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BR tE,F~e.O,N TEN TS Preface xvii P.ART 1: THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT CHAPTER 1 An Introduction to Financial Management 3 CH~PTER 2 Und,brstanding Financial Statements, Taxes, and Cash Flows 31 CHAPTER 3I-- Evaluating a Firms Financial Performance 71 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107 PART 2: VALUATION OF FINANCIAL ASSETS CHAPTER 5 The Value of Money 137 CHAPTER 6 Risk and Rates of Return 181 CHAPTER 7 Valuation and Characteristics of Bonds 22 3 CHAPTER 8 Stock Valuation 255 PART 3: INVESTMENT IN LONG-TERM ASSETS CHAPTER 9 Capital Budgeting Decision Criteria 289 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 CHAPTER 11 Capital Budgeting and Risk Analysis 371 CHAPTER 12 Cost of Capital 405 CHAPTER 13 Managing for Shareholder Value 435 vii
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viii BRIEF CONTENTS , PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER 14 Raising Capital in the Financial Markets 469 CHAPTER 15 Analysis and Impact of Leverage 505 CHAPTER 16 Planning the Firms Financing Mix 551 CHAPTER 17 Dividend Policy and Internal Financing 605 PART 5: WORKING-CAPITAL MANAGEMENT AND SPECIAL TOPICS IN FINANCE CHAPTER 18 Working-Capital Management and Short-Term Financing 645 CHAPTER 19 Cash and Marketable Securities Management 673 CHAPTER 20 Accounts Receivable and Inventory Management 705 PART 6: SPECIAL TOPICS IN FINANCE CHAPTER 21 Risk Management 739 CHAPTER 22 International Business Finance 773 CHAPTER 23 Corporate Restructuring: Combinations and Divestitures* 23-1 CHAPTER 24 Term Loans and Leases* 24-1 Appendixes A-I Glossary G-l Indexes I-I *Chapters 23 and 24 can be found at www.prenhall.comlkeown
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CONTENT:S Preface XVii PART 1: THE SCOPE AND ENVIRONMENT . - OFFINANCIAL MANAGEMENT - -- - -- CHAPTER 1 An Introduction to Financial Management 3 What Is Finance? 4 Goal of the Firm 4 Legal Forms of Business Organization 7 Ten Principles That Form the Basics of Financial Management 12 PRINCIPLE 1: The Risk-Return Trade-Off-We wont take on additional risk unless we expect to be compensated with additional return 13 PRINCIPLE 2: The Time Value of Money-A dollar received today is worth more than a dollar received in the future 14 PRINCIPLE 3: Cash-Not Profits-Is King 14 PRINCIPLE 4: Incremental Cash Flows-Its only what changes that counts 15 ----- PRINCIPLE 5: The Curse of Competitive Markets-Why its hard to find exceptionally profitable projects 15 PRINCIPLE 6: Efficient Capital Markets-The markets are quick and the prices are right 16 PRINCIPLE 7: The Agency Problems-Managers wont work for owners unless its in their best interest 17 PRiNCIPLE 8: Taxes Bias Business Decisions 18 PRINCIPLE 9: All Risk Is Not Equal-Some risk can be diversified away, and some cannot 18 PRINCIPLE 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance 20 Overview of the Text 22 Finance and the Multinational Firm: The New Role 24 How Financial Managers Use This Material 25 Summary 25--/ CHAPTER 2 Understanding Financial Statements, Taxes, and Cash Flows 31 The Income Statement: Measuring a Companys Profits 32 The Balance Sheet: Measuring a Firms Book Value 34 Computing a Companys Taxes 41 Measuring Free Cash Flows 44 Financial Statements and International Finance 49 How Financial Managers Use This Material 50 Summary 50 Appendix 2A: Measuring Cash Flows: An Accounting Perspective 66 ix
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x CONTENTS JCHAPTER 3 Evaluating a Firms Financial Performance 71 Financial Ratio Analysis 72 The DuPont Analysis: An Integrative Approach to Ratio Analysis 85 How Financial Managers Use This Material 89 Summary 89 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107 Financial Forecasting 108 Limitations of the Percent of Sales Forecast Method 113 The Sustainable Rate of Growth 115 Financial Planning and Budgeting 117 How Financial Managers Use This Material 120 Summary 120 PART 2: VALUATION OF FINANCIAL ASSETS .,j CHAPTER 5 The Time Value of Money 137 Compound Interest and Future Value 138 Compound Interest with Nonannual Periods 146 Present Value 147 Annuities-A Level Stream 150 Annuities Due 157 Present Value of Complex Stream 160 Perpetuities and Infinite Annuities 163 Making Interest Rates Comparable 163 The Multinational Firm: The Time Value of Money 164 How Financial Managers Use This Material 165 Summary 165 ,/ CHAPTER 6 Risk and Rates of Return 181 Rates of Return in the Financial Markets 182 The Effects of Inflation on Rates of Return and the Fisher Effect 184 The Term Structure of Interest Rates 185 Expected Return 187 Risk 188 Risk and Diversification 192 Measuring Market Risk 196 Measuring a Portfolios Beta 201 The Investors Required Rate of Return 203 How Financial Managers Use This Material 207 Summary 208
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CONTENTS xi j CHAPTER 7 Valuation and Characteristics of Bonds 223 Types of Bonds 224 Terminology and Characteristics of Bonds 22 7 Definitions of Value 231 Determinants of Value 232 Valuation: The Basic Process 234 Bond Valuation 235 The Bondholders Expected Rate of Return (Yield to Maturity) 238 Bond Valuation: Five Important Relationships 240 How Financial Managers Use This Material 246 Summary 246 / CHAPTER 8 Stock Valuation 255 Features and Types of Preferred Stock 256 Valuing Preferred Stock 259 Characteristics of Common Stock 261 Valuing Common Stock 267 Stockholders Expected Rate of Return 272 How Financial Managers Use This Material 275 Summary 275 Appendix 8A: The Relationship between Value and Earnings 283 PAR T 3: I N VE S T MEN TIN LON G - T E R MAS SET S CHAPTER 9 Capital-Budgeting Decision Criteria 289 Finding Profitable Projects 290 Payback Period 292 Net Present Value 295 Profitability Index (Benefit/Cost Ratio) 298 Internal Rate of Return 299 Ethics in Capital Budgeting 312 A Glance at Actual Capital-Budgeting Practices 313 How Financial Managers Use This Material 314 Summary 315 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 Guidelines for Capital Budgeting 328 An Overview of the Calculations of a Projects Free Cash Flows 332 Complications in Capital Budgeting: Capital Rationing and Mutually Exclusive Projects 344I~
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xii CONTENTS The Multinational Firm: International Complications in Calculating Expected Free Cash Flows 353 How Financial Managers Use This Material 353 Summary 354 CHAPTER 11 Capital Budgeting and Risk Analysis 371 Risk and the Investment Decision 372 Methods for Incorporating Riskinto Capital Budgeting 376 Other Approaches to Evaluating Risk in Capital Budgeting 383 The Multinational Firm: Capital Budgeting and Risk 389 How Financial Managers Use This Material 390 Summary 390 CHAPTER 12 Cost of Capital 405 The Cost of Capital: Key Definitions and Concepts 406 Determining Individual Costs of Capital 407 The Weighted Average Cost of Capital 414 Cost of Capital in Practice: Briggs & Stratton 417 Calculating Divisional Costs of Capital: PepsiCo, Inc. 419 Using a Firms Cost of Capital to Evaluate New Capital Investments 420 How Financial Managers Use This Material 424 Summary 424 CHAPTER 13 Managing for Shareholder Value 435 Who Are the Top Creators of Shareholder Value? 437 Business Valuation-The Key to Creating Shareholder Value 438 Value Drivers 443 Economic Value Added (EVA)® 445 Paying for Performance 448 How Financial Managers Use This Material 456 Summary 457 PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER 14 Raising Capital in the Financial Markets 469 The Financial Manager, Internal and External Funds, and Flexibility 472 The Mix of Corporate Securities Sold in the Capital Market 474 Why Financial Markets Exist 475 Financing of Business: The Movement of Funds Through the Economy 478 Components of the U.S. Financial Market System 481 The Investment Banker 489 More on Private Placements: The Debt Side 493
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CONTENTS xiiiFlotation Costs 494Regulation 495The Multinational Firm: Efficient Financial Markets and Intercountry Risk 499How Financial Managers Use This Material 500?ummary 501CHAPTER 15Analysis and Impact of Leverage 505Business and Financial Risk 506Break-Even Analysis 509Operating Leverage 519Financial Leverage 524Combination of Operating and Financial Leverage 527The Multinational Firm: Business Risk and Global Sales 531How Financial Managers Use This Material 532Summary 533CHAPTER 16Planning the Firms Financing Mix 551Key Terms and Getting Started 552A Glance at Capital Structure Theory 553Basic Tools of Capital Structure Management 568The Multinational Firm: Beware of Currency Risk 580How Financial Managers Use This Material 581Summary 587CHAPTER 17Dividend Policy and Internal Financing 605Dividend Payment Versus Profit Retention 607Does Dividend Policy Affect Stock Price? 608The Dividend Decision in Practice 621Dividend Payment Procedures 625Stock Dividends and Stock Splits 625Stock Repurchases 628The Multinational Firm: The Case of Low Dividend Payments-So Where Do WeInvest? 631How Financial Managers Use This Material 633Summary 633 PART 5: WORKING-CAPITAL MANAGEMENT AND S P E C I A L TOP I C SIN FIN A N C.ECHAPTER 18Working-Capital Management and Short-Term Financing 645Managing Current Assets and Liabilities 646Financing Working Capital with Current Liabilities 647 j
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xiv CONTENTS Appropriate Level of Working Capital 648 Hedging Principles 648 Cash Conversion Cycle 651 Estimation of the Cost of Short-Term Credit 653 Sources of Short-Term Credit 654 Multinational Working-Capital Management 661 How Finance Managers Use This Material 662 Summary 662 CHAPTER 19 Cash and Marketable Securities Management 673 What are Liquid Assets? 674 Why a Company Holds Cash 674 Cash-Management Objectives and Decisions 676 Collection and Disbursement Procedures 678 Composition of Marketable Securities Portfolio 684 The Multinational Firm: The Use of Cash and Marketable Securities 691 How Financial Managers Use This Material 691 Summary 691 CHAPTER 20 Accounts Receivable and Inventory Management 705 Accounts Receivable Management 706 Inventory Management 716 TQM and Inventory-Purchasing Management: The New Supplier Relationships 724 How Financial Managers Use This Material 727 Summary 728 ". ./ CHAPTER 21 Risk Management 739 Futures 740 Options 746 Currency Swaps 757 The Multinational Firm and Risk Management 758 How Financial Managers Use This Material 759 Summary 759 CHAPTER 22 International Business Finance 773 The Globalization of Product and Financial Markets 774 Exchange Rates 775 Interest-Rate Parity Theory 785 Purchasing-Power Parity 785 Exposure to Exchange Rate Risk 787 Multinational Working-Capital Management 791
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CONTENTS xvInternational Financing and Capital-Structure Decisions 793Direct Foreign Investment 794How Financial Managers Use This Material 796Swnmary 796.1~ CHAPTER 23~ Corporate Restructuring: Combinations and Divestitures 23-1Why Mergers Might Create Wealth 23-3Determination of a Firms Value 23-6Divestitures 23-14How Financial Managers Use This Material 23-17Summary 23-19 ~ CHAPTER 24 - , Term Loans and Leases 24-1Term Loans 24-3Loan Payment Calculation 24-5Leases 24-7The Economics of Leasing Versus Purchasing 24-16How Financial Managers Use This Material 24-20Summary 24-20Appendixes A-IGlossary G-lIndexes I-I*Chapters 23 and 24 can be found at www.prenhall.comlkeown
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CHAPTER 1 AN I NTRO DUCTI 0 N TO FINANCIAL MANAGEMENT CHAPTER 2 UNDERSTANDING FINANCIALSTATEMENTS, TAXES, AND CASH FLOWS CHAPTER 3 EVALUATI NG A FIRMS FINANCIAL PERFORMANCE CHAPTER 4 FI NAN CIAL FORECASTING, PLANNING, AND BUDGETING
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CHAPTER 1 An Introd uction to Financial ManagementIn 1985, Harley-Davidson teetered only hours away from bank a successful stock offering, and Spring 2003, Harleys stockruptcy as one of Harleys largest lenders, Citicorp Industrial price rose approximately 125-fold. How did Harley-Davidson, aCredit, was considering bailing out on its loan. Since its begin company whose name grown men and women have tattooedning in 1903, the company survived two world wars, the Great on their arms and elsewhere, a company that conjures upDepression, and competition from countless competitors, but images of burly bad boys and Easy Rider hippies in black leatherby the early 1980s, Harley had become known for questionable jackets riding down the road, pull off one of the biggest busireliability and leaving oil stains on peoples driveways. It looked ness turnarounds of all time? Harley made good decisions.for a while like the future was set, and Harley wouldnt be Thats what were going to look at in this book. Well look atthere. It looked like the future of motorcycles in America would what it takes to turn Harley or any other company around.feature only Japanese names like Honda, Yamaha, Kawasaki, Well look at how a company goes about making decisions toand Suzuki. But none of that happened, and today Harley introduce new product lines. For example, in 2003, HarleyDavidson stands, as President Reagan once proclaimed, as "an Davidson introduced the Buell Lightning Low XB95, a low-cost,American success story." For a company in todays world, sur lightweight bike with a lower seat height aimed at bringingviving one scare is not enough-Today the business world shorter riders into the sport. How did it make this decision?involves a continuous series of challenges. As for Harley, it was Well also follow Harley-Davidson throughout this book, exama major accomplishment to make it through the 1980s, allow ining how its experience fits in with the topics we are examining it to face another challenge in the 1990s: a market that ing. In doing so, we will see that there are countless interaclooked like it might disappear within a few years. How did tions among finance, marketing, management, and accounting.Harley do against what looked like a shrinking market? It Because finance deals with decision making, it takes on imporincreased its motorcycle shipments from just over 60,000 in tance, regardless of your major. Moreover, the tools, techniques,1990 to over 260,000 in 2002 with expected sales in 2003 of and understanding you will gain from finance will not only helparound 290,000! How have the shareholders done? Between you in your business career, but will also help you make edu1986, when Harley-Davidson returned to public ownership with cated personal investment decisionsin the future. ~ CHAPTER PREVIEW ~ In this chapter, we will lay a foundation for the entire decisions. Then, we will describe the golden thread book. We will explain what finance is, and then we that ties everything together: the 10 basic principles will explain the key goal that guides financial deci of finance. Finally, we will look at the importance of sion making: maximization of shareholder wealth. looking beyond our geographic boundaries. We will examine the legal environment of financial 3
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4 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Objective ~ WHAT IS FINANCE? Financial management is concerned with the maintenance and creation of economic value or wealth. Consequently, this course focuses on decision making with an eye toward creating wealth. As such, we will deal with financial decisions such as when to introduce a new product, when to invest in new assets, when to replace existing assets, when to bor row from banks, when to issue stocks or bonds, when to extend credit to a customer, and how much cash to maintain. To illustrate, consider two firms, Merck and General Motors (GM). At the end of 2003, the total market value of Merck, a large pharmaceutical company, was $103 billion. Over the life of the business, Mercks investors had invested about $30 billion in the busi ness. In other words, management created $73 billion in additional wealth for the share holders. GM, on the other hand, was valued at $30 billion at the end of 2003; but over the years, GMs investors had actually invested $85 billion-a loss in value of $55 billion. Therefore, Merck created wealth for its shareholders, while GM lost shareholder wealth. In introducing decision-making techniques,we will emphasize the logic behind those techniques, thereby ensuring that we do not lose sight of the concepts when dealing with the calculations. To the first-time student of finance, this may sound a bit overwhelming. However, as we will see, the techniques and tools introduced in this text are all motivated by 10 underlying principles or axioms that will guide us through the decision-making process. Objective ~ GOAL OF THE FIRM We believe that the preferable goal of the firm should be maximization of shareholder wealth, by which we mean maximization of the price of the existing common stock. Not only will this goal be in the best interest of the shareholders, but it will also provide the most benefits to society. This will come about as scarce resources are directed to their most productive use by businesses competing to create wealth. To better understand this goal, we will first discuss profit maximization as a possible goal for the firm. Then we will compare it to maximization of shareholder wealth to see why, in financial management, the latter is the more appropriate goal for the firm. PROFIT MAXIMIZATION In microeconomics courses, profit maximization is frequently given as the goal of the firm. Profit maximization stresses the efficient use of capital resources, but it is not spe cific with respect to the time frame over which profits are to be measured. Do we maxi mize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating research and devel opment expenditures and cutting down on routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base financial decisions ona goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the.real world. In microeconomics, profit maximization functions largely as a theoretical goal, with economists using it to prove how firms behave rationally to increase profit. Unfortunately, it ignores many real-world complexities that financial managers must address in their deci sions. In the more applied discipline of financial management, firms must deal every day with two major factors not considered by the goal of profit maximization: uncertainty and timing. Microeconomics courses ignore uncertainty and risk to present theory more easily. Projects and investment alternatives are compared by examining their expected values or
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 5 weighted average profits. Whether one project is riskier than another does not enter into these calculations; economists do discuss risk, but only tangentially.! In reality, projects differ a great deal with respect to risk characteristics, and to disregard these differences in the practice of financial management can result in incorrect decisions. As we will discover later in this chapter, there is a very definite relationship between risk and expected return-that is, investors demand a higher expected return for taking on added risk-and to ignore this relationship would lead to improper decisions. Another problem with the goal of profit maximization is that it ignores the timing of the projects returns. If this goal is only concerned with this years profits, we know it inappropriately ignores profit in future years. If we interpret it to maximize the average of future profits, it is also incorrect. Inasmuch as investment opportunities are available for money in hand, we are not indifferent to the timing of the returns. Given equivalent cash flows from profits, we want those cash flows sooner rather than later. Thus the real-world factors of uncertainty and timing force us to look beyond a simple goal of profit maxi mization as a decision criterion. Finally, and possibly most important, accounting profits fail to recognize one of the most important costs of doing business. When we calculate accounting profits, we con sider interest expense as a cost of borrowing money, but we ignore the cost of the funds provided by the firms shareholders (owners). If a company could earn 8 percent on a new investment, that would surely increase the firms profits. However, what if the firms shareholders could earn 12 percent with that same money in another investment of simi lar risk? Should the companys managers accept the investment because it will increase the firms profits? Not if they want to act in the best interest of the firms owners (share holders). Now look at what happened with Burlington Northern. Burlington Northern is a perfect example of erroneous thinking. In 1980, Richard Bressler was appointed as Chief Executive Officer (CEO) of the company. Bressler, unlike his predecessor, was not a "railroad man." He was an "outsider" who was hired for the express purpose of improving the value of the shareholders stock. The reason for the change was that Burlington Northern had been earning about 4 percent on the share holders equity, when Certificates of Deposit (CDs) with no risk were paying 6 percent. Management was certainly increasing the firms profits, but they were destroying share holder wealth by investing in railroad lines that were not even earning a rate of return equal to that paid on government securities. We will turn now to an examination of a more robust goal for the firm: maximization of shareholder wealth. -~ MAXIMIZATION OF SHAREHOLDER WEALTH In formulating the goal of maximization of shareholder wealth, we are doing nothing more than modifying the goal of profit maximization to deal with the complexities of the operating environment. We have chosen maximization of shareholder wealth-that is, maximization of the market value of the existing shareholders common stock-because the effects of all financial decisions are thereby included. Investors react to poor invest ment or dividend decisions by causing the total value of the firms stock to fall, ano they react to good decisions by pushing up the price of the stock. In effect, under this goal, good decisions are those that create wealth for the shareholder. Obviously, there are some serious practical problems in implementing this goal and in using changes in the firms stock to evaluate financial decisions. We know the price of a firms stock fluctuates, often for no apparent r(ason. However, over the long run, price equals value. We will keep this long-run balancing in mind and focus on the effect that I See, for example, Robert S. Pindyck and Daniel Rubenfield, MiC7OecQlwlIIics, 2d ed. (New York: MacmiUan, !992), 244--46. I: }...J........
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 7 LEGAL FORMS OF BUSINESS ORGANIZATtON Objective -.!JIn the chapters ahead, we will focus on financial decisions for corporations. Although thecorporation is not the only legal form of business available, it is the most logical choicefor a firm that is large or growing. It is also the dominant business form in terms of salesin this country. In this section, we will explain why this is so. This will in turn allow us tosimplify the remainder of the text, as we will assume that the proper tax code to follow isthe corporate tax code, rather than examine different tax codes for different legal forms ofbusinesses. Keep in mind that our primary purpose is to develop an understanding of thelogic of financial decision making. Taxes will become important only when they affect ourdecisions, and our discussion of the choice of the legal form of the business is directed atunderstanding why we will limit our discussion of taxes to the corporate form. Legal forms of business organization are diverse and numerous. However, there arethree categories: the sole proprietorship, the partnership, and the corporation. Tounderstand the basic differences between each form, we need to define each form andunderstand its advantages and disadvantages. As we will see, as the firm grows, theadvantages of the corporation begin to dominate. As a result, most large firms take onthe corporate form.SOLE PROPRIETORSHIPThe sole proprietorship is a business owned by a single individual. The owner main- Sole proprietorshiptains title to the assets and is personally responsible, generally without limitation, for the t:- business owned by a singleliabilities incurred. The proprietor is entitled to the profits from the business but must indiVIdual.also absorb any losses. This form of business is initiated by the mere act of beginning the (I:---;Tl e +~, 1::"-~:" o D, ;business operations. Typically, no legal requirement must be met in starting the opera- .,c. - ,_ • . ,~,tion, particularly if the proprietor is conducting the business in his or her own name. If a s. -n~ ,_ ~l ""special name is used, an assumed-name certificate should be filed, requiring a small regis- • ,_ - rtration fee. Termination occurs on the owners death or by the owners choice. Briefly u:, "t.;)]I .Ii J ;"1stated, the sole proprietorship is, for all practical purposes, the absence of any formal!ega!business structure.PARTNERSHIPThe primary difference between a partnership and a sole proprietorship is that the part Partnershipnership has more than one owner. A partnership is an association of two or more persons An association of two or morecoming together as co-owners for the purpose of operating a business for profit. individuals joining together as co-owners to operate a businessPartnerships fall into two types: (1) general partnerships and (2) limited partnerships. for profit.GENE RAL PA RTNERSHIP In a general partnership, each partner is fully responsiblefor the liabilities incurred by the parmership. Thus, any parmers faulty conduct evenhaving the appearance of relating to the firms business renders the remaining partnersliable as well. The relationship among parmers is dictated entirely by the partnershipagreement, which may be an oral commitJnent or a formal document.LIMITED PARTNERSHIP AND LIMITED LIABILITY COMPANY Inadditiontothe general partnership, in which all partners are jointly liable without limitation, manystates provide for a limited partnership. The state statutes permit one or more of the partners to have limited liability, restricted to the amount of capital invested in the partnership. Several conditions must be met to qualify as a limited parmer. First, at least onegeneral partner must remain in the association for whom the privilege of limited liabilitydoes not apply. Second, the names of the limited partners may not appear in the name of j
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8 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT the firm. Third, the limited partners may not participate in the management of the busi ness. If one of these restrictions is violated, all partners forfeit their right to limited liabil ity. In essence, the intent of the statutes creating the limited partnership is to provide lim ited liability for a person whose interest in the partnership is purely as an investor. That individual may not assume a management function within the organization.Limited liability company A limited liability company (LLC) is a cross between a partnership and a corpora(LLC) tion. It retains limited liability for its owners, but is run and taxed like a partnership. BothAn organizational form that is a states and the IRS have rules for what qualifies as an LLC, but the bottom line is that itcross between a partnershipand a corporation. must not look too much like a corporation or it will be taxed as one. CORPORATIONCorporation The corporation has been a significant factor in the economic development of theAn entity that legally functions United States. As early as 1819, ChiefJustice John Marshall set forth the legal definitionseparate and apart from its of a corporation as "an artificial being, invisible, intangible, and existing only in the conowners. templation of law."2 This entity legally functions separate and apart from its owners. As such, the corporation can individually sue and be sued, and purchase, sell, or own prop erty; and its personnel are subject to criminal punishment for crimes. However, despite this legal separation, the corporation is composed of owners who dictate its direction and policies. The owners elect a board of directors, whose members in turn select individuals to serve as corporate officers, including president, vice president, secretary, and treasurer. Ownership is reflected in common stock certificates, designating the number of shares owned by its holder. The number of shares owned relative to the total number of shares outstanding determines the stockholders proportionate ownership in the business. Because the shares are transferable, ownership in a corporation may be changed by a shareholder simply remitting the shares to a new shareholder. The investors liability is confined to the amount of the investment in the company, thereby preventing creditors from confiscating stockholders personal assets in settlement of unresolved claims. This is an extremely important advantage of a corporation. After all, would you be willing to invest in General Electric if you would be liable in the event that one of their airplane engines malfunctions and people die in a crash? Finally, the life of a corporation is not dependent on the status of the investors. The death or withdrawal of an investor does not affect the continuity of the corporation. The management continues to run the corpora tion when stock is sold or when it is passed on through inheritance. See the Finance Matters box, "Ethics: The Enron Lessons." COMPARISON OF ORGANIZATIONAL FORMS Owners of new businesses have some important decisions to make in choosing an organi zational form. Whereas each business form seems to have some advantages over the oth ers, we will see that, as the firm grows and needs access to the capital markets to raise funds, the advantages of the corporation begin to dominate. Large and growing firms choose the corporate form for one re~son: ease in raising capital. Because of the limited liability, the ease of transferring ownership through the sale of common shares, and the flexibility in dividing the shares, the corporation is the ideal business entity in terms of attracting new capital. In contrast, the unlimited liabili: ties of the sole proprietorship and the general partnership are deterrents to raising equity capital. Between the extremes, the limited partnership does provide limited liability for limited partners, which has a tendency to attract wealthy investors. However, the imprac 1 Tbe Trustees ofDmtmrJUtb College v. Woodward, 4 Wheaton 636 (1819).
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CHAPTER AN INTRODUCTION TO FINANCIAL MANAGEMENT 9 THE ENRON LESSONS The bankruptcy and failure of the Enron Corporation on lead to a type of managerial short-sightedness or myopia December 2, 2001 shook the investment community to that focuses managerial attention on "hyping" the firms its very core and resulted in congressional hearings that potential to investors in an effort to reach higher market val- could lead to new regulations with far reaching implica- uations of the firms stock. tions. Enrons failure provides a sober warning to From the shareholders perspective one might ask what is employees and investors and a valuable set of lessons for wrong with achieving a higher stock price? The problem is students of business. The lessons we offer below reach far that this can lead to a situation where investor expectations beyond corporate finance and touch on fundamental become detached from what is feasible for the firm. principles that have always been true, but that are some- Ultimately, when investors realize that the valuation of the times forgotten. firms shares is unwarranted, there is a day of reckoning that can bring catastrophic consequences as it did with Enron. Lesson: Maximizing Share Value Is Not Always Thus, maximizing share value where the firms underlying the BeSt Thing to Do fundamentals do not support such valuations is dangerous If there is a disconnect between current market prices and business. In fact, it is not clear which is worse, having an the intrinsic worth of a firm then attempts to manipulate over- or an undervalued stock price. share value may appear to be possible over the short run. The problems associated with ma.naging for shareholder Under these circumstances problems can arise if firms use value in a capital market that is less than omniscient (per- equity-based compensation based on performance bench- fectly efficient) is largely uncharted territOly for financial marks using stock price or returns. These circumstances can economists.ticality of having a large number of partners and the restricted marketability of an inter-est in a partnership prevent this form of organization from competing effectively with thecorporation. Therefore, when developing our decision models, we will assume that weare dealing with the corporate form. The taxes incorporated in these models will dealonly with the corporate tax codes. Because our goal is to develop an understanding of themanagement, measurement, and creation of wealth, and not to become tax experts, in thefollowing chapter we will only focus on those characteristics of the corporate tax codethat will affect our financial decisions.THE ROLE OF THE FINANCIAL MANAGERIN A CORPORATIONAlthough a firm can assume many different organizational structures, Figure 1-1 presentsa typical representation of how the finance area fits into a corporation. The VicePresident for Finance, also called the Chief Financial OffIcer (CFO), serves under thecorporations Chief Executive Officer (CEO) and is responsible for overseeing financialplanning, corporate strategic planning, and controlling the firms cash flow. Typically, aTreasurer and Controller serve under the CFO. In a smaller firm, the same person mayfill both roles, with just one office handling all the du.ties. The Treasurer generally han-dles the firms financial activities, including cash and credit management, making capitalexpenditure decisions, raising funds, financial planning, and managing any foreign cur-rency received by the firm. The Controller is responsible for managing the firmsaccounting duties, including producing financial swtements, cost accounting, payingtaxes, and gathering and monitoring the data necessary to oversee the firms financialwell-being. In this class, we focus on the duties generally associated with the Treasurerand on how investment decisions are made.
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10 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT FIGURE 1-1 How the Finance Area Fits into a Corporation Board of Directors Chief Executive Officer (CEO) ::=J Vice President- Vice President-Finance Vice President- Marketing or Production and Operations ChiefFinanciaI Officer (CFO) Duties: Oversee financial planning Corporate strategic planning Control corporate cash flow Treasurer Controller Duties: Duties: Cash management Taxes Credit management Financial statements Capital expenditures Cost accounting Raising capital Data processing Financial planning Management of foreign currencies CONCEPT CHECK 1. What are the primary differences among a sole proprietorship, a partnership, and a corporation? 2. Explain why large and growing firms tend to choose the corporate I form. 3. What are the duties of the Corporate Treasurer? Of the Corporate Controller? I - - - -"- -" - -- THE CORPORATION AND THE FINANCIAL MARKETS: THE INTERACTION Without question, the ease of raising capital is the major reason for the popularity of the corporate form. While we will look at the process of raising capital in some detail in Chapter 14, lets spend a moment looking at the flow of capital through the financial mar- kets among the corporation, individuals, and the government. Figure 1-2 examines these flows. (1) Initially, the corporation raises funds in the finan- cial markets by selling securities. The corporation receives cash in return for securities- stocks and debt. (2) The corporation then invests this cash in return-generating assets- new projects for example-and (3) the cash flow from those assets is then either reinvested
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 11 FIGURE 1-2 The Corporation and the Financial Markets: The Interaction1. Initially, the corporation raises funds in the financial markets by selling securities-stocks and bonds; 2. Thecorporation then invests this cash in return-generating assets-new project; 3. The cash flow from those assets is eitherreinvested in the corporation, given back to the investors, or paid to the government in the form of taxes. 1. Primary Markets Corporation Cash Investors Secondaty markets o Securities 2. Corporation Cash reinvested invests in the corporation in return- Securities traded generating 3. among investors assets Cash flow from Cash distributed operations back to investors Taxes (rl)vernmentin the corporation; given back to the investors in the form of dividends or interest pay-ments, or used to repurchase stock, which should cause the stock price to rise; or given tothe government in the form of tax payments. One distinction that is important to understand is the difference between primaryand secondary markets. Again, we will reexamine raising capital and the differencebetween primary and secondary markets in some detail in Chapter 14. To begin with, asecurities market is simply a place where you can buy or sell securities. These markets cantake the form of anything from an actual building on Wall Street in New York City to anelectronic hookup among security dealers all over the world. Securities markets aredivided into primary and secondary markets. Lets take a look at what these terms mean. A primary market is a market in which new, as opposed to previously issued, securi- Primary marketties are traded. This is the only time that the issuing firm actually receives money for it~ A market in which new, as opposed to previously issued,stock. For example, if Nike issues a new batch of stock, this issue would be considered a securities are traded.primary market transaction. In this case, Nike would issue new shares of stock and receive Initial public offering (lPO)money from investors. Actually, there are two different types of {)fferings in the primary The first time the companysmarkets: initial public offerings and seasoned new issues or primary offerings. An initial stock is sold to the public.public offering (IPO) is the first time the companys stock is sold to the general public, Seasoned new issuewhereas a seasoned new issue refers to stock offerings by companies that already have Stock offerings by companiescommon stock traded in the secondary market. Once the newly issued stock is in the pub- that already have commonlics hands, it then begins trading in the secondary market. Securities that have previ- stock traded.ously been issued and bought are traded in the secondary market. For example, if you Secondary marketbought 100 shares of stock in an IPO and then wanted to resell them, you would be The market in which stock previously issued by the firmreselling them in the secondary markets. The proceeds from the sale of a share of IBM trades.stock in the secondary market go to the previous owner of the stock, not to IBM. That isbecause the only time IBM ever receives money from the sale of one of its securities is inthe primary markets.
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12 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT AN INTERVIEW WITH JEFF BlEUSTEIN. HARlEY-DAVIDSONS CEO Jeff Bleustein is the Chief Executive Officer at Harley- much-needed capital to support our operations while we Davidson Company, Inc. In our interview with Mr. Bleustein, paid on the firms large amounts of debt. he highlighted a number of milestones that he believes have • In 1983, we established our Harley Owners Group greatly influenced the companys success over the past two (HOG) to encourage our customers to use their bikes decades. Much of what he had to say related directly to the and stay illYolved with the company. At the end of 2000, main topics of this book. Specifically, he talked about the we had nearly 600,000 members. We also began a pro- companys strategies in the areas of investment decisions, gram of carefully managing the licensing of the Harley- working-capital management, financing decisions, marketing Davidson name. strategies, and global expansion. He also emphasized the • In the 1980s, we began a program to empower our importance of the people who implement these decisions. He employees. We needed to let everyone in the organization insists that there is more to business than crunching the num- know what was expected of him or her, which led us to the bers; it is people that make the difference. Mr. Bleusteins development of our corporate vision and statement ofval- remarks can be summarized as follows: ues! I strongly believe that the only sustainable corporate advantage a company can have is its people. • In 1981, the management of Harley-Davidson bought • In 1994, we began fostering a partnership with our the company from its parent company, ANIF, in a lever- unions to enable them to participate fully in the business. aged buyout. The extremely high level of debt incurred Today our two unions participate fully with the firms to finance the purchase placed the company in a very frail management in a wide range of decision making, includ- financial condition. The downturn in the economy, com- ing the firms strategies. bined with the debt load, created a powerful incentive to • Ve also initiated our circle organization, which involves improve operations to conserve cash. To add to the prob- the use of a team structure at our vice president level of lems, the firms principal lender, Citibank, announced in management to make the decisions. As a result, we elim- 1985 that it wanted out of its creditor position for the inated a whole layer from top management. firm. Last-minute refinancing was arranged on • Beginning in the 19905, we entered into a serious effort to December 31, 1985 to save the company from bank- globalize the company. We established a management team ruptcy. Then, within a few short months the companys in Europe, and over time we acquired our independent dis- financial picture had improved to the point where we tributors in major market~, such as the BenelufX, and Italy. were able to take the company public in an initial public offering. All of these decisions have significant financial implications • During the past two decades, the company has made sig- that are tied to our study of finance. Specifically, they reflect nificant capital investments in new product lines, such as financing choices, investment decisions, and working- the Evolution engine, the Softail motorcycle, and most capital management. So, we invite you to join us in our study recently, the Twin Cam 88 engine, one of our current of finance and, in the process, learn about a company that engine designs. Also, in 1998 we invested in new manu- has accomplished in real terms what few others have been facturing facilities in Kansas City, Missouri, and able to eLl. Menominee Falls, ·Wisconsin. • To improve the films management of its working capital, Harley-D;lvidson Motor Company: mission statement is, ""Ve fulfill we introduced the use of just-in-time inventory conu·ol. dreams through the experiences of motorcycling by providing to motorcy- clists and the general public an expanding line of motorcycles, branded We called our program MAN, which stands for Materials products and services in selected market segments. The firms value state- As Needed. This program allowed us to remove $51 mil- ment is exprcssed as, Tell the tmth, be fair, keep your promises, respect the lion from our work-in-process inventory and provided individual, and encourage intellectual curiosity. Objective --.!J TEN PRINCIPLES THAT FORM THE BASICS OF FINANCIAL MANAGEMENT We will now look at the finance fow1dations that lie behind the decisions made by finan- cial managers. To the first-time student of finance, the subject matter may seem like a col- lection of unrelated decision rules. This could not be further from the truth. In fact, our
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 13decision rules, and the logic that underlies them, spring from 10 simple principles that donot require knowledge of finance to understand. However, while it is not necessary to under-standfinance in order to understand these priluiples, it is necessary to understand these principlesin order to understand finance. Keep in mind that although these principles may at firstappear simple or even trivial, they will provide the driving force behind all that follows.These principles will weave together concepts and techniques presented in this text,thereby allowing us to focus on the logic underlying the practice of financial manage-ment. In order to make the learning process easier for you as a student, we will keepreturning to these principles throughout the book in the form of "Back to the Principles"boxes-tying the material together and letting you son the "forest from the trees." PRINCIPLE The Risk-Return Trade-Oft-We wont take on additional risk unless we expect to be compensated with additional returnAt some point, we have all saved some money. Why have we done this? The answer issimple: to expand our future conswnption opportunities-for example, save for a house,a car, or retirement. We are able to invest those savings and earn a return on our dollarsbecause some people would rather forgo future consumption opportunities to consumemore now-maybe theyre borrowing money to open a new business or a company isborrowing money to build a new plant. Assuming there are a lot of different people thatwould like to use our savings, how do we decide where to put our money? First, investors demand a minimum return for delaying conswnption that must begreater than the anticipated rate of inflation. If they didnt receive enough to compensatefor anticipated inflation, investors would purchase whatever goods they desired ahead oftime or invest in assets that were subject to inflation and earn the rate of inflation onthose assets. There isnt much incentive to postpone conswnption if your savings aregoing to decline in terms of purchasing power. Investment alternatives have different amounts of risk and expected returns.Investors sometimes choose to put their money in risky investments because theseinvestments offer higher expected returns. The more risk an investment has, the higherwill be its expected return. This relationship between risk and expected return is shownin Figure 1-3. FIGURE 1-3 The Risk-Return Relationship E a ~ -g t Expected return :<II for taking on } added riskExpected return { for delaying consumption LI _ Risk
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14 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns from investing will be, but we cant peer into the future and see what those rerurns are actually going to be. If investors could see into the future, no one would have invested money in the software maker Citrix, whose stock dropped 46 percent on June 13, 2000. Citrixs stock dropped when it announced that unexpected problems in its sales channels would cause second-quarter profits to be about half what Wall Street expected. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest convinces some investors to take on the added risk of purchasing a General Motors bond. This risk-return relationship will be a key concept as we value stocks, bonds, and proposed new projects throughout this text. We will also spend some time determining how to measure risk. Interestingly, much of the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 1-3 and how to measure risk. Both the graph and the risk-return relationship it depicts will reappear often in this text. PRINCIPLE 2 The Time Value of Money-A dollar received today is worth more than a dollar received in the future A fundamental concept in finance is that money has a time value associated with it: A dol- lar received today is worth more than a dollar received a year from now. Because we can earn interest on money received today, it is better to receive money earlier rather than later. In your economics courses, this concept of the time value of money is referred to as the opporrunity cost of passing up the earning potential of a dollar today. In this text, we focus on the creation and measurement of wealth. To measure wealth or value, we will use the concept of the time value of money to bring the future benefits and costs of a project back to the present. Then, if the benefits outweigh the costs, the project creates wealth and should be accepted; if the costs outweigh the benefits, the pro- ject does not create wealth and should be rejected. Without recognizing the existence of the time value of money, it is impossible to evaluate projects with future benefits and costs in a meaningful way. To bring future benefits and costs of a project back to the present, we must assume a specific opportunity cost of money, or interest rate. Exactly what interest rate to use is determined by Principle 1: The Risk-Return Trade-Off, which states investors demand higher returns for taking on more risky projects. Thus, when we determine the present value of future benefits and costs, we take into account that investors demand a higher return for taking on added risk. ---., PRINC I PLE 3 Cash-Not Profits-Is King In measuring wealth or value, we will use cash flows, not accounting profits, as our mea- surement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits, that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand. As a result, a firms cash flows and accounting profits may not be the same. For example, a capital expense, such as the purchase of new equipment or a building, is depreciated over sev- eral years, wjth the annual depreciation subtracted from profits. However, the cash flow, or actual dollars, associated with this expense generally occurs immediately. Therefore
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CHAPTER"l AN INTRODUCTION TO FINANCIAL MANAGEMENT 15cash inflows and outflows involve the actual receiving and payout of money-when themoney hits or leaves your hands. As a result, cash flows correctly reflect the timing of thebenefits and costs. PRINCIPLE 4 Incremental Cash Flows-its only what changes that countsIn 2000, Post, the maker of Cocoa Pebbles and Fruity Pebbles, introduced Cinna CrunchPebbles, "Cinnamon sweet taste that goes crunch." There is no doubt that Cinna CrunchPebbles competed directly with Posts other cereals and, in particular, its Pebbles prod-ucts. Certainly some of the sales dollars that ended up with Cinna Crunch Pebbles wouldhave been spent on other Pebbles and Post products if Cinna Crunch Pebbles had notbeen available. Although Post was targeting younger consumers with this sweetenedcereal, there is no question that Post sales bit into-actually cannibalized-sales fromPebbles and other Post lines. Realistically, theres only so much cereal anyone can eat.The difference between revenues Post generated after introducing Cinna Crunch Pebblesversus simply maintaining its existing line of cereals is the incremental cash flows. Thisdifference reflects the true impact of the decision. In making business decisions, we are concerned with the results of those decisions:What happens if we say yes versus what happens if we say no? Principle 3 states that weshould use cash flows to measure the benefits that accrue from taking on a new project.We are now fine tuning our evaluation process so that we only consider incremental cashflows. The incremental cash flow is the difference between the cash flows if the project istaken on versus what they will be if the project is not taken on. What is important is that we think incrementally. Our guiding rule in decidingwhether a cash flow is incremental is to look at the company with and without the newproduct. In fact, we will take this incremental concept beyond cash flows and look at allconsequences from all decisions on an incremental basis. PRINCIPLE 5 The Curse of Competitive Markets-Why its hard to find exceptionally profitable projectsOur job as financial managers is to create wealth. Therefore, we will look closely at themechanics of valuation and decision making. We will focus on estimating cash flows,determining what the investment earns, and valuing assets and new projects. But it will beeasy to get caught up in the mechanics of valuation and lose sight of the process of creat-ing wealth. Why is it so hard to find projects and investments that are exceptionally prof-itable? Where do profitable projects come from? The answers to these questions tell us alot about how competitive markets operate and where to look for profitable projects. In reality, it is much easier evaluating profitable projects than finding them. If anindustry is generating large profits, new entrants are usually attracted. The additionalcompetition and added capacity can result in profits being driven down to the requiredrate of return. Conversely, if an industry is returning profits below the required rate ofreturn, then some participants in the market drop out, reducing capacity and competi-tion. In turn, prices are driven back up. This is precisely what happened in the VCR videorental market in the mid-1980s. This market developed suddenly with the opportunityfor extremely large profits. Because there were no barriers to entry, the market quicklywas flooded with new entries. By 1987, the competition and price cutting produced lossesfor many firms in the industry, forcing them to flee the market. As the competition less-ened with firms moving out of the video rental industry, profits again rose to the pointwhere the required rate of return could be earned on invested capital.
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16 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can we find good projects-that is, projects that return more than their expected rate of return given their risk level (remember Principle 1). Although competition makes them difficult to find, we have to invest in mar- kets that are not perfectly competitive. The two most common ways of making markets less competitive are to differentiate the product in some key way or to achieve a cost advantage over competitors. Product differentiation insulates a product from competition, thereby allowing a company to charge a premium price. If products are differentiated, consumer choice is no longer made by price alone. For example, many people are willing to pay a prernium for Starbucks coffee. They simply want Starbucks and price is not important. In the pharma- ceutical industry, patents create competitive barriers. Schering-Ploughs Claritin, an allergy relief medicine, and Hoffman-La Roches Valium, a tranquilizer, are protected from direct competition by patents. Service and quality are also used to differentiate products. For example, Levis has long prided itself on the quality of its jeans. As a result, it has been able to maintain its market share. Similarly, much of Toyota and Hondas brand loyalty is based on quality Service can also create product differentiation, as shown by McDonalds fast service, cleanliness, and consistency of product that brings customers back. Whether product differentiation occurs because of advertising, patents, service, or quality, the more the product is differentiated from competing products, the less compe- tition it will face and the greater the possibility of large profits. Econornies of scale and the ability to produce at a cost below competition can effec- tively deter new entrants to the market and thereby reduce competition. Wal-Mart is one such case. For Wal-Mart, the fixed costs are largely independent of the stores size. For example, inventory costs, advertising expenses, and managerial salaries are essentially the same regardless of annual sales. Therefore, the more sales that can be built up, the lower the per-sale dollar cost of inventory, advertising, and management. Restocking from warehouses also becomes more efficient as delivery trucks can be used to full potential. Regardless of how the cost advantage is created-by econornies of scale, proprietary technology, or monopolistic control of raw materials-the cost advantage deters new market entrants while allowing production at below industry cost. This cost advantage has the potential of creating large profits. The key to locating profitable investment projects is to first understand how and where they exist in competitive markets. Then the corporate philosophy must be aimed at creating or taking advantage of some imperfection in these markets, either through product differentiation or creation of a cost advantage, rather than looking to new mar- kets or industries that appear to provide large profits. Any perfectly competitive indus- try that looks too good to be true wont be for long. It is necessary to understand this to know where to look for good projects and to accurately measure the projects cash flows. We can do this better if we recognize how wealth is created and how difficult it is to create it. PRINCIPLE 6 Efficient Capital Markets-The markets are quick and the prices are right Our goal as financial managers is the maximization of shareholder wealth. How do weEfficient market measure shareholder wealth? It is the value of the shares that the shareholders hold. ToA market in which the values ofall assets and securities at any understand what causes stocks to change in price, as well as how securities such as bondsinstant in time fully reflect all and stocks are valued or priced in the financial markets, it is necessary to have an under-available public information. standing of the concept of efficient markets.
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CHAPTER t AN INTRODUCTION TO FINANCIAL MANAGEMENT 17 / Whether a market is efficient or not has to do with the speed with which informationis impounded into security prices. An efficient market is characterized by a large numberof profit-driven individuals who act independently. In addition, new information regard-ing securities arrives in the market in a random manner. Given this setting, investorsadjust to new information immediately and buy and sell the security until they feel themarket price correctly reflects the new information. Under the efficient market hypothe-sis, information is reflected in security prices with such speed that there are no opportu-nities for investors to profit from publicly available information. Investors competing forprofits ensure that security prices appropriately reflect the expected earnings and risksinvolved and thus the true value of the firm. What are the implications of efficient markets for us? First, the price is right. Stockprices reflect all publicly available information regarding the value of the company. Thismeans we can implement our goal of maximization of shareholder wealth by focusing onthe effect each decision should have on the stock price if everything else were held con-stant. That is, over time good decisions will result in higher stock prices and bad ones,lower stock prices. Second, earnings manipulations through accounting changes will notresult in price changes. Stock splits and other changes in accounting methods that do notaffect cash flows are not reflected in prices. Market prices reflect expected cash flowsavailable to shareholders. Thus, our preoccupation with cash flows to measure the timingof the benefits is justified. As we will see, it is indeed reassuring that prices reflect value. It allows us to look atprices and see value reflected in them. While it may make investing a bit less exciting, itmakes corporate finance much less uncertain. PRINCIPLE The Agency Problem-Managers wont work for owners unless its in their best interestAlthough the goal of the firm is the maximization of shareholder wealth, in reality, theagency problem may interfere with the implementation of tllis goal. The agency prob- Agency problemlem results from the separation of management and the ownership of the firm. For exam- Problem resulting fromple, a large firm may be nm by professional managers who have little or no ownership in conflicts of interest between the manager (the stockholdersthe firm. Because of this separation of the decision makers and owners, managers may agent) and the stockholders.make decisions that are not in line with the goal of maximization of shareholder wealth.They may approach work less energetically and attempt to benefit themselves in terms ofsalary and perquisites at the expense of shareholders. To begin with, an agent is someone who is given the authority to act on behalf ofanother, referred to as the principal. In the corporate setting, the shareholders are theprincipals, because they are the actual owners of the firm.The board of directors, theCEO, the corporate executives, and all others with decision-making power are agents ofthe shareholders. Unfortunately, the board of directors, the CEO, and the other corpo-rate executives dont always do whats in the best interest of the shareholders. Instead,.they act many times in their own best interest. Not only might tlley benefit themselves interms of salary and perquisites, but they might also avoid any projects that have risk asso-ciated with them-even if theyre great projects witll huge potential returns and a smallchance of failure. Why is this so? Because if tlle project doesnt turn out, these agents ofthe shareholders may lose their jobs. The costs associated with the agency problem are difficult to measure, but occasionallywe see the problems effeCt in the marketplace. For example, if the market feels manage-ment of a firm is damaging shareholder wealth, we might see a positive reaction in stockprice to the removal of that management. In 1989, on the day following the death ofJohnDorrance, Jr., chairman of Campbell Soup, Campbells stock price rose about 15 percent.
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18 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Some investors felt that Campbells relatively small growth in earnings might be improved with the departure of Dorrance. There was also speculation that Dorrance was the major obstacle to a possible positive reorganization. If the management of the firm works for the owners, who are the shareholders, why doesnt the management get fired if it doesnt act in the shareholders best interest? In the- ory, the shareholders pick the corporate board of directors and the board of directors in turn picks the management. Unfortunately, in reality the system frequently works the other way around. Management selects the board of director nominees and then distrib- utes the ballots. In effect, shareholders are offered a slate of nominees selected by the management. The end result is management effectively selects the directors, who then may have more allegiance to managers than to shareholders. This in turn sets up the potential for agency problems with the board of directors not monitoring managers on behalf of the shareholders as they should. We will spend considerable time monitoring managers and trying to align their inter- ests with shareholders. Managers can be monitored by auditing financial statements and managers compensation packages. The interests of managers and shareholders can be aligned by establishing management stock options, bonuses, and perquisites that are directly tied to how closely their decisions coincide with the interest of shareholders. The agency problem will persist unless an incentive structure is set up that aligns the interests of managers and shareholders. In other words, whats good for shareholders must also be good for managers. If that is not the case, managers will make decisions in their best interests rather than maximizing shareholder wealth. PRINCIPLE 8 Taxes Bias Business Decisions Hardly any decision is made by the financial manager without considering the impact of taxes. When we introduced Principle 4, we said that only incremental cash flows should be considered in the evaluation process. More specifically, the cash flows we will consider will be after-tax incremental cash flows to the firm as a whole. When we evaluate new projects, we will see income taxes playing a significant role. When the company is analyzing the possible acquisition of a plant or equipment, the returns from the investment should be measured on an after-tax basis. Otherwise, the com- pany will not truly be evaluating the true incremental cash flows generated by the project. The government also realizes taxes can bias business decisions and uses taxes to encourage spending in certain ways. If the government wanted to encourage spending on research and development projects it might offer an investment tax credit for such invest- ments. This would have the effect of reducing taxes on research and development projects, which would in turn increase the after-tax cash flows from those projects. The increased cash flow would turn some otherwise unprofitable research and development projects into profitable projects. In effect, the government can use taxes as a tool to direct business investment to research and development projects, to the inner cities, and to pro- jects that create jobs. PRINCIPLE 9 All Risk Is Not Equal-Some risk can be diversified away, and some cannot Much of finance centers around Principle 1: The Risk-Retunt Trade-Off. But before we can fully use Principle 1, we must decide how to measure risk. As we will see, risk is difficult to measure. Principle 9 introduces you to the process of diversification and demonstrates how ityan reduce risk. We will also provide you with an understanding of how diversification makes it difficult to measure a projects or an assets risk.
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 19 You are probably already familiar with the concept of diversification. There is an oldsaying, "dont put all of your eggs in one basket." Diversification allows good and badevents or observations to cancel each other out, thereby reducing total variability withoutaffecting expected return. To see how diversification complicates the measurement of risk, let us look at the dif-ficulty Louisiana Gas has in determining the level of risk associated with a new naturalgas well drilling project. Each year, Louisiana Gas might drill several hundred wells, witheach well having only a 1 in 10 chance of success. If the well produces, the profits arequite large, but if it comes up dry, the investment is lost. Thus, with a 90 percent chanceof losing everything, we would view the project as being extremely risky. However, ifLouisiana Gas each year drills 2,000 wells, all with a 10 percent, independent chance ofsuccess, then they would typically have 200 successful wells. Moreover, a bad year mayresult in only 190 successful wells, and a good year may result in 210 successful wells. Ifwe look at all the wells together, the extreme good and bad results tend to cancel eachother out and the well drilling projects taken together do not appear to have much risk orvariability of possible outcome. The amount of risk in a gas well project depends upon our perspective. Looking atthe well standing alone, it looks like a lot; however, if we consider the risk that each wellcontributes to the overall firm risk, it is quite small. This is because much of the risk asso-ciated with each individual well is diversified away within the firm. The point is: We cantlook at a project in isolation. Later, we will see that some of this risk can be further diver-sified away within the shareholders portfolio. Perhaps the easiest way to understand the concept of diversification is to look at itgraphically. Consider what happens when we combine two projects, as depicted in Figure1-4. In this case, the cash flows from these projects move in opposite directions, and whenthey are combined, the variability of their combination is totally eliminated. Notice thatthe return has not changed-each individual projects and their combinations returnaverages 10 percent. In this case, the extreme good and bad observations cancel eachother out. The degree to which the total risk is reduced is a function of how the two setsof cash flows or returns move together. As we will see for most projects and assets, some risk can be eliminated throughdiversification, whereas some risk cannot. This will become an important distinction laterin our studies. For now, we should realize that the process ofdiversification can reduce risk, andas a result, measuring a projects or an assets risk is very difficult. A projects risk changesdepending on whether you measure it standing alone or together with other projects thecompany may taktion. See the Finance Matters box, "Ethics: The Enron Lessons." FIGURE 1-4 Reducing Risk Through Diversification 20 Asset A---.e:, ~ E 10E~ Asset B o Time
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20 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT THE ENRON LESSONS The bankruptcy and failure of the Enron Corporation on well as serving as Enrons CFO. There were times when December 2, 2001 shook the investment community to its he represented the interests of Enron in circumstances very core and resulted in congressional hearings that could that were ill direct conflict with the interests of the part- lead to new regulations with far reaching implications. ners to the partnerships. It is still not clear how he han- Enrons failure provides a sober warning to employees and dled these circumstances, but the source of concern to investors and a valuable set of lessons for students of busi- Enron shareholders is obvious. ness. The lessons we offer below reach far beyond corporate • vVere corporate insiders (executives) selling their stock finance and touch on fundamental principles that have based on their privileged knowledge of the firms true always been true, but that are sometimes forgotten. financial condition during the months prior to the firms failure while outside investors were being duped into hold- Lesson: Trust and Credibility ing their shares? Allegations abound that top corporate Are Essential to Business Success executives at Enron were selling their shares long before The viability of any firm hinges critically on the firms cred- other employees and outside investors knew how serious ibility with its customers, employees, regulators, investors, the firms problems were. Regardless of the outcome in the and even to some degree, its competitors. This is particu- Enron case, this raises a serious dilemma for investors who larly critical for a trading company such as Enron whose pri- cannot know as much about the financial condition of the maIy business rests on the willingness of the firms counter firms in which they invest as the managers do. parties with whom it trades to "trust" in Enrons ability to • Can auditing firms that accept consulting engagements "be there" when the time to settle up arrives. When the faith with their audit clients be truly independent or is that of the investment community was tested with the revelation independence compromised? The Enron failure has of losses from some of its largest investments and the subse- called into question the wisdom of relying on external quent revelation of Enrons off-balance sheet liabilities, auditing firms who are beholden to the firms they audit Enrons trading business evaporated. both for their continued employment as an auditor and In addition, we were reminded of the fact that investors also for consulting fees that can sometimes dwarf their must believe that the firms published financial reports are a auditor fees. fair representation of the firms financial condition. Nithout • Finally, can investors rely on the opinions of equity ana- this trust outside investors would refuse to invest in the shares lysts whom they believe are basing those opinions on of publicly traded firms and financial markets would collapse." their independent research? Investors make the assump- Trust between two entities is hard to sustain when one of tion that the analysts are offering unfettered, indepen- the parties to the relationship has dual and conflicting dent opinions of the companys financial prospects. motives. iVe refer to the presence of multiple motives as a However, in many cases the analysts work for investment conflict of interest and the potential for conflict of interest banks that, in turn, rely on investment banking fees from problems were in abundance as Enron feU to earth. Some of the very companies the analysts cover. The potential the following sources of conflict apply only to Enron while conflict of interest is obvious. others are applicable to many firms: • Enrons chief financial officer (CFO) attempted to serve This is simply a recasting of the famous result from microeconomics stat- ing thlt where informational asymmetry problems between buyers and sell- two masters when he was both the general partner for a crs arc extreme, markets will collapse (George Akerlof, "The Market for series of limited partnerships used by Enron to finance its Lemons: Qualitative Uncertainly and the Market ,;Icchanism," Qunrterly investments and hedge certain investment returns, as ]01I1"1ull ofEc07l01l1i,,;, 84 (1970), 488-500). PRINCIPLE 1 Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance Ethics, or rather a lack of ethics, in finance is a recurring theme in the news. During the late 1980s and early 1990s, the fall ofIvan Boesky and Drexel, Burnham, Lambert, and the near collapse of Salomon Brothers seemed to make continuous headlines.
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 21 Meanwhile, the movie "Wall Street was a hit at the box office and the book Liars Poker, by Michael Lewis, chronicling unethical behavior in the bond markets, became a best seller. Unfortunately, ethics, or the lack of them, continued to make the front page in the early 2000s, with Enron, Worldcom, and Arthur Anderson all serving to illustrate that ethical errors are not forgiven in the business world. Not only is acting in an ethi-. cal manner morally correct, it is congruent with our goal of maximization of share- holder wealth. Ethical behavior means "doing the right thing." A difficulty arises, however, in attempting to define "doing the right thing." The problem is that each of us has his or her own set of values, which forms the basis for our personal judgments about what is the right thing to do. However, every society adopts a set of rules or laws that prescribe what it believes to be "doing the right thing." In a sense, we can think of laws as a set of rules that reflect the values of the society as a whole, as they have evolved. For purposes of this text, we recognize that individuals have a right to disagree about what constitutes "doing the right thing," and we will seldom venture beyond the basic notion that ethical conduct involves abiding by societys rules. However, we will point out some of the ethical dilem- mas that have arisen in recent years with regard to the practice of financial management. So as we embark on our study of finance and encounter ethical dilemmas, we encourage you to consider the issues and form your own opinions. Many students ask, "Is ethics really relevant?" This is a good question and deserves an answer. First, although business errors can be forgiven, ethical errors tend to end careers and terminate future opportunities. Why? Because unethical behavior eliminates trust, and without trust, businesses cannot interact. Second, the most damaging event a business can experi- ence is a loss ofthe pUblics confidence in its ethical standards. In finance, we have seen several recent examples of such events. It was the ethical lapses at Arthur Anderson and its work with Enron that brought down that once-great accounting finn. See the Finance Matters box, "The Wall Street Joumal Workplace-Ethics Quiz." Beyond the question of ethics is the question of social responsibility. In general, cor- porate social responsibility means that a corporation has responsibilities to society beyond the maximization of shareholder wealth. It asserts that a corporation answers to a broader constituency than shareholders alone. As with most debates that center on ethi- cal and moral questions, there is no definitive answer. One opinion is that because finan- cial managers are employees of the corporation, and the corporation is owned by the shareholders, the financial managers should run the corporation in such a way that share- holder wealth is maximized and then allow the shareholders to decide if they would like to fulfill a sense of social responsibility by passing on any of the profits to deserving causes. Very few corporations consistently act in this way. For example, Bristol-Myers Squibb Co. gi,~s away heart medication to those who cannot pay for it. This decision to give away heart medication came in the wake of an American Heart Association report showing that many of the nations working poor face severe health risks because they can- not afford heart drugs. Clearly, Bristol-Myers Squibb felt it had a social responsibility to provide this medicine to the poor at no cost. How do you feel about this decision? A FINAL NOTE ON THE PRINCIPLES Hopefully, these principles are as much statements of common sense as they are theoret- ical statements. These principles provide the logic behind what is to follow. We will build on them and attempt to draw out their implications for decision making. As we continue, try to keep in mind that although the topics being treated may change from chapter to chapter, the logic driving our treatment of them is constant and is rooted in these 10 prin- ciples. See the Entrepreneurs Perspective box, "The Entrepreneur and Finance."
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 23 AN ENTREPRENEURS ~", , . .. 7- P - T I .~ ·::.to t. ~~ THE ENTREPRENEUR AND FINANCE Do you ever think about wanting to someday own your own physical-that must be available. The entrepreneur usu- business? Does being an entrepreneur have any appeal to ally does not have the capital to own all the resources you? Well, it does for a lot of people. During the past that are needed. So she must have access to resources, decade, starting and growing companies have been the pre- but usually cannot afford to own them. Its what we call ferred avenue many have chosen for careers. In fact, while bootstrapping. The goal is to do more with less. many of the large companies are reducing the number of • Launch the venture. All the planning in the world is not employees, smaller companies are creating new jobs by the enough. The entrepreneur must be action oriented. It thousands. A lot of individuals have thought that there was requires a "can do" spirit. greater security in working with a big company, only to be • Grow the business. A business has to grow if it is to be disillusioned in the end when they were informed that successful. Frequently, the firm will not break even for "Friday is your last day." several years, which means that we will be burning up Defining an entrepreneur is not an easy thing to do. But cash each month. Being able to survive during the time we can say with some clarity what entrep"meul"Ship is about. that cash flows are negative is no easy task. If we grow too Entreprenewship has been defined as a relentless pursuit of slow, we lose, but also if we grow too fast, we may lose as opportunity for the purpose of creating value, without con- well. During this time, additional capital will be needed, cern for the resources owned. . which requires that we know how to value the firm and 10 be successful, the entrepreneurial process requires how to structure financing. that the entrepreneur be able to: • Exit the business. If a venture has been successful, the entrepreneur will have created economic value that is • Identify a good opportunity. Oftentimes we may have a locked up in the business. At some point in time, the "good idea," but it may not be a "good opportunity." entrepreneur will want to capture the value that has been Opportunities are market driven. There must be created by the business. It will be time to harvest. enough customers who want to buy our product or service at a price that covers our expenses and leaves To be successful as an entrepreneur requires an understand- an attractive profit-no matter how much we may like ing of finance. At the appropriate places in Financial the idea. Management, we will be presenting how finance relates to • Gain access to the resources needed. For any venture, the entrepreneurial journey. It is an interesting topic that we there are critical resources-human, financial, and think you will enjoy. and tax environment in which these decisions are to be made. Since this environment sets the ground rules, it is necessary to understand it before decision rules can be formulated. The 10 guiding principles that provide the underpinnings for what is to follow are then presented. Chapters 2 through 4 introduce the basic financial tools the financial manager uses to maintain control over the firm and its operations. These tools enable the financial manager to locate potential problem areas and plan for the future. Chapter 5 explores how the firm and its assets are valued. It begins with an examina- tion of the mathematics of finance and the concept of the time value of money. An under-r standing of this topic allows us to compare benefits and costs that occur in different time periods. We move on in Chapter 6 to develop an understanding of the meaning and mea- surement of risk. Valuation of fixed income securities is examined in Chapter 7, and Chapter 8 looks at valuation models that attempt to explain how different financial deci- sions affect the firms stock price. Using the valuation principles just developed, Chapter 9 discusses the capital- budgeting decision, which involves the financial evaluation of investment proposals in fixed assets. We then examine the measurement of cash flows in Chapter 10, andintro- duce methods to incorporate risk in the analysis in Chapter 11. In Chapter 12, we will examine the financing of a firms chosen projects, looking at what costs are associated
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24 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT with alternative ways of raising new funds. Then, in Chapter 13, we look at managing the finn for shareholder value. Chapter 14 examines the financial markets and the act of raising funds. Chapter 15 examines the fums capital structure along with the impact of leverage on returns to the enterprise. Once these relationships between leverage and valuation are developed, we move on to the process of planning the firms financing mix in Chapter 16. This is fol- lowed in Chapter 17 with a discussion of the determination of the dividend-retained earnings decision. Chapters 18 through 20 deal with working-capital management, the management of current assets. We will discuss methods for determining the appropriate investment in cash, marketable securities, inventory, and accounts receivable, as well as the risks associ- ated with these investments and the control of these risks. Chapter 21 presents discussion of the use of futures, options, and swaps by financial managers to reduce risk. The final chapter in the text, Chapter 22, deals with interna- tional financial management, focusing on how financial decisions are affected by the international environment. In addition, Chapter 23, an introduction to corporate restruc- turing including mergers, spinoffs, and leveraged buyouts, is provided on the Internet. Similarly, Chapter 24, Loans and Leases, is also provided on the Internet. Objective ~ FINANCE AND THE MULTINATIONAL FIRM: THE NEW ROLE In the search for profits, U.S. corporations have been forced to look beyond our countrys borders. This movement has been spurred on by the collapse of conununism and the acceptance of the free market system in Third World countries. All of this has taken place at a time when information technology has experienced a revolution brought on by the personal computer (PC). Concurrently, the United States went through an unprece- dented period of deregulation of industries. These changes resulted in the opening of new international markets, and U.S. firms experienced a period of price competition here at home that made it imperative that businesses look across borders for investment opportunities. The end result is that many U.S. companies, including General Electric, IBM, Walt Disney, American Express, and General Motors, have restructured their oper- ations in order to expand internationally. However, not only do U.S. firms have a freer access to international markets, but also foreign firms have an easier job of entering the U.S. markets and competing with U.S. firms on their own turf. The bottom line is that what you think of as a U.S. firm may be much more of a multinational firm than you would expect. For example, Coca-Cola earns over 80 per- cent of its profits from overseas sales. Moreover, Coca-Cola earns more money from its sales in Japan than it does from all its domestic sales, and this is not uncommon. In fact, Dow Chemical, Colgate-Palmolive, 3M, Compaq, Hewlett-Packard, and Gillette make over half their sales overseas and earn over half of their profits from interna- tional sales. In addition to U.S. firms venturing abroad, foreign firms have also made their mark in the United States. You need only look to the auto industry to see what changes the entrance of Toyota, Honda, Nissan, BMW, and other foreign car manu- facturers have made in the auto industry. In addition, foreigners have bought and now own such companies as Brooks Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire & Rubber. Consequently, even if we wanted to, we couldnt keep all our"attention focused on the United States, and even more impor- tant, we wouldnt want to ignore the opportunities that are available across interna- tional borders.
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CHAPTER AN INTRODUCTION TO FINANCIAL MANAGEMENT 25 CONCEPT CHECK 1. What has brought on the era of the multinational corporation? 2. Has looking beyond U.s. borders been a profitable experience for U.s. corporations? HOW FINANCIAL MANAGERS USE THIS MATERIALAs the chapter title states, this chapter provides you with an introduction to financialmanagement. The principles presented in this chapter provide you with some clues as tothe types of questions that will be dealt with by financial managers. As you will find outover the course of your studies, financial questions abound. In the Spring of 2003, head-lines in The Willi Street Journal were full of financial decisions, including the giant drugmakers Pfizer and Pharmacia winning final approval for their merger, Disney nearing adeal to sell its Anaheim Angels baseball team for $160 to $180 million, and AOL TimeWarner Inc. reporting a 2002 net loss of$98.7 billion after taking a fourth-quarter chargeof $45.5 billion, mostly to write down the value of its troubled America Online unit whileit tried to sell its Atlanta-based teams-baseballs Atlanta Braves, basketballs AtlantaHawks, and hockeys Atlanta Thrashers. But financial questions and decisions alsoappeared in the headlines in the sports section when the Washington Redskins signedLavernues Coles to a $35 million contract and basketball coach Ben Howland took theUCLA coaching job at a salary of $900,000 per year. ¥hat do all of these financial decisions have in common? They are all based on the10 principles presented in this chapter, and they all deal with decision making. They areall financial decisions, because the focus of finance is how to raise and spend or investmoney. Your goal as a financial manager is to manage the firm in such a way that share-holder wealth is maximized. As you will see, there are few, if any, major decisions that amanager makes that dont have financial implications.[[ IIThis chapter outlines a framework for the maintenance and creation of wealth. In introducing 0 b j e c t i ve 1 Idecision-making techniques aimed at creating weal til, we will emphasize the logic behind those ~techniques. This chapter begins with an examination of the goal of the firm. The commonlyaccepted goal of profit maximization is contrasted with the more complete goal of maximization 0bj e c t I ve 2 Iof shareholder wealth. Because it deals well with uncertainty and time in a real-world environ- ~ment, the goal of maximization of shareholder wealtll is found to be the proper goal for the firm. The sole proprietorship is a business operation owned and managed by a single individual. 0 b j e c t; ve 3 IInitiating this form of business is Simple and generally does not involve any substantial organiza- ~tional costs. The proprietor has complete control of the firm, but must be willing to assume fullresponsibility for its outcomes. The general partnership, which is simply a coming together of two or more individuals, issimilar to the sole proprietorship. The limitea partnership is another form of partnership sanc-tioned by states to permit all but one of the partners to have limited liability if this is agreeable toall partners. The corporation increases the flow of capital from public investors to the business commu-nity. Although larger organizational costs and regulations are imposed on this legal entity, thecorporation is more conducive to raising large amount, of capital. Limited liability, continuity oflife, and ease of transfer in ownership, which increase the marketability of the investment, havecontributed greatly in attracting large numbers of investors to the corporate environment. The
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26 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT formal control of the corporation is vested in the parties who own the greatest number of shares. However, day-to-day operations are managed by the corporate officers, who theoretically serve on behalf of the COIlUTIon stockholders. Objective ~ This chapter closes with an examination of the 10 principles on which finance is built that motivate the techniques and tools introduced in this text: PRINCIPLE The Risk-Return Trade-Oft-We wont take on additional risk unless we expect to be compensated with additional return PRINCIPLE 2 The Time Value of Money-A dollar received today is worth more than a dollar received in the future PRINCIPLE 3 Cash-Not Profits-Is King PRINCIPLE Incremental Cash Flows-Its only what changes that counts PRINCIPLE The Curse of Competitive Markets-Why its hard to find exceptionally profitable projects PRINCIPLE 6 Efficient Capital Markets-The markets are quick and the prices are right PRINCIPLE The Agency Problem-Managers wont work for owners unless its in their best interest PRINCIPLE 8 Taxes Bias Business Decisions PRINCIPLE 9 All Risk Is Not Equal-Some risk can be diversified away, and some cannot PRINCIPLE Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance Objective ~ With the collapse of communism and the acceptance of the free market system in Third World countries, U.S. firms have been spurred on to look beyond our own boundaries for new business. The end result has been that it is not uncommon for major U.S. companies to earn over half their income from sales abroad. Agency problem, 17 Limited liability Seasoned new issue, 11Go To: Corporation, 8 company (LLC), 8 Secondary market, 11www.prenhall.comlkeown Partnership, 7 Efficient market, 16 Sole proprietorship, 7for downloads and currentevents associated with this lllitialpublicoffering Primary market, 11chapter (lPO),11
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CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 21 STUDY QUESTIONS1-1. What are some of the problems involved in the use of profit maximization as the goal of thefinn? How does the goal of maximization of shareholder wealth deal with those problems?, 1-2. Compare and contrast the goals of profit maximization and maximization of shareholder wealth.1-3. Finns often involve themselves in projects that do not result direccly in profits; for example,IBM and Mobil Oil frequently support public television broadcasts. Do these projects contradictthe goal of maximization of shareholder wealth? Why or why not?1-4. What is the relationship between financial decision making and risk and return? Would allfinancial managers view risk-return trade-offs similarly?1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation.1-6. Identify the primary characteristics of each fonn of legal organization.1-7. Using the following criterl~; specify the legal form of business that is favored: (a) organiza-tional requirements and costs, (b) liability of the owners, (c) continuity of business, (d) transfer-ability of ownership, (e) management control and regulations, (f) ability to raise capital, and(g) income taxes. I NTEGRAT I. VEP ROB L EM IThe final.stage in the interview process for an Assistant Financial Analyst at Caledonia Productsinvolves a test of your understanding of basic financial concepts. You are given the followingmemorandum and asked to respond to the questions. Whether or not you are offered a positionat Caledonia will depend on the accuracy of your response.To: Applicants for the position of Financial AnalystFrom: Mr. V Morrison, CEO, Caledonia ProductsRe: A test of your understanding of basic financial concepts and of the Corporate Tax CodePlease respond to the following questions: 1. What are the differences between the goals of profit maximization and maximization of shareholder wealth? Which goal do you think is more appropriate? 2. What does the risk-return trade-off mean? 3. Why are we interested in cash flows rather than accounting profits in determining the value of an asset? 4. What is an efficient market and what are the implications of efficient markets for us? 5. What is the cause of the agency problem and how do we try to solve it? 6. What do ethics and ethical behavior have to do with finance? 7. Define (a) sole proprietorship, (b) partnership, and (c) corporation. ; CAS E POL E j" ~. ~ _ - ~., ...- ~ .6". 1" ETHie SLIVING AND DYING WITH ASBESTOS accepted and when they should be tenninated. As new infor-What happens when you find your most profitable product is mation surfaces regarding the future profitability of a project,dangerous-an ethical dilemma for the financial manager. the firm always has the choice of terminating that project. When this new infonnation raises the question of whether orMuch of what we deal with in financial management centers not it is ethical to produce a profitable project, the decisionaround the evaluation of projects-when they should be becomes more difficult. Many times, ethical dilemmas pit
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28 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTprofits versus ethics. These decisions become even more diffi- any question about the arbiter of publication, Brown wrote tocult when continuing to produce the product is within the law. officials at the laboratory conducting the tests: Asbestos is a fibrous mineral used for fireproofing, electri- It is our further understanding that the results obtained will becal insulation, building materials, brake linings, and chemical considered the property of those who are advancing thefilters. If you are exposed long enough to asbestos particles- required funds, who will determine whether, to what extentusually 10 or more years-you can develop a chronic lung and in what manner they shall be made public. In the event it isinflammation called asbestosis, which makes breathing diffi- deemed desirable that the results be made public, the manu-cult and infection easy. Also linked to asbestos exposure is script of your srudy will be submitted to us for approval priormesetheJioma, a cancer of the chest lining. This disease some- to publication.times doesnt develop until 40 years after the first exposure. Industry officials were concerned with more than control-Although the first major scientific conference on the dangers ling information flow. They also sought to deny workers earlyof asbestos was not held until 1964, the asbestos industry knew evidence of their asbestosis. Dr. Kenneth Smith, medicalof the dangers of asbestos 60 years ago. director of a Johns-Manville plant in Canada, explained why As early as 1932, the British documented the occupational seven workers he found to have asbestosis should not behazards of asbestos dust inhalation." Indeed, on September 25, informed of their disease:1935, the editors of the trade journal Asbestos wrote to SumnerSimpson, president of Raybestos-Manhattan, a leading It must be remembered that although these men have the X-ray evidence of asbestosis, they are working today and defi-asbestos company, asking permission to publish an article on nitely are not disabled from asbestosis. They have not beenthe dangers of asbestos. Simpson refused and later praised the told of this diagnosis, for it is felt that as long as the man feelsmagazine for not printing the article. In a letter to Vandivar well, is happy at home and at work, and his physical conditionBrown, secretary of Johns-Manville, another asbestos manu- remains good, nothing should be said. When he becomes dis-facrurer, Simpson observed: "The less said about asbestos the abled and sick, then the diagnosis should be made and thebetter off we are." Brown agreed, adding that any article on claim submitted by the Company. The fibrosis of this disease isasbestosis should reflect American, not English, data. irreversible and permanent so that evenrually compensation In fact, American data were available, and Brown, as one of will be paid to each of these men. But as long as the man is notthe editors of the journal, knew it. Working on behalf of disabled, it is felt that he should not be told of his condition soRaybestos-Manhattan and Johns-Manville and their insurance that he can live and work in peace and the Company can bene- fit by his many years of experience. Should the man be told ofcarrier, Metropolitan Life Insurance Company, Anthony Lanza his condition today there is a very definite possibility that hehad conducted research between 1929 and 1931 on 126 workers would become mentally and physically ill, simply through thewith 3 or more years of asbestos exposure. But Brown and oth- knowledge that he has asbestosis.ers were not pleased with the paper Lanza submitted to themfor editorial review. Lanza, said Brown, had failed to portray Vhen lawsuits filed by asbestos workers who had devel-asbestosis as milder than silicosis, a lung disease caused by long- oped cancer reached the industIy in the 1950s, Dr. Smith sug-term inhalation of silica dust and resulting in chronic shortness gested that the industry retain the Industrial Health Foundationof breath. Under the then-pending Workmens Compensation to conduct a cancer srudy that would, in effect, squelch theJaw, silicosis was categorized as a compensable disease. If asbestos-cancer connection. The asbestos companies refused,asbestosis was worse than silicosis or indistinguishable from it, claiming that such a srudy would only bring further unfavorablethen it too would have to be covered. Apparently Brown didnt publicity to the industry, and that there wasnt enough evidencewant this and thus requested that Lanza depict asbestosis as less linking asbestos and cancer industry-wide to warrant it.serious than silicosis. Lanza complied and also omitted from his Shortly before his death in 1977, Dr. Smith was askedpublished report the fact that more than half the workers exam- whether he had ever recommended to Johns-Manville officialsined--D7 of 126--were suffering from asbestosis. that warning labels be placed on insulation products contain- Meanwhile, SUl1U1er Simpson was writing F H. Schulter, ing asbestos. He provided the following testimony:president ofThermoid Rubber Company, to suggest that sev- The reasons why the caution labels were not implementederal manufacrurers sponsor further asbestos experiments. The immediately, it was a business decision as far as I could under-sponsors, said Simpson, could exercise oversight prerogatives; stand. Here was a recommendation, the corporation is in busi-they "could determine from time to time after the findings are ness to make, to provide jobs for people and make money formade whether they wish any publication or not." Added stockholders and they had to take into consideration the effectsSimpson: "It would be a good idea to distribute the informa- of evelything they did, and if the application of a caution label identifying a product as hazardous would cut out sales, theretion to the medical fraternity, providing it is of the right type would be serious financial implications. And the powers that beand would not injure our companies." Lest there should be had to make some effort to judge the necessity of the label vs. the consequences of placing the label on the product.See Samuel S. Epstein, "The Asbestos Pentagon Papers: .. in Mark Greenand Roben Massie, Jr., eds., Tbe Big Business Read.,,: Essays 011 Co,porate Dr. Smiths testimony and related documents have figuredAmerica (New York: Pilgrim Press, 1980), 15+-<>5. This article is the primary prominently in hundreds of asbestos-related lawsuits, totalingsource of the facts and quotations reported here. more than $1 billion. In March 1981, a settlement was reached
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CHAPTER 2 Understanding Financial Statements, Taxes, and Cash FlowsThe year was 1985 when Howard Schultz joined a small firm tion. From that meager beginning, the rest is history. By Octoberlocated in Seattles historic Pike Place Market. The business 2003, the firm had 7,225 stores in 25 countries. Schultz hassold coffee to high-end restaurants and espresso bars. since become Chairman of the Board and Chief Global Strate The company was virtually unknown to the public at that gist. Sales for 2003 were expected to exceed $4 billion.time, but not any more. We all recognize the name today In those early days, Schultz no doubt considered a lot ofStarbucks Coffee. You might be interested to know that the different factors in evaluating the Starbucks opportunity.name came from Herman Melvilles Moby Dick, a classic Amer ·After all, he was about to change the way most of us thinkican novel about the 19th century whaling industry. about coffee and what we are willing to pay for it. Not know As director of retail operations and marketing, Schultz was ing for certain, we can surmise that he thought a great dealtraveling on a business trip to Italy, where he was impressed about such issues as the size and growth potential of the marwith the popularity of espresso bars in Milan. He immediately ket, competition, and the management team.saw the potential for developing a similar coffee bar culture in Schultz would have also considered the economics of theSeattle. deal, such as projected sales, profits, the amount of capital Schultz returned home to convince the founders of Star required, and the potential returns to his investors. Such anbucks to test the coffee bar concept in downtown Seattle. The analysis would have required him to have a good understandexperiment quickly proved to be successful, leading Schultz to ing of income statements, balance sheets, and cash flows-thefound a new business, II Giornale. The business offered brewed very topic of this chapter. And now that Starbucks is a largecoffee and espresso beverages made from Starbucks coffee public corporation, investment analysts, along with managebeans. ment, meticulously study the firm financial statements. So With the backing of local investors, II Giornale acquirea lets begin our own study of financial statements, which willStarbucks assets and changed its name to Starbucks Corpora be continued in Chapter 3. ~ CHAPTER PREVIEW ~ In this chapter, we view the world of finance primar flows. No skill is more important in our study of ily as an accountant sees it. To begin, we review the finance than being able to calculate a firms or a proj two basic financial statements that are used to under ects cash flows. Cash flow is a very significant issue stand how a finn is doing financially-the income for a company and is critical in our understanding of statement, or what is sometimes called the profit and financial management. It will be discussed over and Joss statement, and the balance sheet. We also spend over in the chapters to follow. Thus, it is essential a significant amount of time coming to understand t.hat we begin early to develop a good understanding how to measure and interpret a companys cash of cash flows. 31
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32 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT BACK TO THE PRINCIPL Two principles are especially important in this chapter: Principle 3 tells us that Cash-Not Profits-Is King. In many respects, cash is more important than profits. Thus, in this chapter, considerable time is devoted to learning how to measure cash flows. Second, Principle 7 warns us there may be conflict between management andowners, especially in large firms where man agers and owners have different incentives. That is, Managers Wont Work for the Owners Unless Its In Their Best Interest to 00 So. Although the management is an agent of the own ers, experience suggests that managers do not always act in the best interest of the owners. The incentives for the managers are, at times, different from those of owners. Thus, the firms com mon stockholders, as well as other providers of capital (such as bankers), have a need for infor mation that can be used to monitor the managers actions. Because the owners of large compa nies do not have access to internal information about the firms operations, they must rely on public information from any and all sources. One of the main sources of such information is the companys financial statements that are provided by the firms accountants. Although this infor mation is by no means perfect, it is an important source used by outsiders to assess a companys activities. In this chapter, we learn how to use data from the firms public financial statements to monitor managements actions. Lets begin our study by looking at the basic financial statements that are a primary source of information about a firms financial performance. Only by understanding the makeup of these statements can we have any hope of learning about business, much less finance. Objective -.!J THE INCOME STATEMENT: MEASURING A COMPANYS PROFITSIncome statement An income statement, or profit and loss statement, measures the amount of profits generThe statement of profit or loss ated by a firm over a given time period. In its most basic form, an income statement canfor the period, comprised of be expressed as follows:revenues less expenses for theperiod. sales - expenses = profits -,j" The income statement answers the question, "How profitable is the business?" In provid ing this answer, the income statement reports financial information related to five broad ,r areas of business activity: 1. Revenue (sales)-money derived from selling the companys product or service 2. Cost of goods sold-the cost of producing or acquiring the goods or services to be sold ~I ,; 3. Operating expenses-exP.<rJ;?ses related to (a) marketing and distributing the product or service, and (b) administ~ring the business - 4. Financing costs of doing business-the interest paid to the firms creditors and the dividends paid to preferred stockholders (but not dividends paid to common stock7 holders) 5. Tax expenses-the amount of taxes owed based on a firms taxable income All of these "income statement activities" are illustrated in Table 2-1, where we pre sent the annual income statement for Harley-Davidson, Inc. Looking at the firms income statement, we see that for 2002:
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 33 _! -:-·C 0 - , ~Q.;" (, , o .-.. mJ!DI "0 Harley-Davidson, Inc. Annual Income Statement for the Year Ending .:1. ; 6:. t" 1, December 31, 2002 2002(, Sales,~ re.,<1 "?_ ) $4,195,197 .fle VI(, .]; i (" Salvs, Gyo: (:f " 1. . Cost of goods sold 2,673,129 -,,0 C( .--" Gross profit 1,522,068 . : , .tj C ~ b .::-{I Vv , Q I (j,,~ ~ Selling, general, and administration expenses 465,831 , Dep;pc:iati~ii; 160,119 T6tafoperatlrl9 expenses $ 625,950 -I .-, Operating profit ~B:I:r $ 896,118 .,.,_._ Interest expense 17,849 :.0, ~ Earnings before taxes 878,269 Provision for income taxes 298,052 I I) Net Income 580,217 .,~ It 0. I"; ~h (Net llitOvrS 8 . I < (011)( {; S 1. Sales or revenues-determined by the amount of product sold times the price per unit-were almost $4.2 billion for the year. 2. The firms cost of producing or acquiring its product was $2.67 billion. 3. Harley-Davidson spent $466 million in selling and administration eJl.penses, and had approximately $160.1 million in depreciation expense. G:CSr 7 4. Given these results, the firm had operating income, or eantings before interest Operating income and taxes (EBIT), of $896 million. (eamings before interest 5. The firm owed $17.8 million in interest expense, which is determined by the and ta.xes) Profit from sales minus total amount of Earley-Davidson debt and the interest rate paid on the debt. operating expenses. 6. Harley-Davidson owed $298 million in income tax expense, which was approximately Interest expense - 34 percent of the companys eantings before taxes. Interest paid on a firms 7. Finally, the net income available to Harley-Davidsons owners was equal to outstanding-debt. A finns $580 million. This income may be distributed to the companys owners or reinvested . expense IS tax • !pterest . in the company provided, of course, there is cash available to do so. deductible. What conclusion can we draw from Harley-Davidsons income statement? Well, for one Earnings before taxes thing, we learn that for every $1 in sales, Harley-Davidson earned about $.36 in gross Operating income minus interest expense. profits ($1,522,068 gross profits + $4,195,197 sales), $.21 in operating profits ($896,118 + $4,195,197 sales), and $.138 in net income ($580,217 + $4,195,197). et income To determine if these results are good, we must estimate if these profit-to-sales A figure representing the firms profit or loss for the period.1.t ratios are high enough that shareholder value is being created. We might also gain some also represents the earninmi insight if we could see how Harley-Davidsons performance compares against that of its available to the firms common competition-more about this in Chapter 3. For the time being, simply remember that ~ockholders. the profit-to-sales relationships are important in assessing a firms performance. Three additional issues are important in understanding the information contained in an income statement: 1. Operating income (earnings before interest and taxes) is not affected by how the firm is financed, whether with debt or equiry-..9peratin.g income is the firms profits from all of its assets, regardless of whether the assets are financed from debt or stock. UndefSranding this fact is essential when we later wam t~ evaluate managements performance at creating profits from the firms assets. Just remember that operating income is affected only by managements investment decisions, and not by how the firm is financed.
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34 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT ( 2. Notice that interest expense is subtracted from income before computing the firms , ,... (:. r , t tax liability, which is not true for dividends paid. In other words, interest is a tax deductible expense; that is, for every dollar a company spends on interest, its tax expense is reduced proportionately. For example, if a firms tax rate is 30 percent, $1 paid in interest reduces taxes by $.30, which means that the after-tax cost of a dollar of debt is only $0.70 ($1.00 - $0.30). 3. As we shall see later, the fact that a firm has a positive net income does not necessar ily mean it has any cash-possibly a surprising result to us, but one that we will come to understand. --. CONCEPT CHECK I 1. What does the income statement tell us? Why must we be careful when I I interpreting the income statement? " ,I 2. What is the basic relationship that we see in the income statement? II 3. How is operating income different from net income as both relate to I II the five "business activities" reported in the income statement? --- Objective 1J THE BALANCE SHEET: MEASURING A FIRMS BOOK VALUE Whereas the income statement reports the results from operating the business for aBalance sheet period of time, such as a year, the balance sheet provides a snapshot of the firms A statement of financial financial position at a specific point in time, presenting its asset holdings, liabilities, position at a particular date. and owner-supplied capital. In its simplest form, a balance sheet follows this formula: The form of the statement follows the balance sheet total assets = outstanding debt + shareholders equity equation: total~s = total.fu.bilities + owners~. Assets represent the resources owned by the firm, whereas the liabilities (debt) and share holders equity indicate how those resources are financed. Figure 2-1 presents the basic components of a balance sheet. On the left side of Figure 2-1, the firms assets are listed according to their type; on the right side, we see a listing of the different sources of financing a company could use to finance its assets. TYPES OF ASSETS As shown in Figure 2-1, a companys assets fall into three categories: (1) current assets, (2) fixed assets, and (3) other assets. Assets on a balance sheet are listed in the order of the length of time necessary to convert them into cash in the ordinary course of busi ness. Current assets, excluding cash itself, are expected to be converted into cash withinCurrent assets (gTOSS 12 months, with accounts receivable not taking as long to convert to cash as inventories.working capital) Fixed assets, such as equipment, are used over a number of years, and as such will not beCurrent assets are assets that converted into cash within the normal operating cycle of business.are expected to be convertedinto cash within a year, CUR RE NT ASS ET S Current assets, or gross working capital, as it is sometimesconsisting primarily of cash,marketable securities, accounts called, comprise those assets that are relatively liquid; that is, those that are expected to bereceivable, inventories, and converted into cash within a year. Current assets primarily include cash, marketable secuprepaid expenses. rities, accounts receivable, inventories, and prepaid expenses.
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 35 I ,. ille. l€ (JQ~fiGURE 2-1 The Balance Sheet: An Overview ( 10 LJ t tJ/1 ASSETS t O~qQY- ~J th~ Ie09 th or t lnJe to COllhQ,,: I j1 CCl.S~ (Of vepqfd ) Current assets: _ ~ (Q So; i .-n " (G. (IY) lH ths ./ Current liabilities (debt): • Cash • Accounts payable • Nlarketable securities • Other payables ·~Account:s receivable • Accrued expenses • Inventories •,Short-term notes • Prepaid expenses Total current debt Total current assets Fixed assets: Long-tenn liabilities (debt): • Machinery and equipment • Long-term notes • Buildings ·~es • Land Total long-term debt Total fixed assets Other assets: Equity: • Inyestments • Preferred stock .~ • Common stock Par value Total other assets + Paid-in capital - Treasury stock • Retained earnings Total stockholders equity TOTAL ASSETS TOTAL DEBT AND EQUITY~ Cash. Every firm must have cash for current business operations. A reservoir of cash is needed because of the unequal flow of funds into (cash receipts) and out of (cash expenditures) the business. The amount of the cash balance is determined not only by the volume of sales, but also by the predictability of cash receipts and cash payments. Accounts receivable~ Accounts receivable. The firms accounts receivable consists of payments due A promise to receive cash from customers who purchased from its customers who buy on credit. goods from the firm on credit.~ Inventories. Inventory consists of the raw materials, work-in-progress, and the final .Inventory products held by a firm for eventual sale. Raw materials, work-in-progress,~ Prepaid expenses. A company often needs to prepay some of its expenses. For exam and finished goods held by the ple, insurance premiums may be due before coverage begins, or rent may have to be firm for eventual sale.
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36 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT A FOCUS ON HARLEY-DAVIDSON ~ ,~. .I ... ~ .. ~ l~ ,1 .:",-. . THE PATH TO CFO AT HARLEY-DAVIDSON: AN INTERVIEW WITH JIM ZIEMER For as long as I can remember, I wanted to work at Harley helped me become familiar with all the operations within Davidson. Growing up just three blocks from the plant, I the plant. It was interesting to watch the gears being cut and used to watch the test riders who sometimes ate lunch in my the crankcases being machined, and in the process learning neighbors yard and think "Wouldnt it be great to be paid to all about the inside components of an engine. ride a motorcycle?" Then I got a job in the engineering department. With a I rode my first motorcycle, an M-50 Harley, when I was limited background in engineering and an interest in 15 years old. When I was 19, my wish came tme; I went to accounting, I was put in charge of project management. work for the firm as a union employee, operating the eleva After graduating, I had a number of jobs, ending up in finan tor used to move pans from floor to floor. Theyd punch the cial planning, which allowed me to see what happened in the sheet metal on the first floor for the tanks and fenders and firm as a whole. From there, I worked as the controller in Id take it up to the sixth floor where they painted it. I would parts and accessories, which meant getting involved in sales take tube steel up to the 5th floor where it was bent and and marketing and shipping and receiving. welded into frames. Then the bike flowed downward to the In 1981, management bought the company from AMF (a first floor for the final assembly. It was really great watching conglomerate) through a management buyout, which meant all the components of manufacturing come together into a the firm took on a lot of debt. Shortly thereafter, interest beautiful motorcycle. rates climbed to 20 percent; it was not a pretty sight. The In the meantime, I entered the University of Wisconsin, firm went through a major downsizing that led to laying off Milwaukee, to study accounting. Actually, this was a bit of a about 40 percent of our employees. As a consequence, fluke. When I started college I had no idea of what I wanted everybody ended up doing several jobs, and I became direc to be. I started in the school of engineering, but soon trans tor of all the firms accounting. ferred to the school of science, with an interest in physics, In 1986, we decided to take the company public through and eventually ended up in chemistry. However, my work the initial public offering, which would allow us to get rid of and studies were abmptly interrupted when I received a let a lot of debt. This was happening when I was working on my ter from Uncle Sam requesting my services in the army. MBA, which was a great situation for my masters studies. While in the army, I took some accounting and economics Finally, in February 1987, I became the vice president and courses, and when I got out, I thought, "The quickest way to controller at Harley-Davidson. I remember feeling very for graduate is to major in accounting." So I returned to tunate; I was 37 years old and the controller of what I Harley-Davidson to work part-time and finish myaccount thought was a great company. We had a lot of things to ing degree. In my new job, I worked as a timekeeper, which prove yet, but we were on our way.Prepaid expenses paid in advance. Thus, prepaid expenses are those cash payments recorded on theExpenses that have been paid balance sheet as current assets and then shown as an expense in the income statementin advance. These assets are as they are used.recorded on the balance sheetand e~:pensed oli the ~statement as they are used. FIXED ASSETS Fixed assets include machinery and equipment, buildings, and land.Fixed assets Some businesses are more capital-intensive than others; for example, a manufacturerAssets comprising equipment, would typically be more capital-intensive than a wholesale operation and, therefore, havebuildings, and land. more fixed assets.Other assetsAssets not included in current oTHE R ASS ETS Other assets are all assets that are not current assets or fixed assets,assets or fixed assets. including, for example, intangible assets such as patents, copyrights, and goodwill.Acconnting book value In reporting the dollar amounts of the various types of assets just described, theThe value of an asset as shown conventional practice is to report the value of the assets and liabilities on a historicalon a !inns balance sheet. It cost basis. Thus, the balance sheet is not intended to represent the current marketrepresents the historical cost of~ rathe;-than its curr~ value of the company, but rather reports the historical transactions recorded at theirmarket value or replacement cost, or what we call a firms accounting book value. Determining a fair value of thecost. business is a different matter.
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 37TYPES OF FINANCING DebtWe now turn to the right side of the balance sheet in Figure 2-1, labeled "Liabilities Consists of such sources ~s (Debt) and Equity," which indicates how the firm finances its assets. Financing comes credit extended by suppliers orfrom two main sources: debt (liabilities) and equity. Debt is money that has been bor a loan from a bank.rowed and must be repaid at some predetermined date. Equity, however, represents the EquityShareholders investment in the company. See the Finance Matters box, "Financial Stockholders investr,,,,.lt in theStatements: Fact or Fiction." firm and the cumulative profits retained in the business up toDEB TeA PITAL Debt capital is financing provided by a creditor. As shown in Figure the date of the balance sheet.2-1, it is divided into (1) current, or short-tenn, debt and (2) long-term debt. Current Debt capitaldebt, or short-tenn liabilities, includes borrowed money that must be repaid within the Funds provided to dle firm by a creditor.next 12 months. Sources of current debt include the following: CUlTent debt~ Accounts payable represents credit extended by suppliers to a firm when it purchases Debt due to be paid within inventories. The purchasing firm may have 30 or 60 days before paying for L.1ventory 1 year. that has been purchased. This fonn of credit extension is also called trade credit. Accounts payable (f (ark ,: .~b. .~ Other payables include interest payable and income taxes payable that are owed and Liability of the firm for goods purchased from suppliers on will come due within the year. credit.>- Accmed expenses are short-term liabilities that pave been incurred in the firms Other payables operations, but not yet paid. For example, emplo~€ltsPkrfonn work that may not be Interest payable and income paid for until the following week or month, which are recorded as accrued wages. taxes payable that are to be~ Short-term notes represent amounts borrowed from a bank or other lending source paid within 1 year. that are due and payable within 12 months. Accrued expenses S;:"J.:; . + Expenses that havebeenLON G- TERM DEB T Long-term debt includes loans from banks or other sources that incurred but not yet paid inlend money for longer than 12 months. For example, a firm might borrow money for cash.5 years to buy equipment, or for as long as 25 to 30 years to purchase real estate, such as Short-term notesa warehouse or an office building. Amounts borrowed from a creditor that are due withinEQUITY Equity includes the shareholders investment-both preferred stockholders 1 year. --and common stockholders-in L~e firm. Long-term debt OC"(, Loans from banks or other~ Preferred stockholders receive a dividend that is fixed in amount. In the event of sources that lend money for liquidation of the firm, these stockholders are paid after the firms creditors, but longer than 12 months. before the common stockholders. PrefelTed stockholders~ Conunon stockholders are the residual owners of a business. They receive whatever Investors who own the firms is left over-good or bad-after the creditors and preferred stockholders are paid. preferred stock. The amount of a firms common equity as reported in the balance sheet is equal to Common stockholders Investors who own the firms (1) the net amount the company received from selling stock to investors less stock the common stock. Common firm has repurchased from shareholders plus (2) the firms retained earnings. The stockholders are the residual amount the firm receives from selling stock is recorded in the common equity section owners of the firm. in the accounts of par value and paid-in capital. These amounts may be offset by any Par value and pajd-in stock that has been repurchased by the company, which is typically shown as treasury capital stock. Retained earnings is the cumulative total of alJ. t.~e net income over the firms The amount the firm receivc~ life Jess the common stock dividends that have been paid over the years. Thus, t.~e from selling stock to investors. common equity capital consists of the following: Treasurv stock The firm stock that has been common equity = common stock issued (less treasury stock repurchased) issued and reacquired by the + cumulative net income over the firms life firm. - total dividends paid over the firms life Retained earnings The cumulativ~ earnings thatwhich is shown in the balance sheet as: have been retained and reinvested in the firm over its common equity = common stock (par value + paid-in capital- treasury stock) life (cumulative earnings + retained earnings cumulative dividends).
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 39 Ill!J!JEJEI Harley-Davidson Inc. Annual Balance Sheet ($000) 12131101 12131102 ASSETS CHANGE Cash $ 535,449 $ 795,728 $160,279 Accounts receivable 775,264 964,465 189,201 Inventories 181,115 218,156 37,041 Other current assets 73,436 88,237 14,801 Total current assets $1,665,264 $2,066,586 $401,322. Gross p1an1-2LQperty. ELe.quipJIle!l..!.... $1,705.361 $2,006.256 f$300~895 Accumulated depreciation (813,541) (973,660) Net plant, property, and equipment $ 891,820 $1,032,596 "...,. Other .~~e.ts __. 561,411 762,035 200,62 Total assets $3,118,495 $3,861,217 $742,722 LIABILITIES AND EQUITY LIABILITIES Accounts payable $ 217,051 $ 382,579 $165,528 Accrued expenses 194,683 226,977 32,294 Income taxes payable 65,875 67,886 2,011 Short-term notes 141,191 189,024 47,833 Other interest bearing current liabilities 97.310 123,586 26,276 Total current liabilities $ 716,110 $ 990,052 $273.942 Long-term debt 646,102 638,250 (7,852) Total liabilities $1,362,212 $1,628,302 $266,090 COMMON EQUITY Common stock (par value) $ 3,242 $ 3,254 $ 12 Paid in capital 359,165 386,284 27,119 Retained earnings 1,819,422 2,325,737 506,315 Less treasury stock (425,546) (482,360) (56,814) Total common equity $1,756,283 $2,232,915 $476,632 Total liabilities and equity $ 3,118,495 $3,861,217 $742,722 HARLEY DAVIDSON INC. RECONCILIATION OF RETAINED EARNINGS Retained earnings, December 31,2001 $1,819,422 2002 net income 580,217 Dividends paid 73,902 Retained earnings, December 31,2002 $2,325,737 on December 31, 2001), what happened during the year (income statement for 2002), and the final outcome at the end of the year (balance sheet on December 31, 2002). The firms investment in assets increased $742.7 million over the year, with most of the growth in cash, accounts receivables, and other assets. The increase in the firms assets in turn required additional financing. Looking at the debt and equity parts of the balance sheet, we see that management used two primary sources of money to finance the growth: 1. A $506.3 million increase in retained earnings, which is the result of retaining a por tion of the firms net income, rather than paying it out in dividends. 2. Borrowing $273.9 million in addition~l short-term debt (c1Jfrent liabilities). .Ye also observe in the common equity section that the firms net common stock - was redu_ced ~y $29.7 millio_n, Th.is is due to the increases in common par value
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40 PART 1 THE SCOPE .AND ENVIRONMENT OF FINANCIAL MANAGEMENT Harley-Davidson Balance Sheet as of December 31, 2002 $4 million Total Assets Debt and Equity ~- 1 $3 million + I I ~(,y~.t (JS<;Q.-S : ,l~,(" I "Long-Term Debt : Net working capit:l . $638,250 I $1,076,534 I J I I $2 million I ..j, Net plant and equipment $1,032,596 Equity $1 million $2,232,915 Other assets $762,035 / ($12 thousandLangpaid-in capital ($27.1 million) less the increasein treasu stock of $56.8"miIIlon (-$29.7 million = $12 thousand +$27.1 million - $56.8 million). - - Note that when we are examining the changes in the balance sheet from One year to the next, as we just did with Harley-Davidson, Inc., we are gaining an understanding of where money came from and how it was used. For Harley-Davidson, we see that the firm invested in additional assets ($742.7 milliOn increase in assets). Where did the money come from? The largest amount came from retaining a part of the firms profits ($506.3 million). The remainder came from additional short-term borrowing ($273.9 million). Knowing this information is helpful in better understanding Harley-Davidsons finances. In fact, it is such an important matter that we will return to this issue later in the chapter. To help us visualize Harley-Davidsons financial position, as reflected by its balance sheet, we have graphed the major types of assets and debt and equity in Figure 2-2, as of December 31,2002. In looking at this graph, we see that for every dollar of assets, there - I i r~.~·- must be a dollar of financing. There co...."l be no exception. If we grow the firms assets, we, I had best be prepared to find additional financing. Harley-Davidson has $3,861.2 million Net working capital in total assets, which represents all of the investments made by creditors and stockholders The difference between the in the firm. Two other terms related to the balance sheet need mentioning: net working firms current assets and its capital and debt/equity mix. current liabilities. When the term working capital is used, it is frequently intended to mean NET WORKING CAPITAL Earlier we said that the term current assets is also called gross working net working capital. capital. We can now define net working capital as current assets less current liabilities (cur
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 41 rent assets - current liabilities). Thus, net working capital compares the amount of current 1-- ./. Q - ,-. d~t.ll<>I~"~ ,~,.;. assets (assets that should convert into cash within the next 12 months) to the current liabil :--tC(OJ~;;- ~::.jvC("::J ities (debt that will be due within 12 months). As shown in Figure 2-2, Harley-Davidsons net working capital is $1,076.5 million ($2,066.6 million current assets - $990.1 million J.r II IV.JY ~~~ current liabilities). A ~rn~~ net worki_~lg(;~pital is of particular ~Po~cuoJenders .:v~o. _ _ want to !mow if a company ha~adequate liquiditY-Liquidity is the speed and ease at which Liquidity an asset can be converted into cash. The more current assets that a finn has relative to its The abIlitY of a firm to pay its current liabilities, the greater the finns liquidity. If you loan a company some money, you bills on time, and how quickly a firm converts its liquid assets would want to !mow that it has adequate liquidity to be able to repay the loan. (accounts receivables and inventories) into cash. DEBT/EQUITY MIX We can also see that by the end of 2002, Harley-Davidson was I I _ 0/ I? _ I !; "I 129, financing its assets about 42 percent from debt ($1.63 billion debt -;- $3.86 billion total c::::-(? pt /0 <.t1J/11· assets) and 58 percent from equity ($2.23 billion common equity -;- $3.86 billion total /+~.f A assets). The debt-equity relationship is an important one to lenders and investors, as we will see on numerous occasions in our studies. /: ~i........ , .e 1./..... , _ We next want to look briefly at one of the largest expenses a company encounters .... 1 /Alh ;-"l taxes. t2If,·-ii --;r- -- f("Y CONCEPT CHECK 1. Regarding the time frame reported, how is the balance sheet different from the income statement? 2. State the basic balance sheet formula and its meaning. 3. What is the definition of a firms "accounting book value"? 4. What are the two principal sources of financing? What do these sources consist of? - -- COMPUTING A COMPANYS TAXES Objective ~ Taxes are a critical factor in making many financial decisions. The tax rules can be extremely complex, requiring a lot of specialized expertise to understand them. However,"*, )1.e. for our purposes, we just need to understand how taxes are computed. r I D ~~ Ii! t ~ , . . , --_ To begin, we should ask, "Who is a taxpayer?" For the most part, there are three basic :;W~ ).,)""..1 !";>J( types of taxable business entities: sole proprietors, partnerships, and corporations. Sole pro-, . prietors report their income in their personal tax returns and pay the taxes owed.<ti(o..""- I"-!,.. ~. Partnerships report income from the partnership but do not pay taxes. Each partner reports _ _ his or her portion of the income and pays the corresponding taxes. The corporation, as a sep- .( v, [J ,; arate legal entity, reports its income and pays any taxes related to these profits. The owners (stockholders) of the corporation do not repo~ these. earnings in the~. personal tax returns,;>, 1 , :.. ~ 7., ., (~ / except when all or a part of the profits are dismbuted In the forn1 of diVIdends. Because most -J-. C t! < (: I ",.I firms of any size are corporations, we will resnict our discussion to corporate taxes. , " c~G;J ~- ) ~~r)~,:, (0Ir)~ -(-1" 0X-(jOJ,v (tloJ Ij COMPUTING TAXABLE INCOME - - . R . X Pvu,. The taxable income for a corporation is based on the gross income from all sources less I any tax-deductible expenses. Gross income equals the firms dollar sales from its product G 1 y f0 :..~ J Cili. YJ( less the cost of producing ~Dacquiring the produrJ) Tax-deductible expenses in<;l~u,de any operating expenses, s)lch as marketing expenses, ~aministrative expenses, and a--eprecia- S . . t./ tion expense. Also, int~rest expense paid on the firms outstanding debt is a tax-deductible . expense. However, dividends paid to the firms stockholders are not deductible expenses,
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CHAPTER:2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 43mDDI JaS Corporation Taxable IncomeSales $50,000,000Cost of goods sold / i J { ~ VI).Q ) (23,000,000)Gross profit I, , ,-Y(i..~)j- ~ • $27,000,000 ---?> Go:.> (V) ~"--..-Operating expenses"-- de J.v Administrative expenses Cf0) ~ r:- $4,000,000 ":.f Depreciation expenses ) , 1,500,000 r ) ~ Marketing expenses ~ 4,500,000Total operating expenses (10,000,000)Operating income (;a!"nings before interest and taxes) $17,000,000Interest expense .L:L.--_ _ _ __ (1,000,000)Taxable income $16,000,000Note: Dividends paid to common stockholders ($1,000,000) are not tax-deductible, fA ,,,,LIll1l!DI Corporate Tax Rates ( -/ 1 I U ,; ( F:}jJe -; Iii C y-t (:iv, -Lr~ 2. f:r~ ll~:RATES INCOME lEVELS15% $0-$50,000 ---- " I(~).) 25% $50,001-$75,000,,---) {., ->.J34% $75,001-$100,000 - . - ,- -"7>39% $100,gOl::.$335,OOO. -= -- Q ;-. -;D~ 335,001-$10,000,000 Ii - - - 35% $10,000,001-$15,000,00038% $15,000,001-$18,333,33335% Over $18,333,333finns conunon stockholders. The taxable income for theJ&S Corporation would be $16million, as shown in Table 2-3.COMPUTING THE TAXES OWED The taxes to be paid by a corporation on its taxable income are based on the corporate tax rate structure. The specific rates effective forthe corporation, as of 2002, are given in Table 2-4. If you wonder about the economicrationale for the rates, dont waste your time. There is none. Politicians, not economists,determine the rates. Based on the tax rates, J&S Corporations tax liability would be $5,530,000, as computed in Table 2-5. The tax rates in Table 2-4 are defined as the marginal tax rates, or rates applicable to Marginal tax ratethe next dollar of taxable income. For instance, if a firm has taxable income of $60,000 The tax rate that would beand is contemplating an investment that would yield $10,000 in additional taxable applied to the ~dollar of taxable income.income, the tax rate to be used in calculating the taxes on this added income is the 25 percent marginal tax rate. However, if the corporation already expects $20 million withoutthe new investment, the extra $10,000 in taxable income would be taxed at 35 percent,the marginal tax rate at the $20 million level of income. For theJ&S Corporation, with a taxable income of$16 million, its marginal tax rateis 38 percent; that is, any additional income from new investments will be taxed at a rateof 38 percent-at least until taxable income exceeds $18,333,333. Then the marginal taxrate would decline to 35 percent. Note, however, that while J&S Corporation has a38 percent marginal tax rate, its average tax rate-taxes owed relative to the firms tax Average tax rateable income-is 34.6 percent ($5,:;30,000 -;- $16,000,000). Taxes owed by the firm divided For financial decision making, it is the marginal tax rate, rather than the average tax by the firms taxable income.rate, that matters because it is the marginal rate that is applied to any additional earningsresulting from a decision. Thus, when making financial decisions involving taxes, always
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44 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT IZtJ!lED Tax Calculations for JEtS Corporation EARNINGS x MARGINAL TAX RATE TAXES $50,000 x 15% $ 7,500 $75,000-$50,000 x 25% 6,250 $100,000-$75,000 x 34% 8,500 $335,000-$100,000 x 39% 91,650 $10,000,000-$335,000 x 34% 3,286,100 $15,000,000-$10,000,000 x 35% 1,750,000 $16,000,000-$15,000,000 x 38% 380,000 Total tax liability $5,530,000 use the marginal tax rate in your calculations and not the average tax rate. We cannot overemphasize the importance of remembering the preceding statement, which is a spe cific application of Principle 4-Its Only What Changes That Counts. We should always analyze decisions at the margin. The tax rate structure used in computing the J&S Corporations taxes assumes that the income occurs in the United States. Given the globalization of the economy, it may well be that some of the income originates in a foreign country. If so, the tax rates, and the method of taxing the firm, frequently vary. International tax rates can vary substantially and the job of the financial manager is to minimize the firms taxes by reporting as much income as legaily allowed in the low tax-rate countries and as little as legally allowed in the high tax-rate countries. Of course, other factors, such as political risk, may discourage efforts to minimize taxes across national borders. CONCEPT CHECK 1. Distinguish among sole proprietors, partnerships, and corporations in terms of how th.ey are taxed. 2. What is the difference between marginal tax rates and average tax rates? 3. Why do we use marginal tax rates, rather than average tax rates, when making financial decisions? 4. What should be the firms goal when it comes to international taxes? Objective ~ MEASURING FREE CASH FLOWS While an income statement measures a companys profits, profits are not the same as cash flows; profits are cl.lculated on an accrual basis rather than a cash basis. Accrual-basis accounting records income when it is earned, whether or not the income has been ({Aile. cvl.e 11 ~f received in cash, and records expenses when they are incurred, even if money has not (C ). ~ H-L~ 1" "I actually been paid out. For example, sales reported in the income statement include both cash sales and credit sales. Therefore, sales for a given year do not correspond exactly to the actual cash collected from sales. Similarly, a finn must purchase inventory, but some I_ u:! 0 of the purchases are financed by credit rather than by immediate cash payment. Also, under the accrual system, the purchase of equipment that will last for more than 1 year is ~JS not shown as an expense in the income statement. Instead, the amount is recorded asan , , (1 asset and then depreciated over its useful life. An annual depreciation expense (this is not C ~ a cash flow) is recorded as a way to match the use of the asset with sales generated from its service. We could give more examples to show why profits differ from cash flows, but the point should be clear: Profits and cash flows are not the same thing. Failure to understand and recognize this important fact could cause some real problems.
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 45 In measuring cash flows, we could use the conventional accountants presentation called a statement ofcash flows. However, we are more interested in considering cash flows from the perspective of the firms investors, rather than from an accounting view. So, what follows is similar to a conventional cash flow statement presented as part of a com panys financial statements, but "not exactly." (For a presentation of an accountants state ment of cash flows, see Appendix 2-A.) We can think of a firm as a block of assets that produce cash flow, which can be either positive or negative. Once the firm has paid all its operating expenses and made all its investments, the remaining cash flows are free to distribute to the firms creditors and shareholders-thus, the term free cash flows. However, if the free cash flows are nega Free cash flows tive, the~reditorS)andl1nvestors)are the ones who make up the shortfall-someone has to Amount of cash available from do it. Thus, the cash flows that are generated through a firms assets equal its cash flows operations after paying for investments in net operating paid to-or received from-the companys investors (both creditors and stockholders). working capital and fixed They have to be equal; except that if one is positive (negative) the other will be negative assets. This cash is available to (positive). That is, G r- distribute to the firms creditors el(;( I • 1"(-3 Or cY -f. J.e", I,D S r.l and owners. +(-) Cash flows from assets = -~+) cash flows from financing The two calculations simply give us different perspectives about the firms cash flows. So, lets look at each approach for measuring a companys free cash flows. CALCULATING FREE CASH FLOWS: AN ASSET PERSPECTIVE! A firms free cash flows, viewed from an asset perspective, are the after-tax cash flows gen/ erated from operating the business less the firms investments in assets; that is: / / after-tax operating investment ----- free cash flows = - . -- cash flows In assets ~<. where the investment in assets may be expressed as follows: . . change in gross . . mvestment In assets = change In ng capItaI . + wor ki net operatIng . fixed assets and other assets Thus, the procedure for computing a firms free cash flows on an asset basis involves three steps: 1. Convert the income statement from an 3ccrual basis to a cash basis (~cmpute after-tax cash flows from operations). 2. Calculate the investment in net operating working capital. 3. Compute investments made in fixed assets and other assets (investment activities).cD For the first step, we compute after-tax cash flows from operations as follows: Operating income (earnings before interest and taxes) + depreciation -"> i r5T ( ((Ie n CI S -9 r: I I t () d I, ::, earnings before interest, taxes, depreciation, and amortization (EBITDA) cash tax payments after-tax cash flows from operations Earnings before interest, taxes, depreciation, and In the preceding calculation, we determine earnings before interest, taxes, deprecia amortization (EBITDA) tion, and amortization (EBITDA) by adding back depreciation to operating income Operating income plus because depreciation is not a cash expense. We then subtract taxes to get the cash flows depreciation and amortization on an after-tax basis. expenses.
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46 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Lets return to Harley-Davidson, Inc., to illustrate how to compute a firms after-tax cash flows from operations. Using Harley-Davidsons income statement in Table 2-1, we find that the firms after-tax cash flow from operations is $760,196,000. (in thousands) After tax casbJlQw..s.ir.om operatiQrls: Operating income (See income statement) $ 896,118 Depreciation (See income statement) -)1 (dS~ (y t)·· v)5e.. 160,119 Earnings before;nte!est, tax, depreciation, and amortization 1. TD 8- ") i ,_ $1,056,237 Provision for income taxes (see income statement) $298,052 ///~Le~:e:h:~~~:~~~~~e tax payable 2,011 , Cash taxes $ 296,041 I After-tax cash flows from operations $ 760,196 ( Note that we made an adjustment in computing the taxes Harley-Davidson actually paid, as opposed to what is shown in the income statement, or what is called cash taxes, The income statement indicated that the provision for income tax was $298,05 million. However, look at the balance sheet and notice that income taxes payable~creasl:lr $2.01 , million from December 31, 2001 to December 31, 2002. Why would tffa-~ Simply >- put, management did not pay the full $298.1 million in taxes. Rather they accrued $2.01 million of these taxes instead of paying them. So the cash taxes are computed as follows: Cash taxes = Provision for income taxes ..,.(Cha~} in income taxes payable. = $298.052 million - $2.011 ffillJihil = $296.041 million .... . / ) V For the second step, the increase in net operating working capital is equal to the: • r) I " ;.j I r_ change in tU.fchange in noninterest - bearing] [ current asset1..CV current liabilities ) (~ (Cc. Earlier, we said that net working capital is equal to current assets minus current, or short /Noninterest-bearing term, debt. However, in computing free cash flows, we only consider the noninterest " current liabilities bearin current liabilities incurred in the normal day-to-day operating acti.rities of buy Current liabilities other than ing and sellin e Irm s goo s, suc as accounts ayah e an a~{penses~ Any short-tenn debt. Q.f.., interest-bearing debt (that IS, were you exp Icitly pay interestfor the use of the money) , G-C Co UJit"" ~ o1d.Q -;-;11 be mcluded in computing free --casIlflOws from a financing perspective because bor - QCC~e~~~ fOwing money IS a flriancmg aCtIVIty. - . For Harley-Davidson, the increase in net operating working capital is fOW1d by look ing at the firms balance sheets in Table 2-2 and computing the following: • J ( :~ Jr: 3:- . changein J_[Change in noni~te~e~~-bearing]In ~I~" [ current assets current habllmes ? C"~ = $401.322 million - $197.822 million = $203.5 million " .i r,· . I ., v f " I - . where the noninterest-bearing current liabilities are the firm~ accoUnts payable and accruals. ® The final step involves computing the change in gross fixed assets (not net fixed assets) and an other balanc t assets tha ot a rea c Sl ere For Harley-Davidson, that includes the change in gross fixed assets and other assets, which equals $501,519,000: $300,895,000 f 200,624,000 $501,519,000
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 47 We can now compute Harley-Davidsons free cash flows from an asset perspective as follows: If.~ (in thousands) (j) After-tax cash flow operations $760,196 /7/ Less: G1 Increase in net operating working capital (203,500) G Increase in long-term assets (501,519) Free cash flows (asset perspective) $ 55,177 Given the preceding computations, we see that the firms free cash flows are positive in the amount of $55.2 million. The firms operations generated $760.2 million; but, the firm used cash to increase its investments in net operating working capital by the amount of $203.5 million and the investment in long-term assets of $501.5 million, leaving $55.2 million over and above what is needed within the business; in other words, these are the free cash flows. So, the question should now be: What did Harley-Davidson do with the asset free cash flows? Answer: They gave it to the investors! Lets look at the cash flows going to investors, as indicated by the firms financial statements. FREE CASH FLOWS: FINANCING PERSPECTIVE A firm can either receive money from or distribute money to its investors, or some of both. In general, cash flows between investors and the firm occur in one of four ways. The firm can: 1. Pay interest to creditors. 2. Pay dividends to stockholders.[ 3. Increase or decrease outstanding debt. -4. Issue or repurchase stock from current investors. We can illustrate these computations by returning to Harley-Davidson. We want to determine how the $55 plus million was paid to the investors, which we call the financing cash flows. Wh~~r investor, we include both lenders and th~)J1- Financing cash flows_panis_sh!-~~~s.: B_<?~ver w,e dOno-riI1clu-<i.eJin.an~ng_R[~. __ yaccounts Financing free cash flows the payable and accruei.gp~~s, ~hi£h:NeJ;e_recOgnl.zed .:=rher as part ohhe--flim!s-n.:et firm pays to or receives from the investors (lenders and operating working capital. See the Finance Matters box, "Earningsor-Ca:~h is shareholders). Bettt;?j"- ~ - _ - Looking at Harley-Davidsons income statement and the changes in the balance sheets, we see that cash was paid to the firms investors in the following four ways: 1. Payment of interest to the creditors (income statement) 2. Payment of dividends to the common stockholders (below balance sheet) 3. Reducing the amount of long-term debt outstanding (decrease in long-term debt in -- the balance sheet) 4. Repurchasing more stock than was issued by the firm (increase in treasury stock less the increase in common stock and paid in capital) However, the firm received additional financing from its creditors as indicated by the increases in the following interest-bearing current liabilities in the balance sheet: 1. Interest-bearing short-term notes 2. Other interest-bearing current liabilities J
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 49and if the cash flow from the assets is negative, it will be the amount that the investors hadto provide to the firm to cover the shortage in asset free cash flows.HARLEy-DAVIDSON, INC.: WHAT HAVE WE LEARNED?Based on our review of Harley-Davidson, Inc.s financial statements, we can now drawsome conclusions. To this point, we have learned that:~ For every dollar of sales, Harley-Davidson earns $.36 in gross profits, $.21 in operat ing income, and $.138 in net income.~ Most of the firms investments are in current assets and in fixed assets.~ The firm finances its assets using about 42 percent debt and 58 percent equity.~ Harley-Davidson has positive cash flows from assets because the company generated more money from operations than invested.~ The company increased its working capital (current assets), plant and equipment, and other assets.~ In net, $55.12 million were distributed to Harleys investors.II CONCEPT CHECK 1. Why can an income statement not provide a measurement of a firms cash flows? 2. What is the relationship between a firms asset and financing free cash flows? 3. When computing a firms asset free cash flows, why is it necessary to adjust operating income for increases (decreases) in net operating working capital and fixed assets? 4. What impact do positive or negative operating cash flows have on financing cash flows?II FINANCIAL STATEMENTS Objective J!J AND INTERNATIONAL FINANCE Many countries have different guidelines for firms to use in preparing financial state ments. In other words, even if $1 of United States earnings is equivalent to 1.10 Euro at the current exchange rate, $1 of earnings in the United States is not the same as 1.10 Euros of earnings in a German firm. The two countries simply have different "Generall Accepted Accounting Principles." In fact, the differences in accounting practices are significant enough that afirm reportlrlg according to German standards could have $100 million in profits, but in the United States, that same company might report a loss. Just imagine what this does for an investor trying to interpret financial statements across dif ferent country boundaries. As a result of this situation, the International AccountinK Standards Board (lASB), a private body supported by the worl(lw~ountingprofe~ng to develop international financial-reporting standards that will minimize the problem. The need for international standards became increasingly urgent as a result of the 1997 Asian crisis, which called attention to the perils of lax accounting in many Asian countries. In 2002 accounting scandals associated with the downfall of firms such as Enron and Worldcom brought additional attention on the U.S. GAAP standards as compared to the international accounting standards (lAS). Proponents of an international standardized system state GAAP is a rules-based system while IAS is a principles-based system. The
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50 PART I THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT principles-based system provides guidelines to firms and auditors to determine if an accounting treatment is true and fair. GAAP, the IAS proponents say, is more prone to accounting creativity-if there is no rule against a procedure, it can be done. In October 2002, U.S. and European regulators agreed to create a single set of global accounting standards. Differences in the current standards will be identified in 2003 and eliminated by 2005. Until the international standards are finalized, foreign companies seeking to list their shares in the United States must follow U.S. accounting standards, as developed by the Financial Accounting Standards Board (FASB). HOW FINANCIAL MANAGERS USE THIS MATERIAL In this chapter, we have explained the contents of key financial statements-the income statement and the balance sheet. In addition, we have spent considerable time coming to understand cash flows from a finance perspective. Accounting data are the basis for so much that is done in finance. It is used in almost every aspect of financial management, either directly or indirectly. In a firm of any significant size, the data are used both to evaluate historical performance and to project future expectations. Managers are increas ingly evaluated and compensated based on their firms performance, and performance is measured in terms of financial performance, usually in terms of profitability. For many executives, up to half of their compensation is tied to performance incentives, frequently to increasing company earnings. Not only do the financial managers use the d;Jta, but financial analysts and lenders rely on the firms financial information to advise investors and to make loans. Lenders, for example, often require that the firms earnings before interest, taxes, depreciation, and amortization (EBITDA) cannot fall below a given minimum, usually stated in terms of a ratio of EBITDA to interest and debt principal requirements. Or, they may say that the ·firms equity cannot be less than some minimum amount. Let there be no question, managers throughout an organization rely heavily on finan cial statements. Failure to understand this information would almost certainly prove fatal to the firm and to the careers of most managers. II Objective lJ A finns profits may be viewed as follows: gross profit = sales - cost of goods sold earnings before interest and tax (operating profits) = sales - cost of goods sold - operating expenses net profits (net income) = sales.- cost of goods sold - operating expenses - interest expense - taxes Five activities that drive a companys profits: 1. Revenue derived from selling the companys product or service 2. Cost of producing or acquiring the goods or services to be sold 3. Operating expenses related to (a) marketing and distributing the product or service to the customer and (b) administering the business 4. Financing costs of doing business-namely, the interest paid to the finns creditors 5. Payment of taxes
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 51The balance sheet presents a companys assets, liabilities, and equity as of a specific date. Total 0 bj e c t i ve 2 Iassets must equal debt plus equity. Assets include current assets, fLxed assets, and other assets. ~ Debt includes short-term and long-term debt. Equity includes preferred stock, common stock,and retained earnings. All of the numbers in a balance sheet are based on historical costs. As such,they are considered to equal the firms accounting book value, as opposed to its market value. For the most part, a companys taxes are determined by multiplying the applicable tax rate 0 bj e c t i ve 3 Itimes the firms earnings after all expenses have been paid, including interest expense, but not ~ dividend payments. Free cash flow is the cash that is distributed to or received from the firms investors. Free 0 bj e c t i Ve 4 Icash flow can be computed from an asset perspective or a financing perspective. In either case, ~ they will be equal; that is: FREE CASH FLOW FROMASSET PERSPECTIVE FINANCING PERSPECTIVEEarnings before interest, taxes, - Interest and dividend paymentsdepreciation, and amortization (EBITDA) - decreases in debt and stock or- cash tax payment + increases in debt and stock- additional investments in assets Foreign firms often follow accounting practices that differ significantly from the Generally Objective 5 ~ IAccepted Accounting Principles used by U.S. finns. The reporting differences may provide financialresults that are misleading or misinterpreted. Attempts to implement international financial reporting standards have not been embraced by the U.S. accounting profession and the SEC. Therefore,investors viewing financial statements of foreign-based firms must view the data vith caution. I)Accounting book value, 36 amortization (EBITDA), 45 Net working capital, 40 f~Accounts payable, 37 Noninterest-bearingAccounts receivable, 35 Earnings before taxes, 33 current liabilities, 46 Go To: Equity,37 Operating income ·ww.prenhall.colll/keO~11Accrued expenses, 37 for downloads and current Financing cash flows, 47 (earnings before interestAverage tax rate, 43 events associated with this and taxes), 33Balance sheet, 34 Fixed assets, 36 chapter Other assets, 36Conunon stockholders, 37 Free cash flows, 45 Other payables, 37Current assets (gross Income statement, 32 Par value and paid-in working capital), 34 Interest expense, 33 capital,37Current debt, 37 Inventory, 35 Preferred stockholders, 37Debt, 37 Liquidity, 41 Prepaid expenses, 36Debt capital, 37 Long-term debt, 37 Retained earnings, 37Earnings before interest, Marginal tax rate, 43 Short-term notes, 37 taxes, depreciation, and Net income, 33 Treasury stock, 37 STUDY QUESTIONS2-1. A companys financial statements consist of the balance sheet, income statement, and statement of cash flows. . a. Describe the nature of the balance sheet and the income statement. b. Why have we not used the conventional statement of cash flows in our presentation, computing instead what we call free cash flows?
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52 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT 2-2. What are the differences among gross profits, operating profits, and net income? 2-3. What is the difference between dividends and interest expense? 2-4. Why is it that the common equity section in the balance sheet changes from year to year regardless of whether new shares are bought or sold? 2-5. What is net working capital? How is it different from gross working capital? What is the difference between interest-bearing debt and noninterest-bearing debt? 2-6. Discuss the reasons why one firm could have positive cash flows and be headed for financial trouble, while another firm with negative cash flows could actually be in a good financial position. 2-7. Why is the examination of only the balance sheet and income statement not adequate in evaluating a firm? 2-8. Why do a firms free cash flows from an asset perspective have to equal its free cash flows from a financing perspective? SELF-TEST PROBLEMS ST-l. (Review offinancial statements) Prepare a balance sheet and income statement for the Wood Corporation, given the following information: Accumulated depreciation $38,000 Long-term debt ?? Inventory 5,000 General and administrative expenses 1,000 Interest expense 1,200 Common stock 50,000 Cost of goods sold 6,000 Short-term notes 750 Depreciation expense 600 Sales 13,000 Accounts receivable 10,000 Accounts payable 5,000 Buildings and equipment 120,000 Cash 11,000 Taxes 1,300 Retained earnings 10,250 ST-2. (Corporate income tax) Sales for Davies, Inc. during the past year amounted to $4 million. The finn supplies statistical infonnation to engineering companies. Gross profits totaled $1 mil lion, and operating and depreciation expenses were $500,000 and $350,000, respectively. Compute the corporations tax liability. ST-3. (Measuring cash flows) Given the following information for Neff Industries, compute the firms free cash flows for the year 2003, first from an asset perspective and then from a financing perspective. What do you learn about the firm from these computations? Neff Industries Balance Sheet for December 31, 2002, and December 31, 2003 2002 2003 Cash $ 9,000 $ SUO Accounts receivable 12,500 16,000 Inventories 29,000 45,500 Total current assets $ 50,500 $ 62,000 (continued)
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS. TAXES, AND CASH FLOWS 53 2002 2003Land 20,000 26,000Buildings and equipment 70,000 100,000Less: allowance for depreciation (28,000) (38,000)Total fixed assets $ 62,000 $ 88,000 Tota Iassets $112,500 $150,000Accounts payable $ 10,500 $ 22,000Bank notes 17,000 47,000 Total current liabilities $ 27,500 $ 69,000Long-term debt 28,750 22,950Common stock 31,500 31,500Retained earnings 24,750 26,550 Total liabilities and equity $112,500 $150,000Neff Industries Income Statementfor the Years Ended December 31, 2002, and December 31, 2003 2002 2003Sales $125,000 $160,000Cost of goods sold 75,000 96,000 Gross profit $ 50,000 $ 64,000Operating expense Fixed cash operating expense 21,000 21,000 Variable operating expense 12,500 16,000 Depreciation ~ 10,000 Total operating expense 38,000 47,000Earnings before interest and taxes $ 12,000 $ 17,000 Interest -----1.QQQ ~Earnings before taxes $ 9,000 $ 10,900Taxes ~ ~Net income $ 4,500 $ 5,450 l]2-1A. (Review offinancial statements) Prepare a balance sheet and income statement as ofDecember 31, 2003, for Belmond, Inc., from the following infomlation. In-ventmy $ 6,500 General and administrative expenses 850 E:oIfimon-sri:rck 45,000 € a sh 16,550 Operating expenses 1,350 Notes payaoft:· 600 Interest expense 900 Depreciation expense 500 Net sales 12,800 o-Aecoutns receiViIbie 9,600 Aeeounts-payabte 4,800 Long=teimtfe"Gt 55,000 Cost of goods sold 5,750 .liuildings- a:nd-eqUip1hent 122,000 . -Accu:mulateddepteci"ation 34,000 Taxes 1,440 Retained earnings ?
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54 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT 2-2A. (Review offinancial statements) Prepare a balance sheet and income statement as of December 31, 2003, for the Sharpe Mfg. Co. from the following information. Accounts receivable $120,000 Machinery and equipment 700,000 Accumulated depreciation 236,000 Notes payable 100,000 Net sales 800,000 Inventory 110,000 Accounts payable 90,000 Long-term debt 160,000 Cost of goods sold 500,000 Operating expenses 280,000 Common stock 320,000 Cash 96,000 Retained earnings-prior year ? Retained earnings-current year ? 2-3A. (Corporate inawze tax) Delaney, Inc. sells minicomputers. During the past year, the com panys sales were $4 million. The cost of its merchandise sold came to $2 million, cash operating expenses were $400,000, depreciation expense was $100,000, and the firm paid $150,000 in interest on bank loans. Also, the corporation paid $25,000 in the form of dividends to its own common stockholders. Calculate the corporations tax liability. 2-4A. (Corporate income tax) Potts, Inc. had sales of $6 million during the past year. The cost of goods sold amounted to $3 million. Operating expenses totaled $2.6 million and interest expense was $30,000. Determine the firms tax liability. 2-5A. (Measuring cash flows) Calculate the free cash flows for Pamplin, Inc., for the year ended December 31, 2003, both from an asset and a financing perspective. Interpret your results. Pamplin, Inc., Balance Sheet at 12/31/02 and 12/31/03 ASSETS 2002 2003 Cash $ 200 $ 150 Accounts receivable 450 425 Inventory 550 625 Current assets 1,200 1,200 Plant and equipment 2,200 2,600 less: accumulated depreciation (l,OOO) (1,200) Net plant and equipment 1,200 1,400 Tota I assets $2,400 $2,600 LIABILITIES AND OWNERS EQUITY 2002 2003 Accounts payable $ 200 $ 150 Notes payable-current (9%) o 150 Current liabilities $ 200 $ 300 long-term debt 600 600 Owners equity Common stock $ 300 $ 300 Paid-in capital 600 600 Retained earnings 700 800 Total owners equity $1,600 $1,700 Total liabilities and owners equity $2,400 $2,600
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 55 Pamplin, Inc. Income Statement for years ending 12/31/02 and 12/31/03 ($ in thousands) 2002 2003 Sales $1,200 $1,450 Cost of goods sold 700 850 Gross profit $ 500 $ 600 Operating expenses 30 40 Depreciation 220 200 Net operating income $ 250 $ 360 Interest expense 50 60 Net income before taxes $ 200 $ 300 Taxes (40 0/0) 80 120 Net income $ 120 $ 180 2-6A. (Meamling cash flows) Calculate the free cash flows for T P Jannon Company for the year ended December 31, 2003, both from an asset and a financing perspective. Interpret your results... T. P. Jarmon Company Balance Sheets at 12/31/02 and 12/31/03 ASSETS 2002 2003 Cash $ 15,000 $ 14,000 Marketable securities 6,000 6,200 Accounts receivable 42,000 33,000 Inventory 51,000 84,000 Prepaid rent -----!2QQ -----.1.1QQ Total current assets $115,200 $138,300 Net plant and equipment 286,000 270,000 Total assets $401,200 $408,300 LIABILITIES AND EQUITY 2002 2003 -- Accounts payable $ 48,000 $ 57,000 , Notes payable Accruals / 15,000 6,000 13,000 5,000 Total current liabilities $ 69,000 $ 75,000 Long-term debt $160,000 $150,000 Common stockholders equity $172,200 $183,300 Total liabilities end equity $401,200 $408,300 T. P. Jarmon Company Income Statement for the Year Ended 12/31/03 Sales $600,000 Less: cost of goods sold 460,000 Gross profits $140,000 Less: expenses General and administrative $30,000 Interest 10,000 Depreciation 30,000 Total operating expenses $ 70,000 Earnings before taxes $ 70,000 Less: taxes 27,100 Net income $ 42,900 Net income $ 42,900 Less: cash dividends 31,800 To retained earnings $ 11,100
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56 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT 2-7A. (Measuring cash flows) Calculate the free cash flows for Abrams Manufacturing Company for the year ended December 31, 2003, both from an asset and a financing perspective. Interpret your results. Abrams Manufacturing Balance Sheets at 12/31/2002 and 12/31/2003 2002 2003 Cash $ 89,000 $100,000 Accounts receivable 64,000 70,000 Inventory 112,000 100,000 Prepaid expenses 10,000 10,000 Plant and equipment 238,000 311,000 Accumulated depreciation (40,000) (66,000) Total $473,000 $525,000 Accounts payable $ 85,000 $ 90,000 Accrued liabilities 68,000 63,000 Mortgage payable 70,000 o Preferred stock o 120,000 Common stock 205,000 205,000 Retained earnings 45,000 47,000 Total liabilities Ct equity $473,000 $525,000 Abrams Manufacturing Company Income Statement for the Year Ended 12/31/03 Sales $184,000 Cost of sales 60,000 Gross profit 124,000 Selling, general, and administrative expenses 44,000 Depreciation expense 26,000 Operating income $ 54,000 Interest expense 4,000 Taxes 16,000 Preferred stock dividends 10,000 Net income $ 24,000 Additional information: The firm paid $22,000 in common stock dividends during 2003. 2-8A. f,ftnalyzing free cash flows) Following you will find our computation of the free cash flows for]. T. Williams. Interpret the information in terms of where cash came from and where it was used. J.T. WILLIAMS 2003 FREE CASH FLOWS ($ IN THOUSANDS) CASH FLOWS FROM AN ASSET PERSPECTIVE After-tax cash flows from operations: Operating income $ 156,711 Depreciation 97,797 Earnings before interest, tax, depreciation $254,508 Tax expense $ 62,333 Less change in income tax payable (7,600) Less change in deferred taxes (13,903) Cash taxes 40,830 After-tax cash flows from operations $213,678 Other income (losses) 10,532 $224,210 (continued)
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 57Change in net operating working capital: Change in cash $ (5,751) Change in accounts receivable (3,326) Change in inventories 37,768 Change in other current assets 20,529 Change in current assets $ 49,220 Change in accounts payable $ 1,662 Change in accrued expenses 32,283 Change in noninterest-bearing current debt 33,945 Change in net operating working capital $ 15,275Change in fixed assets and other assets: Purchase of fixed assets $257,292 Change in investments 43,334 Change in other assets --....Z2.!Q Net cash used for investments $308,336Asset free cash flows $ (99,401)CASH FLOWS FROM A FINANCING PERSPECTIVEInterest expense $Plus increase in long-term debt 7,018Plus increase in short-term debt 30,577Less dividendsPlus increase in common stock 61,806Financing free cash flows $ 99,4012-9A. (Analyzing free cash flows) Following you will find our computation of the free cashflows for Johnson, Inc. Interpret the information in terms of where cash came from andwhere it was used.FREE CASH FLOWS FROM AN ASSET PERSPECTIVE ($ It! THOUSANOS)After-tax cash flows from operations: Operating income $(597,683) Depreciation 251,500 Earnings before interest, tax, depreciation $ (346,183) Taxes - After-tax cash flows from operations $ (346,183)Other income (losses) (104,388) $ (450,571)Change in net operating working capital: Change in cash $ 332,743 Change in inventories 191,145 Change in other current assets 64,036 Change in current assets $ 587,924 Change in accounts payable 349,753 Change in net operating working capital $ 238,171Change in fixed assets and other assets: Purchase of fixed assets $ 472,768 Change in investments 1,101,606 Change in other assets (154,261) Net cash used for investments $ 1,420,113Asset free cash flows $(2,108,855)FREE CASH FLOWS FROM A FINANCING PERSPECTIVEInterest expense paid $(87,966)Plus increase in long-term debt 1,118,198Plus increase in short-term debt 13,638Plus increase in other current liabilities 213,969Plus increase in common stock 851,016Financing free cash flows $2,108,855
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58 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT II Go to the Harley-Davidson Website (www.harley-davidson.com) and download the finns financial statements. Calculate the changes in each asset, debt, and equity balance in the balance sheet from the prior year to the most recent year. Explain the changes that occurred between the two years. (See page 39 for an example). Then compare the operating profit margin (operating income -7- sales) for the two years. Did they increase or decrease? . INTEGRATIVE PROBLEM -. . - . The following financial statements are for Davis & Howard. Assume that you would be meeting with]osh Gray, the finns controller. Based on the financials and the free cash flow computations, what would you tell Gray about his finn? What questions would you have for him? Davis 8: Howard Financials ($ in thousands) 2002 2003 ASSETS Cash $ 84,527 $ 60,806 Accounts receivable 136,629 194,096 Inventories 107,876 137,448 Prepaid expenses 21,727 32,413 Other current assets 31,287 34,383 Total current assets $382,046 $459,146 Gross property, plant, and equipment 812,428 874,301 Accumulated depreciation (420,501) (469,847) Net property, plant. and equipment $391,927 $404,454 Investments 2,730 Other assets 19,436 ~ Total assets $793,409 $875,885 LIABILITIES Short-term debt $ 15,000 $ 15,000 Notes payable 19,036 18,159 Accounts payable 76,915 117,757 Taxes payable 10,529 11,901 Accrued expenses 101,465 119,685 Total current liabilities $222,945 $282,502 Long-term debt 128,102 113,307 Other liabilities 125,874 114,166 Total liabilities $476,921 $509,975 EQUITY Common stock $ 289 $ 289 Paid-in capital 37,776 37,422 Retained earnings 531,695 611,075 Less: treasury stock 253,272 282,876 Total equity $316,488 $365,910 Total liabilities and equity $793,409 $875,885 Davis 8: Howard RECONCILIATION OF RETAINED EARNINGS ($ IN THOUSANDS) Retained earnings, December 31, 2002 $531,695 2003 net income 106,101 Dividends paid 26,912 Other gains __ 19_1 Retained earnings, December 31, 2003 $611,075
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 59Davis a Howard Income Statement ($ in thousands) 2002 2003Sales $1,327,610 $1,501,726 Cost of goods sold 1,025,425 1,147,025Gross profit $ 302,185 $ 354,701 2002 2003 Selling, general, and administrative expense 129,986 125,219 Depreciation 47,511 49,346Operating profit $ 124,688 $ 180,136 Interest expense 19,352 17,024 Nonoperating income (expense) 7,809 6,659Income before taxes $ 113,145 $ 169,771 Provision for income taxes 42,500 63,670Net income $ 70,645 $ 106,101Davis a Howard 2003 Free Cash Flows ($ in thousands)CASH FLOWS FROM AN ASSET PERSPECTIVEAfter-tax cash flows from operations: Operating income $180,136 Depreciation 49,346 Earnings before interest, tax, depreciation $229,482 Tax expense $ 63,670 Less change in income tax payable ~) Cash taxes $ 62,298 After-tax cash flows from operations $167,184Other income (losses) ~ $174,034Change in net operating working capital: Change in cash $ (23,721) Change in accounts receivable 57,467 Change in inventories 29,572 Change in prepaid expenses 10,686 Change in other current assets ~ Change in current assets $ 77,100 Change in accounts payable $ 40,842 Change in accrued expenses 18,220 Change in noninterest-bearing current debt $ 59,062 Change in net operating working capital $ 18,Q38Change in fixed assets and other assets: Purchase of fixed assets $ 61,873 Change in investments 2,730 Change in other assets ~) Net cash used for investments $ 54,722Asset free cash flows $101,274CASH flOWS FROM A FINANCING PERSPECTIVE -Interest expense $ (17,024)Less decrease in long-term debt (14,795)Less decrease in other liabilities (11,708)Less decrease in notes payable (877)Less dividends (26,912)Less decrease in common stock (29,958)Financing free cash flows $(101,274)
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60 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT 2-1B. (Review offinancial statements) Prepare a balance sheet and income statement as of December 31, 2003, for the Warner Company from the following list of items. Depreciation $ 66,000 Cash 225,000 Long-term debt 334,000 Sales 573,000 Accounts payable 102,000 General and administrative expenses 79,000 Buildings and equipment 895,000 Notes payable 75,000 Accounts receivable 153,000 Interest expense 4,750 Accrued expenses 7,900 Common stock 289,000 Cost of goods sold 297,000 Inventory 99,300 Taxes 50,500 Accumulated depreciation 263,000 Prepaid expenses 14,500 Taxes payable 53,000 Retained earnings 262,900 2-2B. (Review offinancial statements) Prepare a balance sheet and income statement as of December 31, 2003, for the Sabine Mfg. Co. from the following list of items. Ignore income taxes and interest expense. Accounts receivable $150,000 Machinery and equipment 700,000 Accumulated depreciation 236,000 Notes payable---eurrent 90,000 Net sales 900,000 Inventory 110,000 Accounts payable 90,000 Long-term debt 160,000 Cost of goods sold 550,000 Operating expenses 280,000 Common stock 320,000 Cash 90,000 Retained earnings-prior year ? Retained earnings---eurrent year ? 2-3B. (Corporate income tax) Cook, Inc., sells minicomputers. During the past year, the com- panys sales were $3.5 million. The cost of its merchandise sold came to $2 million, and cash operating expenses were $500,000; depreciation expense was $100,000, and the fum paid $165,000 in interest on bank loans. Also, the corporation paid $25,000 in dividends to its own common stockholders. Calculate the corporations tax liability. 2-4B. (Corporate income tax) Rose, Inc. had sales of $7 million during the past year. The cost of goods sold amounted to $4 million. Operating expenses totaled $2.6 million and interest expense was $40,000. Determine the firms tax liability. 2-5B. (Measuring cash flows) Calculate the free cash flows for the J. B. Chavez Corporation for the year ended December 31, 2003, both from an asset and a financing perspective. Interpret your results.
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 61J. B. Chavez Corporation, Balance Sheetat 12/31/02 and 12/31/03 ($OOO) ASSETS 12131102 12131103Cash $ 225 $ 175Accounts receivable 450 430Inventory 575 625 Current assets $1,250 $1,230Plant and equipment $2,200 $2,500Less: accumulated depreciation (1,000) (1,200) Net plant and equipment $1,200 $1.300 Total assets $2,450 $2,530 LIABILITIES AND OWNERS EQUITY 12131/02 12131103Accounts payable $ 250 $ 115Notes payable-current (9010) o 115Current liabilities $ 250 $ 230Bonds $ 600 $ 600Owners equity Common stock $ 300 $ 300 Paid-in capital 600 600 Retained earnings 700 800 Total owners equity $1,600 $1,700Total liabilities and owners equity $2,450 $2,530J. B. Chavez Corporation. Income Statementfor the years ending 12/31/02 and 12/31/03 ($OOO) 2002 2003Sales $1,250 $1,450Cost of goods sold 700 875Gross profit $ 550 $ 575Operating expenses $ 30 $ 45Depreciation 220 250 200 245Operating income $ 300 $ 330Interest expense 50 60Net income before taxes $ 250 $ 270Taxes (40)010 100 108Net income $ 150 $ 1622-6B. (Measuring cash flows) Calculate the free cash flows for RPI, Inc., for the year endedDecember 31, 2003, both from an asset and a financing perspective. Interpret your results.RPI, Inc.• Balance Sheetsfor 12/31/02 and 12/31/03 ASSETS 2002 2003Cash $ 16,000 $ 17,000Marketable secu rities 7,000 7,200Accounts receivable 42,000 38,000Inventory 50,000 93,000Prepaid rent ----..!.d.QQ ------.1.!QQ Total current assets $116,200 $156,300Net plant and equipment 286,000 290,000 Total assets $402,200 $446,300
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62 PART 1 THE SCO PE AN D ENVI RO NMENT 0 F FI NAN CIAL MA NAG EM ENT LIABILITIES AND STOCKHOLDERS EQUITY 2002 2003 Accounts payable $ 48,000 $ 55,000 Notes payable 16,000 13,000 Accruals ~ ~ Total current liabilities $ 70,000 $ 73,000 Long-term debt $160,000 $150,000 Common stockholders equity $172,200 $223,300 Total liabilities and equity $402,200 $446,300 RPI, Inc., Income Statement for the Year Ended 12/31/03 Sales $700,000 Less: cost of goods sold 500,000 Gross profits $200,000 Less: operating and interest expenses General and administrative $50,000 Interest 10,000 Depreciation 30,000 Total expenses $ 90,000 Profit before taxes $110,000 Less: taxes 27,100 Net income available to common stockholders $ 82,900 Less: cash dividends 31,800 Change in retained earnings $ 51,100 2-7B. (Measuring cash flows) Calculate the free cash flows for the Cameron Company for the year ended December 31, 2003, both from an asset and a financing perspective. Interpret your results. Comparative Balance Sheets for December 31, 2002, and December 31, 2003, for the Cameron Company 2002 2003 Cash $ 89,000 $ 70,000 Accounts receivable 64,000 70,000 Inventory 102,000 80,000 Prepaid expenses 10,000 10,000 Total current assets $265,000 $230,000 Plant and equipment $238,000 $301,000 Accumulated depreciation (40,000) (66,000) Total assets $463,000 $465,000 Accounts payable $ 85,000 $ 80,000 Accrued liabilities 68,000 63,000 Total current liabilities $153,000 $143,000 Mortgage payable 60,000 o Preferred stock o 70,000 Common stock 205,000 205,000 Reta ined ea rn ings 45,000 47,000 Total debt and equity $463,000 $465,000 Camerons 2003 income statement is as follows: Sales $204,000 Cost of sales 84,000
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 63 Gross profit $120,000 Selling, general, and administrative expenses 17,000 Depreciation expense 26,000 Operating income $ 77,000 Interest expense 5,000 Taxes 30,000 Preferred stock dividends 8,000 Net income $ 34,000Additional inftrmation:The firm paid $32,000 in common stock dividends during 2003.2-8B. (AnalyzingJree cash jl(Y/J)s) Following you will find our computation of the free cash flowsfor Hilarys Ice Cream. Interpret the information in terms of where cash came from and where itwas used.Hilarys Free Cash Flows ($ in Thousands)CASH FLOWS FROM AN ASSET PERSPECTIVEAfter-tax cash flows from operations: Operating income $13,129 Depreciation 9,202 Earnings before interest, tax, depreciation $22,331 Tax expense $ 1,823 Less change in income tax payable 1,215 Less change in deferred taxes (4,174) Cash taxes $ 4,782 After-tax cash flows from operations 17,549Other income (losses) (6,596) $10,953Change in net operating working capital:Change in cash $ (638)Change in accounts receivable 7,495Change in inventories 847 Change in other current assets (2,666)Change in current assets $ 5,Q38Change in accounts payable $ 5,456Change in accrued expenses 51Z Change in noninterest-bearing current debt $ 5,973 Change in net operating working capital $ (935)Change in fixed assets and other assets: Purchase of fixed assets $ (757) Change in investments (103) Change in other assets 3,060 Net cash used for investments $ 2,200Asset free cash flows $ 9,688CASH FLOWS FROM A FINANCING PERSPECTIVEInterest expense $(1,634)Less decrease in long-term debt (3,822)Plus increase in short-term debt 361Less dividends -Less decrease in common stock (4,593)Financing free cash flows $(9,688)2-9B. (Analyzing free cash jl(Y/J)s) Following you will find our computation of the free cash flowsfor Retail.com. Interpret the information in terms of where cash came from and where it wasused.
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64 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Retail.com Cash Flows ($ in Thousands) CASH flOWS FROM AN ASSET PERSPECTIVE After-tax cash flows from operations: Operating income $(97,324) Depreciation 29,312 Earnings before interest, tax, depreciation $ (68,012) Cash taxes After-tax cash flows from operations (68,012) Other income (losses) 4,323 $ (63,689) Change in net operating working capital: Change in cash $ 76,680 Change in accounts receivable 3,472 Change in inventories 2,332 Change in other current assets ~ Change in current assets $ 84,962 Change in accounts payable $ 4,657 Change in noninterest-bearing current debt 4,657 Change in net operating working capital $ 80,305 Change in fixed assets and other assets: Purchase of fixed assets $ 31,971 Change in investments 178,108 Change in other assets 250 Net cash used for investments $ 210,329 Asset free cash flows $(354,323) CASH FLOWS FROM A FINANCING PERSPECTIVE Interest expense $ Dividends (23,612) Less decrease in short-term debt (137) Plus increase in other current liabilities 9,609 Plus increase in common stock 368,463 Financing free cash flows $ 354,323 SELF-TEST SOLUTIONS ST-I. INCOME STATEMENT Sales $ 13,000 Cost of goods sold 6.000 Gross profits $ 7,000 Depreciation expense 600 General and administrative expenses ----.!RQQ Operating expenses $ 1,600 Operating income $ 5,400 Interest expense ----.!.dQQ Ea rn ings before taxes $ 4,200 Taxes ----..!.dQQ Net income $ 2.900 BALANCE SHEET Cash $ 11,000 Accounts receivable 10,000 Inventory 5.000 Total current assets $ 26,000 Buildings and equipment 120,000 Accumulated depreciation 38,000 (continlJed)
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CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 65Net buildings and equipment 82,000Total assets $108,000Accounts payable $ 5,000Short-term notes 750Current liabilities $ 5,750Long-term debt $ 42,000Total debt $ 47,750Common stock 50,000Retained earnings 10,250Total debt and equity $108,000ST-2.Gross profits $1,000,000Operating expenses 500,000Depreciation 350,000Taxable income $ 150,000EARNINGS x MARGINAL TAX RATE TAXES$50,000 x 0.15 $ 7,500$75,000-$50,000 x 0.25 6,250$100,000-$75,000 x 0.34 8,500$150,000-$100,000 x 0.39 19,500 $41,750ST-3.Neff Industries Free Cash Flowsfor the Year Ended December 31, 2003FREE CASH FLOWS: OPERATING PERSPECTIVEOperating income $ 17,000Plus depreciation expense 10,000Less tax expense (5,450)Less change in income tax payable oAfter-tax cash flows from operations $ 21,550Change in net operating working capitalChange in cash $ (8,500)Change in accounts receivable 3,500Change in inventories 16,500Change in accounts payable (11,500)Change in net operating working capital $ 0Change in fixed assets and landPurchase of buildings and equipment $ 30,000Purchase of land 6,000Change in fixed assets and land $ 36,000Free cash flows (operating perspective) $(14,450)FREE CASH FLOWS: FINANCING PERSPECTIVEIncrease in short-term notes $ 30,000Decrease in long-term notes (5,800)Dividends (3,650)Interest expense ~)Free cash flows (financing perspective) $ 14,450
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APPENDlX2A Measuring Cash Flows: An Accounting Perspective In this chapter, we measured cash flows from a finance perspective; or what we called free cash flows. However, if you were looking at the financial statements in a firms annual report, you would see something a bit different from what we presented in this chapter. In addition to the income statement and balance sheet, tle firms accountant would also present a statement of cash flows. The purpose of the statement is not to compute free cash flows, but rather to measure the change in cash during a period and explain the sources and uses of the cash. There are two ways that accountants present the cash flow statement: the indirect method and the direct method. We will present the indirect method, since it is generally the preferred format for accountants, and use Harley-Davidson to illustrate the computations. (If you want an explana- tion and illustration of the direct method, refer to the Web site, www.prenhall.comlkeown) STATEMENT OF CASH FLOWS Three elements are used to determine a firms cash flows through the indirect method: 1. After-tax cash flows from day-to-day operations 2. Cash flows related to long-term investments, such as plant and equipment 3. Cash flows from financing activities The statement of cash flows combines the three elements listed above to measure the change in cash for the period. The data needed to prepare this statement include: 1. An income statement for the period. While an income statement does not measure cash flows, its data are necessary for computing cash flows. For example, to measure Harley- Davidsons cash flows for 2002, we need the firms income statement for the year. 2. Two balance sheets, one at the beginning of the period and the other at the end of the period. Again, if we want to compute Harleys cash flows for 2002, we would need the bal- ance sheets for December 31, 2001, and December 31, 2002. Graphically, it would appear as follows: Balance Sheet on Balance Sheet on December 31, 2001 December 31, 2002 l Income Statement for 2002 l • HARLEY-DAVIDSON STATEMENT OF CASH FLOWS Lets prepare a statement of cash flows for Harley-Davidson for 2002. To do so, we will need to refer back to the companys 2002 income statement (Table 2-1) and the year-ending balance sheets for2001 and 2002 (Table 2-2).
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APPENDIX 2A MEASURING CASH FLOWS: AN ACCOUNTING PERSPECTIVE 67CASH FLOWS FROM OPERATIONSTo compute cash from operating activities (the cash flows from day-to-day operations), we beginwith net income, and then make adjustments to convert the income statement from an accrualbasis to a cash basis. Doing so requires the following computations: 1. Start with the firms net income. 2. Add back depreciation expense (a non-cash expense). 3. Subtract (add) any increases (decreases) in operating assets. In this context, operating assets are the same as current assets, excluding cash. It is the money invested in accounts receiv- ables, inventories, and other current assets. Thus, if the firm invests more (an increase in the balance sheet) in accounts receivable, it means the firm is extending credit to its customers. In other words, when the firm sells its product or service, it is reported as a sale, which shows up in the income statement. However, since the company has not received the cash, it needed to subtract the change in accounts receivables from net income for the cash that was not collected. The same would be true for inventories and other current assets. 4. Add (subtract) increases (decreases) in short-term operating liabilities. These are the short- term liabilities that are part of the firms normal operating cycle from the time inventory is acquired, to its sale, and to the time the cash is collected. We can typically identify these lia- bilities as those that are short term where no interest is paid on the debt, such as accounts payable and accruals.For Harley-Davidson, the cash flows from operations for 2002 were $699.1 million, computed asfollows (in $000):Net income $ 580,217Depreciation expense 160,119(Increase) decrease in operating assets (current assets): Change in accounts receivables $(189,201) Change in inventories (37,041) Change in other current assets (14,801) $(241,043)Increase (decrease) in short-term operating liabilities (short-term liabilities that do not pay interest): Change in income tax payable $ 2,011 Change in accounts payables 165,528 Change in accrued expenses 32,294 199,833Cash provided by operating activities $699,126CASH FLOWs-INVESTMENT ACTIVITIESNow that we have calculated the cash flows that were generated from the day-to-day operations atHarley, we will determine the amount of cash used for long-term investments by the firm-thecash flows from investing activities. Relying on Harleys balance sheets, we see that the firminvested $501.5 million in long-term assets-$300.9 million for fixed assets and $200.6 million onother long-term assets, such as patents and intangibles. The computations are as follows (in $000): Increase in fixed assets $(300,895) Increase in other assets (200,624) Cash flows from investing activities $(501,519)The change in fixed assets, or plant and equipment in the balance sheets, has to be based on grossfixed assets rather than net fixed assets. After all, net fixed assets are affected by both the change ingross fixed assets (plant and equipment) and depreciation expense for the year. However, thechange in gross plant and equipment is totally the result of buying and selling these assets.NEVER take the change in net fixed assets, but only the change in gross fixed assets. Again: Nevertake the change in net fIXed assets. It will be wrcmg.
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68 APPENDIX 2A MEASURING CASH FLOWS: AN ACCOUNTING PERSPECTIVE CASH FLOWs-FINANCING ACTIVITIES The last part of cash flows relates to financing activities, including any cash inflows or outflows to or from the firms investors, both lenders of debt and owners. For 2002, Harley had the fol- lowing cash flows associated with the firms financing (in $000): Dividends paid $(73,902) Increase (decrease) in interest-bearing short-term notes 47,833 Increase (decrease) in other interest-bearing current liabilities 26,276 Increase (decrease) in long-term debt (7,852) Increase (decrease) in common stock (29,683) Cash flows from financing activities $(37,328) Thus, Harley had cash inflows from borrowing short-term liabilities of about $74 million ($47.8 million plus $26.3 million). The firm then used cash to pay the common stockholders almost $74 million in dividends, $7.8 million to pay down long-term debt, and $29.7 million to repurchase stock. Also, notice that interest expense is not included as a financing cash flow. Since cash flows from operations begin with net income, as previously calculated, the firms interest expense has already been deducted as part of cash flows from operations. Finally, note that accounts payables and accruals are not included in financing cash flows. We have already included them in cash flows from operations. We may now bring all three parts of the cash flows together into a single report, the state- ment of cash flows, as shown in Table 2A-1. TABLE 2A-1 Harley-Davidson Cash Flow Statement (Indirect Method) ADJUSTMENTS TO RECONCILE NET InCOME TO CASH PROVIDED BY OPERATING ACTIVITIES (IN $000) Net income $ 580,217 Depreciation and amortization 160,119 (Increase) decrease in operating assets: Change in accounts receivables (189,201) Change in inventories (37,041) Change in other current assets (14,801) Increase (decrease) in operating liabilities: Change in income tax payable 2,011 Change in accounts payables 165,528 Change in accrued expenses 32,294 Cash provided by operating activities $ 699,126 INVESTING ACTIVITIES Increase in fixed assets $(300,895) Increase in other assets (200,624) . Cash flows from investing activities $(501,519) FINANCING ACTIVITIES Dividends paid $ (73,902) Increase (decrease) in interest-bearing short-term notes 47,833 Increase (decrease) in other interest-bearing current liabilities 26,276 Increase (decrease) in long-term debt (7,852) Increase (decrease) in common stock (29,683) Cash flows from financing activities $ (37,328) Change in cash $ 160,279 Beginning cash (Dec. 31, 2001) 635,449 Ending cash (Dec. 31, 2002) $ 795,728
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APPENDIX 2A MEASURING CASH FLOWS: AN ACCOUNTING PERSPECTIVE 69 Thus, Harleys cash flows during 2002 increased $160.3 million, resulting from $699.1 mil-lion flowing into the firm from operations, investing $501.5 million in long-term assets, and pay-ing down debt of $37.3 million. As a result, the firms cash balances on the balance sheetincreased from $635.4 million to $795.7 million from December 31, 2001, to December 31,2002. Now we know where Harleys cash came from and how it was used, which is the purposeof a statement of cash flows.
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CHAPTER 5 The Time Value of MoneyIn business and in personal finance, there is probably no single resulted in the construction of the Franklin"Union, helpedconcept with more power or applications than the time value countless medical students with loans, and still contains overof money. In his landmark book, A History of Interest Rates, $3 million in the account. Philadelphia, likewise, has reapedHomer Sidney noted that if $1,000 were invested for 400 significant rewards. Bear in mind that all this came from ayears at 8 percent interest, it would grow to $23 quadrillion combined gift of $2,000 and some serious help from the timeapproximately $5 million per person on earth. He was not giv value of money.ing a plan to make the world rich, but effectively pointing out The power of the time value of money can also be illustratedthe power of the time value of money. through a story Andrew Tobias tells in his book Money Angles. The time value of money is certainly not a new concept. In the story, a peasant wins a chess tournament sponsored byBenjamin Franklin had a good understanding of how it worked the king. The king then asks him what he would like as the prize.when he bequest $1,000 each to Boston and Philadelphia. The peasant answers that, for his village, he would like oneWith his gift, he left instructions that the cities were to lend piece of grain to be placed on the first square of his chessboard,the money, charging the going interest rate, to worthy two pieces on the second square, four on the third, eight on theapprentices. Then, after the money had been invested this way fourth, and so forth. The king, thinking he was getting off easy,for 100 years, they were to use a portion of the investment to pledged his word of honor that this would be done. Unfortubuild something of benefit to the city and hold some back for nately for the king, by the time all 64 squares on the chessboardthe future. In the 213 years that followed, Bens gift to Boston were filled, there were 18.5 million trillion grains of wheat on ~ CHAPTER PREVIEW )so In the next six chapters, we will focus on detennin Different investment proposals produce different ing the value of the firm and the value of invest sets of cash flows over different time periods. How ment proposals. A key concept that underlies this does the manager compare these? We will see that the material is the time value ofmoney; that is, a dollar concept of the time value of money will let us do this. today is worth more than a dollar received a year Thus, an understanding of the time value of money is from now because a dollar today ·can be invested essential to an understanding offinancial management, and earn interest. Intuitively this idea is easy to whether basic or advanced. In this chapter, we develop understand. We are all familiar with the concept of the tools to incorporate Principle 2: The Time interest. This concept illustrates what economists Value of Money-A dollar received today is worth call an opportunity cost of passing up the earning more than a dollar received in the future into our potential of a dollar today. This opportunity cost is calculations. In coming chapters, we will use this con the time value of money. cept to measure value by bringing the benefits and costs from a project back to the present. 137
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r/I 138 PART 2 VALUATION oF FINANCIAL ASSETS the board-the kernels were compounding at a rate of 100 percent over the 64 squares of the chessboard. Needless to say, no one in the village ever went hungry; in fact, that is so much wheat that if the kernels were one-quarter inch long (the estimate Andrew Tobias provides) they could stretch to the sun and back 391,320 times if laid end to end. Understanding the techniques of compounding and moving money through time are critical to almost every business decision. It will also help you to understand such varied things as how stocks and bonds are valued, how much you should save for your childrens education, and how much your mortgage payments will be. Objective lJ COMPOUND INTEREST AND FUTURE VALUE Most of us encounter the concept of compound interest at an early age. Anyone who has ever had a savings account or purchased a government savings bond has received com Compound interest pound interest. Compound interest occurs when interest paid on the investment during Interest that occurs when the first period is added to the principal; then, during the second period, interest is earned interest paid on the investment on this new sum. during the first period is added to the principal; then, during For example, suppose we place $100 in a savings account that pays 6 percent the second period, interest is interest, compounded annually. How will our savings grow? At the end of the first earned on this new sum. year we have earned 6 percent, or $6 on our initial deposit of $100, giving us a total of $106 in our savings account. The mathematical formula illustrating this relation ship is FV1 = PV(l + i) (5-1) where FV1 = the future value of the investment at the end of one year i = the annual interest (or discount) rate PV = the present value, or original amount invested at the beginning of the first year In our example FVj = PV(l + i) = $100 (l + .06) = $100 (1.06) = $106 Carrying these calculations one period further, we find that we now earn the 6 percent interest on a principal Of $106, which means we earn $6.36 in interest dur ing the second year. Why do we earn more interest during the second year than we did during the first? Simply because we now earn interest on the sum of the original principal, or present value, and the interest we earned in the first year. In effect, we are now earning interest on interest-this is the concept of compound interest. Examining the mathematical formula illustrating the earning of interest in the second year, we find FV2 = FV1(1 + i) (5-2) which, for our example, gives FV2 = $106 (1.06) = $112.36
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CHAPTER 5 THE TIME VALUE OF MONEY 139 Looking back at equation 5-1 we can see that FVl or $106, is actually equal toPV(1 + z), or $100 (1 + .06). If we substitute these values into equation 5-2, we get FVi = PV(l + i)(1 + i) (5-3) = PV(1 + i)lCarrying this forward into the third year, we find that we enter the year with $112.36 andwe earn 6 percent, or $6.74, in interest, giving us a total of $119.10 in our savingsaccount. Expressing this mathematically FVj = FVi(l + i) (5-4) = $112.36 (1.06) = $119.10If we substitute the value in equation 5-3 for FVl into equation 5-4, we find FVj = PV(1 + i)(l + i)(l + i) (5-5) PV(1 + i)3By now a pattern is beginning to be evident. We can generalize this formula to illustratethe value of our investment if it is compounded annually at a rate of i for n years to be FV71 = PV(l + i)71 (5-6) where FV71 = the future value of the investment at the end of n years n = the number of years during which the compounding occurs i = the annual interest (or discount) rate PV = the present value or original amount invested at the beginning of the first year Table 5-1 illustrates how this investment of $1 00 would continue to grow for thefirst 10 years at a compound interest rate of 6 percent. Notice how the amount ofinterest earned annually increases each year. Again, the reason is that each yearinterest is received on the sum of the original investment plus any interest earned inthe past.mJIDII Illustration of Compound Interest CalculationsYEAR BEGINNING VALUE INTEREST EARNED ENDING VALUE 1 $100.00 $ 6.00 $106.00 2 106.00 6.36 112.36 3 112.36 6.74 119.10 4 119.10 7.15 126.25 5 126.25 7.57 133.82 6 133.82 8.03 141.85 7 141.85 8.51 150.36 8 150.36 9.02 159.38 9 159.38 9.57 168.9510 168.95 10.13 179.08
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140 PART 2 VALUATION OF FINANCIAL ASSETS FIGURE 5-1 Future Value of $100 Initially Deposited and Compounded at O. 5. and 10 Percent 300 10% 250 ~ 200 to == 0 :s. ~ 5% ::l 150 ";l ;. . ~ a 100 0% ::l ~ 50 0 0 3 Year When we examine the relationship between the number ofyears an initial investment is compounded for and its future value, as shown graphically in Figure 5-1, we see that we can increase the future value of an investment by increasing the number of years we let it compound or by compounding it at a higher interest rate. We can also see this from equa tion 5-6, because an increase in either i or n while PV is held constant will result in an increase in FV,I Keep in mind that future cash flows are assumed to occur at the end of the time period during which they accrue. For example, if a cash flow of $100 occurs in time period 5, it is assumed to occur at the end of time period 5, which is also the beginning of time period 6. In addition, cash flows that occur in time t = 0 occur right now; that is, they are already in present dollars. EXAMPLE: FUTURE VALUE OF A SINGLE FLOW If we place $1,000 in a savings account paying 5 percent interest compounded annually, how much will our account accrue in 10 years? Substituting PV = $1,000, i = 5 percent, and n = 10 years into equation 5-6, we get FVn = PV(l + it = $1,000 (1 + .05io = $1,000 (1.62889) = $1,628.89 Thus, at the end of 10 years, we will have $1,628.89 in our savings account.
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CHAPTER 5 THE TIME VALUE OF MONEY 141II!IIIJII FVIFi,n or the Compound Sum of $1n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210 3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 .. 1.587 1.677 1.772 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.35810 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.59411 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.85312 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.13813 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.45214 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.79715 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 As the determination of fUUlre value can be quite time-consuming when an investment is held for a number of years, the future-value interest factor for i and n Future-value interest factor(FVIFi,u) defined as (1 + 1)", has been compiled in the back of the book for various val (FVIFi •u )ues of i and n. An abbreviated compound interest or future-value interest factor table The value (1 + I)" used as a multiplier to calculate anappears in Table 5-2, with a more comprehensive version of this table appearing in amounts furure value.Appendix B at the back of this book. Alternatively, the FVIF,11 values could easily bedetermined using a calculator. Note that the compounding factors given in these tablesrepresent the value of $1 compounded at rate i at the end of the nth period, Thus, to calculate the future value of an initial investment, we need only determine the FVIFi ",using a calculator or the tables in Appendix B, and multiply this times the initial inve~tment. In effect, we can rewrite equation 5-6 as follows: FV" = PV(FVJFi"J (5-6a)EXAMPLE: FUTURE VALUE OF AN ANNUITYIf we invest $500 in a bank where it will earn 8 percent compounded annually, howmuch will it be worth at the end of seven years? Looking at Table 5-2 in row n = 7 andcolumn i = 8%, we find that FVIFS%,7yrs has a value of 1.714. Substituting this in equation 5-6a, we find FV" = PV(FVIFS%,7yrS> = $500 (1.714) = $857Thus, we will have $857 at the end of seven years. We will find several uses for equation 5-6: Not only will we find the fuulre value ofan investment, but we can also solve for pv, i, or n. When we are given three of thefour variables, we can solve for the fourth.
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142 PART 2 VALUATION OF FINANCIAL ASSETS EXAMPLE: SOLVING FOR N Lets assume that the Chrysler Corporation has guaranteed that the price of a new Jeep will always be $20,000, and youd like to buy one but currently have only $7,752. How many years will it take for your initial investment of$7,752 to grow to $20,000 if it is invested at 9 percent compounded annually? We can use equation 5-6a to solve for this problem as well. Substituting the known values in equation 5-6a, you find FVn = PV(FVIFj,1I) $20,000 = $7,752 (FVIF9%,1Iyrs) $20,000 $7,752 (FVIF<)%,nyrs) $7,752 $7,752 2.58 = FVIF9%,nyrs Thus, you are looking for a value of2.58 in the FVIFi,71 tables, and you know it must be in the 9% column. To finish solving the problem, look down the 9% column for the value closest to 2.58. You find that it occurs in the n = 11 row. Thus, it will take 11 years for an initial investment of $7,752 to grow to $20,000 if it is invested at 9 per- cent compounded annually. EXAMPLE: SOLVING FOR I Now lets solve for the compound annual growth rate, and lets go back to that Jeep that always costs $20,000. In 10 years, youd really like to have $20,000 to buy a new Jeep, but you only have $11,167. At what rate must your $11,167 be compounded annually for it to grow to $20,000 in 10 years? Substituting the known variables into equation 5-6a, you get FVn = PV(FVIFj,n) $20,000 = $11,167 (FVIFj,lOyrS> $20,000 $11,167 (FVIFj,IOyrs) $11,167 $11,167 1.791 = FVIFj,lOyrs You know you are looking in the n = 10 row of the FVIFi,n tables for a value of 1.791, and you find this in the i = 6% column. Thus, if you want your initial investment of $11,167 to grow to $20,000 in 10 years, you must invest it at 6 percent. Just how powerful is the time value of money? Manhattan Island was purchased by Peter Minuit from the Indians in 1626 for $24 in "knickknacks" and jewelry. If at the end of 1626 the Indians had invested their $24 at 8 percent compounded annually, it would be worth over $103.4 trillion today (by the end of 2004,3)8 years later). Thats certainly enough to buy back all of Manhattan. In fact, with $103 trillion in the bank, the $90 to
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CHAPTER 5 THE TIME VALUE OF MONEY 143$100 billion youd have to pay to buy back all of Manhattan would only seem like pocketchange. This story illustrates the incredible power of time in compounding. There sim-ply is no substitute for it. l ,.--- - -- CONCEPT CH ECK ~ 1. Principle 2 states that "A Dollar Received Today Is Worth More Than a I Dollar Received in the Future." Explain this statement. 2. How does compound interest differ from simple interest? 3. Explain the formula FVn = PV(l + nn ...... _- ... - - -MOVING MONEY THROUGH TIME WITH THE AIDOF A FINANCIAL CALCULATORTime value of money calculations can be made simple with the aid of a financial calculator.In solving time value of money problems with a financial calculator, you will be giventhree of four variables and will have to solve for the fourth. Before presenting any solu-tions using a financial calculator, we will introduce the calculators five most commonkeys. (In most time value of money problems, only four of these keys are relevant.) Thesekeys are:MENU KEY DESCRIPTIONN Stores (or calculates) the total number of payments or compounding periods.I/Y Stores (or calculates) the interest or discount rate.FV Stores (or calculates) the present value of a cash flow or series of cash flows.FV Stores (or calculates) the future value, that is, the dollar amount of a final cash flow or the compound value of a single flow or series of cash flows.PMT Stores (or calculates) the dollar amount of each annuity payment deposited or received at the end of each year. When you use a financial calculator, remember that outflows generally have to beentered as negative numbers. In general, each problem will have two cash flows: one anoutflow with a negative value, and one an inflow with a positive value. The idea is thatyou deposit money in the bank at some point in time (an outflow), and at some otherpoint in time you take money out of the bank (an inflow). Also, every calculator operatesa bit differently with respect to entering variables. Needless to say, it is a good idea tofamiliarize yourself with exactly how your calculator functions. In any problem, you will be given three of four variables. These four variables willalways include Nand IIY; in addition, two out of the final three variables PV; PV; andPMTwili also be included. To solve a time value of money problem using a financialcalculator, all you need to do is enter the appropriate numbers for three of the fourvariables, and press the key of the final variable to calculate its value. It is also a goodidea to enter zero for any of the five variables not included in the problem in order toclear that variable. Now lets solve the previous example using a financial calculator. We were tryingto find at what rate $100 must be compounded annually for it to grow to $179.10 in10 years. The solution using a financial calculator would be as follows:
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144 PART 2 VALUATION OF FINANCIAL ASSETS Step 1: Input values of known variables DATA INPUT FUNCTION KEY DESCRIPTION 10 N Stores N = 10 years -100 PV Stores PV= -$100 179.10 FV Stores FV= $179.10 o PMT Clears PMTto = 0 Step 2: Calculate the value of the unknown variable FUNCTION KEY ANSWER DESCRIPTION CPT IIY 6.000/0 Calculates flY = 6.000/0 Any of the problems in this chapter can easily be solved using a financial calculator, and the solutions to many examples using a Texas Instrument (II) BAIl Plus financial calculator are provided in the margins. If you are using the TI BAIl Plus, make sure that you have selected both the "END MODE" and "one payment per year" (PlY = 1). This sets the pay ment conditions to a maximum of one payment per period occurring at the end of the period. One final point: You will notice that solutions using the present-value tables versus solutions using a calculator may vary slightly-a result of rounding errors in the tables. For further explanation of the TI BAIl Plus, see Appendix A at the end of the book. SPREADSHEETS AND THE TIME VALUE OF MONEY Without question, in the real world most calculations involving moving money through time will be carried out with the help of a spreadsheet. While there are several competing spreadsheets, the most popular one is Microsoft Excel. Just as with the keystroke calcula tions on a financial calculator, a spreadsheet can make easy work of most common finan cial calculations. Following are some of the most common functions used with Excel when moving money through time: Calculation Formula Present value = PV(rate,number of periods,payment,future value,type) Future value = FV(rate,number of periods,payment,present value,type) Payment = PMT(rate,number of periods,present value,future value,type) Number of periods = NPER(rate,payment,present value,future value,type) Interest rate =RATE(number of periods,payment,present value,future value,type,guess) where: Rate = i, the interest rate or discount rate Number of periods = n, the number of years or periods Payment = PMT, the annuity payment deposited or received at the end of each period Future value = FV, the future value of the investment at the end of n periods or years Present value = pv, the present value of the future sum of money Type = when the payment is made (0 if omitted) o= at end of period 1 = at beginning of period Guess =a starting point when calculating the interest rate; if omitted, the calculations begin with a value of 0.1, or 10%
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CHAPTER 5 THE TIME VALUE OF MONEY 145 Just like with a financial calculator, the outflows have to be entered as negative num bers. In general, each problem will have two cash flows--one positive and one negative. The idea is that you deposit money at some point in time (an outflow or negative value) and at some point later in time, you withdraw your money (an inflow or positive value). For example, lets look back at the example on page 141. -- W ~ ... A-,jI13.:::J[-C--II-:D-.-IL_ E_ .JCF -3C-G-----.:Ir=-H-_ Ir-I.~.~~ I -- r- - - I Spreadsheets and the nme Value of Moneyi ! , ! -I I IF _ .. I._ .. __ -_~ I __ ,-__ i -]_ --1--- ~~~~l-~I~:S~o~~0~Ui~h~~~1ti:~;B~;P:h;~n.~:r;i~~",~ --=r-:: . - . - (i) = I bill E --;----1 7 _ __ . rate _ ~: _ _ _ a. _n~fperiodsJr:t)= .Z: ---c ; .P2YI12~!J~~D =, r9lJ._0l.resent valu.~<ElY) =1 $o~ __ -I- $500 L __ ...... - - F ~ 1 _ 1 ~_YY-~-=-- r~---~ m. -----1I - t e = at end of eriod = F :1 =t= Future value = $856.91 0 -l-=E3 1 1141 1 l5-IExcel formula: =FV~,number of periodsr-yment,present value,ty~) ~ ~ I I I I II Entered value in cell d13: =FV(d7,d8,d9,-d10.E11) I rn-INotice that present value ($500) took on a neJ@tive value. ~ . r I ---l----r· I Sheetll Sbeet2 1 Sheet3.. J - : 11M _ __ _ d "00 _C~-IIB-IIC-Ir-:-D.::-JCE-. .1IF-I~ .G~ ~Now lets~!.!h--l value Of.h1US!~~_~.e id on~g_eI142. Spreadsheets: Solvinq for i 1 I r- r- -. r H E-3 I I I I 1 I E--J I I __ 1 I_~j 6~1_ L L :I Excel formula: =RATE(number of periods,payment,present value ,future value,t ee,guess) . .9. ._, .-J . -.~--I I _ ---.J --- - __ ~. En!er..~_~~in cell d16: =RATl(d28,d29.fd3o,d31 ,d32,d33) r - - -- --- _._._-----.- ____ ~oticet~atprEl.~~r:t.!.~51I~.~J~.1.1n.1§71t~kon. a n_e.9.ati~e..value. ~ 23. Also n~~if.1.0u didn~ assi.sn a value to guess., it would be.g.in calculation;> . - ==t _ I 24 ~!!! .~yalue of 0.1 orJQ!<>o.. lf!.!.~o_:l.ld_ r:t~! E~rneuPnl"li!~a v~.I!-l.~.!~! L~ft~!~ --I 25 20 iterations, you would receive the #NUM! error message. Generally a m guessi;i;i;;:;;!en ffi-and--OO ~ercent-willwork:----- - - T-~ , - LI ------ ----.-- I ~ rflifJ Sheetl 1 SheetZ 1. Sheet3 7 I~ ITt.------r "--:----.
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146 PA RT 2 VALUATION 0 F FI NAN CIAL ASS ETS Objective --.!J COMPOUND INTEREST WITH NONANNUAL PERIODS Until now, we have assumed that the compounding period is always annual; however, it need not be, as evidenced by savings and loan associations and commercial banks that compound on a quarterly, and in some cases a daily, basis. Fortunately, this adjustment of the compounding period follows the same format as that used for annual compounding. If we invest our money for five years at 8 percent interest compounded semiannually, we are really investing our money for 10 six-month periods during which we receive 4 per cent interest each period. If it is compounded quarterly, we receive 2 percent interest per period for 20 three-month periods. Table 5-3 illustrates the importance of nonannual compounding. For example, if you invested $100 at 15 percent you would end up with about 5 percent more if it was compounded semiannually instead of annually, and about 10 percent more if the compounding occurred daily. This process can easily be general ized, giving us the following formula for finding the future value of an investment for which interest is compounded in nonannual periods: FV" = PV (1 + ~ r" (5-7) where FVn = the future value of the investment at the end of n years 11 = the number of years during which the compounding occurs i = annual interest (or discount) rate PV = the present value or original amount invested at the beginning of the first year m = the number of times compounding occurs during the year CALCU LAlOR SOLUTION Data Input Function Key EXAMPLE: NONANNUAL COMPOUNDING 20 N If we place $100 in a savings account that yields 12 percent compounded quarterly, 3 I/Y what,will our invesuuent grow to at the end of five years? Substituting n = 5, In = 4, 100 PV i = 12 percent, and PV = $100 into equation 5-7, we find o PMT 45 Function Key Answer FVr; = $100 ( 1 + .~2 ) CPT FV -180.61 = $100 (1 + .03)20 $100 (1.806) $180.60 Thus, we will have $180.60 at the end of five years. Notice that the calculator solution is slightly different because of rounding errors in the tables, as explained in the previ ous section, and that it also takes on a negative value. Obviously, the choice of the interest rate plays a critical role in how much an invest ment grows, but do small changes in the interest rate have much of an impact on future values? To answer this question, lets look back to Peter Minuits purchase of Manhattan. If the Indians had invested their $24 at 10 percent rather than 8 percent compounded annually at the end of 1626, they would have over $106 quadrillion by the end of 2004 (378 years). That is 106 followed by 15 zeros, or $106,000,000,000,000,000. Actually, that is enough to buy back not only Manhattan Island, but the entire world and still have plenty left over! Now lets assume a lower interest rate-say, 6 percent. In that case, the
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..... CHAPTER 5 THE TIME VALUE OF MONEY 147IIlJl!DI The Value of $100 Compounded at Various Nonannual PeriodsFOR 1 YEAR AT ; PERCENT ; = 2% 5% 10% 15%Compounded annually $ 102.00 $105.00 $110.00 $ 11 5.00Compounded semiannually 102.01 105.06 110.25 11 5.56Compounded quarterly 102.02 105.09 110.38 11 5.87Compounded monthly 102.02 105.12 110.47 11 6.08Compounded weekly (52) 102.02 105.12 110.51 116.16Compounded daily (365) 102.02 105.13 110.52 116.18FOR 10 YEARS AT ; PERCENT ; = 2% 5% 10% 15%Compounded annually $ 121.90 $162.89 $259.37 $404.56Compounded semiannually 122.02 163.86 265.33 424.79Compounded quarterly 122.08 164.36 268.51 436.04Compounded monthly 122.12 164.70 270.70 444.02Compounded weekly (52) 122.14 164.83 271.57 447.20Compounded daily (365) 122.14 164.87 271.79 448.03$24 would have only grown to a mere $88.3 billion-less than 1I100th of what it grew toat 8 percent, and only one-millionth of what it would have grown to at 10 percent. Withtoclays real estate prices, youd have a tough time buying Manhattan, but if you did, youprobably couldnt pay your taxes! To say the least, the interest rate is extremely importantin investing. CONCEPT CHECK 1. Why does the future value of a given amount increase when interest is compounded nonannually as opposed to annually? 2. How do you adjust the present and future value formulas when interest is compounded monthly? PRESENT VALUE Objective ~Up until this point, we have been moving money forward in time; that is, we know howmuch we have to begin with and are trying to determine how much that sum will grow ina certain number of years when compounded at a specific rate. We are now going to lookat the reverse question: What is the value in todays dollars of a sum of money to bereceived in the future? The answer to this question will help us determine the desirabilityof investment projects in Chapters 9 through 11. In this case, we are moving futuremoney back to the present. We will be determining the present value of a lump sum, Present valuewhich in simple terms is the current value of a future payment. What we will be doing is, The current value of ain fact, nothing other than inverse compounding. The differences in these techniques future sum.come about merely from the investors point of view. In compounding, we talked aboutthe compound interest rate and the initial investment; in determining the present value,we will talk about the discount rate, and the present value of future cash flows.Determination of the discount rate is the subject of Chapter 6, and can be defined as therate of return available on an investment of equal risk to what is being discounted. Otherthan that, the technique and the terminology remain the same, and the mathematics are
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148 PART 2 VALUATION OF FINANCIAL ASSETS simply reversed. In equation 5-6, we attempt to determine the future value of an initial investment. We now want to determine the initial investment or present value. By divid ing both sides of equation 5-6 by (1 + I)", we get PV = FVn [ 1 ] (5-8) (1 + i)" where PV == the present value of the future sum of money FV" == the future value of the investment at the end of 11 years 11 = the number of years until the payment will be received i = the annual discount (or interest) rate Because the mathematical procedure for determining the present value is exactly the inverse of determining the future value, we also find that the relationships among 11, i, and PVare just the opposite of those we observed in future value. The present value of a future sum of money is inversely related to both the number of years until the payment will be received and the discount rate. Graphically, this relationship can be seen in Figure 5-2. Although the present value equation (equation 5-8) will be used extensively in evaluating new investment proposals, it should be stressed that the present value equation is actually the same as the future value or compounding equation (equation 5-6) where it is solved for PV CALCULATOR SOLUTION EXAMPLE: PRESENT VALUE OF A FUTURE CASH FLOW Data Input Function Key What is the present value of$500 to be received 10 years from today if our discount 10 N rate is 6 percent? Substituting FVIO = $500, 11 = lO,and i = 6 percent into equation 6 I/Y 5-8, we find 500 fV o PMT PV = 500 [ 1 ] (1 + .06)10I Food;," K" Answer CPT PV -279.20 == $500 (_I_J 1.791 = $500 (.5 58) == $279 Thus, the present value of the $500 to be received in 10 years is $279.Present-value interest To aid in the computation of present values, the present-value interest factorfactor (PVlFj ,,) for i and 11, or PVIF.", which is equal to [1/(1 + i)"], has been compiled for various I,The value [11(1 + 1)"] used as a combinations of i and 11 and appears in Appendix C at the back of this book. Anmultiplier to calculate anamounts present value. abbreviated version of Appendix C appears in Table 5-4. A close examination shows that the values in Table 5-4 are merely the inverse of those found in Appendix B. This, of course, is as it should be, as the values in Appendix B are (I + I)" and those in Appendix Care [1/(1 + i)"J. Now to determine the present value of a sum of money to be received at some future date, we need only determine the value of the appro priate PVlF. I either by using a calculator or consulting the tables, and multiply it by , the future value. In effect, we can use our new notation and rewrite equation 5-8 as follows: PV = FV"(PVlFj ,,,) (5-8a)
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ImIIDD Present Value of $100 to Be Received at a Future Date and Discounted Back to the Present at 0, 5. and 10 Percent S 70 = 60 o S III ~ 50 ~ 1:: 40 III <Il 10% £::L 10 00 1 2 4 5 6 7 8 9 10 Year CALCULATOR SOLUTIONEXAMPLE: PRESENT VALUE CALCULATION Data Input Function Key 10 NYoure on vacation in a rather remote part of Florida and see an advertisement stating 6 IfYthat if you take a sales tour of some condominiwns, "you will be given $100 just for 100 FVtaking the tour." However, the $100 that you get is in the form of a savings bond thatwill not pay you the $100 for 10 years. What is the present value of$l00 to be received o PMT10 years from today if your discount rate is 6 percent? By looking at the n =1() row and Function Key Answeri = 6% column of Table 5-4, you find the PVIF6%,IOyrs is .558. Substituting FVlO = CPT$100 and PVlF6%,IOyrs = .558 into equation 5-8a, you find PV -55.84 PV = $100 (PVIF6%,IOyrs) = $100 (.558) = $55.80 Thus, the value in todays dollars of that $100 savings bond is only $55.80.ImDI PVIFi.n or the Present Value of $1n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909 2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826 3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751 4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683 5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621 6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564 7 .933 .871 .813 .760 .711 .655 .623 .583 .547 .513 8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467 9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .42410 .905 .820 .744 .676 .614 .558 .508 .463 .422 .38611 .896 .804 .722 .650 .585 .527 .475 .429 .388 .35012 .887 .789 .701 .625 .557 .497 .444 .397 .356 .31913 .879 .773 .681 .601 .530 .469 .415 .368 .326 .29014 .870 .758 .661 .577 .505 .442 .388 .340 .299 .26315 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239
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150 PART 2 VALUATION OF FINANCIAL ASSETS DEALING WITH MULTIPLE, UNEVEN CASH FLOWS Again, we only have one present value-future value equation; that is, equations 5-6 and 5-8 are identical. We have introduced them as separate equations to simplify our calcula tions; in one case, we are determining the value in future dollars and in the other case, the value in todays dollars. In either case, the reason is the same: To compare values on alter native investments and to recognize that the value of a dollar received today is not the same as that of a dollar received at some future date, we must measure the dollar values in dollars of the same time period. In the chapter opening we discussed Harley-Davidson investing in the costly develop ment of the Buell Lightning Low in 2000 and receiving income on that investment in the year 2003 and beyond. The concept of present value allows us to bring those future cash flows back to the present and view them in terms of todays dollars. Moreover, because all present values are comparable (they are all measured in dollars of the same time period), we can add and subtract the present value of inflows and outflows to determine the present value of an investment. Lets now look at an example of an investment that has two cash flows in different time periods and detennine the present value of this investment. EXAMPLE: PRESENT VALUE OF A SINGLE FLOW AND AN ANNUITY What is the present value of an investment that yields $500 to be received in five years and $1,000 to be received in 10 years if the discount rate is 4 percent? Substituting the values of n = 5, i = 4 percent, and FVs = $500; and n = 10, i = 4 percent, and FVlO = $1,000 into equation 5-8 and adding these values together, we find PV = $500 [ 1 5] + $1,000 [ (1 + .04) 1 (1 + .04) 10] = $500 (PVIF4%,syrs) + $1,000 (PVIF4%,lOyrs) = $500 (.822) + $1,000 (.676) = $411 + $676 = $1,087 Again, present values are comparable because they are measured in the same time periods dollars. - ~--~ - ~-- II II CONCEPT CHECK 1. What is the relationship between the present value equation (5-7) and the future value or compounding equation (5-6)? 2. Why is the present value of a future sum always less than that sums future value? _. - - - - __ - _ _ c_ --- -- Objective ~ ANNUITIES~A LEVEL STREAMAnnuity An annuity is a series of equal dollar payments for a specified number of years. BecauseA series of equal dollar annuities occur frequently in finance-for example, interest payments on bonds are inpayments for a specified effect annuities-we will treat them specially. Although compounding and determiningnumber of years. the present value of an annuity can be dealt with using the methods we have just
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" CHAPTER 5 THE TIME VALUE OF MONEY 151 described, these processes can be time-consuming, especially for larger annuities. Thus we have modified the formulas to deal directly with annuities. Although all annuities involve a series of equal dollar payments for a specified number of years, there are two basic types of annuities: an ordinary annuity and an annuity due. Ordinary annuity ( ._ /1 d ) With an ordinary annuity, we assu,me that the payments occur at the end of each period; An annuity in which the . payments occur at the end of with an annuity due, the payments occur at the begillfLing of each period. Because an annu each period. ity due provjdes the payments earlier (at the beginning of each period instead of the end as Annuity due ( b- ~,- I ,, with an ordinary annuity), it has a greater present value. After we master ordinary annuities, An ann~ity in which the we will examine annuities due. However, in finance, ordinary arumities are used much more payments occur at the frequently than are annuities due. Thus, in tlus text, whenever the term "annuity" is used, beginning of each period. you should assume that we are referring to an ordinary annuity unless otherwise specified. COMPOUND ANNUITIES Acompound annuity involves depositing or investing an equal sum of money at the end Compound amlUity of each year for a certain number of years and allowing it to grow. Perhaps we are saving Depositing an equal sum of money for education, a new car, or a vacation home. In any case, we want to know how money at the end of each year for a certain number of years much our savjngs will have grown by some point in the future. and allowing it to grow. Actually, we can find the answer by using equation 5-6, our compounding equation, and compounding each of the individual deposits to its future value. For example, if to provide for a college education we are going to deposit $500 at the end of each year for the next five years in a bank where it will earn 6 percent interest, how much will we have at the end of five years? Compounding each of these values using equation 5-6, we find that we will have $2,818.50 at the end of five years. FVs = $500 (l + .06)4 + $500 (1 + .06)3 + $500 (1 + .06i + $500 (1 + .06) + $500 CALCULATOR SOLUTION = $500 (1.262) + $500 (1.191) + $500 (1.124) + $500 (1.060) + $500 Data Input Function Key = $631.00 + $595.50 + $56200 + $530.00 + $500.00 5 N = $2,818.50 6 IIY To better understand whats happening, lets look at tlUs problem using a time line. A o PV time line is simply a horizontal line on which the present-rime period zero-is at the left 500 PMT most end. Future rime periods are then shown along the line moving from left to right. The Function Key Answer dollar amount of the cash flow is shown below the line, with positive values representing CPT cash inflows, and negative values representing cash outflows. We will frequently use time FV -2,818.55 lines to illustrate the timing of an investments cash flows. In the present example, cash flows of$500 are received at the end of years one through five and are presented graphically in Table 5-5. From exailUning the mathematics involved and the graph of the movement of money through time in Table 5-5, we can see that this procedure can be generalized to FV. ~ PM~ [~ (I q- (5-9) where FV71 = the future value of the annuity at the end of the nth year PMT= the annuity payment deposited or received at the end of each year i = the annual interest (or discount) rate n = the number of years for which the annuity will last Future-value interest factor for an annuity (FVIFA i ,,,) To aid in compounding annuities, the future-value interest factor for an annuity The value [~(1 + i/ ] for i and n (FVlFA j ,71) defined as [ L. (1 + i)t 71-1 ] , is provided in Appendix 0 for various t=O used as a multiplier to calculate combinations of nand i. An abbreviated version is shown in Table 5-6. the future value of an annuity.
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152 PA RT 2 VALUATION 0 F FI NAN CIAL AS SETS IIl1lIJBI Illustration of a Five-Year $500 Annuity Compounded at 6 Percent YEAR 0 2 3 4 5 Dollar deposits at end of year 500 500 500 500 500 l I Lh: $ 500.00 530.00 562.00 595.50 631.00 Future value of the annuity $2,818.50 Using this new notation, we can rewrite equation 5-9 as follows: FVn = PMT(FVIFA j ,,) (S-9a) The FVIFA j n can also be calculated as follows: FVIFA;,n = (1 + i~n - 1 (S-9b) 1 This fonnula is useful if you dont have a financial calculator or tables. Reexamining the previous example, in which we determined the value after five years of $500 deposited at the end of each of the next five years in the bank at 6 percent, we would look in the i = 6% column and n = 5 year row and find the value of the FVIFA 6%,5yrs to be 5.637. Substituting this value into equation 5-9a, we get FV5 = $500 (5.637) = $2,818.50 This is the same answer we obtained earlier. Rather than asking how much we will accumulate if we deposit an equal sum in a sav ings account each year, a more common question is how much we must deposit each year to accumulate a certain amount of savings. This problem frequently occurs with respect to saving for large expenditures and pension funding obligations.EJJ!DI FVIFAi,n or the Sum of an Annuity of $1 for n Yearsn 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310 4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 9 9.368 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.57910 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.93711 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.53112 12.682 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.38413 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.52314 14.947 15.974 17.086 18.292 19.598 21.015 22.550 24.215 26.019 27.97515 16.097 17.293 18.599 20.023 21.578 23.276 25.129 27.152 29.361 31.772
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... CHAP TER 5 THE TIM E VA LUE 0 F M0 NEY 153 For example, we may know that we need $10,000 for education in eight years; how much CALCULATOR SOLUTION must we deposit at the end of each year in the bank at 6 percent interest to have the college Data Input Function Key money ready? In this case, we know the values of 11, i, and FV" in equation 5-9; what we do 8 N: not know is the value of PMT. Substituting these example values in equation 5-9, we find 6 I{Y 8-1 ] 10,000 ,Pol $10,000 = PMT ~ (1 + .06)1 o PV [ Function Key Answer $10,000 = PMT(FVIF4,%,8yrs) CPT $10,000 = PMT(9.897) PMT -1,010.36 $10,000 = PMT 9.897 PMT = $1,010.41 Thus, we must deposit $1,010.41 in the bank at the end of each year for eightyears at 6 percent interest to accumulate $10,000 at the end of eight years. CALCULATOR SOLUTION EXAMPLE: SOLVING FOR PAYMENT Data Input Function Key 10 N How much must we deposit in an 8 percent savings account at the end of each year 8 I{Y to accumulate $5,000 at the end of 10 years? Substituting the values FVIO = $5,000, n = 10, and i = 8 percent into equation 5-9, we find 5.000 fI o PiJ, 10-1 ] Function Key Answer $5,000 = PMT [ ~ (l + .08l = PMT(FVIFA 8%,IOyrs) CPT PMT -345.15 $5,000 = PMT(14.487)I $5,000 = PMT 14.487 PMT == $345.14/ Thus, we must deposit $345.14 per year for 10 years at 8 percent to accumulate $5,000.I PRESENT VALUE OF AN ANNUITY Pension funds, insurance obligations, and interest received from bonds all involve annuities. To value them, we need to know the present value of each. See the Finance Matters box, "Make a Child (or Yourself) a Millionaire." Although we can find this by using the present value table in Appendix C, this can be time-consuming, particularly when the annuity lasts for several years. For example, if we wish to know what $500 received at the end of the next five years is worth to us today given the appropriate discount rate of 6 percent, we can sim ply substitute the appropriate values into equation 5-8, such that PV = $500 [ 1 (1 + .06)1 ] + $500 1 I L (1 + .06)2 ] + $500 [ 1 (1 + .06)3 ] + $500 [ 1 ] + $500 [ 1 ] (l + .06)4 (l + .06)5 = $500 (.943) + $500 (.890) + $500 (.840) + $500 (.792) + $500 (.747) = $2,106
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• CHAPTER 5 THE TIME VALUE OF MONEY 155 IlJJIDI Illustration of a 5-Year $500 Annuity Discounted Back to the Present at 6 Percent YEAR o 2 3 4 5 Dollars received at the end of year 500 500 500 500 500 $ 471.50~ I I ~H~~ II Present value of the annuity :f------------ 373.50 .... $2,106.00 To simplify the process of determining the present value for an annuity, the present- Present-value interest value interest factor for an annuity for i and n(PVlFA i,,,) defined as 11 (1 1] f factor for an annuity (PVlFA i ,.,) [t L. [ +1 t=[ has The value _1_] been compiled for various combinations of i and 11 in Appendix E, with an abbreviated 1=1 (1 + i) version provided in Table 5-8. used as a multiplier to calculate Using this new notation, we can rewrite equation 5-10 as follows: the present value of an annuity. PV = PMT(PVlFAi,n) (S-10a) The PVlFAi,n can also be calculated as follows: 1_ 1 PVlFA;,l1 = (1 + i)" (S-10b) This formula is useful if you dont have a financial calculator or tables. Solving the previous example to find the present value of $500 received at the end of each of the next five years discounted back to the present at 6 percent, we look in the i = 6% column and n = 5 year row and find the PVlFA 6 %,syrs to be 4.212. Substituting the appropriate values into equation 5-1 Oa, we find PV = $500 (4.212) = $2,106 mJ!.IlD PVIFAi,n or the Present Value of an Annuity of $1 n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% c 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 7 8 5.795 6.728 7.652 . 5.601 6.472 7.326 5.417 6.230 7.020 5.242 6.002 6.733 5.076 5.786 6.463 4.917 5.582 6.210 4.767 5.389 5.971 4.623 5.206 5.747 4.486 5.033 5.535 4.355 4.868 5.335 9 8.566 8:162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
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156 PART 2 VALUATION OF FINANCIAL ASSETS IZ!DDI Present Value of a Six-Year Annuity Discounted at 8 Percent $1 RECEIVED AT THE END OF YEAR 1 2 3 4 5 6 Present value ~~~~ ~: ~E------------------ .794 .... .735 ...- ----J .681 .630 ...- ,----- -J 4.623 Present value of the annuity This, of course, is the same answer we calculated when we individually discounted each cash flow to the present. The reason is that we really only have one table: All of the tables are derived from Table 5-2; the Table 5-8 value for an n-year annuity for any discount rate i is merely the sum of the first n values in Table 5-4. We can see this by comparing the value in the present-value-of-an-annuity table (Table 5-8) for i = 8 percent and n = 6 years, which is 4.623, with the sum of the values in the i = 8% colunm and n = 1, ... , six rows of the present-value table (Table 5-4), which is equal to 4.623, as shown in Table 5-9. CALCULATOR SOLUTION Data Input Function Key EXAMPLE: PRESENT VALUE OF AN ANNUITY 10 N What is the present value of a la-year $1,000 annuity discounted back to the present 5 I/Y at 5 percent? Substituting 11 = 10 years, i = 5 percent, and PMT= $1,000 into equation 1,000 PMT 5-10, we find o FV Function Key CPT Answer PV = $1,000 [ L (1 + 1.05) ] = $1,000 (PVIFAs%,lOyrs) IO t=1 t Pol -7,721.73 Determining the value for the PVIFA 5%,lOyrs from Table 5-8, row n = 10, column i = 5%, and substituting it in, we get PV = $1,000 (7.722) = $7,722 Thus, the present value of this annuity is $7,722. As with our other compounding and present-value tables, given any three of the four unknowns in equation 5-10, we can solve for the fourth. In the case of the present-value of-an-annuity table, we may be interested in solving for PMTif we know i, n, and PV.The CALCULATOR SOLUTION financial interpretation of this action would be: How much can be withdrawn, perhaps as Data Input Function Key a pension or to make loan payments, from an account that earns i percent compounded 5 N annually for each of the next n years if we wish to have nothing left at the end of ii years? 8 I/Y For an example, if we have $5,000 in an account earning 8 percent interest, how large an 5,000 PV annuity can we draw out each year if we want nothing left at the end of five years? In this o FV case, the present value, pv, of the annuity is $5,000, n = 5 years, i = 8 percent, and PMT is unknown. Substituting this into equation 5-10, we find Function Key Answer (PT $5,000 = PMT(3.993) PMT -1,252.28 $1,252.19 = PMT
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CHAPTER 5 THE TIME VALUE OF MONEY 157 Thus, this account will fall to zero at the end of five years if we withdraw $1,252.19 atthe end of each year. - -- i CONCEPT CHECK 1 1. How could you determine the future value of a three-year annuity using the formula for the future value of a single cash flow? I 2. What is the PVIFA 100f0,3yr/ Now add up the values for the PVIF10010 ,rryrs for L = n 1, 2, and 3. What is this value? Why do these values have the rela tionship they do? ANNUITIES DUE o b j ec Ii v e -.!JBecause annuities due are really just ordinary annuities in which all the annuity paymentshave been shifted forward by one year, compounding them and determining their presentvalue is actually quite simple. Remember, with an annuity due, each annuity paymentoccurs at the beginning of each period rather than at the end of the period. Lets first lookat how this affects our compounding calculations. Because an annuity due merely shifts the payments from the end of the year to thebeginning of the year, we now compound the cash flows for one additional year.Therefore, the compound sum of an annuity due is simply FVn(annuity due) = PMT(FV1FA i,n)(l + i) For example, earlier we calculated the value of a five-year ordinary annuity of $500invested in the bank at 6 percent to be $2,818.50. If we now assume this to be a five-yearannuity due, its future value increases from $2,818.50 to $2,987.61. FVs = $500 (FV1F4>%,syrs)(1 + .06) = $500 (5.637)(1.06) = $2,987.61 Likewise, with the present value of an annuity due, we simply receive each cash flowone year earlier-that is, we receive it at the beginning of each year rather than at the endof each year. Thus, since each cash flow is received one year earlier, it is discounted backfor one less period. To determine the present value of an annuity due, we merely need tofind the present value of an ordinary annuity and multiply that by (l + 1), which in effectcancels out one years discounting. PV(annuity due) = PMT(PV1FA i,n)(l + i) Reexamining the earlier example where we calculated the present value of a five-yearordinary annuity of $500 given an appropriate discourii: rate of 6 percent, we now findthat if it is an annuity due rather than an ordinary annuity, the present value increasesfrom $2,106 to $2,232.36. PV = $500 (PV1F4>%,syrs)(l + .06) =~$500 (4.212)(1.06) = $2,232.36 The result of all this is that both the future and present values of an annuity due arelarger than that of an ordinary annuity because in each case all payments are receivedearlier. Thus, when compounding an annuity due, it compounds for one additional year;
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158 PART:2 VALUATION OF FINANCIAL ASSETS whereas when discounting an annuity due, the cash flows are discounted for one less year. Although annuities due are used with some frequency in accounting, their usage is quite limited in finance. Therefore, in the remainder of this text, whenever the term,annuity is used, you should assume that we are referring to an ordinary annuity. . EXAMPLE: PRESENT VALUE OF AN ANNUITY DUE The VIrginia State Lottery runs like most other state lotteries: You must select six out of 44 numbers correctly in order to win the jackpot. If you come close, there are some sig nificantly lesser prizes-we will ignore them for now. For each million dollars in the lot tery jackpot, you receive $50,000 per year for 20 years, and your chance of winning is 1 in 7.1 million. One of the recent advertisements for the Virginia State Lottery went as follows: "Okay, you got two kinds of people. Youve got the kind who play Lotto all the time and the kind who play Lotto some of the time. You know, like only on a Saturday when they stop in at the store on the cbmer for some peanut butter cups and diet soda and the jackpot happens to be really big. I mean, my friend Ned? Hes like, Hey, its only 2 million dollars this week. Well, hellloooo, anybody home? I mean, I dont know about you, but I wouldnt mind having a measly 2 mill coming my way...." What is the present value of these payments? The answer to this question depends upon what assumption you make as to the time value of money-in this case, lets assume that your required rate of return on an investment with this level of risk is ° 1 percent. Keep in mind that the Lotto is an annuity due-that is, on a $2 million lot tery you would get $100,000 immediately and $100,000 at the end of each of the next 19 years. Thus, the present value of this 20-year annuity due discounted back to present at 10 percent becomes: PV~nnujty due = PMT(PVIFA i%,lIyrs)(l + 1) = $100,000 (PVIFA IO%,2Oyrs)(l + .10) = $100,000 (8.514)(1.10) = $851,400 (1.10) =$936,540 Thus, the present value of the $2 million Lotto jackpot is less than $1 million if ° 1 percent is the appropriate discount rate. Moreover, because the chance of win ning is only 1 in 7.1 million, the expected value of each dollar "invested" in the lot tery is only (1/7.1 million) x ($936,540) = 13 .19 cents. That is, for every dollar you spend on the lottery, you should expect to get (on average) about 13 cents back-not a particularly good deal. Although this ignores the minor payments for corning close, it also ignores taxes. In this case, it looks like "my friend Ned" is doing the right thing by staying clear of the lottery. Obviously, the main value of the lottery is entertainment. Unfortunately, without an understanding of the time value of money, it can sound like a good investment. , I CONCEPT CHECK 1. How does an annuity due differ from an ordinary annuity? 2. Why are both the future and present values greater for an annuity due ! than for an ordinary annuity? - -
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CHAPTER 5 THE TIME VALUE OF MONEY 159 AMORTIZED LOANS The procedure of solving for PMT is also used to determine what payments are associ ated with paying off a loan in equal installments over time. Loans that are paid off this way, in equal periodic payments, are called amortized loans. For example, suppose you Amortized loan want to buy a used car. To do this, you borrow $6,000 to be repaid in four equal payments A loan paid off in equal at the end of each of the next four years, and the interest rate that is paid to the lender is installments. 15 percent on the outstanding portion of the loan. To determine what the annual pay CALCULATO R SOLUTI ON ment associated with the repayment of this debt will be, we simply use equation 5-1 0 and solve for the value of PMT, the annual annuity. Again, we know three of the four values in Data Input Function Key that equation, pv, i, and n. pv, the present value of the future annuity, is $6,000; i, the 4 N annual interest rate, is 15 percent; and n, the number of years for which the annuity will 15 I/Y last, is four years. PMT, the annuity payment received (by the lender and paid by you) at 6.000 PV the end of each year, is unknown. Substituting these values into equation 5-10, we find 0 FVIq Function Key Answer1 $6,000 " PMT[~ (1 + 5)] CPT PMT -2.101.59 $6,000 PMT(PVlFA I5 %,4yrs) $6,000 PMT(2.855) $2,101.58 PMT To repay the principal and interest on the outstanding loan in four years, the annual pay ments would be $2,101.58. The breakdown of interest and principal payments is given in , the loan amortization schedule in Table 5-10, with very minor rounding errors. As you Loan amortization can see, the interest payment declines each year as the loan outstanding declines, and schedule A breakdown of loan payments more of the principal is repaid each year. into interest and principal payments: CONCEPT CHECK 1. What is an amortized loan? 1--=_ . A~-:-e-Ii:--C-=lr--D-CE~r-F=:1r---G~I=-~I~ N.!".L~t:Sl()o~..!.l.-a--"~!L.~rn,()~g.~~!!.PLoblem~~menl. occur !"-,,~!.h!Y.-"-~0.g..!.."lre~h,~~t . r -,.. +- - l --:J - +-- i-- Spreadsheet.: Ihe Loan Amortization Problem I I 1 ~~..!y..a new h()~~.you ~e O.l!1.a~ear ,,!.ortg".9~..fo!.~HlQ.~._ wo" "",. m~-"m."" """"-"-"",",eo ~. I~~_y~~~ga.g~s ~.~ercef!t? _ -1- ~__.~ lOT;"" things io1~epJn mind ~~;-Y:ouIeworkjli:gThi"P!;;.t,le:m; .fir.,I: _ l_- - . . JOY~ . L d - ~--=-= .J _ 11: h~l~.~()n.ve.rt..he "Q.l}.u~Lra!~o!,8y~.ce.r!.t.Jnlo .a .rn-"nl1:>lyr"I~_~Lc!iviEi!.g il. f.2 ~y.J] .. ~Ls~s.Qnc!.yo.!1Iha~e.!~.con~~rt.th~ n~,!,~.r of p~~o~s !~to.",o,n!.hs 14 ~L!.UI!iPJy,ing1?,ti.m.~~.!2,fo!.~~t~of~.mo.n.h"c, - .;. f- - -+-. -- ~ , . 3;Or ~_.__ 1-± = ~ L ._ +-=- ~ -= 15 E~c.~U~l1llula: _=.I:IMT(~.te ,number prya.nq~,prasent value ,fulure valua ,Iypel } _ +- _ -1 _ =·...Fi Lr.~"i.(Q.:tBo/;;h2:"" --_ .... - OrJl"!i!.c!~.tn)r.,., 17 - 16 Ji __ ..;umber __ -+- . 19 _ Pl~~,~~lu..JI=V)=j $1~,c.JO; . - . t _ ~ L..~!~.". ~!~.(f.1..:7 ~.• ,$JJ._~" -.J-- 20. - . ~,_, ~~j::t~~r~j)·=-r- . ~ -- _ ••• -! - , E:nlaradval!!s.i!.,C.lUf~:::P.1!l1:<@f.12J.~~f·~19.~-,-d;!1)_ ~I - - f I ___ ._• .1. L--. - . --t _ 25l..._,,!qnh.I~.!2.!19-"9~eaY.!!.~:71 iJ171.B2 --.- _. __ "!P,I~.e.t~~~!!)~.nl~Y.p.!Y",a~s.!!"-U.n.-".!,9!I,~.~,IY" ~ 29,~ay~_e.m.4- bSheetl ~ -- I + . h beca!!u."!- I : i_roll.·. __ T -r- . .. ..- -
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160 PART 2 VALUATION OF FINANCIAL ASSETS TABLE 5-10 Loan Amortization Schedule Involving a $6.000 Loan at 15 Percent to Be Repaid in Four Years REPAYMENT OF OUTSTANDING INTEREST PORTION THE PRINCIPAL LOAN BALANCE OF THE PORTION OF AFTER THE YEAR ANNUITY ANNUITY" THE ANNUlTyb ANNUITY PAYMENT 1 $2,101.58 $900.00 $1,201.58 $4,798.42 2 2,101.58 719.76 1,381.82 3,416.60 3 2,101.58 512.49 1,589.09 1,827.51 4 2,101.58 274.07 1,827.51 The interest portion of the annuity is calculated by multiplying the outstanding loan balance at the beginning of the year by the interest rate of 15 percent. Thus, for year 1 it was $6,000.00 x .15 = $900.00. for year 2 it was $4,798.42 x .15 = $719.76. and so on. bRepayment of the principal portion of the annuity was calculated by subtracting the interest portion of the annuity (column 2) from the annuity (column 1). Objective ~ PRESENT VALUE OF COMPLEX STREAM Although some projects will involve a single cash flow and some annuities, many projects will involve uneven cash flows over several years. Chapter 9, which examines iiwestments in fixed assets, presents this situation repeatedly. There we will be comparing not only the present value of cash flows between projects, but also the cash inflows and outflows within a particular project, trying to determine that projects present value. However, this will not be difficult because the present value of any cash flow is measured in todays dol
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CHAPTER 5 THE TIME VALUE OF MONEY 161 TABLE 5-11 Illustration of an Example of Present Value of an Uneven Stream Involving One Annuity Discounted to Present at 6 PercentYEAR 0 1 2 3 4 5 6 7 8 9 10Dollars received at end of year 500 200 --400 500 500 5DO 500 500 500 500 $ 471.50 ~ I 178.00 -336.00 : I $2,791 $2,344.44 OIl( ITotal present value $2,657.94lars and thus can be compared, through addition for inflows and subtraction for outflows,to the present value of any other cash flow also measured in todays dollars.YEAR CASH FLOW YEAR CASH FLOW1 $50b 6 $5002 200 7 5003 -400 8 5004 500 9 5005 500 10 500For example, if we wished to find the present value of the cash flows provided abovegiven a 6 percent discount rate, we would merely discount the flows back to the pres ent and total them by adding in the positive flows and subtracting the negative ones.However, this problem also contains the annuity of $500 that runs from years 4through 10. To accommodate this, we can first discount the annuity back to the begin ning of period 4 (or end of period 3) by multiplying it by the value of PVIFA 6%,7yrs andget its present value at that point in time. We then multiply this value times thePVIF6%,3yrs in order to bring this single cash flow (which is the present value of theseven-year annuity) back to the present. In effect, we discount twice-first back to theend of period 3, then back to the present. This is shown graphically in Table 5-11 andnumerically in Ta ble 5-12. Thus, the present value of this uneven stream of cash flowsis $2,657.94. TABLE 5-12 Determination of the Present Value of an Uneven Stream Involving One Annuity Discounted to Present at 6 Percent1. Present value of $500 received at the end of 1 year = $500(.943) = $ 471.502. Present value of $200 received at the end of 2 years = $200(.890) = 178.003. Present value of a $400 outflow at the end of 3 years =-$400(.840) = -336.004. (a) Value at the end of year 3 of a $500 annuity, years 4 through 10 = $500(5.582) = $2,791 (b) Present value of $2,791 received at the end of year 3 = $2,791 (.840) = $2,344.445. Tot:: present value = $2,657.94
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162 PART 2 VALUATION OF FINANCIAL ASSETS .~ EXAMPLE: PRESENT VALUE OF MULTIPLE CASH FLOWS What is the present value of an investment involving $200 received at the end of years 1 through 5, a $300 cash outflow at the end of year 6, and $500 received at the end of years 7 through 10, given a 5 percent discount .:ate? Here we have two annuities, one that can be discounted directly back to the present by multiplying it by the value of the PVlFA 5%,s}TS and one that must be discounted twice to bring it back to the present. This second annuity, which is a four-year annuity, must first be discounted back to the beginning of period 7 (or end of period 6) by multiplying it by the value of the PVIFA S%,4vrs Then the present value of this annuity at the end of period 6 (which can as be viewed a single cash flow) must be discounted back to the present by multiplying it by the value of the PVIFS%,6yrs To arrive at the total present value of this investment, we subtract the present value of the $300 cash outflow at the end ofyear 6 from the sum of the present value of the two annuities. Table 5-13 shows this graphically; Table 5-t4 gives the calculations. Thus, the present value of this series of cash flows is $1,964.66. Remember, once the cash flows from an investment have been brought back to present they can be combined by adding and subtracting to determine the projects total present value. TABLE 5-13 Illustration of an Example of Present Value of an Uneven Stream Involving Two Annuities Discounted to Present at 5 PercentYEAR 0 2 3 4 5 6 7 8 9 10Dollars received at end of year 200 200 200 200 200 -300 500 500 500 500 I I lLLJ $ 865.80: -223.80 I $1,773 1,322.66 .... !Total present value $1,964.66 TABLE 5-14 Determination of Present Value of an Example with Uneven Stream Involving Two Annuities Discounted to Present at 5 Percent 1. Present value of first annuity, years 1 through 5 = $200(4.329) = $ 865.80 2. Present value of $300 cash outflow = -$300(.746) = -223.80 3. (a) Value at end of year 6 of second annuity, years 7 through 10 = $500(3.546) = $1,773 = (b) Present value of $1,773 received at the end of year 6 $1,773(.746) = 1,322.66 4. Total present value = $1,964.66 CONCEPT CHECK 1. If you wanted to calculate the present value of an investment that pro duced cash flows cif $100 received at the end of year 1 and $700 at the end of year 2, how wou Id you do it?
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CHAP TE R 5 THE TIM E VA LUE 0 F M0 NEY 163 PER PET U I TIE SAN 0 I NFl N I TE ANN U IT I E S Objective -.!JAperpetuity is an annuity that continues forever; that is, every year from its establish Perpetuityment, this investment pays the same dollar amount. An example of a perpetuity is pre An annuity that continues forever.ferred stock that yields a constant dollar dividend infinitely. Determining the presentvalue of a perpetuity is delightfully simple; we merely need to divide the constant flow bythe discount rate. l For example, the present value of a $100 perpetuity discounted back tothe present at 5 percent is $100/.05 = $2,000. Thus, the equation representing the presentvalue of a perpetuity is PV = PP 1 (5-11)where PV = the present value of the perpetuity PP = the constant dollar amount provided by the perpetuity i = the annual interest (or discount) rateEXAMPLE: PRESENT VALUE OF A PERPETUITYWhat is the present value of a $500 perpetuity discounted back to the present at 8 percent? Substituting PP = $500 and i = .08 into equation (5-11), we find PV = $500 = $6250 .08 Thus, the present value of this perpetuity is $6,250.1- ~ --~ ~-- CONCEPT CHECK 1. What is a perpetuity? 2. When i, the annual interest (or discount) rate, increases, what happens to the present value of a perpetuity? Why?I -- - - - ... MAKING INTEREST RATES COMPARABLE Objective l!JIn order to make intelligent decisions about where to invest or borrow money, it isimportant that we make the stated interest rates comparable. Unfortunately, some ratesare quoted as compounded annually, whereas others are quoted as compounded quarterlyor compounded daily. But we already know that it is not fair to compare interest rateswith different compounding periods to each other. Thus, the only way interest rates canlogically be compared is to convert them to some common compounding period and thencompare them. That is what is done with the annual percentage yield. In order to under stand the pmcess of making different interest rates comparable, it is first necessary to Nominal or quoteddefine the nominal or quoted interest rate. interest rate The nominal or quoted rate is the rate of interest stated on the contract. For example, if The stated rate of interest onyou shop around for loans and are quoted 8 percent compounded annually and 7.85 percent the contract.I See Chapter 8 for a mathematical derivation,
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164 PART 2 VALUATION GF FINANCIAL ASSETS compounded quarterly, then 8 percent and 7.85 percent would both be nominal rates. Unfortunately, because on one the interest is compounded annually, but on the other inter est is compounded quarterly, they are not comparable. In fact, it is never appropriate to com pare nominal rates unless they include the same number of compounding periods per year. To make them comparable, we must calculate their equivalent rate at some common comA~nual percentage yield pounding period. We do this by calculating the annual percentage yield (APY) or(APY) or effective annual effective annual rate (EAR). This is the annual compound rate that produces the samerate (EAR) return as the nominal or quoted rate.The annual compound ratethat produces the same return Lets assume that you are considering borrowing money from a bank at 12 percentas the nominal or quoted rate. compounded monthly. To convert this to an APY, we must determine the annual rate that would produce the same return as the nominal rate. In the case of a 12 percent loan com pounded monthly, by looking in the FVIF table in the back of the book, we see that the future value of $1 in one year at 12 percent compounded monthly (that is, compounded at 1 percent per month for 12 one-month periods) is $1.1268 (FVIF1%.12periods = 1.1268). This tells us that 12.68 percent is t..~e APY, because if we compound $1 at the nominal rate of 12 percent compounded monthly, we would have $1.1268 after one year. Generalizing on this process, we can calculate the APY using the following equation: APYor EAR = (1 + quoted rate/m)1n - 1 (5-12) where APYor EAR is the annual percentage yield and m is the number of compounding periods within a year. Given the wide variety of compounding periods used by businesses and banks, it is important to know how to make these rates comparable so that logical decisions can be made. Objective -.!J TH EMU LTIN AT ION A L FIR M: THE TIME VALUE OF MONEY From Principle 1: The Risk-Return Tradeoff-We wont take on additional risk unless we expect to be compensated with additional return, we found that investors demand a return for delaying consumption, as well as an additional return for taking on added risk. The discount rate that we use to move money through time should reflect this return for delaying consumption; and it should reflect anticipated inflation. In the United States, anticipated inflation is quite low, although it does tend to fluctuate over time. Elsewhere in the world, however, the inflation rate is difficult to predict because it can be dramatically high and undergo huge fluctuations. Lets look at Argentina, keeping in mind that similar examples abound in Central and South America and Eastern Europe. At the beginning of 1992, Argentina intro duced the fifth currency in 22 years, the new peso. The austral, the currency that was replaced, was introduced in June 1985 and was initially equal in value to $1.25, U.S. currency. Five and a half years later, it took 100,000 australs to equal $1. Inflation had reached the point where the stack of money needed to buy a candy bar was bigger and weighed more than the candy bar itself, and many workers received their weeks wages in grocery bags. Needless to say, if we were to move australs through time, we would have to use an extremely high interest or discount rate. Unfortunately, in countries suffering from hyperinflation, inflation rates tend to fluctuate dramatically, and this makes estimating the expected inflation rate even more difficult. For example, in 1989 the inflation rate in Argentina was 4,924 percent; in 1990 it dropped to 1,344 percent; in 1991 it was only 84 percent; in 1992, only 18 percent; and in 1997 it had fallen to 0.3 percent. However, as inflation in Argentina dropped, inflation in Brazil heated up, going from 426 percent in 1991 to 1,094 percent in 1995, and finally coming under control in 1999 and 2000. But while inflation in one area of the world is finally con
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CHAPTER 5 THE TIME VALUE OF MONEY 165 trolled, it pops up in another area-for example, in mid-2000 inflation in Turkey was over 60 percent. Finally, at the extreme, in 1993 in Serbia the inflation rate reached 360,000,000,000,000,000 percent. The bottom line on all this is that because of the dramatic fluctuations in inflation that can take place in the international setting, choosing the appropriate discount rate of moving money through time is an extremely difficult process. CONCEPT CHECK 1. How does the international setting complicate the choice of the appropri ate interest rate to use when discounting cash flows back to the present? HOW FINANCIAL MANAGERS USE THIS MATERIALAlmost all business decisions involve cash flow occurring in different time periods. It isthe techniques and tools introduced in this chapter that allow you to compare these cashflows and, therefore, make the appropriate decision. Perhaps youll work for Marriott andyoull be deciding whether to build a hotel resort or some new time-share units on thebeachfront land Marriott owns on Hilton Head Island. Thats a decision that involvesspending the money right now to build the complex and then, sometime in the future,either selling the time-share units or receiving rent from tourists at the new hotel resort.Its an understanding of the time value of money that allows you to compare these cashflows that occur in different time periods. In fact, any time youre evaluating a new prod uct, the time value of money comes into play. In short, there isnt another tool in businessthat is more essential to making good decisions. As you will see later, the time value of money also plays a central role in determiningthe price that a share of common stock sells for. That is to say, it was an understanding ofthe time value of money that allowed the folks at Friendly Ice Cream to determine thatFriendlys common stock should be offered to the public at $18 per share when it was firstsold. Those same people use the time value of money to determine how much theyshould save for their childrens college education and for retirement, and whether theyshould refinance their home mortgage. Truly, the concept of the time value of money isone that not only affects all corporate finance decisions, but also affects all personalfinance decisions.IITo make decisions, financial managers must compare the costs and benefits of alternativesthat do not occur during the same time period. Whether to make profitable investments or totake advantage of favorable interest rates, financial decision making requires an understanding of the time value of money. Managers who use the time value of money in all of theirfinancial calculations assure themselves of more logical decisions. The time value process firstmakes all dollar values comparable; because money has a time value, it moves all dollar flowseither back to the present or out to a common future date. All time value formulas presentedin this chapter actually stem from the single compounding formula FVn = PV(l + i)n. The formulas are used to deal simply with common financial situations, for example, discounting single flows, compounding annuities, and discounting annuities. Table 5-15 provides a summaryof these calculations.
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166 PART 2 VALUATION OF FINANCIAL ASSETS TABLE 5-15 Summary of Time Value of Money Equations a CALCULATION EQUATION .-!JObjectiveO.b j e c ti ve -.!J Future value of a single payment Future value of a single payment with nonannual compounding FIIn = PV(l + ;r FIIn = PV(l + I)n or PV(FIIIFi,n) nObjective -.!J Present value of a single payment PV Fn (1 [ _ l ] or FVn(PVIFi) V + ilnObjective --.!.J Future value of an annuity FIIn = PMT[~ (1 ~ + iJ1] or PMT(FIIIFA.~n) 1=0Objective -.!J Present value of an annuity PV = PMT[t (1 1=1 ~ iJ1] or PMT{PVIFA i) Present value of a perpetuity PV = PF: 1Objective --.!J Annual percentage yield (APY) APY = [ 1 + quoted rate m Jm Notation: FIIn = the future value of the investment at the end of n years n = the number of years until payment will be received or during which compounding occurs i = the annual interest or discount rate PV= the present value of the future sum of money m = the number of times compounding occurs during the year PMT = the annuity payment deposited or received at the end of each year PP= the constant dollar amount provided by the perpetuity Related tables appear in Appendices B through E at the end of the book. AJnortizedloan, 159 Future-value interest Ordinary annuity, 151 Annual percentage yield factor (FVIFi ,,), 141 Perpetuity, 163Go To: (APY) or effective Future-value interest Present value, 147www.prenllall.comlkeowll annual rate (EAR), 164 factor for an annuityfor downloads and current Present-value interest Annuity, 150 (FVIFAi,,,) 151even ts associated with this factor (PVIFi,,,) 148 Annuity due, 151 Loan amortizationchapter Present-value interest schedule, 159 Compound annuity, 151 factor for an annuity Nominal or quoted (PVIFA i ,,), 155 Compound interest, 138 interest rate, 163 . STUDY QUESTIONS 5-1. What is the time value of money? Why is it so important? 5-2. The processes of discounting and compounding are related. Explain this relationship. 5-3. How would an increase in the interest rate (I) or a decrease in the holding period (n) affect the future value (FVn ) of a sum of money? Explain why. 5-4. Suppose you were considering depositing your savings in one of three .banks, all of which pay 5 percent interest; bank A compounds annually, bank B compounds semiannually, and bank C compounds daily. Which bank would you choose? Why?
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CHAPTER 5 THE TIME VALUE OF MONEY 1675-5. What is the relationship between the PVIFi,n (Table 5-4) and the PVIFAi,n (Table 5-8)?What is the PVIFA 1O%.lOyr/ Add up the values of the PVIF10 %,1I for n = 1, ... , 10. What is thisvalue? Why do these values have the relationship they do?5-6. What is an annuity? Give some examples of annuities. Distinguish between an annuity andaperpetuity. S,E-LF?rEs t pR0 BfE.lVf$, . . ,c,ST-l. You place $25,000 in a savings account paying annual compound interest of 8 percent forthree years and then move it into a savings account that pays 10 percent interest compoundedannually. How much will your money have grown at the end of six years?ST-2. You purchase a boat for $35,000 and pay $5,000 down and agree to pay the rest over thenext 10 years in 10 equal annual payments that include principal payments plus 13 percent ofcompound interest on the unpaid balance. What will be the amount of each payment?ST-3. For an investment to grow eightfold in nine years, at what rate would it have to grow? II5-1A. (Compound interest) To what amount will the following investments accumulate? a. $5,000 invested for 10 years at 10 percent compounded annually b. $8,000 invested for 7 years at 8 percent compounded annually c. $775 invested for 12 years at 12 percent compounded annually d. $21,000 invested for 5 years at 5 percent compounded annually5-2A. (Compound value solvingfor n) How many years will the following take? a. $500 to grow to $1,039.50 if invested at 5 percent compounded annually b. $35 to grow to $53.87 if invested at 9 percent compounded annually c. $100 to grow to $298.60 if invested at 20 percent compounded annually d. $53 to grow to $78.76 if invested at 2 percent compounded annually5-3A. (CrrmpouruJ. value solvingfol i) At what annual rate would the following have to be invested? a. $500 to grow to $1,948.00 in 12 years b. $300 to grow to $422.10 in 7 years c. $50 to grow to $280.20 in 20 years d. $200 to grow to $497.60 in 5 years5-4A. (Present value) What is the present value of the following future amounts? a. $800 to be received 10 years from now discounted back to the present at 10 percent b. $300 to be received 5 years from now discounted back to the present at 5 percent c. $1,000 to be received 8 years from now discounted back to the present at 3 percent d. $1,000 to be received 8 years from now discounted back to the present at 20 percent5-5A. (Compound annuity) What is the accumu,lated sum of each of the following streams ofpayments? a. $500 a year for 10 years compounded annually at 5 percent b. $100 a year for 5 years compounded annually at 10 percent c. $35 a year for 7 years compounded annually at 7 percent d. $25 a year for 3 years compounded annually at 2 percent5-6A. (Present value ofan annuity) What is the present value of the following annuities? a. $2,500 a year for 10 years discounted back to the present at 7 percent b. $70 a year for 3 years discounted back to the present at 3 percent c. $280 a year for 7 years discounted back to the present at 6 percent d. $500 a year for 10 years discounted back to the present at 10 percent
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168 PART 2 VALUATION OF FINANCIAL ASSETS 5-7A. (Compound value) Brian Mosallam, who recently sold his Porsche, placed $10,000 in a savings account paying annual compound interest of 6 percent. a. Calculate the amount of money that will have accrued if he leaves the money in the bank for 1, 5, and 15 years. b. If he moves his money into an account that pays 8 percent or one that pays 10 percent, rework part (a) using these new interest rates. c. What conclusions can you draw about the relationship between interest rates, time, and future sums from the calculations you have done above? 5-8A. (Compound interest with nonannual periods) Calculate the amount of money that will be in each of the following accounts at the end of the given deposit period: ANNUAL COMPOUNDING PERIOD DEPOSIT AMOUNT INTEREST (COMPOUNDED EVERY PERIOD ACCOUNT DEPOSITED RATE _MONTHS) (YEARS) Theodore Logan III $ 1,000 10% 12 10 Vernell Coles 95,000 12 1 1 Thomas Elliott 8,000 12 2 2 Wayne Robinson 120,000 8 3 2 Eugene Chung 30,000 10 6 4 Kelly Cravens 15,000 12 4 3 5-9A. (Compound interest with nonannual periods) a. Calculate the future sum of $5,000, given that it will be held in the bank five years at an annual interest rate of 6 percent. b. Recalculate part (a) using a compounding period that is (1) semiannual and (2) bimonthly. c. Recalculate parts (a) and (b) for a 12 percent annual interest rate. d. Recalculate part (a) using a time horizon of 12 years (annual interest rate is still 6 percent). e. With respect to the effect of changes in the stated interest rate and holding periods on future sums in parts (c) and (d), what conclusions do you draw when you compare these figures with the answers found in parts (a) and (b)? 5-10A. (Solvingfor i in annuities) Nicki Johnson, a sophomore mechanical engineering student, receives a call from an insurance agent who believes that Nicki is an older woman ready to retire from teaching. He talks to her about several annuities that she could buy that would guarantee her an annual fixed income. The annuities are as follows: INITIAL PAYMENT INTO DURATION ANNUITY AMOUNT OF MONEY OF ANNUITY ANNUITY (AT t = 0) RECEIVED PER YEAR (YEARS) A $50.000 $8,500 12 B 60,000 7,000 25 C 70,000 8,000 20 If Nicki could earn 11 percent on her money by placing it in a savings account, should she place it instead in any of the annuities? Which ones, if any- Why? 5-11A. (Future value) Sales of a new finance book were 15,000 copies this year and were expected to increase by 20 percent per year. What are expected sales during each of the next three years? Graph this sales trend and explain. 5-12A. (Future value) Reggie Jackson, formerly of the New York Yankees, hit 41 home runs in 1980. If his home-run output grew at a rate of 10 percent per year, what would it have been over the following five years 5-13A. (Loan amortization) Mr. Bill S. Preston, Esq., purchased a new house for $80,000. He paid $20,000 down and agreed to pay the rest over the next 25 years in 25 equal annual payments that include principal payments plus 9 percent compound interest on the unpaid balance. What will these equal payments be?
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CHAPTER 5 THE TIME VALUE OF MONEY 1695-14A. (Solvingftr PMT in an annuity) To pay for your childs education, you wish to have accumulated $15,000 at the end of 15 years. To do this, you plan to deposit an equal amount into thebank at the end of each year. If the bank is willing to pay 6 percent compounded annually, howmuch must you deposit each year to obtain your goal?5-15A. (Solvingfor i in compound interest) If you were offered $1,079.50 10 years from now inreturn for an investment of $500 currently, what annual rate of interest would you earn if youtook the offer?5-16A. (Future value ofan annuity) In 10 years, you plan to retire and buy a house in Oviedo,Florida. The house you are looking at currently costs $100,000 and is expected to increase invalue each year at a rate of 5 percent. Assuming you can earn 10 percent annually on your investments, how much must you invest at the end of each of the next 10 years to be able to buy yourdream home when you retire?5-17A. (Compound value) The Aggarwal Corporation needs to save $10 million to retire a$10 million mortgage that matures in 10 years. To retire this mortgage, the company plans to puta fixed amount into an account at the end of each year for 10 years. The Aggarwal Corporationexpects to earn 9 percent annually on the money in this account. What equal annual contributionmust it make to this account to accumulate the $10 million by the end of 10 years?5-18A. (Compound interest with nonannual periods) After examining the various personal loan ratesavailable to you, you find that you can borrow funds from a finance company at 12 percent compounded monthly or from a bank at 13 percent compounded annually. Which alternative is themost attractive?5-19A. (Present value ofan uneven stream ofpayments) You are given three investment alternativesto analyze. The cash flows from these three investments are as follows:InvestmentEND OF YEAR A B c 1 $10,000 $10,000 2 10,000 3 10,000 4 10,000 5 10,000 $10,000 6 10,000 50,000 7 10,000 8 10,000 9 10,00010 10,000 10,000Assuming a 20 percent discount rate, find the present value of each investment.5-20A. (Present value) The Kumar Corporation plans to issue bonds that pay no interest butcan be converted into $1,000 at maturity, seven years from their purchase. To price thesebonds competitively with other bonds of equal risk, it is determined that they should yield10 percent, compounded annually. At what price should the Kumar Corporation sell thesebonds?5-21A. (Perpetuities) What is the present value of the following? a. A $300 perpetuity discounted back to the present at 8 percent b. A $1,000 perpetuity discounted back to the present at 12 percent c. A $100 perpetuity discounted back to the present at 9 percent d. A $95 perpetuity discounted back to the present at 5 percent5-22A. (Present value of an annuity due) What is the present value of a 10-year annuity due of$1,000 annually given a 10 percent discount rate?5-23A. (Solvingftr n with nonannual periods) About how many years would it take for your investment to grow fourfold if it were invested at 16 percent compounded semiannually?5-24A. (Present value ofan uneven stream ofpayments) You are given three investment alternativesto analyze. The cash flows from these three investments are as follows:
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170 PART 2 VALUATION OF FINANCIAL ASSETS Investment END OF YEAR A B C 1 $2,000 $2,000 $5,000 2 3,000 2,000 5,000 3 4,000 2,000 -5,000 4 -5,000 2,000 -5,000 5 5,000 5,000 15,000 ° What is the present value of each of these three investments if 1 percent is the appropriate dis count rate? 5-25A. (Crrmplex present value) How much do you have to deposit today so that beginning 11 years from now you can withdraw $10,000 a year for the next five years (periods 11 through 15) plus an additional amount of $20,000 in the last year (period 15)? Assume an interest rate of 6 percent. 5-26A. (Loan amortization) On December 31, Beth Klernkosky bought a yacht for $50,000, paying $10,000 down and agreeing to pay the balance in 10 equal annual installments that include both the ° principal and 1 percent interest on the declining balance. How big would the annual payments be? 5-27A. (Solvingfor i in an annuity) You lend a friend $30,000, which your friend will repay in five equal annual payments of $10,000, with the first payment to be received one year from now. What rate of return does your loan receive? 5-28A. (Solving for i in crrmpound interest) You lend a friend $10,000, for which your friend will repay you $27 ,027 at the end of five years. What interest rate are you charging your "friend"? 5-29A. (Loan amortization) A firm borrows $25,000 from the bank at 12 percent compounded annually to purchase some new machinery. This loan is to be repaid in equal annual installments at the end of each year over the next five years. How much will each annual payment be? 5-30A. (Present-value comparison) You are offered $1,000 today, $10,000 in 12 years, or $25,000 in 25 years. Assuming that you can earn 11 percent on your money, which should you choose? 5-31A. (Crrmpound annuity) You plan to buy some property in Florida five years from today. To do this, you estimate that you will need $20,000 at that time for the purchase. You would like to accu mulate these funds by making equal annual deposits in your savings account, which pays 12 percent annually. If you make your first deposit at the end of this year, and you would like your account to reach $20,000 when the final deposit is made, what will be the amount cif your deposits? 5-32A. (Complex present value) You would like to have $50,000 in 15 years. To accumulate this amount, you plan to deposit each year an equal sum in the bank, which will earn 7 percent inter est compounded annually. Your first payment will be made at the end of the year. a. How much must you deposit annually to accumulate this amount? b. Ifyou decide to make a large lump-sum deposit today instead of the annual deposits, how large should this lump-sum deposit be? (Assume you can earn 7 percent on this deposit.) c. At the end of five years, you will receive $10,000 and deposit this in the bank toward your goal of $50,000 at the end of 15 years. In addition to this deposit, how much must you deposit in equal annual deposits to reach your goal? (Again, assume you can earn 7 per cent on this deposit.) 5-33A. (Crrmprehensive present value) You are trying to plan for retirement in 10 years and currently you have $100,000 in a savings account and $300,000 in stocks. In addition, you plan to add to your savings by depositing $10,000 per year in your savings account at the end of each of the next five years and then $20,000 per year at the end of each year for the final five years until retirement. a. Assunling your savings account returns 7 percent compounded annually and your invest ment in stocks will return 12 percent compounded annually, how much will you have at the end of 10 years? (Ignore taxes.) b. If you expect to live for 20 years after you retire, and at retirement you deposit all ofyour savings in a bank account paying 10 percent, how much can you withdraw each year after retirement (20 equal withdrawals beginning one year after you retire) to end up with a zero balance at death? 5-34A. (Loan amortization) On December 31, Son-Nan Chen borrowed $100,000, agreeing to repay this sum in 20 equal annual installments that include both the principal and 15 percent interest on the declining balance. How large will the annual payments be?
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CHAPTER 5 THE TIME VALUE OF MONEY 1715-35A. (Loan amortiz.ation) To buy a new house you must borrow $150,000. To do this, you takeout a $150,000, 30-year, 10 percent mortgage. Your mortgage payments, which are made at theend of each year (one payment each year), include both principal and 10 percent interest on thedeclining balance. How large will your annual payments be? 5-36A. (Present value) The state lottel)"s million-dollar payout provides for $1 million to be paid.over 19 years in $50,000 amounts. The first $50,000 payment is made immediately and the 19 remaining $50,000 payments occur at the end of each of the next. 19 years. If 10 percent is the appropriate discount rate, what is the present value of this stream of cash flows? If 20 percent is the appropriate discount rate, what is the present value of the cash flows? 5-37A. (Compounding an annuity due) Find the future value at the end of year 10 of an annuity due of$I,OOO per year for 10 years compounded annually at 10 percent. What would be the future value of this annuity if it were compounded annually at 15 percent? 5-38A. (Present value ofan annuity due) Determine the present value of an annuity due of $1,000 per year for 10 years discounted back to the present at an annual rate of 10 percent. What would be the present value of this annuity due if it were discounted at an annual rate of 15 percent? 5-39A. (Present value ofa future annuity) Determine the present value of an ordinal) annuity of $1,000 per year for 10 years with the first cash flow from the annuity coming at the end of year 8 (that is, no payments at the end of years 1 through 7 and annual payments at the end of years 8 through 17) given a 10 percent discount rate. 5-40A. (Solving far i in compound interest-financial calmlatar needed) In September 1963, the first issue of the comic book X-MEN was issued. The original price for the issue was 12 cents. By September 2000,38 years later, the value of this comic book had risen to $6,500. What arulUal rate of interest would you have earned if you had bought the comic in 1963 and sold it in 2000? 5-41A. (Comprehensive present value) You have just inherited a large sum of money, and you are try ing to determine how much you should save for retirement and how much you can spend now. For retirement, you will deposit today Ganuary 1,2004) a lump sum in a bank account paying 10 percent compounded annually. You dont plan on touching this deposit until you retire in five years Ganual) 1, 2009), and you plan on living for 20 additional years and then to drop dead on December 31, 2028. During your retirement, you would like to receive income of $50,000 per year to be received the first day of each year, with the first payment on January 1, 2009, and the last payment on January 1, 2028. Complicating this objective is your desire to have one final three-year fling during which time youd like to track down all the original members of Leave It to Beaver and The Brady BU1U:h and get their autographs. To finance this, you want to receive $250,000 on January 1, 2024, and nothing onJanual) 1, 2025 and January 1, 2026, because you will be on the road. In addition, after you passon Ganuary 1, 2029), you would like to have a total of$100,000 to leave to your children. a. How much must you deposit in the bank at 10 percent on January 1, 2004, to achieve your goal? (Use a time line to answer this question.) b. What kinds of problems are associated with this analysis and its assumptions?5-42A. (Spreadsheet problem) If you invest $900 in a bank where it will earn 8 percent com pounded annually, how much will it be worth at the end of seven years? Use a spreadsheet to doyour calculations.5-43A. (Spreadsheet problem) In 20 years you would like to have $250,000 to buy a vacation home,but you have only $30,000. At what rate must your $30,000 be compounded annually for it togrow to $250,000 in 20 years? Use a spreadsheet to calculate your answer.5-44A. (Spreadsheet problem) You take out a 2s-year mortgage for $300,000 to buy a new house.What will your monthly interest rate payments be if the interest rate on your mortgage is 8 per cent? Use a spreadsheet to calculate your answer. Now, calculate the portion of the 48th monthlypayment that goes toward interest and principal.5-45A. (Future and present value using a calculator) Bill Gates billions! Over the past few yearsMicrosoft founder Bill Gates net worth has fluctuated between $30 and $130 billion. In early2003 it was about $33 billion-after he reduced his stake in Microsoft from 21 percent to around14 percent by moving billions into his charitable foundation. Lets see what Bill Gates can dowith his money in the following problems. a. Ill take Manhattan? Manhattans native tribe sold Manhattan Island to Peter Minuit for $24 in 1626. Now, 378 years later in 2004, Bill Gates wants to buy the island from the
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172 PART 2 VALUATION OF FINANCIAL ASSETS "current natives." How much would Bill have to pay for Manhattan if the "current natives" want a 6 percent annual return on the original $24 purchase price? b. Microsoft Seattle? Bill Gates decides to pass on Manhattan and instead plans to buy the citY of Seattle, Washington, for $200 billion in 10 years. How much would Mr. Gates have to invest today at 10 percent compounded annually in order to purchase Seattle in 10 years) c. Now assume Bill Gates only wants to invest half his net worth today, $50 billion, in order to buy Seattle for $200 billion in 10 years. What annual rate of return would he have to earn in order to coniplete his purchase in 10 years? d. Margaritaville? Instead of buying and running large cities, Bill Gates is considering quit ting the rigors of the business world and retiring to work on his golf game. To fund his retirement, Bill Gates would invest his $100 billion fortune in safe investments with an expected annual rate of return of 7 percent. Also, Mr. Gates wants to make 40 equal annual withdrawals from this retirement fund beginning a year from today. How much can Mr. Gates annual withdrawal be in this case? S-46A. (Compounding using a calculator) Bart Simpson, age 10, wants to be able to buy a really cool new car when he turns 16. His really cool car costs $15,000 today, and its cost is expected to increase 3 percent annually. Bart wants to make one deposit today (he can sell his mint-condition original Nuclear Boy comic book) into an account paying 7.5 percent annually in order to buy his car in six years. How much will Barts car cost, and how much does Bart have to save today in order to buy this car at age 16? S-47A. (Compounding using a calculator) Lisa Simpson wants to have $1,000,000 in 45 years by making equal annual end-of-the-year deposits into a tax-deferred account paying 8.75 percent annually. What must be Lisas annual deposit? . S-48A. (Compounding using a calculator) Springfield mogul Montgomery Bums, age 80, wants to retire at age 100 in order to steal candy from babies fuJI time. Once Mr. Burns retires, he wants to withdraw $1 billion at the beginning of each year for 10 years from a special off-shore account that will pay 20 percent annually. In order to fund his retirement, Mr. Burns will make 20 equal end-of-the-year deposits in this same special account that will pay 20 percent annually. How much money will Mr. Burns need at age 100, and how large of an annual deposit must be made to fund this retirement fund amount? S-49A. (Compounding using a calculator and annuities due) Imagine Homer Simpson actually invested the $100,000 he earned providing Mr. Bums entertainment five years ago at 7.5 percent annual inter est and starts investing an additional $1,500 a year today and at the beginning of each year for 20 years at the same 7.5 percent annual rate. How much money will Homer have 20 years from today? S-SOA. (Nonannual compounding using a calculator) Prof. Finance is thinking about trading cars. He estimates he will still have to borrow $25,000 to pay for his new car. How large will Prof. Finances monthly car loan payment be if he can get a five-year (60 equal monthly payments) car loan from the vrech Credit Union at 6.2 percent APR? S-SlA. (Nonannual compounding using a calculator) Bowflexs television ads say you can get a fitness machine that selJs for $999 for $33 a month for 36 months. What is the APR for this Bowflex loan? S-S2A. (Nonannual compounding using a calculator) Fords current incentives include 4.9 percent APR financing for 60 months or $1,000 cash back on a Mustang. Lets assume Suzie Student wants to buy the premium Mustang convertible, which costs $25,000, and she has no down pay ment other than the cash back from Ford. If she chooses the $1,000 cash back, Suzie can borrow from the vrech Credit Union at 6.9 percent APR for 60 months (Suzies credit isnt as good as that of Prof. Finance). What will Suzie Students monthJy payment be under each option? Which option should she choose? S-S3A. (Nonannual compounding using a calculator) Ronnie Rental plans to invest $1,000 at the end of each quarter for four years into an account that pays 6.4 percent APR compounded quar terly. He will use this money as a down payment on a new home at the end of the four years. How large will his down payment be four years from today? S-S4A. (Calculating an APY) Your Grandma asks for your help in choosing a CD. CD #1 pays 4.95 percent APR compounded daily. CD #2 pays 5.0 percent APR compounded monthJy. Wbat is the annual percentage yield (the APY or EAR) of each CD, and which CD do you recommend to your Grandma?
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CHAPTER 5 THE TIME VALUE OF MONEY 17,3 5-55A. (Nonannual compounding using a calculator) Dennis Rodman has a $5,000 debt balance on his Visa card that charges 12.9 percent APR compounded monthly. Dennis current minimum monthly payment is 3 percent of his debt balance, which is $150. How many months (round up) will it take Dennis Rodman to payoff his credit card if he pays the current minimum payment of $150 at the end of each month?,5-56A. (Nonannual compounding using a calculator) Should we have bet the kids college fund at the dog track? In the early 2000s investors suffered substantial declines of mutual funds used in tax-sheltered college savings plans (called 529 plans) around the country. One specific case dis cussed in the article was a college professor Oets call him Prof. ME) with two young children who, two years ago, had deposited $160,000 hoping to have $420,000 available 12 years later when the first child started college. However, the accounts balance is now only $140,000. Lets figure out what is needed to get Prof. MEs college savings plan back on track. a. Vhat was the original annual rate of return needed to reach Prof. MEs goal when he started the fund two years ago? b. Now with only $140,000 in the fund and 10 years remaining until his first child starts college, what annual rate of return would the fund have to earn to reach Prof. MEs $420,000 goal if he adds nothing to the account? c. Shocked by his experience of the past two years, Prof. ME feels the college fund has invested too much in stocks and wants a low risk fund in order to ensure he has the nec essary $420,000 in 10 years and is willing to make end-of-the-month deposits to the fund as well. He finds he can get a fund that promises to pay a guaranteed return of 6 percent compounded monthly. Prof. ME decides to transfer the $140,000 to this new fund and make the necessary monthly deposits. How large of a monthly deposit must Prof. ME make into this new fund? d. Now, Prof. ME gets sticker shock from the necessary monthly deposit he has to make into the guaranteed fund in the last question, and decides to invest the $140,000 today and $500 at the end of each month for the next 10 years into a fund consisting of 50 per cent stock and 50 percent bonds and hope for the best. What APR would the fund have to earn in order to reach Prof. MEs $420,000 goal? ~ ~ <.: y . l] 1 . 5-1WW How fast will my money grow? Use the financial calculaM provided by Financenter(partners.financenter.com/financenter/calculate/us-eng/savings14.fcs) to determine howlong it will take $50,000 to grow to $90,000 if it earns 10 percent. Again using the financial calculator provided by Financenter (partners.financenter.comlfinancenter/calculate/us-ellglsavings14.fcs), if you start with $50,000 and invest an additional $250 per month every month, °how long will it take to grow to $90,000 if it earns 1 percent?5-2WW. How much money will you need to start with if you make no additional investments? You want to have $90,000 in six years and your invesnnent will gTow at 10 percent. Usethe financial calculator provided by Financente1 (pa1:ners.financenter.com/financenterlcalculate/us-englsavings14.fcs) to determine how much money you will need to start with.5-3WY. Financial calculators. Compare some of the different financial calculators that areavailable on the Internet. Look at both the Financial Visions calculators (www.fvisions.com/consumercalculators/modules.htm) and the USA . Todays Internet calculators(www.usatoday.comlmoney/calculator.htm)-consumer loan, tuition, new car, mortgage,retirement, and 401(k) calculators. Also check out Kiplinger Online calculators (www.kiplinger.com/tools/index.html) which include saving and investing, mutual funds, bonds, stocks, home,auto, credit cards, and budgeting online calculators. Finally look at Mortgage and FinancialCalculators by Hugh Chou (www.interest.com/hugh/calcl). Which financial calculators do youfind to be the most useful? Why?5-4WY. Understanding annuities. Home mortgage payments are an annuity, as are any loanswhere the payments remain constant. In effect, if you can understand annuities, youll understand how mortgages and other loans are calculated. What would your monthly loan paymentsbe ifyou bought a new 60-inch television for $3,400? You put $300 down, and plan to finance the
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174 PART 2 VALUATION OF FINANCIAL ASSETS loan over 36 months at 12 percent interest. In addition, when you bought the new television, you received $100 for the trade-in of your old set. Use an online financial caleulatm (www.calcbuilder.com/cgi-binicalcs/AUT5.cgiIKiplingel·) to determine your answer. 5-5WW College Savings Planning. Try out Great Western Banks College Savings Planner (www.greatwestembank.comlCollcge.html). Enter data in every field except for the monthly savings. Let the interest rate vary and see the effect on how much you must save. What did you learn from this? How does the interest level you can earn affect how much you must save? For your job as the business reporter for a local newspaper, you are given the task of putting together a series of articles that explains the power of the time value of money to your readers. Your editor would like you to address several specific questions in addition to demonstrating for the readership the use of the time value of money techniques by applying them to several prob lems. What would be your response to the following memorandum from your editor? TO: Business Reporter FROM: Perry White, Editor, Daily Planet RE: Upcoming Series on the Importance and Power of the Time Value of Money In your upcoming series on the time value of money, I would like to make sure you cover several specific points. In addition, before you begin this assignment, I want to make sure we are all reading from the same script, because accuracy has always been the cornerstone of the Daily Planet. In this regard, Id like responses to the following questions before we proceed: 1. What is the relationship between discounting and compounding? 2. What is the relationship between the PVIFi,n and PVIFA i,/ 3. a. What will $5,000 invested for 10 years at 8 percent compounded annually grow to? b. How many years will it take $400 to grow to $1,671, if it is invested at 10 percent com pounded annually? c. At what rate would $1,000 have to be invested to grow to $4,046 in 10 years? 4. Calculate the future sum of$I,OOO, given that it will be held in the bank for five years and earn 10 percent compounded semiannually. 5. What is an annuity due? How does this differ from an ordinary annuity? 6. What is the present value of an ordinary annuity of $1 ,000 per year for seven years discounted back to the present at 10 percent? What would be the present value if it were an annuity due? 7. What is the future value of an ordinary annuity of $1,000 per year for seven years com pounded at 10 percent? What would be the future value if it were an annuity due? 8. You have just borrowed $100,000, and you agree to pay it back over the next 25 years in 25 equal end-of-year annual payments that include the principal payments plus 10 percent compound interest on the unpaid balance. What will be the size of these payments? 9. What is the present value of a $1,000 perpetuity discounted back to the present at 8 percent? 10. What is the present value of a $1,000 annuity for 10 years with the first payment occurring at the end of year 10 (that is, ten $1,000 payments occurring at the end of year 10 through year 19) given an appropriate discount rate of 10 percent? 11. Given a 10 percent discount rate, what is the present value of a perpetuity of $1 ,000 per year if the first payment does not begin until the end of year 1O? 12. What is the annual percentage yield (APY) on an 8 percent bank Joan compounded quarterly? 5-1B. (Compound intel°est) To what amount will the following invesnnents accumulate? a. $4,000 invested for 11 years at 9 percent compounded annually b. $8,000 invested for 10 years at 8 percent compounded annually
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CHAPTER 5 THE TIME VALUE OF MONEY 175 c. $800 invested for 12 years at 12 percent compounded annually d. $21,000 invested for 6 years at 5 percent compounded annually5-2B. (Compound value solvingfor n) How many years will the following take? a. $550 to grow to $1,043.90 if invested at 6 percent compounded annually b. $40 to grow to $88.44 if invested at 12 percent compounded annually c. $110 to grow to $614.79 if invested at 24 percent compounded annually d. $60 to grow to $78.30 if invested at 3 percent compounded annually5-3B. (Compound value solvingfor i) At what annual rate would the following have to be invested? a. $550 to grow to $1,898.60 in 13 years b. $275 to grow to $406.18 in 8 years c. $60 to grow to $279.66 in 20 years d. $180 to grow to $486.00 in 6 years5-4B. (Present value) What is the present value of the following future amounts? a. $800 to be received 10 years from now discounted back to the present at 10 percent b. $400 to be received 6 years from now discounted back to the present at 6 percent c. $1,000 to be received 8 years from now discounted back to the present at 5 percent d. $900 to be received 9 years from now discounted back to the present at 20 percent5-5B. (Compound annuity) What is the accumulated sum of each of the following streams ofpayments? a. $500 a year for 10 years compounded annually at 6 percent b. $150 a year for 5 years compounded annually at 11 percent c. $35 a year for 8 years compounded annually at 7 percent d. $25 a year for 3 years compounded annually at 2 percent5-6B. (Present value ofan annuity) What is the present value of the following annuities? a. $3,000 a year for 10 years discounted back to the present at 8 percent b. $50 a year for 3 years discounted back to the present at 3 percent c. $280 a year for 8 years discounted back to the present at 7 percent d. $600 a year for 10 years discounted back to the present at 10 percent5-7B. (Compound value) Trish Nealon, who recently sold her Porsche, placed $20,000 in a savings account paying annual compound interest of 7 percent. a. Calculate the amount of money that will have accrued if she leaves the money in the bank for 1, 5, and 15 years. b. If she moves her money into an account that pays 9 percent or one that pays 11 percent, rework part (a) using these new interest rates. c. What conclusions can you draw about the relationship among interest rates, time, and future sums from the calculations you have done?5-8B. (Compound interest with nonannual periods) Calculate the amount of money that will be ineach of the following accounts at the end of the given deposit period: ANNUAL COMPOUNDING PERIOD DEPOSIT AMOUNT INTEREST (COMPOUNDED EVERY PERIODACCOUNT DEPOSITED RATE _MONTHS) (YEARS)Korey Stringer $ 2,000 12% 2 2Erica Moss 50.000 12 1 1Ty Howard 7,000 18 2 2Rob Kelly 130,000 12 3 2Mary Christopher 20.000 14 6 4Juan Diaz 15,000 15 4 35-9B. (Compound interest with nonannual periods) a. Calculate the future sum of $6,000, given that it will be held in the bank five years at an annual interest rate of 6 percent. b. Recalculate part (a) using a compounding period that is (1) semiannual and (2) bimonthly.
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176 PART 2 VALUATION OF FINANCIAL ASSETS c. Recalculate parts (a) and (b) for a 12 percent alillual interest rate. d. Recalculate part (a) using a time horizon of 12 years (annual interest rate is stiJl6 percent). e. With respect to the effect of changes in the stated interest rate and holding periods on future sums in parts (c) and (d), what conclusions do you draw when you compare these figures with the answers fOW1d in parts (a) and (b)? 5-10B. (Solving for i in annuities) Ellen Denis, a sophomore mechanical engineering student, receives a call from an insurance agent, who believes that Ellen is an older woman ready to retire from teaching. He talks to her about several annuities that she could buy that would guarantee her an annual fixed income. The annuities are as follows: INITIAL PAYMENT INTO ANNUITY AMOUNT OF MONEY DURATION OF ANNUITY ANNUITY (AT t ~ 0) RECEIVED PER YEAR (YEARS) A $50,000 $8,500 12 B 60,000 7,000 25 C 70,000 8,000 20 If Ellen could earn 12 percent on her money by placing it in a savings account, should she place it instead in any of the annuities? Which ones, if any:> Why? 5-11B. (Future value) Sales of a new marketing book were 10,000 copies this year and were expected to increase by 15 percent per year. VI/hat are expected sales during each of the next three years? Graph this sales trend and explain. 5-12B. (Future value) Reggie Jackson, formerly of the New York Yankees, hit 41 home runs in 1980. If his home-run output grew at a rate of 12 percent per year, what would it have been over the following five years? 5-13B. (Loan amortization) Stefani Moore purchased a new house for $150,000. She paid $30,000 down and agreed to pay the rest over the next 25 years in 25 equal annual payments that include principal payments plus 10 percent compound interest on the W1paid balance. What will these equal payments be? 5-14B. (SolvingfOr PMT in an annuity) To pay for your childs education, you wish to have accu mulated $25,000 at the end of 15 years. To do this, you plan to deposit an equal amoW1t into the bank at the end of each year. If the bank is willing to pay 7 percent compoW1ded annually, how much must you deposit each year to obtain your goal? 5-15B. (Solving fOr i in compound interest) If you were offered $2,376.5010 years from now in return for an investment of $700 currently, what annual rate of interest would you earn if you took the offer? 5-16B. (Future value of an annuity) In 10 years, you plan to retire and buy a house in Marco Island, Florida. The house you are looking at currently costs $125,000 and is expected to increase in value each year at a rate of 5 percent. Assuming you can earn 10 percent annually on your investments, how much must you invest at the end of each of the next 10 years to be able to buy your dream home when you retire? 5-17B.(Compoundvalue) The Knutson Corporation needs to save $15 million to retire a $15 million mortgage that matures in 10 years. To retire this mortgage, the company plans to put a fixed amount into an account at the end of each year for 10 years. The Knutson Corporation expects to earn 10 percent annually on the money in this account. What equal annual contribution must it make to this account to accumulate the $15 million by the end of 10 years? 5-18B. (Compound interej7with nonannualperiods) After examining the various personal loan rates available to you, you find that you can borrow funds from a finance company at 24 percent com pounded monthly or from a bank at 26 percent compounded alillually. Which alternative is the most attractive? 5-19B. (Present value ofan uneven stream ofpayments) You are given three investment alternatives to analyze. The cash flows from these three investments are as follows:
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CHAPTER 5 THE TIME VALUE OF MONEY 177 Investment END OF YEAR A B c 1 $15,000 $20,000 2 15,000 3 15,000• 4 15.000 5 15,000 $15,000 6 15,000 60,000 7 15,000 8 15,000 9 15,000 10 15,000 20,000Assuming a 20 percent discount rate, find the present value of each investment,5-20B. (Present value) The Shin Corporation is planning on issuing bonds that pay no interestbut can be converted into $1,000 at maturity, eight years from their purchase. To price thesebonds competitively with other bonds of equal risk, it is determined that they should yield 9 per cent, compounded annually. At what price should the Shin Corporation sell these bonds?5-21B. (Perpetuities) iVhat is the present value of the following? a. A $4D0 perpetuity discounted back to the present at 9 percent b. A $1,500 perpetuity discowlted back to the present at 13 percent c. A $150 perpetuity discounted back to the present at 10 percent d. A $100 perpetuity discounted back to the present at 6 percent5-22B. (Present value ofan annuity due) What is the present value of a five-year annuity due of$1,000 annually given a 10 percent discount rate?5-23B. (Solvingfor n with nonannual periods) About how many years would it take for your investment to grow sevenfold if it were invested at 10 percent compounded semiannually?5-24B. (Present vallie ofan uneven stream ofpayments) You are given three invesnnent alternativesto analyze. The cash flows from these three investments are as follows:InvestmentEND OF YEAR A B C1 $5,000 $1,000 $10,0002 5,000 3,000 10,0003 5,000 5,000 10,0004 -15,000 10,000 10,0005 15,000 -10,000 -40,000What is the present value of each of these three investments if 10 percent is the appropriate discount rate?5-25B. (Complex present value) I-low much do you have to deposit today so that beginning 11 yearsfrom now you can withdraw $10,000 a year for the next five years (periods 11 through 15), plus anadditional amount of$15,000 in the last year (period 15)? AssW11e an interest rate of7 percent.5-26B. (Loan amortization) On December 31, Loren Billingsley bought a yacht for $60,000, paying$15,000 down and agreeing to pay the balance in 10 equal a.n.nual installments that include both theprincipal and 9 percent interest on the declining balance. How big will the annual payments be?5-27B. (Solvingfoli in an annuity) You lend a friend $45,000, which your friend will repay in fiveequal annual payments of $9,000 with the first payment to be received one year from now. VVhatrate of return does your loan receive-5-28B. (Solving fOr i in compound interest) You lend a friend $15,000, for which your friend willrepay you $37,313 at the end of five years. VVhat interest rate are you charging your "friend"?5-29B. (Loan amortization) A firm borrows $30,000 from the bank at 13 percent compoundedannually to purchase some new machinery. This loan is to be repaid in equal annual installmentsat the end of each year over the next four years. How much will each annual payment be?
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178 PART 2 VALUATION OF FINANCIAL ASSETS 5-30B. (Present value comparison) You are offered $1,000 today, $10,000 in 12 years, or $25,000 in 25 years. Assuming that you can earn 11 percent on your money, which should you choose? 5-31B. (Compound annuity) You plan to buy some property in Florida five years from today. To do this, you estimate that you will need $30,000 at that time for the purchase. You would like to accu mulate these funds by making equal annual deposits in your savings account, which pays 10 percent annually. If you make your first deposit at the end of this year and you would like your account to reach $30,000 when the final deposit is made, what will be the amount of your deposits? 5-32B. (Complex present value) You would like to have $75,000 in 15 years. To accumulate this amount, you plan to deposit each year an equal sum in the bank, which will earn 8 percent inter est compounded annually. Your first payment will be made at the end of the year. a. How much must you deposit annually to accumulate this amount? b. If you decide to make a large lump-sum deposi t today instead of the annual deposits, how large should this lump-sum deposit be? (Assume you can earn 8 percent on this deposit.) c. At the end of five years, you will receive $20,000 and deposit this in the bank toward your goal of $75,000 at the end of 15 years. In addition to this deposit, how much must you deposit in equal annual deposits to reach your goal? (Again, assume you can earn 8 per cent on this deposit.) 5-HB. (Comprehensive present value) You are trying to plan for retirement in 10 years and currently you have $150,000 in a savings account and $250,000 in stocks. In addition, you plan to add to your savings by depositing $8,000 per year in your savings account at the end of each of the next five years and then ~1 0,000 per year at the end of each year for the final five years until retirement. a. Assuming your savings account reUlrns 8 percent compounded annually and your invest ment in stocks will reUlrn 12 percent compounded annually, how much will you have at the end of 10 years? (Ignore taxes.) b. If you expect to live 20 years after you retire, and at retirement you deposit all of your savings in a bank account paying 11 percent, how much can you withdraw each year after retirement (20 equal withdrawals beginning one year after you retire) to end up with a zero-balance at death? 5-34B. (Loan amortization) On December 31, Eugene Chung borrowed $200,000, agreeing to repay this sum in 20 equal annual installments that include both the principal and 10 percent interest on the declining balance. How large will the annual payments be? . 5-35B. (Loan amortization) To buy a new house, you must borrow $250,000. To do this, you take out a $250,000, 30-year, 9 percent mortgage. Your mortgage payments, which are made at the end of each year (one payment each year), include both principal and 9 percent interest on the declining balance. How large will your annual payments be? 5-36B. (Present value) The state lotterys million-dollar payout provides for $1 million to be paid over 24 years in $40,000 amounts. The first $40,000 payment is made immediately with the 24 remaining $40,000 payments occurring at the end of each of the next 24 years. If 10 percent is the appropriate discount rate, what is the present value of this stream of cash flows? If 20 percent is the appropriate discount rate, what is the present value of the cash flows? 5-37B. (Compounding an annuity due) Find the fuUlre value at the end of year 5 of an annuity due of $1,000 per year for five years compoW1ded annually at 5 percent. What would be the future value of this annuity if it were compounded annually at 8 percent? 5-38B. (Present value ofan annuity) Determine the present value of an annuity due of $1 ,000 per year for 15 years discoW1ted back to the present at an annual rate of 12 percent. What would be the present value of this annuity due if it were discounted at an annual rate of 15 percent? 5-39B. (Present value ofa future annuity) Determine the present value of an ordinary annuity of $1,000 per year for 10 years with the first cash flow from the annuity coming at the end of year 8 (that is, no payments at the end of years 1 through 7 and annual payments at the end of years 8 through 17) given a 15 percent discount rate. 5-40B. (Solving for i in compound intelest-financial calculator needed) In March 1963, issue num ber 39 of Tales ofSuspense was issued. The original price for that issue was 12 cents. By March of 2001,38 years later, the value of this comic book had risen to $3,500. What annual rate of inter est would you have earned if you had bought the comic in 1963 and sold it in 200 l?
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CHAPTER 5 THE TIME VALUE OF MONEY 1795-41B. (Comprehensive present value) You have just inherited a large sum of money and you are try-ing to determine how much you should save for retirement and how much you can spend now. Forretirement you will deposit today Oanuary 1, 2005) a lump sum in a bank account paying 10 percentcompounded annually. You dont plan on touching this deposit until you retire in five yearsGaImary 1,2010), and you plan on living for 20 additional years and then drop dead on December31,2029. During your retirement, you would like to receive income of $60,000 per year to berdeived the first day of each year, with the first payment on January 1,2010, and the last paymentonJanuary 1, 2029. Complicating this objective is your desire to have one final three-year fling,during which time youd like to track down all the original members of The Mr. Ed Show and TheMrmkees and get their autographs. To finance this, you want to receive $300,000 on January 1, 2025,and lwthing on January 1, 2026, and January 1,2027, as you will be on the road. In addition, afteryou pass on Oanuary 1,2030), you would like to have a total of $100,000 to leave to your children. a. How much must you deposit in the bank at 10 percent on January 1,2005, in order to achieve your goal? (Use a time line in order to answer this question.) b. That kinds of problems are associated with this analysis and its assumptions? SELF-TEST SOLUTIONSST-I. This is a compound interest problem in which you must first find the future value of$25,000 growing at 8 percent compounded annually for three years and then allow that futurevalue to grow for an additional three years at 10 percent. First, the value of the $25,000 afterthree years growing at 8 percent is FV3 = PV(l + i)71 FV3 = $25,000(1 + .08)3 FV3 = $25,000(1.260) FV3 = $31, 500Thus, after three years, you have $31,500. Now this amount is allowed to grow for three years at10 percent. Plugging this into equation 5-6, with PV = $31,500, i = 10 percent, n = 3 years, wesolve for FV3: FV3 = $31,500(1 + .10)3 FV3 = $31,500(1.331) FV3 = $41,926.50Thus, after six years, the $25,000 will have grown to $41,926.50.ST-2. This loan amortization problem is actually just a present-value-of-an-annuity problem inwhich we know the values of i, n, and pv, and are solving for PMT In this case, the value of i is13 percent, n is 10 years, anQ PVis $30,000. Substituting these values into equation 5-10, we find $30,000 = PMJ f 1 L=l (1 + .13/ ] $30,000 = PMT(5.426) $5,528.93 = PMTST-3. This is a simple compound interest problem in which FV9 is eight times larger than PVHere again, three of the four variables are known: n = 9 years, FV9 = 8, and PV = 1, and we aresolving for i. Substituting these values into equation 5-6, we find FV9 = PV(1 + i)" FV9 = PV(FVIFi ,,,) 8 = 1 (FVIF 9yrs) J, 8.00 = FVIF 9yr " sThus, we are looking for an FVIFi ,9yrs with a value of 8 in Appendix B, which occurs in the nine-year row. If we look in the nine-year row for a value of 8.00, we find it in the 26 percent column(8.004). Thus, the answer is 26 percent.
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CHAPTER 6 R·sk and Rates.of ReturnOne of the most important concepts in all of finance deals its March 2000, high. Imagine how you would feel if you had.with risk and return, and our first principle addresses this jumped on the bandwagon in 2000. However, these highlytopic. As an illustration of risk and return, consider what was volatile price changes were part of the 1999-2002 landscapehappening to the stock price of many of the high-tech stocks if you bought and sold high-tech stocks. In other words, theseduring 2000. stocks may produce high rates of return to their owners, but From January 1, 2000, through March 10, 2000, the Nasdaq they are risky investments, as signified by their high volatility.Composite Index, dominated by such firms as Microsoft, Ora As the owner of high-tech stocks during this time, you maycle, and Intel, increased 25 percent in value-not bad for a have eaten well on the good days, but you certainly didntmere two months. Many of us probably wished that we had sleep very well some nights. Welcome to the world where highbeen so "smart" as to buy a group of these high-tech stocks. rates of return go hand in hand with high risk. But by January 2003, the Nasdaq was down 74 percent from <={ CHAPTER PREVIEW ~ The need to recognize risk in financial decisions has chip? Will people buy it in large numbers? And the already been emphasized in earlier chapters. In biotech industry is more volatile still---:-will a cure Chapter 1, we introduced Principle 1: The Risk for AIDS be found? If so, we can imagine that Return Trade-Off-We wont take an additional there would be a big payoff, but a lot of money risk unless we expect to be compensated with could be spent along the way. additional returns. In the previous chapter, we Now consider individual companies involved in observed the importance of the discount rate in com seeking an AIDS cure. There are large companies, paring financial assets and investment proposals. But such as GlaxoSrnithKline and Pfizer, and small start we assumed the interest rate to be a given. Now we ups. Do we have any basis for thinking the larger want to examine where the appropriate rate comes companies have a better chance than the smaller trom. We will see that risk is a prime factor in setting ones? Does size imply financial commitment or the appropriate rate. superior resources? There is an intuitive aspect to thinking about Now think about a particular company, such as risk. Lets approach this by looking at an industry, a Pfizer. Finding an AIDS cure could give it a huge firm, and an individual investment proposal. For boost in profits. But Pfizer has many different prod instance, think intuitively about different indus ucts. An AIDS cure may not be as important to tries, such as soft drinks, computers, and biotechs. Pfizers future as it would be for a one-product Vhich one would we expect to be the most stable? startup company. The obvious answer is soft drinks. vVe can reason In all of these cases, we have an intuitive sense ably anticipate this industry to keep chugging of differences in prospects. We will now turn to how along. The computer industry, however, is more this intuitive sense flows into the returns one volatile. That happens if Intel introduces a faster can expect to receive from a particular investment (continued) 181
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182 PART 2 VALUATION OF FINANCIAL ASSETS proposal. We will see the relationship between risk Principle 1: The Risk-Return Trade-Off-We and average returns of different investments. We will wont take on additional risk unless we expect show how we can quantify this concept of risk, and to be compensated with additional returns; how this determines the interest rate we used in dis Principle 3: Cash-Not Profits-Is King; counting to compare projects. The concept of risk is Principle 9: All Risk Is Not Equal-Some risk a crucial one for the financial manager. This chapter can be diversified away, and some cannot. will show where it comes from and how it can be Watch for these principles and let them be the used to compare financial assets. thread that connects the ideas presented in this chap Three principles will serve as the foundation for ter. Lets now begin our study by looking at what we this chapter. Keeping them in mind throughout will mean by the expected rate of return and how it can be helpful in your study. These axioms are be measured. Objective 1J RATES OF RET URN I NTH E FINANCIAL MARKETS In the financial markets where stocks and bonds are sold, net users of money, such as companies that make investments, have to compete with one another for capital. To obtain financing for projects that will benefit a firms stockholders, a company must offer investors a rate of return that is competitive with the next best investment alternative avail able to the investor. This rate of return on the next best investment alternative to theOppol1:unity cost of funds saver is known as the investors opportunity cost of funds.The next best rate of return As managers, we need to understand the investors opportunity cost of investing; thatavailable to the investor for a is, what could an investor earn by investing in another company of similar risk? Only bygiven level of risk. answering this question can a financial manager begin to understand whether the share holders are receiving a fair return on their investments. Also, from an investors perspec tive, there is a need to know the historical experience of other investors in the capital markets; otherwise, there is no basis for knowing what can be reasonably expected in terms of rates of returns. THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN History can tell us a great deal about the returns that investors earn in the financial mar kets. A primary source for an historical perspective comes from Ibbotson and Sinquefields Stocks, Bonds, Bills, and Inflation, which examines the realized rates of return for a wide variety of securities spanning the period from 1926 through 2002. Their data are comprehensive and extremely useful both to investors and financial managers in their respective needs for understanding rates of returns in the capital markets. In their results, they summarize, among other things, the annual returns for different portfolios of secu ri ties, five of them being: 1 1. Common stocks of small firms 2. Common stocks of large companies 3. Long-term corporate bonds 4. Long-term U.S. government bonds 5. U.S. Treasury bills J Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills, and Inflntion: Histmical Retum (1926-1999) (Chicago, 11: Ibbotson Associates, 2003).
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CHAPTER 6 RISK AND RATES OF RETURN 183IlD!DI Annual Rates of Return 1926-2002 NOMINAL STAf.lDARD REAL AVERAGESECURITIES AVERAGE ANNUAL DEVIATION ANNUAL RISK RETURNS OF RETURNS RETURNS· PREMIUMbSmall-company 16.9% 33.2% 13.8% 13.10f0StocksLarge-company 12.2 20.5 9.1 8.4StocksLong-term 6.2 8.7 3.1 2.4CorporateBondsLong-term 5.8 9.4 2.7 2.0GovernmentBondsU.s. Treasury Bills 3.8 3.2 0.7 0.0Real return equals the nominal return less the average inflation rate from 1926 through 2002 of 3.1 percent.bRisk premium equals the nominal return less the average risk-free rate (Treasury bills) of 3.8 percent.Source: R. G. Ibbotson and R. A. Sinquefield, Stocks, Bonds, Bills, and Inflation: Historical Returns (Chicago. Il: Ibbotson Associates.2003): 31. <J Ibbotson Associates. Before comparing the actual rates of returns and their variability (risk), we should firstthink about what to expect. First, we would intuitively expect a Treasury bill to be the leastrisky of the five portfolios. Because a Treasury bill has a short-term maturity date, the priceis less volatile (less risky) than the price of a long-term government security.2 In turn,because there is a chance of default on a corporate bond, which is essentially nonexistentfor government securities, a long-term government bond is less risky than a long-termcorporate bond. Finally, common stock of large companies is more risky than a corporatebond, with small-company stocks being more risky than the portfolio of large-firm stocks. By smaller firm, we do not mean the "mom-and-pop" store down on the corner, butrather the smallest companies listed on the New York Stock Exchange (the bottom20 percent, to be exact). It is believed that these smaller companies are more risky thanthe really large firms. Why might that be? First, smaller businesses experience greaterrisk in their operations-they are more sensitive to business downturns, and some operate in niche markets that can quickly appear and then quickly disappear. Second, they relymore heavily on debt financing than do larger firms. These differences create more variability in their profits and cash flows, which translates into greater risk. With the foregoing in mind, we should expect different rates of return to the holdersof these varied securities. If the market rewards an investor for assuming risk, the averageannual rates of return should increase as risk increases. A comparison of the annual rates of return for the five portfolios listed previously forthe years 1926 to 2002 is provided in Table 6-1. Four attributes of these returns are /included: (1) the nominal average annual rate of return; (2) the standard deviation of thereturns, which measures the volatility or riskiness of the portfolios: (3) the real averageannual rate of return, which is the nominal return less the inflation rate; and (4) the riskpremium, which represen~s the additional return received heyond the risk-free rate(Treasury bill rate) for assuming risk. Looking first at the two columns of average annual returns and standard deviations,we gain an overview of the risk-return relationships that have existed over the 76 yearsending in 2002. For the most part, there has been a positive relationship between risk and1 For an explanation of the greater volatility for long-term bonds relative to short-term bonds, see Chapter 7.
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184 PART 2 VALUATION OF FINANCIAL ASSETS return, with Treasury bills being the least risky and common stocks of small companies being the most risky. The return information in Table 6-1 demonstrates that common stock has been the investors primary inflation hedge (returns are greater than the inflation rate) in the long run-the average inflation rate has been 3.1 percent-and offered the highest risk pre mium. However, it is equally apparent that the common stockholder is exposed to sizable risk, as demonstrated by a 20.5 percent standard deviation for large-company stocks and a 33.2 percent standard deviation for small-company stocks. In fact, in the 1926 to 2002 time frame, large-company common shareholders received negative returns in 22 of the 76 years, compared with only 1 in 76 for Treasury bills. Objective --.!J THE EFFECTS OF INFLATION ON RATES OF RETURN AND THE FISHER EFFECT When a rate of interest is quoted, it is generally the nominal, or observed rate. TheRea! rate of interest real rate of interest, in contrast, represents the rate of increase in actual purchasingThe nominal rate of interest power, after adjusting for inflation. For example, if you have $100 today and lend it toless the expected ra te of someone for a year at a nominal rate of interest of 11.3 percent, you wi]] get backinflation over the maturity ofthe fixed-income security. This $111.30 in one year. But if during the year prices of goods and services rise by 5 perrepresents the expected cent, it wi]] take $105 at year end to purchase the same goods and services that $100increase in actual purchasing purchased at the beginning of the year. What was your increase in purchasing powerpower to the investor. over the year? The quick and dirty answer is found by subtracting the inflation rate from the nominal rate, 11.3 - 5 = 6.3 percent, but this is not exactly correct. To be more precise, let the nominal rate of interest be represented by krf , the anticipated rate of inflation by IRP, and the real rate of interest by k·. Using these notations, we can express the relationship among the nominal interest rate, the rate of inflation, and the real rate of interest as follows: 1 + krf= (l + k*) (1 + IRP) (6-1) or krf= k + IRP + (f x IRP) Consequently, the nominal rate of interest (k,j) is equal to the sum of the real rate of interest (k *), the inflation rate (IRP), and the product of the real rate and the inflation rate. This relationship
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