pressure on poor performers, and helps corporate governance work?

Corporate Raiders In the movie Pretty Woman, Richard Gere plays the role of an asset stripper, Edward Lewis. He buys companies, takes them apart, and sells the bits for more than he paid for the total package. In the movie Wall Street, Gordon Gekko buys a failing airline, Blue Star, in order to break it up and sell the bits. Real corporate raiders may not be as ruthless as Edward Lewis or Gordon Gekko, but they do target companies whose assets can be profitably split up and redeployed.

This has led some to complain that raiders seek to carve up established companies, often leaving them with heavy debt burdens, basically in order to get rich quick. One German politician has likened them to “swarms of locusts that fall on companies, devour all they can, and then move on.”

Finance in Practice Ethical Disputes in Finance

20

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It is not always easy to know what is ethical behavior, and there can be many gray areas. The nearby box presents three ethical controversies in finance. Think about where you stand on these issues and where you would draw the ethical line.

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Goldman Sachs causes a ruckus

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Chapter 5 The Time Value of Money 165

MINICASE Old Alfred Road, who is well-known to drivers on the Maine Turn- pike, has reached his 70th birthday and is ready to retire. Mr. Road has no formal training in finance but has saved his money and invested carefully.

Mr. Road owns his home—the mortgage is paid off—and does not want to move. He is a widower, and he wants to bequeath the house and any remaining assets to his daughter.

He has accumulated savings of $180,000, conservatively invested. The investments are yielding 9% interest. Mr. Road also has $12,000 in a savings account at 5% interest. He wants to keep the savings account intact for unexpected expenses or emergencies.

Mr. Road’s basic living expenses now average about $1,500 per month, and he plans to spend $500 per month on travel and hob- bies. To maintain this planned standard of living, he will have to rely on his investment portfolio. The interest from the portfolio is $16,200 per year (9% of $180,000), or $1,350 per month.

Mr. Road will also receive $750 per month in Social Security payments for the rest of his life. These payments are indexed for

inflation. That is, they will be automatically increased in propor- tion to changes in the consumer price index.

Mr. Road’s main concern is with inflation. The inflation rate has been below 3% recently, but a 3% rate is unusually low by historical standards. His Social Security payments will increase with inflation, but the interest on his investment portfolio will not.

What advice do you have for Mr. Road? Can he safely spend all the interest from his investment portfolio? How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact?

Suppose Mr. Road will live for 20 more years and is willing to use up all of his investment portfolio over that period. He also wants his monthly spending to increase along with inflation over that period. In other words, he wants his monthly spending to stay the same in real terms. How much can he afford to spend per month?

Assume that the investment portfolio continues to yield a 9% rate of return and that the inflation rate will be 4%.

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192 Part Two Value

32. Credit Risk. (LO6-5) a. Several years ago, Castles in the Sand Inc. issued bonds at face value at a yield to maturity

of 7%. Now, with 8 years left until the maturity of the bonds, the company has run into hard times and the yield to maturity on the bonds has increased to 15%. What is now the price of the bond? (Assume semiannual coupon payments.)

b. Suppose that investors believe that Castles can make good on the promised coupon pay- ments but that the company will go bankrupt when the bond matures and the principal comes due. The expectation is that investors will receive only 80% of face value at maturity. If they buy the bond today, what yield to maturity do they expect to receive?

33. Credit Risk. Suppose that Casino Royale has issued bonds that mature in 1 year. They currently offer a yield of 20%. However, there is a 50% chance that Casino will default and bondholders will receive nothing. What is the expected yield on the bonds? (LO6-5)

34. Credit Risk. Bond A is a 10-year U.S. Treasury bond. Bond B is a 10-year corporate bond. True or false? (LO6-3 and LO6-5) a. If you hold bond A to maturity, your return will be equal to the yield to maturity. b. If you hold bond B to maturity, your return will be equal to or less than the yield to maturity. c. If you hold bond A for 5 years and then sell it, your return could be greater than the yield to

maturity.

35. Credit Risk. A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Suppose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody’s from an Aa to A rating. (LO6-5) a. Is the bond likely to sell above or below par value before the downgrade? b. Is the bond likely to sell above or below par value after the downgrade?

36. Credit Risk. Sludge Corporation has two bonds outstanding, each with a face value of $2 million. Bond A is a senior bond; bond B is subordinated. Sludge has suffered a severe downturn in demand, and its assets are now worth only $3 million. If the company defaults, what payoff can the holders of bond B expect? (LO6-5)

37. Credit Risk. Slush Corporation has two bonds outstanding, each with a face value of $2 million. Bond A is secured on the company’s head office building; bond B is unsecured. Slush has suffered a severe downturn in demand. Its head office building is worth $1 million, but its remaining assets are now worth only $2 million. If the company defaults, what payoff can the holders of bond B expect? (LO6-5)

WEB EXERCISES 1. Log on to www.investopedia.com to find a simple calculator for working out bond prices.

(Start by clicking the Investing link.) Check whether a change in yield has a greater effect on the price of a long-term or a short-term bond.

2. When we plotted the yield curve in Figure 6.7, we used the prices of Treasury strips. You can find current prices of strips by logging on to The Wall Street Journal website (www.wsj.com) and clicking on Market, Market Data, and then Rates. Try plotting the yields on stripped cou- pons against maturity. Do they currently increase or decline with maturity? Can you explain why? You can also use The Wall Street Journal site to compare the yields on nominal Treasury bonds with those on TIPS. Suppose that you are confident that inflation will be 3% per year. Which bonds are the better buy?

3. You can find the most recent bond rating for many companies by logging on to finance.yahoo. com and going to the Bond Center. Find the bond rating for some major companies. Were they investment-grade or below?

4. In Figure 6.9, we showed how bonds with greater credit risk have promised higher yields to maturity. This yield spread goes up when the economic outlook is particularly uncertain. You can check how much extra yield lower-grade bonds offer today by logging on to www. federalreserve.gov and comparing the yields on Aaa and Baa bonds. Look for the Economic Research & Data tab. How does the spread in yields compare with the spread in November 2008 at the height of the financial crisis?

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Interest Rate Risk We have just seen that bond prices fluctuate as interest rates change. In other words, bonds are subject to interest rate risk. Bond investors cross their fingers that market interest rates will fall, so that the price of their bond will rise. If they are unlucky and the market interest rate rises, the value of their investment falls.

A change in interest rates has only a modest impact on the present value of near- term cash flows but a much greater impact on the value of distant cash flows. There- fore, any change has a greater impact on the price of long-term bonds than the price of short-term bonds. For example, compare the two curves in Figure 6.5. The blue line shows how the value of the 3-year, 1.25% coupon bond varies with the interest rate. The green line shows how the price of a 30-year, 1.25% bond varies. You can see that the 30-year bond is more sensitive to interest rate fluctuations than the 3-year bond. This should not surprise you. If you buy a 3-year bond and rates then rise, you will be stuck with a bad deal—you could have got a better interest rate if you had waited. However, think how much worse it would be if the loan had been for 30 years rather than 3 years. The longer the loan, the more income you have lost by accepting what turns out to be a low interest rate. This shows up in a bigger decline in the price of the longer-term bond. Of course, there is a flip side to this effect, which you can also see from Figure 6.5. When interest rates fall, the longer-term bond responds with a greater increase in price.

interest rate risk The risk in bond prices due to fluctuations in interest rates.

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How changes in interest rates affect long- and short-term bonds

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Which is the longer-term bond?

FIGURE 6.5 Plot of bond prices as a function of the interest rate. The price of long- term bonds is more sensitive to changes in the interest rate than is the price of short-term bonds.

0

200

400

600

800

1,000

1,200

1,400

1,600

0 2 4 6 8 10 12 14

Interest rate (%)

B o

n d

p ri

ce (

$ )

30-year bond

3-year bond

When the interest rate equals the 1.25% coupon rate, both bonds sell for face value

Yield to Maturity

Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10%. Your investment adviser quotes a price for the bond. How do you calculate the rate of return the bond offers?

6.3

Suppose that the market interest rate is 4% and then drops overnight to 2%. Calculate the present values of the 1.25%, 3-year bond and of the 1.25%, 30-year bond both before and after this change in interest rates. Assume annual coupon payments. Confirm that your answers correspond with Figure 6.5. Use your financial calculator or a spreadsheet. You can find a box on bond pricing using Excel later in this chapter.

Self-Test6.4

“Beyond the Page” Interactive Content and Applications Additional resources and hands-on applications are just a click away. Students can tap or click the icons in the e-version or use the direct web links to learn more about key concepts and try out calculations, tables, and figures when they go “Beyond the Page.”

Web Exercises Select chapters include Web Exercises that allow students to utilize the Internet to apply their knowledge and skills with real-world companies.

Minicases Integrated minicases allow students to apply their knowledge to relatively complex, practical problems and typical real-world scenarios.

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xvii

∙ Offers students quick access to the Beyond the Page features, Excel files and templates, lectures, eBooks, and more.

∙ Provides instant practice material and study questions, easily accessible on the go.

Student Progress Tracking Connect keeps instructors informed about how each student, section, and class is per- forming, allowing for more productive use of lecture and office hours. The progress- tracking function enables you to:

∙ View scored work immediately and track individual or group performance with assignment and grade reports.

∙ Access an instant view of student or class performance relative to learning objectives.

∙ Collect data and generate reports required by many accreditation organi- zations, such as AACSB and AICPA.

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For customer support, call 800-331-5094 or visit www.mhhe.com/support. One of our technical support analysts will be able to assist you in a timely fashion.

test bank content. The instructors can then organize, edit, and customize questions and answers to rapidly generate tests for paper or online administration. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical tem- plates. TestGen’s random generator pro- vides the option to display different text or calculated number values each time ques- tions are used. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.

PowerPoint Presentations These visually stimulating slides have been fully updated by Matthew Will, with color- ful graphs, charts, and lists. The slides can be edited or manipulated to fit the needs of a particular course.

Beyond the Page Content The authors have created a wealth of additional examples, explanations, and applications, available for quick access by instructors and students. Each “Beyond the Page” feature is called out in the text with an icon that links directly to the content.

Excel Solutions and Templates Excel templates are available in Connect for select exhibits and various end-of- chapter problems that have been set as Excel spreadsheets. They correlate with specific concepts in the text and allow stu- dents to work through financial problems and gain experience using spreadsheets. Also refer to the valuable Spreadsheet Solutions Boxes that are sprinkled throughout the text for some helpful prompts on working in Excel.

Student Study Center The Connect Student Study Center is the place for students to access additional resources. The Student Study Center:

Instructor Library The Connect Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Instructor Library includes all of the instructor supplements for this text.

Solutions Manual Mishal Rawaf worked with the authors to prepare this resource containing detailed and thoughtful solutions to all the end-of- chapter problems.

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Marlena Akhbari Wright State University

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Acknowledgments

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In addition, we would like to thank the dedicated experts who have helped with updates to our instructor materials and online content in Connect and LearnSmart, including Kay Johnson, Annie Treinen, Mishal Rawaf, Matt Will, Blaise Roncagli, Peter Crabb, Deb Bauer, Marc-Anthony Isaacs, and Nicholas Racculia. Their efforts are much appreciated as they will help both students and instructors. We also appreciate help from Aleijda de Cazenove Balsan and Malcolm Taylor.

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1 Goals and Governance of the Corporation 2

2 Financial Markets and Institutions 32

3 Accounting and Finance 56

4 Measuring Corporate Performance 86

5 The Time Value of Money 118

6 Valuing Bonds 166

7 Valuing Stocks 196

8 Net Present Value and Other Investment Criteria 238

9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 274

10 Project Analysis 302

11 Introduction to Risk, Return, and the Opportunity Cost of Capital 330

12 Risk, Return, and Capital Budgeting 360

13 The Weighted-Average Cost of Capital and Company Valuation 390

14 Introduction to Corporate Financing 418

15 How Corporations Raise Venture Capital and Issue Securities 440

16 Debt Policy 466

17 Payout Policy 504

18 Long-Term Financial Planning 528

19 Short-Term Financial Planning 550

20 Working Capital Management 570

21 Mergers, Acquisitions, and Corporate Control 610

22 International Financial Management 638

23 Options 664

24 Risk Management 692

25 What We Do and Do Not Know about Finance 712

Appendix: Present Value and Future Value Tables A-1

Glossary G-1

Global Index IND-1

Subject Index IND-5

in Brief

Part One Introduction

Part Two Value

Part Three Risk

Part Four Financing

Part Five Debt and Payout

Policy

Part Six Financial Analysis

and Planning

Part Seven Special Topics

Part Eight Conclusion

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Chapter 1 Goals and Governance of the Corporation 2 1.1 Investment and Financing Decisions 4

The Investment (Capital Budgeting) Decision 6

The Financing Decision 6

1.2 What Is a Corporation? 8

Other Forms of Business Organization 9

1.3 Who Is the Financial Manager? 10

1.4 Goals of the Corporation 12

Shareholders Want Managers to Maximize Market Value 12

1.5 Agency Problems, Executive Compensation, and Corporate Governance 15

Executive Compensation 16

Corporate Governance 17

1.6 The Ethics of Maximizing Value 18

1.7 Careers in Finance 21

1.8 Preview of Coming Attractions 22

1.9 Snippets of Financial History 23

Summary 25 Questions and Problems 26

Chapter 2 Financial Markets and Institutions 32 2.1 The Importance of Financial Markets and

Institutions 34

2.2 The Flow of Savings to Corporations 35

The Stock Market 37

Other Financial Markets 38

Financial Intermediaries 40

Financial Institutions 42

Total Financing of U.S. Corporations 43

2.3 Functions of Financial Markets and Intermediaries 44

Transporting Cash across Time 45

Risk Transfer and Diversification 45

Liquidity 46

The Payment Mechanism 46

Information Provided by Financial Markets 47

2.4 The Crisis of 2007–2009 49

Summary 51 Questions and Problems 52

Chapter 3 Accounting and Finance 56 3.1 The Balance Sheet 58

Book Values and Market Values 61

3.2 The Income Statement 63

Income versus Cash Flow 64

3.3 The Statement of Cash Flows 67

Free Cash Flow 69

3.4 Accounting Practice and Malpractice 70

3.5 Taxes 73

Corporate Tax 73

Personal Tax 74

Summary 76

Questions and Problems 76

Chapter 4 Measuring Corporate Performance 86 4.1 How Financial Ratios Relate to Shareholder

Value 88

4.2 Measuring Market Value and Market Value Added 89

4.3 Economic Value Added and Accounting Rates of Return 91

Accounting Rates of Return 93

Problems with EVA and Accounting Rates of Return 95

4.4 Measuring Efficiency 96

4.5 Analyzing the Return on Assets: The Du Pont System 97

The Du Pont System 98

4.6 Measuring Financial Leverage 100

Leverage and the Return on Equity 102

4.7 Measuring Liquidity 103

4.8 Interpreting Financial Ratios 104

4.9 The Role of Financial Ratios 108

Summary 109 Questions and Problems 110 Minicase 116

Part One Introduction

Contents

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Part Two Value

Chapter 5 The Time Value of Money 118 5.1 Future Values and Compound Interest 120

5.2 Present Values 123

Finding the Interest Rate 127

5.3 Multiple Cash Flows 128

Future Value of Multiple Cash Flows 128

Present Value of Multiple Cash Flows 130

5.4 Reducing the Chore of the Calculations: Part 1 131

Using Financial Calculators to Solve Simple Time-Value-of- Money Problems 131

Using Spreadsheets to Solve Simple Time-Value-of-Money Problems 132

5.5 Level Cash Flows: Perpetuities and Annuities 135

How to Value Perpetuities 135

How to Value Annuities 136

Future Value of an Annuity 140

Annuities Due 143

5.6 Reducing the Chore of the Calculations: Part 2 144

Using Financial Calculators to Solve Annuity Problems 145

Using Spreadsheets to Solve Annuity Problems 145

5.7 Effective Annual Interest Rates 146

5.8 Inflation and the Time Value of Money 148

Real versus Nominal Cash Flows 148

Inflation and Interest Rates 150

Valuing Real Cash Payments 151

Real or Nominal? 153

Summary 153

Questions and Problems 154

Minicase 165

Chapter 6 Valuing Bonds 166 6.1 The Bond Market 168

Bond Characteristics 168

6.2 Interest Rates and Bond Prices 169

How Bond Prices Vary with Interest Rates 172

Interest Rate Risk 174

6.3 Yield to Maturity 174

Calculating the Yield to Maturity 176

6.4 Bond Rates of Return 176

6.5 The Yield Curve 178

Nominal and Real Rates of Interest 181

6.6 Corporate Bonds and the Risk of Default 182

Protecting against Default Risk 185

Not All Corporate Bonds Are Plain Vanilla 187

Summary 187

Questions and Problems 188

Chapter 7 Valuing Stocks 196 7.1 Stocks and the Stock Market 198

Reading Stock Market Listings 199

7.2 Market Values, Book Values, and Liquidation Values 201

7.3 Valuing Common Stocks 203

Valuation by Comparables 203

Price and Intrinsic Value 204

The Dividend Discount Model 206

7.4 Simplifying the Dividend Discount Model 209

Case 1: The Dividend Discount Model with No Growth 209

Case 2: The Dividend Discount Model with Constant Growth 209

Case 3: The Dividend Discount Model with Nonconstant Growth 214

7.5 Valuing a Business by Discounted Cash Flow 218

Valuing the Concatenator Business 218

Repurchases and the Dividend Discount Model 219

7.6 There Are No Free Lunches on Wall Street 220

Random Walks and Efficient Markets 221

7.7 Market Anomalies and Behavioral Finance 225

Market Anomalies 225

Bubbles and Market Efficiency 226

Behavioral Finance 227

Summary 228

Questions and Problems 229

Minicase 236

Chapter 8 Net Present Value and Other Investment Criteria 238 8.1 Net Present Value 240

A Comment on Risk and Present Value 241

Valuing Long-Lived Projects 242

Choosing between Alternative Projects 244

8.2 The Internal Rate of Return Rule 245

A Closer Look at the Rate of Return Rule 246

Calculating the Rate of Return for Long-Lived Projects 246

A Word of Caution 248

Some Pitfalls with the Internal Rate of Return Rule 248

8.3 The Profitability Index 253

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Capital Rationing 254

Pitfalls of the Profitability Index 254

8.4 The Payback Rule 255

Discounted Payback 256

8.5 More Mutually Exclusive Projects 256

Problem 1: The Investment Timing Decision 257

Problem 2: The Choice between Long- and Short-Lived Equipment 258

Problem 3: When to Replace an Old Machine 260

8.6 A Last Look 261

Summary 262

Questions and Problems 263

Minicase 270

Appendix: More on the IRR Rule 271

Using the IRR to Choose between Mutually Exclusive Projects 271

Using the Modified Internal Rate of Return When There Are Multiple IRRs 271

Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 274 9.1 Identifying Cash Flows 276

Discount Cash Flows, Not Profits 276

Discount Incremental Cash Flows 278

Discount Nominal Cash Flows by the Nominal Cost of Capital 281

Separate Investment and Financing Decisions 282

9.2 Calculating Cash Flow 283

Element 1: Capital Investment 283

Element 2: Operating Cash Flow 283

Element 3: Changes in Working Capital 285

9.3 An Example: Blooper Industries 286

Cash-Flow Analysis 286

Calculating the NPV of Blooper’s Project 288

Further Notes and Wrinkles Arising from Blooper’s Project 289

Summary 293

Questions and Problems 294

Minicase 301

Chapter 10 Project Analysis 302 10.1 How Firms Organize the Investment Process to Draw on

Their Competitive Strengths 304

The Capital Budget 304

Problems and Some Solutions 305

10.2 Reducing Forecast Bias 305

10.3 Some “What-If” Questions 306

Sensitivity Analysis 307

Scenario Analysis 310

10.4 Break-Even Analysis 310

Accounting Break-Even Analysis 311

NPV Break-Even Analysis 312

Operating Leverage 315

10.5 Real Options and the Value of Flexibility 317

The Option to Expand 317

A Second Real Option: The Option to Abandon 319

A Third Real Option: The Timing Option 319

A Fourth Real Option: Flexible Production Facilities 320

Summary 321

Questions and Problems 322

Minicase 328

Part Three Risk

Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 330 11.1 Rates of Return: A Review 332

11.2 A Century of Capital Market History 333

Market Indexes 333

The Historical Record 333

Using Historical Evidence to Estimate Today’s Cost of Capital 336

11.3 Measuring Risk 338

Variance and Standard Deviation 338

A Note on Calculating Variance 341

Measuring the Variation in Stock Returns 341

11.4 Risk and Diversification 343

Diversification 343

Asset versus Portfolio Risk 344

Market Risk versus Specific Risk 350

11.5 Thinking about Risk 351

Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable 351

Message 2: Market Risks Are Macro Risks 352

Message 3: Risk Can Be Measured 353

Summary 354

Questions and Problems 355

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Calculating Company Cost of Capital as a Weighted Average 394

Use Market Weights, Not Book Weights 396

Taxes and the Weighted-Average Cost of Capital 396

What If There Are Three (or More) Sources of Financing? 398

The NPV of Geothermal’s Expansion 398

Checking Our Logic 399

13.3 Interpreting the Weighted-Average Cost of Capital 400

When You Can and Can’t Use WACC 400

Some Common Mistakes 400

How Changing Capital Structure Affects Expected Returns 401

What Happens When the Corporate Tax Rate Is Not Zero 401

13.4 Practical Problems: Measuring Capital Structure 401

13.5 More Practical Problems: Estimating Expected Returns 403

The Expected Return on Bonds 403

The Expected Return on Common Stock 404

The Expected Return on Preferred Stock 405

Adding It All Up 406

Real-Company WACCs 406

13.6 Valuing Entire Businesses 406

Calculating the Value of the Deconstruction Business 408

Summary 409

Questions and Problems 410

Minicase 415

Chapter 12 Risk, Return, and Capital Budgeting 360 12.1 Measuring Market Risk 362

Measuring Beta 362

Betas for U.S. Steel and PG&E 365

Total Risk and Market Risk 365

12.2 What Can You Learn from Beta? 367

Portfolio Betas 367

The Portfolio Beta Determines the Risk of a Diversified Portfolio 370

12.3 Risk and Return 371

Why the CAPM Makes Sense 373

The Security Market Line 374

Using the CAPM to Estimate Expected Returns 375

How Well Does the CAPM Work? 375

12.4 The CAPM and the Opportunity Cost of Capital 378

The Company Cost of Capital 380

What Determines Project Risk? 380

Don’t Add Fudge Factors to Discount Rates 381

Summary 381

Questions and Problems 382

Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 390 13.1 Geothermal’s Cost of Capital 392

13.2 The Weighted-Average Cost of Capital 393

Part Four Financing

Chapter 14 Introduction to Corporate Financing 418 14.1 Creating Value with Financing Decisions 420

14.2 Patterns of Corporate Financing 420

Are Firms Issuing Too Much Debt? 423

14.3 Common Stock 424

Ownership of the Corporation 426

Voting Procedures 427

Classes of Stock 428

14.4 Preferred Stock 428

14.5 Corporate Debt 429

Debt Comes in Many Forms 429

Innovation in the Debt Market 432

14.6 Convertible Securities 434

Summary 435

Questions and Problems 436

Chapter 15 How Corporations Raise Venture Capital and Issue Securities 440 15.1 Venture Capital 442

Venture Capital Companies 443

15.2 The Initial Public Offering 444 Arranging a Public Issue 445

Other New-Issue Procedures 449

The Underwriters 449

15.3 General Cash Offers by Public Companies 450 General Cash Offers and Shelf Registration 451

Costs of the General Cash Offer 452

Market Reaction to Stock Issues 452

15.4 The Private Placement 453

Summary 454 Questions and Problems 454 Minicase 459 Appendix: Hotch Pot’s New-Issue Prospectus 461

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Part Five Debt and Payout Policy

Part Six Financial Analysis and Planning

Chapter 16 Debt Policy 466 16.1 How Borrowing Affects Value in a Tax-Free

Economy 468

MM’s Argument—A Simple Example 469

How Borrowing Affects Earnings per Share 470

How Borrowing Affects Risk and Return 472

16.2 Debt and the Cost of Equity 473

No Magic in Financial Leverage 476

16.3 Debt, Taxes, and the Weighted-Average Cost of Capital 477

Debt and Taxes at River Cruises 478

How Interest Tax Shields Contribute to the Value of Stockholders’ Equity 479

Corporate Taxes and the Weighted-Average Cost of Capital 480

The Implications of Corporate Taxes for Capital Structure 481

16.4 Costs of Financial Distress 482

Bankruptcy Costs 482

Costs of Bankruptcy Vary with Type of Asset 484

Financial Distress without Bankruptcy 485

16.5 Explaining Financing Choices 487

The Trade-Off Theory 487

A Pecking Order Theory 488

The Two Faces of Financial Slack 489

Is There a Theory of Optimal Capital Structure? 490

Summary 491

Questions and Problems 492

Minicase 499

Appendix: Bankruptcy Procedures 501

Chapter 17 Payout Policy 504 17.1 How Corporations Pay Out Cash to Shareholders 506

How Firms Pay Dividends 507

Limitations on Dividends 507

Stock Dividends and Stock Splits 508

Stock Repurchases 509

17.2 The Information Content of Dividends and Repurchases 509

17.3 Dividends or Repurchases? The Payout Controversy 511

Dividends or Repurchases? An Example 512

Repurchases and the Dividend Discount Model 513

Dividends and Share Issues 514

17.4 Why Dividends May Increase Value 515

17.5 Why Dividends May Reduce Value 517

Taxation of Dividends and Capital Gains under Current Tax Law 518

Taxes and Payout—A Summary 518

17.6 Payout Policy and the Life Cycle of the Firm 518

Summary 519

Questions and Problems 520

Minicase 526

Chapter 18 Long-Term Financial Planning 528 18.1 What Is Financial Planning? 530

Why Build Financial Plans? 530

18.2 Financial Planning Models 531

Components of a Financial Planning Model 531

18.3 A Long-Term Financial Planning Model for Dynamic Mattress 532

Pitfalls in Model Design 537

Choosing a Plan 538

18.4 External Financing and Growth 539

Summary 542

Questions and Problems 543

Minicase 549

Chapter 19 Short-Term Financial Planning 550 19.1 Links between Long-Term and Short-Term

Financing 552

19.2 Tracing Changes in Cash 554

19.3 Cash Budgeting 556

Preparing the Cash Budget 556

19.4 Dynamic’s Short-Term Financial Plan 559

Dynamic Mattress’s Financing Plan 559

Evaluating the Plan 560

A Note on Short-Term Financial Planning Models 561

Summary 563

Questions and Problems 563

Minicase 568

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Chapter 20 Working Capital Management 570 20.1 Working Capital 572

Components of Working Capital 572

Working Capital and the Cash Cycle 572

20.2 Accounts Receivable and Credit Policy 575

Terms of Sale 576

Credit Agreements 577

Credit Analysis 578

The Credit Decision 579

Collection Policy 584

20.3 Inventory Management 586

20.4 Cash Management 588

Check Handling and Float 589

Other Payment Systems 590

Electronic Funds Transfer 591

International Cash Management 592

20.5 Investing Idle Cash: The Money Market 593

Money Market Investments 593

Calculating the Yield on Money Market Investments 594

Yields on Money Market Investments 595

The International Money Market 595

20.6 Managing Current Liabilities: Short-Term Debt 596

Bank Loans 596

Commercial Paper 597

Summary 598

Questions and Problems 600

Minicase 608

Part Seven Special Topics

Chapter 21 Mergers, Acquisitions, and Corporate Control 610 21.1 Sensible Motives for Mergers 612

Economies of Scale 614

Economies of Vertical Integration 614

Combining Complementary Resources 615

Mergers as a Use for Surplus Funds 616

Eliminating Inefficiencies 616

Industry Consolidation 616

21.2 Dubious Reasons for Mergers 617

Diversification 617

The Bootstrap Game 617

21.3 The Mechanics of a Merger 619

The Form of Acquisition 619

Mergers, Antitrust Law, and Popular Opposition 619

Cross-Border Mergers and Tax Inversion 620

21.4 Evaluating Mergers 620

Mergers Financed by Cash 620

Mergers Financed by Stock 622

A Warning 623

Another Warning 623

21.5 The Market for Corporate Control 624

21.6 Method 1: Proxy Contests 625

21.7 Method 2: Takeovers 625

21.8 Method 3: Leveraged Buyouts 627

Barbarians at the Gate? 628

21.9 Method 4: Divestitures, Spin-Offs, and Carve-Outs 630

21.10 The Benefits and Costs of Mergers 630

Merger Waves 630

Summary 632

Questions and Problems 633

Minicase 636

Chapter 22 International Financial Management 638 22.1 Foreign Exchange Markets 640

Spot Exchange Rates 640

Forward Exchange Rates 642

22.2 Some Basic Relationships 643

Exchange Rates and Inflation 643

Real and Nominal Exchange Rates 646

Inflation and Interest Rates 646

The Forward Exchange Rate and the Expected Spot Rate 649

Interest Rates and Exchange Rates 650

22.3 Hedging Currency Risk 651

Transaction Risk 651

Economic Risk 652

22.4 International Capital Budgeting 653

Net Present Values for Foreign Investments 653

Political Risk 655

The Cost of Capital for Foreign Investment 656

Avoiding Fudge Factors 656

Summary 657

Questions and Problems 658

Minicase 663

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Chapter 23 Options 664 23.1 Calls and Puts 666

Selling Calls and Puts 668

Payoff Diagrams Are Not Profit Diagrams 669

Financial Alchemy with Options 670

Some More Option Magic 671

23.2 What Determines Option Values? 672

Upper and Lower Limits on Option Values 672

The Determinants of Option Value 673

Option-Valuation Models 675

23.3 Spotting the Option 678

Options on Real Assets 678

Options on Financial Assets 679

Summary 682

Questions and Problems 683

Chapter 24 Risk Management 692 24.1 Why Hedge? 694

The Evidence on Risk Management 695

24.2 Reducing Risk with Options 696

24.3 Futures Contracts 696

The Mechanics of Futures Trading 699

Commodity and Financial Futures 700

24.4 Forward Contracts 701

24.5 Swaps 702

Interest Rate Swaps 702

Currency Swaps 704

And Some Other Swaps 704

24.6 Innovation in the Derivatives Market 705

24.7 Is “Derivative” a Four-Letter Word? 705

Summary 706

Questions and Problems 707

Part Eight Conclusion

Chapter 25 What We Do and Do Not Know about Finance 712 25.1 What We Do Know: The Six Most Important Ideas in

Finance 714

Net Present Value (Chapter 5) 714

Risk and Return (Chapters 11 and 12) 714

Efficient Capital Markets (Chapter 7) 715

MM’s Irrelevance Propositions (Chapters 16 and 17) 715

Option Theory (Chapter 23) 715

Agency Theory 716

25.2 What We Do Not Know: Nine Unsolved Problems in Finance 716

What Determines Project Risk and Present Value? 716

Risk and Return—Have We Missed Something? 717

Are There Important Exceptions to the Efficient-Market Theory? 718

Is Management an Off-Balance-Sheet Liability? 718

How Can We Explain Capital Structure? 719

How Can We Resolve the Payout Controversy? 719

How Can We Explain Merger Waves? 719

What Is the Value of Liquidity? 720

Why Are Financial Systems Prone to Crisis? 720

25.3 A Final Word 721

Questions and Problems 721

Appendix A A-1

Glossary G-1

Global Index IND-1

Subject Index IND-5

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Fundamentals of

Corporate Finance

Ninth EDITION

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R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D I N C O N N E C T.

C H A P T E R

Goals and Governance of the Corporation

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1-1 Give examples of the investment and financing decisions that financial managers make.

1-2 Distinguish between real and financial assets.

1-3 Cite some of the advantages and disadvantages of organizing a business as a corporation.

1-4 Describe the responsibilities of the CFO, treasurer, and controller.

1-5 Explain why maximizing market value is the natural financial goal of the corporation.

1-6 Understand what is meant by “agency problems,” and cite some of the ways that corporate governance helps mitigate agency problems.

1-7 Explain why unethical behavior does not maximize market value.

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To grow from small beginnings to a major corporation, FedEx needed to make good investment and financing decisions. Frank Kovalchek via Alaskan Dude/Flickr/CC BY 2.0

T o carry on business, a corporation needs an almost endless variety of assets. Some are tangi- ble assets such as plant and machinery, office

buildings, and vehicles; others are intangible assets such as brand names and patents. Corporations finance these assets by borrowing, by reinvesting profits back into the firm, and by selling additional shares to the firm’s shareholders.

Financial managers, therefore, face two broad ques- tions. First, what investments should the corporation make? Second, how should it pay for these investments? Investment decisions spend money. Financing deci- sions raise money for investment.

We start this chapter with examples of recent invest- ment and financing decisions by major U.S. and foreign corporations. We review what a corporation is and describe the roles of its top financial managers. We then turn to the financial goal of the corporation, which is usually expressed as maximizing value, or at least

adding value. Financial managers add value whenever the corporation can invest to earn a higher return than its shareholders can earn for themselves.

But managers are human beings; they cannot be perfect servants who always and everywhere maximize value. We will consider the conflicts of interest that arise in large corporations and how corporate gover- nance helps to align the interests of managers and shareholders.

If we ask managers to maximize value, can the corpo- ration also be a good citizen? Won’t the managers be tempted to try unethical or illegal financial tricks? They may sometimes be tempted, but wise managers realize that such tricks are not just dishonest; they almost always destroy value, not increase it. More challenging are the gray areas where the line between ethical and unethical financial actions is hard to draw.

Finally, we look ahead to the rest of this book and look back to some entertaining snippets of financial history.

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1.1 Investment and Financing Decisions Fred Smith is best known today as the founder of FedEx. But in 1965 he was still a sophomore at Yale, where he wrote an economics term paper arguing that delivery systems were not keeping up with increasing needs for speed and dependability.1 He later joined his stepfather at a struggling equipment and maintenance firm for air carriers. He observed firsthand the difficulties of shipping spare parts on short notice. He saw the need for an integrated air and ground delivery system with a central hub that could connect a large number of points more efficiently than a point-to-point delivery system. In 1971, at the age of 27, Smith founded Federal Express.

Like many start-up firms, Federal Express flirted again and again with failure. Smith and his family had an inheritance of a few million dollars, but this was far from enough. The young company needed to purchase and retrofit a small fleet of aging Dassault Falcon jets; build a central-hub facility; and hire and train pilots, delivery, and office staff. The initial source of capital was short-term bank loans. Because of the company’s shaky financial position, the bank demanded that the planes be used as collateral and that Smith personally guarantee the loan with his own money.

In April 1973, the company went live with a fleet of 14 jets, servicing 25 U.S. cities out of its Memphis hub. By then, the company had spent $25 million and was effec- tively flat broke, without enough funds to pay for its weekly delivery of jet fuel. In desperation, it managed to acquire a bank loan for $23.7 million. This loan had to be backed by a guarantee from General Dynamics, which in return acquired an option to buy the company. (Today, General Dynamics must regret that it never exercised this option.)

In November of that year, the company finally achieved some financial stability when it raised $24.5 million from venture capitalists, investment firms that provide funds and advice to young companies in return for a partial ownership share. Eventu- ally, venture capitalists invested about $90 million in Federal Express.

In 1977, private firms were allowed for the first time to compete with the Postal Service in package delivery. Federal Express responded by expanding its operations. It acquired seven Boeing 727s, each with about seven times the capacity of the Falcon jets. To pay for these new investments, Federal Express raised about $19 million by selling shares of stock to the general public in an initial public offering (IPO). The new stockholders became part-owners of the company in proportion to the number of shares they purchased.

From this point on, success followed success, and the company invested heavily to expand its air fleet as well as its supporting infrastructure. It introduced an automated shipping system and a bar-coded tracking system. In 1994, it launched its fedex.com website for online package tracking. It opened several new hubs across the United States as well as in Canada, France, the Philippines, and China. In 2007, FedEx (as the company was now called) became the world’s largest airline measured by number of planes. FedEx also invested in other companies, capped by the acquisition of Kinko’s for $2.4 billion in 2004. By 2016, FedEx had 325,000 employees, annual revenue of $49 billion, and a stock market value of almost $40 billion. Its name had become a verb—to “FedEx a package” was to ship it overnight.

Even in retrospect, FedEx’s success was hardly a sure thing. Fred Smith’s idea was inspired, but its implementation was complex and difficult. FedEx had to make good investment decisions. In the beginning, these decisions were constrained by lack of financing. For example, used Falcon jets were the only option, given the young com- pany’s precarious financial position. At first it could service only a short list of the major cities. As the company grew, its investment decisions became more complex. Which type of planes should it buy? When should it expand coverage to Europe and

1 Legend has it that Smith received a grade of C on this paper. In fact, he doesn’t remember the grade.

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Asia? How many operations hubs should it build? What computer and tracking sys- tems were necessary to keep up with the increasing package volume and geographic coverage? Which companies should it acquire as it expanded its range of services?

FedEx also needed to make good financing decisions. For example, how should it raise the money it needed for investment? In the beginning, these choices were limited to family money and bank loans. As the company grew, its range of choices expanded. Eventually it was able to attract funding from venture capitalists, but this posed new questions. How much cash did the firm need to raise from the venture capitalists? How big a share in the firm would the venture capitalists demand in return? The initial public offering of stock prompted similar questions. How many shares should the company try to sell? At what price? As the company grew, it raised more funds by borrowing money from its banks and by selling publicly traded bonds to investors. At each point, it needed to decide on the proper form and terms of financing as well as the amounts to be raised.

In short, FedEx needed to be good at finance. It had a head start over potential competitors, but a series of bad financial decisions would have sunk the company. No two companies’ histories are the same, but, like FedEx, all successful companies must make good investment and financing decisions. And, as with FedEx, those decisions range from prosaic and obvious to difficult and strategically crucial.

Let’s widen our discussion. Table 1.1 gives an example of a recent investment and financing decision for 11 corporations. Seven are U.S. corporations. Four are foreign: Virgin Atlantic’s headquarters are in London, TransCanada’s in Calgary, LVMH’s in Paris,2  and Vale’s in Rio de Janeiro. We have chosen very large public corporations that you are likely to be familiar with. You may have flown with Virgin Atlantic, shopped at Walmart, or posted a picture on Facebook.

TABLE 1.1 Examples of recent investment and financing decisions by major public corporations

Company Recent Investment Decisions Recent Financing Decisions

Entergy Purchased the Union Power generating station near El Dorado, Arkansas, for $948 million.

Entergy’s Arkansas subsidiary issued $325 million of bonds maturing in 2026.

ExxonMobil Cut total capital investment for 2016 to $34 billion, down 12% because of plummeting oil prices.

Eliminated share repurchases for 2016, thus reducing payout to stockholders.

Facebook Spent $60 million to acquire Pebbles, an Israeli company developing virtual reality software.

Financed capital investment and acquisitions with operating cash flow.

Ford Announced plan to invest $1 billion to build an assembly plant in Mexico.

Ford’s credit subsidiary issued $3.5 billion in long-term debt.

John Deere Total capital investment fell to $655 million, after completing investments for producing clean-burning diesel engines.

Maintained credit lines with banks that allowed it to borrow up to $7.2 billion.

LVMH Acquired Luxola, a Singapore cosmetics e-commerce start-up.

Repaid €750 million in debt issued in 2009 and 2011.

Procter & Gamble Spent $2.0 billion on research and development in 2015.

Spent $4.6 billion to repurchase its common stock.

TransCanada Announced purchase of Columbia Pipeline Group for $10.2 billion.

Will pay Columbia shareholders in cash and also assume $2.8 billion of existing Columbia debt.

Vale Started up the Caue Itabiritos iron-ore project after capital investment of $927 million.

Announced plan to issue at least $750 million of 30-year debt.

Virgin Atlantic Airlines Ordered 12 new Airbus A350-1000 planes. Used value of its landing slots at London’s Heathrow Airport as collateral for a £220 million bond issue.

Walmart Announced plans to open more than 200 new stores in 2016.

Raised its annual dividend to $2.00 a share.

2 LVMH (Moët Hennessy Louis Vuitton) markets perfumes and cosmetics, wines and spirits, leather goods, watches, and other luxury products. And, yes, we know what you are thinking, but “LVMH” really is short for “Moët Hennessy Louis Vuitton.”

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Take a look at the decisions now. We think you will agree that they appear sensible—at least there is nothing obviously wrong with them. But if you are new to finance, it may be difficult to think about why these companies made these decisions and not others.

The Investment (Capital Budgeting) Decision Investment decisions, such as those shown in Table 1.1, are also called capital budgeting or capital expenditure (CAPEX) decisions. Some of the investments in the table, such as Walmart’s new stores or Virgin Atlantic’s new planes, involve tangible assets—assets that you can touch and kick. Others involve intangible assets, such as research and development (R&D), advertising, and the design of computer software. For example, major pharmaceutical manufacturers invest billions every year on R&D for new drugs.

Most of the investments in Table 1.1 have long-term consequences. For example, the planes acquired by Virgin Atlantic may still be flying 20 or 30 years from now. Other investments may pay off in only a few months. For example, with the approach of the Christmas holidays, Walmart spends nearly $50 billion to stock up its ware- houses and retail stores. As the goods are sold over the following months, the company recovers its investment in these inventories.

The world of business can be intensely competitive, and corporations prosper only if they can keep launching new products or services. In some cases, the costs and risks of doing so are amazingly large. For example, the cost of developing the Gorgon natural gas field in Australia has been estimated at $54 billion. It’s not surprising that this cost is being shared among several major energy companies. But do not think of companies as making billion-dollar investments on a daily basis. Most investment decisions are smaller, such as the purchase of a truck, machine tool, or computer system. Corporations make thousands of such investments each year. The cumulative amount of these small expenditures can be just as large as the occasional jumbo invest- ments, such as those shown in Table 1.1.

Not all investments succeed. In October 2011 Hewlett-Packard (HP) paid $11.1 billion to acquire the British software company Autonomy. Just 13 months later, HP wrote down the value of this investment by $8.8 billion. HP claimed that it was misled by improper accounting at Autonomy. Nevertheless, the Autonomy acquisition was a disastrous investment for HP. HP’s CEO was fired in short order.

There are no free guarantees in finance. But you can tilt the odds in your favor if you learn the tools of investment analysis and apply them intelligently. We cover these tools in detail later in this book.

The Financing Decision The financial manager’s second main responsibility is to raise the money that the firm requires for its investments and operations. This is the financing decision. When a company needs to raise money, it can invite investors to put up cash in exchange for a share of future profits, or it can promise to pay back the investors’ cash plus a fixed rate of interest. In the first case, the investors receive shares of stock and become shareholders, part-owners of the corporation. The investors in this case are referred to as equity investors, who contribute equity financing. In the second case, the investors are lenders, that is, debt investors, who one day must be repaid. The choice between debt and equity financing is often called the capital structure decision. Here “capital” refers to the firm’s sources of long-term financing. A firm that is seeking to raise long- term financing is said to be “raising capital.”

Notice the essential difference between the investment and financing decisions. When the firm invests, it acquires real assets, which are then used to produce the firm’s goods and services. The firm finances its investment in real assets by issuing financial assets to investors. A share of stock is a financial asset, which has value as a

capital budgeting or capital expenditure (CAPEX) decision Decision to invest in tangible or intangible assets.

financing decision Decision on the sources and amounts of financing.

real assets Assets used to produce goods and services.

financial assets Financial claims to the income generated by the firm’s real assets.

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claim on the firm’s real assets and on the income that those assets will produce. A bank loan is a financial asset also. It gives the bank the right to get its money back plus interest. If the firm’s operations can’t generate enough income to repay the bank, the bank can force the firm into bankruptcy and stake a claim on its real assets. Financial assets that can be purchased and traded by investors in public markets are called securi- ties. The shares of stock issued by the public corporations in Table 1.1 are all securities. Entergy’s 10-year bond in Table 1.1 is a security. But a bank loan from JPMorgan to Entergy is not called a security unless the bank resells the loan to public investors.

The firm can issue an almost endless variety of financial assets. Suppose it decides to borrow. It can issue debt to investors, or it can borrow from a bank. It can borrow for 1 year or 20 years. If it borrows for 20 years, it can reserve the right to pay off the debt early if interest rates fall. It can borrow in Paris, receiving and promising to repay euros, or it can borrow dollars in New York. (As Table 1.1 shows, Ford chose to bor- row U.S. dollars, but it could have borrowed euros or Japanese yen instead.)

In some ways, financing decisions are less important than investment decisions. Financial managers say that “value comes mainly from the investment side of the bal- ance sheet.” Also, the most successful corporations sometimes have the simplest financing strategies. Take Microsoft as an example. It is one of the world’s most valu- able corporations. In early 2016, Microsoft shares traded for $53 each. There were 7.91 billion shares outstanding. Therefore Microsoft’s market value—its market capitaliza- tion or market cap—was 53 × 7.91 = $419 billion. Where did this market value come from? It came from Microsoft’s products, from its brand name and worldwide cus- tomer base, from its R&D, and from its ability to make profitable future investments. It did not come from sophisticated financing. Microsoft’s financing strategy is very simple: It finances almost all investment by retaining and reinvesting operating cash flow.

Financing decisions may not add much value compared to good investment deci- sions, but they can destroy value if they are stupid or ambushed by bad news. For example, when a consortium of investment companies bought the energy giant TXU in 2007, the company took on an additional $40 billion in debt. This may not have been a stupid decision, but it did prove fatal. The consortium did not foresee the expansion of shale gas production and the resulting sharp fall in natural gas and electricity prices, and in April 2014 the company (renamed Energy Future Holdings) was bankrupt.

We have emphasized the financial manager’s responsibility for two decisions:

The investment decision = purchase of real assets The financing decision = sale of financial assets

But this is an oversimplification because the financial manager is also involved in many other day-to-day activities that are essential to the smooth operation of a business.

Are the following capital budgeting or financing decisions? (Hint: In one case the answer is “both.”)

a. Intel decides to spend $7 billion to develop a new microprocessor factory. b. BMW borrows 350 million euros (€350 million) from Deutsche Bank. c. Royal Dutch Shell constructs a pipeline to bring natural gas onshore from a

production platform in Australia. d. Avon spends €200 million to launch a new range of cosmetics in European

markets. e. Pfizer issues new shares to buy a small biotech company.

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For example, if the firm sells goods or services on credit, it needs to make sure that its customers pay on time. Corporations that operate internationally must constantly trans- fer cash from one currency to another. And the manager must keep an eye on the risks that the firm runs and ensure that they don’t land the firm in a pickle.

3 In the United States, corporations are identified by the label “Corporation,” “Incorporated,” or “Inc.,” as in Caterpillar Inc. The United Kingdom identifies public corporations by “plc” (short for “Public Limited Corporation”). French corporations have the suffix “SA” (“Société Anonyme”). The corresponding labels in Germany are “GmbH” (“Gesellschaft mit beschränkter Haftung”) and “AG” (“Aktiengesellschaft”). 4 “Shareholder” and “stockholder” mean exactly the same thing and are used interchangeably.

1.2 What Is a Corporation? We have been referring to “corporations.” But before going too far or too fast, we need to offer some basic definitions.

A corporation is a distinct, permanent legal entity. Suppose you decide to create a new corporation.3 You would work with a lawyer to prepare articles of incorporation, which set out the purpose of the business and how it is to be financed, managed, and governed. These articles must conform to the laws of the state in which the business is incorporated. For many purposes, the corporation is considered a resident of its state. For example, it can enter into contracts, borrow or lend money, and sue or be sued. It pays its own taxes (but it cannot vote!).

A corporation’s owners are called shareholders or stockholders.4 The shareholders do not directly own the business’s real assets (factories, oil wells, stores, etc.). Instead they have indirect ownership via financial assets (the shares of the corporation).

A corporation is legally distinct from the shareholders. Therefore, the shareholders have limited liability and cannot be held personally responsible for the corporation’s debts. When the U.S. financial corporation Lehman Brothers failed in 2008, no one demanded that its stockholders put up more money to cover Lehman’s massive debts. Shareholders can lose their entire investment in a corporation, but no more.

corporation A business organized as a separate legal entity owned by stockholders.

limited liability The owners of a corporation are not personally liable for its obligations.

Business Organization

Suppose you buy a building and open a restaurant. You have invested in the building itself, kitchen equipment, dining-room furnishings, plus various other assets. If you do not incorpo- rate, you own these assets personally, as the sole proprietor of the business. If you have borrowed money from a bank to start the business, then you are personally responsible for this debt. If the business loses money and cannot pay the bank, then the bank can demand

Example 1.1 ⊲

Which of the following are financial assets, and which are real assets?

a. A patent. b. A share of stock issued by Wells Fargo Bank. c. A blast furnace in a steelmaking factory. d. A mortgage loan taken out to help pay for a new home. e. After a successful advertising campaign, potential customers trust FedEx to

deliver packages promptly and reliably. f. An IOU (“I owe you”) from your brother-in-law.

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When a corporation is first established, its shares may be privately owned by a small group of investors, perhaps the company’s managers and a few backers. In this case, the shares are not publicly traded and the company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, its shares are traded in public markets such as the New York Stock Exchange. Such corporations are known as public companies. Most well-known corporations in the United States are public companies with widely dispersed shareholdings. In other countries, it is more common for large corporations to remain in private hands, and many public companies may be controlled by just a handful of investors.

A large public corporation may have hundreds of thousands of shareholders, who together own the business. An individual may have 100 shares, receive 100 votes, and be entitled to a tiny fraction of the firm’s income and value. On the other hand, a pension fund or insurance company may own millions of shares, receive millions of votes, and have a correspondingly large stake in the firm’s performance.

Public shareholders cannot possibly manage or control the corporation directly. Instead, they elect a board of directors, who in turn appoint the top managers and monitor their performance. This separation of ownership and control gives corporations permanence. Even if managers quit or are dismissed, the corporation survives. Today’s stockholders can sell all their shares to new investors without disrupting the operations of the business. Corporations can, in principle, live forever, and in practice they may survive many human lifetimes. One of the oldest corporations is the Hudson’s Bay Company, which was formed in 1670 to profit from the fur trade between northern Canada and England. The company still operates as one of Canada’s leading retail chains.

The separation of corporate ownership and control can also have a downside, for it can open the door for managers and directors to act in their own interests rather than in the stockholders’ interest. We return to this problem later in the chapter.

There are other disadvantages to being a corporation. One is the cost, in both time and money, of managing the corporation’s legal machinery. These costs are particu- larly burdensome for small businesses.

There is also an important tax drawback to corporations in the United States. Because the corporation is a separate legal entity, it is taxed separately. So corpora- tions pay tax on their profits, and shareholders are taxed again when they receive dividends from the company or sell their shares at a profit. By contrast, income gener- ated by businesses that are not incorporated is taxed just once as personal income.6

Other Forms of Business Organization Corporations do not have to be prominent, multinational businesses such as those listed in Table 1.1. You can organize a local plumbing contractor or barber shop as a corporation if you want to take the trouble. But most corporations are larger

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S-corporations

that you raise cash by selling other assets—your car or house, for example—in order to repay the loan. But if you incorporate the restaurant business, and then the corporation borrows from the bank, your other assets are shielded from the restaurant’s debts. Of course, incorporation also means that the bank will be more cautious in lending, because the bank will have no recourse to your other assets.5

Notice that if you incorporate your business, you exchange direct ownership of its real assets (the building, kitchen equipment, etc.) for indirect ownership via financial assets (the shares of the new corporation). ■

5 The bank may ask you to put up personal assets as collateral for the loan to your restaurant corporation. But it has to ask and get your agreement. It doesn’t have to ask if your business is a sole proprietorship. 6 The U.S. tax system is somewhat unusual in this respect. To avoid taxing the same income twice, many other countries give shareholders at least some credit for the taxes that the corporation has already paid.

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businesses or businesses that aspire to grow. Small “mom-and-pop” businesses are usually organized as sole proprietorships.

What about the middle ground? What about businesses that grow too large for sole proprietorships but don’t want to reorganize as corporations? For example, suppose you wish to pool money and expertise with some friends or business associates. You can form a partnership and enter into a partnership agreement that sets out how decisions are to be made and how profits are to be split up. Partners, like sole proprietors, face unlimited liability. If the business runs into difficulties, each partner can be held responsible for all the business’s debts.

Partnerships have a tax advantage. Partnerships, unlike corporations, do not have to pay income taxes. The partners pay personal income taxes on their shares of the profits.

Some businesses are hybrids that combine the tax advantage of a partnership with the limited liability advantage of a corporation. In a limited partnership, partners are classified as general or limited. General partners manage the business and have unlimited personal liability for its debts. Limited partners are liable only for the money they invest and do not participate in management.

Many states allow limited liability partnerships (LLPs) or limited liability compa- nies (LLCs). These are partnerships in which all partners have limited liability. Another variation on the theme is the professional corporation (PC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally, for example, for malpractice.

Most large investment banks such as Morgan Stanley and Goldman Sachs started life as partnerships. But eventually these companies and their financing requirements grew too large for them to continue as partnerships, and they reorganized as corpora- tions. The partnership form of organization does not work well when ownership is widespread and separation of ownership and management is essential.

1.3 Who Is the Financial Manager? What do financial managers do for a living? That simple question can be answered in several ways. We can start with financial managers’ job titles. Most large corporations have a chief financial officer (CFO), who oversees the work of all financial staff. As you can see from Figure 1.1, the CFO is deeply involved in financial policy and financial planning and is in constant contact with the chief executive officer (CEO) and other top management. The CFO is the most important financial voice of the corporation and explains earnings results and forecasts to investors and the media.

chief financial officer (CFO) Supervises all financial functions and sets overall financial strategy.

Treasurer Responsible for: Cash management Raising of capital Banking relationships

Controller Responsible for: Preparation of financial statements Accounting Taxes

Chief Financial O�cer (CFO) Responsible for: Financial policy Corporate planning

FIGURE 1.1 Financial managers in large corporations

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Below the CFO are usually a treasurer and a controller. The treasurer looks after the firm’s cash, raises new capital, and maintains relationships with banks and other investors that hold the firm’s securities. The controller prepares the financial state- ments, manages the firm’s internal budgets and accounting, and looks after its tax affairs. Thus the treasurer’s main function is to obtain and manage the firm’s capital, whereas the controller ensures that the money is used efficiently.

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The role of the corporate treasurer

treasurer Responsible for financing, cash management, and relationships with banks and other financial institutions.

controller Responsible for budgeting, accounting, and taxes.

In large corporations, financial managers are responsible for organizing and super- vising the capital budgeting process. However, major capital investment projects are so closely tied to plans for product development, production, and marketing that managers from these other areas are inevitably drawn into planning and analyzing the projects. If the firm has staff members specializing in corporate planning, they are naturally involved in capital budgeting too. For this reason, we will use the term finan- cial manager to refer to anyone responsible for an investment or financing decision. Often we will use the term collectively for all the managers drawn into such decisions.

Now let’s go beyond job titles. What is the essential role of the financial manager? Figure 1.2 gives one answer. The figure traces how money flows from investors to the corporation and back again to investors. The flow starts when cash is raised from investors (arrow 1 in the figure). The cash could come from banks or from securities sold to investors in financial markets. The cash is then used to pay for the real assets (investment projects) needed for the corporation’s business (arrow 2). Later, as the business operates, the assets generate cash inflows (arrow 3). That cash is either reinvested (arrow 4a) or returned to the investors who furnished the money in the first place (arrow 4b). Of course, the choice between arrows 4a and 4b is constrained by the promises made when cash was raised at arrow 1. For example, if the firm borrows money from a bank at arrow 1, it must repay this money plus interest at arrow 4b.

You can see examples of arrows 4a and 4b in Table 1.1. Facebook financed its investments by reinvesting earnings (arrow 4a). Procter & Gamble decided to return cash to shareholders by buying back its stock (arrow 4b). It could have chosen instead to pay the money out as additional cash dividends, also on arrow 4b.

Notice how the financial manager stands between the firm and outside investors. On the one hand, the financial manager is involved in the firm’s operations,

FIGURE 1.2 Flow of cash between investors and the firm’s operations. Key: (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors.

(2)

(3)

(1)

(4b)

(4a) Financial Manager

Firm’s Operations

Real Assets

Investors

Financial Assets

Fritz and Frieda went to business school together 10 years ago. They have just been hired by a midsize corporation that wants to bring in new financial managers. Fritz studied finance, with an emphasis on financial markets and institutions. Frieda majored in accounting and became a CPA 5 years ago. Who is more suited to be treasurer and who controller? Briefly explain.

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particularly by helping to make good investment decisions. On the other hand, he or she deals with financial institutions and other investors and with financial markets such as the New York Stock Exchange. We say more about these financial institutions and markets in the next chapter.

1.4 Goals of the Corporation

Shareholders Want Managers to Maximize Market Value For small corporations, shareholders and management may be one and the same. But for large corporations, separation of ownership and management is a practical necessity. For example, Walmart has nearly 300,000 shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated.

How can shareholders effectively delegate decision making when they all have different tastes, wealth, time horizons, personal opportunities, and tolerance for risk? Delegation can work only if the shareholders have a common goal. Fortunately there is a natural financial objective on which almost all shareholders can agree: Maximize the current market value of shareholders’ investment in the firm.

This simple, unqualified goal makes sense when the shareholders have access to well-functioning financial markets and institutions. Access gives them the flexibility to manage their own savings and consumption plans, leaving the corporation’s finan- cial managers with only one task, to increase market value. For example, a corpora- tion’s roster of shareholders will usually include both risk-averse and risk-tolerant investors. You might expect the risk-averse to say, “Sure, maximize value, but don’t touch too many high-risk projects.” Instead, they say, “Risky projects are okay, pro- vided that expected profits are more than enough to offset the risks. If this firm ends up too risky for my taste, I’ll adjust my investment portfolio to make it safer.” For example, the risk-averse shareholder can shift more of his or her portfolio to safe assets, such as U.S. government bonds. Shareholders can also just say good-bye, selling off shares of the risky firm and buying shares in a safer one. If the risky invest- ments increase market value, the departing shareholders are better off than they would be if the risky investments were turned down.

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Foundations of the NPV rule

Value Maximization Fast-Track Wireless shares trade for $20. It has just announced a “bet the company” investment in a high-risk, but potentially revolutionary, WhyFi technology. Investors note the risk of failure but are even more impressed with the technology’s upside. They conclude that the possibility of very high future profits justifies a higher share price. The price goes up to $23.

Caspar Milquetoast, a thoughtful but timid shareholder, notes the downside risks and decides that it’s time for a change. He sells out to more risk-tolerant investors. But he sells at $23 per share, not $20. Thus he captures the value added by the WhyFi project without having to bear the project’s risks. Those risks are transferred to other investors, who are more risk-tolerant or more optimistic.

In a well-functioning stock market, there is always a pool of investors ready to bear downside risks if the upside potential is sufficiently attractive. We know that the upside potential was sufficient in this case, because Fast-Track stock attracted investors willing to pay $23 per share. ■

Example 1.2 ⊲

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The same principles apply to the timing of a corporation’s cash flows, as the following Self-Test illustrates.

Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to “maximize profits.” That sounds reasonable. After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined corporate objective. Here are two reasons:

1. Maximize profits? Which year’s profits? A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that will not add value unless the outlays were wasteful in the first place. Shareholders will not welcome higher short-term profits if long-term profits are damaged.

2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a very low rate of return on the extra investment.

Maximizing—or at least maintaining—value is necessary for the long-run survival of the corporation. Suppose, for example, that its managers forget about value and decide that the only goal is to increase the market share of its products. So the managers cut prices aggressively to attract new customers, even when this leads to continuing losses. As losses mount, the corporation finds it more and more difficult to borrow money and sooner or later cannot pay existing debts. Nor can it raise new equity financing if share- holders see that new equity investment will follow previous investments down the drain.

This firm’s managers would probably pay the price for this business malpractice. For example, outside investors would see an opportunity for easy money. They could buy the firm from its current shareholders, toss out the managers, and reemphasize value rather than market share. The investors would profit from the increase in value under new management.

Managers who pursue goals that destroy value often end in early retirement— another reason that the natural financial goal of the corporation is to maximize market value.

The Investment Trade-Off Okay, let’s take the objective as maximizing market value, or at least adding market value. But why do some investments increase market value, while others reduce it? The answer is given by Figure 1.3, which sets out the fundamental trade-off for corporate investment decisions. The corporation has a proposed investment project (the purchase of a real asset). Suppose it has sufficient cash on hand to finance the project. The financial manager is trying to decide whether to go ahead. If he or she decides not to invest, the corporation can pay out the cash to shareholders, say as an extra dividend. (The investment and dividend arrows in Figure 1.3 are arrows 2 and 4b in Figure 1.2.)

Assume that the financial manager is acting in the interests of the corporation’s owners, its stockholders. What do these stockholders want the financial manager to do?

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B-corporations

Rhonda and Reggie Hotspur are working hard to save for their children’s college education. They don’t need more cash for current consumption but will face big tuition bills in 2025. Should they therefore avoid investing in stocks that pay generous current cash dividends? (Hint: Are they required to spend the dividends on current consumption?) Explain briefly.

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The answer depends on the rate of return on the investment project and on the rate of return that stockholders can earn by investing in financial markets. If the return offered by the investment project is higher than the rate of return that shareholders can get by investing on their own, then the shareholders would vote for the investment project. If the investment project offers a lower return than shareholders can achieve on their own, the shareholders would vote to cancel the project and take the cash instead.

Figure 1.3 could apply to Virgin Atlantic’s decisions to invest in new aircraft. Suppose the company has cash set aside to buy five more Airbus A350-1000s. It could go ahead with the purchase, or it could choose to cancel the investment and instead pay out the cash to its stockholders. If it pays out the cash, the stockholders could then invest for themselves.

Suppose that Virgin’s investment in new planes is just about as risky as the stock market and that investment in the stock market offers a 10% expected rate of return. If the new planes offer a superior rate of return, say 20%, then Virgin’s stockholders would be happy to let the company keep the cash and invest it in the new planes. If the planes offer only a 5% return, then the stockholders are better off with the cash and without the new project; in that case, the financial manager should turn down the project.

As long as a corporation’s proposed investments offer higher rates of return than its shareholders can earn for themselves in the stock market (or in other financial markets), its shareholders will applaud the investments and the market value of the firm will increase. But if the company earns an inferior return, shareholders boo, market value falls, and stockholders clamor to get their money back so that they can invest on their own.

In our example, the minimum acceptable rate of return on Virgin’s new aircraft is 10%. This minimum rate of return is called the hurdle rate or opportunity cost of capital. It is called an opportunity cost of capital because it depends on the alternative investment opportunities available to shareholders in financial markets. Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to invest the cash on their own. Corporations increase value by accepting investment projects that earn more than the opportunity cost of capital.

Figure 1.3, which compares rates of return on investment projects with the opportu- nity cost of capital, illustrates a general principle: A corporation should direct cash to investments that add market value, compared with the investments that shareholders could make on their own.7

opportunity cost of capital Expected rate of return given up by investing in a project rather than in the capital market.

FIGURE 1.3 The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

Investment opportunity (real asset)

Invest Alternative: pay out cash

to shareholders

Shareholders invest for

themselves

Firm Shareholders Investment

opportunities (financial assets)

Cash

7 We have mentioned 5% or 20% as possible future rates of return on Virgin Atlantic’s new planes. We will see in Chapter 8 that future rates of return are sometimes difficult to calculate and interpret. The general principle always holds, however. In Chapters 8 and 9 we show you how to apply the principle by calculating the net present value (NPV) of investment projects.

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Notice that the opportunity cost of capital depends on the risk of the proposed investment project. Why? It’s not just because shareholders are risk-averse. It’s also because shareholders have to trade off risk against return when they invest on their own. The safest investments, such as U.S. government debt, offer low rates of return. Investments with higher expected rates of return—the stock market, for example—are riskier and sometimes deliver painful losses. (The U.S. stock market fell 38% in 2008, for example.) Other investments are riskier still. For example, high-tech growth stocks offer the prospect of higher rates of return than typical stocks but are also more volatile than typical stocks.

Managers look to the financial markets to measure the opportunity cost of capital for the firm’s investment projects. They can observe the opportunity cost of capital for safe investments by looking up current interest rates on safe debt securities. For risky investments, the opportunity cost of capital has to be estimated. We start to tackle this task in Chapter 11.

1.5 Agency Problems, Executive Compensation, and Corporate Governance

Sole proprietors face no conflicts in financial management. They are both owners and managers, reaping the rewards of good decisions and hard work and suffering when they make bad decisions or slack off. Their personal wealth is tied to the value of their businesses.

In most large corporations, the owners are mostly outside investors, and so the managers may be tempted to act in their own interests rather than maximize share- holder value. For example, they may shy away from valuable but risky investment projects because they worry more about job security than maximizing value. They may build empires by overaggressive investment or overconfident acquisitions of other companies.

The temptation for such value-destroying actions arises because the managers are not the shareholders, but agents of the shareholders. Therefore, the actions are called agency problems. Losses in value from agency problems—or from costs incurred to mitigate the problems—are called agency costs.

Agency problems sometimes lead to outrageous behavior. When Dennis Kozlowski, the former CEO of Tyco, threw a $2 million birthday bash for his wife, he charged half the cost to the company. Conrad Black, the former boss of Hollinger International, used the company jet for a trip with his wife to Bora Bora. These, of course, are extreme examples. The agency problems encountered in the ordinary course of business are often subtle and mundane. But agency problems do arise whenever managers think just a little less hard about spending money that is not their own.

agency problem Managers are agents for stockholders and are tempted to act in their own interests rather than maximizing value.

agency cost Value lost from agency problems or from the cost of mitigating agency problems.

Investing $100,000 in additional raw materials, mostly palladium, should allow Cryogenic Concepts to increase production and earn an additional $112,000 next year. This payoff could cover the investment, plus a 12% return. Palladium is traded in commodity markets. The CFO has studied the history of returns from investments in palladium and believes that investors in the precious metal can reasonably expect a 15% return. What is the opportunity cost of capital? Is Cryogenic’s proposed investment in palladium a good idea? Why or why not?

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Think of the corporation’s value as a pie that is divided among several classes of claimants. These include managers and workers as well as shareholders and lenders. The government is a claimant, too, because it taxes sales and profits. The claimants are called stakeholders because each has a stake in the firm. Agency problems arise whenever the stakeholders’ interests do not coincide.

stakeholder Anyone with a financial interest in the corporation.

8 Most restricted stock does not “vest” immediately. Suppose the vesting period is 3 years. If the manager quits or is fired in year 2, the restricted stock stays behind. Vesting gives the managers an incentive to stay at the corporation, in this example, for at least 3 years.

Agency problems are controlled in practice in three ways. First, corporations set up internal controls and decision-making procedures to prevent wasteful spending and discourage careless investment. We discuss the controls and procedures in several later chapters. For example, Chapters 8, 9, and 10 cover procedures for disciplined, value- maximizing capital investment decisions. Second, corporations try to design compensa- tion schemes that align managers’ and shareholders’ interests. Third, the corporations are constrained by corporate governance. We comment on compensation and gover- nance here.

Executive Compensation The compensation packages of top executives are almost always tied to the financial performance of their companies. The package typically includes a fixed base salary plus an annual award tied to earnings or other measures of financial performance. The more senior the manager, the smaller the base salary as a fraction of total compen- sation. Also, compensation is not all in cash, but partly in shares. The shares are usually restricted stock, which the manager is required to hold onto while employed by the corporation.8 Many corporations also include stock options in compensation packages. Stock options, which we cover in Chapter 23, give especially powerful incentives to maximize stock price per share.

The upside compensation potential for a few top managers is enormous. For exam- ple, Larry Ellison, CEO of the business software giant Oracle, received total compen- sation of $64 million for 2015. Only $1 of that amount was base salary. The rest came from grants of stock and options. The options will be worthless if Oracle’s stock price falls from its 2015 level but will pay off handsomely if the price rises. In addition, as a founder of Oracle, Ellison owns shares worth $49 billion. No one can say for certain how hard Ellison would have worked with a different compensation package, but one thing is clear: He has a huge personal stake in Oracle’s market value.

Well-designed compensation schemes alleviate agency problems by encouraging managers to maximize shareholder wealth. But some schemes are not well designed; they reward managers even when value is destroyed. For example, during Robert Nardelli’s 6-year tenure as CEO, Home Depot’s stock price fell by 20% while shares of its rival Lowe’s nearly doubled. When Nardelli was ousted in January 2007, he received a farewell package worth $210 million. Needless to say, many shareholders were livid.

In 2010, the Dodd-Frank financial reform law gave U.S. shareholders the right to express their opinion on executive compensation through nonbinding “say on pay” votes at 1- or 3-year intervals. (Shareholders of U.K. companies have a similar right.)

What are agency problems and agency costs? Give two or three examples of decisions by managers that can lead to agency costs.

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9 A large block of shares may give effective control even when there is no majority owner. For example, Larry Ellison’s billion-plus shares give him a 25% stake in Oracle. Barring some extreme catastrophe, this holding means that he can run the company as long as he wants to.

Most votes have endorsed compensation policy, but occasionally shareholders refuse. For example, in 2011 Hewlett-Packard’s shareholders voted against a $40 million com- pensation package for its new CEO. When there is a “no” vote, the company generally changes the pay package to make it less generous; other companies look anxiously over their shoulders to check that their compensation package is not next in the spotlight.

Corporate Governance Financial markets and institutions are supposed to direct financing to firms that can invest to add value. But financing moves from investors to firms only if investors are protected and if agency problems within firms are absent or at least tolerable. Thus there is a need for a system of corporate governance so that money can flow to the right firms at the right times. “Corporate governance” refers to the laws, regulations, institutions, and corporate practices that protect shareholders and other investors. When scandals happen, we say that corporate governance has broken down. When corporations compete to deliver value to shareholders, we are comforted that corporate governance is working properly.

Good corporate governance relies in part on well-designed management compensa- tion packages. Other elements of good corporate governance include the following.

Legal Requirements Good governance requires laws and regulations that protect investors from self-dealing by insiders. CEOs and financial managers have a fiduciary duty to stockholders. That is, they are required to act fairly and responsibly in the stockholders’ interests. If they don’t, they may end up in jail like Tyco’s Dennis Kozlowski and Hollinger’s Conrad Black.

Boards of Directors The board of directors appoints top managers, including the CEO and CFO, and must approve important financial decisions. For example, only the board has legal authority to approve a dividend or a public issue of securities. The board approves compensation schemes and awards to top management. Boards usually delegate decision making for small and medium-size investments, but the authority to approve large investments is almost never delegated.

The board of directors is elected by shareholders and is supposed to represent their interests. Boards have been portrayed as passive supporters of top management, but the balance has tipped toward independence. The Sarbanes-Oxley Act of 2002 (SOX) requires that more directors be independent—that is, not affiliated with management. The majority of directors are now independent. Boards must also meet in executive sessions with the CEO not present. SOX also requires CEOs and CFOs to sign off personally on the corporation’s accounting procedures and results.

Activist Shareholders Institutional shareholders, including pension funds, have become more active in monitoring management and pushing for changes. CEOs have been forced out as a result, including the CEOs of JCPenney, Procter & Gamble, Barnes & Noble, Citigroup, Yahoo!, and Carnival. Boards outside the United States, which have traditionally been more management-friendly, have also become more willing to replace underperformers. The list of foreign companies with CEO departures includes Barclays, Carrefour, Siemens, Barrick, and Rio Tinto.

Although U.S. corporations typically have thousands of individual shareholders, they often also have blockholders, that is, investors who own 5%, 10%, or more of outstanding shares. The blockholders may include wealthy individuals or families— for example, descendants of a founder. They may also include other corporations, pension funds, or foundations.9 When a 5% blockholder calls, the CFO answers.

corporate governance The laws, regulations, institutions, and corporate practices that protect shareholders and other investors.

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10 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Random House, 1937; first published 1776), p. 14. 11 Shareholders value integrity. Firms that are regarded as trustworthy by their employees and that are voted as good places to work tend to be more highly valued by investors and to perform better. See A. Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” Journal of Financial Economics 101, no. 3 (September 2011), pp. 621–640; and L. Guiso, P. Sapienza, and L. Zingales, “The Value of Corporate Culture,” Journal of Financial Economics 117, no. 1 (July 2015), pp. 60–76.

Disgruntled shareholders can also take the “Wall Street Walk” by selling out and moving on to other investments. The Wall Street Walk can send a powerful message. If enough shareholders bail out, the stock price tumbles, which damages top manag- ers’ compensation and reputation.

Takeovers The Wall Street Walk also opens the door for takeovers. The further the stock price falls, the easier it is for another company to buy up the majority of shares and take over. The old management team is then likely to find itself out on the street. We discuss takeovers in Chapter 21. Information for Investors Corporate governance can’t work unless outside investors get detailed, up-to-date information. If a firm is transparent—if investors can see its true profitability and prospects—then problems will show up right away in a falling stock price. That in turn generates extra scrutiny from security analysts, bond rating agencies, and banks and other lenders, who keep an eagle eye on the progress of their borrowers.

The U.S. Securities and Exchange Commission (SEC) sets accounting and report- ing standards for public companies. We cover accounting and finance in Chapter 3.

Chapter 1 is not the right place for a worldwide tour of corporate governance. But be aware that governance laws, regulations, and practice vary. The differences are more dramatic in continental Europe and Japan than in Canada, the United Kingdom, Austra- lia, and other English-speaking countries. In Germany, for example, banks often control large blocks of stock and can push hard for changes in the management or strategy of poorly performing companies. (Banks in the United States are prohibited from large or permanent holdings of the stock of nonfinancial corporations.) Large German firms also have two boards of directors: the supervisory board (Aufsichtsrat) and the management board (Vorstand). Half of the supervisory board’s members are elected by employees. Some French firms also have two boards, one including employee representatives.

1.6 The Ethics of Maximizing Value Shareholders want managers to maximize the market value of their shares. But per- haps this begs the question: Is it desirable for managers to act in the narrow, selfish interest of their shareholders? Does a focus on shareholder value mean that the manag- ers must act as greedy mercenaries riding roughshod over widows and orphans?

Most of this book is devoted to financial policies that increase value. None of these policies requires galloping over widows and orphans. In most instances, there is little conflict between doing well (maximizing value) and doing good. The first step in doing well is doing good by your customers. Here is how Adam Smith put the case in 1776:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.10

Profitable firms are those with satisfied customers and loyal employees; firms with dissatisfied customers and a disgruntled workforce will probably end up with declin- ing profits and a low stock price.11

Of course, ethical issues do arise in business as in other walks of life. When the stakes are high, it is often tempting for managers to cut corners. Laws and regulations seek to prevent managers from undertaking dishonest actions. But written rules and laws can help only so much. In business, as in other day-to-day affairs, there are also

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Things are not always fair in love or business

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unwritten rules of behavior. They are reinforced because good managers know that their firm’s reputation is one of its most important assets, and therefore playing fair and keeping one’s word are simply good business practices. Thus financial deals are regularly sealed by a handshake, and each side knows that the other will not renege later if things turn sour.

Reputation is particularly important in finance. If you buy a well-known brand in a supermarket, you can be fairly sure of what you are getting. But in financial transac- tions, the other party often has more information than you, and it is less easy to be sure of the quality of what you are buying. Therefore, honest financial firms seek to build long-term relationships with their customers and to establish a name for fair dealing and financial integrity. Major banks and securities firms protect their reputations.

When something happens to undermine reputations, the costs can be enormous. Volkswagen (VW) is a recent case in point. VW had installed secret software that cut back pollution from its diesel cars, but only when the cars were tested. Actual pollu- tion in regular driving was much higher—and far in excess of legal maximums. Discovery of the software scandal in 2015 caused a tidal wave of opprobrium. VW’s stock price dropped by 35%. Its CEO was fired. VW diesel vehicles piled up unsold on car dealers’ lots. Potential fines imposed by the U.S. and European governments could be enormous. VW set aside $7.3 billion to cover costs and losses, but some analysts viewed this amount as much too low.

Charlatans and swindlers sometimes prey on individual investors, especially in booming markets. (It’s only “when the tide goes out that you learn who’s been swimming naked.”12) The tide went out in 2008 and a number of frauds were exposed. One notorious example was the Ponzi scheme run by the disgraced financier Bernard Madoff (pronounced “Made-off ”).13 Individuals and institutions invested around $20 billion with Madoff and were told that their investments had grown to $65 billion. That figure turned out to be completely fictitious. (It’s not clear what Madoff did with all this money, but much of it was apparently paid out to early investors in the scheme to create an impression of superior investment performance.) With hindsight, the investors should not have trusted Madoff or the financial advisers who steered money to him.

Madoff’s Ponzi scheme was (we hope) a once-in-a-lifetime event. (Ponzi schemes pop up frequently, but few have approached the scope and duration of Madoff’s.) It was astonishingly unethical and illegal and was bound to end in tears. Needless to say, it was not designed to add value for investors.

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Business culture and unethical behavior

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The Great Albanian Ponzi Scheme

12 The quotation is from Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway, March 2008. 13 Ponzi schemes are named after Charles Ponzi, who founded an investment company in 1920 that promised investors unbelievably high returns. He was soon deluged with funds from investors in New England, taking in $1 million during one 3-hour period. Ponzi invested only about $30 of the money that he raised. But he used part of the cash provided by later investors to pay generous dividends to the original investors, thus promoting the illusion of high profits and quick payoffs. Within months the scheme collapsed and Ponzi started a 5-year prison sentence.

Without knowing anything about the personal ethics of the owners, which company would you trust more to keep its word in a business deal?

a. Harry’s Hardware has been in business for 50 years. Harry’s grandchildren, now almost adults, plan to take over and operate the business. Successful hardware stores depend on long-term loyal customers.

b. Victor’s Videos just opened for business. It rents a storefront in a strip mall and has financed its inventory with a bank loan. Victor has little of his own money invested in the business. Video shops usually command little customer loyalty.

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But sometimes raids can enhance shareholder value. For example, in 2012 and 2013, Relational Investors teamed up with the California State Teachers’ Retirement System (CSTRS, a pension fund) to try to force Timken Co. to split into two separate companies, one for its steel business and one for its industrial bearings business. Relational and CSTRS believed that Timken’s combination of unrelated businesses was unfo- cused and inefficient. Timken management responded that breakup would “deprive our shareholders of long-run value— all in an attempt to create illusory short-term gains through financial engineering.” But Timken’s stock price rose at the prospect of a breakup, and a nonbinding shareholder vote on Relational’s proposal attracted a 53% majority. Finally in 2014 Timken spun off its steel business in a new corporation, Timken Steel.

How do you draw the ethical line in such examples? Was Relational Investors a “raider” (sounds bad) or an “activist investor” (sounds good)? Breaking up a portfolio of busi- nesses can create difficult adjustments and job losses. Some stakeholders lose. But shareholders and the overall economy can gain if businesses are managed more efficiently.

Tax Avoidance In 2012 it was revealed that during the 14 years that Starbucks had operated in the United Kingdom, it paid hardly any taxes. Public outrage led to a boycott of Starbucks shops, and the company responded by promising that it would voluntarily pay to the taxman about $16 million more than it was required to pay by law. Several months later, a U.S. Senate committee investigating tax avoidance by U.S. technology firms reported that Apple had used a “highly questionable” web of offshore entities to avoid billions of dollars of U.S. taxes.

Multinational companies, such as Starbucks and Apple, could reduce their tax bills using legal techniques with exotic names such as the “Dutch Sandwich,” “Double Irish,” and “Check-the-Box.” But the public outcry over the revelations suggested that many believed that use of these techniques, though legal, was unethical. If they were unethical, that leaves an awkward question: How do companies decide which tax schemes are ethical and which are not? Can a company act in shareholders’ interest if it voluntarily pays more taxes than it is legally obligated to pay? * We need not go into the mechanics of short sales here, but note that the seller is obligated to buy back the security, even if its price skyrockets far above what he or she sold it for. As the saying goes, “He who sells what isn’t his’n, buys it back or goes to prison.”

† The story of Paulson’s trade is told in G. Zuckerman, The Greatest Trade Ever (Broadway Business, 2009). The trade was controversial for reasons beyond short-selling. Scan the nearby Beyond the Page icon “Goldman Sachs causes a ruckus” to learn more.

Short-Selling Investors who take short positions are betting that securities will fall in price. Usually they do this by borrowing the security, selling it for cash, and then waiting in the hope that they will be able to buy it back cheaply.* In 2007, hedge fund manager John Paulson took a huge short position in mortgage-backed securities. The bet paid off, and that year Paulson’s trade made a profit of $1 billion for his fund.†

Was Paulson’s trade unethical? Some believe not only that he was profiting from the misery that resulted from the crash in mortgage-backed securities, but that his short trades accentuated the collapse. It is certainly true that short-sellers have never been popular. For example, following the crash of 1929, one commentator compared short-selling to the ghoul- ishness of “creatures who, at all great earthquakes and fires, spring up to rob broken homes and injured and dead humans.”

Short-selling in the stock market is the Wall Street Walk on steroids. Not only do short-sellers sell all the shares they may have previously owned, but they borrow more shares and sell them too, hoping to buy them back for less when the stock price falls. Poorly performing companies are natural targets for short-sellers, and the companies’ incumbent managers naturally complain, often bitterly. Governments sometimes listen to such complaints. For example, in 2008 the U.S. government temporarily banned short sales of financial stocks in an attempt to halt their decline.

But defendants of short-selling argue that selling securi- ties that one believes are overpriced is no less legitimate than buying those that appear underpriced. The object of a well-functioning market is to set the correct stock prices, not always higher prices. Why impede short-selling if it conveys truly bad news, puts pressure on poor performers, and helps corporate governance work?

Corporate Raiders In the movie Pretty Woman, Richard Gere plays the role of an asset stripper, Edward Lewis. He buys companies, takes them apart, and sells the bits for more than he paid for the total package. In the movie Wall Street, Gordon Gekko buys a failing airline, Blue Star, in order to break it up and sell the bits. Real corporate raiders may not be as ruthless as Edward Lewis or Gordon Gekko, but they do target companies whose assets can be profitably split up and redeployed.

This has led some to complain that raiders seek to carve up established companies, often leaving them with heavy debt burdens, basically in order to get rich quick. One German politician has likened them to “swarms of locusts that fall on companies, devour all they can, and then move on.”

Finance in Practice Ethical Disputes in Finance

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It is not always easy to know what is ethical behavior, and there can be many gray areas. The nearby box presents three ethical controversies in finance. Think about where you stand on these issues and where you would draw the ethical line.

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14 The careers are fictitious but based on the actual experiences of several of the authors’ students.

1.7 Careers in Finance Well over 1 million people work in the financial services industry in the United States, and many others work as financial managers in corporations. We can’t tell you what each one does all day, but we can give you some idea of the variety of careers in finance. The nearby box summarizes the experience of a small sample of recent graduates.14

We explained earlier that corporations face two principal financial decisions: the investment decision and the financing decision. Therefore, as a newly recruited finan- cial analyst, you may help to analyze a major new investment project. Or you may instead help to raise the money to pay for it, perhaps by negotiating a bank loan or by arranging to lease the plant and equipment. Other financial analysts work on short- term finance, managing collection and investment of the company’s cash or checking whether customers are likely to pay their bills. Financial analysts are also involved in monitoring and controlling risk. For example, they may help to arrange insurance for the firm’s plant and equipment, or they may assist with the purchase and sale of options, futures, and other exotic tools for managing risk.

Instead of working in the finance department of a corporation, you may join a financial institution. The largest employers are banks. Banks collect deposits and relend the cash to corporations and individuals. If you join a bank, you may start in a branch office, where individuals and small businesses come to deposit cash or to seek a loan. You could also work in the head office, helping to analyze a $500 million loan to a large corporation.

Banks do many things in addition to lending money, and they probably provide a greater variety of jobs than other financial institutions. For example, if you work in the cash management department of a large bank, you may help companies to transfer huge sums of money electronically as wages, taxes, and payments to suppliers. Banks also buy and sell foreign exchange, so you could find yourself working in front of one of those computer screens in a foreign exchange trading room. Another glamorous bank job is in the derivatives group, which helps companies to manage their risk by buying and selling options, futures, and so on. This is where the mathematicians and the computer buffs thrive.

Investment banks, such as Goldman Sachs or Morgan Stanley, help companies sell their securities to investors. They also have large corporate finance departments that assist firms in mergers and acquisitions. When firms issue securities or try to take over another firm, a lot of money is at stake and the firms may need to move fast. Thus, working for an investment bank can be a high-pressure activity with long hours. It can also pay very well.

The insurance industry is another large employer. Much of the insurance industry is involved in designing and selling insurance policies on people’s lives and property, but businesses are also major customers. So, if you work for an insurance company or a large insurance broker, you could find yourself arranging insurance on a Boeing 787 in the United States or an oil rig in Indonesia.

Life insurance companies are major lenders to corporations and to investors in com- mercial real estate. (Life insurance companies deploy the insurance premiums received from policyholders into medium- or long-term loans; banks specialize in shorter-term financing.) So you could end up negotiating a $50 million loan for construction of a new shopping center or investigating the creditworthiness of a family-owned manufac- turing company that has applied for a loan to expand production.

Then there is the business of “managing money,” that is, deciding which compa- nies’ shares to invest in or how to balance investment in shares with safer securities, such as the bonds (debt securities) issued by the U.S. Treasury. Take mutual funds, for example. A mutual fund collects money from individuals and invests in a portfolio of

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Albert Rodriguez, European Markets Group, Major New York Bank I joined the bank after majoring in finance. I spent the first 6 months in the bank’s training program, rotating among departments. I was assigned to the European markets team just before the 2010 Greek crisis, when worries about a possible default caused interest rates on Greek govern- ment debt to jump to more than 4% above the rate on comparable German government debt. Those rates soon went much higher! There was a lot of activity, with every- one trying to figure out whether Greece might be forced to abandon the euro and how this would affect our busi- ness. My job is largely concerned with analyzing econo- mies and assessing the prospects for bank business. There are plenty of opportunities to work abroad, and I hope to spend some time in Madrid or one of our other European offices.

Sherry Solera, Branch Manager, Regional Bank I took basic finance courses in college, but nothing spe- cific for banking. I started here as a teller. I was able to learn about banking through the bank’s training program and also by evening courses at a local college. Last year I was promoted to branch manager. I oversee the branch’s operations and help customers with a wide variety of prob- lems. I’m also spending more time on credit analysis of business loan applications. I want to expand the branch’s business customers, but not by making loans to shaky companies.

Susan Webb, Research Analyst, Mutual Fund Group After majoring in biochemistry, I joined the research depart- ment of a large mutual fund group. Because of my back- ground, I was assigned to work with the senior pharmaceuticals analyst. I start the day by reading The Wall Street Journal and reviewing the analyses that come in each day from stock- broking firms. Sometimes we need to revise our earnings forecasts and meet with the portfolio managers to discuss possible trades. The remainder of my day is spent mainly in analyzing companies and developing forecasts of revenues and earnings. I meet frequently with pharmaceutical analysts in stockbroking firms, and we regularly visit company man- agement. In the evenings I study for the Chartered Financial Analyst (CFA) exam. I did not study finance at college, so this is quite challenging. I hope eventually to move from a research role to become a portfolio manager.

Richard Gradley, Project Finance, Large Energy Company After leaving college, I joined the finance department of a large energy company. I spent my first year helping to ana- lyze capital investment proposals. I then moved to the project finance group, which is responsible for analyzing indepen- dent power projects around the world. Recently, I have been involved in a proposal to set up a company that would build and operate a large new electricity plant in southeast Asia. We built a spreadsheet model of the project to make sure that it was viable. We had to check that the contracts with the builders, operators, suppliers, and so on, were all in place before we could arrange bank financing for the project.

Finance in Practice Working in Finance

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stocks or bonds. A financial analyst in a mutual fund analyzes the prospects for the securities and works with the investment manager to decide which should be bought and sold. Many other financial institutions also contain investment management departments. For example, you might work as a financial analyst in the investment department of an insurance company. (Insurance companies also invest in traded securities.) Or you could be a financial analyst in the trust department of a bank that manages money for retirement funds, universities, and charities.

Stockbroking firms help investment management companies and private individu- als to invest in securities. They employ sales staff and dealers who make the trades. They also employ financial analysts to analyze the securities and help customers to decide which to buy or sell.

Investment banks and stockbroking firms are largely headquartered in New York, as are many of the large commercial banks. Insurance companies and investment manage- ment companies tend to be more scattered. For example, some of the largest insurance companies are headquartered in Hartford, Connecticut, and many investment manage- ment companies are located in Boston. Of course, some U.S. financial institutions have large businesses outside the United States. Finance is a global business. So you may spend some time working in a branch overseas or making the occasional trip to one of the other major financial centers, such as London, Tokyo, Hong Kong, or Singapore.

1.8 Preview of Coming Attractions This book covers investment decisions, then financing decisions, and finally a variety of planning issues that require an understanding of both investment and financing. But first there are three further introductory chapters that should be helpful to readers who

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Chapter 1 Goals and Governance of the Corporation 23

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are making a first acquaintance with financial management. Chapter 2 is an overview of financial markets and institutions. Chapter 3 reviews the basic concepts of account- ing, and Chapter 4 demonstrates the techniques of financial statement analysis.

We have said that the financial manager’s task is to make investment and financing decisions that add value for the firm’s shareholders. But that statement opens up a treasure chest of follow-up questions that will occupy us from Chapter 4 onward:

∙ How do I calculate the value of a stream of future cash flows? A dollar that you receive today is worth more than the promise of a dollar in 10 or 20 years’ time. So, when measuring the effect of a new project on firm value, the financial manager needs to recognize the timing of the cash flows. In Chapters 5 through 10, we show how to calculate the present value of an investment that produces a stream of future cash flows. We begin by calculating the present value of bonds and stocks and then look at how to value the cash flows resulting from capital investment projects. Present value is a workhorse concept of corporate finance that shows up in almost every chapter.

∙ How do I measure risk? In Chapters 5 through 10, we largely ignore the issue of risk. But risky cash flows are less valuable than safe ones. In Chapters 11, 12, and 13, we look at how to measure risk and how it affects present values.

∙ Where does financing come from? Broadly speaking, it comes from borrowing or from cash invested or reinvested by stockholders. But financing can get complicated when you get down to specifics. Chapter 14 gives an overview of the sources of finance. Chapters 15, 16, and 17 then look at how companies sell their securities to investors, the choice between debt and equity, and the decision to pay out cash to stockholders.

∙ How do I ensure that the firm’s financial decisions add up to a sensible whole? There are two parts to this question. The first is concerned with making sure that the firm can finance its future growth strategy. This is the role of long-term planning. The second is concerned with ensuring that the firm has a sensible plan for managing and financing its short-term assets such as cash, inventories, and money due from customers. We cover long- and short-term planning in Chapters 18, 19, and 20.

∙ What about some of those other responsibilities of the financial manager that you mentioned earlier? Not all of the financial manager’s responsibilities can be classified simply as an investment decision or a financing decision. In Chapters 21 through 24, we review four such topics. First we look at mergers and acquisitions. Then we consider international financial management. All the financial problems of doing business at home are present overseas, but the international financial manager faces the additional complications created by multiple currencies, different tax systems, and special regulations imposed by foreign institutions and governments. Finally, we look at risk management and the specialized securities, including futures and options, which managers can use to hedge or lay off risks.

That’s enough material to start, but as you reflect on this chapter, you can see certain themes emerging that you will encounter again and again throughout this book:

1. Corporate finance is about adding value. 2. The opportunity cost of capital sets the standard for investments. 3. A safe dollar is worth more than a risky one. 4. Smart investment decisions create more value than smart financing decisions. 5. Good governance matters.

1.9 Snippets of Financial History Now let’s lighten up a little. In this book we are going to describe how financial decisions are made today. But financial markets also have an interesting history. Look at the nearby box, which lays out bits of this history, starting in prehistoric times, when the growth of bacteria anticipated the mathematics of compound interest, and continu- ing nearly to the present. We have keyed each of these episodes to the chapter of the book that discusses its topic.

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undertaking of great advantage but nobody to know what it is.” Within 5 hours he had raised £2,000; within 6 hours he was on his way out of the country. Readers nearly two cen- turies later could only wonder at the naïve or foolhardy investors in these ventures—that is, until they had a chance to participate in the follies unearthed by the financial crisis of 2008–2009. (Chapter 2)

1792 Formation of the New York Stock Exchange The New York Stock Exchange (NYSE) was founded in 1792 when a group of brokers met under a buttonwood tree* and arranged to trade shares with one another at agreed rates of commission. Today the NYSE is the largest stock exchange in the world, trading on average about 1.5 billion shares a day. (Chapter 7)

1929 Stock Market Crashes Common stocks are risky invest- ments. In September 1929 stock prices in the United States reached an all-time high, and the economist Irving Fisher forecast that they were at “a permanently high pla- teau.” Some 3 years later, stock prices were almost 90% lower, and it was to be a quarter of a century before the prices of September 1929 were seen again. Eighty years later, history came close to repeating itself. After stock prices peaked in July 2007, they slumped over the next 20 months by 54%. (Chapter 11)

1960s Eurodollar Market In the 1950s the Soviet Union trans- ferred its dollar holdings from the United States to a Russian-owned bank in Paris. This bank was best known by its telex address, eurobank, and consequently dollars held outside the United States came to be known as euro- dollars. In the 1960s, U.S. taxes and regulation made it much cheaper to borrow and lend dollars in Europe than in the United States, and a huge market in eurodollars arose. (Chapter 14)

1971 Corporate Bankruptcies Every generation of investors is shocked and surprised by a major corporate bankruptcy. In 1971 the Penn Central Railroad, a pillar of American industry, suddenly collapsed. At that time, it was the larg- est corporate bankruptcy in history. In 2008, the invest- ment bank Lehman Brothers smashed Penn Central’s record. (Chapter 16)

1972 Financial Futures Financial futures allow companies to protect themselves against fluctuations in interest rates, exchange rates, and so on. It is said that they originated from a remark by the economist Milton Friedman that he was unable to profit from his view that sterling (the U.K. currency) was overpriced. The Chicago Mercantile Exchange founded the first financial futures market. Today futures exchanges trade 6 billion contracts a year of financial futures. (Chapter 24)

1986 Capital Investment Decisions The largest investment project undertaken by a single private company was the construction of the tunnel under the English Channel. This started in 1986 and was completed in 1994 at a total cost of $15 billion. The cost of the Gorgon natural gas project in Australia is estimated at $54 billion. (Chapters 8, 9)

1988 Mergers The 1980s saw a wave of takeovers culminat- ing in the $25 billion takeover of RJR Nabisco. Over a

Date unknown Compound Growth Bacteria start to propa- gate by subdividing. They thereby demonstrate the power of compound growth. (Chapter 5)

c. 1800 b.c. Interest Rates In Babylonia, Hammurabi’s Code established maximum interest rates on loans. Borrowers often mortgaged their property and sometimes their spouses, but lenders were obliged to return spouses in good condition within 3 years. (Chapter 6)

c. 1000 b.c. Options One of the earliest recorded options is described by Aristotle. The philosopher Thales knew by the stars that there would be a great olive harvest, so, hav- ing a little money, he bought options for the use of olive presses. When the harvest came, Thales was able to rent the presses at great profit. Today financial managers need to be able to evaluate options to buy or sell a wide variety of assets. (Chapter 23)

15th century International Banking Modern international banking had its origins in the great Florentine banking houses. But the entire European network of the Medici empire employed only 57 people in eight offices. Today the London-based bank HSBC has around 260,000 employees in 71 different countries. (Chapter 14)

1650 Futures Futures markets allow companies to protect themselves against fluctuations in commodity prices. During the Tokugawa era in Japan, feudal lords collected rents in the form of rice, but often they wished to trade their future rice deliveries. Rice futures therefore came to be traded on what was later known as the Dojima Rice Market. Rice futures are still traded, but now companies can also trade in futures on a range of items from pork bel- lies to stock market indexes. (Chapter 24)

17th century Joint Stock Corporations Although investors have for a long time combined together as joint owners of an enterprise, the modern corporation with a large num- ber of stockholders originated with the formation in England of trading firms like the East India Company (est. 1599). (Chapter 15)

17th century Money America has been in the forefront in the development of new types of money. Early settlers often used a shell known as wampum. For example, Peter Stuyvesant raised a loan in wampum, and in Massachu- setts it was legal tender. Unfortunately, the enterprising settlers found that with a little dye the relatively common white wampum shells could be converted profitably into the more valuable black ones, which confirmed Gresham’s law that bad money drives out good. The first issue of paper money in America was by the Massachusetts Bay Colony in 1690, and other colonies soon set their printing presses to producing money. In 1862 Congress agreed to an issue of paper money that would be legal tender. These notes, printed in green ink, immediately became known as “greenbacks.” (Chapters 19, 20)

1720 New-Issue Speculation From time to time investors have been tempted by speculative new issues. During the South Sea Bubble in England, one company was launched to develop perpetual motion. Another enterpris- ing individual announced a company “for carrying on an

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eight other countries. This is not the first time that different countries have agreed on a common currency. In 1865 France, Belgium, Switzerland, and Italy came together in the Latin Monetary Union, and they were joined by Greece and Romania the following year. Members of the European Monetary Union (EMU) hope that the euro will be a longer- lasting success than this earlier experiment. As we write this in early 2016, the euro appears to have weathered the worst of the crisis caused by the Greek government’s debt default. (Chapter 23)

2002 Financial Scandals A seemingly endless series of financial and accounting scandals climaxed in this year. Resulting bankruptcies included the icons Enron (and its accounting firm, Arthur Andersen), WorldCom, and the Italian food company Parmalat. Congress passed the Sarbanes-Oxley Act to increase the accountability of cor- porations and executives. (Chapters 1, 14)

2007–2009 Subprime Mortgages Subprime mortgages are housing loans made to homeowners with shaky credit standing. After a decade in which housing prices had con- sistently gone up, lenders became complacent about the risks of these home loans and progressively loosened lending standards. When housing prices stalled and inter- est rates increased in 2007, many of these loans went bad. Some large banks such as Lehman Brothers went to the wall, while others such as Wachovia and Merrill Lynch were rescued with the aid of government money. (Chapters 2, 14)

2011 Defaults on Sovereign Debt By 2010 the Greek govern- ment had amassed a huge $460 billion of debt. Other eurozone governments and the International Monetary Fund (IMF) rushed to Greece’s aid, but their assistance was insufficient, and in 2011 the Greek government defaulted on $100 billion of debt. It was the largest-ever sovereign default. Investors nervously eyed other highly indebted eurozone countries. (Chapter 2)

* The American sycamore, Planatus occidentalis.

period of 6 weeks, three groups battled for control of the company. As one of the contestants put it, “We were charging through the rice paddies, not stopping for anything and taking no prisoners.” The takeover was the largest in history and generated almost $1 billion in fees for the banks and advisers. (Chapter 21)

1993 Inflation Financial managers need to recognize the effect of inflation on interest rates and on the profitability of the firm’s investments. In the United States inflation has been relatively modest, but some countries have suffered from hyperinflation. In Hungary after World War II, the gov- ernment issued banknotes worth 1,000 trillion pengoes. In Yugoslavia in October 1993, prices rose by nearly 2,000% and a dollar bought 105 million dinars. The inflation rate in Venezuela in late 2015 was about 180%. (Chapter 5)

1780 and 1997 Inflation-Indexed Debt In 1780, Massachu- setts paid Revolutionary War soldiers with interest- bearing notes rather than its rapidly eroding currency. Interest and principal payments on the notes were tied to the subse- quent rate of inflation. After a 217-year hiatus, the U.S. Treasury issued inflation-indexed notes called TIPS (Treasury Inflation Protected Securities). Many other coun- tries, including Britain and Israel, had done so previously. (Chapter 6)

1993 Controlling Risk When a company fails to keep close tabs on the risks being taken by its employees, it can get into serious trouble. This was the fate of Barings, a 220-year-old British bank that numbered the queen among its clients. In 1993 it discovered that Nick Leeson, a trader in its Singapore office, had hidden losses of $1.3 billion (£869 million) from unauthorized bets on the Japanese equity market. The losses wiped out Barings and landed Leeson in jail, with a 6-year sentence. In 2008 a rogue trader at Morgan Stanley established a new record by los- ing $9 billion on unauthorized deals. (Chapter 24)

1999 The Euro Large corporations do business in many currencies. In 1999 a new currency came into existence when 11 European countries adopted the euro in place of their separate currencies. They have since been joined by

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SUMMARY Financial management can be broken down into (1) the investment or capital budgeting decision and (2) the financing decision. The firm has to decide (1) which real assets to invest in and (2) how to raise the funds necessary to pay for those investments.

Real assets include all assets used in the production or sale of the firms’ products or services. They can be tangible (plant and equipment, for example) or intangible (patents or trademarks, for example). In contrast, financial assets (such as stocks or bonds) are claims on the income generated by real assets.

Corporations are distinct, permanent legal entities. They allow for separation of owner- ship and control, and they can continue operating without disruption even as management or ownership changes. They provide limited liability to their owners. On the other hand,

What are the two major decisions made by financial managers? (LO1-1)

What does “real asset” mean? (LO1-2)

What are the advantages and disadvantages of forming a corporation? (LO1-3)

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26 Part One Introduction

managing the corporation’s legal machinery is costly. Also, corporations are subject to double taxation, because they pay taxes on their profits and the shareholders are taxed again when they receive dividends or sell their shares at a profit.

Almost all managers are involved to some degree in investment decisions, but some man- agers specialize in finance, for example, the treasurer, controller, and CFO. The treasurer is most directly responsible for raising capital and maintaining relationships with banks and investors that hold the firm’s securities. The controller is responsible for preparing financial statements and managing budgets. In large firms, a chief financial officer oversees both the treasurer and the controller and is involved in financial policymaking and corporate planning.

Value maximization is the natural financial goal of the firm. Shareholders can invest or consume the increased wealth as they wish, provided that they have access to well-functioning financial markets.

Companies either can invest in real assets or can return the cash to shareholders, who can invest it for themselves. The return that shareholders can earn for themselves is called the opportunity cost of capital. Companies create value for shareholders whenever they can earn a higher return on their investments than the opportunity cost of capital.

Conflicts of interest between managers and stockholders can lead to agency problems and agency costs. Agency problems are kept in check by financial controls, by well- designed compensation packages for managers, and by effective corporate governance.

Shareholders do not want the maximum possible stock price; they want the maximum honest price. But there need be no conflict between value maximization and ethical behav- ior. The surest route to maximum value starts with products and services that satisfy customers. A good reputation with customers, employees, and other stakeholders is important for the firm’s long-run profitability and value.

Who are the principal financial managers in a corporation? (LO1-4)

Why does it make sense for corporations to maximize shareholder wealth? (LO1-5)

What is the fundamental trade-off in investment decisions? (LO1-5)

How do corporations ensure that managers act in the interest of stockholders? (LO1-6) Is value maximization ethical? (LO1-7)

QUESTIONS AND PROBLEMS 1. Vocabulary Check. Choose the term within the parentheses that best matches each of the

following descriptions. (LO1-1–LO1-7) a. Expenditure on research and development (financing decision / investment decision) b. A bank loan (real asset / financial asset) c. Listed on a stock exchange (closely held corporation / public corporation) d. Has limited liability (partnership / corporation) e. Responsible for bank relationships (the treasurer / the controller) f. Agency cost (the cost resulting from conflicts of interest between managers and shareholders

/ the amount charged by a company’s agents such as the auditors and lawyers)

2. Financial Decisions. Which of the following are investment decisions, and which are financing decisions? (LO1-1) a. Should we stock up with inventory ahead of the holiday season? b. Do we need a bank loan to help buy the inventory? c. Should we develop a new software package to manage our inventory? d. With a new automated inventory management system, it may be possible to sell off our

Birdlip warehouse. e. With the savings we make from our new inventory system, it may be possible to increase

our dividend. f. Alternatively, we can use the savings to repay some of our long-term debt.

3. Financial Decisions. What is the difference between capital budgeting decisions and capital structure decisions? (LO1-1)

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Chapter 1 Goals and Governance of the Corporation 27

4. Real versus Financial Assets. Which of the following are real assets, and which are financial? (LO1-2) a. A share of stock b. A personal IOU c. A trademark d. A truck e. Undeveloped land f. The balance in the firm’s checking account g. An experienced and hardworking sales force h. A bank loan agreement

5. Real and Financial Assets. Read the following passage and fit each of the following terms into the most appropriate space: financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names. (LO1-2)

Companies usually buy _____ assets. These include both tangible assets such as _____ and intangible assets such as _____. To pay for these assets, they sell _____ assets such as _____. The decision about which assets to buy is usually termed the _____ or _____ decision. The decision about how to raise the money is usually termed the _____ decision.

6. Corporations. Choose in each case the type of company that best fits the description. (LO1-3) a. The business is owned by a small group of investors. (private corporation / public

corporation) b. The business does not pay income tax. (private corporation / partnership) c. The business has limited liability. (sole proprietorship / public corporation) d. The business is owned by its shareholders. (partnership / public corporation)

7. Corporations. What do we mean when we say that corporate income is subject to double taxation? (LO1-3)

8. Corporations. Which of the following statements always apply to corporations? (LO1-3) a. Unlimited liability b. Limited life c. Ownership can be transferred without affecting operations d. Managers can be fired with no effect on ownership

9. Corporations. What is limited liability, and who benefits from it? (LO1-3) 10. Corporations. Which of the following are correct descriptions of large corporations? (LO1-3)

a. Managers no longer have the incentive to act in their own interests. b. The corporation survives even if managers are dismissed. c. Shareholders can sell their holdings without disrupting the business. d. Corporations, unlike sole proprietorships, do not pay tax; instead, shareholders are taxed on

any dividends they receive.

11. Corporations. Is limited liability always an advantage for a corporation and its shareholders? (Hint: Could limited liability reduce a corporation’s access to financing?) (LO1-3)

12. Financial Managers. Which of the following statements more accurately describes the treasurer than the controller? (LO1-4) a. Monitors capital expenditures to make sure that they are not misappropriated b. Responsible for investing the firm’s spare cash c. Responsible for arranging any issue of common stock d. Responsible for the company’s tax affairs

13. Financial Managers. Explain the differences between the CFO’s responsibilities and the treasurer’s and controller’s responsibilities. (LO1-4)

14. Goals of the Firm. Give an example of an action that might increase short-run profits but at the same time reduce stock price and the market value of the firm. (LO1-5)

15. Cost of Capital. Why do financial managers refer to the opportunity cost of capital? How would you find the opportunity cost of capital for a safe investment? (LO1-5)

16. Goals of the Firm. You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize

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28 Part One Introduction

stock price should be less subject to an overemphasis on short-term results than one that simply maximizes profits. (LO1-5)

17. Goals of the Firm. Fritz is risk-averse and is content with a relatively low but safe return on his investments. Frieda is risk-tolerant and seeks a very high rate of return on her invested savings. Yet both shareholders will applaud a high-risk capital investment if it offers a superior rate of return. Why? What is meant by “superior”? (LO1-5)

18. Goals of the Firm. We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal? (LO1-5) a. The firm adds a cost-of-living adjustment to the pensions of its retired employees. b. The firm reduces its dividend payment, choosing to reinvest more earnings in the business. c. The firm buys a corporate jet for its executives. d. The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5.

19. Goals of the Firm. Fill in the blanks in the following passage by choosing the most appropriate term from the following list (some of the terms may be used more than once or not used at all): expected return, financial assets, lower, market value, higher, opportunity cost of capital, real assets, dividend, shareholders. (LO1-5)

Shareholders want managers to maximize the _____ of their investments. The firm faces a trade-off. Either it can invest its cash in _____ or it can give the cash back to _____ in the form of a(n) _____ and they can invest it in _____. Shareholders want the company to invest in _____ only if the _____ is _____ than they could earn for themselves in equivalent risk investments. The return that shareholders could earn for themselves is therefore the _____ for the firm.

20. Goals of the Firm. Explain why each of the following may not be appropriate corporate goals. (LO1-5) a. Increase market share b. Minimize costs c. Underprice any competitors d. Expand profits

21. Goals of the Firm. We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example, the manager might do the following:  a. Make shareholders as wealthy as possible by investing in real assets. b. Modify the firm’s investment plan to help shareholders achieve a particular time pattern of

consumption. c. Choose high- or low-risk assets to match shareholders’ risk preferences. d. Help balance shareholders’ checkbooks.

However, in well-functioning capital markets, shareholders will vote for only one of these goals. Which one will they choose? (LO1-5)

22. Cost of Capital. British Quince comes across an average-risk investment project that offers a rate of return of 9.5%. This is less than the company’s normal rate of return, but one of Quince’s directors notes that the company can easily borrow the required investment at 7%. “It’s simple,” he says. “If the bank lends us money at 7%, then our cost of capital must be 7%. The project’s return is higher than the cost of capital, so let’s move ahead.” How would you respond? (LO1-5)

23. Cost of Capital. In a stroke of good luck, your company has uncovered an opportunity to invest for 10 years at a guaranteed 6% rate of return. How would you determine the opportunity cost of capital for this investment? (LO1-5)

24. Cost of Capital. Pollution Busters Inc. is considering a purchase of 10 additional carbon sequesters for $100,000 apiece. The sequesters last for only 1 year before becoming saturated. Then the carbon is sold to the government. (LO1-5) a. Suppose the government guarantees the price of carbon. At this price, the payoff after 1 year

is $115,000 for sure. How would you determine the opportunity cost of capital for this investment?

b. Suppose instead that the sequestered carbon has to be sold on the London Carbon Exchange. Carbon prices have been extremely volatile, but Pollution Busters’ CFO learns that average rates of return from investments on that exchange have been about 20%. She thinks this is a

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Chapter 1 Goals and Governance of the Corporation 29

reasonable forecast for the future. What is the opportunity cost of capital in this case? Is the purchase of additional sequesters a worthwhile capital investment?

25. Goals of the Firm. It is sometimes suggested that instead of seeking to maximize shareholder value and, in the process, pursuing profit, the firm should seek to maximize the welfare of all its stakeholders, such as its employees, its customers, and the community in which it operates. How far would this objective conflict with one of maximizing shareholder value? Do you think such an objective is feasible or desirable? (LO1-5)

26. Agency Issues. Many firms have devised defenses that make it much more costly or difficult for other firms to take them over. How might such takeover defenses affect the firm’s agency prob- lems? Are managers of firms with formidable takeover defenses more or less likely to act in the firm’s interest rather than their own? (LO1-6)

27. Agency Issues. Sometimes lawyers work on a contingency basis. They collect a percentage of their clients’ settlements instead of receiving fixed fees. Why might clients prefer this arrange- ment? Would the arrangement mitigate an agency problem? Explain. (LO1-6)

28. Agency Issues. One of the “Finance through the Ages” episodes that we cited is the 1993 collapse of Barings Bank, when one of its traders lost $1.3 billion. Traders are compensated in large part according to their trading profits. How might this practice have contributed to an agency problem? (LO1-6)

29. Agency Issues. When a company’s stock is widely held, it may not pay an individual share- holder to spend time monitoring managers’ performance and trying to replace poor performers. Explain why. Do you think that a bank that has made a large loan to the company is in a different position? (LO1-6)

30. Agency Issues. Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock. Which company’s compensation package would most effectively mitigate conflicts of interest between managers and shareholders? (LO1-6)

31. Corporate Governance. How do clear and comprehensive financial reports promote effective corporate governance? (LO1-6)

32. Corporate Governance. Some commentators have claimed that the U.S. system of corporate governance is “broken” and needs thorough reform. What do you think? Do you see systematic failures in corporate governance or just a few “bad apples”? (LO1-6)

33. Agency Issues. Which of the following forms of compensation is most likely to align the inter- ests of managers and shareholders? (LO1-6) a. A fixed salary b. A salary linked to company profits c. A salary that is paid partly in the form of the company’s shares

34. Agency Costs. What are agency costs? List some ways by which agency costs are mitigated. (LO1-6)

35. Reputation. As you drive down a deserted highway, you are overcome with a sudden desire for a hamburger. Fortunately, just ahead are two hamburger outlets; one is owned by a national brand, and the other appears to be owned by “Joe.” Which outlet has the greater incentive to serve you cat meat? Why? (LO1-7)

36. Ethics. In some countries, such as Japan and Germany, corporations develop close long-term rela- tionships with one bank and rely on that bank for a large part of their financing needs. In the United States, companies are more likely to shop around for the best deal. Do you think that this practice is more or less likely to encourage ethical behavior on the part of the corporation? (LO1-7)

37. Ethics. Is there a conflict between “doing well” and “doing good”? In other words, are policies that increase the value of the firm (doing well) necessarily at odds with socially responsible policies (doing good)? When there are conflicts, how might government regulations or laws tilt the firm toward doing good? For example, how do taxes or fees charged on pollutants affect the firm’s decision to pollute? Can you cite other examples of “incentives” used by governments to align private interests with public ones? (LO1-7)

38. Ethics. Look at some of the practices described in the Finance in Practice box on ethic disputes in finance. What, if any, do you believe are the ethical issues involved? (LO1-7)

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30 Part One Introduction

SOLUTIONS TO SELF-TEST QUESTIONS 1.1 a. The development of a microprocessor is a capital budgeting decision. The investment of

$1 billion will purchase a real asset, the microprocessor design and production facilities. b. The bank loan is a financing decision. This is how BMW will raise money for its

investment. c. Capital budgeting. d. Capital budgeting. The marketing campaign should generate a real, though intangible,

asset. e. Both. The acquisition is an investment decision. The decision to issue shares is a financing

decision. 1.2 a. A real asset. Real assets can be intangible assets.

b. Financial. c. Real. d. Financial. e. Real. f. Financial.

1.3 Fritz would more likely be the treasurer and Frieda the controller. The treasurer raises money from the financial markets and requires a background in financial institutions. The controller requires a background in accounting.

1.4 There is no reason for the Hotspurs to avoid high-dividend stocks, even if they wish to invest for tuition bills in the distant future. Their concern should be only with the risk and expected return of the shares. If a particular stock pays a generous cash dividend, they always have the option of reinvesting the dividend in that stock or, for that matter, in other securities. The dividend payout does not affect their ability to redirect current investment income to their future needs as they plan for their anticipated tuition bills.

1.5 Because investors can reasonably expect a 15% return in other investments in palladium, the firm should take this as the opportunity cost of capital for its proposed investment. Although the project is expected to show an accounting profit, its expected return is only 12%. Therefore, the firm should reject the project: Its expected return is less than the 15% expected return offered by equivalent-risk investments.

1.6 Agency problems arise when managers and shareholders have different objectives. Managers may empire-build with excessive investment and growth. Managers may be unduly risk- averse, or they may try to take excessive salaries or perquisites.

1.7 Harry’s has a far bigger stake in the reputation of its business than Victor’s. The store has been in business for a long time. The owners have spent years establishing customer loyalty. In contrast, Victor’s has just been established. The owner has little of his own money tied up in the firm, and so has little to lose if the business fails. In addition, the nature of the business results in little customer loyalty. Harry’s is probably more reliable.

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32

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LEARNING OBJECTIVES

After studying this chapter, you should be able to:

2-1 Understand how financial markets and institutions channel savings to corporate investment.

2-2 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds.

2-3 Explain the functions of financial markets and institutions.

2-4 Understand the main events behind the financial crisis of 2007–2009 and the subsequent eurozone crisis.

C H A P T E R

2 Financial Markets and Institutions

R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D I N C O N N E C T.

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I f a corporation needs to issue more shares of stock, then its financial manager had better understand how the stock market works. If it wants to take out a bank

loan, the financial manager had better understand how banks and other financial institutions work. If the firm contemplates a capital investment, such as a factory expansion or a new product launch, the financial man- ager needs to think clearly about the cost of the capital that the firm raises from outside investors. As we pointed out in Chapter 1, the opportunity cost of capital for the firm is the rate of return that its stockholders expect to get by investing on their own in financial markets. This means that the financial manager must understand how prices are determined in the financial markets in order to make wise investment decisions.

Financial markets and institutions are the firm’s finan- cial environment. You don’t have to know everything about that environment to begin the study of financial

management, but a general understanding provides useful context for the work ahead. For example, it will help you to understand why you are calculating the yield to maturity of a bond in Chapter 6, the net present value of a capital investment in Chapter 9, or the weighted-average cost of capital for a company in Chapter 13.

This chapter does three things. First, it surveys finan- cial markets and institutions. We will cover the stock and bond markets, banks and insurance companies, and mutual and pension funds. Second, we will set out the functions of financial markets and institutions and look at how they help corporations and the economy. Third, we will discuss the financial crisis of 2007–2009 and the eurozone crisis that followed. An understanding of what happens when financial markets do not function well is important for understanding why and how finan- cial markets and institutions matter.

Read this chapter before you visit the New York Stock Exchange. Alexander Baxevanis/Flickr/CC BY 2.0

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The Importance of Financial Markets and Institutions

In the previous chapter, we explained why corporations need to be good at finance in order to survive and prosper. All corporations face important investment and financing decisions. But, of course, those decisions are not made in a vacuum. They are made in a financial environment. That environment has two main segments: financial markets and financial institutions.

Businesses have to go to financial markets and institutions for the financing they need to grow. When they have a surplus of cash, and no need for immediate financing, they have to invest the cash, for example, in bank accounts or in securities. Let’s take Apple Computer Inc. as an example.

Table 2.1 presents a time line for Apple and examples of the sources of financing tapped by Apple from its start-up in a California garage in 1976 to its cash-rich status in 2016. The initial investment in Apple stock was $250,000. Apple was also able to get short-term financing from parts suppliers who did not demand immediate payment. Apple got the parts, assembled and sold the computers, and afterward paid off its accounts payable to the suppliers. (We discuss accounts payable in Chapter 19.) Then,

2.1

TABLE 2.1 Examples of financing decisions by Apple Computer

April 1976: Apple Computer Inc. founded

Mike Makkula, Apple’s first chairman, invests $250,000 in Apple shares.

1976: First 200 computers sold

Parts suppliers give Apple 30 days to pay. (Financing from accounts payable.)

1978–79 Apple raises $3.5 million from venture capital investors. December 1980: Initial public offering

Apple raises $91 million, after fees and expenses, by selling shares to public investors.

May 1981 Apple sells 2.6 million additional shares at $31.25 per share. April 1987 Apple pays its first dividend at an annual rate of $.12 per share. Early 1990s Apple carries out several share repurchase programs. 1994 Apple issues $300 million of debt at an interest rate of 6.5%. 1996–97: Apple reports a $740 million loss in the second quarter of 1996. Lays off 2,700 employees in 1997.

Dividend is suspended in February 1996. Apple sells $661 million of debt to private investors in June 1996. The borrowing provides “sufficient liquidity” to execute Apple’s strategic plans and to “return the company to profitability.”

September 1997: Acquires assets of Power Computing Corp.

Acquisition is financed with $100 million of Apple stock.

2004: Apple is healthy and profitable, thanks to iMac, iPod, and other products.

Apple pays off the $300 million in long-term debt issued in 1994, leaving the company with no long-term debt outstanding.

2005–13 Apple’s profits grow rapidly. It invests in marketable securities, which accumulate to $147 billion by June 2013.

2012–13 Apple announces plans to pay out $100 billion to shareholders over the next 3 years. It also borrows a record $17 billion.

2013–15 Apple’s Capital Return Program distributes cash to shareholders by paying dividends and repurchasing shares. The planned total distribution is $200 billion by 2017.

2015 Apple issues $14.5 billion in dollar-denominated debt, €4.8 billion in euro debt, as well as debt issued in U.K. pounds, Swiss francs, and Japanese yen.

February 2016 Apple’s market capitalization, the total market value of all its outstanding shares, is $521 billion, far in excess of the $119 billion cumulative investment by Apple’s shareholders. The cumulative investment includes $92 billion of retained earnings.

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as Apple grew, it was able to obtain several rounds of financing by selling Apple shares to private venture capital investors. (We discuss venture capital in Chapter 15.) In December 1980, it raised $91 million in an initial public offering (IPO) of its shares to public investors. There was also a follow-up share issue in May 1981.1

After Apple became a public company, it could raise financing from many sources, and it was able to pay for acquisitions by issuing more shares. We show a few exam- ples in Table 2.1.

Apple started paying cash dividends to shareholders in 1987, and it also distributed cash to investors by stock repurchases in the early 1990s. But Apple hit a rough patch in 1996 and 1997, and regular dividends were eliminated. The company had to borrow $661 million from a group of private investors in order to cover its losses and finance its recovery plan. However, the rough patch ended with the release of the iMac in 1998 and the iPod in 2001. Apple’s profitability increased rapidly, and it was able to finance its growth by plowing back earnings into operations. These retained earnings had grown to $92 billion by September 2015.

As the twenty-first century progressed, Apple’s profits grew so fast that it piled up a cash mountain, which grew to more than $200 billion by 2016. It resumed cash divi- dends and started a massive program of share repurchases. Its Capital Return Program, which began in 2012, will distribute $200 billion in cash to its shareholders by 2017.

Apple is well known for its product innovations, including the Macintosh computer, the iPhone, and the iPad. Apple is not special because of financing. In fact, the story of its financing is not too different from that of many other successful companies. But access to financing was vital to Apple’s growth and profitability. Would we have iMac computers, iPhones, or iPads if Apple had been forced to operate in a country with a primitive financial system? Definitely not. A prosperous economy requires a well- functioning financial system.

A modern financial system offers financing in many different forms, depending on the company’s age, its growth rate, and the nature of its business. For example, Apple relied on venture capital financing in its early years and only later floated its shares in public stock markets. Still later, as the company matured, it turned to other forms of financing, including the examples given in Table 2.1. But the table does not begin to cover the range of financing channels open to modern corporations. We will encounter many other channels later in the book, and new channels are opening up regularly. The nearby box describes one recent financial innovation, micro-lending funds that make small loans to businesspeople in the poorer parts of the world.

The Flow of Savings to Corporations

The money that corporations invest in real assets comes ultimately from savings by investors. But there can be many stops on the road between savings and corpo- rate investment. The road can pass through financial markets, financial interme- diaries, or both.

Let’s start with the simplest case of a small, closely held corporation, like Apple in its earliest years. The orange arrows in Figure 2.1 show the flow of savings from share- holders in this simple setting. There are two possible paths: The firm can sell new shares, or it can reinvest cash back into the firm’s operations. Reinvestment means additional savings by existing shareholders. The reinvested cash could have been paid out to those shareholders and spent by them on personal consumption. By not taking and spending the cash, shareholders have reinvested their savings in the corporation.

2.2

1 Many of the shares sold in the 1981 issue were previously held by Apple employees. Sale of these shares allowed the employees to cash out and diversify some of their Apple holdings but did not raise additional financing for Apple.

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The interest rates on these micro loans are relatively high; this is because the cost of writing and administering such small loans is high and the loans are made in nations with weak currencies. However, default rates on the loans are only about 4%. “There is a deep pride in keeping up with pay- ments,” says Deidre Wagner, an executive vice president of Starbucks, who invested $100,000 in a microfinance fund in 2003. “In some instances, when an individual is behind on payments, others in the village may make up the difference.” Investors and borrowers know that when the micro loans are repaid, the money gets recycled into new loans, giving still more borrowers a chance to move up the economic ladder.

Source: Adapted from Eric Uhlfelder, “Micro Loans, Solid Returns,” Business- Week, May 9, 2005, pp. 100–102.

Vahid Hujdur had dreams of opening his own business. With about $200 of his own money and a $1,500 loan, he was able to rent space in the old section of Sarajevo, and he began repairing and selling discarded industrial sewing machines. After just 8 years, Hujdur has 10 employees building, installing, and fixing this industrial machinery. Hujdur didn’t get his initial loan from a local bank. “They were asking for guarantees that were impossible to get,” he recalls. Instead, the capital came from LOKmicro, a local financial institution specializing in microfinance—the lending of small amounts to the poor in developing nations to help them launch small enterprises.

Microfinance institutions get capital from individual and institutional investors via microfinance funds, which collect the investors’ money, vet the local lenders, offer them man- agement assistance, and administer investors’ accounts.

Finance in Practice Micro Loans, Solid Returns

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Cash retained and reinvested in the firm’s operations is cash saved and invested on behalf of the firm’s shareholders.

Of course, a small corporation has other financing choices. It could take out a bank loan, for example. The bank in turn may have raised money by attracting savings accounts. In this case, investors’ savings flow through the bank to the firm.

Now consider a large, public corporation, for example, Apple Computer in September 2015. What’s different? Scale, for one thing: Apple’s annual revenues for the previous 12 months were $234 billion, and its balance sheet showed total assets of $290 billion. The scope of Apple’s activities has also expanded: It now has dozens of product lines and operates worldwide. Because of this scale and scope, Apple attracts investors’ savings by a variety of different routes. It can do so because it is a large, profitable, public firm.

The flow of savings to large public corporations is shown in Figure 2.2. Notice two key differences from Figure 2.1. First, public corporations can draw savings from inves- tors worldwide. Second, the savings flow through financial markets, financial interme- diaries, or both. Suppose, for example, that Bank of America raises $900 million by a new issue of shares. An Italian investor buys 4,000 of the new shares for $15 per share. Now Bank of America takes that $60,000, along with money raised by the rest of the issue, and makes a $300 million loan to Apple. The Italian investor’s savings end up flowing through financial markets (the stock market), to a financial intermediary (Bank of America), and finally to Apple.

Of course, our Italian friend’s $60,000 doesn’t literally arrive at Apple in an enve- lope marked “From L. DaVinci.” Investments by the purchasers of the Bank of America’s stock issue are pooled, not segregated. Signor DaVinci would own a share of all of Bank of America’s assets, not just one loan to Apple. Nevertheless, investors’ savings are flowing through the financial markets and the bank to finance Apple’s capital investments.

FIGURE 2.1 Flow of savings to investment in a closely held corporation. Investors use savings to buy additional shares. Investors also save when the corporation reinvests on their behalf.

Investment in real assets

Corporation Shareholders

in closely held corporation

InvestorsCash raised from share issues

Cash reinvested

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The Stock Market A financial market is a market where securities are issued and traded. A security is just a traded financial asset, such as a share of stock. For a corporation, the stock mar- ket is probably the most important financial market.

As corporations grow, their requirements for outside capital can expand dramati- cally. At some point the firm will decide to “go public” by issuing shares on an orga- nized exchange such as the New York Stock Exchange (NYSE) or NASDAQ; that first issue is called an initial public offering or IPO. The buyers of the IPO are helping to finance the firm’s investment in real assets. In return, the buyers become part-owners of the firm and participate in its future success or failure. (Most investors in the Inter- net IPOs of 1999 and 2000 are by now sorely disappointed, but many IPOs pay off handsomely. If only we had bought Apple shares on their IPO day in 1980 .  .  .) Of course a corporation’s IPO is not its last chance to issue shares. For example, Bank of America went public in the 1930s, but it could make a new issue of shares tomorrow.

A new issue of shares increases both the amount of cash held by the company and the number of shares held by the public. Such an issue is known as a primary issue, and it is sold in the primary market. But in addition to helping companies raise new cash, financial markets also allow investors to trade securities among themselves. For example, Smith might decide to raise some cash by selling her Apple stock at the same time that Jones invests his spare cash in Apple. The result is simply a transfer of own- ership from Smith to Jones, which has no effect on the company itself. Such purchases and sales of existing securities are known as secondary transactions, and they take place in the secondary market. Notice that Smith and Jones might be less happy for Apple to raise new capital and invest in long-term projects if they could not sell their stock in the secondary market when they needed the cash for personal use.

Stock markets are also called equity markets because stockholders are said to own the common equity of the firm. You will hear financial managers refer to the capital structure decision as “the choice between debt and equity financing.”

Now may be a good time to stress that the financial manager plays on a global stage and needs to be familiar with markets around the world. For example, Apple’s stock is traded on the NASDAQ market and also in Germany on the Deutsche Börse. China Telecom, Deutsche Bank, Ferrari, Novartis, Petrobras (Brazil), Sony, Unilever, Man- chester United football club, and more than 500 other overseas firms have listed their shares on the NYSE. We return to the trading and pricing of shares in Chapter 7.

financial market Market where securities are issued and traded.

primary market Market for the sale of new securities by corporations.

secondary market Market in which previously issued securities are traded among investors.

FIGURE 2.2 Flow of savings to investment for a large, public corporation. Savings come from investors worldwide. The savings may flow through financial markets or financial intermediaries. The corporation also reinvests on shareholders’ behalf.

Stock markets Fixed-income markets Money markets

Financial Markets

Mutual Funds Pension funds

Financial Intermediaries

Banks Insurance companies

Financial Institutions

Investors WorldwideInvestment

in real assets

Corporation Reinvestment

BEYOND THE PAGE

mhhe.com/brealey9e

Stock exchanges: From clubs to commercial businesses

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Other Financial Markets Debt securities as well as equities are traded in financial markets. The Apple bond issue in 1994 was sold publicly to investors (see Table 2.1). Table 1.1 in the previous chapter also gives examples of debt issues, including issues by Virgin Atlantic and Entergy Arkansas.

A few corporate debt securities are traded on the NYSE and other exchanges, but most corporate debt securities are traded over the counter, through a network of banks and securities dealers. Government debt is also traded over the counter.

A bond is a more complex security than a share of stock. A share is just a propor- tional ownership claim on the firm, with no definite maturity. Bonds and other debt securities can vary in maturity, in the degree of protection or collateral offered by the issuer, and in the level and timing of interest payments. Some bonds make “floating” interest payments tied to the future level of interest rates. Many can be “called” (repur- chased and retired) by the issuing company before the bonds’ stated maturity date. Some bonds can be converted into other securities, usually the stock of the issuing company. You don’t need to master these distinctions now; just be aware that the debt or fixed-income market is a complicated and challenging place. A corporation must not only decide between debt and equity finance. It must also consider the design of debt. We return to the trading and pricing of debt securities in Chapter 6.

The markets for long-term debt and equity are called capital markets. A firm’s capital is its long-run financing. Short-term securities are traded in the money markets. “Short term” means less than 1 year. For example, large, creditworthy corporations raise short-term financing by issues of commercial paper, which are debt issues with maturities of no more than 270 days. Commercial paper is issued in the money market.

fixed-income market Market for debt securities.

capital market Market for long-term financing.

money market Market for short-term financial assets.

Do you understand the following distinctions? Briefly explain in each case.

a. Primary market vs. secondary market. b. Capital market vs. money market. c. Stock market vs. fixed-income market.

Self-Test

The financial manager regularly encounters other financial markets. Here are three examples, with references to the chapters where they are discussed:

∙ Foreign exchange markets (Chapter 22). Any corporation engaged in international trade must be able to transfer money back and forth between dollars and other currencies. Foreign exchange is traded over the counter through a network of the largest international banks.

∙ Commodities markets (Chapter 24). Dozens of commodities are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange. You can buy or sell corn, wheat, cotton, fuel oil, natural gas, copper, silver, platinum, and so on.

∙ Markets for options and other derivatives (Chapters 23 and 24). Derivatives are securities whose payoffs depend on the prices of other securities or commodities. For example, you can buy an option to purchase IBM shares at a fixed price on a fixed future date. The option’s payoff depends on the price of IBM shares on that date. Commodities can be traded by a different kind of derivative security called a futures contract.

2.1

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Trump contracts declined. But as it became clear that Trump was headed toward a big victory in the New York primary in April, the price of Trump contracts dramatically recovered.

The red line in the figure is for “Rest of field” (i.e., a con- tract that will pay off $1 if anyone other than the named candi- dates in the figure wins the nomination). The 20 cent price for this contract in early April is evidence that even at this late date, there was meaningful uncertainty about the prospects for a contested convention in which someone other than the current leaders would be selected as the Republican candi- date. By May, however, Trump futures were selling for $.92, and the "Rest of field" price had fallen to $.06.

Participants in prediction markets are putting their money where their mouth is. So the forecasting accuracy of these markets compares favorably with that of major polls. Some businesses have formed internal prediction markets to survey the views of their staff. For example, Google operates an internal market to forecast product launch dates, the number of Gmail users, and other strategic questions.*

* Google’s experience is analyzed in B. Cowgill, J. Wolfers, and E. Zitzewitz, “Using Prediction Markets to Track Information Flows: Evidence from Google,” working paper, Dartmouth College, January 2009.

Stock markets allow investors to bet on their favorite stocks. Prediction markets allow them to bet on almost anything else. These markets reveal the collective guess of traders on issues as diverse as New York City snowfall, an avian flu out- break, and the occurrence of a major earthquake.

Prediction markets are conducted on a number of online exchanges such as PredictIt (www.predictit.org) and Iowa Elec- tronic Markets (tippie.uiowa.edu/iem). Take the 2016 presiden- tial primaries as an example. On the Iowa Electronic Markets you could have bet that Donald Trump would win the Republi- can nomination by buying one of his contracts. Each Trump contract promised to pay $1 if he won the nomination and noth- ing if he lost. If you thought that the probability of a Trump vic- tory was 55% (say), you would have been prepared to pay up to $.55 for his contract. Someone who was relatively pessimistic about Trump’s chances would have been happy to sell you such a contract because that sale would turn a profit if he were to lose. With many participants buying and selling, the market price of a contract revealed the collective wisdom of the crowd.

Take a look at the accompanying figure from the Iowa Electronic Markets. It shows the contract prices for the various contenders for the Republican nomination between January and May 2016. You can see that as Ted Cruz beat Trump in a series of primaries and caucuses during March, the price of

Finance in Practice Prediction Markets

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2016 U.S. Republican Convention Nomination Market

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Commodity and derivative markets are not sources of financing but markets where the financial manager can adjust the firm’s exposure to business risks. For example, an electric generating company may wish to lock in the future price of natural gas by trad- ing in commodity markets, thus eliminating the risk of a sudden jump in the price of its raw materials.

Wherever there is uncertainty, investors may be interested in trading, either to spec- ulate or to lay off their risks, and a market may arise to meet that trading demand. In recent years, several smaller markets have been created that allow punters to bet on a single event. The nearby box discusses how prices in these markets can reveal people’s predictions about the future.

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Financial Intermediaries A financial intermediary is an organization that raises money from investors and provides financing for individuals, companies, and other organizations. For corpora- tions, intermediaries are important sources of financing. Intermediaries are a stop on the road between savings and real investment.

Why is a financial intermediary different from a manufacturing corporation? First, it may raise money in different ways, for example, by taking deposits or selling insur- ance policies. Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to businesses or individuals. In contrast, a manufacturing company’s main investments are in plant, equipment, or other real assets.

We will start with two important classes of intermediaries, mutual funds and pen- sion funds.

Mutual funds raise money by selling shares to investors. The investors’ money is pooled and invested in a portfolio of securities. Investors can buy or sell shares in mutual funds as they please, and initial investments are often $3,000 or less. Van- guard’s Explorer Fund, for example, held a portfolio of more than 700 stocks with a market value of about $10 billion in early 2016. An investor in Explorer can increase her stake in the fund’s portfolio by buying additional shares, and so gain a higher share of the portfolio’s subsequent dividends and price appreciation.2 She can also sell her shares back to the fund if she decides to cash out of her investment.3

The advantages of a mutual fund should be clear: Unless you are very wealthy, you cannot buy and manage a 700-stock portfolio on your own, at least not efficiently. Mutual funds offer investors low-cost diversification and professional manage- ment. For most investors, it’s more efficient to buy a mutual fund than to assem- ble a diversified portfolio of stocks and bonds.

Most mutual fund managers also try their best to “beat the market,” that is, to generate superior performance by finding the stocks with better-than-average returns. Whether they can pick winners consistently is another question, which we address in Chapter 7.

In exchange for their services, the fund’s managers take out a management fee. There are also the expenses of running the fund. For Explorer, fees and expenses absorb about .5% of portfolio value each year. This seems reasonable, but watch out: The typical mutual fund charges more than Explorer does. In some cases, fees and expenses add up to 2% per year. That’s a big bite out of your investment return.

Mutual funds are a stop on the road from savings to corporate investment. Suppose Explorer purchases part of the new issue of shares by Bank of America. Again we show the flow of savings to investment by orange arrows:

financial intermediary An organization that raises money from investors and provides financing for individuals, corporations, or other organizations.

mutual funds An investment company that pools the savings of many investors and invests in a portfolio of securities.

2 Mutual funds are not corporations but investment companies. They pay no tax, providing that all income from dividends and price appreciation is passed on to the funds’ shareholders. The shareholders pay personal tax on this income. 3 Explorer, like most mutual funds, is an open-end fund. It stands ready to issue shares to new investors in the fund and to buy back existing shares when its shareholders decide to cash out. The purchase and sale prices depend on the fund’s net asset value (NAV) on the day of purchase or redemption. Closed-end funds have a fixed number of shares traded on an exchange. If you want to invest in a closed-end fund, you must buy shares from another stockholder in the fund.

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U.S. mutual funds

There are about 8,000 mutual funds in the United States. In fact, there are more mutual funds than public companies! The funds pursue a wide variety of investment strategies. Some funds specialize in safe stocks with generous dividend payouts. Some specialize in high-tech growth stocks. Some “balanced” funds offer mixtures of stocks and bonds. Some specialize in particular countries or regions. For example, the Fidelity Investments mutual fund group sponsors funds for Canada, Japan, China, Europe, and Latin America.

Bank of America Explorer Fund Sells shares

$

Investors Issues shares

$

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Like mutual funds, hedge funds also pool the savings of different investors and invest on their behalf. But they differ from mutual funds in at least two ways. First, because hedge funds usually follow complex, high-risk investment strategies, access is usually restricted to knowledgeable investors such as pension funds, endowment funds, and wealthy individuals. Don’t try to send a check for $3,000 or $5,000 to a hedge fund; most hedge funds are not in the “retail” investment business. Second, hedge funds try to attract the most talented managers by compensating them with potentially lucrative, performance-related fees.4 In contrast, mutual funds usually charge a fixed percentage of assets under management.

Hedge funds follow many different investment strategies. Some try to make a profit by identifying overvalued stocks or markets and selling short. (We will not go into procedures for short-selling here. Just remember that short-sellers profit when prices fall.5) “Vulture funds” specialize in the securities of distressed corporations. Some hedge funds take bets on firms involved in merger negotiations, others look for mis- priced convertible bonds, and some take positions in currencies and interest rates. Hedge funds manage less money than mutual funds, but they sometimes take very big positions and have a large impact on the market.

There are other ways of pooling and investing savings. Consider a pension plan set up by a corporation or other organization on behalf of its employees. There are several types of pension plan. The most common type of plan is the defined-contribution plan. In this case, a percentage of the employee’s monthly paycheck is contributed to a pension fund. (The employer and employee may each contribute 5%, for example.) Contributions from all participating employees are pooled and invested in securities or mutual funds. (Usually the employees can choose from a menu of funds with different investment strategies.) Each employee’s balance in the plan grows over the years as contributions continue and investment income accumulates. The balance in the plan can be used to finance living expenses after retirement. The amount available for retirement depends on the accumulated contributions and on the rate of return earned on the investments.6

Pension funds are designed for long-run investment. They provide professional management and diversification. They also have an important tax advantage: Contri- butions are tax-deductible, and investment returns inside the plan are not taxed until cash is finally withdrawn.7

Pension plans are among the most important vehicles for savings. Total assets held by U.S. pension plans were about $15 trillion in 2015.

hedge funds Private investment fund that pursues complex, high-risk investment strategies.

pension fund Fund set up by an employer to provide for employees’ retirement.

4 Sometimes these fees can be very large indeed. For example, Forbes estimated that the top hedge fund man- ager in 2012 earned $2.2 billion in fees. 5 A short-seller borrows a security from another investor and sells it. Of course, the seller must sooner or later buy the security back and return it to its original owner. The short-seller earns a profit if the security can be bought back at a lower price than it was sold for. 6 In a defined-benefit plan, the employer promises a certain level of retirement benefits (set by a formula) and the employer invests in the pension plan. The plan’s accumulated investment value has to be large enough to cover the promised benefits. If not, the employer must put in more money. Defined-benefit plans are gradually giving way to defined-contribution plans. 7 Defined-benefit pension plans share these same advantages, except that the employer invests rather than the employees. In a defined-benefit plan, the advantage of tax deferral on investment income accrues to the employer. This deferral reduces the cost of funding the plan.

Individual investors can buy bonds and stocks directly, or they can put their money in a mutual fund or a defined-contribution pension fund. What are the advantages of the second strategy?  

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Financial Institutions Banks and insurance companies are financial institutions.8 A financial institution is an intermediary that does more than just pool and invest savings. Institutions raise financing in special ways, for example, by accepting deposits or selling insurance poli- cies, and they provide additional financial services. Unlike a mutual fund, they not only invest in securities but also lend money directly to individuals, businesses, or other organizations.

Commercial Banks There are about 5,400 commercial banks in the United States.9 They vary from giants such as JPMorgan Chase with $2.6 trillion of assets to relative dwarfs like Cambridge Bancorp with assets of $1.7 billion.

Commercial banks are major sources of loans for corporations. (In the United States, they are generally not allowed to make equity investments in corporations, although banks in most other countries can do so.) Suppose that a local forest products company negotiates a 9-month bank loan for $2.5 million. The flow of savings is:

financial institutions A bank, insurance company, or similar financial intermediary.

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The world’s largest banks

8 We may be drawing too fine a distinction between financial intermediaries and institutions. A mutual fund could be considered a financial institution. But “financial institution” usually suggests a more complicated inter- mediary, such as a bank. 9 Banks that accept deposits and provide financing mostly to businesses are called commercial banks. Savings banks and savings & loans (S&Ls) accept deposits and lend mostly to individuals, for example, as mortgage loans to home buyers. 10 Investment banks do not take deposits and do not lend money to businesses or individuals, except as bridge loans made as temporary financing for takeovers or other transactions. Investment banks are sometimes called merchant banks.

Company Bank

(Institution) Issues debt to bank

$2.5 million Investors

(Depositors) Accepts deposits

$2.5 million

The bank provides debt financing for the company and, at the same time, provides a place for depositors to park their money safely and withdraw it as needed.

Investment Banks We have discussed commercial banks, which raise money from depositors and other investors and then make loans to businesses and individuals. Investment banks are different. Investment banks do not generally take deposits or make loans to companies.10 Instead, they advise and assist companies in obtaining finance. For example, investment banks underwrite stock offerings by purchasing the new shares from the issuing company at a negotiated price and reselling the shares to investors. Thus the issuing company gets a fixed price for the new shares, and the investment bank takes responsibility for distributing the shares to investors. We dis- cuss share issues in more detail in Chapter 15.

Investment banks also advise on takeovers, mergers, and acquisitions. They offer investment advice and manage investment portfolios for individual and institutional investors. They run trading desks for foreign exchange, commodities, bonds, options, and other derivatives.

Investment banks can invest their own money in start-ups and other ventures. For example, the Australian Macquarie Bank has invested in airports, toll high- ways, electric transmission and generation, and other infrastructure projects around the world.

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The largest investment banks are financial powerhouses. They include Goldman Sachs, Morgan Stanley, Lazard, Nomura (Japan), and Macquarie Bank.11 In addition, the major commercial banks, including Bank of America and Citigroup, all have investment banking operations.12

Insurance Companies Insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations.

Suppose a company needs a loan of $2.5 million for 9 years, not 9 months. It could issue a bond directly to investors, or it could negotiate a 9-year loan with an insurance company:

11 The distinction between investment and commercial banks is not a legal one. Since 2008 both Goldman Sachs and Morgan Stanley have held banking licenses and are supervised by the Federal Reserve. However, they are not in the business of taking retail deposits or providing loans. 12 Bank of America owns Merrill Lynch, one of the largest investment banks. Merrill was rescued by Bank of America in 2009 after making huge losses from mortgage-related investments.

Company Insurance company

(Institution) Issues debt

$2.5 million Investors

(Policyholders) Sells policies

$2.5 million

The money to make the loan comes mainly from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company and get a financial asset (the policy) in exchange. You receive no interest payments on this financial asset, but if a fire does strike, the company is obliged to cover the dam- ages up to the policy limit. This is the return on your investment. (Of course, a fire is a sad and dangerous event that you hope to avoid. But if a fire does occur, you are better off getting a payoff on your insurance policy than not having insurance at all.)

The company will issue not just one policy but thousands. Normally the incidence of fires “averages out,” leaving the company with a predictable obligation to its policy- holders as a group. Of course, the insurance company must charge enough for its poli- cies to cover selling and administrative costs, pay policyholders’ claims, and generate a profit for its stockholders.

Total Financing of U.S. Corporations The pie chart in Figure 2.3 shows the investors in bonds and other debt securities. Notice the importance of institutional investors—mutual funds, pension funds, insur- ance companies, and banks. Households (individual investors) hold less than 5% of the debt pie. The other slices represent the rest of the world (investors from outside the United States) and other, smaller categories of investors.

The pie chart in Figure 2.4 shows holdings of the shares issued by U.S. corpora- tions. Here, households make a stronger showing, with 37.2% of the total. Pension

What are the key differences between a mutual fund and a bank or an insurance company?  

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funds, insurance companies, and mutual funds add up to 45.9% of the total. Remem- ber, banks in the United States do not usually hold stock in other companies. The rest- of-the-world slice is 16.0%.

The aggregate amounts represented in these figures are enormous. There is $11.9 trillion of debt behind Figure 2.3 and $34.1 trillion of equity behind Figure 2.4 ($34,100,000,000,000).

Chapter 14 reviews corporate financing patterns in more detail.

Functions of Financial Markets and Intermediaries

Financial markets and intermediaries provide financing for business. They channel savings to real investment. That much should be loud and clear from Sections 2.1 and 2.2 of this chapter. But there are other functions that may not be quite so obvious.

2.3

FIGURE 2.4 Holdings of corporate equities, September 30, 2015. The total amount is $34.1 trillion.

Insurance companies (5.8%)Rest of world

(16.0%)

Pension funds (13.8%)

Households (37.2%)

Mutual funds (26.3%)

Other (0.9%)

Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts, Table L.223 (www.federalreserve.gov).

FIGURE 2.3  Holdings of corporate and foreign bonds, September 30, 2015. The total amount is $11.9 trillion.

Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts, Table L.213 (www.federalreserve.gov).

Banks & savings institutions (6.0%)Rest of world

(25.4%)

Pension funds (10.7%)

Insurance companies (23.3%)

Mutual funds (24.8%)

Households (4.3%)

Other (5.6%)

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Transporting Cash across Time Individuals need to transport expenditures in time. If you have money now that you wish to save for a rainy day, you can (for example) put the money in a savings account at a bank and withdraw it with interest later. If you don’t have money today, say to buy a car, you can borrow money from the bank and pay off the loan later. Modern finance provides a kind of time machine. Lenders transport money forward in time; borrowers transport it back. Both are happier than if they were forced to spend income as it arrives. Of course, individuals are not alone in needing to raise cash from time to time. Firms with good investment opportunities, but a shortage of internally generated cash, raise cash by borrowing or selling new shares. Many governments run deficits and finance current outlays by issuing debt.

Young people saving for retirement may transport their current earnings 30 or 40 years into the future by means of a pension fund. They can even transport income to their heirs by purchase of a life insurance policy.

In principle, individuals or firms with cash surpluses could take out newspaper advertisements or surf the web looking for counterparties with cash shortages. But it is usually cheaper and more convenient to use financial markets and intermediaries. It is not just a matter of avoiding the cost of searching for the right counterparty. Follow-up is needed. For example, banks don’t just lend money and walk away. They monitor the borrower to make sure that the loan is used for its intended purpose and that the bor- rower’s credit stays solid.

Risk Transfer and Diversification Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. Insurance companies are an obvious example. When you buy homeowner’s insurance, you greatly reduce the risk of loss from fire, theft, or acci- dents. But your policy is not a very risky bet for the insurance company. It diversifies by issuing thousands of policies, and it expects losses to average out over the policies.13 The insurance company allows you to pool risk with thousands of other homeowners.

Investors should diversify too. For example, you can buy shares in a mutual fund that holds hundreds of stocks. In fact, you can buy index funds that invest in all the stocks in the popular market indexes. For example, the Vanguard 500 Index Fund holds the stocks in the Standard & Poor’s Composite stock market index. (The “S&P 500” tracks the performance of the largest U.S. stocks. It is the index most used by profes- sional investors.) If you buy this fund, you are insulated from the company-specific risks of the 500 companies in the index. These risks are averaged out by diversifica- tion. Of course you are still left with the risk that the level of the stock market as a whole will fall. In fact, we will see in Chapter 11 that investors are mostly concerned with market risk, not the specific risks of individual companies.

Index mutual funds are one way to invest in widely diversified portfolios at low cost. Another route is provided by exchange-traded funds (ETFs), which are portfolios of stocks that can be bought or sold in a single trade. For example, Standard & Poor’s Depositary Receipts (SPDRs, or “spiders”) invest in portfolios that match Standard & Poor’s stock market indexes. The total amount invested in the spider that tracks the benchmark S&P 500 index was $134 billion in early 2016.

ETFs are in some ways more efficient than mutual funds. To buy or sell an ETF, you simply make a trade, just as if you bought or sold shares of stock.14  This is

13 Unfortunately for insurance companies, the losses don’t always average out. Hurricanes and earthquakes can damage thousands of homes at once. The potential losses are so great that property insurance companies buy reinsurance against such catastrophes. 14 ETFs are in this respect like closed-end mutual funds (see footnote 3). But ETFs do not have managers with the discretion to try to “pick winners.” ETF portfolios are tied down to indexes or fixed baskets of securities. ETF issuers make sure that the ETF price tracks the price of the underlying index or basket.

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How ETFs work

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different from investing in an open-end mutual fund. In that case you have to send money to the fund in exchange for newly issued shares. And, if you want to withdraw the investment, you have to notify the fund, which redeems your shares and sends you a check. Also, many of the larger ETFs charge lower fees than mutual funds. State Street Global Advisors charges just .11% a year for managing the Standard & Poor’s 500 Index Spider. For a $100,000 investment, the fee is only .0011 × 100,000 = $110.

Financial markets provide other mechanisms for sharing risks. For example, a wheat farmer and a baking company are each exposed to fluctuations in the price of wheat after the harvest. The farmer worries about low prices, the baker about high prices. They can both rest easier if the baker can agree with the farmer to buy wheat in the future at a fixed price. Of course, it would be difficult, to say the least, if the baker and the farmer had to contact an Internet dating service to get together to make a deal. Fortunately, no dating service is needed: Each can trade in commodity markets, the farmer as a seller and the baker as a buyer.

Liquidity Markets and intermediaries also provide liquidity, that is, the ability to turn an invest- ment back into cash when needed. Suppose you deposit $5,000 in a savings bank on February 1. During that month, the bank uses your deposit and other new deposits to make a 6-month construction loan to a real estate developer. On March 1, you realize that you need your $5,000 back. The bank can give it to you. Because the bank has thousands of depositors, and other sources of financing if necessary, it can make an illiquid loan to the developer financed by liquid deposits made by you and other cus- tomers. If you lend your money for 6 months directly to the real estate developer, you will have a hard time retrieving it 1 month later.15

The shares of public companies are liquid because they are traded more or less con- tinuously in the stock market. An Italian investor who puts $60,000 into Bank of America shares can recover that money on short notice. (A $60,000 sell order is a drop in the bucket compared with the normal trading volume of Bank of America shares.) Mutual funds can redeem their shares for cash on short notice because the funds invest in traded securities, which can be sold as necessary.

Of course, liquidity is a matter of degree. Foreign exchange markets for major curren- cies are exceptionally liquid. Bank of America or Deutsche Bank could buy $200 million worth of yen or euros in the blink of an eye, with hardly any effect on foreign exchange rates. U.S. Treasury securities are also very liquid, and the shares of the largest compa- nies on the major international stock exchanges are only slightly less so.

Liquidity is most important when you’re in a hurry. If you try to sell $500,000 worth of the shares of a small, thinly traded company all at once, you will probably knock down the price to some extent. If you’re patient and don’t surprise other inves- tors with a large, sudden sell order, you may be able to unload your shares on better terms. It’s the same problem that you may face in selling real estate. A house or con- dominium is not a liquid asset in a panic sale. If you’re determined to sell in an after- noon, you’re not going to get full value.

The Payment Mechanism Think how inconvenient life would be if you had to pay for every purchase in cash or if Boeing had to ship truckloads of hundred-dollar bills around the country to pay its suppliers. Checking accounts, credit cards, and electronic transfers allow individuals

liquidity The ability to sell an asset on short notice at close to the market value.

15 Of course, the bank can’t repay all depositors simultaneously. To do so, it would have to sell off its loans to the real estate developer and other borrowers. These loans are not liquid. This raises the specter of bank runs, where doubts about a bank’s ability to pay off its depositors cause a rush of withdrawals, with each depositor trying to get his or her money out first. Bank runs are rare because bank deposits are backed up by the U.S. Federal Deposit Insurance Corporation, which insures bank accounts up to $250,000 per account.

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and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payment services, but they are not alone. For example, if you buy shares in a money market mutual fund, your money is pooled with that of other investors and used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit.

Information Provided by Financial Markets In well-functioning financial markets, you can see what securities and commodities are worth, and you can see—or at least estimate—the rates of return that investors can expect on their savings. The information provided by financial markets is often essential to a financial manager’s job. Here are three examples of how this information can be used.

Commodity Prices Catalytic converters are used in the exhaust systems of cars and light trucks to reduce pollution. The catalysts include platinum, which is traded on the New York Mercantile Exchange (NYMEX).

In March a manufacturer of catalytic converters is planning production for October. How much per ounce should the company budget for purchases of platinum in that month? Easy: The company’s CFO looks up the futures price of platinum on the New York Mercantile Exchange—$972 per ounce for delivery in October (this was the closing price for platinum in March 2016, for delivery in October). The CFO can lock in that price if she wishes. The details of such a trade are covered in Chapter 24.

Interest Rates The CFO of Catalytic Concepts has to raise $400 million in new financing. She considers an issue of long-term bonds. What will the interest rate on the bonds be? To find out, the CFO looks up interest rates on existing bonds traded in financial markets.

The results are shown in Table 2.2. Notice how the interest rate climbs as credit quality deteriorates: The largest, safest companies, which are rated AAA (“triple-A”), can raise long-term debt at a 2.59% interest rate. The interest rates for AA, A, and BBB rise to 2.62%, 3.03%, and 4.32%, respectively. BBB companies are still regarded as investment grade, that is, good quality, but the next step down takes the investor into junk bond territory. The interest rate for BB debt climbs to 5.62%. Single-B companies are riskier still, so investors demand 8.32%.

There will be more on bond ratings and interest rates in Chapter 6. But you can see how a financial manager can use information from fixed-income markets to forecast the interest rate on new debt financing. For example, if Catalytic Concepts can qualify as a BBB-rated company, and interest rates are as shown in Table 2.2, it should be able to raise new debt financing for approximately 4.32%.

Company Values How much was Callaway Golf worth in March 2016? How about Alaska Air Group, Entergy, Yum! Brands, or GE? Table 2.3 shows the market capital- ization of each company. We simply multiply the number of shares outstanding by the price per share in the stock market. Investors valued Callaway Golf at $821 million and GE at $283 billion.

TABLE 2.2 Interest rates on long-term corporate bonds, March 2016. The interest rate is lowest for top-quality (AAA) issuers. The rate rises as credit quality declines.

Credit Rating Interest Rate

AAA 2.59%

AA 2.62 A 3.03 BBB 4.32 BB 5.62 B 8.32

Source: Thomson Reuters.

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Stock prices and company values summarize investors’ collective assessment of how well a company is doing, both its current performance and its future pros- pects. Thus an increase in stock price sends a positive signal from investors to managers.16 That is why top management’s compensation is linked to stock prices. A manager who owns shares in his or her company will be motivated to increase the company’s market value. This reduces agency costs by aligning the interests of manag- ers and stockholders.

This is one important advantage of going public. A private company can’t use its stock price as a measure of performance. It can still compensate managers with shares, but the shares will not be valued in a financial market.

Cost of Capital Financial managers look to financial markets to measure, or at least estimate, the cost of capital for the firm’s investment projects. The cost of capital is the minimum acceptable rate of return on the project. Investment projects offering rates of return higher than their cost of capital are worthwhile because they add value; they make both the firm and its shareholders better off financially. Projects offering rates of return less than the cost of capital subtract value and should not be undertaken.17

Thus the hurdle rate for investments inside the corporation is actually set outside the corporation. The expected rate of return on investments in financial markets deter- mines the opportunity cost of capital.

The opportunity cost of capital is generally not the interest rate that the firm pays on a loan from a bank or insurance company. If the company is making a risky invest- ment, the opportunity cost of capital is the expected rate of return that investors can achieve in financial markets at the same level of risk. The expected rate of return on risky securities is normally well above the interest rate on corporate borrowing.

We introduced the cost of capital in Chapter 1, but this brief reminder may help to fix the idea. We cover the cost of capital in detail in Chapters 11 and 12.

cost of capital Minimum acceptable rate of return on capital investment.

TABLE 2.3 Calculating the market capitalization of Callaway Golf and other companies in March 2016. (Shares and market values in millions. Ticker symbols in parentheses.)

Number of Shares × Stock Price = Market Capitalization 

($ millions)

Callaway Golf (ELY) 93.8 × $8.76 = $821 Alaska Air Group (ALK) 124.7 × $80.77 = $10,074 Entergy (ETR) 178.5 × $75.92 = $13,551 Yum! Brands (YUM) 408.7 × $77.77 = $31,875 General Electric (GE) 9,331.0 × $30.34 = $283,091

Source: Yahoo! Finance, finance.yahoo.com.

16 We can’t claim that investors’ assessments of value are always correct. Finance can be a risky and dangerous business—dangerous for your wealth, that is. With hindsight we see horrible mistakes by investors, for example, the gross overvaluation of Internet and telecom companies in 2000. On average, however, it appears that finan- cial markets collect and assess information quickly and accurately. We’ll discuss this issue again in Chapter 7. 17 Of course, the firm may invest for other reasons. For example, it may invest in pollution control equipment for a factory. The equipment may not generate a cash return but may still be worth investing in to meet legal and ethical obligations.

Which of the functions described in this section require financial markets? Explain briefly.

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The Crisis of 2007–2009

The financial crisis of 2007–2009 raised many questions, but it settled one question conclusively: Yes, financial markets and institutions are important. When financial markets and institutions ceased to operate properly, the world was pushed into a global recession.

The financial crisis had its roots in the easy-money policies that were pursued by the U.S. Federal Reserve and other central banks following the collapse of the Internet and telecom stock bubble in 2000. At the same time, large balance-of-payments sur- pluses in Asian economies were invested back into U.S. debt securities. This also helped to push down interest rates and contribute to lax credit.

Banks took advantage of this cheap money to expand the supply of subprime mort- gages to low-income borrowers. Many banks tempted would-be homeowners with low initial payments, offset by significantly higher payments later.18 (Some home buyers were betting on escalating housing prices so that they could resell or refinance before the higher payments kicked in.) One lender is even said to have advertised what it dubbed its “NINJA” loan—NINJA standing for “No Income, No Job, and No Assets.” Most subprime mortgages were then packaged together into mortgage-backed securi- ties  (MBSs) that could be resold. But, instead of selling these securities to investors who could best bear the risk, many banks kept large quantities of the loans on their own books or sold them to other banks.

The widespread availability of mortgage finance fueled a dramatic increase in house prices, which doubled in the 5 years ending June 2006. At that point, prices started to slide and homeowners began to default on their mortgages. A year later, Bear Stearns, a large investment bank, announced huge losses on the mortgage invest- ments that were held in two of its hedge funds. By the spring of 2008, Bear Stearns was on the verge of bankruptcy, and the U.S. Federal Reserve arranged for it to be acquired by JPMorgan Chase.

The crisis peaked in September 2008, when the U.S. government was obliged to take over the giant federal mortgage agencies Fannie Mae and Freddie Mac, both of which had invested several hundred billion dollars in subprime mortgage-backed securities. Over the next few days, the financial system started to melt down. Both Merrill Lynch and Lehman Brothers were in danger of failing. On September 14, the government arranged for Bank of America to take over Merrill in return for financial guarantees. However, it did nothing to rescue Lehman Brothers, which filed for bankruptcy protec- tion the next day. Two days later, the government reluctantly lent $85 billion to the giant insurance company AIG, which had insured huge volumes of mortgage-backed securities and other bonds against default. The following day, the Treasury unveiled its first proposal to spend $700 billion to purchase “toxic” mortgage-backed securities.

After the failure of Lehman and the forced rescues of Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, and AIG, investors and financial institutions had to ask, “Who will be next? Do I dare trade with or lend money to Bank X?” In many situations, the cautious answer was “No.” Customary day-to-day financial transactions were canceled or com- pleted on onerous terms.19 At the same time, trading in MBSs and other hard-to-value securities dried up; it therefore became even harder to know what these securities were worth. As banks and other financial institutions became reluctant to trade securities or lend to one another, the supply of credit to the economy contracted and business invest- ment was cut back. The U.S. economy suffered one of its worst setbacks since the Great Depression. Unemployment rose rapidly and business bankruptcies tripled.

2.4

18 With a so-called option ARM loan, the minimum mortgage payment was often not even sufficient to cover that month’s interest on the loan. The unpaid interest was then added to the amount of the mortgage, so the homeowner was burdened by an ever-increasing mortgage that one day would need to be paid off. 19  The interest rate on interbank loans rose in 2008 to 4.6% above the rate on U.S. Treasury debt. The normal spread over Treasuries is less than .5%.

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Housing prices in the financial crisis

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Time line of the financial crisis

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The rise and fall of Lehman Brothers

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Few developed economies escaped the crisis. As well as suffering from a collapse in their own housing markets, a number of foreign banks had made large investments in U.S. subprime mortgages and had to be rescued by their governments. Many European governments were already heavily in debt and, as the cost of the bank bailouts mounted, investors began to worry about the ability of the governments to repay their debts. Thus in Europe, the banking crisis became entwined with a sovereign debt crisis.

The invention of MBSs also made mortgages liquid. They are actively traded among banks, insurance companies, mutual funds, pension funds, and endowments.

The MBS market has grown explosively. With the growth came more and more complexity. Issuers were not content with the simple pass-through MBS described earlier. They issued complicated packages of securities called tranches. The most senior tranches were given first call on all cash flows from the mortgage portfolio and were viewed as almost risk-free. Bond-rating agencies gave their highest, triple-A rat- ings to the senior tranches, even for MBSs based on sub- prime mortgages for homeowners with weak credit. Many investors in triple-A tranches lost a lot of money in the crisis of 2007–2009. We discuss bond ratings in Chapter 6.

The MBS market survived. It is still by far the largest source of mortgage financing. By 2015, the aggregate MBSs out- standing exceeded $2 trillion. MBSs are part of a broader market for asset-backed securities, which include securities that work like MBSs but are based on portfolios of other types of assets, including car loans, bank loans to businesses, and financing for commercial real estate.

Mortgage-backed securities (MBSs) provide another exam- ple of how financial markets convey savings to finance investment in real assets. In this case, the real assets are homes, which homeowners finance in part with mort- gage loans.

In the old days—the 1960s, for example—most mortgage loans were made by local banks, savings banks, and savings and loan institutions (S&Ls), which accepted deposits and sav- ings accounts and made mortgage and other local loans. We will use an S&L as the example. The flow of savings would be as described by the figure in Panel a, at the bottom of this box.

The typical mortgage was long term, up to 30 years matu- rity, with a fixed interest rate. The S&Ls’ liabilities—chiefly sav- ings accounts—had much shorter maturities, perhaps a year or two on average. The S&Ls were therefore “borrowing short, lending long,” a dangerous investment strategy. When interest rates rose in the 1970s and 1980s, the S&Ls’ interest costs on savings accounts rose, too, but their interest income was locked up in long-term, fixed-rate mortgages. Losses mounted. The S&L crisis of the 1980s followed.*

The invention of the MBS allowed S&Ls to eliminate the risks of borrowing short and lending long. You can still get a mortgage from your local S&L, but now the S&L does not have to keep it. The S&L originates the mortgage, but will probably resell it to an MBS issuer—for example, Fannie Mae (Federal National Mort- gage Association or FNMA†) or Bank of America. The issuer com- bines your mortgage with hundreds or thousands of others and issues an MBS backed by the combined portfolio. The MBS is sold to investors such as life insurance companies that want to hold long-term, fixed-rate obligations. Cash flows from the mort- gage portfolio are passed through to investors.‡

Suppose a life insurance company purchases an MBS. The flow of savings would now match the figure in Panel b.

Finance in Practice Mortgage-Backed Securities

* For a history of the crisis, see Edward J. Kane, The S&L Insurance Mess: How Did It Happen? (Washington, D.C.: Urban Institute Press, 1989).

† Fannie Mae and Freddie Mac (Federal Home Loan Mortgage Corp.) are government-sponsored entities (GSEs) charged with increasing the availability of mortgage credit. The GSEs purchase “conforming loans” and package and resell them as MBSs. Nonconforming loans—for example, large, “jumbo” mortgages—are packaged by banks such as Citigroup or Bank of America.

‡ You still send monthly payments to your local S&L. The S&L extracts a small servicing fee and sends your payments along to the MBS issuer, which also extracts a small servicing fee. Net cash flows from the portfolio of mortgages then go to the MBS investors.

Homeowner S&L Mortgage loan

(a) $

Investors (Depositors)

Savings account

$

Homeowner

(b)

S&L Mortgage

loan

$ MBS

Issuer Mortgage

loan

Issuer assembles portfolio of mortgages

$ Insurance Company

MBS

$

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Greece was in the worst shape. It had accumulated €350 billion (about $460 billion) of government debt. Greece is a member of the single-currency euro club, so it had no control over its currency and could not just print more euros to service its debts. In 2011 it defaulted on debts totaling €100 billion.

Greece was still on shaky ground in early 2016, despite a series of rescue packages from the European Union, the European Central Bank, and the International Monetary Fund. Spain, Portugal, Ireland, and other European countries that had also worried investors avoided default and seemed to be recovering. But unemployment in many European countries remained stubbornly high and economic growth anemic.

What lessons can you, as a student of finance, draw from these financial crises? Here are three. First, note the sorry consequences for the economy when financial markets and institutions do not carry out the functions described in this chapter. For example, the crisis was amplified by the sudden disappearance of liquidity in many markets, including the market for MBSs. That meant that potential buyers of the illiq- uid assets could not know for sure what they were worth. Thus, the informational func- tion of financial markets was also compromised.

Second, why were Bear Stearns, Lehman, Merrill Lynch, and the other distressed firms so fragile? One reason is that they were mostly financed with borrowed money, much of it short-term debt that had to be refinanced frequently. Investment banks like Lehman typically were financed with more than 95% debt and less than 5% equity capital. Thus a 5% fall in their asset values could wipe out their equity “cushions” and leave the banks insolvent. Regulators since the crisis have therefore required banks to finance with much more equity. This requirement has also affected payout to share- holders. A U.S. bank’s dividend payments can be stopped by regulators if the bank’s equity capital ratio is not up to snuff. We cover decisions about debt versus equity financing and payout in Chapters 16 and 17.

Third, some causes of the crisis can be traced back to agency problems noted in Chapter 1. Managers in the mortgage business were probably at least dimly aware that promoting and selling massive amounts of subprime MBSs was likely to end badly. They didn’t wake up in the morning thinking, “Hey, maybe I can cause a financial crisis,” but their incentives did call for trying to squeeze out one more fat bonus before the game ended. Their incentives were not aligned with shareholders’. The value of their firms suffered accordingly.

SUMMARY The ultimate source of financing is individuals’ savings. The savings may flow through financial markets and intermediaries. The intermediaries include mutual funds, pension funds, and financial institutions, such as banks and insurance companies.

It’s simple: Corporations need access to financing in order to innovate and grow. A modern financial system offers different types of financing, depending on a corporation’s age and the nature of its business. A high-tech start-up will seek venture capital financing, for example. A mature firm will rely more on bond markets.

In that case, the corporation is saving on behalf of its shareholders.

Mutual and pension funds allow investors to diversify in professionally managed portfo- lios. Pension funds offer an additional tax advantage, because the returns on pension investments are not taxed until withdrawn from the plan.

Where does the financing for corporations come from? (LO2-1)

Why do nonfinancial corporations need modern financial markets and institutions? (LO2-1)

What if a corporation finances investment by retaining and reinvesting cash generated from its operations? (LO2-1)

What are the key advantages of mutual funds and pension funds? (LO2-2)

BEYOND THE PAGE

mhhe.com/brealey9e

The Dodd-Frank Act

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Financial markets help channel savings to corporate investment, and they help match up borrowers and lenders. They provide liquidity and diversification opportunities for inves- tors. Trading in financial markets provides a wealth of useful information for the financial manager.

Financial institutions carry out a number of similar functions to financial markets but in different ways. They channel savings to corporate investment, and they serve as financial intermediaries between borrowers and lenders. Banks also provide liquidity for deposi- tors and, of course, play a special role in the economy’s payment systems. Insurance com- panies allow policyholders to pool risks.

The financial crisis of 2007–2009 provided a dramatic illustration. The huge expansion in subprime mortgage lending in the United States led to a collapse of the banking system. The government was forced into costly bailouts of banks and other financial institutions. As the credit markets seized up, the country suffered a deep recession. In much of Europe, the financial crisis did not end in 2009. As governments struggled to reduce their debt mountains and to strengthen their banking systems, many countries suffered sharp falls in economic activity and severe unemployment.

Do financial institutions have different functions? (LO2-3)

What happens when financial markets and institutions no longer function well? (LO2-4)

What are the functions of financial markets? (LO2-3)

QUESTIONS AND PROBLEMS 1. Corporate Financing. How can a small, private firm finance its capital investments? Give two

or three examples of financing sources. (LO2-1)

2. Financial Markets. The stock and bond markets are not the only financial markets. Give two or three additional examples. (LO2-1)

3. Financial Markets and Institutions. True or false? (LO2-1) a. Financing for public corporations must flow through financial markets. b. Financing for private corporations must flow through financial intermediaries. c. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New

York and London. d. Derivative markets are a major source of finance for many corporations. e. The opportunity cost of capital is the capital outlay required to undertake a real investment

opportunity. f. The cost of capital is the interest rate paid on borrowing from a bank or other financial

institution.

4. Corporate Financing. Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes: (LO2-1) a. Investor to financial intermediary, to financial markets, and to the corporation b. Investor to financial markets, to a financial intermediary, and to the corporation c. Investor to financial markets, to a financial intermediary, back to financial markets, and to

the corporation

5. Financial Intermediaries. You are a beginning investor with only $5,000 in savings. How can you achieve a widely diversified portfolio at reasonable cost? (LO2-2)

6. Financial Intermediaries. Is an insurance company also a financial intermediary? How does the insurance company channel savings to corporate investment? (LO2-2)

7. Corporate Financing. Choose the most appropriate term to complete each sentence. (LO2-2) a. Households hold a greater percentage of (corporate equities / corporate bonds). b. (Pension funds / Banks) are major investors in corporate equities. c. (Investment banks / Commercial banks) raise money from depositors and make loans to

individuals and businesses.

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8. Financial Markets. Which of the following are financial markets? (LO2-2) a. NASDAQ b. Vanguard Explorer Fund c. JPMorgan Chase d. Chicago Mercantile Exchange

9. Financial Intermediaries. True or false? (LO2-2) a. Exchange traded funds are hedge funds that can be bought and sold on the stock exchange. b. Hedge funds provide small investors with low-cost diversification. c. The sale of insurance policies is a source of financing for insurance companies. d. In defined-contribution pension plans, the pension pot depends on the rate of return earned

on the contributions by the employer and employee.

10. Liquidity. Securities traded in active financial markets are liquid assets. Explain why liquidity is important to individual investors and to mutual funds. (LO2-2)

11. Liquidity. Bank deposits are liquid; you can withdraw money on demand. How can the bank provide this liquidity and at the same time make illiquid loans to businesses? (LO2-2)

12. Financial Institutions. Summarize the differences between a commercial bank and an invest- ment bank. (LO2-2)

13. Mutual Funds. Why are mutual funds called financial intermediaries? Why does it make sense for an individual to invest her savings in a mutual fund rather than directly in financial markets? (LO2-2)

14. Functions of Financial Markets. Fill in the blanks in the following passage by choosing the most appropriate term from the following list: CFO, save, financial intermediaries, stock mar- ket, savings, real investment, bonds, commodity markets, mutual funds, shares, liquid, ETFs, banks. Each term should be used once only. (LO2-3)

Financial markets and _____ channel _____ to _____. They also channel money from individu- als who want to _____ for the future to those who need cash to spend today. A third function of financial markets is to allow individuals and businesses to adjust their risk. For example, _____, such as the Vanguard Index fund, and _____, such as SPDRs or “spiders,” allow individuals to spread their risk across a large number of stocks. Financial markets provide other mechanisms for sharing risks. For example, a wheat farmer and a baker may use the _____ to reduce their exposure to wheat prices. Financial markets and intermediaries allow investors to turn an invest- ment into cash when needed. For example, the _____ of public companies are _____ because they are traded in huge volumes on the _____. _____ are the main providers of payment ser- vices by offering checking accounts and electronic transfers. Finally, financial markets provide information. For example, the _____ of a company that is contemplating an issue of debt can look at the yields on existing _____ to gauge how much interest the company will need to pay.

15. Financial Markets and Intermediaries. List the major functions of financial markets and intermediaries in a modern financial system. (LO2-3)

16. Functions of Financial Markets. On a mountain trek, you discover a 6-ounce gold nugget. A friend offers to pay you $2,500 for it. How do you check whether this is a fair price? (LO2-3)

17. Functions of Financial Markets. What kinds of useful information can a financial manager obtain from financial markets? Give examples. (LO2-3)

18. Functions of Financial Markets. Look back at Section 2.3 and then answer the following ques- tions: (LO2-3) a. The price of Entergy stock has risen to $90. What is the market value of the firm’s equity if

the number of outstanding shares does not change? b. The rating agency has revised Catalytic Concepts’ bond rating to A. What interest rate,

approximately, would the company now need to pay on its bonds? c. A farmer and a meatpacker use the commodity markets to reduce their risk. One agrees to

buy live cattle in the future at a fixed price, and the other agrees to sell. Which one sells?

19. The Financial Crisis. True or false? (LO2-4) a. The financial crisis was largely caused by banks taking large positions in the options and

futures markets. b. The prime cause of the financial crisis was an expansion in bank lending for the overheated

commercial real estate market.

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c. Many subprime mortgages were packaged together by banks for resale as mortgage-backed securities (MBSs).

d. The crisis could have been much more serious if the government had not stepped in to rescue Merrill Lynch and Lehman Brothers.

e. The crisis in the eurozone finally ended when other eurozone countries and the IMF pro- vided a massive bailout package to stop Greece from defaulting on its debts.

WEB EXERCISES

1. Log on to finance.yahoo.com and use the website to update Table 2.3. How have market values of these companies changed?

2. Find the websites for the Vanguard Group, Fidelity Investments, and Putnam Investments. Pick three or four funds from these sites and compare their investment objectives, risks, past returns, fund fees, and so on. Read the prospectuses for each fund. Who do you think should, or should not, invest in each fund?

3. Morningstar provides data on mutual fund performance. Log on to its website. Which category of funds has performed unusually well or badly?

SOLUTIONS TO SELF-TEST QUESTIONS 2.1 a. Corporations sell securities in the primary market. The securities are later traded in the

secondary market. b. The capital market is for long-term financing; the money market, for short-term

financing. c. The market for stocks versus the market for bonds and other debt securities.

2.2 Efficient diversification and professional management. Pension funds offer an additional advantage, because investment returns are not taxed until withdrawn from the fund.

2.3 Mutual funds pool investor savings and invest in portfolios of traded securities. Financial institutions such as banks or insurance companies raise money in special ways, for example, by accepting deposits or selling insurance policies. They not only invest in securities but also lend directly to businesses. They provide various other financial services.

2.4 Liquidity, risk reduction by investment in diversified portfolios of securities (through a mutual fund, for example), information provided by trading.

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56

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LEARNING OBJECTIVES

After studying this chapter, you should be able to:

3-1 Interpret the information contained in the balance sheet, income statement, and statement of cash flows.

3-2 Distinguish between market and book values.

3-3 Explain why income differs from cash flow.

3-4 Understand the essential features of the taxation of corporate and personal income.

C H A P T E R

3 Accounting and Finance

R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D I N C O N N E C T.

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I n Chapter 1 we pointed out that a large corporation is a team effort. All the players—the shareholders, lend- ers, directors, management, and employees—have a

stake in the company’s success, and all therefore need to monitor its progress. For this reason, the company prepares regular financial accounts and arranges for an independent firm of auditors to certify that these accounts present a “true and fair view.”

Until the mid-nineteenth century, most businesses were owner-managed and seldom required outside capital beyond personal loans to the proprietor. There was little need, therefore, for firms to produce compre- hensive accounting information. But with the industrial revolution and the creation of large railroad and canal companies, the shareholders and bankers demanded information that would help them gauge a firm’s finan- cial strength. That was when the accounting profession began to come of age.

We don’t want to get lost in the details of accounting practice. But because we will refer to financial state- ments throughout this book, it may be useful to review briefly their main features. In this chapter, we introduce the major financial statements: the balance sheet, the income statement, and the statement of cash flows. We discuss the important differences between income and cash flow and between book values and market values. We also discuss the federal tax system.

This chapter is our first look at financial statements and is meant primarily to serve as a brief review of your accounting class. It will be far from our last look. For example, we will see in the next chapter how managers use financial statements to analyze a firm’s performance and assess its financial strength.

Accounting is not the same as finance, but the two are related. © g-stockstudio/iStock/Getty Images RF

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The Balance Sheet

Public companies are obliged to file their financial statements with the SEC each quar- ter. These quarterly reports (or 10Qs) provide the investor with information about the company’s earnings during the quarter and its assets and liabilities at the end of the quarter. In addition, companies need to file annual financial statements (or 10Ks) that provide rather more detailed information about the outcome for the entire year.

The financial statements show the firm’s balance sheet, the income statement, and a statement of cash flows. We will review each in turn.1

Firms need to raise cash to pay for the many assets used in their businesses. In the process of raising that cash, they also acquire obligations or “liabilities” to those who provide the funding. The balance sheet presents a snapshot of the firm’s assets and liabilities at one particular moment. The assets—representing the uses of the funds raised—are listed on the left-hand side of the balance sheet. The liabilities— representing the sources of that funding—are listed on the right.

Some assets can be turned more easily into cash than others; these are known as liquid assets. The accountant puts the most liquid assets at the top of the list and works down to the least liquid. Look, for example, at Table 3.1, which shows the consoli- dated balance sheet for Home Depot (HD), at the end of its 2014 fiscal year.2 (“Con- solidated” simply means that the balance sheet shows the position of Home Depot and any companies it owns.) You can see that Home Depot had $1,723 million of cash and marketable securities. In addition, it had sold goods worth $1,484 million but had not yet received payment. These payments are due soon, and therefore the balance sheet shows the unpaid bills or accounts receivable (or simply receivables) as a current asset. The next asset consists of inventories. These may be (1) raw materials and ingre- dients that the firm bought from suppliers, (2) work in progress, and (3) finished prod- ucts waiting to be shipped from the warehouse. For Home Depot, inventories consist largely of goods in the warehouse or on the store shelves; for manufacturing compa- nies, inventories would be more skewed toward raw materials and work in progress. Of course, there are always some items that don’t fit into neat categories. So there is a fourth entry, other current assets.

Up to this point, all the assets in Home Depot’s balance sheet are likely to be used or turned into cash in the near future. They are therefore described as current assets. The next assets listed in the balance sheet are longer-lived or fixed assets and include items such as buildings, equipment, and vehicles.

The balance sheet shows that the gross value of Home Depot’s property, plant, and equipment is $40,353 million. This is what the assets originally cost. But they are unlikely to be worth that now. For example, suppose the company bought a delivery van 2 years ago; that van may be worth far less now than Home Depot paid for it. It might, in principle, be possible for the accountant to estimate separately the value today of the van, but this would be costly and somewhat subjective. Accountants rely instead on rules of thumb to estimate the depreciation in the value of assets, and with rare exceptions they stick to these rules. For example, in the case of that delivery van, the accountant may deduct a third of the original cost each year to reflect its declining value. So if Home Depot bought the van 2 years ago for $15,000, the balance sheet would show that accumulated depreciation is 2 × $5,000 = $10,000. Net of deprecia- tion the value is only $5,000. Table 3.1 shows that Home Depot’s total accumulated

3.1

balance sheet Financial statement that shows the firm’s assets and liabilities at a particular time.

1 In addition, the company provides a statement of the shareholders’ equity, which shows how much of the firm’s earnings has been retained in the business rather than paid out as dividends and how much money has been raised by issuing new shares or spent by repurchasing stock. We will not review in detail the statement of shareholders’ equity. 2 Home Depot’s fiscal 2014 ended February 1, 2015. The balance sheet in Table 3.1, therefore, shows the firm’s assets and liabilities on this date. We have simplified and eliminated some of the detail in the company’s published financial statements.

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depreciation on fixed assets is $17,633 million. So while the assets cost $40,353 million, their net value in the accounts is only $40,353 − $17,633 = $22,720 million.

In addition to its tangible assets, Home Depot also has valuable intangible assets, such as its brand name, skilled management, and a well-trained labor force. Accoun- tants are generally reluctant to record these intangible assets in the balance sheet unless they can be readily identified and valued.

There is, however, one important exception. When Home Depot has acquired other businesses in the past, it has paid more for their assets than the value shown in the firms’ accounts. This difference is shown in Home Depot’s balance sheet as “goodwill.” Most of the intangible assets on Home Depot’s balance sheet consist of goodwill.

Now look at the right-hand portion of Home Depot’s balance sheet, which shows where the money to buy its assets came from. The accountant starts by looking at the company’s liabilities—that is, the money owed by the company. First come those liabili- ties that are likely to be paid off most rapidly. For example, Home Depot has borrowed $328 million, due to be repaid shortly. It also owes its suppliers $9,473 million for goods that have been delivered but not yet paid for. These unpaid bills are shown as accounts payable (or payables). Both the borrowings and the payables are debts that Home Depot must repay within the year. They are therefore classified as current liabilities.

Home Depot’s current assets total $15,302 million; its current liabilities amount to $11,269 million. Therefore, the difference between the value of Home Depot’s current assets and its current liabilities is $15,302 − $11,269 = $4,033 million. This figure is known as Home Depot’s net current assets or net working capital. It roughly measures the company’s potential reservoir of cash.

Below the current liabilities Home Depot’s accountants have listed the firm’s long- term liabilities, such as debts that come due after the end of a year. You can see that banks and other investors have made long-term loans to Home Depot of $16,869 million.

Home Depot’s liabilities are financial obligations to various parties. For example, when Home Depot buys goods from its suppliers, it has a liability to pay for them; when it borrows from the bank, it has a liability to repay the loan. Thus the suppliers and the bank have first claim on the firm’s assets. What is left over after the liabilities

End of Fiscal End of Fiscal

Assets 2014 2013 Liabilities and Shareholders’ Equity 2014 2013

Current assets Current liabilities Cash and marketable securities $ 1,723 $ 1,929 Debt due for repayment $ 328 $ 33 Receivables 1,484 1,398 Accounts payable 9,473 9,379 Inventories 11,079 11,057 Other current liabilities 1,468 1,337 Other current assets 1,016 895 Total current liabilities $11,269 $10,749 Total current assets $15,302 $15,279 Fixed assets Long-term debt $16,869 $14,691 Tangible fixed assets Deferred income taxes 642 514 Property, plant, and equipment $40,353 $39,064 Other long-term liabilities 1,844 2,042 Less accumulated depreciation 17,633 15,716 Net tangible fixed assets $22,720 $23,348 Total liabilities $30,624 $27,996 Intangible assets (goodwill) 1,353 1,289 Shareholders’ equity Other assets 571 602 Common stock and other paid-in capital $ 8,521 $ 8,536

Retained earnings 26,995 23,180 Total assets $39,946 $40,518 Treasury stock (26,194) (19,194)

Total shareholders’ equity $ 9,322 $12,522 Total liabilities and shareholders’ equity $39,946 $40,518

TABLE 3.1 Home Depot’s balance sheet (figures in $ millions)

Note: Column sums subject to rounding error. Source: Derived from Home Depot annual reports.

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have been paid off belongs to the shareholders. This figure is known as the sharehold- ers’ equity. For Home Depot the total value of shareholders’ equity amounts to $9,322 million. Table 3.1 shows that Home Depot’s equity is made up of three parts. One por- tion, $8,521 million, has resulted from the occasional sale of new shares to investors. A much larger amount, $26,995 million, has come from earnings that Home Depot has retained and reinvested in the business on the shareholders’ behalf.3 Finally, treasury stock is a large negative number, −$26,194 million. This represents the amount that Home Depot has spent on buying back its shares. The money to repurchase them has gone out of the firm and reduced shareholders’ equity.

Figure 3.1 shows how the separate items in the balance sheet link together. There are two classes of assets—current assets, which will soon be used or turned into cash, and long-term or “fixed” assets, which may be either tangible or intangible. There are also two classes of liability—current liabilities, which are due for payment shortly, and long-term liabilities.

The difference between the assets and the liabilities represents the amount of the shareholders’ equity. This is the basic balance sheet identity. Shareholders are some- times called “residual claimants” on the firm. We mean by this that shareholders’ equity is what is left over when the liabilities of the firm are subtracted from its assets:

Shareholders’ equity = net assets = total assets − total liabilities (3.1)

3 Here is an occasional source of confusion. You may be tempted to think of retained earnings as a pile of cash that the company has built up from its past operations. But there is absolutely no link between retained earnings and cash balances. The earnings that Home Depot has plowed back into the business may have been used to buy new equipment, trucks, warehouses, and so on. Typically only a small proportion will be kept in the bank. Notice that Home Depot’s balance sheet lists $26,995 in retained earnings but only $1,723 in cash and marketable securities.

Current assets Cash & securities Receivables Inventories + Fixed assets Tangible assets Intangible assets

=

THE MAIN BALANCE SHEET ITEMS

Current liabilities Payables Short-term debt

+ Long-term liabilities

+ Shareholders’ equity

FIGURE 3.1 Assets and liabilities on the balance sheet

When comparing financial statements, analysts often calculate a common-size balance sheet, which re-expresses all items as a percentage of total assets. Table 3.2 is Home Depot’s common-size balance sheet. The financial manager might look at this common-size balance sheet and notice right away that in 2014 receivables accounted for a higher proportion of the firm’s assets than they did in the previous year. There may be good reasons for this, but the manager might wish to check that the company has not become lazy in collecting its customers’ unpaid bills.

common-size balance sheet All items in the balance sheet are expressed as a percentage of total assets.

Suppose that Home Depot borrows $500 million by issuing new long-term bonds. It places $100 million of the proceeds in the bank and uses $400 million to buy new machinery. What items of the balance sheet would change? Would shareholders’ equity change?

Self-Test3.1

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By the way, it is easy to obtain the financial statements of almost any publicly traded firm. Most firms make their annual reports available on the web. You also can find key financial statements of most firms at Yahoo! Finance (finance.yahoo.com) or Google Finance (finance.google.com).

Book Values and Market Values Throughout this book, we will frequently make a distinction between the book values of the assets shown in the balance sheet and their market values.

Items in the balance sheet are valued according to generally accepted accounting principles, commonly called GAAP. These state that assets must be shown in the bal- ance sheet at their historical cost adjusted for depreciation. Book values are therefore “backward-looking” measures of value. They are based on the past cost of the asset, not its current market price or value to the firm. For example, suppose that 2 years ago Home Depot built an office building for $30 million and that in today’s market the building would sell for $40 million. The book value of the building would be less than its market value, and the balance sheet would understate the value of Home Depot’s asset.

Or consider a specialized plant that Intel develops for producing special-purpose computer chips at a cost of $800 million. The book value of the plant is $800 million less accumulated depreciation. But suppose that shortly after the plant is constructed, a new chip makes the existing one obsolete. The market value of Intel’s new plant could fall by 50% or more. In this case, market value would be less than book value.

The difference between book value and market value is greater for some assets than for others. It is zero in the case of cash but potentially very large for fixed assets where the accountant starts with initial cost and then depreciates that figure according to a prespecified schedule. The purpose of depreciation is to allocate the original cost of the asset over its life, and the rules governing the depreciation of asset values do not reflect actual loss of market value. Usually the market value of fixed assets is much higher than the book value, but sometimes it is less.

generally accepted accounting principles (GAAP) U.S. procedures for preparing financial statements.

book value Net worth of the firm according to the balance sheet.

End of Fiscal End of Fiscal

Assets 2014 2013 Liabilities and Shareholders’ Equity 2014 2013

Current assets Current liabilities Cash and marketable securities 4.3% 4.8% Debt due for repayment 0.8% 0.1% Receivables 3.7 3.5 Accounts payable 23.7 23.1 Inventories 27.7 27.3 Other current liabilities 3.7 3.3 Other current assets 2.5 2.2 Total current liabilities 28.2% 26.5% Total current assets 38.3% 37.7% Fixed assets Long-term debt 42.2% 36.3% Tangible fixed assets Deferred income taxes 1.6 1.3 Property, plant, and equipment 101.0% 96.4% Other long-term liabilities 4.6 5.0 Less accumulated depreciation 44.1 38.8 Net tangible fixed assets 56.9% 57.6% Total liabilities 76.7% 69.1% Intangible assets (goodwill) 3.4% 3.2% Shareholders’ equity: Other assets 1.4% 1.5% Common stock and other paid-in capital 21.3% 21.1%

Retained earnings 67.6 57.2 Total assets 100.0% 100.0% Treasury stock (65.6) (47.4)

Total shareholders’ equity 23.3% 30.9% Total liabilities and shareholders’ equity 100.0% 100.0%

TABLE 3.2 Common-size balance sheet of Home Depot (all items expressed as a percentage of total assets)

Note: Column sums subject to rounding error.

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The same goes for the right-hand side of the balance sheet. In the case of liabilities, the accountant simply records the amount of money that you have promised to pay. For short-term liabilities, this figure is generally close to the market value of that promise. For example, if you owe the bank $1 million tomorrow, the accounts show a book liability of $1 million. As long as you are not bankrupt, that $1 million is also roughly the value to the bank of your promise. But now suppose that $1 million is not due to be repaid for several years. The accounts still show a liability of $1 million, but how much your debt is worth depends on what happens to interest rates. If interest rates rise after you have issued the debt, lenders may not be prepared to pay as much as $1 million for your debt; if interest rates fall, they may be prepared to pay more than $1 million.4 Thus the market value of a long-term liability may be higher or lower than the book value. Market values of assets and liabilities do not generally equal their book values. Book values are based on historical or original values. Market values measure current values of assets and liabilities.

The difference between book value and market value is likely to be greatest for shareholders’ equity. The book value of equity measures the cash that shareholders have contributed in the past plus the cash that the company has retained and reinvested in the business on their behalf. But this often bears little resemblance to the total mar- ket value that investors place on the shares.

If the market price of the firm’s shares falls through the floor, don’t try telling the shareholders that the book value is satisfactory—they won’t want to hear. Sharehold- ers are concerned with the market value of their shares; market value, not book value, is the price at which they can sell their shares. Managers who wish to keep their share- holders happy will focus on market values.

We will often find it useful to think about the firm in terms of a market-value balance sheet. Like a conventional balance sheet, a market-value balance sheet lists the firm’s assets, but it records each asset at its current market value rather than at historical cost less depreciation. Similarly, each liability is shown at its market value. The difference between the market values of assets and liabilities is the market value of the shareholders’ equity claim. The stock price is simply the market value of shareholders’ equity divided by the number of outstanding shares.

4 We will show you how changing interest rates affect the market value of debt in Chapter 6.

market-value balance sheet Balance sheet showing market rather than book values of assets, liabilities, and stockholders’ equity.

Market- versus Book-Value Balance Sheets

Jupiter has developed a revolutionary auto production process that enables it to produce cars 20% more efficiently than any rival. It has invested $10 billion in building its new plant. To finance the investment, Jupiter borrowed $4 billion and raised the remaining funds by selling new shares of stock in the firm. There are currently 100 million shares of stock outstanding. Investors are very excited about Jupiter’s prospects. They believe that the flow of profits from the new plant justifies a stock price of $75.

If these are Jupiter’s only assets, the book-value balance sheet immediately after it has made the investment is as follows:

Example 3.1 ⊲

BOOK-VALUE BALANCE SHEET FOR JUPITER MOTORS (Figures in $ billions)

Assets Liabilities and Shareholders’ Equity

Auto plant 10 Debt 4 Shareholders’ equity 6

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5 Jupiter has borrowed $4 billion to finance its investment, but if the interest rate has changed in the meantime, the debt could be worth more or less than $4 billion.

MARKET-VALUE BALANCE SHEET FOR JUPITER MOTORS (Figures in $ billions)

Assets Liabilities and Shareholders’ Equity

Auto plant 11.5 Debt 4 Shareholders’ equity 7.5

Investors are placing a market value on Jupiter’s equity of $7.5 billion ($75 per share times 100 million shares). We assume that the debt outstanding is worth $4 billion.5 There- fore, if you owned all Jupiter’s shares and all its debt, the value of your holdings would be $7.5 + $4 = $11.5 billion. In this case, you would own the company lock, stock, and barrel and would be entitled to all its cash flows. Because you can buy the entire company for $11.5 billion, the total value of Jupiter’s assets must also be $11.5 billion. In other words, the market value of the assets must be equal to the market value of the liabilities plus the mar- ket value of the shareholders’ equity.

We can now draw up the market-value balance sheet as follows:

Notice that the market value of Jupiter’s plant is $1.5 billion more than the plant cost to build. The difference is due to the superior profits that investors expect the plant to earn. Thus, in contrast to the balance sheet shown in the company’s books, the market-value balance sheet is forward-looking. It depends on the profits that investors expect the assets to provide. ■

Is it surprising that market value generally exceeds book value? It shouldn’t be. Firms find it attractive to raise money to invest in various projects because they believe the projects will be worth more than they cost. Otherwise, why bother? You will usually find that shares of stock sell for more than the value shown in the company’s books.

The Income Statement

If Home Depot’s balance sheet resembles a snapshot of the firm at a particular time, its income statement is like a video. It shows how profitable the firm has been during the past year.

Look at the summary income statement in Table 3.3. You can see that during fiscal 2014, Home Depot sold goods worth $83,176 million and that the total cost of acquir- ing and selling those goods was $54,222 + $16,699 = $70,921 million. The largest expense item, amounting to $54,222 million, consisted of the cost of goods sold. This included the acquisition cost of Home Depot’s goods, the wages of its employees, and the other expenses incurred to obtain and sell its wares. Almost all the remaining

3.2

income statement Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

a. What would be Jupiter’s price per share if the auto plant had a market value of $14 billion?

b. How would you reassess the value of the auto plant if the value of outstand- ing stock was $8 billion?

Self-Test3.2

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expenses were administrative expenses such as head office costs, advertising, and distribution.

In addition to these out-of-pocket expenses, Home Depot also made a deduction for the value of the plant and equipment used up in producing the goods. In 2014, this charge for depreciation was $1,786 million. Thus Home Depot’s earnings before interest and taxes (EBIT) were

EBIT

=

total revenues + other income − costs − depreciation

= 83, 176 + 337 − ( 54, 222 + 16, 699 ) − 1, 786

= $10, 806 million

The remainder of the income statement shows where these earnings went. As we saw earlier, Home Depot has partly financed its investment in plant and equipment by borrowing. In 2014, it paid $830 million of interest on this borrowing. A further slice of the profit went to the government in the form of taxes. This amounted to $3,631 million. The $6,345 million that was left over after paying interest and taxes belonged to the shareholders. Of this sum, Home Depot paid out $2,530 million in dividends and reinvested the remaining $3,815 million in the business. Presumably, these rein- vested funds made the company more valuable.

The $3,815 of earnings that Home Depot retained and reinvested in the firm show up on its balance sheet as an increase in retained earnings. Notice that retained earn- ings in Table 3.1 increased by $3,815 million in 2014, from $23,180 million to $26,995 million. However, shareholders’ equity fell during the year because Home Depot also repurchased some of its stock.

Just as it is sometimes useful to prepare a common-size balance sheet, we can also prepare a common-size income statement. In this case, all items are expressed as a percentage of revenues. The last column of Table 3.3 is Home Depot’s common-size income statement. You can see, for example, that the cost of goods sold consumed 65.2% of revenues and that selling, general, and administrative expenses absorbed a further 20.1%.

Income versus Cash Flow It is important to distinguish between Home Depot’s income and the cash that the company generated. Here are two reasons that income and cash are not the same:

1. Depreciation. When Home Depot’s accountants prepare the income statement, they do not simply count the cash coming in and the cash going out. Instead, the accountant starts with the cash payments but then divides these payments into two

common-size income statement All items on the income statement are expressed as a percentage of revenues.

TABLE 3.3 Home Depot’s income statement, fiscal 2014

$ Million % of Sales

Net sales $83,176 100.0% Other income 337 0.4 Cost of goods sold 54,222 65.2 Selling, general, and administrative expenses 16,699 20.1 Depreciation 1,786 2.1 Earnings before interest and income taxes (EBIT) $10,806 13.0% Interest expense 830 1.0 Taxable income $ 9,976 12.0% Taxes 3,631 4.4 Net income $ 6,345 7.6% Allocation of net income Dividends $ 2,530 3.0% Addition to retained earnings $ 3,815 4.6%

Source: Derived from Home Depot annual reports.

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groups—current expenditures (such as wages) and capital expenditures (such as the purchase of new machinery). Current expenditures are deducted from current profits. However, rather than deducting the cost of long-lived machinery in the year it is purchased, the accountant spreads its acquisition cost over its forecasted life by making an annual charge for depreciation.

Thus, when calculating profits, the accountant does not deduct the expenditure on new equipment that year, even though cash is paid out. However, the accountant does deduct depreciation on assets previously purchased, even though no cash is currently paid out. For example, suppose a $100,000 investment is depreciated by $10,000 a year for 10 years.6 This depreciation is treated as an annual expense, although the cash actually went out of the door when the asset was first purchased. For this reason, the deduction for depreciation is classified as a noncash expense.

To calculate the cash produced by the business, it is necessary to add the depreciation charge (which is not a cash payment) back to accounting profits and to subtract the expenditure on new capital equipment (which is a cash payment).

2. Cash versus accrual accounting. Consider a manufacturer that spends $60 to produce goods in period 1. In period 2 it sells these goods for $100, but its customers pay their bills with a delay, so payment is not received until period 3. The following diagram shows the firm’s cash flows. In period 1 there is a cash outflow of $60. Then, when customers pay their bills in period 3, there is an inflow of $100.

+$100 (collect payment)

-$60 (pay for goods)

1 2 3 Period

6 We discuss depreciation rules in Chapter 9.

It would be misleading to say that the firm was running at a loss in period 1 (when cash flow was negative) or that it was extremely profitable in period 3 (when cash flow was positive). Therefore, to construct the income statement, the accountant looks at when the sale was made (period 2 in our example) and gathers together all the revenues and expenses associated with that sale. For our company, the income statement would show:

Revenue $100 Less cost of goods sold 60 Profit $ 40

This practice of matching revenues and expenses is known as accrual accounting. Of course, the accountant does not ignore the actual timing of the cash expenditures and payments. So the cash outlay in the first period will be treated not as an expense but as an investment in inventories. Subsequently, in period 2, when the goods are taken out of inventory and sold, the accountant shows a reduction in inventories.

To go from the cost of goods sold in the income statement to the cash outflows, we need to subtract the investment in inventories that is shown in the balance sheet:

Period: 1 2

Cost of goods sold (income statement) 0 60 + Investment in inventories (balance sheet) 60 −60 = Cash paid out 60 0

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The accountant also does not ignore the fact that the firm has to wait until period 3 to collect its bills. When the sale is made in period 2, the figure for accounts receivable in the balance sheet is increased to show that the company’s customers owe an extra $100 in unpaid bills. Later, when the customers pay those bills in period 3, accounts receivable are reduced by $100. Therefore, to go from the sales shown in the income statement to the cash inflows, we need to subtract the investment in receivables:

Period: 2 3

Sales (income statement) 100 0 − Investment in receivables (balance sheet) 100 −100 = Cash received 0 +100

We will return to these issues in more detail in Chapter 9, but for now we summa- rize the key points as follows: Cash outflow is equal to the cost of goods sold, which is shown in the income statement, plus the change in inventories. Cash inflow is equal to the sales shown in the income statement less the change in uncollected bills.

Profits versus Cash Flows

Suppose our manufacturer spends a further $80 to produce goods in period 2. It sells these goods in period 3 for $120, but customers do not pay their bills until period 4.

The cash flows from these transactions are now as follows:

Example 3.2 ⊲

Period: 1 2 3

Cost of goods sold (income statement) 0 60 80 + Investment in inventories (balance sheet) 60 −60 + 80 = 20 −80 = Cash paid out 60 80 0

$100 (collect payment)

$120 (collect further payment)

-$60 (pay for goods) -$80

(pay for more goods)

1 2 3 4 Period

How do the new transactions affect the income statement and the balance sheet? The income statement will match costs with revenues and record the cost of goods sold when the sales are made in periods 1 and 2. The difference between the costs shown in the income statement and the cash flows is recorded as an investment (and later, disinvestment) in inventories. Thus, in period 1 the accountant shows an investment in inventories of $60 just as before. In period 2, these goods are taken out of inventory and sold, but the firm also produces a further $80 of goods. Thus, there is a net increase in inventories of $20. As these goods in turn are sold in period 3, inventories are reduced by $80. The following table confirms that the cash outflow in each period is equal to the cost of goods sold that is shown in the income statement plus the change in inventories.

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The Statement of Cash Flows

The firm requires cash when it buys new plant and machinery or when it pays interest to the bank and dividends to the shareholders. Therefore, the financial manager needs to keep track of the cash that is coming in and going out.

We have seen that the firm’s cash flow can be quite different from its net income. These differences can arise for at least two reasons:

1. The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Instead, it spreads those expenses over time in the form of an annual deduction for depreciation.

2. The income statement uses the accrual method of accounting, which means that revenues and expenses are recognized when sales are made, rather than when the cash is received or paid out.

The statement of cash flows shows the firm’s cash inflows and outflows from opera- tions as well as from its investments and financing activities. Table 3.4 is the cash-flow statement for Home Depot. It contains three sections. The first shows the cash flow from operations. This is the cash generated from Home Depot’s normal business activities. Next comes the cash that Home Depot has invested in plant and equipment or in the acquisition of new businesses. The final section reports cash flows from financing activ- ities such as the sale of new debt or stock. We will look at each of these sections in turn.

The first section, cash flow from operations, starts with net income but adjusts that figure for those parts of the income statement that do not involve cash coming in or going out. Therefore, it adds back the allowance for depreciation because depreciation is not a cash outflow, even though it is treated as an expense in the income statement.

Any additions to current assets (other than cash itself) need to be subtracted from net income because these absorb cash but do not show up in the income statement. Conversely, any additions to current liabilities need to be added to net income because these release cash. For example, you can see that the increase of $86 million in accounts

3.3

statement of cash flows Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

Period: 2 3 4

Sales (income statement) 100 120 0 − Investment in receivables (balance sheet) 100 −100 + 120 = 20 −120 = Cash received 0 +100 +120

The following table provides a similar reconciliation of the difference between the reve- nues shown in the income statement and the cash inflow:

In the income statement the accountant records sales of $100 in period 1 and $120 in period 2. The fact that the firm has to wait for payment is recognized in the balance sheet as an investment in receivables. The cash that the company receives is equal to the sales shown in the income statement less the investment in receivables. ■

Consider a firm that spends $200 to produce goods in period 1. In period 2, it sells half of those goods for $150, but it doesn’t collect payment until one period later. In period 3, it sells the other half of the goods for $150, and it collects payment on these sales in period 4. Calculate the profits and the cash flows for this firm in periods 1 to 4.

Self-Test3.3

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receivable is deducted from income. In addition, Home Depot increased inventories by $22 million. This increase in inventory levels also absorbed cash and must be deducted from net income when calculating cash flows. On the other hand, Home Depot does not pay all its bills immediately. These delayed payments show up as payables. In 2014, Home Depot had larger bills outstanding than a year earlier: Accounts payable increased by $94 million. Delaying these payments freed up extra cash.

We have pointed out that depreciation is not a cash payment; it is simply the accoun- tant’s allocation to the current year of the original cost of the capital equipment. However, cash does flow out the door when the firm actually buys and pays for new capital equipment. Therefore, these capital expenditures are set out in the second section of the cash-flow statement. You can see that Home Depot spent $1,289 million on new capital equipment. Notice that (gross) property, plant, and equipment on Home Depot’s balance sheet increased by precisely this amount. On the other hand, Home Depot freed up $31 million by selling off other investments. Total cash used by investments was $1,258 million.

Finally, the third section of the cash-flow statement shows the cash from financing activities. For example, Home Depot raised $2,178 million by issuing long-term debt. But it paid out $2,530 million to stockholders in the form of dividends and used another $7,000 million to repurchase stock.7

To summarize, the cash-flow statement tells us that Home Depot generated $8,127 million from operations, spent $1,258 million on new investments, and used $7,075 million in financing activities. Home Depot earned and raised less cash than it spent.

7 You might think that interest payments also ought to be listed in this section. However, it is usual to include interest in the first section with cash flow from operations. This is because, unlike dividends, interest payments are not discretionary. The firm must pay interest when a payment comes due, so these payments are treated as a business expense rather than as a financing decision.

TABLE 3.4 Home Depot’s statement of cash flows (figures in $ millions)

Cash Provided by Operations

Net income $6,345

Depreciation 1,786 Changes in working capital items Decrease (increase) in accounts receivable −86 Decrease (increase) in inventories −22 Decrease (increase) in other current assets −121 Increase (decrease) in accounts payable 94 Increase (decrease) in other current liabilities 131 Total decrease (increase) in working capital −$ 4 Cash provided by operations $8,127

Cash Flows from Investments

Cash provided by (used for) disposal of (additions to) property, plant, and equipment

−$1,289

Sales (acquisitions) of other long-term assets 31 Cash provided by (used for) investments −$1,258

Cash Provided by (Used for) Financing Activities

Increase (decrease) in short-term debt $ 295 Increase (decrease) in long-term debt 2,178 Dividends −2,530 Repurchases of stock −7,000 Other −18 Cash provided by (used for) financing activities −$7,075 Net increase (decrease) in cash and cash equivalents −$ 206

Source: Calculated from data in Tables 3.1 and 3.3.

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Therefore, its cash balance decreased by $206 million. To calculate this change in cash balance, we subtract the uses of cash from the sources:

In Millions

Cash flow from operations $8,127 − Cash flow for new investment −1,258 + Cash provided by new financing −7,075 = Change in cash balance −$ 206

Look back at Table 3.1 and you will see that cash accounts on the balance sheet did indeed decrease by $206 million in 2014.8

8 Home Depot’s published statement of cash flows differs from the cash-flow statement that we derived from the balance sheet and income statement. This is a common occurrence, particularly if the company has engaged in mergers or divestitures during the year.

Free Cash Flow The value of a company depends on how much cash it can generate for investors after it has paid for any new capital investments. This cash is called the company’s free cash flow. Free cash flow is available to be paid out to investors as interest or dividends or to repay debt or buy back stock.

free cash flow Cash available for distribution to investors after firm pays for new investments or additions to working capital.

Free Cash Flow for Home Depot

Let’s use Home Depot’s income and cash-flow statements to calculate its free cash flow in 2014. We start with the earnings produced by the firm’s ongoing operations. This is equal to 

Net income + debt interest = $6,345 + $830 = $7,175 million

We need to make two adjustments to this figure for those parts of the income statement that do not involve cash coming in or going out. First, we must add back depreciation because depreciation is not a cash outflow, even though it is treated as an expense in the income statement. Second, accounting income is not cash in the bank. For example, the firm may need to lay out money to buy materials ahead of time, or its customers may not pay for their purchases immediately. Therefore, to measure the cash from ongoing operations, we need to subtract those additions to net working capital shown in the top panel of the state- ment of cash flows. This gives us cash flow from operations:

Cash flow from operations = (net income + interest) + depreciation − additions to

net working capital = $7,175 + $1,786 − $4 = $8,957 million

Example 3.3 ⊲

Would the following activities increase or decrease the firm’s cash balance?

a. Inventories are increased. b. The firm reduces its accounts payable. c. The firm issues additional common stock. d. The firm buys new equipment.

Self-Test3.4

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Accounting Practice and Malpractice

Managers of public companies face constant scrutiny. Much of that scrutiny focuses on earnings. Security analysts forecast earnings per share, and investors then wait to see whether the company can meet or beat the forecasts. A shortfall, even if it is only a cent or two, can be a big disappointment. Investors might judge that if you could not find that extra cent or two of earnings, the firm must be in a really bad way.

Managers complain about this pressure, but do they do anything about it? Unfortu- nately, the answer appears to be yes, according to Graham, Harvey, and Rajgopal, who surveyed about 400 senior managers.11 Most of the managers said that accounting earnings were the single most important number reported to investors. Most admitted to adjusting their firms’ operations and investments to produce the earnings that inves- tors were looking for. For example, 80% were prepared to decrease discretionary spending on R&D, advertising, or plant maintenance to meet earnings targets.

Of course, managers may not need to adjust the firm’s operations if they can instead adjust their accounting methods. U.S. accounting rules are spelled out by the Financial Accounting Standards Board (FASB) and its generally accepted accounting principles (GAAP). Yet, inevitably, rules and principles leave room for discretion, and managers under pressure to perform are tempted to take advantage of this leeway to satisfy

3.4

This cash is not all available to be paid out to investors, for the company needs some of the cash for new capital expenditures. So the capital that is free for distribution is

Free cash flow = cash flow from operations − capital expenditures = $8,957 − $1,258 = $7,699 million

Notice that free cash flow differs from the addition-to-cash balances found in the state- ment of cash flows (Table 3.4). First, when we calculate free cash flow, we ignore altogether items in the last panel of Table 3.4, “Cash provided by financing activities.”9 This is because free cash flow measures how much cash the company’s operations generate for possible distribution to investors. The available amount should not be confused with the amount that the company actually raised by financing activities. Second, we add back interest payments when computing free cash flow, as those payments are part of the distributions made to investors.10

It is often useful to ask what Home Depot’s free cash flow would have been if the company had been financed entirely by equity. In that case, all the free cash flow would belong to the shareholders. However, if Home Depot no longer paid out $830 million as interest, pretax income would be increased by that amount, and the company would pay an additional .35 × 830 = $290.50 million in tax. Thus, if the company was financed solely by equity, free cash flow would have been $7,699 − $290.50 = $7,408.50 million. ■

9 For this reason, when we calculated cash flow from operations, we ignored the change in holdings of short- term debt, even though this short-term debt is listed under current liabilities. We were interested only in the items of working capital that arose from the firm’s operations. 10 We can check the logic linking free cash flow to the statement of cash flows as follows:

11 J. R. Graham, C. R. Harvey, and S. Rajgopal, “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics 40 (2005), pp. 3–73.

Increase in cash balance from Table 3.4 −$ 206 + Cash used for financing activities from Table 3.4 7,075 + Interest payments 830 Free cash flow $7,699

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investors. Investors worry about the fact that some companies seem particularly prone to inflate their earnings by playing fast and loose with accounting practice. They refer to such companies as having “low-quality” earnings, and they place a correspondingly lower value on the firms’ stock.

Here are some examples of ambiguities in accounting rules that have been used by companies to conceal unflattering information:

∙ Revenue recognition. As we saw earlier, firms record a sale when it is made, not when the customer actually pays. But the date of sale is not always obvious. Suppose it is November and you are concerned that if your firm does not meet its sales target, you can forget about your annual bonus. You contact your main customers, and they agree to increase their December orders as long as they have the right to return any unsold goods. Your firm then books these shipments as “sales,” even though there is a high likelihood that many of the goods will be returned. That is almost certainly illegal and will get you into serious trouble. But suppose instead that you tell your customers that the price of your product may rise in the new year and suggest that they place an extra order in December. This practice, known as “channel stuffing,” increases this year’s sales at the expense of next year’s sales.

Many companies have been thought to use channel stuffing to overstate their earnings, but very blatant instances are liable to attract the SEC’s attention. For example, in 2002 the pharmaceutical giant, Bristol Myers Squibb, disclosed that wholesalers were holding hundreds of millions of dollars in excessive inventories of its products and the company’s earnings for 2002 might be just half of its 2001 earnings as wholesalers worked down these inventories. Following an investigation by the SEC, the company agreed to pay $150 million to settle accusations that this channel stuffing had improperly inflated its sales and earnings. In Chapter 1, we mentioned Hewlett-Packard’s disastrous acquisition of the British company Autonomy. Hewlett-Packard paid $11.1 billion for Autonomy. Just over a year later, it wrote down the value of the company by $8.8 billion, alleging that Autonomy had used channel stuffing to greatly inflate its revenues.

∙ Cookie-jar reserves. The giant mortgage-pass-through firm Freddie Mac earned the Wall Street nickname “Steady Freddie” for its unusually smooth and predictable pattern of earnings growth, at least until 2008 when it suddenly collapsed in the wake of the meltdown in subprime mortgages. Unfortunately, it emerged in 2003 that Freddie achieved this predictability in part by misusing its reserve accounts. Normally, such accounts are intended to allow for the likely impact of events that might reduce earnings, such as the failure of customers to pay their bills. But Freddie seemed to “overreserve” against such contingencies so that it could “release” those reserves and bolster income in a bad year. Its steady growth was largely a matter of earnings management.

∙ Off–balance sheet assets and liabilities. Before its bankruptcy in 2001 (at that time, the second largest in U.S. history), Enron had accumulated large debts and had also guaranteed the debts of other companies in which it had an ownership stake. To present a fair view of the firm, Enron should have recognized these potential liabilities on its balance sheet. But the firm created and placed paper firms— so-called special-purpose entities (SPEs)—in the middle of its transactions and excluded these liabilities from its financial statements.

The collapse of Enron illustrates how dishonest managers with creamy compensa- tion packages may be tempted to conceal the truth from investors. If the company had been more transparent to outsiders—that is, if they could have assessed its true profit- ability and prospects—its problems would have shown up right away in a falling stock price. This in turn would have generated extra scrutiny from security analysts, bond rating agencies, lenders, and investors.

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With transparency, corporate troubles generally lead to corrective action. But the top management of a troubled and opaque company may be able to maintain its stock price and postpone the discipline of the market. Market discipline caught up with Enron only a month or two before bankruptcy.

Enron was not the only company to be mired in accounting scandals in the early years of the century. Firms such as Global Crossing, Qwest Communications, and WorldCom misstated profits by billions of dollars. Overseas, the Italian dairy com- pany Parmalat falsified the existence of a bank account to the tune of $5.5 billion, and the French media and entertainment company Vivendi came close to bankruptcy after it was accused of accounting fraud. In response to these scandals, Congress passed the Sarbanes-Oxley Act, widely known as SOX. A major goal of SOX is to increase trans- parency and ensure that companies and their accountants provide directors, lenders, and shareholders with the information they need to monitor progress.

SOX created the Public Accounting Oversight Board to oversee the auditing of public companies; it banned accounting firms from offering other services to compa- nies whose accounts they audit; it prohibited any individual from heading a firm’s audit for more than 5 years; and it required that the board’s audit committee consist of directors who are independent of the company’s management. Sarbanes-Oxley also required that management certify that the financial statements present a fair view of the firm’s financial position and demonstrate that the firm has adequate controls and procedures for financial reporting. All this has come at a price. Managers and inves- tors worry that the costs of SOX and the burden of meeting detailed, inflexible regu- lations are pushing some corporations to return from public to private ownership. Some blame SOX and onerous regulation in the United States for the fact that an increasing number of foreign companies have chosen to list their shares in London rather than New York.

There is also a vigorous debate over “rules-based” versus “principles-based” approaches to accounting standards. The United States follows a rules-based approach,

companies must be ready to defend their accounting prac- tices in light of the general principles laid out in the IFRS. By contrast, in the United States, GAAP are accompanied by thousands of pages of prescriptive regulatory guidance and interpretations from auditors and accounting groups. For example, more than 160 pieces of authoritative literature relate to how and when companies record revenue. This leaves less room for judgment, but detailed rules rapidly become out of date, and unscrupulous companies have been able to structure transactions so that they keep to the letter but not the spirit of the rules.

By 2014, it had become clear that the SEC’s plan to move to IFRS was effectively dead and that, while the SEC and IASB would continue to collaborate on accounting rules, there was little prospect of any agreement over a single global standard that included the United States.

The International Financial Reporting Standards (IFRS), which are set by the London-based International Accounting Standards Board (IASB), aim to harmonize financial reporting around the world. They are the basis for reporting throughout the European Union. In addition, some 100 other countries, such as Australia, Canada, Brazil, India, and China, have adopted them or plan to do so.

For some years, the SEC has worked to bring U.S. account- ing standards more in line with international rules. For exam- ple, until 2007 foreign companies that traded on U.S. stock exchanges were required to show how their accounts dif- fered from U.S. GAAP. This was a very expensive exercise that cost some companies millions of dollars annually and caused many to delist their stocks. These companies can now simply report results using international accounting stan- dards. Subsequently, in August 2008, the SEC released its plans to allow some large U.S. multinationals, representing approximately $2.5 trillion in market capitalization, to eventu- ally use IFRS for financial statements.

This shift from GAAP to IFRS would involve a major change in the way that accountants in the United States approach their task. IFRS tend to be “principles-based,” which means that there are no hard-and-fast codes to follow. Instead,

Finance in Practice The Rise and Stall of Convergence in Accounting Standards

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Accounting acronyms

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with detailed rules governing virtually every circumstance that possibly can be antici- pated. In contrast, the European Union takes a principles-based approach to account- ing. Its International Financial Reporting Standards set out general approaches that financial statements should take to valuing assets. Europe and the United States have been engaged for years in attempts to coordinate their systems, and many in the United States have lobbied for the greater simplicity that principles-based accounting standards might offer. The nearby box reports on these efforts.

Taxes

Taxes often have a major effect on financial decisions. Therefore, we should explain how corporations and investors are taxed.

Corporate Tax Companies pay tax on their income. Table 3.5 shows that there are special low rates of corporate tax for small companies, but for large companies (those with income over $18.33 million) the corporate tax rate is 35%.12 Thus for every $100 that the firm earns it pays $35 in corporate tax.

When firms calculate taxable income, they are allowed to deduct expenses. These expenses include an allowance for depreciation. However, the Internal Revenue Service (IRS) specifies the rates of depreciation that the company can use for different types of equipment. The rates of depreciation used to calculate taxes are not the same as the rates used when the firm reports its profits to shareholders.13

The company is also allowed to deduct interest paid to debtholders when calculat- ing its taxable income, but dividends paid to shareholders are not deductible. These dividends are therefore paid out of after-tax income. Table 3.6 provides an example of how interest payments reduce corporate taxes. Although EBIT for both firms A and B

3.5

Taxable Income ($) Tax Rate (%)

0–50,000 15 50,001–75,000 25 75,001–100,000 34 100,001–18,333,333 Varies between 39 and 34 Over 18,333,333 35

TABLE 3.5 Corporate tax rates, 2016

Firm A Firm B

EBIT $100 $100 Interest 40 0 Pretax income $ 60 $100 Tax (35% of pretax income) 21 35 Net income $ 39 $ 65

TABLE 3.6 Firms A and B both have earnings before interest and taxes (EBIT) of $100 million, but A pays out part of its profits as debt interest. This reduces the corporate tax paid by A.

Note: Figures in millions of dollars.

12 In addition, corporations pay state income taxes, which we ignore here for simplicity. 13 If the company assumes a slower rate of depreciation in its income statement than the Internal Revenue Service assumes, the tax charge shown in the income statement will be higher in the early years of a project’s life than the actual tax payment. This difference is recorded in the balance sheet as a liability for deferred tax. We will tell you more about depreciation allowances in Chapter 9.

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is $100 million, firm A, which has $40 million of interest expense, has lower pretax income and therefore pays less taxes.

The bad news about taxes is that each extra dollar of revenue increases taxable income by $1 and results in 35 cents of extra taxes. The good news is that each extra dollar of expense reduces taxable income by $1 and therefore reduces taxes by 35 cents. For example, if the firm borrows money, every dollar of interest it pays on the loan reduces taxes by 35 cents. Therefore, a dollar of interest reduces after-tax income by only 65 cents.

14 Losses can be carried back for a maximum of 3 years and forward for up to 15 years.

Taxable Income ($)

Single Taxpayers Married Taxpayers Filing Joint Returns Tax Rate (%)

0–9,275 0–18,550 10.0 9,276–37,650 18,551–75,300 15.0

37,651–91,150 75,301–151,900 25.0 91,151–190,150 151,901–231,450 28.0

190,151–413,350 231,451–413,350 33.0 413,351–415,050 413,351–466,950 35.0

415,051 and above 466,951 and above 39.6

TABLE 3.7 Personal tax rates, 2016

When firms make profits, they pay 35% of the profits to the Internal Revenue Service. But the process doesn’t work in reverse; if the firm suffers a loss, the IRS does not send it a check for 35% of the loss. However, the firm can carry the losses back, deduct them from taxable income in earlier years, and claim a refund of past taxes. Losses can also be carried forward and deducted from taxable income in the future.14

Personal Tax Table 3.7 shows the U.S. rates of personal tax. Notice that as income increases, the tax rate also increases. Notice also that the top personal tax rate is higher than the top corporate rate.

The tax rates presented in Table 3.7 are marginal tax rates. The marginal tax rate is the tax that the individual pays on each extra dollar of income. For example, as a single taxpayer, you would pay 10 cents of tax on each extra dollar you earn when your income is below $9,275, but once income exceeds $9,275, you would pay 15 cents of tax on each extra dollar of income up to an income of $37,650. If your total income is $50,000, your tax bill is 10% of the first $9,275 of income, 15% of the next $28,375 (i.e., 37,650 − 9,275), and 25% of the remaining $12,350:

Tax = (.10 × $9,275) + (.15 × $28,375) + (.25 × $12,350) = $8,271.25

marginal tax rate Additional taxes owed per dollar of additional income.

Recalculate the figures in Table 3.6, assuming that firm A now has to make inter- est payments of $60 million. What happens to taxes paid? Does net income fall by the additional $20 million interest payment compared with the case consid- ered in Table 3.6, where interest expense was only $40 million?

Self-Test3.5

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The average tax rate is simply the total tax bill divided by total income. In this example it is $8,271.25/$50,000 = .165, or 16.5%. Notice that the average rate is lower than the marginal rate. This is because of the lower rates on the first $37,650.

average tax rate Total taxes owed divided by total income.

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Average and marginal tax rates

The tax rates in Table 3.7 apply to “ordinary income,” primarily income earned as salary or wages. Interest earnings also are treated as ordinary income.

The U.S. government also taxes investment earnings, for example dividends or capital gains. The treatment of dividend income in the United States leads to what is commonly dubbed the “double taxation” of corporate earnings. Each dollar the com- pany earns is taxed at the corporate rate. Then, if the company pays a dividend out of this after-tax income, the shareholder pays personal income taxes on the distribution. The original earnings are taxed first as corporate income and again as dividend income. Suppose instead that the company earns a dollar which is paid out as interest. The dol- lar escapes corporate tax because the interest payment is considered a business expense that reduces the firm’s taxable income.

Capital gains are also taxed, but only when the gains are realized. Suppose that you bought Bio-technics stock when it was selling for 10 cents a share. Its market price today is $1 a share. As long as you hold on to your stock, there is no tax to pay on your gain. But if you sell, the 90 cents of capital gain is taxed. 

Table 3.8 shows tax rates on investment income. For most investors, the effective tax rate is either 15% or 18.8% (15% plus a potential 3.8% surcharge), but the highest income investors pay an effective rate of 23.8%.

Financial managers need to worry about the tax treatment of investment income because tax policy will affect the prices individuals are willing to pay for the compa- ny’s stock or bonds. We will return to these issues in Part 5 of the text.

The tax rates in Table 3.7 and Table 3.8 apply to individuals. But financial institu- tions are major investors in corporate securities. These institutions often have special tax provisions. For example, pension funds are not taxed on interest or dividend income or on capital gains.

* These rates apply to capital gains and dividends on assets held for at least one year. ** In addition to these nominal rates, an additional 3.8% surtax is assessed on net investment income for taxpayers with total income over $200,000 (single filers) or $250,000 (married filing jointly).

What are the average and marginal tax rates for a single taxpayer with a taxable income of $80,000? What are the average and marginal tax rates for married taxpayers filing joint returns if their joint taxable income is also $80,000?

Self-Test3.6

TABLE 3.8 Tax rates on investment income* corresponding to 2016 tax brackets**

Taxable Income ($)

Single Taxpayers Married Taxpayers Filing Joint Returns Tax Rate (%)

0–9,275 0–18,550 0 9,276–37,650 18,551–75,300 0

37,651–91,150 75,301–151,900 15 91,151–190,150 151,901–231,450 15

190,151–413,350 231,451–413,350 15 413,351–415,050 413,351–466,950 15 415,051 and above 466,951 and above 20

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SUMMARY Investors and other stakeholders in the firm need regular financial information to help them monitor the firm’s progress. Accountants summarize this information in a balance sheet, income statement, and statement of cash flows.

The balance sheet provides a snapshot of the firm’s assets and liabilities. The assets consist of current assets that can be rapidly turned into cash and fixed assets such as plant and machinery. The liabilities consist of current liabilities that are due for payment within a year and long-term debts. The difference between the assets and the liabilities represents the amount of the shareholders’ equity.

The income statement measures the profitability of the company during the year. It shows the difference between revenues and expenses.

The statement of cash flows measures the sources and uses of cash during the year. The change in the company’s cash balance is the difference between sources and uses.

It is important to distinguish between the book values that are shown in the company accounts and the market values of the assets and liabilities. Book values are historical measures based on the original cost of an asset. For example, the assets in the balance sheet are shown at their historical cost less an allowance for depreciation. Similarly, the figure for shareholders’ equity measures the cash that shareholders have contributed in the past or that the company has reinvested on their behalf. In contrast, market value is the current price of an asset or liability.

Income is not the same as cash flow. There are two reasons for this: (1) Investment in fixed assets is not deducted immediately from income but is instead spread (as charges for depre- ciation) over the expected life of the equipment, and (2) the accountant records revenues when the sale is made, rather than when the customer actually pays the bill, and at the same time deducts the production costs even though those costs may have been incurred earlier.

For large companies the marginal rate of tax on income is 35%. In calculating taxable income the company deducts an allowance for depreciation and interest payments. It can- not deduct dividend payments to the shareholders.

Individuals are also taxed on their income, which includes dividends and interest on their investments. Capital gains are taxed, but only when the investment is sold and the gain realized.

What information is contained in the balance sheet, income statement, and statement of cash flows? (LO3-1)

What is the difference between market and book values? (LO3-2)

Why does accounting income differ from cash flow? (LO3-3)

What are the essential features of the taxation of corporate and personal income? (LO3-4)

LISTING OF EQUATION

3.1 Shareholders’ equity = net assets = total assets − total liabilities

QUESTIONS AND PROBLEMS 1. Financial Statements. Earlier in the chapter, we characterized the balance sheet as providing a

snapshot of the firm at one point in time and the income statement as providing a video. What did we mean by this? Is the statement of cash flow more like a snapshot or a video? (LO3-1)

2. Balance Sheet. Balance sheet items are usually entered in order of declining liquidity. Place each of the terms below in the appropriate place in the following balance sheet. (LO3-1) Accounts payable Total current assets Net fixed assets Accounts receivable Debt due for repayment Total current liabilities Cash and marketable securities Inventories Equity Long-term debt

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3. Balance Sheet. Construct a balance sheet for Sophie’s Sofas given the following data. What is shareholders’ equity? (LO3-1) Cash balances = $10,000 Inventory of sofas = $200,000 Store and property = $100,000 Accounts receivable = $22,000 Accounts payable = $17,000 Long-term debt = $170,000

4. Income Statement. A firm’s income statement included the following data. The firm’s average tax rate was 20%. (LO3-1) Cost of goods sold $8,000 Income taxes paid $2,000 Administrative expenses $3,000 Interest expense $1,000 Depreciation $1,000

Assets Liabilities and Equity

a. f. b. g. c. h. d. i. e. j.

Total assets Total liabilities and equity

a. What was the firm’s net income? b. What must have been the firm’s revenues? c. What was EBIT?

5. Balance Sheet/Income Statement. The year-end 2015 balance sheet of Brandex Inc. listed common stock and other paid-in capital at $1,100,000 and retained earnings at $3,400,000. The next year, retained earnings were listed at $3,700,000. The firm’s net income in 2016 was $900,000. There were no stock repurchases during the year. What were the dividends paid by the firm in 2016? (LO3-1)

6. Financial Statements. South Sea Baubles has the following (incomplete) balance sheet and income statement. (LO3-1, LO3-4)

BALANCE SHEET AT END OF YEAR (Figures in $ millions)

Assets 2015 2016 Liabilities and Shareholders’ Equity 2015 2016

Current assets $ 90 $140 Current liabilities $ 50 $ 60 Net fixed assets 800 900 Long-term debt 600 750

INCOME STATEMENT, 2016 (Figures in $ millions)

Revenue $1,950 Cost of goods sold 1,030 Depreciation 350 Interest expense 240

a. What is shareholders’ equity in 2015? b. What is shareholders’ equity in 2016? c. What is net working capital in 2015?  d. What is net working capital in 2016? e. What are taxes paid in 2016? Assume the firm pays taxes equal to 35% of taxable income.

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f. What is cash provided by operations during 2016? Pay attention to changes in net working capital, using Table 3.4 as a guide.

g. Net fixed assets increased from $800 million to $900 million during 2016. What must have been South Sea’s gross investment in fixed assets during 2016?

h. If South Sea reduced its outstanding accounts payable by $35 million during the year, what must have happened to its other current liabilities?

7. Financial Statements. Here are the 2015 and 2016 (incomplete) balance sheets for Newble Oil Corp. (LO3-1)

BALANCE SHEET AT END OF YEAR (Figures in $ millions)

Assets 2015 2016 Liabilities and Shareholders’ Equity 2015 2016

Current assets $ 310 $ 420 Current liabilities $210 $240 Net fixed assets 1,200 1,420 Long-term debt 830 920

BALANCE SHEET

Payables $ 35 Inventories $50 Less accumulated depreciation 120 Receivables 35 Total current assets Total current liabilities Long-term debt $350 Interest expense $25 Property, plant, and equipment 520 Total liabilities Net fixed assets Shareholders’ equity $90 Total assets Total liabilities and shareholders’ equity

INCOME STATEMENT

Net sales $700 Cost of goods sold 580 Selling, general, and administrative expenses 38 EBIT Debt due for repayment $ 25 Cash 15 Taxable income Taxes $ 15 Depreciation 12 Net income

a. What was shareholders’ equity at the end of 2015? b. What was shareholders’ equity at the end of 2016? c. If Newble paid dividends of $100 in 2016 and made no stock issues, what must have been

net income during the year? d. If Newble purchased $300 in fixed assets during 2016, what must have been the depreciation

charge on the income statement? e. What was the change in net working capital between 2015 and 2016? f. If Newble issued $200 of new long-term debt, how much debt must have been paid off

during the year?

8. Financial Statements. Henry Josstick has just started his first accounting course and has pre- pared the following balance sheet and income statement for Omega Corp. Unfortunately, although the data for the individual items are correct, he is very confused as to whether an item should go in the balance sheet or income statement and whether it is an asset or liability. Help him by rearranging the items and filling in the blanks.

What is the correct total for the following? (LO3-1) a. Current assets b. Net fixed assets c. Total assets

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d. Current liabilities e. Total liabilities f. Total liabilities and shareholders’ equity g. EBIT h. Taxable income i. Net income

9. Market versus Book Values. The founder of Alchemy Products Inc. discovered a way to turn gold into lead and patented this new technology. He then formed a corporation and invested $200,000 in setting up a production plant. He believes that he could sell his patent for $50 million. (LO3-2) a. What is the book value of the firm? b. What is the market value of the firm? c. If there are 2 million shares of stock in the new corporation, what is the book value per share? d. What is the price per share?

10. Market versus Book Values. State whether each of the following events would increase or decrease the ratio of market value to book value. (LO3-2) a. Big Oil announces the discovery of a major new oil field in Costaguana. b. Big Autos increases its depreciation provision. c. Since Big Stores purchased its assets, inflation has risen sharply.

11. Market versus Book Values. (LO3-2) a. In early 2015, the market values of the shares of many banks (e.g., Bank of America or

Citigroup) were less than book value per share. How would you interpret this pattern? b. At the same time, Google’s market value per share was more than four times its book value.

Is this consistent with your analysis in part (a)?

12. Income versus Cash Flow. Explain why accounting income generally differs from a firm’s cash inflows. (LO3-3)

13. Cash Flows. Will the following actions increase or decrease the firm’s cash balance? (LO3-3) a. The firm sells some goods from inventory. b. The firm sells some machinery to a bank and leases it back for a period of 20 years. c. The firm buys back 1 million shares of stock from existing shareholders.

14. Income versus Cash Flow. Butterfly Tractors had $14 million in sales last year. Cost of goods sold was $8 million, depreciation expense was $2 million, interest payment on outstanding debt was $1 million, and the firm’s tax rate was 35%. (LO3-3) a. What was the firm’s net income? b. What was the firm’s cash flow? c. What would happen to net income and cash flow if depreciation were increased by

$1 million? d. Would you expect the change in depreciation to have a positive or negative impact on the

firm’s stock price? e. What would be the impact on net income if depreciation was $1 million and interest expense

was $2 million? f. What would be the impact on cash flow if depreciation was $1 million and interest expense

was $2 million?

15. Working Capital. QuickGrow is in an expanding market, and its sales are increasing by 25% per year. Would you expect its net working capital to be increasing or decreasing? (LO3-3)

16. Income Statement. Sheryl’s Shipping had sales last year of $10,000. The cost of goods sold was $6,500, general and administrative expenses were $1,000, interest expenses were $500, and depreciation was $1,000. The firm’s tax rate is 35%. (LO3-3) a. What are earnings before interest and taxes? b. What is net income? c. What is cash flow from operations?

17. Income versus Cash Flow. Start-up firms typically have negative net cash flows for several years. (LO3-3) a. Does this mean that they are failing? b. Accounting profits for these firms are also commonly negative. How would you interpret

this pattern? Is there a shortcoming in our accounting rules?

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18. Income versus Cash Flow. Can cash flow from operations be positive if net income is negative? Can it be negative if net income is positive? Give examples. (LO3-3)

19. Income versus Cash Flow. During the last year of operations, Theta’s accounts receivable increased by $10,000, accounts payable increased by $5,000, and inventories decreased by $2,000. What is the total impact of these changes on the difference between profits and cash flow? (LO3-3)

20. Income versus Cash Flow. Candy Canes Inc. spends $100,000 to buy sugar and peppermint in April. It produces its candy and sells it to distributors in May for $150,000, but it does not receive payment until June. For each month, find the firm’s sales, net income, and net cash flow, and fill in the following table. (LO3-3)

Sales Net Income Cash Flow

April a. b. c. May d. e. f. June g. h. i.

INCOME STATEMENT OF QUICK BURGER CORP., 2016 (Figures in $ millions)

Net sales $27,567 Costs 17,569 Depreciation 1,402 Earnings before interest and taxes (EBIT) $ 8,596 Interest expense 517 Pretax income 8,079 Taxes 2,614 Net income $ 5,465

21. Income versus Cash Flow. Ponzi Products produced 100 chain-letter kits this quarter, resulting in a total cash outlay of $10 per unit. It will sell 50 of the kits next quarter at a price of $11, and the other 50 kits in the third quarter at a price of $12. It takes a full quarter for Ponzi to collect its bills from its customers. (Ignore possible sales in earlier or later quarters.) (LO3-3) a. What is the net income for Ponzi next quarter? b. What are the cash flows for the company this quarter? c. What are the cash flows for the company in the third quarter? d. What is Ponzi’s net working capital in the next quarter?

22. Income versus Cash Flow. Value Added Inc. buys $1 million of sow’s ears at the beginning of January but doesn’t pay immediately. Instead, it agrees to pay the bill in March. It processes the ears into silk purses, which it sells for $2 million in February. However, it will not collect payment on the sales until April. (LO3-3) a. What is the firm’s net income in February? b. What is its net income in March? c. What is the firm’s net new investment in working capital in January? d. What is its net new investment in working capital in April? e. What is the firm’s cash flow in January? f. What is the firm’s cash flow in February? g. What is the cash flow in March? h. What is the cash flow in April?

23. Free Cash Flow. Free cash flow measures the cash available for distribution to debtholders and shareholders. Look at Section 3.3, where we calculate free cash flow for Home Depot. Show how this cash was distributed to investors. How much was used to build up cash reserves? (LO3-3)

24. Free Cash Flow. The following table shows an abbreviated income statement and balance sheet for Quick Burger Corporation for 2016.

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BALANCE SHEET OF QUICK BURGER CORP., 2016 (Figures in $ millions)

Assets 2016 2015 Liabilities and Shareholders’ Equity 2016 2015

Current assets Current liabilities

Cash and marketable securities $ 2,336 $ 2,336 Debt due for repayment — $ 367 Receivables 1,375 1,335 Accounts payable $ 3,403 3,143 Inventories 122 117 Total current liabilities $ 3,403 $ 3,509 Other current assets 1,089 616 Total current assets $ 4,922 $ 4,403 Fixed assets Long-term debt $13,633 $12,134 Property, plant, and equipment $24,677 $22,835 Other long-term liabilities 3,057 2,957 Intangible assets (goodwill) 2,804 2,653 Total liabilities $20,093 $18,600 Other long-term assets 2,983 3,099 Total shareholders’ equity 15,294 14,390 Total assets $35,387 $32,990 Total liabilities and shareholders’ equity $35,387 $32,990

In 2016 Quick Burger had capital expenditures of $3,049. (LO3-3) a. Calculate Quick Burger’s free cash flow in 2016. b. If Quick Burger was financed entirely by equity, how much more tax would the company

have paid? (Assume a tax rate of 35%.) c. What would the company’s free cash flow have been if it was all-equity financed?

25. Tax Rates. (LO3-4) a. What would be the marginal tax rate for a married couple with income of $90,000? b. What would be the average tax rate for a married couple with income of $90,000? c. What would be the marginal tax rate for an unmarried taxpayer with income of $90,000? d. What would be the average tax rate for an unmarried taxpayer with income of $90,000?

26. Tax Rates. Using Table 3.7, calculate the marginal and average tax rates for a single taxpayer with the following incomes: (LO3-4) a. $20,000 b. $50,000 c. $300,000 d. $3,000,000

27. Taxes. A married couple earned $95,000 in 2016. How much did they pay in taxes? (LO3-4) a. What was their marginal tax bracket? b. What was their average tax bracket?

28. Tax Rates. What would be the marginal and average tax rates for a corporation with an income level of $100,000? (LO3-4)

29. Tax Rates. You have set up your tax preparation firm as an incorporated business. You took $70,000 from the firm as your salary. The firm’s taxable income for the year (net of your salary) was $30,000. Assume you pay personal taxes as an unmarried taxpayer. (LO3-4) a. How much tax must be paid to the federal government, including both your personal taxes

and the firm’s taxes? Use the tax rates presented in Tables 3.5 and 3.7. b. By how much will you reduce the total tax bill if you cut your salary to $50,000, thereby

leaving the firm with taxable income of $50,000? c. What allocation will minimize the total tax bill? Hint: Think about marginal tax rates and

the ability to shift income from a higher marginal bracket to a lower one.

30. Tax Rates. Turn back to Table 3.7, which shows marginal personal tax rates. Make a table in Excel that calculates taxes due for income levels ranging from $10,000 to $10 million. (LO3-4) a. For each income, calculate the average tax rate of a single taxpayer. Plot the average tax rate

as a function of income. b. What happens to the difference between the average and top marginal tax rates as income

becomes very large?

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The table below contains data on Fincorp Inc. that you should use for Problems 31–38. The balance sheet items correspond to values at year-end 2015 and 2016, while the income statement items correspond to revenues or expenses during the year ending in either 2015 or 2016. All values are in thousands of dollars.

2015 2016

Revenue $4,000 $4,100 Cost of goods sold 1,600 1,700 Depreciation 500 520 Inventories 300 350 Administrative expenses 500 550 Interest expense 150 150 Federal and state taxes* 400 420 Accounts payable 300 350 Accounts receivable 400 450 Net fixed assets† 5,000 5,800 Long-term debt 2,000 2,400 Notes payable 1,000 600 Dividends paid 410 410 Cash and marketable securities 800 300

* Taxes are paid in their entirety in the year that the tax obligation is incurred. † Net fixed assets are fixed assets net of accumulated depreciation since the asset was installed.

31. Balance Sheet. Construct a balance sheet for Fincorp for 2015 and 2016. What is shareholders’ equity? (LO3-1)

32. Working Capital. What was the change in net working capital during the year? (LO3-1) 33. Income Statement. Construct an income statement for Fincorp for 2015 and 2016. What were

reinvested earnings for 2016? (LO3-1)

34. Earnings per Share. Suppose that Fincorp has 500,000 shares outstanding. What were earnings per share? (LO3-1)

35. Balance Sheet. Examine the values for depreciation in 2016 and net fixed assets in 2015 and 2016. What was Fincorp’s gross investment in plant and equipment during 2016? (LO3-1)

36. Book versus Market Value. Suppose that the market value (in thousands of dollars) of Fincorp’s fixed assets in 2016 is $6,000 and that the value of its long-term debt is only $2,200. In addition, the consensus among investors is that Fincorp’s past investments in developing the skills of its employees are worth $2,900. This investment of course does not show up on the balance sheet. What will be the price per share of Fincorp stock? (LO3-2)

37. Income versus Cash Flows. Construct a statement of cash flows for Fincorp for 2016. (LO3-3) 38. Tax Rates. (LO3-4)

a. What was the firm’s average tax bracket for each year? b. Do you have enough information to determine the marginal tax bracket?

WEB EXERCISES 1. Find Microsoft (MSFT) and Ford (F) on finance.yahoo.com, and examine the financial state-

ments of each. Which firm uses more debt finance? Which firm has higher cash as a percentage of total assets? Which has higher EBIT per dollar of total assets? Which has higher profits per dollar of shareholders’ equity?

2. Now choose two highly profitable technology firms, such as Intel (INTC) and Microsoft (MSFT), and two electric utilities, such as American Electric Power (AEP) and Duke Energy (DUK). Which firms have the higher ratio of market value to book value of equity? Does this

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make sense to you? Which firms pay out a higher fraction of their profits as dividends to share- holders? Does this make sense?

3. Log on to the website of a large nonfinancial company and find its latest financial statements. Draw up a simplified balance sheet, income statement, and statement of cash flows as in Tables 3.1, 3.3, and 3.4. Some companies’ financial statements can be extremely complex; try to find a relatively straightforward business. Also, as far as possible, use the same headings as in these tables, and don’t hesitate to group some items as “other current assets,” “other expenses,” and so on. Look first at your simplified balance sheet. How much was the company owed by its cus- tomers in the form of unpaid bills? What liabilities does the company need to meet within a year? What was the original cost of the company’s fixed assets? Now look at the income state- ment. What were the company’s earnings before interest and taxes (EBIT)? Finally, turn to the cash-flow statement. Did changes in working capital add to cash or use it up?

4. The schedule of tax rates for individuals changes frequently. Check the latest schedules on either www.irs.gov or www.bankrate.com. What is your marginal tax rate if you are single with a taxable income of $70,000? What is your average tax rate?

SOLUTIONS TO SELF-TEST QUESTIONS 3.1 Cash and equivalents would increase by $100 million. Property, plant, and equipment would

increase by $400 million. Long-term debt would increase by $500 million. Shareholders’ equity would not increase: Assets and liabilities have increased equally, leaving shareholders’ equity unchanged.

3.2 a. If the auto plant were worth $14 billion, the equity in the firm would be worth $14 − $4 = $10 billion. With 100 million shares outstanding, each share would be worth $100.

b. If the outstanding stock were worth $8 billion, we would infer that the market values the auto plant at $8 + $4 = $12 billion.

3.3 The profits for the firm are recognized in periods 2 and 3 when the sales take place. In both of those periods, profits are $150 − $100 = $50. Cash flows are derived as follows.

In period 2, half the units are sold for $150 but no cash is collected, so the entire $150 is treated as an increase in accounts receivable. Half the $200 cost of production is recognized, and a like amount is taken out of inventory. In period 3, the firm sells another $150 of product but collects $150 from its previous sales, so there is no change in outstanding accounts receivable. Net cash flow is the $150 collected in this period on the sale that occurred in period 2. In period 4, cash flow is again $150, as the accounts receivable from the sale in period 3 are collected.

3.4 a. An increase in inventories uses cash, reducing the firm’s net cash balance. b. A reduction in accounts payable uses cash, reducing the firm’s net cash balance. c. An issue of common stock is a source of cash. d. The purchase of new equipment is a use of cash, and it reduces the firm’s net cash balance.

3.5

Period: 1 2 3 4

Sales $ 0 $150 $150 $ 0 − Change in accounts receivable 0 150 0 − 150 − Cost of goods sold 0 100 100 0 − Change in inventories − 200 −100 − 100 0 = Net cash flow −$200 $ 0 +$150 +$150

Firm A Firm B

EBIT 100 100 Interest 60 0 Pretax income 40 100 Tax (35% of pretax income) 14 35 Net income 26 65

Note: Figures in millions of dollars.

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Taxes owed by firm A fall from $21 million to $14 million. The reduction in taxes is 35% of the extra $20 million of interest income. Net income does not fall by the full $20 million of extra interest expense. It instead falls by interest expense less the reduction in taxes, or $20 million − $7 million = $13 million.

3.6 For a single taxpayer with taxable income of $80,000, total taxes paid are

(.10 × 9,275) + [.15 × (37,650 − 9,275)] + [.25 × ( 80, 000  − 37,650)] = $15,771.25 The marginal tax rate is 25%, but the average tax rate is only 15,771.25/80,000 = .197, or

19.7%. For the married taxpayers filing jointly with taxable income of $80,000, total taxes paid are

(.10 × 18,550) + [.15 × (75,300 − 18,550)] + [.25 × (80,000 − 75,300)] = $11,542.50

The marginal tax rate is 25%, and the average tax rate is 11,542.50/80,000 = .144, or 14.4%.

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LEARNING OBJECTIVES

After studying this chapter, you should be able to:

4-1 Calculate and interpret the market value and market value added of a public corporation.

4-2 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity.

4-3 Calculate and interpret key measures of operating efficiency, leverage, and liquidity.

4-4 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales.

4-5 Compare a company’s financial standing with that of its competitors and its own position in previous years.

C H A P T E R

R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D I N C O N N E C T.

4 Measuring Corporate Performance

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87

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When managers need to judge a firm’s performance, they start with some key financial ratios. © Wavebreakmedia Ltd UC4/ Alamy RF

I n Chapter 1 we introduced the basic objective of corporate finance: Maximize the current value of shareholders’ investment in the firm. For public

corporations, this value is set in the stock market. It equals market price per share multiplied by the number of shares outstanding. Of course, the fluctua- tions in market value partly reflect events that are outside the manager’s control. Nevertheless, good managers always strive to add value by superior invest- ment and financing decisions.

How can we judge whether managers are doing a good job at adding value or where there may be scope for improvement? We need measures of value added. We also need measures that help explain where the value added comes from. For example, value added depends on profitability, so we need measures of profit- ability. Profitability depends in turn on profit margins and on how efficiently the firm uses its assets. We will describe the standard measures of profitability and efficiency in this chapter.

Value also depends on sound financing. Value is destroyed if the firm is financed recklessly and can’t pay its debts. Value is also destroyed if the firm does not maintain adequate liquidity and therefore has difficulty finding the cash to pay its bills. Therefore, we will describe the measures that financial managers and investors use to assess debt policy and liquidity.

These financial measures are mostly financial ratios calculated from the firm’s income statement and bal- ance sheet. Therefore, we will have to take care to remember the limitations of these accounting data.

You have probably heard stories of whizzes who can take a company’s accounts apart in minutes, calculate a list of financial ratios, and divine the company’s future. Such people are like abominable snowmen: often spoken of but never truly seen. Financial ratios are no substitute for a crystal ball. They are just a convenient way to summarize financial data and to assess and com- pare financial performance. The ratios help you to ask the right questions, but they seldom answer them.

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88 Part One Introduction

How Financial Ratios Relate to Shareholder Value

The good news about financial ratios is that they are usually easy to calculate. The bad news is that there are so many of them. To make it worse, the ratios are often presented in long lists that seem to require memorization first and understanding maybe later.

We can mitigate the bad news by taking a moment to preview what the ratios are measuring and how the ratios connect to the ultimate objective of value added for shareholders.

Shareholder value depends on good investment decisions. The financial manager evaluates investment decisions by asking several questions, including: How profitable are the investments relative to the cost of capital? How should profitability be measured? What does profitability depend on? (We will see that it depends on efficient use of assets and on the bottom-line profits on each dollar of sales.)

Shareholder value also depends on good financing decisions. Again, there are obvi- ous questions: Is the available financing sufficient? The firm cannot grow unless financing is available. Is the financing strategy prudent? The financial manager should not put the firm’s assets and operations at risk by operating at a dangerously high debt ratio, for example. Does the firm have sufficient liquidity (a cushion of cash or assets that can be readily sold for cash)? The firm has to be able to pay its bills and respond to unexpected setbacks.

Figure 4.1 summarizes these questions in somewhat more detail. The boxes on the left are for investment, the boxes on the right for financing. In each box, we have posed a question and, where appropriate, given examples of financial ratios or other measures that the financial manager can use to answer the question. For example, the bottom box on the far left of Figure 4.1 asks about efficient use of assets. Three financial ratios that measure asset efficiency are turnover ratios for assets, inventory, and accounts receivable.

The two bottom boxes on the right ask whether financial leverage (the amount of debt financing) is prudent and whether the firm has enough liquidity for the coming year. The ratios for tracking financial leverage include debt ratios, such as the ratio of debt to equity, and interest coverage ratios. The ratios for liquidity are the current, quick, and cash ratios.

4.1

Shareholder Value How much value has been generated?

Turnover ratios for assets, inventory, and receivables

E�cient use of assets? Profits from sales?

Operating profit margin

Prudent financial leverage?

Su�cient liquidity for the coming year?

Current, quick, and cash ratios

Debt ratios Interest coverage ratios

Economic value added (EVA) Returns on capital, assets, and equity

How profitable? How can the firm safely finance future growth?

Investment Financing

Market value added Market-to-book ratio

FIGURE 4.1 An organization chart for financial ratios. The figure shows how common financial ratios and other measures relate to shareholder value.

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We will explain how to calculate and interpret these and the other ratios in Figure 4.1. For now you can read the figure as an organization chart that locates some important financial ratios and shows how they relate to the objective of shareholder value.

Now we start at the top of the figure. Our first task is to measure value. We will explain market capitalization, market value added, and the market-to-book ratio.

Measuring Market Value and Market Value Added

Twenty years have passed since your introductory finance class. You are well into your career, and Home Depot is on your mind. Perhaps you are a mutual fund manager trying to decide whether to allocate $25 million of new money to Home Depot stock. Perhaps you are a major shareholder pondering a sellout. You could be an investment banker seeking business from Home Depot or a bondholder concerned with Home Depot’s credit standing. You could be the treasurer or CFO of Home Depot or of one of its competitors. You want to understand Home Depot’s value and financial performance. How would you start?

Home Depot’s common stock closed fiscal 2014 at a price of $114.75 per share. There were 1,307 million shares outstanding, so Home Depot’s market capitalization or “market cap” was $114.75 × 1,307 = $149,978 million, or nearly $150 billion. This is a big number, of course, but Home Depot is a big company. Home Depot’s shareholders have, over the years, invested billions in the company. Therefore, you decide to compare Home Depot’s market capitalization with the book value of Home Depot’s equity. The book value measures shareholders’ cumulative investment in the firm.

You turn to Home Depot’s income statement and balance sheet, which are repro- duced in Tables 4.1 and 4.2.1 At the end of 2014, the book value of Home Depot’s equity was $9,322 million. Therefore, Home Depot’s market value added, the differ- ence between the market value of the firm’s shares and the amount of money that shareholders have invested in the firm, was $149,978 − $9,322 = $140,656 million. In other words, Home Depot shareholders have contributed about $9.3 billion and ended up with shares worth almost $150 billion. They have accumulated $140.7 billion in market value added.

4.2

market capitalization Total market value of equity, equal to share price times number of shares outstanding.

market value added Market capitalization minus book value of equity.

1 For convenience the statements are repeated from Chapter 3. We are pretending that you actually had these statements on February 3, 2015, the close of Home Depot’s fiscal year. They were not published until March.

$ Millions

Net sales $83,176 Other income 337 Cost of goods sold 54,222 Selling, general, and administrative expenses 16,699 Depreciation 1,786 Earnings before interest and income taxes (EBIT) $10,806 Interest expense 830 Taxable income $ 9,976 Taxes 3,631 Net income $ 6,345 Allocation of net income Dividends $ 2,530 Addition to retained earnings $ 3,815

TABLE 4.1 Income statement for Home Depot, fiscal 2014

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90 Part One Introduction

End of Fiscal End of Fiscal

Assets 2014 2013 Liabilities and Shareholders’ Equity 2014 2013

Current assets Cash and marketable securities $ 1,723 $ 1,929 Current liabilities Receivables 1,484 1,398 Debt due for repayment $ 328 $ 33 Inventories 11,079 11,057 Accounts payable 9,473 9,379 Other current assets 1,016 895 Other current liabilities 1,468 1,337 Total current assets $15,302 $15,279 Total current liabilities $11,269 $10,749

Fixed assets Long-term debt $16,869 $14,691 Tangible fixed assets Deferred income taxes 642 514 Property, plant, and equipment $40,353 $39,064 Other long-term liabilities 1,844 2,042 Less accumulated depreciation 17,633 15,716 Net tangible fixed assets $22,720 $23,348 Total liabilities $30,624 $27,996 Intangible assets (goodwill) 1,353 1,289 Shareholders’ equity Other assets 571 602 Common stock and other paid-in capital $ 8,521 $ 8,536

Retained earnings 26,995 23,180 Total assets $39,946 $40,518 Treasury stock (26,194) (19,194)

Total shareholders’ equity $ 9,322 $12,522 Total liabilities and shareholders’ equity $39,946 $40,518

TABLE 4.2 Home Depot’s balance sheet (figures in $ millions)

Note: Column sums subject to rounding error.

TABLE 4.3 Stock market measures of company performance, February 2015. Companies are ranked by market value added (dollar values in millions).

Market Value Added Market-to-Book Ratio

Apple $627,589 6.41 Microsoft 242,343 2.55 Walmart 185,339 3.99 ExxonMobil 171,465 2.30 Coca-Cola 150,102 5.95 Delta Airlines 2,850 1.41 Time Warner 75 1.02 Alcoa −7,772 0.93 Sprint −42,682 0.87 Bank of America −118,151 0.60

Source: We are grateful to EVA Dimensions for providing these statistics.

The consultancy firm EVA Dimensions calculates market value added for a large sample of U.S. companies. Table 4.3 shows a few of the firms from EVA’s list. They include some of the most and least successful companies. Apple heads the group. It has created $627.6 billion of wealth for its shareholders. Bank of America lan- guishes near the bottom: The market value of its shares is $118 billion less than the amount of shareholders’ money invested in the firm.

The top-listed companies in Table 4.3 are large firms. Their managers have lots of assets to work with. A small firm could not hope to create so much extra value. Therefore, financial managers and analysts also like to calculate how much value has been added for each dollar that shareholders have invested. To do this, they compute the ratio of market value to book value. For example, Home Depot’s market-to-book ratio in early 2015 (at the end of its 2014 fiscal year) was2

Market-to-book ratio = market value of equity

___________________ book value of equity

= $149,978

_______ $9,322

= 16.1

market-to-book ratio Ratio of market value of equity to book value of equity.

2 The market-to-book ratio can also be calculated by dividing stock price by book value per share.

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In other words, Home Depot has multiplied the value of its shareholders’ investment 16.1 times.

Table 4.3 shows a sample of market-to-book ratios for 2014. Notice that Coca-Cola has a much higher market-to-book ratio than ExxonMobil. But Exxon’s market value added is higher because of its larger scale.

The market-value performance measures in Table 4.3 have three drawbacks. First, the market value of the company’s shares reflects investors’ expectations about future performance. Investors pay attention to current profits and investment, of course, but they also avidly forecast investment and growth. Second, market values fluctuate because of many risks and events that are outside the financial manager’s control. Thus, market values are noisy measures of how well the corporation’s management is performing. Third, you can’t look up the market value of privately owned companies whose shares are not traded. Nor can you observe the market value of divisions or plants that are parts of larger companies. You may use market values to satisfy your- self that Home Depot as a whole has performed well, but you can’t use them to drill down to compare the performance of the lumber and home improvement divisions. To do this, you need accounting measures of profitability. We start with economic value added (EVA).

Economic Value Added and Accounting Rates of Return

When accountants draw up an income statement, they start with revenues and then deduct operating and other costs. But one important cost is not included: the cost of the capital the firm employs. Therefore, to see whether the firm has truly created value, we need to measure whether it has earned a profit after deducting all costs, including the cost of its capital.

Recall from Chapters 1 and 2 that the cost of capital is the minimum acceptable rate of return on capital investment. It is an opportunity cost of capital because it equals the expected rate of return on opportunities open to investors in financial markets. The firm creates value only if it can earn more than its cost of capital, that is, more than its investors can earn by investing on their own.

The profit after deducting all costs, including the cost of capital, is called the company’s economic value added or EVA. The term “EVA” was coined by Stern Stewart & Co., which did much to develop and promote the concept. EVA is also called residual income.

In calculating EVA, it’s customary to take account of all the long-term capital con- tributed by investors in the corporation. That means including bonds and other long- term debt as well as equity capital. Total long-term capital, usually called total capitalization, is the sum of long-term debt and shareholders’ equity.

4.3

economic value added (EVA) Net income minus a charge for the cost of capital employed. Also called residual income.

Shares of Notung Cutlery Corp. closed 2015 at $75 per share. Notung had 14.5 million shares outstanding. The book value of equity was $610 million. Compute Notung’s market capitalization, market value added, and market-to- book ratio.

Self-Test4.1

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92 Part One Introduction

Home Depot entered fiscal 2014 with a total capitalization of $27,213 million, which was made up of $14,691 million of long-term debt and $12,522 million of shareholders’ equity. This was the cumulative amount that had been invested by Home Depot’s debt and equity investors. Home Depot’s cost of capital was about 9%.3 So we can convert the cost of capital into dollars by multiplying total capitalization by 9%: .09 × $27,213 million = $2,449.2 million. To satisfy its debt and equity inves- tors, Home Depot needed to earn total income of $2,449.2 million.

Now we can compare this figure with the income that Home Depot actually generated for its debt and equity investors. In 2014, debt investors received interest income of $830 million. The after-tax equivalent, using Home Depot’s 35% tax rate, is (1 − .35) × 830 = $539.5 million.4 Net income to shareholders was $6,345 million. Therefore, Home Depot’s after-tax interest and net income totaled 539.5 + 6,345 = $6,884.5 million. If you deduct the dollar cost of capital from this figure, you can see that the company earned 6,884.5 − 2,449.2 = $4,435.3  million more than investors required. This was Home Depot’s EVA or residual income:

EVA = after-tax interest + net income − (cost of capital × total capitalization) = 539.5 + 6,345 − 2,449.2 = $4,435.3 million

The sum of Home Depot’s net income and after-tax interest is its after-tax operating income. This is what Home Depot would earn if it had no debt and could not take interest as a tax-deductible expense. After-tax operating income is what the company would earn if it were all-equity-financed. In that case it would have no (after-tax) inter- est expense and all operating income would go to shareholders.

Thus EVA also equals:

EVA = after-tax operating income − (cost of capital × total capitalization) = 6,884.5 − 2,449.2 = $4,435.3 million

Of course Home Depot and its competitors do use debt financing. Nevertheless, EVA comparisons are more useful if focused on operating income, which is not affected by interest tax deductions.

Table 4.4 shows estimates of EVA for our sample of large companies. Apple again heads the list. It earned $30.3 billion more than was needed to cover its cost of capital. By contrast, Bank of America was a laggard. Although it earned an accounting profit of $13.7 billion, this figure was calculated before deducting the cost of capital. After deducting the cost of capital, the company made an EVA loss of $7.5 billion.

Notice how the cost of capital differs across the 10 firms in Table 4.4. The variation is due to differences in business risk. Relatively safe companies like Walmart and Coca-Cola tend to have low costs of capital. Riskier companies like Apple and Microsoft have high costs of capital.

EVA, or residual income, is a better measure of a company’s performance than is accounting income. Accounting income is calculated after deducting all costs except the cost of capital. By contrast, EVA recognizes that companies need to cover their opportunity costs before they add value.

3 This is an after-tax weighted-average cost of capital, or WACC. A company’s WACC depends on the risk of its business. The WACC is almost the same as the opportunity cost of capital, but with the cost of debt calculated after tax. We will explain WACC and how to calculate it in Chapter 13. 4 Why do we take interest after tax? Remember from Chapter 3 that when a firm pays interest, it reduces its taxable income and therefore its tax bill. This tax saving, or tax shield, will vary across firms depending on the amounts of debt financing. But we want to focus here on operating results. To put all firms on a common basis, we subtract the interest tax shield from reported income, or, equivalently, we look at after-tax interest payments. By ignoring the tax shield, we calculate each firm’s income as if it had no debt outstanding and shareholders got the (after-tax) interest. To be consistent, the cost of capital is defined as an after-tax weighted-average cost of capital (WACC). We have more to say about these issues in Chapters 13 and 16.

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1. After-Tax Interest + Net Income

2. Cost of Capital (WACC) (%)

3. Total Long-Term Capital

4. EVA = 1 − (2 × 3)

5. Return on Capital (ROC)

(%) = 1 ÷ 3

Apple $43,337 9.14% $142,657 $30,298 30.4% Microsoft 22,738 8.66 48,992 18,495 46.4 Walmart 17,194 5.26 154,846 9,049 11.1 ExxonMobil 39,467 6.77 301,902 19,028 13.1 Coca-Cola 8,671 5.28 59,742 5,517 14.5 Alcoa 1,340 8.36 30,463 −1,207 4.4 Delta Airlines 1,509 7.39 49,253 −2,131 3.1 Time Warner 4,313 6.76 112,137 −3,267 3.8 Sprint 1,269 6.54 122,304 −6,730 1.0 Bank of America 13,692 7.50 283,138 −7,543 4.8

TABLE 4.4 EVA and ROC, 2015. Companies are ranked by EVA (dollar values in millions).

Source: We are grateful to EVA Dimensions for providing these statistics.

EVA makes the cost of capital visible to operating managers. There is a clear target: Earn at least the cost of capital on assets employed. A plant or divisional manager can improve EVA by reducing assets that aren’t making an adequate contribution to profits. Evaluating performance by EVA pushes managers to flush out and dispose of such underutilized assets. Therefore, a growing number of firms now calculate EVA and tie managers’ compensation to it.

Accounting Rates of Return EVA measures how many dollars a business is earning after deducting the cost of capital. Other things equal, the more assets the manager has to work with, the greater the opportunity to generate a large EVA. The manager of a small division may be highly competent, but if that division has few assets, she is unlikely to rank high in the EVA stakes. Therefore, when comparing managers, it can be helpful to measure the firm’s profits per dollar of assets. Three common measures are the return on capital (ROC), the return on equity (ROE), and the return on assets (ROA). These are called book rates of return, because they are based on accounting information.

Return on Capital (ROC) The return on capital is equal to after-tax operating income divided by total capitalization. In 2014, Home Depot’s operating income was $6,885 million. It started the year with total capitalization (long-term debt plus share- holders’ equity) of $27,213 million. Therefore, its return on capital (ROC) was5

ROC =  after tax operating income

___________________ total capitalization

 =  6,885

______ 27,213

 = .253, or 25.3%

return on capital (ROC) Net income plus after-tax interest as a percentage of long-term capital.

5 The numerator of Home Depot’s ROC is again its after-tax operating income, calculated by adding back after- tax interest to net income. More often than not, financial analysts forget that interest is tax-deductible and use pretax interest to calculate operating income. This complicates comparisons of ROC for companies that use different fractions of debt financing. It also muddies comparisons of ROC with the after-tax weighted-average cost of capital (WACC). We cover WACC in Chapter 13.

Roman Holidays Inc. had operating income of $30 million on a start-of-year total capitalization of $188 million. Its cost of capital was 11.5%. What was its EVA?

Self-Test4.2

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94 Part One Introduction

As we noted earlier, Home Depot’s cost of capital was about 9%. This was the return that investors could have expected to earn at the start of 2014 if they invested their money in other companies or securities with the same risk as Home Depot’s busi- ness. So in 2014 the company earned 25.3 − 9.0 = 16.3% more than investors required.

When we calculated ROC, we compared a flow measure (income earned over the year) with a snapshot measure (capital at the start of the year). We therefore ignored the company’s additional financing and investment during that year. If the additional investment contributed a significant part of the year’s operating income, it may be better to divide by the average of the total capitalization at the beginning and end of the year. In the case of Home Depot, the company increased long-term debt in 2014 and repurchased some of its stock. So it actually ended the year with less capital than it had at the start. Therefore, if we divide operating income by average capitalization, Home Depot’s ROC for 2014 increases slightly to

ROC =  after-tax operating income

___________________ average total capitalization

= 6,885 _______________

(26,191 + 27,213)/2  = .258, or 25.8%

Is one measure better than another? It is difficult to generalize, but if you would like to know more about when one might prefer to use average rather than start-of-year figures to calculate a financial ratio, the icon in the margin provides a link to a short discussion of the issue.6

The last column in Table 4.4 shows ROC for our sample of well-known companies. Notice that Microsoft’s return on capital was 46.4%, over 37 percentage points above its cost of capital. Although Microsoft had a higher return on capital than ExxonMobil, it had a lower EVA. This was partly because it was riskier than Exxon and so had a higher cost of capital, but also because it had far fewer dollars invested than Exxon.

The five companies in Table 4.4 with negative EVAs all have ROCs less than their cost of capital. The spread between ROC and the cost of capital is really the same thing as EVA but expressed as a percentage return rather than in dollars.

Return on Assets (ROA) Return on assets (ROA) measures after-tax operating income as a fraction of the firm’s total assets. Total assets (which equal total liabilities plus shareholders’ equity) are greater than total capitalization because total capitaliza- tion does not include current liabilities. For Home Depot, ROA was

Return on assets =  after-tax operating income

___________________ total assets

= 6,885

_____ 40,518

 = .170 or 17.0%

Using average total assets, ROA was slightly higher:

ROA =  after-tax operating income

___________________ average total assets

= 6,885 _______________

(39,946 + 40,518)/2  = .171, or 17.1%

For both ROA and ROC, we use after-tax operating income, which is calculated by adding after-tax interest to net income. We are again asking how profitable the com- pany would have been if it were all-equity-financed. This what-if calculation is helpful when comparing the profitability of firms with different capital structures. The tax deduction for interest is often ignored, however, and operating income is calculated using pretax interest. Some financial analysts take no account of interest payments and measure ROA as net income for shareholders divided by total assets. This calculation is really—we were about to say “stupid,” but don’t want to offend anyone. The calculation ignores entirely the income that the firm’s assets have generated for debt investors.

BEYOND THE PAGE

mhhe.com/brealey9e

Average or start- of-year assets

return on assets (ROA) Net income plus after-tax interest as a percentage of total assets.

6 Sometimes it’s convenient to use a snapshot figure at the end of the year, although this procedure is not strictly correct.

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Return on Equity (ROE) We measure the return on equity (ROE) as the income to shareholders per dollar that they have invested. Home Depot had net income of $6,345 million in fiscal 2014 and shareholders’ equity of $12,522 million at the start of the year. So Home Depot’s ROE was

Return on equity = ROE =  net income

________ equity

 =  6,345

______ 12,522

 = .507, or 50.7%

Using average equity, ROE was

ROE =  net income

___________ average equity

 =  6,345 _____________

( 9,322 + 12,522 ) / 2  = .581, or 58.1%

return on equity (ROE) Net income as a percentage of shareholders’ equity.

Problems with EVA and Accounting Rates of Return Rates of return and economic value added have some obvious attractions as measures of performance. Unlike market-value-based measures, they show current performance and are not affected by all the other things that move stock market prices. Also, they can be calculated for an entire company or for a particular plant or division. However, remember that both EVA and accounting rates of return are based on book (balance sheet) values for assets. Debt and equity are also book values. As we noted in the previous chapter, accountants do not show every asset on the balance sheet, yet our calculations take accounting data at face value. For example, we ignored the fact that Home Depot has invested large sums in marketing in order to establish its brand name. This brand name is an important asset, but its value is not shown on the balance sheet. If it were shown, the book values of assets, capital, and equity would increase, and Home Depot would not appear to earn such high returns.

EVA Dimensions, which produced the figures in Tables 4.3 and 4.4, does make a number of adjustments to the accounting data. However, it is impossible to include the value of all assets or to judge how rapidly they depreciate. For example, did Microsoft really earn a return on capital of 46.4%? It’s difficult to say because its investment over the years in operating systems and other software is not shown in the balance sheet and cannot be measured exactly.

Remember also that the balance sheet does not show the current market values of the firm’s assets. The assets in a company’s books are valued at their original cost less any depreciation. Older assets may be grossly undervalued in today’s market condi- tions and prices. So a high return on assets indicates that the business has performed well by making profitable investments in the past, but it does not necessarily mean that you could buy the same assets today at their reported book values. Conversely, a low return suggests some poor decisions in the past, but it does not always mean that today the assets could be employed better elsewhere.

What is the difference between after-tax operating income and net income to shareholders? How is after-tax operating income calculated? Why is it useful in calculating EVA, ROC, and ROA?

Self-Test4.3

Explain the differences among ROE, ROC, and ROA.

Self-Test4.4

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96 Part One Introduction

Measuring Efficiency

We began our analysis of Home Depot by calculating how much value that company has added for its shareholders and how much profit the company is earning after deducting the cost of the capital that it employs. We examined its rates of return on equity, capital, and total assets, which were all impressively high. Our next task is to probe a little deeper to understand the reasons for Home Depot’s success. What factors contribute to this firm’s overall profitability? One is the efficiency with which it uses its various assets.

Asset Turnover Ratio The asset turnover, or sales-to-assets, ratio shows how much sales are generated by each dollar of total assets, and therefore it measures how hard the firm’s assets are working. For Home Depot, each dollar of assets produced $2.05 of sales:

Asset turnover =  sales __________________

total assets at start of year  = 

83,176 ______

40,518 = 2.05

Like some of our profitability ratios, the sales-to-assets ratio compares a flow measure (sales over the entire year) to a snapshot measure (assets on one day). Therefore, finan- cial managers and analysts often calculate the ratio of sales over the entire year to the average level of assets over the same period. In this case, the value is about the same:

Asset turnover =  sales ______________

average total assets  = 

83,176 ______________

( 39,946 + 40,518 ) / 2  = 2.07

The asset turnover ratio measures how efficiently the business is using its entire asset base. But you also might be interested in how hard particular types of assets are being put to use. A couple of examples are provided next.

Inventory Turnover Efficient firms don’t tie up more capital than they need in raw materials and finished goods. They hold only a relatively small level of inventories of raw materials and finished goods, and they turn over those inventories rapidly.

The balance sheet shows the cost of inventories rather than the amount that the finished goods will eventually sell for. So it is usual to compare the level of inventories with the cost of goods sold rather than with sales. In Home Depot’s case,

Inventory turnover =  cost of good sold

_________________ inventory at start of year

 =  54,222

______ 11,057

 = 4.9

Another way to express this measure is to look at how many days of output are represented by inventories. This is equal to the level of inventories divided by the daily cost of goods sold:

Average days in inventory =  inventory at start of year

_________________ daily cost of good sold

 =  11,057

_________ 54,222 / 365

 = 74 days

You could say that on average Home Depot has sufficient inventories to maintain operations for 74 days.

In Chapter 20 we will see that many firms have managed to increase their inventory turnover in recent years. Toyota has been the pioneer in this endeavor. Its just-in-time inventory system ensures that auto parts are delivered exactly when they are needed. Toyota now keeps only about one month’s supply of parts and finished cars in inven- tory and turns over its inventory about 11 times a year.

Receivables Turnover Receivables are sales for which you have not yet been paid. The receivables turnover ratio measures the firm’s sales as a multiple of its receiv- ables. For Home Depot,

Receivables turnover =  sales ___________________

receivables at start of year  = 

83,176 ______

1,398  = 59.5

4.4

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If customers are quick to pay, unpaid bills will be a relatively small proportion of sales and the receivables turnover will be high. Therefore, a high ratio often indicates an efficient credit department that is quick to follow up on late payers. Sometimes, however, a high ratio may indicate that the firm has an unduly restrictive credit policy and offers credit only to customers who can be relied on to pay promptly.7

Another way to measure the efficiency of the credit operation is by calculating the average length of time for customers to pay their bills. The faster the firm turns over its receivables, the shorter the collection period. On average, Home Depot’s customers pay their bills in about 6.1 days:

Average collection period =  receivables at start of year

___________________ average daily sales

 =  1,398 ________

83,176/365  = 6.1 days

7 Where possible, it makes sense to look only at credit sales. Otherwise, a high receivables turnover ratio (or, equivalently, a low average collection period) might simply indicate that a small proportion of sales are made on credit. For example, if a retail customer pays cash for a purchase at Home Depot, that transaction will have a collection period of zero, regardless of any policies of the firm’s credit department.

The receivables turnover ratio and the inventory turnover ratio may help to highlight particular areas of inefficiency, but they are not the only possible indicators. For exam- ple, a retail chain might compare its sales per square foot with those of its competitors, an airline might look at revenues per passenger-mile, and a law firm might look at revenues per partner. A little thought and common sense should suggest which mea- sures are likely to produce the most helpful insights into your company’s efficiency.

Analyzing the Return on Assets: The Du Pont System

We have seen that every dollar of Home Depot’s assets generates $2.05 of sales. But Home Depot’s success depends not only on the efficiency with which it uses its assets to generate sales but also on how profitable those sales are. This is measured by Home Depot’s profit margin.

Profit Margin The profit margin measures the proportion of sales that finds its way into profits. It is sometimes defined as

Profit margin =  net income

________ sales

 =  6,345

______ 83,176

 = .076, or 7.6%

This definition can be misleading. When companies are partly financed by debt, a portion of the revenue produced by sales must be paid as interest to the firm’s lenders. So profits from the firm’s operations are divided between the debtholders and the shareholders. We would not want to say that a firm is less profitable than its rivals simply because it employs debt finance and pays out part of its income as interest. Therefore, when we are calculating the profit margin, it makes sense to add back the

4.5

The average collection period measures the number of days it takes Home Depot to collect its bills. But Home Depot also delays paying its own bills. Use the information in Tables 4.1 and 4.2 to calculate the average number of days that it takes Home Depot to pay its bills. [Like days in inventory, payment delay should be calculated using only direct cost of goods sold–these do not include indirect costs (i.e., selling, general, and administrative).]

Self-Test4.5

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98 Part One Introduction

after-tax debt interest to net income. This leads us again to after-tax operating income and to the operating profit margin:

Operating profit margin =  after-tax operating income

______________________ sales

=  6,345 + (1 − .35) × 830

____________________ 83,176

 = .083, or 8.3%

The Du Pont System We calculated earlier that Home Depot has earned a return of 17.0% on its assets. The following equation shows that this return depends on two factors—the sales that Home Depot generates from its assets (asset turnover) and the profit that it earns on each dollar of sales (operating profit margin):

Return on assets = after-tax operating income

______________________ assets

(4.1)

= sales

_____ assets

 ×  after-tax operating income

______________________ sales

↑ asset turnover

↑ operating

profit margin

This breakdown of ROA into the product of turnover and margin is often called the Du Pont formula, after the chemical company that popularized the procedure. In Home Depot’s case, the formula gives the following breakdown of ROA:

ROA = asset turnover × operating profit margin = 2.05 × .0803 = .170

The Du Pont formula is a useful way to think about a company’s strategy. For exam- ple, a retailer may strive for high turnover at the expense of a low profit margin (a “Walmart strategy”), or it may seek a high profit margin even if that results in low turnover (a “Bloomingdales strategy”). You would naturally prefer both high profit mar- gin and high turnover, but life isn’t that easy. A high-price and high-margin strategy will typically result in lower sales per dollar of assets, so firms must make trade-offs between these goals. The Du Pont formula can help sort out which strategy the firm is pursuing.

All firms would like to earn a higher return on their assets, but their ability to do so is limited by competition. The Du Pont formula helps to identify the constraints that firms face. Fast-food chains, which have high asset turnover, tend to operate on low margins. Classy hotels have relatively low turnover ratios but tend to compensate with higher margins.

operating profit margin After-tax operating income as a percentage of sales.

Du Pont formula ROA equals the product of asset turnover and operating profit margin.

Turnover versus Margin

Firms often seek to improve their profit margins by acquiring a supplier. The idea is to cap- ture the supplier’s profit as well as their own. Unfortunately, unless they have some special skill in running the new business, they are likely to find that any gain in profit margin is offset by a decline in asset turnover.

A few numbers may help to illustrate this point. Table 4.5 shows the sales, profits, and assets of Admiral Motors and its components supplier, Diana Corporation. Both earn a 10% return on assets, though Admiral has a lower operating profit margin (20% versus Diana’s 25%). Because all of Diana’s output goes to Admiral, Admiral’s management reasons that it would be better to merge the two companies. That way, the merged company would capture the profit margin on both the auto components and the assembled car.

Example 4.1 ⊲

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Sales Profits Assets Asset

Turnover Profit

Margin ROA

Admiral Motors $20 $4 $40 0.50 20% 10% Diana Corp. 8 2 20 0.40 25 10 Diana Motors (the merged firm) 20 6 60 0.33 30 10

TABLE 4.5 Merging with suppliers or customers will generally increase the profit margin, but this will be offset by a reduction in asset turnover

The bottom row of Table 4.5 shows the effect of the merger. The merged firm does indeed earn the combined profits. Total sales remain at $20 million, however, because all the components produced by Diana are used within the company. With higher profits and unchanged sales, the profit margin increases. Unfortunately, the asset turnover is reduced by the merger since the merged firm has more assets. This exactly offsets the benefit of the higher profit margin. The return on assets is unchanged. ■

Figure 4.2 shows evidence of the trade-off between turnover and profit margin. You can see that industries with high average turnover ratios tend to have lower average profit margins. Conversely, high margins are typically associated with low turnover. The classic examples here are electric or water utilities, which have enormous capital requirements and therefore low asset turnover ratios. However, they have extremely low marginal costs for each unit of additional output and therefore earn high markups. The two curved lines in the figure trace out the combinations of profit margin and turnover that result in an ROA of either 3% or 10%. Despite the enormous dispersion across industries in both margin and turnover, that variation tends to be offsetting, so for most industries the return on assets lies between 3% and 10%. The notable exception is mining, which was suffering badly in 2015 from the slump in commodity prices.

Asset turnover

-30

-20

-10

0

10

20

30

40

Computer peripherals

Mining

Food stores

O p

e ra

ti n

g p

ro fi

t m

a rg

in (

% )

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

FIGURE 4.2 Operating profit margin and asset turnover for 45 industries

Source: U.S. Census Bureau, Quarterly Report for Manufacturing and Trade Corporations, Second Quarter 2015 (www.census.gov/econ/qfr). This is an updated version of a figure that first appeared in Thomas I. Selling and Clyde P. Stickney, “The Effects of Business Environments and Strategy on a Firm’s Rate of Return on Assets,” Financial Analysts Journal, January–February 1989, pp. 43–52.

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100 Part One Introduction

Measuring Financial Leverage

As Figure 4.1 indicates, shareholder value depends not only on good investment decisions and profitable operations, but also on sound financing decisions. We look first at measures of financial leverage and then at measures of liquidity.

When a firm borrows money, it promises to make a series of interest payments and then to repay the amount that it has borrowed. If profits rise, the debtholders continue to receive only the fixed interest payment, so all the gains go to the shareholders. Of course, the reverse happens if profits fall. In this case, shareholders bear most of the pain. If times are sufficiently hard, a firm that has borrowed heavily may not be able to pay its debts. The firm is then bankrupt, and shareholders lose most or all of their entire investment.

Because debt increases returns to shareholders in good times and reduces them in bad times, it is said to create financial leverage. Leverage ratios measure how much financial leverage the firm has taken on. CFOs keep an eye on leverage ratios to ensure that lenders are happy to continue to take on the firm’s debt.

Debt Ratio Financial leverage is usually measured by the ratio of long-term debt to total long-term capital (that is, to total capitalization). Here long-term debt should include not just bonds or other borrowing, but also financing from long-term leases.8 For Home Depot,

Long-term debt ratio =  long-term debt

_________________ long-term debt + equity

 =  16,869 ___________

16,869 + 9,322  = .64, or 64%

This means that 64 cents of every dollar of long-term capital is in the form of debt. Leverage may also be measured by the debt-equity ratio. For Home Depot,

Long-term debt-equity ratio =  long-term debt

___________ equity

 =  16,869

______ 9,322

 = 1.81

For highly leveraged companies, the difference between these two ratios is large. For example, a company financed two-thirds with debt and one-third with equity has a long-term debt ratio of 67% (2/3) and a debt-equity ratio of 2. Sometimes you see projects such as oil pipelines financed with 90% debt and 10% equity. In that case, the debt-equity ratio is 90/10 = 9.

The long-term debt ratio for the average U.S. manufacturing company is about 33%, about half the ratio for Home Depot. Some companies deliberately operate at much higher debt levels. For example, in Chapter 21 we will look at leveraged buyouts (LBOs). Firms that are acquired in a leveraged buyout usually issue large amounts of debt. When LBOs first became popular in the 1990s, these companies had average debt ratios of about 90%. Many of them flourished and paid back their debtholders in full; others were not so fortunate.

4.6

8 A finance lease is a long-term rental agreement that commits the firm to make regular payments. This commit- ment is just like the obligation to make payments on an outstanding loan.

The Du Pont formula (Equation 4.1) seems to suggest that companies with above-average asset turnover ratios generally will have above-average ROAs. Why may this not be so?

Self-Test4.6

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Notice that debt ratios make use of book (accounting) values rather than market values.9 In principle, lenders should be more interested in the market value of the company, which reflects the actual value of the company’s assets and the actual cash flows those assets will produce. If the market value of the company covers its debts, then lenders should get their money back. Thus, you would expect to see the debt ratio computed using the market values of debt and equity. Yet book debt ratios are used almost universally.

Does use of book rather than market leverage ratios matter much? Perhaps not; after all, the market value of the firm includes the value of intangible assets generated by research and development, advertising, staff training, and so on. These assets are not easy to sell, and if the company falls on hard times, their value may disappear altogether. Thus, when banks demand that a borrower keep within a maximum debt ratio, they usually define that ratio in terms of book values, and they ignore the intangible assets that contribute to the market value of the firm but are not shown on the balance sheet.

Notice also that these measures of leverage ignore short-term debt. That probably makes sense if the short-term debt is temporary or is matched by similar holdings of cash, but if the company is a regular short-term borrower, it may be preferable to widen the definition of debt to include all liabilities. In this case,

Total debt ratio =  total liabilities

__________ total assets

 =  30,624

______ 39,946

 = .77, or 77%

Therefore, Home Depot is financed 77% with long- and short-term debt and 23% with equity.10 We could also say that its ratio of total debt to equity is 30,624/9,322 = 3.28.

Managers sometimes refer loosely to a company’s debt ratio, but we have just seen that the debt ratio may be measured in several different ways. For example, Home Depot has a debt ratio of .64 (the long-term debt ratio) and also .77 (the total debt ratio). This is not the first time we have come across several ways to define a financial ratio. There is no law stating how a ratio should be defined. So be warned: Do not use a ratio without understanding how it has been calculated.

Times Interest Earned Ratio Another measure of financial leverage is the extent to which interest obligations are covered by earnings. Banks prefer to lend to firms with earnings that cover interest payments with room to spare. Interest coverage is measured by the ratio of earnings before interest and taxes (EBIT) to interest payments. For Home Depot,

Times interest earned =  EBIT _____________

interest payments  = 

10,806 ______

830  = 13.0

By this measure, Home Depot is conservatively financed. Sometimes lenders are con- tent with coverage ratios as low as 2 or 3.

The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The interest coverage ratio measures how much clear air there is between hurdle and hurdler. The ratio is only part of the story, however. For example, it doesn’t tell us whether Home Depot is generating enough cash to repay its debt as it becomes due.

Cash Coverage Ratio As we explained in Chapter 3, depreciation is not a cash expense. Depreciation is deducted when calculating the firm’s earnings, even though

9 In the case of leased assets, accountants estimate the value of the lease commitments. In the case of long-term debt, they simply show the face value, which can be very different from market value. 10 In this case, the 77% of debt includes other liabilities, including accounts payable and other current liabilities.

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102 Part One Introduction

no cash goes out the door. Suppose we add back depreciation to EBIT in order to cal- culate operating cash flow. We then calculate a cash coverage ratio.11 For Home Depot,

Cash coverage ratio = EBIT + depreciation

_______________ interest payments

= 10,806 + 1,786

___________ 830

= 15.2

11 Depreciation of intangible assets is called amortization and is therefore also added back to EBIT. This gives EBIT + depreciation + amortization = EBITDA. EBITDA coverage ratios are common. You may also encounter still other ratios, in addition to the standard ratios covered here. 12 Again, we use after-tax operating income, which is the sum of net income and after-tax interest.

Leverage and the Return on Equity When the firm raises cash by borrowing, it must make interest payments to its lenders. This reduces net profits. On the other hand, if a firm borrows instead of issuing equity, it has fewer equityholders to share the remaining profits. Which effect dominates? An extended version of the Du Pont formula helps us answer this question. It breaks down the return on equity (ROE) into four parts:

ROE =  net income

_________ equity

 =  assets

______ equity

×  sales

_____ assets

 × after-tax operating income

_______________ sales

 × 

↑ ↑ ↑ ↑

  net income

_________ after-tax

operating income

leverage ratio

asset turnover

operating profit margin “debt burden”

(4.2)

Notice that the product of the two middle terms in Equation 4.2 is the return on assets. It depends on the firm’s production and marketing skills and is unaffected by the firm’s financing mix.12 However, the first and fourth terms do depend on the debt-equity mix. The first term, assets/equity, which we call the leverage ratio, can be expressed as (equity + liabilities)/equity, which equals 1 + total-debt-to-equity ratio. The last term, which we call the “debt burden,” measures the proportion by which interest expense reduces profits.

Suppose that the firm is financed entirely by equity. In this case, both the leverage ratio and the debt burden are equal to 1, and the return on equity is identical to the return on assets. If the firm borrows, however, the leverage ratio is greater than 1 (assets are greater than equity) and the debt burden is less than 1 (part of the profits is absorbed by interest). Thus leverage can either increase or reduce return on equity. In fact, we will see in Chapter 16 that leverage increases ROE when the firm’s return on assets is higher than the interest rate it pays on its debt. Because Home Depot’s return on capital exceeds the interest rate on its debt, return on equity is higher than return on capital.

A firm repays $10 million face value of outstanding debt and issues $10 million of new debt with a lower rate of interest. What happens to its long-term debt ratio? What happens to its times interest earned and cash coverage ratios?

Self-Test4.7

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Measuring Liquidity

If you are extending credit to a customer or making a short-term bank loan, you are interested in more than the borrower’s financial leverage. You want to know whether the company can lay its hands on the cash to repay you. That is why credit analysts and bankers look at several measures of liquidity. Liquid assets can be converted into cash quickly and cheaply.

Think, for example, what you would do to meet a large unexpected bill. You might have some money in the bank or some investments that are easily sold, but you would not find it so easy to turn your old sweaters into cash. Companies, likewise, own assets with different degrees of liquidity. For example, accounts receivable and inventories of fin- ished goods are generally quite liquid. As inventories are sold off and customers pay their bills, money flows into the firm. At the other extreme, real estate may be quite illiquid. It can be hard to find a buyer, negotiate a fair price, and close a deal at short notice.

There is another reason to focus on liquid assets: Their book (balance sheet) values are usually reliable. The book value of a catalytic cracker may be a poor guide to its true value, but at least you know what cash in the bank is worth.

Liquidity ratios also have some less desirable characteristics. Because short-term assets and liabilities are easily changed, measures of liquidity can rapidly become out- dated. You might not know what the catalytic cracker is worth, but you can be fairly sure that it won’t disappear overnight. Cash in the bank can disappear in seconds.

Also, assets that seem liquid sometimes have a nasty habit of becoming illiquid. This happened during the subprime mortgage crisis in 2008. Some financial insti- tutions had set up funds known as structured investment vehicles (SIVs) that issued short-term debt backed by residential mortgages. As mortgage default rates began to climb, the market in this debt dried up and dealers became very reluctant to quote a price.

Bankers and other short-term lenders applaud firms that have plenty of liquid assets. They know that when they are due to be repaid, the firm will be able to get its hands on the cash. But more liquidity is not always a good thing. For example, efficient firms do not leave excess cash in their bank accounts. They don’t allow customers to postpone paying their bills, and they don’t leave stocks of raw materials and finished goods littering the warehouse floor. In other words, high levels of liquid- ity may indicate sloppy use of capital. Here, EVA can highlight the problem because it penalizes managers who keep more liquid assets than they really need.

Net Working Capital to Total Assets Ratio Current assets include cash, market- able securities, inventories, and accounts receivable. Current assets are mostly liquid. The difference between current assets and current liabilities is known as net working capital. It roughly measures the company’s potential net reservoir of cash. Because current assets usually exceed current liabilities, net working capital is usually positive. For Home Depot,

Net working capital = 15,302 − 11,269 = $4,033 million

4.7

liquidity The ability to sell an asset on short notice at close to the market value.

a. Sappy Syrup has a profit margin below the industry average, but its ROA equals the industry average. How is this possible?  

b. Sappy Syrup’s ROA equals the industry average, but its ROE exceeds the industry average. How is this possible?  

Self-Test4.8

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104 Part One Introduction

Home Depot’s net working capital was 10% of total assets:

Net working capital

______________ Total assets

 =  4,033

______ 39,946

= .10, or 10%

Current Ratio The current ratio is just the ratio of current assets to current liabilities:

Current ratio =  current assets

____________ current liabilities

 =  15,302

_____ 11,269

 = 1.36

Home Depot has $1.36 in current assets for every dollar in current liabilities. Changes in the current ratio can be misleading. For example, suppose that a com-

pany borrows a large sum from the bank and invests it in marketable securities. Current liabilities rise and so do current assets. If nothing else changes, net working capital is unaffected but the current ratio changes. For this reason, it is sometimes preferable to net short-term investments against short-term debt when calculating the current ratio.

Quick (Acid-Test) Ratio Some current assets are closer to cash than others. If trou- ble comes, inventory may not sell at anything above fire-sale prices. (Trouble typically comes because the firm can’t sell its inventory of finished products for more than production cost.) Thus managers often exclude inventories and other less liquid components of current assets when comparing current assets to current liabilities. They focus instead on cash, marketable securities, and bills that customers have not yet paid. This results in the quick ratio:

Quick ratio =  cash + marketable securities + receivables

______________________________ current liabilities

 =  1,723 + 1,484

__________ 11,269

 = .28

Cash Ratio A company’s most liquid assets are its holdings of cash and marketable securities. That is why analysts also look at the cash ratio:

Cash ratio =  cash + marketable securities

____________________ current liabilities

 =  1,723

_____ 11,269

 = .15

A low cash ratio may not matter if the firm can borrow on short notice. Who cares whether the firm has actually borrowed from the bank or whether it has a guaranteed line of credit that lets it borrow whenever it chooses? None of the standard measures of liquidity takes the firm’s “reserve borrowing power” into account.

Interpreting Financial Ratios

We have shown how to calculate some common summary measures of Home Depot’s performance and financial condition. These are summarized in Table 4.6.

Now that you have calculated these measures, you need some way to judge whether they are a matter for concern or congratulation. In some cases, there may be a natural

4.8

a. A firm has $1.2 million in current assets and $1 million in current liabilities.