CH-1-4 Goals and Governance of the Firm – Fundamentals of Corporate Finance : Chapter Notes

This Document Contains Chapters 1 to 4 CHAPTER 1 GOALS AND GOVERNANCE OF THE FIRM CHAPTER IN PERSPECTIVE Part One, Introduction, of this new edition has one more chapter, which is a re-write of Chapter 17 from the previous edition, Financial Statement Analysis. This change puts back-to-back two chapters, Chapters 3 and 4, which are closely related to accounting. For professors who wish to cover accounting measures in the course, accounting measures naturally follows after Chapter 3, Accounting and Finance. In this new edition Chapter 1 tells the story of Mike Lazaridis, one of the founders of Research in Motion (RIM), at the beginning of Section 1.1, Investment and Financing Decisions, to illustrate the investment and financing decision as the chief task of the financial managers. The story tells us about how financial management played a pivotal role in the birth and growth of RIM. Then the chapter provides the student with a look at the scope of finance and financial management. The scope of the managerial finance cycle, which includes raising funds in financial markets from investors, investing funds, managing the returning cash flow and the dividend/reinvestment decision, is effectively presented in the following chart. This is the chapter and time to provide a “big picture” look at the scope, concerns, and issues of corporate finance. It is important for students to have this overview, and to be reminded of it as future chapters present small, detailed parts of the “big picture.” Students tend to focus on the details and see neither how it all fits together nor the overall scope of finance. Presenting this “big picture” is an important role of the professor, and this first chapter provides several themes that will be reemphasized throughout the text: Maximize shareholder value Capital budgeting NPV IRR Risk- Adjustments Financing Agency problems Retained earnings: Dividend policy Debt Stock Preferred stock Cost of capital Cost of capital Capital structure Investing 1-1 This Document Contains Chapters 1 to 5 1. The goal of corporation is value maximization. It is concerned with cash flows and the timing and variability of the cash flows, is the preferred decision criterion and is consistent with the financial market processes that determine value for securities. 2. The major decisions that a financial manager is required to make: investment and financing decisions. 3. The investment decision is also called the capital budgeting decision. If a project’s value is greater than its required investment, then the project is attractive financially. The capital budgeting decision criteria, such as Net Present Value (NPV) and Internal Rate of Return (IRR), help financial manager to identify attractive capital investment projects. 4. The major capital components are debt (bond) and equity (stock). The choice between debt and equity financing is the capital structure decision. 5. Identify the range of agency problems that exist related to financial management, from global firms to the hardware up the street. One of the most important decisions that a new business must make is the choice of business organization. This book focuses on corporations, one of the three primary forms, sole proprietorship, partnership, and corporation. Instead of skipping the discussion, consider this choice as an important financial decision that must be made before others. Each form has a risk/return trade-off that affects the ability to raise capital, so it does not take the students long to realize that the corporation is the likely choice once beyond a certain level of operations. This risk/return discussion is a good one to have early, before the topic is formally introduced. 1-2 CHAPTER OUTLINE 1.1 INVESTMENT AND FINANCING DECISIONS The Investment (Capital Budgeting) Decision The Financing Decision 1.2 WHAT IS A CORPORATION? 1.3 OTHER FORMS OF BUSINESS ORGANIZATION Sole Proprietorships Partnerships Hybrid Forms of Business Organization 1.4 WHO IS THE FINANCIAL MANAGER? 1.5 GOALS OF THE CORPORATION Shareholders Want Managers to Maximize Market Value Ethics and Management Objectives Do Managers Really Maximize Firm Value? 1.6 CAREERS IN FINANCE 1.7 TOPICS COVERED IN THIS BOOK Snippets of History 1.8 SUMMARY 1-3 TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 1.1 INVESTMENT AND FINANCING DECISIONS A. The primary functions of the financial manager or financial decision maker are to raise funds in financial markets (the financing decision), to invest such funds (capital budgeting decision), to generate cash from efficient operations, and to allocate cash flows generated for reinvestment, or to pay cash dividends. See Figure 1.1. B. Funds are raised in financial markets by selling financial assets or securities to investors (stocks and bonds) and investing cash, in the case of manufacturing firms, in real assets, or physical assets used to produce goods and services. The Investment (Capital Budgeting) Decision A. The decision as to the amount and which tangible and/or intangible assets to acquire is an investment (capital budgeting) decision. B. Where cash is invested affects the amount of future cash flows generated, the timing of those cash flows, and the variability or riskiness of those future cash flows and thus, the value or worth of the capital budgeting decisions. The Financing Decision A. Determining the maturity and type of funds raised in financial markets is part of the financing decision. B. The selection and mix of long-term debt and equity securities sold in capital markets determines the capital structure of the firm. Financial Manager Firm's operations Investors (2 (1 (3 (4a Real assets (4b 1-4 1.2 WHAT IS A CORPORATION A. A corporation is a legal entity separate from its owners, namely the shareholders. Shareholder owners have limited liability; their personal assets are free from the obligations of the corporations. If the corporation cannot pay its bills, its shareholders have no requirement to provide any money, beyond their initial investment in the shares. With limited liability to protect the shareholders, sometimes corporations are more inclined to invest in riskier asset ventures to create value than other types of business organizations. B. A corporation may incorporate federally, under the Canadian Business Corporation Act or provincially, under relevant provincial laws. A provincially incorporated firm may conduct its business in that province but may need additional permissions to do business elsewhere. C. The incorporation documents are called articles of incorporation in most provinces.1 When approved by the relevant government agency, these documents provide the charter to the firm to conduct its business as a corporation. D. Shareholders vote for the board of directors, who, in turn, appoint senior management, creating a legal separation of ownership and management of the business. This legal separation of ownership and management gives corporations permanence. If management is changed or if the shareholders change, the corporation carries on. E. Corporations are able to combine the capital of many shareholders and thereby garner substantial resources. Corporations whose shares are listed for trading on a stock exchange are public corporations. Shareholders of public corporations are able to freely trade their shares. Also, the corporation can easily raise additional equity financing by selling more shares. Being a public company increases the company’s financial flexibility. However, the company must pay for a stock listing, provide financial information on a regular basis and disclose material changes. Public companies must also comply with the rules for operating the firm in the interest of its shareholders, known as corporate governance rules. F. Corporations whose shares are not listed on a stock exchange are called private corporations. Private corporations face more restrictions on the sale of new 1These are also called letters patent or memorandum of association in some provinces. 1-5 securities but do not need to make public information disclosures and are not subject to the governance requirements of a public company. G. Whether it is a public or private corporation, each corporation is a taxable entity. It pays taxes on its earnings before distributing dividends to its shareholders, who then pay tax on their dividend income. H. To summarize, a corporation has the advantages of providing limited liability to its shareholders and the perpetual life provided by the separation of ownership from management. This makes it possible to become a public corporation, with shares trading on stock exchange and the convenience of issuing more shares to raise new capital. Private corporations can also sell more shares to raise financing, but cannot just sell them to anyone. 1.3 OTHER FORMS OF BUSINESS ORGANIZATION Sole Proprietorships A. The sole proprietorship business blends the personal and business assets of the individual in a business venture. On the other hand, it is cheap and easy to set up a sole proprietorship. B. The sole proprietor incurs unlimited liability (exposure of personal assets to business obligations), limited life, business and personal income/assets are viewed by taxing authorities as one, and because of these risks, has considerable difficulty raising funds in financial markets. Partnerships A. A partnership is an agreement between individuals to pool their assets and talents in a business. B. Like the sole proprietorship, partners are exposed to unlimited personal liability and limited life of the business. Also, business income is combined with personal income for tax purposes. Unlike a sole proprietorship, more than one person is involved, and thus, more capital may be raised in financial markets. Hybrid Forms of Business Organization A. A limited partnership has both limited (limited liability) partners and, at least, one general (unlimited liability) partner, who is the primary manager. Limited partners 1-6 usually have a restricted role and cannot take part in the day-to-day management of the partnership but they have the right to share in partnership profits and to have their contributions returned if the business is dissolved. B. A limited liability partnership (LLP) is a partnership that enables its partners to enjoy some of the limited liability features of corporations, but continue to be taxed as partners, thereby avoiding double taxation. As in an ordinary partnership, individual partners in an LLP continue to have unlimited liability for their own professional negligence or malpractice but are not liable for the negligence or malpractice of their other partners. C. Similarly, the professional corporation (PC), used by doctors and other professionals, has limited liability for owners, except in the area of malpractice. D. Income trusts are another hybrid business form. Trust is not taxed but passes its earnings to its unit holders (sort of similar to shares). Income trusts became very popular around 2004 when corporations used the structure to reduce taxes. However, the income trust boom came to sudden end on October 31, 2006, when the Federal Government announced plans to change the taxation of trust, removing the advantage of becoming an income trust. E. The following chart summarizes the key aspects of the three main forms of business organizations: Sole Proprietorship Partnership Corporation Who owns the Business? The manager Partners Shareholders Are managers and owner(s) separate? No No Usually What is the owner’s liability? Unlimited Unlimited Limited Are the owner and business taxed separately? No No Yes F. The choice of business organization affects the risk and the potential return in the form of after-tax cash flow and thus, the value of the business. 1-7 G. Compare and contrast the following business organizational forms by: 1. The exposure or risks of personal assets from a business venture—limited or unlimited liability. 2. The ease and cost of organization and maintenance of the business organization. 3. The expected life of the business under each form of business organization. 4. The relative tax exposure of the earnings of the business. 5. The relative ease of raising capital in financial markets. 1.4 WHO IS THE FINANCIAL MANAGER? The Financial Manager A. The financial manager is anyone responsible for a significant corporate investment or financing decision. The term is more oriented to the decisions rather than a specific title or job position. This book studies a number of financial manager decision areas, several of which, have a significant impact on shareholder value. B. Traditional financial manager titles include treasurer and controller. The treasurer’s duties include financing, cash management, and financial market relationships, while the controller tends to be associated with more traditional accounting functions of financial statements, budgeting, and auditing. See Figure 1.2. The chief financial officer, in larger firms, oversees the treasurer and controller and is involved in formulating corporate strategy and financial policy. 1.5 GOALS OF THE CORPORATION Shareholders Want Managers to Maximize Market Value A. Shareholders want managers to make decisions based upon which alternative will maximize the market value of the shareholders’ investment. Value maximization is preferred decision criterion for the financial manager. B. Making decisions that maximize shareholder value or wealth focuses the financial manager on expected cash flows from investments, the timing of the cash flows, and the variability or riskiness of those cash flows. 1-8 C. Other decision criteria, such as profit maximization or market share maximization, do not achieve value maximization. Making decisions based on profit maximization may focus on accounting income and not consider cash flow, is biased toward short-run returns perhaps ignoring the longer run implications of decisions, and ignores the relative riskiness of the decision alternatives. Ethics and Management Objectives A. Shareholders and the public are concerned that managers operate within the law and maintain the reputation and ethical good standing of the business. The corporations who do business unethically have to pay heavily eventually. B. Fair and ethical relationships build and maintain long-run value. There is positive relation between maximizing value and doing business ethically. Do Managers Really Maximize Firm Value? A. The separation between ownership (principals) and management (agents) may create a potential conflict of interest between owners and managers. The study of this conflict and resolutions is called agency theory. B. Shareholders are concerned that managers work for maximizing shareholders’ wealth and not managers’ wealth and lifestyle. Agency problems exist when managers, as agents of shareholders, have a conflict of interest with shareholders. C. There are many diverse interests with a “stake” in the well-being of a business: managers, workers, suppliers, customers, government, shareholders, etc. These stakeholders’ interest may conflict at times; managers must work to resolve these diverse interests. D. Compensation plans should motivate managers to work for their own best personal interest and the best interest of the shareholders, thus resolving some agency problems. E. The board of directors, elected by shareholders, oversees, and at times interferes, if managers do not act in the best interest of shareholders. F. Managers whose company does not perform in the best interest of shareholders are candidates for a takeover by a new investor group. G. Every public company and its managers are scrutinized and monitored by stock analysts. This specialist monitoring tends to focus managers on value creation. H. Dishonest managers with stock option compensations may seek to hide the truth 1-9 from investors. The scandals like WorldCom led the US Congress to pass the Sarbanes-Oxley Act, which aims to ensure that companies and their accountants provide directors, lenders, and shareholders with reliable financial information. Similar scandals, such as Nortel, occurred in Canada as well. Bill C-198, passed in Ontario, is known as “Canada’s Sarbanes Oxley”. I. There are legal and regulatory requirements for CEOs and financial managers to act responsibly and in the interests of investors. 1.6 CAREERS IN FINANCE A. Careers in finance cover a wide range of activities but can be categorized into three areas: corporate finance, investments, and financial services. B. Careers in corporate finance, starting as a financial analyst, include investment and financing analyses, cost analyses, and treasury management activities. C. Careers in investments focus on researching investments, building portfolios, and managing portfolios for financial institutions (chartered banks, investment dealers, insurance companies, mutual funds, pension funds). D. Careers in financial services are associated with providing customers, business and consumers, with financial services ranging from payment services, investments, credit services, insurance, trust, and financial advising. Services are provided by a wide range of financial institutions, including chartered banks, investment dealers, caisses populaires, credit unions, property/casualty and life insurance companies, credit card companies, and trust companies. Careers are also available for the regulatory agencies of the institutions listed. 1.7 TOPICS COVERED IN THIS BOOK Following the definition of the financial manager, this book first studies investment decision making, and then financing decisions, then a variety of special issues. Snippets of History This book presents today’s financial practices and theories in a logical order, while financial practices and theories have a long, interesting history. A historical perspective underscores the fact that financial practices and theories are constantly evolving and new innovations are expected to emerge in the future. In this edition, this section has been updated with discussion of financial practices that led to the recent global financial crisis and also the current situation with European 1-10 countries such as Greece. 1.8 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - Consider reviewing the table of contents of the text with the students at the end of your first chapter lecture. It will reinforce the “big picture” perspective, and give them a plan for your course. This chapter provides a “big picture” perspective that many students will soon forget as they get mired in the detailed chapters which follow. In future lectures always tie the day’s chapter at hand back to the basic themes of the text, and perhaps your first chapter lecture. When the student has a sense of where and how a chapter fits into the whole, they can begin to tie chapters and concepts together, instead of staying mired in terms, computations, and specific topics. Student Career Planning - One of the greatest opportunities you can provide for your students is the chance to purchase Canadian newspapers and business publications such as The Globe and Mail, National Post, or Canadian Business or U.S. publications such as Wall Street Journal, Business Week, Fortune, etc., many of which are likely to be available at students’ rates. The excitement and desire to keep up with current events in the field is an important part of the student becoming a professional. Internet Exercises - The growing Internet has a vast number of finance-related sites. This section of the IM will analyze two Internet sites related to the chapter and suggest ways in which you can use the sites in your class. They can serve as “show and tell,” if you have access to the Internet in your classroom or print out the home page of the site and distribute it in class. It has the purpose of providing a bibliography for continued study and reinforcement of chapter concepts or to boost student interest in the subject. http://www.smartmoney.com Smartmoney.com is a comprehensive “finance” site and is a good place for students to view the wide scope of finance. A simple investment game could be devised for the students to focus their attention on current events and the market valuation process. You could “give” them $100,000 and ask them to invest the funds in a stock portfolio for the term. They could then be asked to select from five to eight companies, allocate their funds (company stock price times number of shares), and follow the stocks for the semester. There are many stock portfolio games on the Internet, but this is simple. They are asked to link to http://www.fortune.com and select their companies from the many lists available. Most of the companies available on this link would be U.S. based but several large Canadian companies would be included also. The students could then be asked to research their companies at Smartmoney.com. This site has easy graphing capability, comparisons with industry/competitor performance, and even a portfolio manager. Using 1-11 the valuation theme of the text as the major theme for the course, references to the stock market performance, and their stocks brings the text materials to real time! The many lists provided by Fortune also link to company home pages, where students can research careers available from the company. http://www.fpdata.finpost.com The Financial Post database is also an excellent source of researching Canadian companies. Universities often have access to the database through licensing arrangements. The database includes separate reference sources, namely, Financial Post Dividends, Profiler, Reports, and Analyzer. The Profiler and Dividends databases offer detailed financial information on a large number of publicly traded Canadian companies; the corporate Reports database provides access to historical, investor and industry reports of leading Canadian companies; while the Analyzer database allows the user to retrieve and analyze data. http://www.canadiancareers.com This site provides a collection of resources by occupation, occupational profiles, and Canadian career planning and occupational links. Information on Canadian labour market trends is also provided. http://www.careers.org The site provides exhaustive links to employment and University resources available in the U.S. and Canada. This site also gives a detailed list of financial services organizations in the US and Canada and offers links to financial company sites. http://www.careers-in-business.com/ The Careers-in-Business site has in-depth analysis of several finance, accounting, and marketing careers; an excellent bibliography of “careers” books; and links to most of the major career sites on the Internet. For each career listed, the site provides an overview of the career, skills and talents required, job options, salaries, and links to related sites. Overall, this site is an excellent place to start a review of careers in finance. 1-12 CHAPTER 2 FINANCIAL MARKETS AND INSTITUTIONS CHAPTER IN PERSPECTIVE This fifth edition expands the discussions on the contributions of financial markets and institutions to the growth of corporations and the productivity of overall economy. In this new edition the current chapter revisits agency problems in Section 2.2, Agency Problems and Corporate Governance, to emphasize the importance of corporate governance. Another addition to the new edition, Finance in Practice Box Prediction Markets, provides an interesting example on how market works. This example can also prepare the students for the later more in-depth discussion of efficient market hypothesis in Chapter 7. The financial system is a significant part of the operating environment of any business, and especially a larger, public corporation, which is the primary focus of this text. Of course corporations "finance" in financial markets and have a constant "performance evaluation" from financial markets as told through securities prices. Corporations also "invest" in financial markets (marketable securities and equity investments), and increasingly use the derivative contracts traded in financial markets to manage risks of the business. The payments system, a part of the financial system, is an important means of managing cash flow for any business today, combining communications and computing technology to manage funds flows both "to" and "from" a company. Investors and financial markets determine the required rate of return that corporate managers must earn on asset investments, so financial managers must constantly "assess" or interpret their "cost" of capital from capital market data. The concept of opportunity cost of capital is introduced in this chapter and will be an important part of the "value maximization" theme that runs throughout the text. CHAPTER OUTLINE 2.1 THE IMPORTANCE OF FINANCIAL MARKETS AND INSTITUTIONS 2.2 THE FLOW OF SAVINGS TO CORPORATIONS 2-1 The Stock Market Agency Problems and Corporate Governance Other Financial Markets Financial Intermediaries Financial Institutions Total Financing of Canadian Corporations 2.3 FUNCTIONS OF FINANCIAL MARKETS AND INTERMEDIARIES Transporting Cash across Time Risk Transfer and Diversification Liquidity The Payment Mechanism Information Provided by Financial Markets 2.4 VALUE MAXIMIZATION AND THE COST OF CAPITAL Value Maximization The Opportunity Cost of Capital 2.5 THE CRISIS OF 2007-2009 2.5 SUMMARY 2-2 TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 2.1 THE IMPORTANCE OF FINANCIAL MARKETS AND INSTITUTIONS A. Financial market is one of the key factors to the modern economy. The history of Research in Motion shows the key role played by financial market. B. Financial markets provide financing to the corporation’s growth. A modern financial system offers financing in many different forms, depending on the company’s age, growth rate and nature of its business. The Finance in Action article on page 35 illustrates how innovation in the financial sector has helped to finance business ventures in developing countries. 2.2 THE FLOW OF SAVINGS TO CORPORATIONS A. Households and foreign investors provide most of the saving for corporate financing; financial markets and institutions provide the process and contracts to channel funds from savers to corporations (financial investment) for real investment. Figure 2.1 is an excellent graphic for this discussion. B. Corporations (businesses) also generate cash from operations (cash in less cash out) for reinvestment in real assets. Smaller businesses are especially dependent upon internally generated funds. The Stock Market A. Funds are traded for securities, issued by corporations, in financial markets. Financial Manager Firm's operations Investors (2 (1 (3 (4a Real assets (4b 2-3 1. The initial sale of securities or initial public offering (IPO), and receipt of cash to the corporation, is in the primary market. 2. Subsequent sale of securities in financial markets, between investors, are in secondary markets. B. Common stocks of publicly traded companies are traded in stock or equity markets. 1. Trading takes place at physical exchanges, such as the Toronto Stock Exchange (TSX) in Canada or the New York Stock Exchange (NYSE) in the U.S. or between networks of dealers in the over-the-counter (OTC) markets such as the NASDAQ. Also, new alternate trading systems, such as Pure Trading, provide additional ways to trade securities. 2. Stocks of major corporations trade in many markets throughout the world on a continuous basis. Agency Problems and Corporate governance A. An agency problem arises when a manager owns less than the total common stock of the firm. This fractional ownership can lead the managers to shirk and to consume more perquisites because other owners bear part of the costs. B. An important theme of corporate governance is to ensure the accountability of the managers in a company through mechanisms that try to reduce or eliminate the principal-agent problem. Other Financial Markets A. Debt securities (contractual obligations to pay) are traded in the fixed-income market or bond markets. B. The market for long-term debt and equity securities is called the capital market, whereas the market for short-term, high quality, liquid debt securities is called the money market. C. Other financial asset (security) markets for immediate or spot or future delivery (foreign exchange, futures, options) and real assets (commodities) exist throughout the world. 2-4 Financial Intermediaries A. Savings may flow to real investment directly through financial markets or indirectly through financial intermediaries. B. Mutual funds issue shares or units to savers and invest in a variety of portfolios of financial assets, providing professional management and diversification. C. Exchange-traded funds (ETF) also raise funds by selling units to investors. Once the ETF is established, its units are listed for trading on stock exchanges. Investors can buy and sell the ETF units just as they can buy and sell shares of a corporation. D. A financial investor (saver) may own corporate stock or securities directly (hold the shares) or indirectly through financial intermediaries, such as mutual funds and EFTs. E. Pension funds, funds contributed by employers and/or employees for future retirement, are a significant financial intermediary today and a very large common stock investor. Financial Institutions A. Financial intermediaries that also provide payment, investing, lending, and risk management services, are called financial institutions. B. The big six domestic chartered banks are Canada’s most familiar financial institutions, accounting for about 88 percent of the country’s bank industry assets and over 50 percent of the total domestic assets held by the financial sector. Other financial intermediaries include other domestic banks and foreign bank branches and subsidiaries, caisses populaires, credit unions, insurance companies, pension funds and trust companies. C. Banks and insurance companies intermediate funds from savings to investment (two contracts), but also provide contracts for financial services (checking services and insurance). Total Financing of Canadian Corporations A. The capital market securities of Canadian corporations (bonds, debentures and shares) are owned by individuals and financial intermediaries from around the world. See Figure 2.3 and 2.4. 2-5 2.3 FUNCTIONS OF FINANCIAL MARKETS AND INTERMEDIARIES Financial markets and intermediaries provide "financing" for business by providing for the transfer or investment in corporate securities. In addition, they provide a variety of other economic functions to the corporation. Transporting Cash across Time A. Financial markets and institutions provide savers (cash inflow exceeding cash outflow for period) an opportunity to enter into contracts (financial investments) to transport purchasing power to future periods (retirement funds). Both initial principal and accumulated earnings on investments will be available for later. B. Financial markets and institutions provide borrowers (cash inflow less than outflow for the period) an opportunity to contract with lenders (borrow) funds to be earned in later periods for use now. The interest paid on loans is the cost of transporting future income to present consumption. Risk Transfer and Diversification A. Financial markets and institutions (insurance companies) provide a means of contractually reducing or reallocating business and financial risk to others. B. Insurance via insurance contracts may be available for pure, insurable risks (casualty risks) or risk may be hedged via futures, options, and swap contracts traded on exchanges or directly. C. Holding assets in portfolios takes advantage of the opportunity to diversify away part of the risk of assets. When the authors mention investors in the text, it is assumed that they are well diversified. Liquidity A. Financial markets (ability to trade assets owned) and institutions (stored in financial assets or lines of credit) provide businesses liquidity. Liquidity, the ability to get to cash, is a direct function of time and transaction costs (direct and indirect). B. Corporations may store liquidity in money market securities or issue money market securities (commercial paper) or buy bank CD's or establish a line of credit 2-6 at a commercial bank. C. The efficiency of the payments mechanism (process of paying for a transaction) provided by the financial system enhances trade of real goods and services and financial markets/institutions transactions. The Payment Mechanism A. Payment services provided by bands and other financial institutions allow firms and individuals to send and receive payments quickly and safely over long distance Information Provided by Financial Markets A. Information from financial markets aid the financial manager by providing a constant evaluation (pricing) of a corporation's securities. The pricing of securities imparts required rate of return information for new corporate investments (cost of capital) on a continuous basis. B. A continuous flow of information about economic levels, commodity prices, interest rates and company stock prices aids the financial manager to make decisions that will best maximize the long-run value of the corporation. 2.4 VALUE MAXIMIZATION AND THE COST OF CAPITAL Access to well-functioning financial markets and institutions allow the shareholders who differ in their risk-tolerance to share and transfer risks. Financial markets and institutions give shareholders the flexibility to manage their own saving and investment plans. The Opportunity Cost of Capital A. The cost of capital is the minimum acceptable of return needed on capital investments to maintain the current value of their securities. It is the minimum return demanded by investors for investments of a certain risk level available in the market. B. The rates of return on investments outside the corporation set the minimum return for investment projects inside the corporation. In other words, the cost of capital for corporate investments is set by the rates of return on investment opportunities 2-7 in financial markets – the opportunity cost of capital. C. Investment projects offering rates of return higher than the cost of capital add value to the firm. Projects offering rates of return less than the cost of capital actually subtract value and should not be undertaken. 2.5 THE CRISIS OF 2007-2009 A. The financial crisis of 2007–2009 raised many questions, but it settled one question conclusively: Yes, financial markets and institutions are important. When financial markets and institutions ceased to operate properly, the world was pushed into a global recession. B. The financial crisis had its roots in the easy-money policies that were pursued by the U.S.Federal Reserve and other central banks following the collapse of the Internet and telecom stock bubble in 2000. Banks took advantage of this cheap money to expand the supply of subprime mortgages to low-income borrowers. Most subprime mortgages were then packaged together into mortgage-backed securities that could be resold. But, instead of selling these securities to investors who could best bear the risk, many banks kept large quantities of the loans on their own books or sold them to other banks. The crisis peaked in September 2008. C. Few developed economies escaped the crisis. As well as suffering from a collapse in their own housing markets, many foreign banks had made large investments in U.S. subprime mortgages. D. The banking crisis and subsequent recession left many governments with huge mountains of debt. By 2010 investors were becoming increasingly concerned about the position of Greece, where for many years government spending had been running well ahead of revenues. 2.6 SUMMARY PEDAGOGICAL IDEAS General Teaching Note – This is the second introductory chapter and continues on the “big picture” theme, this time emphasizing the financial environment. Students learn that corporations obtain “financing” in financial markets and undergo a constant process of monitoring and “performance evaluation” in such markets through, for instance, the pricing of their securities. Financial markets and intermediaries channel savings to corporations. This chapter introduces different types of financial markets, including the stock market as well as the markets for long term and short term debt. It is important to 2-8 describe the different types of financial institutions and intermediaries operating in Canada highlighting their role and some of their unique features. For instance, you may want to discuss the banking sector wherein different banking institutions fall under different schedules under the Bank Act. For instance, Canada’s chartered banks fall under Schedule 1; what does this mean? Discuss the role of mutual funds, insurance companies, pension funds, credit unions and caisse populaires. Investors and financial markets determine the required rate of return that corporate managers must earn on asset investments, so financial managers must constantly "assess" or interpret their "cost" of capital from capital market data. As mentioned earlier, the concept of opportunity cost of capital is introduced in this chapter and will be an important part of the "value maximization" theme that runs throughout the text. Student Career Planning - For this financial markets discussion, ask students to evaluate the efficiency of the entry-level job market. Review the conditions necessary for high levels of efficiency, and students quickly see that inefficiency lurks everywhere. As a transition from financial markets, I always ask students to evaluate every market situation that they face, whether it is the entry-level job market or, later, the product market of their business. Information is king, and in the entry-level job market, information access is a long, nurturing process which includes networking, data bases, reading, communications, and recently, even the Internet. There are few short cuts unless they are the boss’s daughter or son, and that is valuable information for their fellow students! Internet Exercises – The websites below are referred to in the book and are well worth exploring. http://www.cba.ca/ The website of the Canadian Bankers Association provides a wealth of information on the nation’s banking industry. You will find information on Canada’s chartered banks as well as other domestic and foreign banks and bank branches operating in the country. The website provides useful and updated statistics on the banking industry. Also, you can read about important legislative enactments, historical milestones on Canadian banking, and news features on the industry. http://www.ific.ca/ This is the site of the Investment Funds Institute of Canada (IFIC) and provides good information on the mutual fund industry. You may want to check out their monthly industry statistics updates. You can also link to individual member mutual fund websites in addition to other sites that would be of interest to finance professionals. The IFIC Education link will take you to relevant information on professional study courses such as 2-9 the Certified Financial Planner program or the Canadian Investment Funds course. The “regulations and committees” link provides relevant information on the regulatory environment for the mutual funds industry. Try out the “glossary” link as well; it contains an array of terms and related definitions that would be of interest to anyone in the finance profession. 2-10 CHAPTER 3 ACCOUNTING AND FINANCE CHAPTER IN PERSPECTIVE In this fifth edition the old Chapter 17, Financial Statement Analysis, has been re-written, renamed Measuring Corporate Performance and moved to Chapter 4. This change puts the two chapters closely related to accounting back-to-back. Chapter 3 describes financial statements. Chapter 4 explains how financial statements can be used to understand why a firm has performed well or badly. This third preliminary chapter, Accounting and Finance, continues to establish a financial manager perspective. The financial manager is concerned with cash flows after taxes, their timing, and the potential variability of the cash flows, each important aspects of the process of creating value. The major aspects of International Financial Reporting Standards (IFRS) financial statements are discussed and illustrated with the IFRS financial statements of AstraZeneca. One of the unresolved issues about the current conversion to IFRS by Canadian corporations is what names corporations are going to use for various financial statements and also the names of all of items on the financial statement. For example, will the balance sheet be called the statement of financial position by most Canadian companies using IFRS? Many of these issues will be resolved by the end of 2012 when IFRS based Canadian companies annual reports based on IFRS are finally produced. So, if you want to decide what to call various statements look at the annual report of public Canadian companies that uses IFRS. For example, you can look at www.sedar.com and look at annual reports. Accounting measures of value and income and cash flow measurements are discussed, followed by a discussion of two important cash flow concepts: cash flow from assets and financing flow. The chapter ends with a brief introduction to taxation and its implications for decision-making. Students typically come to this course with one or more courses in accounting behind them. Basic knowledge of IFRS and/or GAAP and financial statements is implied, we move quickly to provide a financial manager/shareholder perspective to the financial statements. While easily verifiable and objectively determined, historical cost is quickly judged as irrelevant. Economic value or market value assessment of assets, liabilities, and equity is the focus of value assessors such as managers, analysts, and shareholders. We spend time looking at the statement of cash flow, showing how it can be used to better understand where the cash is generated and where it is used in the business. We then take the statement of cash flow and use it to calculate the very important measure of cash flow for at firm: free cash flow. We show that free cash flow equals the cash generated through the operation of the business (cash flow from assets) and also equals the cash generated through the financing activities of the firm (financial flow). 3-1 Even though valuation concepts are introduced later, the cash flow connection to business or financial value should be made in this chapter, as should timing of cash flows in the next chapter. Use some class time to discuss how these first three chapters fit with our important financial decision criterion, value maximization, covered later in the next section of the book. The tax implications of business and financial decisions have considerable effect on the amount and timing of future cash flows. For decision-making, the marginal tax rate is the relevant variable. For our corporate model, we typically use a 30 percent marginal tax rate in text examples and problems. The after-tax implications of a dollar of expense, such as interest expense, are an important foundation block for later capital structure discussion. Remind students of the difference between interest expense and return of principal, including how they are accounted for and their tax treatment. CHAPTER OUTLINE 3.1 THE STATEMENT OF FINANCIAL POSITION OR BALANCE SHEET Book Values and Market Values 3.2 THE INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Consolidated Statement of Changes in Equity Profits versus Cash Flow 3.3 THE STATEMENT OF CASH FLOWS 3.4 CASH FLOW FROM ASSETS, FINANCING FLOW, AND FREE CASH FLOW 3.5 ACCOUNTING PRACTICE AND ACCOUNTING MALPRACTICE 3.6 TAXES Corporate Tax Personal Tax 3.7 SUMMARY 3-2 TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 3.1 THE STATEMENT OF FINANCIAL POSITION OR THE BALANCE SHEET A. The statement of financial position (the IFRS name for the GAAP balance sheet) presents the accounting value of assets and the sources of money used to purchase those assets at a particular point in time. B. Assets are usually listed in descending order of liquidity, or the ability to convert to cash. 1. Cash and cash equivalents (money immediately accessible in bank accounts), trade and other receivables, and inventories, other investments (include marketable securities) are current assets, each of which expect to cycle through cash over the next year. 2. Non-current assets (called long-term assets by some) include tangible assets (called fixed assets by some) like property, plant and equipment and intangible assets such as patents, licenses and trademarks, will not be converted to cash but are expected to generate cash over future accounting cycles. C. While the assets depict what is owned, liabilities and equity represent what is owed or who provided the funding for the assets. 1. Current liabilities, such as interest-bearing loans and borrowing, trade and other payables, represent obligations requiring cash payment within the next year. 2. Current assets minus current liabilities are net working capital, or the extent to which current assets are financed with long-term sources of financing. 3. Non-current (long-term) liabilities include debt obligations due beyond one year. 4. The difference between the accounting value of the assets and the liabilities is the shareholders’ equity, representing the original capital contribution plus the earnings retained in the business. See Figure 3.1 for a mental picture of the balance sheet. THE MAIN BALANCE SHEET ITEMS Current Assets Cash & cash equivalents Receivables Inventories + Long-term Assets Tangible assets Intangible assets = Current liabilities Short-term debt Payables + Non-current Liabilities Long-term debt Other payables + 3-3 Shareholder’s Equity Book Values and Market Values A. International Financial Reporting Standards (IFRS) provide guidelines for preparing financial statements. B. According to IFRS, assets are recorded using either the revaluation method or cost method. The cost method is similar to GAAP and records the assets at the historical or original cost value. The revaluation method uses the fair value (market value) of the assets or liabilities. The company must revalue the assets very few years. C. The book value of a business represents the accounting value or the balance sheet value. The book value of net worth or equity is the book value of assets less liabilities, or the historical contributions of owners including original cash contributions (sale of stock) plus reinvested earnings (retained earnings.) D. Now with IFRS it is crucial to read the notes to the statement of financial position to know how the company is valuing its assets and liabilities. So although some assets’ book values are based on original cost, others can be fair value, which is close to their current market value, based on value in use or economic value: the ability to generate future cash flows. Liabilities can be valued various ways too. E. Shareholders and managers are concerned about the market value of their stock, so their focus is on a market value driven balance sheet. F. The market value of assets minus the market value of liabilities is the market value of shareholders’ equity. See the Jupiter Motors Example 3.1. G. Book values are based upon IFRS or GAAP and market values of assets and liabilities, and thus net worth, are driven by economic value factors studied in later chapters. Seldom are they the same. 3.2 THE INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME A. The income statement is a financial statement listing the revenues, expenses, and net income from the operation of the firm over a period of time. The statement of comprehensive income includes the income statement and also other comprehensive income which are usually are due to changes in book value of assets and liabilities. B. The income statement indicates where operating profit (EBIT) came from (revenues - operating costs - depreciation) and where operating income was 3-4 distributed (interest to creditors, taxes to governments, and profits to shareholders). Consolidated Statement of Changes in Equity A. Under IFRS the statement of comprehensive income does not include transactions with shareholders. So the last line is profits, not addition to retained earnings. The Statement of Changes in Equity provides the information about dividends, share issuance, share repurchases, addition to retained earnings, dividends. The bottom line of the statement of changes in equity is the same as equity on the statement of financial position. Profits versus Cash Flow A. Shareholders and managers are concerned about maximizing shareholder value, and therefore are oriented toward estimating and generating cash flows. B. Profits from an income statement and cash flow usually differ because cash flow and profits are measured differently. Cash flow equals the actual dollars generated by the company minus the cash paid out. By contrast, when income or profits are measured, the accountants attempt to smooth spending over time, to correspond with the use of assets and the generation of revenues. C. Instead of deducting the cost of a machine in the year it is purchased, the accountant spreads the cost over time through an annual charge called depreciation. Depreciation is an example of the smoothing done to match the cost of an asset with its use. By contrast, cash flow is reduced by the full cost of the assets when they are purchased. With the IFRS method for measuring asset value some of the change in asset value can be due to impairment, reduction in fair value of the asset. So the change in asset value in a year can be both depreciation and impairment charge. D. Noncash expenses, such as depreciation, amortization and impairment, are allocated to a specific period to measure accounting profit. These noncash expenses cause profit to be less than actual operating cash flow. Thus noncash expenses (noncash revenues) must be added back to (subtracted from) profit to estimate cash flow in a period. E. Another reason why profits and cash flow differ is explained by comparing cash accounting versus accrual accounting. Accrual accounting emphasizes profit measurement in a period: the revenue earned in the period; the expenses incurred in the period. However, the expenses are matched to the revenues: the accountant gathers together all of the expenses associated with the goods and services sold, regardless of when the actual costs were incurred. Cash flow is oriented to cash collected versus disbursed in a period. Adjusting entries, accruals, receivables, 3-5 prepaid expenses, and payable liabilities cause accounting profits measured in a period to differ from cash flow in the same period. F. Inventories are another reason for difference between cash flow and profit. Inventories produced or purchased typically incur an outlay of cash, but are not be expensed (through cost of goods sold) until sold. Thus, increases in inventories are paid from cash but do not affect profits until the inventory is sold. 3.3 THE STATEMENT OF CASH FLOWS A. The statement of cash flow is a financial statement that shows the firm’s cash receipts and cash payments over a period of time. Whether a firm uses IFRS or GAAP the annual statement of cash flow has the same basic structure and provides very important information about cash production and use over the past year. B. The statement of cash flows explains why the firm’s cash (IFRS cash and cash equivalents) changed over the period. The increase (or decrease) in cash shown at the bottom of the statement of cash flow equals the increase (or decrease) in cash calculated using the balance sheet cash account. C. The statement of cash flow is divided into three sections. 1. The cash flow provided by operating activities for a period is the sum of net income plus (minus) noncash expenses (noncash revenue) plus (minus) the net sources (uses) of cash from changes in various working capital accounts. Decreases (increases) in current asset (current liability) accounts are sources of cash. Increases (decreases) in current asset (current liability) accounts are applications or uses of cash during a period. 2. The cash flow from (used in) investments represents added net (purchase less sale) long-term (capitalized) asset investment in the period. 3. The cash flows from financing activities are listed last and include the net change in debt outstanding, cash dividends paid, and the sale or repurchase of common stock. 4. Since every income statement ledger item and the changes in statement of financial position (balance sheet) ledger items in the period, except the change in the cash and cash equivalents, has been listed in the statement of cash flows, the balancing sum of net cash flows must equal the net change in the cash and cash equivalents account in the period. 3-6 3.4 CASH FLOW FROM ASSETS, FINANCING FLOW, AND FREE CASH FLOW A. The basic equation from the statement of cash flows is: Change in cash and cash equivalents = cash inflow (outflow) from operating activities + cash inflow (outflow) from investing activities + cash inflow (outflow) from) financing activities B. Cash flow generated by the firm’s operations is defined as: cash flow from assets = cash inflow (outflow) from operating activities + cash inflow (outflow) from investing activities C. Cash flow to lenders and shareholders plus increase in cash balances is defined as financing flow = change in cash and cash equivalents - cash inflow (outflow) from) financing activities The key thing to note is that cash flow to lenders and shareholders is negative cash flow from the perspective of the company because it is cash the company pays to its lenders and shareholders. D. Rearrange the basic equation of the statement of cash flows as: cash inflow (outflow) from operating activities + cash inflow (outflow) from investing activities = Change in cash and cash equivalents - cash inflow (outflow) from investing activities Then replace cash inflow (outflow) from operating activities + cash inflow (outflow) from investing activities with “cash flow from assets” and replace change in cash and cash equivalents - cash inflow (outflow) from investing activities with “financing flow”. This shows that cash flow from assets = financing flow. E. Cash flow from assets is some times called free cash flow. It is because it is cash flow available to pay to shareholders and lenders. This is because cash flow from assets equals financing flow. F. In the statement of cash flow, prepared according to IFRS, interest paid to debtholders can be classified as an operating expense and not as a financing flow. To accurately measure the cash flow to debtholders, interest expense must be reclassified as a financing flow. This is accomplished by adding the interest expense back to the cash flow from assets and adding it to the financing flows. With this adjustment, the financing flow is a more complete measure of the cash paid out to the firm's financiers. G. When interest is reclassified as a financing flow, use the following equations: Cash flow from assets (adjusted) = cash flow from assets + interest 3-7 Financing flow (adjusted) = cash flow to debtholders + cash flow to shareholders + increase (decrease) in cash in the bank Cash flow to debtholders = interest + net debt repayment (net debt issuance) Cash flow to shareholders = dividends + net equity repayment (net equity issuance) H. Positive cash flow from assets (or positive free cash flow) means that the company generated more cash from its operations than it spent on its investments. Where does the surplus cash go? Either it is distributed to debtholders and shareholders or shows up in the firm’s bank account. Negative cash flow from assets means that the firm used more cash in its investments than it generated from its operations. This cash shortfall is met by either raising net new financing from bondholders and shareholders or by drawing down surplus cash reserves of the company. I. Managers must understand the cash flow from assets and financing flow of their company. Financing decisions and dividend payouts affect the availability of cash to pay for investments. Investors too care about the firm's cash flows. Will the company have cash to pay dividends and repay borrowed funds? Cash flow from assets is at the heart of valuation. The value of the company depends on the cash flow from assets the business will generate. 3.5 ACCOUNTING PRACTICE AND ACCOUNTING MALPRACTICE A. While accounting is concerned with a presentation of earnings and book values according to IFRS or GAAP, financial analysts, managers, and shareholders, current and prospective, are also interested in balance sheet and income statement adjustments that allow them to measure market values and cash flows. B. The work of the International Accounting Standards Committee toward standardizing accounting conventions worldwide will encourage the globalization of financial markets. Now that IFRS is used by public Canadian companies their accounting standards are the same as many other countries in the world, including Australia, Japan, India and the European Union who have already adopted IFRS and other countries have convergence programs underway. C. The big debate in the US about IFRS is the fact that IFRS is “principles- based” rather than “rules-based”. So using IFRS companies must pick their own financial rules and this means that financial statements must be read with the notes to be able to completely interpret the financial information. 3-8 3.6 TAXES Taxes paid to governments affect cash flow available for shareholders. Usually there is a tax implication for every financial decision. The basic tax concepts which follow will assist in making the “tax adjustments” needed for the financial decisions studied in future chapters. Corporate Tax A. The corporation is taxed on its taxable revenue adjusted for tax-deductible business expenses, such as cost of goods sold, salaries, interest paid, and so forth. The tax tables listed in Table 3.5 on page 84 lists the federal and provincial tax rates for corporate taxable income. B. Interest expense for the corporation is tax deductible; cash dividends paid to shareholders are not. The after-tax cost of a dollar of interest expense paid, with a 35 percent marginal tax bracket, is $1.00 times (1 - marginal tax rate of .35) or $.65. The cost of a $1.00 of dividends is $1.00, for dividends are not tax deductible. This special tax deduction for interest will have important implications when the financing decision of debt or equity is discussed. Personal Tax A. Interest income for individuals (not corporations) is taxed as ordinary income at the appropriate marginal tax rate. Both the federal government and each province charge its own taxes and have its own tax rates. See Table 3.7 on page 86. B. The marginal tax rate represents the added taxes per dollar owed for each additional dollar of taxable income. The marginal tax rate is the relevant tax rate for financial decision-making analysis. The concept is future oriented, consistent with financial decision-making. C. The average tax rate represents the total taxes owed divided by income before taxes. The average tax rate is a historical, after-the-fact measure and not a valid decision-making tool. D. Dividends are taxed at a rate lower than salary or interest income. The Canadian tax system recognizes that dividends are paid from a company’s after-corporate tax income. Individuals are given a tax credit, recognizing that some tax has already been paid. Now the personal taxation of dividends takes into consideration the tax rate of the company paying the dividends. Dividends are classified as eligible or non-eligible. Dividends paid by high tax Canadian corporations are eligible has get the higher gross-up factor (1.41 times the dividend) and the higher dividend tax credit (16.44% for federal taxes). Dividends paid by Canadian 3-9 companies with low tax rates (due to lower small business corporate tax rate) have a lower gross-up factor (1.25) and lower dividend tax credit (13.33% for federal taxes) To calculate taxes on dividends, dividends are first grossed up the relevant gross-up factor o. Gross federal taxes equal the tax rate times the grossed up dividend. Then the dividend tax credit is calculated by multiplying the relevant dividend tax credit rate times the grossed up dividend. Then the dividend tax credit is subtracted to give net federal taxes. The process is repeated with the appropriate provincial dividend tax credit and provincial tax rate to calculate the provincial dividend tax. See Example 3.3. E. Capital gains are taxed at one-half of the tax rate on salary and interest income. This applies to both personal and corporate capital gains. Capital gains are only taxable when realized (when the asset is sold for more than was originally paid to purchase it). See Example 3.4. 3.7 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - While the simple or scientific calculator, typically used in high school, has helped the student through two chapters, it is time to make a “pitch” for the purchase of a financial calculator in preparation for the next chapter. For around $40.00, Sharp, TI, or HP provides a full financial and statistical model with IRR and NPV functions built in. The time value concepts of present value, etc., and financial decision models such as IRR and NPV may be covered with relatively simple arithmetic or “financial table” examples, but the students quickly see the economies of a financial calculator. With so much new material in this course, it is time to increase our efficiency in the time value area. Whole number growth rates, years, and values are history; mixed numbers, monthly payments, and ninety-day annualized rates of return are here and are “real.” Lead by example. Have your financial calculator (similar to theirs) with you each day, and the flock will follow. Student Career Planning - The challenges confronting many business students in the entry-level job market has impacted many business schools and faculty. With good jobs scarce, there has been increased emphasis on career planning by students and many faculty. To the extent that you, the professor, feel you ought to be involved in this process, this section is designed to provide a variety of career planning and personal development ideas that you might share with your students. Most are probably not unique but serve as reminders of the variety of issues involved in the career planning process. An important factor in career preparedness is early involvement in the university’s placement service activities. Early involvement with the career center provides an opportunity for skills assessment and remedial work, whether it is computer or 3-10 communication skills needed, informational interviews, and resume preparation for internship and co-op opportunities. Career planning is a big unknown for most students, so rationalization usually dominates over action. Give them a nudge today. Circulate memos from the placement center. Let them know about the service. Additional Internet Resources - This chapter focuses on two topics: a review of accounting financial statements and tax concepts. Our first set of Internet resources are the websites of three accounting standards boards. The second set of resources are sources of tax information. Financial Accounting Standards Boards Canada's Accounting Standards Board, AcSB: http://www.acsbcanada.org/index.cfm/ci_id/186/la_id/1.htm U.S. Financial Accounting Standards Board, FASB: http://www.fasb.org/ International Accounting Standards Board, IASB: http://www.iasb.org Each board establishes generally accepted accounting principles for financial statements produced by businesses for investors. As the economy changes, new industries arise, such as the “dotcom” industry. How are accounting standards established for new issues that arise? Poke around each of the websites to learn the process by which accounting standards are determined. Each site also has news releases section, new accounting issues, currently being discussed, are covered. Once the AcSB, FASB or ISCB proposes a new accounting rule or convention, it is open for discussion from all stakeholders. The “Exposure Drafts” of proposed accounting policies are listed on the site. Tax Information Information about Canadian taxation is available at the website of the Canada Revenue Agency, CRA. http://www.cra-arc.gc.ca/menu-e.html For current personal tax rates: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html For current corporate tax rates: http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/rts-eng.html Also the accounting firms provide tax information. See for example, 3-11 PricewaterhouseCoopers’ tax website, www.ca.taxnews.com and also the Canadian Tax Foundation, www.ctf.ca Ask your students to look up the current federal and provincial tax rates for individuals and corporations residing in your province. 3-12 CHAPTER 4 MEASURING CORPORATE PERFORMANCE CHAPTER IN PERSPECTIVE This chapter is a re-write of Chapter 17 from the previous edition, Financial Statement Analysis. Chapter 4 continues with the example of AstraZeneca’s financial statements in the previous chapter. For professors who wish to cover accounting measures early in the course, this section could easily follow after Chapter 3, Accounting and Finance. Students tend to describe accounting and finance in a disconnected way and tend to misunderstand their relation. The excellent discussions in this chapter can help students conceptualizing the integrated and dynamic roles of accounting and finance in corporate finance. Accounting data record the history of a business up to a point in time. The data provide the link between accounting and finance. Performance evaluation is backward looking, while financial decision is forward looking, and both rely on the data. The process is dynamic and constantly updating in dynamic business environments. This chapter categorizes the scope of financial ratio analysis into six areas: (1) market value, (2) economic value added (EVA) and accounting measure of profitability, (3) efficiency or turnover, (4) leverage, (5) liquidity, and (6) sustainable growth. Several ratios are covered for each area, including an explanation of why the ratio is a good proxy for the concept. Table 4.6 on page 118 lists the ratios covered and what accounting and other data are needed for calculation. Table 4.7 presents a variety of ratios for several industries. 4-1 We caution our students that financial statements do not present hard “facts”. Although people refer to “accounting rules”, much of financial accounting involves judgement and reflects the goals of those putting the statements together. We encourage our students to be skeptical users of financial statements, to read the footnotes and think about the accounting conventions followed, rather than blindly accepting the numbers as the truth. We also encourage our students to take more financial accounting courses. Now with the conversion to IFRS for public Canadian companies there is more information in a firm’s financials but it is essential to read the notes to know the accounting rules being used. Another issue discussed in the text is accounting scandals, such as Enron and WorldCom. So with IFRS and potential accounting scandals we have more reason to tell our students to use caution when interpreting financial statements, and to draw on other sources of information about the company in addition to its financial statements. CHAPTER OUTLINE 4.1 MEASURING MARKET VALUE AND MARKET VALUE ADDED 4.2 ECONOMIC VALUE ADDED AND ACCOUNTING RATES OF RETURN Accounting Rates of Return Problems with EVA and Accounting Rates of Return 4-2 4.3 MEASURING EFFICIENCY 4.4 ANALYZING THE RETURN ON ASSETS: THE DU PONT SYSTEM The Du Pont System 4.5 MEASURING FINANCIAL LEVERAGE EBITDA Leverage and the Return on Equity 4.6 MEASURING LIQUIDITY 4.7 CALCULATING SUSTAINABLE GROWTH 4.8 INTERPRETING FINANCIAL RATIOS 4.9 THE ROLE OF FINANCIAL RATIOS – AND A FINAL NOTE ON TRANSPARENCY Transparency 4.10 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 4.1 MEASURING MARKET VALUE AND MARKET VALUE ADDED A. Companies who earn positive NPVs on their investments most likely will have generated market value added, the extent to which market value of equity exceeds the book value of equity (Table 4.3). 4-3 B. Market value company performance indicators include: Market-to-book ratio measures how much value has been added for each dollar that share holders have invested: Market-to-book ratio = market value of equity / book value of equity Market value added ($) the difference between the market value of a firm’s share and the amount of money that shareholders have invested in the firm. C. Market value performance measures have two disadvantages: 1. The current stock price in the market value performance measures can vary for many reasons. For example, the current stock price is based on investors’ expectations about future company performance. For example, high market price could be due to the expectation that positive NPV projects will continue to be made. Another issue with market value performance measures is the fact that stock price can fluctuate due to economics events that are outside the control of the company’s management. 2. Market value-based indicators are difficult to estimate for privately held companies. 4.2 ECONOMIC VALUE ADDED AND ACCOUNTING RATES OF RETURN A. Net operating profits after tax less the dollar cost of capital = economic value added (EVA) or residual income. EVA formula can be stated several ways: 4-4 EVA = Net income + after-tax interest expense – cost of capital x total capitalization EVA = NOPAT – cost of capital x total capitalization B. NOPAT (net operating profit after tax) is net income plus after-tax interest expense. NOPAT indicates the profit of the firm independently of how it is financed. Since net income is reduced by the interest expense but the interest expense reduces the firm’s taxes adding the after-tax interest expense (= (1-tax rate) x interest expense) to net income get the profits earned before any payment is made to lenders or shareholders. This concept is also used in several other financial ratios. One issue for measuring NOPAT is getting the company’s tax rate. The tax rate can be estimated using taxes/profit before taxes from the firm’s income statement. C. The cost of funds used to finance the firm, the opportunity cost of capital, is the minimum return necessary to pay bondholders and shareholders their opportunity rate of return. Details about measuring the cost of capital (WACC) are in Chapter 13 and Chapter 16. D. Accounting profits do not recognize the cost of capital. EVA is a better measure of company profits than accounting profit because the cost of capital it takes into consideration the required rate of return of investors in the company. So the cost of capital times the total capitalization is the amount of dollars that is needed to paid to investor in the firm. So NOPAT minus dollars that need to be paid to investors is a more sensible measure of the firm’s profits. Accounting Rates of Return A. Return on capital (ROC) is a measure of return to all investors. It is the net income plus after-tax interest as a percentage of long-term capital: Return on capital = (net income + after-tax interest) / (long-term debt + equity) = NOPAT/total capitalization B. Another performance measure of return to all investors is the return on assets (ROA) Return on assets = NOPAT / average total assets C. The return on equity (ROE) measures the profitability of the common stockholder’s equity or return per dollar of invested equity capital: 4-5 Return on equity = net income /equity D. All ratios calculated with income statement data and statement of financial position (balance sheet) data are relating data measured over a period of time (a year if an annual income statement is used) to data measured at a point in time (from the statement of financial position or balance sheet). So, the assets or equity can be measured at the start of the period, the end of period or as the average of the start and end of the year. Because of the variations in the measurement of the assets it is crucial that those who calculate financial ratios state the ratio definition that is used. Many of the accounting rates of return ratios used in this chapter use the average of the assets or equity at the start of the year and end of the year. 4.3 MEASURING EFFICIENCY A. Another area of financial analysis, efficiency ratios, measures how effectively the business is using its assets. “Using” relates to liquidity or profitability or performance. The numerators used in efficiency ratios are activity-based items, such as sales, cost of sales, etc., while the denominators are generally some average balance sheet amount. Turnover ratios are often converted to a time-line focus by dividing turnover ratios into 365 days. B. In a typical efficiency ratio, "flow" data from the income statement is measured against a "stock" (snapshot) data from the balance sheet, creating the possibility of distortion from timing differences. For example, a rapidly growing company's total assets at the end of the year will likely be substantially larger than its assets at the start of the year. If sales are measured over the entire year, then the end-of- year assets will be "too" high. Analysts deal with this problem several ways. One way is to use average assets (average of the assets at the end of the current year and the assets at the end of the previous year), rather than end-of-year assets. A second way is to change the sales measure to cover a period closer to end of the year, say take 12 times the sales during the last month of the year. This won't work if the company's sales are markedly seasonal. C. The asset turnover ratio measures the sales activity derived from total assets, or the revenue generated per dollar of total assets. The asset turnover is also an important component of asset profitability studied later, measuring the revenue per dollar invested: Asset turnover ratio = sales/average total asset Sales, a measure of activity, may also be compared to a variety of balance sheet accounts (e.g. non-current assets, net working capital, shareholders’ equity, etc.) to measure the revenue-generating efficiency of the account. D. The inventory turnover ratio, using the cost of goods sold representing the 4-6 cumulative amount of inventory sold in a period as the numerator and end of year inventory as the denominator, measures the number of times the value of inventory turns over in a period: Inventory turnover = cost of goods sold/average inventories The inventory turnover may be converted to a time line concept, the number of day sales in inventories, by finding the reciprocal (1/x) of the inventory turnover times 365 or: Average days in inventories = average inventories/daily cost of sales or Average days in inventories= inventory1 turnover × 365 E. The receivables turnover applies the same concept above to trade receivables. The receivable turnover ratio measures the firm’s sales as a proportion of its receivables: Receivable turnover = sales / average trade receivables If customers are quick to pay, the receivables turnover will be high. F. The average collection period applies the same concept above to trade receivables. The average collection period is the estimated number of days it takes to collect trade receivables: Average collection period = average trade receivables/average daily sales = (beginning + ending trade receivables)/2 Sales/365 The more days’ sales outstanding, the greater amount of capital is tied up in trade receivables relative to sales. 4.4 ANALYZING THE RETURN ON ASSETS: THE DU PONT SYSTEM A. Profitability refers to some measure of profit relative to revenue or an amount invested. The profit margin measures the proportion of sales revenue that is profit available for sources of funds. There are as many definitions of profit margin as there are ways to measure profit. One version is profit margin = net income / sales 4-7 However, net income is profits less interest and taxes. So this is not a measure of total earnings from operations. The profit margin is affected by the leverage (debt financing). A firm with more debt (higher leverage), paying more interest paid will have less net income than an otherwise identical firm with lower leverage. B. To compare the operating earnings of firms the impact of financing needs to be removed. Some people just add back interest to net income and calculate the net profit margin = (net income + interest)/ sales. However, this does not completely remove the impact of the firm’s financing decision because interest is tax deductible. C. To completely remove the impact of the firm’s financing on its profits add back the after-tax interest expense: NOPAT = net income + after tax interest. The best measure of the firm’s profit margin is its operating profit margin: Operating profit margin = NOPAT/Sales The operating profit margin indicates the how much earnings were made on sales, without being affected by how the firm choose to finance itself. The Du Pont System A. The Du Pont System is a process of analyzing component ratios, (also called decomposition) of the ROA and ROE to explain their level or changes. B. The ROA is comprised of the product of the profit margin, what the firm earns on every dollar of sales, times the asset turnover or the extent to which a business utilizes its assets: ROA = NOPAT = sales x NOPAT total assets total assets sales = asset turnover x operating profit margin Both the operating profit margin and asset turnover can be broken down in subcomponents (decomposed) to assess the cause of the level or changes in the ROA. The ability to earn on assets is comprised of expense control per sales (profit margin) and the effective use of assets to generate revenue (asset turnover). A level of ROA can be generated or changed by affecting the margin or turnover. 4.5 MEASURING FINANCIAL LEVERAGE A. The use of fixed cost financing, either debt or preferred stock, is called financial leverage. Financial leverage presents a debt/equity financing choice. Shareholders may magnify their earnings/returns, by the use of fixed cost financing but, on the other hand, debt is a fixed cost, contractual commitment to pay regardless of the asset earning rate. Leverage also provides the tax-shield benefit because interest payments are tax deductible. 4-8 B. Creditors, owners, and suppliers are interested in the extent to which a firm has used debt financing because the more debt a company has, everything else being equal, the greater the chance it will not be able to pay the interest and repay the debt. So assess the impact of leverage there are two types of leverage ratios: debt ratios (measure the amount of debt) and coverage ratios (assess the ability to pay the amount owed) Debt Ratios A. Debt ratios are statement of cash flows (balance sheet) ratios comparing leverage capital to total capital or total assets. The analyst must decide what to consider as debt, or fixed cost financing. This would include capital leases and may also include operating leases, especially when they involve significant amounts of money. Wherever a reference is made to debt, think of fixed cost financing. B. The long-term debt ratio measures the proportion of the capital structure or total capitalization that is made up of debt and lease obligations: Long-term debt ratio = long-term debt+value of leases long-term debt + values of leases + preferred equity + equity The higher is the ratio, the greater the use of financial leverage, posing an increased risk-return situation for investors. C. Debt-to-equity ratio measures the amount of long-term debt to equity or the amount of leverage capital in relation to the equity cushion under the debt: Long-term debt-equity ratio = long-term debt + value of leases preferred and common equity D. No standard definition of "long-term debt" exists. Generally, one looks for interest-bearing obligations that must be repaid. Often the current portion of long-term debt is included as part of long-term debt. Capital leases (on- balance sheet financing), operating leases (off-balance sheet financing) and other debt equivalents can be included, especially if the amounts owed are material. Preferred shares are also long-term fixed obligations and may be included with long-term debt. E. Since the liabilities on the statement of financial position can include obligations that are essentially due to accounting procedures rather than financing decisions of the firm the total debt ratio includes all selected debt to debt plus equity: 4-9 Total debt ratio = short-term debt + long-term debt + value of leases short term debt + long-term debt + preferred and common equity F. The total debt ratio measures total liabilities, current and long-term, relative to total assets or the proportion of assets financed by debt: debt-to-asset ratio = total liabilities total assets Coverage ratios A. A coverage ratio, such as times interest earned and cash coverage ratio, measures the amount of earnings available relative to an amount owed. B. Times interest earned ratio (TIE), measures an amount available relative to interest owed. How many times is the obligation covered? Times interest earned = EBIT interest expense C. The cash coverage ratio broadens the numerator to cash flow from operations relative to the interest expenses: Cash coverage ratio = EBIT + depreciation and amortization interest expense D. Fixed charge coverage ratios are even broader. One may include principal payments necessary per period, on a before-tax basis, in the denominator to assess the ability of operating earnings to cover the total debt obligation of principal and interest. Other obligations that may be useful to include are dividend payments on preferred equity and any sinking fund obligations. Remember, though, these are all paid out of after-tax cash flow and should be converted to a before-tax amount by dividing by (1 – tax rate). EBITDA A. Earnings before interest, taxes, depreciation, and amortization, EBITDA, is a measure of earnings without the impact of the firm’s financing and also removes the non-cash charges. The cash coverage ratio can be calculated as EBITDA/interest expense 4-10 Leverage and the Return on Equity A. The DuPont System can be used to decompose ROE into operating components (asset turnover and operating profit margin) and leverage (leverage ratio and debt burden). So ROE, return on equity, depends on both the use of debt (leverage) and firm’s operating efficiency and profitability: ROE = net income equity = assets equity × sales assets × NOPAT sales × net income NOPAT ROE= leverage ratio × asset turnover × operating profit margin ×debt burden B. The leverage ratio term, Assets/equity, is the not same as the other leverage ratios. It increases with leverage. If the firm’s debt increases but assets don’t change then its equity is lower and this ratio is bigger. This leverage ratio can be expressed using another leverage ratio: replace assets with equity + liabilities. So: assets/equity = (equity +liabilities)/equity = 1 + liabilities/equity. C. The debt burden term, net income/NOPAT, measures the proportion by which after-tax interest expense reduces profits. NOPAT is not affected by interest expense but net income is reduced when interest expense increases. Since NOPAT = net income +after-tax interest expense, then Net income = NOPAT – after-tax interest expense. If the firm had no debt, Net income/NOPAT would equal 1. With interest expense then net income is reduced and the ratio of net income to NOPAT will be less than 1. D. Recall the decomposition of ROA: ROA = NOPAT = sales x NOPAT total assets total assets sales = asset turnover x operating profit margin So the middle two terms in the decomposition of ROE are ROA: ROE = leverage ratio × ROA × debt burden 4.6 MEASURING LIQUIDITY A. Liquidity ratios attempt to measure the ability to pay obligations such as current liabilities and assess the pool of assets available to cover the obligations. Liquidity is the ability of an asset to be converted to cash quickly at low cost. Converting an asset into cash occurs in one of two ways: sell the asset, hoping it has reasonable liquidity, or in the case of a financial asset, like accounts receivable or Treasury bill, maturity brings cash. Working capital circulates from inventory to accounts receivable to cash, etc. Accounting value estimates of liquid 4-11 assets are reasonable estimates of their value. B. Current assets (the pool of circulating cash assets available to be allocated to pay bills) minus current liabilities (the pool of obligations the business must pay in the near future) is an analytical amount called net working capital (NWC). NWC is a rough measure of the current assets left over if the current liabilities were paid. The NWC to total assets ratio estimates the proportion of assets in net current assets, another name for NWC: Net working capital/total asset ratio = net working capital total asset C. The current ratio is the classic liquidity ratio, but is merely a variation of the idea above—what pool of circulating assets is available relative to the pool of current obligations: Current ratio = current assets current liabilities D. Continuing the theme of assets available to pay obligations, the quick or acid-test ratio eliminates inventories, the least liquid current asset, from current assets: Quick ratio = cash and cash equivalents + current other investments + trade receivables current liabilities E. The cash ratio eliminates inventories and accounts receivable from current assets to review the cash assets relative to the current liabilities: Cash ratio = cash and cash equivalents current liabilities F. The interval measure of liquidity measures the firm’s pool of liquid, quick assets relative to the daily expenditures from operations and gives an estimate of the number of days’ obligations that are circulating in the quick assets. The more days, the greater the ability to meet obligations: Interval measure = cash + marketable securities + accounts receivable average daily expenses from operations The denominator represents annual cash (not depreciation) expenses divided by 365. 4-12 4.7 CALCULATING SUSTAINABLE GROWTH A. The company’s financial statements tell the past not the future of the company. However, financial managers and analysts can ask how fast the company will grow if it maintains its current level of profitability. B. The proportion of earnings that is paid out as dividends is called the payout ratio: Payout ratio = dividends / earnings The complement of the payout ratio is the plowback ratio studied earlier, or the proportion of earnings retained in the period: Plowback ratio = 1 - payout ratio = earnings - dividends earnings = earnings retained in period earnings C. The plowback ratio times the return on equity (ROE) is an estimate of the growth rate in common equity from internally generated earnings, or the sustainable growth rate in assets that the business can support from internal earnings without changing the total debt/total asset ratio: Growth in equity = earnings retained in period from plowback equity = earnings retained in period x earnings earnings equity = plowback ratio x ROE 4-13 NOTE: the ROE used in the sustainable growth rate must be earnings divided by equity at the beginning of the period. 4.8 INTERPRETING FINANCIAL RATIOS A. Knowing reasonable ranges for the above ratios calculated requires practice, comparison of the trends over time, and compared to averages, a successful business or similar benchmark for comparison. B. Industry ratios are available from a number of sources. See Table 4.7. Differences from averages or earlier trends is not wrong, but provides a beginning for understanding why the differences or changes occurred. 4.9 THE ROLE OF FINANCIAL RATIOS – AND A FINAL NOTE ON TRANSPARENCY A. Financial ratios often serve as: 1. Goals representing optimal financial condition or performance. 2. Benchmarking comparisons with competitors or higher valued similar companies. 3. Minimums below, which the company hesitates to venture. 4. Rating agencies analyze a company’s financial ratios to rate companies (see Table 4.9). Transparency 4-14 Applications of financial ratios assume that accountants are following the International Financial Reporting Standards (IFRS) or generally acceptable accounting principles (GAAP) or firms are transparent. This assumption is not always true. 1. Managers may seek their own interests (agency problems) and seek to hide the truth from investors. 2. IFRS have considerable leeway in accounting for asset/liability values and income, so that it is often difficult to make an absolute comparison of company ratio with other companies or the industry ratios. 3. Government regulations, such as Sarbanes-Oxley, have their limits and are often costly to public companies and economies. 4.10 SUMMARY PEDAGOGICAL IDEAS General Teaching Note—Students often have difficulty making the transition from accounting to finance. One area of concern is their conception of a business “at a point in time,” versus a business as a “flow” or a “process.” They tend to have a statement of cash flow (balance sheet), business-at-rest focus after accounting and have some difficulty conceptualizing the flow of values, such as the working capital cycle. Two techniques that assist students in understanding that a business is a “flow” is the standard “fluid dynamics” diagram of liquid flowing from cash to inventory stages to accounts receivable to cash. Working capital accounts are reservoirs that slow the flow, and of course, require added investment. A cross-section of the flow diagram is the balance sheet at a point in time. Another visual, and many students must visualize when conceptualizing, is the classic time line, such as used in Figure 20.2. The time line visualizes the length of the pipe carrying the flow of values; the fluid dynamics chart measures the diameter of the pipe. Daily volume times time and the product is the current working capital investment. Managers get paid for maintaining and controlling the size of the flow. Help your students make the accounting, balance sheet-focused transition to a finance, flow consideration. Visuals help make the transition. Student Career Planning—Students that are looking forward to graduation in the next year often note that they are “moving away” or “getting out of town.” If that is the case, how does one prepare for it? Plan for it is the best first step after making sure graduation will take place. As in finance, information is king. Visiting target cities or intended locations on “breaks” or weekends is a good start. Subscribing to newspapers (check the library), writing to Chambers of Commerce, realtors, businesses, etc., will provide a steady flow of mail for the interested and proactive 4-15 student. WetFeet.com, reviewed in an earlier chapter, has a useful “Cost-of-Living Comparisons.” The consumer price indexes for a large number of cities and living areas are presented, giving the student a sense of the price levels in various parts of the country. The Consumer Price Index, published by Statistics Canada and located in the library, provides detailed price levels for housing, etc., for many Canadian and U.S. locations. Remind students that it is time to plan and information seeking is the key for real planning, and differentiates planning from dreaming! Most provinces and cities, and their Chambers of Commerce now have internet sites with extensive information. Internet Exercises - The topic of this chapter has been financial analysis with a focus on ratio analysis. The availability of financial ratios of public companies on the Internet is improving. Reuters.com is a free source that provides financial information about public companies, including financial ratios. The website provides the ability to compare a company’s ratios with the industry ratios and other comparisons. Print out a sampling of the data provided and pass it around the class or select a sample company and provide a classroom demonstration. http://money.ca.msn.com/investing/stocks/ Microsoft Money provides extensive financial ratio information for most public Canadian companies. Click on a company to get financial data. You will see Financial Results on the leftside column. Now, while you are on the page of one company you can also search for another company by putting the company in the box beside “Name or Symbol(s)” then click on “Go”. At Yahoo Finance, finance.yahoo.com, you can find financial information for Canadian companies that are also listed for trading the U.S. 4-16 Instructor Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011