Understanding Corporate Finance Text

Understanding Corporate Finance
Robert N. Holt,Ph.D.,C.P.A.
Fifth Edition
Copyright 2015
Ivy Software
Table of Contents
Title
Page
Introduction..................................................................................................................................1
Chapter One- Analyzing Financial Statements............................................................................2
Chapter Two- Projecting Earnings and Cash Flow....................................................................20
Chapter Three- Creating Value for Stockholders.......................................................................29
Chapter Four- Capital Budgeting................................................................................................40
Chapter Five- Calculating the Cost of Raising Capital...............................................................49
Chapter Six- Assessing Merger and Acquisition Targets...........................................................61
Chapter Seven- Financing Investments.......................................................................................68
Illustrations..................................................................................................................................78
Introduction
Students of finance quickly learn that it is a complex discipline. Many balk at the prospect of continuing
their study when they realize that it is a field that no one will ever wholly master. Others are dismayed when they
realize that the best financial managers are those which keep themselves continually apprised of the latest theoretical
and practical developments: the commitment necessary to sustain excellence in this profession is a profound one.
Because finance is such an encompassing field, specialization is prevalent. There are experts in investment
analysis, security analysis, lending, security underwriting, leasing, personal finance, and corporate finance, to name
a very few of the specializations. Pick up an annual report of any financial services company and you will gain an
understanding of the diversity.
Despite the diversity of the subject, there are a few basic principles which apply to the entire field. The
notion of value creation and the importance of judgment in financial decisions are two principles that will never be
superseded by new analytical techniques.
In effort to focus the purpose of this text, a perspective has been chosen. The reader should understand that
this entire book has been written from the point of view of a general manager in a public corporation. The special
problems and opportunities in private businesses are not addressed. However, all of the analytical techniques that
are discussed are applicable to both kinds or organizations.
Understanding Corporate Finance is a practitioner-oriented, introductory text designed for managers and
analysts. In this book new theoretical trails are not blazed; rather, it is the intent of the author to provide the reader
with the basic analytical skills which are necessary for one to function effectively as a general manager. If there has
been little theoretical pioneering, current theory has been provided when such knowledge is necessary to the
understanding of an analytical method.
This text is a cumulative one. It is necessary to understand Chapter 1 before preceding to Chapter 2, and so
on. Important terms, and those that the user will likely see again, are presented in bold type. Understanding
Corporate Finance is intended as a companion piece to the personal computer-based course of the same name. It
is in the interactive problem sessions that the user will test his or her understanding, and be presented with an
opportunity to learn about corporate finance by participating in the resolution of real problems.
What will the student gain by completing this course? It is intended that a user will master the basic financial
skills that every general manager should understand. Furthermore, it is hoped that the reader will gain a perspective
that will foster ability to understand the financial behavior of corporations and capital markets.
The author is indebted to the teaching methods and subject material of the Colgate Darden Graduate School
of Business Administration First Year program. Without the benefit of an individual's experience in that program,
this work would not have been possible. I am especially indebted to Dana Dame, who wrote the first draft of this
book.
Learning Objectives
Chapter 1- Analyzing Financial Statements
After studying this chapter, you should be able to:
Discuss generally accepted accounting principles.
Describe and explain a corporations financial statements.
Calculate operating performance ratios, liquidity ratios and financial
strength ratios.
Contrast horizontal analysis with vertical analysis.
Chapter 1
Analyzing Financial Statements

INTRODUCTION
Financial statements can be the source of information for several dissimilar groups. Banks may wish to
examine a firm's reports to make lending decisions, or union locals may want to know how their company is
performing in order to structure an upcoming round of contract negotiationsthe users of a company's external
financial reports can be found both inside and outside the firm and can be friendly or hostile.
The basic quantitative tools that analysts use to interpret a firm's reports are not difficult to grasp. As long
as the statements that are being used are comparable, performance measures can be easily calculated. Today,
government agencies and certain professional organizations oversee the form and content of external financial
statements so that they can be successfully compared. This ability for an analyst to easily compare financial reports
has not always been possible.
In 1934, because of the disparities that existed in financial reports and other reasons, Congress created the
Securities and Exchange Commission (SEC). The SEC was charged with regulating all companies that have
publicly traded securities. Since the creation of the SEC, only such "public" companies have been required to
publish external financial statements. Private companies, although not required to do so, prepare financial
statements for external users, if not the public as a whole. A bank, for instance, often requires private companies to
provide it with financial reports before it considers issuing loans.
One of the primary objectives of the SEC is to ensure that a firm's external statements contain accurate
financial information that fairly represents underlying economic reality. In order to execute this basic philosophy,
the SEC periodically publishes Accounting Series Releases (ASRs), which dictate the standards to be followed by
the accounting profession. Although the SEC has the Congressional authority to set accounting standards, it has
through the years allowed the accounting profession to regulate itself, subject, naturally, to the SEC's approval.
Since 1934, various committees of accounting professionals have provided this service. Today, the principal
organization to which the SEC has implicitly granted authority to monitor accounting standards is the Financial
Accounting Standards Board (FASB). The FASB has outlined a set of major goals for financial accounting:
The objectives [of external financial reporting] stem primarily from the informational needs of
external users who lack the authority to prescribe the financial information they want from an
enterprise and therefore, must use the information that management communicates to them.
Financial reporting should provide information that is useful to present and potential
investors, creditors and other users in making rational investment, credit and similar decisions.
The role of financial reporting in the economy is to provide information that is useful in
making business and economic decisions, not to determine what those decisions should be. The role
of financial reporting requires it to provide evenhanded, neutral or unbiased information.1
The FASB further indicates that financial statements should report not only a firm's economic resources, but claims
on those resources by creditors and investors as well.
It is important to realize that the SEC and FASB do not precisely delineate all accounting standards, but
rather they choose to provide flexible guidelines in many cases. Flexibility in accounting standards is desirable
because there are vast differences among firms. A body of customs, not unlike English common law, has evolved
and comprise what is known as Generally Accepted Accounting Principles (GAAP). One of the fundamental goals
of GAAP is to provide a framework for financial reporting so that the statements of very different firms can be
compared. Other goals of GAAP include rules governing:
Accounting Periods financial reports should be prepared periodically, and cover periods of equal length.
Companies may choose the time of year that they desire their accounting periods to end (the SEC requires a
report at least annually).
Matching in their statements, firms should include all expenses incurred to realize the revenues that they
report.
Conservatism firms, given a situation where measurement uncertainties produce equally likely profit
figures, should report the lowest figure. Firms should strive to anticipate all expenses, and not report
revenues until they can be properly recognized. Deliberate understatement is forbidden.
Understandability the information contained in reports should be written at a level that a reader with a
reasonable comprehension of business principles can understand.
Relevance reports should contain information that is relevant to the decisions at hand, and be useroriented.
Reliability information that is provided must be complete and verifiable.
Consistency firms should strive to use consistent accounting methods so that their statements can be
compared over time.
The preceding list of concepts does by no means include all of the GAAP, but rather those that are especially
relevant to external reporting. In addition to these principles, the FASB has identified specific requirements that
apply to the external reports of all firms. These requirements include that all firms must report
The Financial Position at Period's End
FASB, Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises" (Stanford, Conn.: 1978), pars.
28, 33, 34.
The Cash Flows for the Period

The Earnings for the Period
The Comprehensive Income for the Period
The Investments by and Distributions to Owners for the Period
In the next section, the financial statements which fulfill these requirements will be introduced.
THE FINANCIAL STATEMENTS
Before the statements can be presented, a few general concepts about financial statements should be
understood. Since accounting principles allow a certain degree of leeway in external reporting, an analyst should
become acquainted with the particular methods that the company under study has chosen to use in its reports. For
example, a firm recently may have switched from the First-In-First-Out (FIFO) method of valuing inventory to the
Last-In-First-Out (LIFO) method. In inflationary times this switch would result in the firm assigning a higher cost
to the goods sold than it would have under the previous method. This in turn would cause the reported income to
appear lower under the new method, given an equal sales level in the two years, and the analyst might err in his
conclusion about the cause of the lower earnings unless it is realized that the switch has occurred. In addition to
understanding the accounting principles that are being used, the analyst must look beyond the mere statements
themselves to the footnotes of the reports. Frequently, the footnotes contain the clues that are necessary to
understand which accounting principles apply. A third consideration for an analyst is whether the statements have
been independently audited. Quarterly statements frequently are not examined. Where reports have been
independently audited, the auditor's report should be read carefully. A qualified opinion attached to an annual report,
where the auditor qualifies the company's application of accounting principles, may be cause for serious concern.
It may, however, merely indicate one of several conditions, such as industry practice, that cannot be verified by the
auditors using Generally Accepted Auditing Standards.
With the idea that the statements of real companies should be approached somewhat cautiously, we are ready
to proceed to the financial statements of a fictional toy manufacturer.
The Balance Sheet

The balance sheet, or statement of financial position, fulfills the FASB requirement that a firm report its
financial position at period's end. It records a firm's assets, liabilities, and owners' equity at a point in time, the last
day of the reporting period, in accordance with the universal accounting convention:
Assets = Liabilities + Owners' Equity
As mentioned earlier, reporting periods are chosen at management's discretion, but must be consistent from
year to year. Firms ordinarily choose to end their fiscal years in a month where their statements will record their
most favorable financial position, or the season which most accurately reflects their typical financial situation. As
shown in Figure 1.1, the Clever Toy Company has chosen to end its reporting period on December 31st. At this
time of year, as a company with seasonal sales, Clever Toy has much lower inventory levels than it would during
the peak production months of the summer, when inventory is allowed to build for the heavy fall sales season. By
December, large inventories have been converted to sales. A balance sheet prepared in June would record a very
different picture.
Examine Figure 1.1 for a moment. Notice that the heading indicates that this report represents the financial
position on a particular day. The accounts have been arranged into "current" (having due dates less than one year
or reporting period) and "noncurrent" (having due dates greater than one year or reporting period) portions.
Accounts are conventionally listed in order of decreasing liquidity. Liquidity is a measure of how easily an item
may be converted to cashthe greater an item's liquidity, the easier it can be converted to cash.
Since the financial position is displayed for more than one year, the report shown is called a comparative
balance sheet
Figure 1.1
The Clever Toy Company
Balance Sheet
As of December 31
ASSETS
2015
2014
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses and Other Assets
$ 160,000
146,000
390,000
372,000
97,000
$ 88,000
42,000
376,000
404,000
128,000
Total Current Assets
$1,165,000
$1,038,000
367,000
64,000
309,000
708,000
337,000
64,000
301,000
720,000
$2,613,000
$2,460,000
Current Liabilities
Bank Notes Payable
Current Portion - Long Term Debt
Accounts Payable and Accrued Expenses
Accrued Taxes
$ 42,000
11,000
532,000
109,000
$ 35,000
25,000
473,000
129,000
Total Current Liabilities
$ 694,000
$ 662,000
370,000
88,000
326,000
87,000
$1,152,000
$1,075,000
235,000
50,000
1,176,000
235,000
50,000
1,100,000
$2,613,000
$2,460,000
Long-Term Assets
Investments
Land
Buildings
Equipment
Total Assets
LIABILITIES AND OWNERS' EQUITY
Long-Term Liabilities
Long Term Debt
Deferred Income Taxes
Total Liabilities
Owners' Equity
Common Stock (100,000 shares)
Paid-in Capital
Retained Earnings
Total Liabilities and Owners' Equity
The Income Statement

The income statement, also referred to as a statement of earnings or profit and loss (P&L) statement,
fulfills the requirement that a firm disclose its earnings for a period and show a comprehensive report of the factors
that influenced those earnings during that period. Therefore, the intent of the income statement is to match a
company's expenses with its revenues for an entire reporting period, whether that is a week, month, quarter or fiscal
year.
The difference between the firm's revenues and all expenses, including taxes, is the firm's net income for the
period. Net income is also referred to as net profit, net earnings, or profit after tax in various circles. It is very
important to realize that the company's net income and its cash flow for the same period are rarely the same figure.
When they are equivalent, it is purely coincidental. There are certain noncash expenses, such as depreciation and
amortization, which reduce net income but do not reduce a firm's cash position, because noncash expenses do not
involve a transfer of cash. All expenses are deducted from a firm's revenues to arrive at a net income figure, but all
expenses do not use cash. Neither are all cash outlays recorded as expenses: purchases of inventory or property,
plant, and equipment are not expenses.
The Clever Toy Company's income statement is shown in Figure 1.2. Examine that statement for a moment.
Notice that the heading clearly indicates that the report covers a period of time, in this case a full year. An income
statement by convention begins with a figure representing the company's revenues (or sales) for the period. From
this figure, the cost of producing the company's goods or services, which is the cost of goods sold or cost of sales,
is then deducted. The remaining subtotal is referred to as the gross margin or gross profit. From the gross margin,
the remaining expenses which the company chooses not to directly allocate to the cost of sales, are subtracted. These
expenses include operating expenses, interest on loans, and taxes. Notice the presence of the noncash expense,
depreciation.
Financial analysts use certain subtotals from income statements in their calculations. Unfortunately, often
there are variations in the statements which force analysts to perform detective work to ascertain what these subtotals
are. Some of the more popular subtotals from income statements that have not been previously discussed include:
Operating Income The firm's income after operating expenses from its main line of business, before
inclusion of income from investments, and before interest or taxes have been deducted.
Earnings Before Interest and Taxes (EBIT) The firm's total income from all sources before interest or
taxes have been deducted.
Earnings Before Tax (EBT) The firm's EBIT, less interest charges.
When examining income statements, analysts must be as familiar with the company's preparation methods
as they are when they examine the firm's balance sheets.
Figure 1.2
Income Statement
For the Year Ended December 31
2015
2014
$3,414,000
1,886,000
$3,010,000
1,580,000
1,528,000
1,430,000
Less Operating Expenses

Salaries
Sales and Administration
Other Expenses
Depreciation
300,000
680,000
80,000
175,000
280,000
640,000
79,000
175,000
Operating Income
Plus Income from Investments
Less Interest Expense
293,000
26,000
35,000
256,000
18,000
27,000
Operating Income Before Taxes

Less Income Taxes
284,000
120,000
247,000
104,000
$ 164,000
$ 143,000
Net Revenues
Less Cost of Goods Sold
Gross Profit
Net Income
Statement of Owners' Equity

The statement of owners' equity, or statement of stockholders' equity, fulfills the requirement that a
company publicize all investments in the firm, and all distributions to owners, during the course of the reporting
period. Stated in other words, the purpose of this statement is to describe all changes which have occurred in the
owners' equity accounts. Sources of new equity, or investments in the firm, include the firm's earnings and proceeds
from the sale of stock during the reporting period, if any. Reductions in equity include the distribution of dividends,
and the purchase and retirement of outstanding stock (outstanding shares which have been purchased but not yet
retired are referred to as treasury stock).
As in all financial statements, formats vary in statements of owners' equity. The format illustrated in Figure
1.3 is typical. Notice the entries in Figure 1.3. As in the income statement, this report clearly indicates that the
statement covers an entire period. The three columns of figures listed make up all of the components of owners'
equity, as listed on the balance sheet. Beneath the beginning balances, figures are entered only where they are
appropriate. The dashed lines mean "not applicable". Notice which entries define sources, and which ones are uses
of owners' equity, as discussed earlier in this section. Refer back to Figure 1.1, and compare the owners' equity
entries on the balance sheet to this statement.
A subset of this statement, which only includes the changes in the firm's retained earnings account for the
period, is often included in a company's financial statements. It is referred to as a statement of retained earnings,
and may be incorporated in the income statement.
Figure 1.3
Statement of Owners Equity
For the Year Ended December 31, 2015
Common Stock
$235,000
Balance December 31, 2014
Paid-in Capital
$50,000
Retained Earnings
$1,100,000
Add:
Net Income
Proceeds from Sale of Stock
164,000
-
Subtract:
Dividends
Increase in Treasury Stock
88,000
-
$235,000
Balance December 31, 2015
$50,000
$1,176,000
Perhaps you have realized that the reason "retained earnings" are so named is that they are earnings that the
firm has "retained" and not distributed in the form of dividends. Retained earnings are not cash. Compare the cash
balance with the retained earnings entry on Clever Toy's balance sheet. The retained earnings entry represents the
cumulative total of net income that the company has earned, and not distributed, since it came into being.
The Statement of Cash Flows
In December 1987, the Financial Accounting Standards Board (FASB) published Statement of Financial
Accounting Standards No. 95, Statement of Cash Flows. This pronouncement requires for the first time that
companies present a statement of cash flows in published financial statements. Prior to this announcement,
companies presented a statement of changes in financial position (often referred to as a "funds statement"). The
statement of changes in financial position could be presented on either a working capital flow basis or a cash flow
basis. The working capital approach explained the changes in working capital, whereas the cash basis explained the
changes in cash during a period. The current format of the statement of cash flows is shown in Figure 1.4.
There are three major headings in Figure 1.4: (1) Cash Flow from Operating Activities, (2) Cash Flow from
Investing Activities and (3) Cash Flow from Financing Activities. Cash Flow from Operating Activities begins with
net income and proceeds to add noncash expenses and in addition shows certain other adjustments. Depreciation is
added to net income since depreciation is a noncash expense. In other words, depreciation requires no cash outlay,
yet it is an expense and does reduce net income. Adding it back to net income is justified since we are trying to
translate net income to cash. Changes in current assets and liabilities is the next major section of the statement. As
sales increase, one would expect to see increases in accounts receivable and inventories to support these sales.
Unfortunately as receivables and/or inventories increase, cash is "used up." In this case receivables increased by
$14,000 - See figure 1-1. An increase in inventories from one year to the next indicates that cash has been invested
in the inventory increase. On the other hand, if inventories decrease, cash is "freed up." The inventory decrease
from one year to the next indicates a disinvestment in this asset. In this case, inventories decreased by $32,000. For
current liabilities such as accounts payable, the opposite entails. If an accounts payable increases, cash is "freed up"
since the payment is delayed. If an accounts payable balance decreases from one year to the next, cash is "used up,"
since the company repaid more debt than it incurred during the year. In this case, the total current liabilities increase
(other than taxes) was $52,000.
The second section of the statement of cash flows is cash flow from investing activities and presents cash
flows related to the purchase and sale of property, plant and equipment and other noncurrent assets such as longterm investments. To some extent these purchases and sales are discretionary, since management may postpone the
purchase of assets or even sell assets when the economic or business outlook is poor and cash is scarce. According
to Clever Toy Company's balance sheet, building and equipment acquisitions net of dispositions was $171,000.
This is calculated by taking the 2015 ending balance of buildings and equipment ($1,017,000) and adding to it the
depreciation for 2015 ($175,000). The result is all buildings and equipment subject to depreciation during the year.
The total is $1,192,000. Subtracting the beginning balance of the buildings and equipment for 2015 ($1,021,000)
gives the acquisitions net of dispositions (171,000). In addition, the long-term investments increased by $30,000.
Cash flows from financing activities shows the effects of financing transactions such as issuance and
repayment of debt, issuance and repurchase of stock and payment of dividends. Clever Toy Company's long-term
debt increased by $44,000 during 2015. This is reflected as a source of cash in the statement of cash flows. Had
the long-term debt decreased during the year, this would have indicated that the company repaid more debt than it
borrowed, and thus would have been a use of cash. The deferred income tax account (another long-term liability)
increased by $1,000. The common stock paid-in capital accounts were unchanged indicating no new issuance of
stock. The change in retained earnings of $76,000 has been partially explained by net income that was reported in
the operating activities section. The remainder of the change in retained earnings is attributable to cash dividends
paid of $88,000 as reported in the Statement of Owners' Equity. The dividends are a use of cash. The net cash used
by financing activities was $43,000. The net increase in cash was $72,000.
To summarize the cash flow statement, The Clever Toy Company earned $164,000 in 2015, but because of
noncash expenses and changes in current assets and liabilities, it generated operating cash of $316,000. It obtained
long-term financing of $44,000 and used the total cash generated of $360,000 to acquire buildings, equipment and
long-term investments (net of dispositions) of $201,000. In addition, cash dividends of $88,000 were paid and cash
increased by $72,000.
Figure 1.4
Statement of Cash Flows (Indirect Method)
For the year ended December 31, 2015
(dollars in thousands)
Cash Flow From Operating Activities
Net Income
Adjustment to Reconcile Net Income to
Cash Provided by Operating Activities:
Depreciation
Change in Current Assets and Liabilities
Accounts Receivable (increase) decrease
Inventory (increase) decrease
Other current Assets (increase) decrease
Accounts Payable and Accrued
Expenses increase (decrease)
Taxes Payable increase (decrease)
Cash Provided by Operating Activities
$ 164
175
(14)
32
(73)
52
(20)
$ 316
Cash Flow From Investing Activities

Acquisition of Property, Plant and Equipment
Cash Provided by Investing Activities
$ 201
(201)
Cash Flow from Financing Activities

Issuance of Long-Term Debt
$ 45
Cash Dividends Paid

Cash Provided (Used) by Financing Activities
Net Increase (Decrease) in Cash
Cash Balance at Beginning of Year
(88)
(43)
72
88
Cash Balance at End of Year
$ 160
RATIO CALCULATION
The balance sheet, income statement, owners' equity report, and cash flow statement often constitute the total
amount of information that an analyst can obtain when researching a company. Through the years, certain ratios
that can be derived from these statements have been developed. These ratios are easy to calculate, but can be
deceptively difficult to interpret, especially when inferences must be made about the economic realities that lie
beneath the numbers.
The ratios that are used most often vary with the analysts' perspectives. An issuer of short-term credit will
concentrate on numbers which indicate a firm's short-term health, for example. Ratios can be organized into three
categories. Operating Performance ratios measure a firm's profitability and asset usage skill. Liquidity ratios
measure a firm's ability to meet its short-term financial obligations, and its skill in managing working capital. Ratios
of Financial Strength indicate the risk which can be associated with the way a company has packaged the debt and
equity that it uses to finance its assets
The following ratios will be calculated from Clever Toy's financial statements.
I.
Operating Performance Ratios

Profit Margin indicates a firm's ability to convert sales into earnings; also called return on sales.
Clever Toy's profit margin for 2015 is $164,000 or 4.8%.

$3,414,000
When considered alone, a profit margin of 4.8% might be deemed a small return on sales. However, the percentage
must be considered within the context of the toy manufacturing industry. A 4.8% margin may be commendable for
producers of toys. A retail grocer might be content with a profit margin of 1%. A software firm, on the other hand,
may earn a 40% ROS.
Gross Margin indicates the average percentage by which the sales price of a company's goods or services
exceeds the cost of those goods or services.
Clever Toy's gross margin for 2015 is $1,528,000 or 44.8%.
$3,414,000
A manufacturing company's gross margin typically falls between 25 and 50%.
Asset Turnover measures a firm's ability to generate sales through its assets; it is especially important to
consider this ratio along with qualitative issues. For example, a high asset turnover may be the result of a company
having neglected essential investments in new equipment rather than having highly productive assets.
Our toy manufacturer's asset turnover equals $3,414,000 (net sales) divided by the average total assets for the year.
The average total assets is the amount at the beginning of 2015, $2,460,000, plus the amount at the end of the year,
$2,613,000, divided by 2. $3,414,000 divided by $2,535,500 is 1.35.
Thus, Clever Toy "turns over" its assets 1.35 times per year. A capital-intensive firm such as an electric
utility may have an asset turnover below one, while a service-oriented firm could turn its assets ten times in a year.
Return on Assets (ROA) is considered by many to be the best indicator of a firm's asset usage skill, and is
composed of two elements. ROA is also referred to as return on investment (ROI).
Return on Assets = Profit Margin x Asset Turnover

or:
You can easily derive ROA by dividing net income by average total assets, but by examining the two components
you can determine where changes in the firm's ROA may have come from.
10
Clever Toy's ROA for 2015 is 4.8% x 1.35 or 6.48%. In industrial settings, ROA figures between 5 and
10% are common. By contrast, a well-managed bank may have an ROA as low as 1.0%.
Return on Equity (ROE) measures the return on investment for the firm's shareholders a bit more discretely
than the ROA ratio. ROA includes the return for both owners and creditors (since assets are typically funded by a
combination of debt equity).
In this formula, net income (after interest and taxes) may be used unless there are holders of preferred stock. "Net
income available to shareholders" is net income minus any dividends paid to preferred stockholders. Since Clever
Toy has never issued preferred stock, its ROE for 2015 is $164,000 divided by the average owners' equity,
$1,423,000, or 11.5%. This figure is in the range of a typical industrial company.
Earnings per Share (EPS) is simply the company's net income available to shareholders divided by the
average number of shares of common stock outstanding during the year; analysts use changes in this figure from
period to period to measure a company's performance. Recent criticisms have been leveled at those who focus too
closely on this measure, because of its short-term perspective. Nevertheless, it remains an extremely sensitive and
influential measure. Clever Toy's EPS for 2015 is
Since firms may have different numbers of common shares outstanding, it is not generally useful to compare EPS
figures among companies.
Price-Earnings Ratio (P/E) is the market price of the company's stock divided by EPS; it is the multiple of
a firm's earnings per share that investors are willing to pay for one of the company's shares. The P/E indicates the
stock market's opinion of a company's prospects for growth and earnings, as well as the market's perception of the
firm's risk. If the market perceives that a company's earnings or growth potential has improved, then the P/E will
generally rise. If a firm's prospects deteriorate, or its perceived risk in the eyes of the market increases, then the P/E
will generally fall. Since our toy company's stock is currently trading at $30.00 per share, its P/E is
A P/E is high or low with respect to an industry or stock exchange average. If the exchange on which Clever Toy's
stock is traded has an average P/E of 12 for all companies, then 18.3 would be considered fairly high, though not
extraordinarily so.
Payout Ratio refers to the percentage of earnings per share that a company distributes in the form of
dividends, or similarly, the percentage of net income that a company pays out in dividends. This percentage is
influenced by the composition of the firm's shareholders, the type of industry that the firm is in, and the firm's growth
prospects. Generally, young, high-growth companies pay few, if any, dividends, while more mature companies in
mature industries tend to pay higher dividends. Clever Toy's payout ratio in 2015 is
11
A payout ratio of 55% is reasonably high and reflects the mature industry in which Clever Toy competes.
Times Interest Earned is a ratio that indicates how many times a firm's earnings exceed its interest
obligations, and is used by creditors as a rough estimate of the firm's ability to meet its payments. However, because
earnings are not equivalent to cash flows, it is only an approximation.
The numerator in this ratio, EBIT, is used instead of Net Income, because it is the intent of the ratio to reveal
how many times interest charges could be covered by the annual income. Including interest expense or its affect on
taxes in the numerator would double-count the coverage. The times interest earned ratio for Clever Toy is $293,000
+ $26,000 divided by $35,000, or 9.11 in 2015. The firm's earnings have exceeded its interest obligations 9.11
times. There are variations on this ratio in which other obligations such as dividends, sinking funds, and various
combinations may be substituted in the denominator. These kinds of calculations are collectively referred to as
coverage ratios.
II.
Liquidity Ratios
Current Ratio measures a company's ability to meet short-term obligations and unforeseen needs, and is
stated in terms of working capital.
Acceptable current ratios are varied because industries differ in their working capital requirements. Generally,
creditors accept lower current ratios in stable industries than they do in others. Clever Toy's current ratio for 2015
is:
Quick Ratio is a variation of the current ratio which uses only assets which can readily be converted into
cash in the numerator; this ratio is sometimes referred to as the acid test ratio. Some analysts prefer this ratio
because they question a firm's ability to convert assets other than cash equivalents (such as inventory) completely
into cash, as the current ratio assumes. A quick ratio which is excessively high suggests that the firm may not be
productively employing its cash.
The quick ratio for Clever Toy in 2015 is
As with the current ratio, industry specific figures are the only relevant guide for comparison of quick ratios.
12
Receivables Turnover indicates how quickly a company ordinarily converts accounts receivable into cash.
This ratio can perhaps be one of the most misleading. One must remember that the balance sheet is a snapshot of
the company's finances, which are likely to vary significantly during a year. Inventories build toward peak selling
seasons and then are sold and converted to accounts receivable or cash. However, if one remembers this caveat, the
ratio can be a useful tool. The ratio for this toy company in 2015 is $3,414,000 divided by the average accounts
receivable figure for 2015, $383,000, or 8.91 times. Essentially, this ratio indicates that if the December 31 balance
of accounts receivable is representative of the average balance throughout the year, then the receivables "turn over"
about 9 times during the year.
Days Sales Outstanding (DSO) merely converts the receivables turnover figure into the equivalent number
of days.
The receivables turnover figure for Clever Toy calculated above is an annual one. Therefore, the DSO is 365 days
divided by 8.91 times, or 40.96. The average age of an uncollected account is therefore about 41 days. The most
useful comparisons of DSO figures are ordinarily conducted within a firm. If, for instance, a firm's stated collection
policy is terms of 30 days, and the average "age" of the company's receivables exceeds that by several weeks, then
actions should be taken to bring the receivables into line.
Inventory Turnover is another indicator of how well a company is managing its working capital accounts,
in this case its investment in inventory; in managing inventory, a company must solve the dilemma of overinvestment in inventory versus the risk of stockouts. Generally, companies strive to maximize this ratio. Cost of
goods sold is used in the numerator rather than sales because cost of goods sold represents the total amount of
inventory that was sold during the period. Sales figures include markups over the cost of goods sold.
As with the receivables turnover, the calculation of inventory turnover can be misleading when annual figures are
used. Clever Toy's turnover ratio is:
You should look for trends within a company when you consider this ratio. As with DSO, an inventory
turnover figure that is slipping (increasing disproportionately to an increase in sales, for instance) should be regarded
with concern.
Days Inventory converts the above ratio into days in the same manner as DSO. Therefore, our toy
company's average days inventory is
13
Operating Cycle calculations allow an analyst to estimate how long it takes a business to complete the cycle of (1)
purchase of inventory, (2) conversion of inventory to finished goods, (3) sale of finished goods, and (4) collection
of the ensuing receivable. It should be a corollary to the calculation of a current ratio.
Operating Cycle = DSO + Days Inventory
The operating cycle for our company in 2015 is 75 + 41 = 116 days. A firm which is reducing the length of this
cycle would be improving its performance.
Accounts Payable Turnover indicates how far a company is "stretching" its trade payable obligations.
Since companies are not required to divulge their purchases during a reporting period, the cost of goods sold plus
changes in inventory levels between periods is used as a proxy by many analysts. For Clever Toy this proxy figure
is the COGS, $1,886,000, minus the decrease in the inventory level from 2014 to 2015, $32,000, which nets
$1,854,000. The average accounts payable for the year is $502,500. The turnover ratio is thus 3.68 times for
2015. A company's discretion in controlling this ratio depends on its creditors, and to what extent its payables have
been previously extended.
Days Payable converts the above ratio into the appropriate number of days in exactly the same way as DSO
is calculated. Our example is
The operating cycle described earlier can be modified to include the number of days that payables are extended.
This figure, DSO + Days inventory - DPO, is referred to as the working capital cycle. For Clever Toy the working
capital cycle is 75 days + 41 days - 99 days or 17 days net.
III.
Financial Strength Ratios
Debt to Total Assets calculations indicate the percentage of the company's assets which is being provided
by creditors.
The debt to assets ratio for Clever Toy is
Aggressively managed firms will attempt to maximize this ratio, confident that the earnings of the company will
more than cover the fixed cost of the debt. Acceptable maximums range from as low as .3 to over 1.0. As with
most of these ratios, industry-specific norms are better guides than a general industry average.
14
Stockholders' Equity to Assets is the percentage which complements the ratio above by describing the
percentage of assets paid through contributions of the firm's shareholders.
The equity to assets ratio for Clever Toy is
An investor in the equity of a company feels "safer" as this ratio approaches the theoretical limit of 1.0, because at
that level a firm would have no liabilities. For years, the management of E. I. duPont deNemours held fast to the
principle that debt was to be avoided; duPont's equity to assets ratio was consistently near 1.0. However, today the
equity markets (and even duPont) believe that a firm should use a certain level of debt in its capital structure in order
to financially lever the firm's earnings. Financial leverage will be discussed more fully in the next chapter. The
result of these two opposing forces is that this ratio falls somewhere between the extremes, and an acceptable figure
is industry-specific.
Debt to Capitalization is a popular ratio calculated in many ways; as with all of these financial strength ratios, it is
more useful when compared to other companies with similar characteristics in the same industry. The numerator
of this ratio differs from that of debt to total assets in that the former includes only long term debt, i.e., that which
will not mature within one year.
Many debts can be classified as "long term", and therein lies the source of differences in the calculation. The
important rule is for the analyst to be consistent. A popular method among financial analysts is to include deferred
income taxes with long term debt in this ratio. Clever Toy's ratio thus calculated is
Debt to Equity indicates the proportion of borrowing to equity in the capital structure. The ratio is calculated
accordingly:
Clever Toy's ratio is
There are several other ratios of financial strength, and variations of the ones presented here, that may have the same
names. When a particular ratio is quoted, therefore, a prudent analyst always determines how the ratio was
calculated.
15
The duPont Formula

The ratios described here under the categories of operating performance, liquidity, and financial strength do
by no means exhaust the total number that are available. Analysts are always free to create ratios that best suit their
purposes. Neither are ratios examined singly all the time. There are various combinations and series which are
useful. One such series allows an analyst to investigate the components of a firm's return on equity. First developed
at E.I. duPont deNemours, this famous series has come to be referred to as the "duPont Formula". To an informed
analyst, the duPont formula presents a snapshot of almost every key ingredient of a firm's financial performance.
The formula is calculated as follows:
By examining changes in the components over a series of accounting periods, an analyst can determine which
figures have most influenced the firm's profitability, or determine what may have caused changes. For example, if
in the analysis of two years' financial statements you see that ROE has increased dramatically, you should know
that: 1) the firm reaped more profit out of each dollar of sales, 2) assets were used more efficiently, thereby
generating increased revenues, or 3) the financial leverage of the firm increased. The duPont methodology allows
you to isolate which of these factors is responsible for the boost in ROE.
Sustainable Growth
Another widely used series of ratios is used to calculate a firm's sustainable rate of growth. Often, managers
wish to know to what extent their company can grow without having to obtain outside financing. A company's sales
cannot expand without commensurate growth in the level of inventory that the company must carry, or without the
size of the company's investment in accounts receivable having to expand to accommodate additional customers.
Not only does the asset base which generates sales have to expand, but as the logic of the fundamental accounting
concept that:
suggests, the size of the debt or equity financing the assets must increase by the same degree. This internally funded
sustainable growth rate (G) can be determined by making a few assumptions and then examining the following
series of ratios, some of which have been introduced:
If one assumes that in the coming year, the company will attempt to keep these ratios consistent with the current
year, then the product of these ratios yields the internally funded sustainable rate of growth. For Clever Toy, the
sustainable rate of growth is calculated as follows (numbers represent thousands of dollars).
16
In this example, Clever Toy would be able to expand its asset base by only 5% in the coming year without obtaining
outside funds (either debt or equity).
Take a few minutes and consider the relationships in the sustainable growth formula. As one can do in the
duPont formula, it is quite easy to cancel terms and simplify this equation, to "ROE times the retention ratio (one
minus the payout ratio)". Often this abbreviated form of the equation suits an analyst's needs adequately. However,
an understanding of the components which make up the expanded version enables a manager to see the relationships
among the firm's assets, liabilities, equity, and dividend policy. Moreover, the complete formula can reveal how
certain decisions can influence the growth of a firm. This relationship will be explored further in a later chapter.
FINANCIAL ANALYSIS
Ratios from financial statements provide concise measures for business performance. However, ratios can
have meaning only when they can be compared to something. Percentage changes in various components of
financial statements are also sources of information for analysts, and they, too, require comparisons.
Horizontal percentage changes measure differences from year to year in discrete components of financial
statements. For example, a horizontal analysis of Clever Toy's income statement reveals the following changes
from 2014 to 2015:
Percentage increase
Net Revenues
Cost of Goods Sold
Gross Profit
Total Operating Expenses
Operating Income
Net Income
13.4%
19.4
6.8
5.2
15.0
14.7
Vertical Percentage analyses reveal percentage changes in another way. In this type of analysis, one component
(usually sales) is chosen as a benchmark and used to express other components. A vertical analysis of Clever Toy's
income statement for the years 2014 and 2015 reveals the following:
Components as a Percent of Sales
Cost of Goods Sold

Gross Profit
Total Operating Expenses
Operating Income
Net Income
2015
2014
55.2%
44.7
36.2
8.6
4.8
52.5%
47.5
39.0
8.5
4.7
The percentage changes in both kinds of analyses raise questions to which answers must be found. For example,
the company reduced its operating expenses by nearly 3% of sales. Why did its net income increase by only one
tenth of a percent of sales?
17
As mentioned previously, one of the fundamental goals of financial accounting is to ensure that financial
statements are comparable. That comparability is possible not only within a firm, but between firms and industries,
and over the course of years.
Trend Analysis
Many analysts are interested in how a company has performed over time. Such historical comparisons are
used to judge how management has met its obligations in the past, and also as a basis to project how management
may perform in the future. While year to year changes can be very important, trends are preeminent.
Comparing various ratios in successive years is one way that trends may be discovered. Performing
percentage analyses as illustrated above is another.
Comparative Analysis
An investor may have chosen a particular industry in which he plans to purchase stock, but still must choose
a company, or a manager may wish to know how his company is performing compared to his company's chief
competitor. Such situations provide opportunities for intercompany analyses. The same kinds of techniques that
are used in intracompany analyses are appropriate. However, the most useful comparisons are made between
companies of similar size. Also, you must be wary of the different accounting methods which may have been used.
Finally, you should be aware of the different strategies that the companies are pursuing before drawing conclusions.
For example, one company may have decided to produce its product as inexpensively as possible and to rely on
advertising expenditures for sales. Its competitor may be producing a very expensive product which it believes will
intrinsically attract customers. These two companies might be of equal size, have equal sales and incomes, yet have
very different expense figures on their income statements.
Comparison to Industry
Extremely useful comparisons can be drawn between a company and the industry in which it competes.
Industry figures are widely available from such publishers as Robert Morris Associates and Standard and Poor. One
must realize, however, that several accounting practices are represented in industry composites. Nevertheless, a
firm's performance relative to its industry has consequences as far reaching at its bond rating and the price its stock
can command on Wall Street.
A Final Word on Financial Analysis
No financial analysis is complete that is comprised of mere numbers. A quantitative analysis must be
balanced with serious consideration of the galaxy of qualitative issues in which companies exist. It is essential that
an analyst understand how changes in the general and sectoral portions of the economy will affect an industry in
general and a firm in particular. Changes in price levels, raw material availability, and interest rates can all have
significant impact. An investigation of how a firm fared in the past when faced with such changes can be extremely
rewarding to an observer. No less important than economic considerations is an understanding of the bases of
competition within an industry, and an assessment as to whether the subject company has identified those "keys to
success". A company may understand the keys to success yet still have a poor record of execution. A qualitative
analysis should precede the quantitative portion, because it may highlight the numbers which should be of greatest
interest.
18
Learning Objectives
Chapter 2- Projecting Earnings and Cash Flow
Describe and explain a pro forma financial statement.
Discuss the qualitative factors used in preparing a pro forma financial
statement.
Using a quantitative approach, prepare a pro forma financial statement.
Discuss the use of sensitivity analysis in pro forma financial statement
preparation.
19
Chapter 2
Projecting Earnings and Cash Flow

INTRODUCTION
Forecasting is perhaps the world's second oldest profession.
From the court astrologers of the ancient

Babylonian kings, to the President's Council of Economic Advisors, soothsayers have long been consulted for the
purpose of financial planning. Forecasting of any kind is an artistic endeavor, for it requires that you take certain
observations from the surrounding world and translate them into a medium. Those who make financial projections
attempt to be of the Realist School, and their medium is the pro forma financial statement.
There are many groups, internal and external, that seek to project a company's future financial performance.
Within a firm, the Chief Financial Officer may wish to review pro forma statements in order to estimate the amount
of external funding that the firm will need to fund expected growth in the coming year. On the other hand, the
potential sources of those external funds will certainly want to assess the company's needs and its ability to repay
them. These assessments also rely on the creation of pro forma statements.
As was mentioned in the last chapter, financial analysis can have two general objectives. The first is to
allow the analyst to judge a firm's past performance. The second objective is to collect information to use as the
foundation for projections. For instance, a horizontal percentage analysis might reveal that a firm has experienced
annual sales growth of ten percent for the last five years. Is it not reasonable to believe that this kind of growth will
continue next year? A vertical percentage analysis could indicate that the same firm has also had consistent
advertising expenditures for the same time period. Wouldn't a reasonable person expect the company to continue
this trend? The answer to both of those questions is another equation: are those really reasonable assumptions?
The truth is that pro forma statements are only as accurate as the assumptions that underlie them.
In every industry, there are certain factors that influence its well being. An industry may have developed
practices to mitigate the uncertainties which surround some of those factors, but rarely all of them. Furthermore,
certain components of financial statements can influence the "bottom line" more than others. The level of sales in
a given year, of course, always significantly impacts a firm's profitability. However, other components can be
important, too. A company with typically thin gross margins, whose cost of goods sold quickly reflects fluctuations
in its raw material prices, can experience erratic earnings despite stable revenues. Another firm's profitability may
be susceptible to interest rate increases. In short, cost structures vary widely among industries and companies. The
qualitative issues that analysts should address can underscore not only those kinds of risks, but also the opportunities
as well. If financial forecasting must be based on assumptions which are tenuous at best, then what can be done
about it? The only solution is to try many assumptions. Only after having done so can one be prudently confident
in a forecast.
For the remainder of this chapter, we will work through the pro forma development process. This process
will introduce you to the fundamental skills which you must understand in order to develop your own methods for
financial forecasting. The process illustrated is a rather complete one; your experienced judgment may in time
20
indicate where an analysis can be streamlined. Because there are so many uses for financial projections, there are
naturally many techniques. Every famous artist has a unique style.
DEVELOPING PRO FORMA STATEMENTS
The process of developing pro forma statements involves three distinct steps. The first step, the qualitative
analysis, enables you to identify the key assumptions that will frame the next step, the quantitative analysis. During
this quantitative step, an analyst uses many of the comparative techniques that were discussed in Chapter 1 to
examine a firm's historical performance. Then, using a variety of tools, the forecaster combines historical trends
with judicious assumptions and projects the statements. The final task in developing a forecast is to test the critical
assumptions that you used in step two.
Qualitative Analysis
This first step in financial forecasting is the same one used in any financial analysis: to acquaint yourself
with the qualitative issues facing both the company and the industry in which it competes. Since your forecast will
be based largely on assumptions, it is useful to know the factors which influence a company's performance. The
best place to start is to assess the factors which may influence the industry as a whole. It is ordinarily safe to assume
that consequences which can affect an industry will affect a company within that industry. The following is an
outline of qualitative factors which should be analyzed in detail, as each directly impacts the profitability of a firm
and its competitive posture:
Qualitative Factors - Industry
I.
II.
III.
Industry Definition
A. Product or Service - Number and Diversity
B. Product Users - Number and Diversity
C. Industry Maturity and Profit Trends
D. Fragmentation or Concentration - Number and Size of Players
E. Competition Basis - Operations
F. Capital Investment Required
G. Barriers to Entry into the Industry by Competitors
H. Important Changes in the Competitive Environment Over Time
Sales Influences
A. General Economic Conditions
B. Marketing Strategies
C. Specific Areas of the Economy Impacted
Cost Structure
A. Components of Costs of Producing (Variable Costs)
B. Unavoidable Costs (Fixed Costs)
C. Required Resource Availability
D. Percentage of Fixed and Variable in Total Costs
E. Price Level Effects on Costs
Admittedly, this is a rather extensive list of qualitative considerations. Some of these questions can only be
answered with educated guesses, while others are widely documented. The important thing to remember is that
there is a sound reason for asking these questions: it is critical for a forecaster to establish which assumptions will
most influence his projection.
21
Having examined the industry, the next step is to ask some company-specific questions. They can be similarly
categorized in the following outline:
Qualitative Factors - Company
I.
Company Definition
A. Products or Services
1. Innovative or Mainstream
2. Number Offered
B. Product Users - Relative Strength of Customers
C. Current Management
1. Composition
2. Tenure
D. Large or Small Player in Industry
E. Competitive Reputation
F. Age of Facilities
G. Relative Strength of Suppliers
II. Sales Influences

A. Marketing Strategy
III. Cost Structure
A. Components of Costs of Producing (Variable Costs)
B. Unavoidable Costs (Fixed Costs)
C. Required Resource Availability
D. Percentage of Fixed and Variable in Total Costs
E. Price Level Effects on Costs
By addressing these questions, you accomplish several things. You can now form an opinion on the predictability
of the company in question. It may have characteristics that are fully consistent with its industry, or it may be a
maverick. By considering the company's management, intended strategies, facilities, size, product line, and cost
structure, you can define the critical variables that will significantly influence the firm's future performance. These
critical variables will be the critical assumptions upon which your pro forma statements will be built.
Quantitative Analysis
In this portion of the analysis, time horizons are very important. The salient issues identified in the last step can
help define a framework for research and can establish a point in the future where projections might lose their
credibility. At one extreme, there are mature, stable industries where decades of information is both available and
useful; at the other, there are those which have existed only for months, and for whom virtually no information can
be found. There is similar difficulty associated with establishing a projection's horizon. A typical company falls
somewhere between the extremes. In every case, accuracy diminishes with the length of time.
In this mathematical part of the problem, we have two objectives. The first is to determine how a company has
performed in the past, and the second is to use that foundation and your assumptions to project the future.
22
Historical Evaluation
Using reliable information, such as industry surveys published by Robert Morris Associates, Standard & Poor's,
Value Line, and others, you should locate the key ratios for the industry. Important ratios may be all of the ones
introduced in the last chapters, or the few critical variables that you have identified. Additional information needs
may be suggested by your reasons for developing the pro formas. At minimum, you should obtain the information
required to quantify the industry's historical sales growth, asset usage skill, profitability, return on equity, dividend
policy, liquidity, and capital structure.
This information serves two purposes. You can test the assumptions that you have made during the first part of
the analysis. You have also quantified the industry's record, and this may prove useful later.
The next step is to perform a similar analysis of the company. Since individual company figures are not
published as frequently as industry figures on certain trends such as sales growth rates, it may be necessary to use
percentage analysis to ascertain some of the numbers. Both horizontal and vertical methods are appropriate. As
with the industry, in addition to figures that you may otherwise need, you should determine the firm's rate of sales
growth, skill in asset usage, profitability, return on equity, dividend policy, liquidity, and capital structure. The
firm's cost structure must also be thoroughly analyzed.
Having determined these two sets of figures, one should compare them. Do the company's numbers compare
favorably with the industry's, or are there significant differences? In performing this comparison, it is useful to
remember qualitative issues such as the firm's age, and the composition of its management. Such issues may provide
insights into the differences that you may notice. From this comparison, a forecaster can ordinarily form the
judgments needed to project the company's future statements.
Projecting the Statements

At this point, an analyst has a fairly good understanding of the company and industry. Knowing the past,
however, is not the same as knowing the future. This is the portion of the analysis where the qualitative ideas that
were formed are married to the numbers. Estimates must be made about the factors which influence the company.
For instance, if a company's sales are inextricably entwined with the general economy, then the analyst must guess
how the economy will perform. Other equally large guesses may also be required. You should not be concerned
about achieving great accuracy at this stage of the forecast. Remember that you will be testing these assumptions
later in the analysis.
There is a trap that analysts frequently fall into when making the basic assumptions about a company's future.
Faced with uncertainty, they compensate by making the most conservative estimates possible. The great challenge
is to resist this temptation, and instead, using the qualitative and quantitative information at hand, make projections
that are consistent with what you have observed.
Having made the necessary assumptions, the forecaster next applies those assumptions to the numbers. The
most prevalent method is to directly project the statements with percentages. Ordinarily, sales growth rates are
decided upon first. From these sales figures, income statements are constructed using the desired vertical
percentages. For example, an analyst may have decided that it is likely that a company will experience ten percent
sales growth during the chosen time horizon. Using the last known sales figure, and the percentages projected for
the cost structure, an income statement might be forecast as follows:
23
ABC Company
Income Statement
Assumed % Actual Pro Forma............................
of Sales
2014 2015 2016 2017 2018
Sales (10% growth)
Cost of Goods Sold
Gross Margin
Operating Expenses
Interest Expense
100
65
1000
630
20
2
370
190
20
1100 1210 1331 1464

715 787 865
952
385
220
22
423
242
24
466
266
27
512
293
29
Earnings Before Taxes

160
143 157 173
190
________________________________________________________________
Taxes (40% assumed)
64
57
63
69
76
________________________________________________________________
Net Earnings
96
86
94 104
114
Notice that the projected cost structure (operating expenses, in this example) for the pro formas portion is different
from that actually experienced in 2014. You may be wondering how particular percentages of growth and cost are
chosen. In addition to making educated guesses based upon historical trends and healthy assumptions, statistical
methods may be employed.
If the historical observations are indistinguishable, that is, there were no unique influences associated with a
particular year, then averages, variances, standard deviations, and other statistical devices may be directly employed
to derive percentages. If, as is the usual case, there were unique events associated with particular observations, then
statistical methods may still be useful, if the appropriate allowances are made. There is danger that an analyst will
be lead into a false sense of security when extreme accuracy is sought through statistical methods, or in minutely
detailed projections. Always remember that the most significant portions of your projection are, no matter how
carefully contrived, still little more than educated guesses.
Balance sheets are ordinarily projected after income statements, because the firm's growth in retained earnings,
an outcome of projected income, is a required input for the balance sheet. Balance sheets are projected with the
same percentage methods as income statements. The forecaster assumes a certain relationship between assets and
liabilities, and combines this with the changes in owners' equity that result from his projection of net income,
dividends, and capital injections. The analyst, in doing this, makes judgments about the firm's working capital
policies, cash reserves, capital expenditures, and debt structure. The sustainable growth formula can often provide
insight into the relationships which must be maintained in order for the firm to meet the requirements of a certain
growth rate.
One useful technique in balance sheet projections is to use a "plug". A plug is used to force the basic accounting
equation:
24
It is disheartening to many students when they realize that projected balance sheets will never, of their own accord,
balance. Because asset growth, liabilities and equity are forecast independently, the likelihood that projected assets
will equal projected liabilities and equities is, indeed, remote. For this reason, the "plug method" has been
developed. Where assets have been projected to grow at a rate faster than liabilities and equity, the plug would
indicate outside financing (either debt or equity) must be obtained. Conversely, where projected assets are less than
the projected liabilities and equity, the firm will possess an overabundance of capital, which would be displayed as
an "excess cash" (or other current asset) plug figure. In sophisticated projections, assumptions may be made as to
the character of the plug. For instance, it may be assumed that a negative plug (i.e., a capital shortfall) will be
financed through the issuance of long-term debt. Since debt is generally not lent without charge, interest must be
added to the amount of debt. This, naturally, increases the size of the plug, effectively borrowing enough to pay
both the interest and the other projected expenditures. An increase in interest charges will accordingly reduce pretax
income and income taxes. This, of course, changes net income which, in truth, causes retained earnings to change.
Alas, now that we have adjusted the income statement to accommodate interest charges, we find that the resultant
change in retained earnings has caused the balance sheet not to balance.
Fortunately, computers can solve the fabulously complex interrelationships which can arise when making
financial projections. For purposes of illustration, however, let's simplify our assumptions, as shown below, in
continuing the forecast of the ABC Company.
Assumptions:
1.
ABC Company will maintain its current working capital policy.
2.
No dividends will be paid.
3.
The company will increase its investment in property, plant and equipment in 2015 and 2016, and
thereafter will invest only enough to offset depreciation charges.
4.
Owners equity will only grow by the amounts previously forecast in the income statement, about 2.8%
annually. No new stock will be sold.
5.
There will be no interest expense or interest income incurred as a result of the plug figure.
25
ABC Company
Balance Sheets
Actual
2014
Pro Forma...................................
2015
2016
2017
2018
Current Assets
Noncurrent Assets
Total Assets
1100
3000
4100
1130
3100
4230
1160
3200
4360
1190
3200
4390
1225
3200
4425
Current Liabilities
Noncurrent Liabilities
Owners' Equity
Total Liabilities &
Owners' Equity
Plug:
Excess Cash
Notes Payable
Total Liabilities,
Owners' Equity &
Plug
600
300
3200
600
300
3286
600
300
3380
600
300
3484
600
300
3598
4100
4186
4280
4384
4498
44
__80
73
-
4100
4230
4360
4390
4425
Notice that only the current assets and owners' equity accounts are increased. One fundamental assumption being
made is that the $3200 asset base of property, plant and equipment will support the projected sales growth. Another
is that the company's credit and inventory policies will adjust to meet the new sales levels (as is indicated by the
increase in current assets). Liabilities, on the other hand, are explicitly kept constant. The plug figure, notes payable
or excess cash, thus reflects the total amount of funding that will be required or be in the excess of the explicit need.
Once these figures have been determined it is management's responsibility to decide where that funding may come
from.
Balance sheets and income statements are the two statements that are typically forecasted. The remaining
statements, if required, can be derived from them. In addition to financial statements, analysts frequently forecast
cash flows. Forecasting a cash budget combines methods used in forecasting income statements and balance sheets.
In such projections, detailed information is required about the firm's working capital policy, its planned purchases,
operating cycle, and typical seasonal sales patterns. Cash budgets are ordinarily projected by month, rather than by
year. Since external analysts rarely have access to such detailed information, they often project cash flow from
operations. These projections are annual, and as defined in Chapter 1, require only that the analyst have net income
figures and an idea of the firm's noncash charges. Projected noncash charges are simply added to net income to
arrive at the cash flow from operations for a given year. Most of the analytical techniques that will be discussed in
the rest of this text will use "cash flow from operations".
Sensitivity Analysis
The final and perhaps most crucial portion of financial forecasting is to test the assumptions that were used to
derive the projection. This assumption testing is referred to as sensitivity analysis. In this step you are, in essence,
testing the validity of your calculations by subjecting them to change. If you recall that forecasts are often based
upon how an analyst believes the general economy is going to perform in the future, you will realize the significance
of this step. To perform a sensitivity analysis of a forecast, you must recall the critical assumptions made to develop
the projection. An assumption is critical if it has significant bearing on the company's statements. After identifying
26
these crucial elements again, substitute them in your pro formas, varying them one by one, and examine their impact.
To gain initial information and avoid confusion, it is important to vary only one at a time, holding other variables
constant. Once you have done this, the results may suggest appropriate pairings to change. To determine the degree
that the variables must be changed requires judgment on the analyst's part. A useful place to begin is in the historical
figures. Calculating a variance for past sales levels and other components of the statements may provide a useful
range for your sensitivity analysis. Often, "best" and "worst" case scenarios are envisioned and calculated. As you
may have imagined, sensitivity analysis can be a very involved process. The gravity of the situation requiring the
projections is the only guide to how "sensitive" your conclusions may be, and how much analysis is required. The
advent of electronic spreadsheets has rendered this task a more easily manageable one. Variables can be changed
at will, and the results are almost instantaneous.
The results of a sensitivity analysis are finally reviewed in light of the decision at hand. The figures ordinarily
reveal a certain sales level or cost figure at which a "go" decision may become a "no go" one, as well as a minimum
earnings or cash flow to support the decision. These points on which decisions depend must be separately reflected
upon. If necessary, they can be assigned probabilities or considered in terms of the decision-maker's risk profile.
The creation of pro forma statements thus requires that the decision maker consider the problem from two
perspectives. In doing so, the exact composition of the firm's future may not be correctly foretold, but a range of
reasonable possibilities will. Such a framework for decision making is far superior to pure guess work or wishful
thinking.
27
Learning Objectives
Chapter 3- Creating Value for Stockholders
Summarize the concept of financial risk.
Describe and explain the process of a compound growth rate.
State and define the concept of present value.
Calculate the present value of an amount to be received in the future using
an assumed discount rate.
28
Chapter 3
Creating Value for Stockholders
In the preceding chapters, certain analytical tools have been introduced. While every general manager should
be familiar with these basic methods, it is more important for a manager to be able to apply the results of an analysis
to the larger issues confronting the firm. Informed decisions are more likely to result in a stronger company.
Every manager has varied, and occasionally conflicting, allegiances within the firm. Financial managers have
one additional chargeto conduct the affairs of the firm in the stockholders' best interests. In this respect, financial
managers share points of view with the firm's top managers, and with its board of directors.
Why should a company be concerned with the stockholders' interests? A cynical manager may surmise that
stockholders who are unhappy with a managerial decision have the right to sell their holdings in the firm. This is
undeniably true; however, when stock is offered for sale in quantities which exceed market demand, the price (value)
associated with those shares will, in response to the law of supply and demand, be driven down. If a sufficient
number of stockholders sell their shares, a company will find that its stock price has significantly declined. It is
naturally in a company's best interest to maintain its stocks' value at the highest level the market will allowthis
enables the company to acquire more funds from fewer shares in a stock issue, for example. For this reason alone,
companies endeavor to avoid shareholder dissatisfaction.
There are other important reasons. Stockholders are the owners of the firm; managers have traditionally
answered to owners. If contemporary managers can be found guilty of disregarding this traditional relationship, it
may be because they are more removed from the owners in a corporation, with its board of directors and several
layers of management, than they may have been in the simpler business structures of the past. Nonetheless,
managers, and indeed all employees, bear a fiduciary responsibility to the owners of the firm, whether there be one
or one hundred thousand, to preserve and build the owners' investment in the firm. This philosophy represents the
under-pinning of capitalism.
From a legal perspective, another important reason for managers to act on behalf of equity holders is related to
the terms which usually accompany debt that the firm chooses to absorb. The claims of a company's debt holders
are nearly always senior to the company's stockholders. Debt service and contractual obligations of any kind
ordinarily take precedence over dividends.
In the event of bankruptcy, creditors are satisfied before the owners may claim the firm's residual assets, if any
remain. Therefore, managers are by default the shareholders' fiduciary representatives in the firm. Only they can
conduct the affairs of the company in such a way that it can provide an acceptable return to the owners, in excess of
the company's contractual obligations.
To maintain the firm's stock price and other traditional reasons, then, the prudent financial manager carefully
considers a major company decision from two vantage points. The first is to project how the determination will
directly affect the firm. The second is to predict the resulting shareholder reaction. Often, the two results are not
compatible and a compromise must be sought. In solving these dilemmas, there should be a dominant goal in the
29
mind of the manager: the creation of value. As long as a company can continue to enhance the value of the owners'
holdings in the firm, then it is worthwhile for managers to resolve the disagreements that may arise.
The Creation of Value
The concept of the creation of value is one of the most comprehensive and significant issues that you will
encounter in the study of finance. Theoretically, managerial intentions should be enacted only when they can add
value to the firm. Value is added to a firm when earnings are enhanced, operational or financial risks are reduced,
or when efficiencies result as the consequence of a decision, among other reasons. Decisions which added value to
the firm, in turn add value to the owners of the firmwhether in the form of increased dividends which can be paid
to them, or in the value of their stockholdings, which appreciate as a result of the decision. One other significant
tenet of the "creation of value" theory is that management should continue to reinvest capital in the business only
for as long as the returns being generated by the business exceed those which the shareholders could realize by
investing their capital elsewhere, assuming comparable risks. Management obtains capital for investment in the
firm from a variety of sourcesdebt, retained earnings (which, essentially, are withheld dividends), and new equity
issues. The various forms of capital are employed in the purchase of assets, which ostensibly provide a certain
return. Management's return on investment in assets is measured in terms of earnings or cash flows. A firm's
investors (debt holders and shareholders) receive their returns on investment in the form of interest payments,
dividends, or rising stock values.
All investors require returns which are commensurate with the risk of their investments. Investors require higher
returns on risky investments, and conversely, will accept lower returns for less risky pursuits. As long as a firm's
owners are able to acquire a rate of return which exceeds the cost of the capital they have invested, value is being
added to their portfolios. It is management's obligation to appraise the business opportunities that are available to
the firm, and to act in the shareholders' interests. Such considerations should dictate the firm's dividend policy. If
management is able to invest capital in such a way that a high return can be realized, then a relatively low dividend
payout can be justified. In such a case, shareholders should not object to their potential dividends being reinvested
in the firm. On the other hand, if managers cannot foresee attractive investments, it is their duty to return the
shareholders' capital so that they can invest their funds elsewhere. Between these extremes, where a firm in a stable
business has expectations of steady if not rapidly growing earnings, relatively high payout ratios can be seen. It is
for these reasons that a "growth" company may pay no dividends, a mature, stable one may pay high dividends, and
a dying company may liquidate itself.
Thus far, we have explored management's relationship to a company's owners. A financial manager's premier
responsibility is to add value to the firm, so that this increase can filter through to the firm's investors. How do
managers create this additional value? To explore this question, we return to the most basic accounting identity,
and express it as follows:
Assets = Debt + Equity
This equation indicates that a firm's assets must be balanced by an equal package of debt and equity. Debt may
be in the form of payables and accruals, loans, or any form of liability that you can imagine. Equity can be retained
earnings, the net value of its stock issues, or paid-in capital. There are certain exotic forms of debt and equity, such
as convertibles and preferred stock, which have characteristics of both debt and equity, and will not be discussed at
present. This combination of debt and equity which balances a firm's assets is referred to as the firm's capital
structure, or capitalization. Managers have two methods by which they can add value to a firm, through
components on either side of this accounting equality.
Perhaps the most intuitively apparent means by which value can be added to firms is through investment in new
income-producing assets. Additional assets can come in any forms. A firm may invest in more efficient machinery
30
which will save the company operating costs. Or, growing sales may warrant an investment in plant expansion,
working capital accounts, or additional marketing expenditures. In short, new assets can be tangible (PP&E) or
intangible (marketing expenditures, accounts receivable, etc.). The important consequence of an asset acquisition
should be that it creates new income, cash flow, or efficiency that outweighs its cost. If such a result occurs, then
value has been added to the firm.
To create value on the right side of the balance sheet is a more complex undertaking. In the most fundamental
sense, value can be created in a firm's capital structure if its managers select proportions of debt and equity, which
are used to finance the firm's assets, in the most efficient possible way. Consider the following diagram, which is
an expanded version of the basic accounting identity:
Common Stock + Retained Earnings
Net Income - Dividends

In this relational diagram, you can see the financing choices a manager has when a new asset is to be
acquired. Again, for the moment, exotic securities will be ignored. Conventionally, financial managers try to match
financing with the life of an asset a long-term asset is financed with long-term financing and a short-term asset
is financed with short-term sources. Typical long-term sources of debt are loans and bond issues. Short-term debt
has many forms, and can be supplier credit, loans, commercial paper, or bank lines of credit. Equity is considered
a source of long-term funds. Notice the sources of equity: equity can be obtained from within the firm, by
withholding dividends from stockholders, or from without the firm, through the issuance of new securities.
When a manager selects a source of financing, he creates value by selecting the most appropriate form for
the situation at hand. To arrive at a choice, a manager first considers the impact of the decision on factors within
the firm.
One internal consideration is the amount of funding needed, relative to the size of the firm's capital structure.
A relatively small requirement might preclude the option of a bond or stock issue, for example, because such sources
are usually reserved for large funding needs. Another consideration is the cost of the various sources. Lenders
obviously require payments of interest on debtborrowers are legally bound to make timely payments of interest
and principal as dictated in the loan agreement or they may be forced into bankruptcy. Common stock also bears a
cost, dividends, though it is not as legally compelling as the payment of interest, for management can choose to
withhold dividend payments without the retribution of bankruptcy proceedings. The cost of interest, as any
homeowner knows, is deductible for tax purposes. In effect, the government subsidizes as much as 46% of the cost
of borrowing by allowing interest payments to shield corporate income from taxation. Dividends, on the other hand,
receive no such preferential treatment. In fact, dividends are taxed both at the corporate level, because they are not
considered a deductible outlay, and at the personal level of the stockholder. Management is thrust with the
responsibility of balancing the cheaper after-tax cost of borrowing with the contractual burden to pay interest. This
dilemma will be investigated further in Chapter 7.
Another internal issue to be considered is the composition of the firm's existing capitalization. Is there a
disproportionate amount of either debt or equity already present? A firm which is already heavily laden with debt
may find it difficult to pay more interest. If the company has a large proportion of its capital structure comprised of
common stock, managers may avoid issuing additional shares for fear of alienating the existing shareholders or
losing control of the company: equity markets do not prevent the purchase of common shares by unfriendly buyers.
31
The last internal issue that will be discussed at present is the question of a company's future needs. If
managers know that they will be needing more funds in the future, they may wish to select their sources in a
particular order, based on considerations already mentioned. For example, external factors such as high interest
rates, or a low current stock price, may influence managers to select one form of financing this year, in hope that
conditions will be better for an alternative next year.
Most of these internal considerations affect the firm's owners by influencing the security and size of their
dividends. External factors, on the other hand, influence the market price of their shares. The most significant
external consideration that managers make is an assessment of how the capital markets will receive their financing
choice. Naturally, choices which please the markets are preferred.
Generally, capital markets approve of managerial decisions which enhance earnings per share, dividends, or
operating cash flow they respond favorably when they perceive that value has been created in a firm's shares.
The markets will, however, balance their enthusiasm with an assessment of the firm's risk. For the moment, since
we are discussing financing decisions, we will address financial risk.
Financial risk is the uncertainty associated with a company's ability to convert operating income (Earnings
Before Interest and Taxes) to a given level of earnings per share, and as a result, a commensurate level of dividends
per share. Since taxes are a constant which all businesses factor into their EPS, the remaining factor which
determines financial risk is interest payments. The most commonly used indicators for a firm's financial risk are the
capitalization ratios introduced in Chapter 1, although there are others that you will be introduced to in a later
chapter. You may have concluded that zero interest is most favored by capital markets. Surprisingly, although a
firm with no debt does have the lowest possible financial risk, it may not enjoy its highest possible stock price.
On the contrary, capital markets prefer a certain level of debt, which varies by industry and company, in a firm's
capital structure. Because earnings do not have to be distributed over as large a number of shares of common stock,
earnings are higher per share in a capital structure where some debt is present. Assets must be funded in some way,
and to a point, the fewer shares which are allotted earnings, the better. Conversely, the process by which a given
level of earnings is spread over a greater number of shares is known as dilution. Earnings which are more leveraged
are less dilute. Financial leverage and financial risk are opposite forces which exert pressure on EPS and a share's
market value.
Examine Figure 3.1 for a moment. In the rising portion of the "EPS/Debt %" curve, the influence of financial
leverage is stronger than financial risk. At the pinnacle of the curve, the ideal balance between the two forces is
shown in the highest EPS and share value. In the descending portion of the curve, the financial risk associated with
ever higher interest payments overwhelms the benefits of increasing leverage, so EPS and stock price decline.
32
Figure 3.1
Financial managers, with due consideration given to internal matters, attempt to base their financing
decisions on this financial leverage curve. It is often difficult to ascertain exactly where the company's capitalization
is located, and misjudgments are quite possible. Furthermore, cautious companies try to maintain additional debt
capacities for unexpected catastrophes debt can ordinarily be obtained more quickly than market-supplied equity.
A financing decision is an iterative process funding choices are considered one by one, with the appropriate
internal and external factors in mind.
The importance of each factor varies among companies, and within the same company over a period of time.
The manner in which value is created through capitalization is by no means constant and is sometimes a choice
of the least of many evils. You should understand one final note about value creation in a firm's capital structure.
Managers can always restructure a firm's capitalization when the financial climate is attractive. A financial
restructuring need not be accompanied by an asset acquisition. Managers may, for instance, retire some of the debt
in the firm's capital structure through a stock issue, if market conditions are favorable. Or they may wish to apply
additional leverage shares from the marketplace. There are several ways in which value can be created.
It is possible then, for managers to "add value" to their firms and stockholders through actions which affect
both sides of the balance sheet. It is extremely important for each side of the balance sheet to be considered
separately, however. A decision to acquire new assets must stand entirely on its own merits, and must not be
influenced in any way by financing opportunities which exist. Conversely, if only marginal financing opportunities
are available, an investment which will add value to the firm should be financed. This is not to advocate that the
two decisions need not make sense when considered together. Both decisions should be the best available
alternative, and should be chosen without considering the benefits or disadvantages of the other. The resolution of
an investment/capitalization issue typically follows this pattern: (1) from the realm of proposals an investment is
chosen, (2) a capitalization package for financing the investment is envisioned, (3) both are considered together.
The preceding section has been intended as an introduction to the creation of value in firms. Each method
of adding value will be treated separately in subsequent chapters.
Unquestionably, to determine if value has been created, results must be measured by some means. Most
contemporary methods share a basis in another of the most fundamental of financial concepts: the concept of
present value.
33
An Introduction to Present Value

"Time is money." The notion that money has a different value over time is not an intuitive leap that is easy
to make. A dollar last year is the same dollar this year. However, the effects of inflation painfully illustrate that the
purchasing power of money certainly differs with the passage of time. In the late 1970's it would have been easy to
convince someone that they would rather have $1000 this year than next year. In considering the value of money,
firms must consider not only the ravages of inflation, but also the investment opportunities that await them. Many
firms have several choices, and their objective is to choose those which are most lucrative.
Individuals are confronted with a similar choice when they are considering opening a savings account. Is it
better to open an account which features interest payments that are compounded quarterly, or an account which
offers higher interest that is compounded annually? In order to answer this question, the individual has to determine,
after a certain period of time, in which account he would receive the greater return. In conducting this analysis, a
person must provide the variables which are common to all investments: the size, duration, return, and timing of
the return. Assume that a person has an option to invest cash in an account which pays 10.38% interest annually,
or elsewhere at a rate of 10% compounded quarterly. The quarterly compounding would result in four periods of
2% interest each. The person has $1000, and intends to leave the money in savings for one year. Which account
is best? Shown below is the schedule of interest payments for both choices.
Quarterly Compounding
Beginning Balance
Quarter 1:
Interest .025 x $1000.00
Ending Balance
Annual Compounding
$1000.00
$1000.00
25.00
1025.00
0.00
1000.00
Quarter 2:
Interest .025 x $1025.00
Ending Balance
25.62
1050.62
0.00
1000.00
Quarter 3:
Interest .025 x $1050.62
Ending Balance
26.27
1076.89
0.00
1000.00
Quarter 4:
Interest .025 x $1076.89
Ending Balance
26.91 .1038 x $1000.00

$1103.80
103.80
$1103.80
In this situation, the individual would be indifferent in his choice of account--the interest which accrues is the
same. However, an interesting phenomenon is apparent: even though the quarterly account paid interest at a lower
rate, its performance was able to match the higher paying account. It was able to do so because of the timing of its
payments. The interest accrued in the first quarter was received quickly enough to be reinvested in the second;
interest from the second quarter earned additional interest in the third quarter, and so on.
34
Consider another investment choice. An individual has to choose between the following investments which will
return payments as the schedule indicates:
Return in Year
(Cost)
Investment X
Investment Y
($10,000) 5,000 6,250 5,250

($10,000) 3,000 4,000 10,000
Total
Return
16,500
17,000
Investment Y appears to be the best choice, for its total return exceeds that of Investment X. However, what would
happen if the payments were deposited in a savings account as they were received? If the best available interest rate
is 10%, compounded annually, the investment returns would accumulate as shown below:
Investment X
Year
Payment Received
Interest Earned
5,000 6,250
0
500
3
5,250
1,175
Total Return
Total
16,500
1,675
18,175
Investment Y
Year
Payment Received
Interest Earned
1
3,000
0
2
4,000
300
Total Return
3
10,000
730
Total
17,000
1,030
18,030
Based on these results, our investor should choose Investment X.

The point of our two examples is this: since individuals and firms usually have continual investment
opportunities, the timing of the payments may be more important than the apparent returns. In every case, with total
returns being equal, the investment which provides cash flows sooner is the superior choice. Flows which are
received sooner can be put back to work more quicklyand that is the basis for the notion that money has different
value over time. Incidentally, investments should always be evaluated on the basis of their cash flows. While a
company may invest in an asset to improve its earnings, assets are not purchased with "earnings". Earnings are
derived through accounting conventions, which as you know, may differ among firms. Banks and creditors accept
only cold, hard cash. Since a firm must outlay cash to acquire assets, their returns should be evaluated with the
same terms.
In considering the two investment choices in both examples, the investor based his decision on the
accumulated or future value of the alternatives. The future value of an investment is the sum of the payments
35
received up to a future time. When an investment such as a savings account returns payments at a regular rate, the
following formula can be used in place of laborious addition to determine its future value:
Future Value = (1 + Periodic Interest Rate) number of periods x Initial Investment
In the case of the 10%, quarterly compounding account, the variables would be
FV
= (1 + .10/4)4 x $1,000
= (1.025)4 x $1,000
= 1.1038 x $1,000
= $1,103.80
Notice that the rate is converted to a number which is equivalent to the rate per period. A 10% annual
interest rate, compounded quarterly, pays 2.5% per quarter. Provided you have a calculator or computer, this
formula is quite easy to solve.
While individuals and firms are concerned with how valuable an investment will be in the future, many are
equally concerned about what the value of an investment is today. Furthermore, as you notice in the investment
examples above, returns do not often accrue on an equal, regular basis when choices must be made. To counter this
problem, the concept of present value was devised. The present value of an investment answers the following
question: Given the rate of return that I am confident can be otherwise achieved, and a schedule of the payments
that will accrue from this investment, what amount of money received today would make me indifferent to accepting
the offer? In calculating the present value, the rate of return that an individual is certain can be achieved is used as
a discount factor. The discount factor is the rate that an investor believes he can enjoy, whether or not the
investment is chosen. A discount factor has the same function in present value calculations that an interest rate has
in calculating future values. The only difference in the two is the direction that a figure's value is compounded. An
interest rate is used to compound a known value forward to arrive at a future value; a discount factor is used to
restate a series of future payments in terms of current values. For example, a 10% annual interest rate yields a future
value of $1,100 on a $1,000 deposit, after one year. If the $1,100 future value is discounted back one year, with a
discount factor of 10%, the present value of the investment is $1,000. The formula for present value can be derived
from the future value equation, by restating the equation in terms of the "initial investment".
Let's work an example. An investor has been assured that a certain project will pay $20,000 five years from
now. This investor's best alternative investment guarantees an annual return of 11%. The variables in the present
value equation are:
PV = $20,000 / (1 + .11)5
= $20,000 / 1.685
= $11,869
The present value of this investment is $11,869.
36
Conversely, if $11,869 were invested today at the same 11% rate, five years of compound interest would net
$20,000 nearly double the initial investment.
A handy rule of thumb employed by bankers for years before the advent of electronic calculators is the "Rule
of 72". This process allows one to determine, in approximate terms, what combination of interest rate and years
will cause an investment to double. For example, the value of a nine percent investment will double in
approximately eight years (8 x 9 = 72). Similarly, a six percent investment requires twelve years to double. And
so on.
What if an investment does not return its total payment in a lump sum, but rather in a series of payments
over years? Each year's payment must be discounted separately, and then added together after discounting. The
present value of the following series of payments would be calculated as shown.
Discount Rate = 10%
Year
Payment
$1,000
Discount Factors .909
Present Value
$ 909
3,000
.826
2,479
3,000
.751
2,254
2,000
.683
1,366
5
2,000
.621
1,242
Total Present Value = $909 + 2,479 + 2,254 + 1,366 + 1,242

Present Value = $8,250
The power and utility of present value calculations is especially apparent when an investor must choose between
competing investments. The following example will demonstrate:
Discount Rate = 15%

Year
Year End Payment:

Investment A
$5,000 5,000
Investment B
$1,000 1,000
2,000
1,000
1,000
11,000
Total
13,000
14,000
Present Value, Investment A = $10,015

Present Value, Investment B = $8,572
In this situation, the investor is presented with a choice between two investments that have returns with not
only different magnitudes, but different schedules. The present value calculation demonstrates that, because of the
time value of money, an investment which at first sight is far less lucrative than its alternative, is in fact superior.
Fortunately, all present value calculations need not be carried out through the use of cumbersome formulae.
Many books have present value tables which streamline calculations. Individual present values must still be
combined, however, as was done in this last example. Calculators which perform present value calculations are
37
even better. Many financial calculators perform all the necessary operations of discounting and recombining cash
flows simultaneously.
You have seen briefly how present value calculations can be used to select investments. If present value is
used as a selection criterion in asset acquisitions, then managers are able to create value in their firms by selecting
those which provide the greatest returns. Since present value can be used to describe not only future returns, but the
present value of future costs, it can be employed on the financing side of the balance sheet as well. There are several
evaluative techniques which use present values. In the next chapter, you will be introduced to some of them.
38
Learning Objectives
Chapter 4- Capital Budgeting
Discuss the concept of differential analysis.
Describe and explain the non-present value methods used in capital
budgeting.
Describe and list the present value methods used in capital budgeting.
Discuss the qualitative factors impacting the capital budgeting decision.
39
Chapter 4
Capital Budgeting
INTRODUCTION
In the last chapter, we explored many of the issues surrounding the creation of value. One of the methods
through which value may be created is through investments in assets. Assets may be short or long term, tangible or
intangible. Investments which provide returns for a period greater than one year are referred to as capital
investments. Capital investments may be expenditures for property, plant or equipment; marketing campaigns;
research and development programs; or permanent additions to working capital. In order to evaluate capital
investment proposals, companies have developed several methods. The most popular method is referred to as
capital budgeting.
Capital budgeting, like other forms of financial analysis, involves qualitative and quantitative considerations.
Both kinds of considerations extend to the (1) generation of investment ideas, (2) evaluation and ranking of
alternatives, (3) selection of investments and (4) continuing appraisal of past investment performance.
THE CAPITAL BUDGETING PROCESS

I.
Identifying Alternatives
No degree of quantitative sophistication in evaluating alternatives is as important as generating the

alternatives. The companies which are most creative in developing ideas will be the most successful, if their
managers are competent. The importance of fostering ideas within firms cannot be overemphasized. Unfavorable
conditions in financial markets, real or imaginary, should not preclude considerations of new investments. There
are, of course, physical limits to the amount of funding that a firm can hope to obtain in a given year. More often
than not, however, the barriers which restrict investments are the limitations of a firm's managers. A firm can,
however, develop an unwieldy number of considerations as well. The challenge to managers is to design an
organization which ensures that the best ideas are fully considered. It must also be remembered that an alternative
to every investment is to maintain the status quo.
II.
Quantifying the Alternatives
Once a firm has assembled its investment opportunities, each must be evaluated and ranked. In capital
budgeting, alternatives are evaluated on the basis of their costs and benefits, in terms of incremental cash flows.
Incremental cash flows can also be referred to as relevant cash flows. Incremental costs and benefits are those
which will exist only if an investment is implemented. Because investments are evaluated in terms of cash flows,
capital budgeting does not necessarily demonstrate the effect that an investment will have on a firm's income
statement: cash flows are not earnings. Incremental cash flows may be difficult to isolate, in some cases. Many
companies incorrectly attribute prior cash outlays, such as research and development costs undertaken before an
investment was envisioned, to projects that are under evaluation. If a company has experienced a cash outflow that
40
it will have to bear even if the investment is not undertaken, then that flow should not be considered an incremental
cost during an analysis. Such a prior expenditure is referred to as a sunk cost.
The costs which are associated with investments may be thought of as uses of cash. Costs include the
acquisition costs and the operating costs. Acquisition costs include the cash payments that are required for
ownership, and any subsequent expenditures required to extend the life of the asset, such as a major overhaul. Actual
cash payments required for the acquisition of assets may differ from listed purchase prices: purchase prices can be
offset by discounts, trade-ins, and other means, or may be increased by installation charges or freight. Operating
costs are the periodic (usually annual) costs associated with using the asset. These costs are normal, recurring
expenses, whereas a major overhaul is not.
The benefits from investments can be thought of as sources of cash. They include operating cost savings,
additional revenues, tax savings, cash proceeds from the sale of assets that are being replaced, and the predicted
salvage value of the new asset at the end of its useful life. Estimates of future salvage values are tricky, and should
not be used to justify marginal investments. Incremental costs and benefits are summarized in Figure 4.1.
Figure 4.1
Incremental Cash Flows
From Investments
BENEFITS:
COSTS:
1. Cash proceeds from sale of old asset

2. Cost savings over old asset
3. New depreciation charges, a noncash expense
4. Tax benefits such as ITC; capital losses on
sale of old asset
5. Additional revenue possible because
of investment
6. Salvage value of new asset
1. Acquisition costs, not necessarily price

2. Annual operating cost and routine maintenance
3. Depreciation lost from sale of old asset
4. Tax consequences of capital gain on sale of old asset;
increased taxes resulting from improved profitability
5. Revenue lost from sale of old asset
6. Major overhauls
Taxes may provide costs and benefits. For instance, if an investment is a replacement for an existing asset, then
the old asset may be sold or retained. The cash proceeds from the sale of the old asset is a benefit, as mentioned
earlier. However, the sale will be subject to taxes if the asset is sold for any price other than book value (original
value less accumulated depreciation). If the sales price exceeds book value, then the excess is considered as
additional income and will be taxed at a certain rate. The rate, over the past several years, has varied from the
ordinary corporate tax rate to the capital gains rate ( a much lower rate). If the sales price is less than the book value,
however, the difference is considered a loss and, again, the appropriate rate is applied.
When an old asset that has not been fully depreciated is sold, the company loses the tax shelter of that asset. To
account for this in capital budgeting, the net book value of the asset (typically purchase price + improvements depreciation taken) is compared to the selling price to determine a taxable gain or loss on the transaction. Only after
all of the tax implications are considered can the analysis be deemed complete. Most tax complications are avoided
when the old asset is retained.
There are several tax laws which will not be discussed here, because tax regulations are not among the immutable
laws of nature. One that is worth mentioning, however, is the investment tax credit. Investment tax credits were
first ordained by Congress in the 1960's as a means of stimulating the economy by encouraging investment in
machinery and equipment. The ITC amounts to a credit equal to a certain percentage of the cost of the investment.
41
This percentage has ranged from 0% to 10% over the past several years. In a capital budgeting analysis, an ITC
would be considered a reduction in the initial outlay.
Some incremental cash flows imply a comparison with the status quo. A technique that is widely used to identify
these incremental benefits, as well as incremental costs, is known as a differential analysis. A differential analysis
is simply a table in which the benefits and costs of investment alternatives are compared. Each alterative is
represented by a column of figures. For example, if an investment decision involves a choice between maintaining
the status quo, or purchasing a new plant, a differential analysis will compare the two alternatives. One column lists
each of the costs and benefits as they are before the investment is undertaken, and in the second column, each is
listed as they will appear if the investment is undertaken. The differences between the two columns are found, and
the results are the incremental cash flows that can be attributed to the project. When performing differential analysis,
it is very important to choose and retain a reference point for comparisons. Hours of circular calculations can be
avoided. A typical reference point is the company as it is before any investments are undertaken. While reference
points may reflect personal preferences, the most important practice in capital budgeting is consistency. A
differential analysis is illustrated in Figure 4.2.
Figure 4.2
An Annual Differential Analysis
For New Plant vs. Old Plant
In this example, the old plant is being sold for book value. Notice that depreciation and any other noncash items
should be added back to the incremental net income to compute the investment's incremental cash flow. Where
operating costs are less for the new asset, they are represented as negative expenses in the "difference" column.
After the useful life of the new asset is estimated, a differential analysis is conducted for each year that the new
asset will be in service. The useful life is the estimated economic life of the asset, which is the number of years that
the asset is expected to be productive. After the differential analyses are conducted, the figures are collected and
arranged within the chosen time horizon of the capital budgeting analysis.
Time horizons may be chosen arbitrarily, but they usually conform to the period of time that the analyst can be
confident in the predicted figures. Time horizons are frequently selected so that they match the new asset's
42
depreciable life. Depreciable life is the number of years that the company will depreciate the new asset, and is a
function of the depreciation method that is chosen. All of the examples in this text will be predicated on straightline depreciation.
When considering investment alternatives, equal time horizons must be used. Frequently, when a new asset is
compared to an old one, a time horizon which could be easily used for the new asset must be foreshortened, because
the old asset has a shorter remaining useful life. In such cases the old asset's useful life is used for the time horizon,
and the residual cash flows for the new asset are estimated. Conventionally, the residual value is the present value
of the future cash flows for the new asset, as of the last year of the chosen time horizon. In other words, an old asset
may force the choice of a shortened time horizon. The residual value quantifies the future benefits of the new asset,
and converts these future benefits into a form which can be used in the reduced time period.
When all of the estimates and cash flow differences are found, the numbers are arranged in a table. The form
shown in Figure 4.3 is commonly used by analysts, and is useful in helping one to view the investment as a whole.
Examine Figure 4.3 for a moment.
Figure 4.3
Incremental Cash Flows
Of Investment "Y"
($000s)
Year
Investment:
Cash Paid
(300)
Sale of Old Asset 80
Future Overhaul
Salvage Value
(40)
140
Incremental Revenue 200 200 200 200 200 200 200 200
Operating Cost Savings 40 40 40 40 40 40 40 40
Net Depreciation
(15) (15) (15) (15) (15) (15) (15) (15)
Taxable Savings:
225 225 225 225 225 225 225
225
(90) (90) (90) (90) (90) (90) (90)
(90)
Incremental Net Income 135 135 135 135 135

135 135
Add Back Noncash Items15 15 15 15 15 15 15 15
135
Yearly Cash Flow(220)150 150 150 110 150
290
Tax (40%)
Notes and Assumptions:

1.
2.
3.
4.
5.
6.
Old asset sold at book value.

Depreciable life of new asset = 8 years, straight line.
In year zero, old asset had 8 years useful and depreciable life remaining.
Useful life of new asset = 8 years.
Revenues and cost savings are inflation adjusted.
Cash flows come at end of year
43
150 150
Year "zero" is defined as the moment that the investment is implemented. Notice that the total investment
is equal to the cash paid plus the proceeds from the sale of the old asset. Therefore, the acquisition cost must have
been $220,000. The salvage value of the new asset at the end of its useful life is estimated at $140,000, and is
recorded as a cash inflow at the end of the time horizon. The assumption underlying the salvage value estimate is
that the asset will be sold at the end of the eighth year. The general assumptions that are made are always shown in
this format.
After quantifying alternatives, they must be ranked in some fashion so that managers can make proper
choices. Remember that the primary reason for making investments is to create value in a firm.
III.
Ranking the Alternatives
Investments can be numerically ranked through comparisons of their returns. Most methods are based on
the present value concepts that you learned in the last chapter. There are, however, widely used methods which are
not, and we will begin by examining a few of those. Regardless of the method that is chosen, the cash flows which
are used should not be considered to be immutable. The judicious application of sensitivity analysis to results is
always appropriate.
A.
Nonpresent Value Methods
Payback is a method which is quite popular, and most certainly has its merits, even when considered among the
more sophisticated methods that are available. An investment's payback is simply the number of years that will
pass before returns equal the original investment. For this reason, it can also be referred to as a break-even analysis.
If the investment does not return regular, equal installments, then the payback can be found by adding each
year's return successively until a figure is obtained that equals the original investment. The year that the point is
reached is the payback. The advantage of a payback calculation is that a firm can predict when the cost of an
investment will be recovered so that the funds can be employed elsewhere. One serious drawback to this method is
that it does not recognize the magnitude of returns beyond the payback date. An investment with a faster payback
could be selected over an investment that has much larger future returns. The payback for the example in Figure
4.3 occurs between the first and second years, or more precisely, 1.47 years ($220/$150).
Benefit/Cost Ratio is simply the ratio of the total incremental cash flows to the acquisition cost. The
benefit/cost ratio for the investment in Figure 4.3 is $1,300/$220 = 5.91. The greatest disadvantage of this method,
like payback, is that it fails to compensate for the time value of money.
B.
Present Value Methods
All of these valuation methods, save one, use discount factors to restate future cash flows in present terms.
The choice of discount factors is as important as the valuation method.
For illustrative reasons, a discount factor was defined in the last chapter as a rate of return that an investor
is reasonably sure of, if the investment under consideration is rejected. This definition is applicable only for specific
cases. In general, a discount factor is simply the chosen discount rate, and may vary as the investor wishes. Discount
factors are usually varied to compensate for risk. A large discount factor reduces future cash flows at a faster rate
44
than a small one. Because of this, investors compensate for riskier investments by using higher discount factors.
This practice ensures, for reasons that you will see later, that risky investments that are chosen have higher returns
than less risky ones. Investors require higher returns for riskier investments.
Discount factors that firms employ are referred to as hurdle rates. Several hurdle rates may be applicable
within the same firm. The most commonly used hurdle rate is one that approximates the risk of the firm itself. The
firm's risk is equal to the rate of return required by its owners. This risk can be approximated by using the firm's
ROE, or determined more accurately through calculating the firm's cost of capital. The ROE represents a firm's
historical opportunity cost of employing capital: it is the return that the firm has been able to achieve. A firm's cost
of capital, on the other hand, reflects the capital market's assessment of a firm's future risk. A firm's normal hurdle
rate often represents a compromise between its opportunity costs and cost of capital. When the average hurdle rate
is used, the analyst implicitly assumes that the risk of the investment is equal to the risk of the firm.
Many firms use only one hurdle rate, and rely on managers' opinions of the present values which result, to
make investment selections. Others use varying hurdle rates. If an investment is perceived as being less risky than
the firm's ordinary business, then a hurdle rate is chosen that is lower than the normal rate. An investment which is
less risky than the business as a whole might be the purchase of land, company vehicles, and the like. If an
investment is considered more risky than the firm's normal business, then a higher hurdle rate is used. Such an
investment might be in the machinery required to produce a new, untested product, for example. Assessing and
providing for risk is one of the most profound challenges that confront managers, and hurdle rate choices are only
one example of the ways managers deal with risk.
A more detailed discussion of risk and the cost of capital will follow in the next chapter.
Now that you have an idea where discount factors come from, we can proceed to the investment valuation
methods that are based on present value.
Present Value Payback is identical to payback, except that the present values of the annual cash flows are
used in place of future values.
Like the regular payback, this method can be myopic and fail to recognize the value of returns beyond the payback
date. Using the cash flows from our example, and a hurdle rate of 12%, the PV payback is:
45
Year
Cash Flow
(220)
(22)
Present Value
Cumulative Cash Flow (220)
150
134
(86)
150
120
34
150
107
141
110
70
211
150
85
296
150
76
372
150
68
440
290
117
557
Initial Investment
First Year
Remainder
PV Payback
= $220
-134
= $ 86
= 1.7 Years
86/120 .7
Since the discounted values of the cash flows are used, present value payback are always greater than regular
payback.
Present Value Index (PVI) is identical to the benefit/cost ratio, except that it does allow for the time of the cash
flows.
In this case the PVI is $777/$220=3.53. Since this method allows for the time value of the cash flows, it should be
recognized as the most accurate representation of an investment's total return that has yet been discussed.
Net Present Value (NPV) is perhaps the most popular of all present value methods. An investment's net present
value is simply the present value of the future cash flows, minus the initial investment. Managers prefer this method
because it expresses an investment's returns, in excess of the initial payment, in terms of present dollars. The major
shortcoming of this measure is that it disregards the size of competing investments. For example, a very large
investment is likely to have a higher NPV than a smaller one. NPV does not measure the proportion of returns to
initial cash outlay, as does a PVI. For this reason, it can be misleading to use NPV when comparing investments of
different magnitudes. Nevertheless, NPV calculations are the method of choice in ranking investment opportunities.
When an investment is chosen that has a positive NPV, then value has been created. The NPV of our example is
$777 - $220 = $557.
Internal Rate of Return (IRR) is the discount factor necessary to make an investment's NPV equal to zero.
The determination of this magic discount factor is a laborious trial and error process, and is more efficiently
performed by computers and financial calculators. If an analyst were to attempt to find the internal rate of return
for an investment manually, then the process would be this: the cash flows, positive and negative, would be set
down in a table similar to Figure 4.3. Then, the analyst would randomly select discount factors, gradually refining
the choices, until the PV of the investment's returns were equal to the cash flow in year zero. This process can be
performed smoothly, until a change in signs of the cash flows occurs (positive cash flows switch to negative) during
any year other than the initial investment. In such a case, the apparent IRR is misleading, if not impossible to find.
IRR calculations are a more popular return valuation method, though, because they describe an investment's returns
in a way that can be easily compared to a firm's hurdle rate. If the IRR is less than the firm's chosen hurdle rate,
then the investment will be rejected. Aside from the misleading results that can arise if there are sign changes in the
cash flows, there is another significant disadvantage: IRR's do not compare the magnitudes of returns.
46
Rather than relying on one of these methods, it is better to use more than one of them to rank investments.
Unless a company is routinely faced with investments of short duration, present-value-based methods are superior
to others, because they compensate for the time value of money. Preferable though they may be, each of the PV
methods has its deficiencies. By using a combination of techniques, these imperfections can be ameliorated. Most
analysts include NPV calculations among their choices. By definition, an investment with a positive NPV creates
value.
It should be mentioned that all of the cash flows that you have seen in the examples were end of year flows.
Many investments provide returns uniformly through a given year. If that is the case, then allowances must be
made. You can approximate uniform cash flows by using PV tables that are based on "middle of the year" figures.
Uniform distributions can be more accurately computed by using months in the place of years in the PV formula.
Financial calculators can accommodate shorter compounding periods quite easily.
Once the relevant costs and benefits of competing investments have been evaluated and ranked, they are
selected.
IV. Selecting Investments
"Number crunching" is only half of the investment selection process. Every alternative must be considered in
the light of qualitative matters. Analytical sophistication does not release managers from the burden of employing
their best judgment.
When investments are implemented, there may be consequences within and outside of the firm. Qualitative
assessments include appraisals of the impact of decisions on personnel, the community, the environment, and the
law. Another important consideration is the strategy of the company: is this investment consistent with the strategy?
In short, there may be factors which compel a firm to choose other than the most lucrative alternatives.
After choices have been made, it is extremely important for investment performances to be monitored.
Assumptions that were made can be tested for accuracy for future investment decisions. The role of assumptions in
creating value through assets is as crucial as it is in projecting the company's future.
47
Learning Objectives
Chapter 5- Calculating the Cost of Raising Capital
Discuss the efficient market hypothesis.
Calculate the cost of equity.
Calculate the cost of debt.
Discuss the cost of hybrids.
Calculate the weighted average cost of capital.
48
Chapter 5
Calculating the Cost of Raising Capital
INTRODUCTION
When firms evaluate investments, they frequently measure total returns through the use of hurdle rates.
Hurdle rates are the discount factors that are used in present value calculations, or the benchmarks that are used to
judge internal rates of return. Hurdle rate choices have far-reaching consequence they shape the results of return
measures, regardless of the method that is chosen. If, for example, a firm consistently uses very high hurdle rates,
it may find that it has very few investment choices which will pass the test for selection. Selecting investments on
the basis of high hurdle rates also has the consequence of increasing the risk of the firm. The once lofty hurdle rate
eventually becomes the average the risk of the firm increases if it consistently chooses investments with very
high returns, because high returns accompany risky investments. A firm may or may not want to increase its risk.
Hurdle rate choices are rarely static. They are frequently varied to compensate for risk. Before they can be
varied, a reference point, the average or normal hurdle rate, must be established. Managers define an average hurdle
rate as the company's opportunity cost, or as the company's cost of capital. Both of these quantities are appropriate
for defining the average return on an investment in the company's assets.
A company's opportunity cost is determined from a perspective within the firm. It can either be the average
return that the company has earned on its assets (ROI), or it can be the company's return on equity (ROE). Both of
these measures are deficient, however, in that they are historical. What has happened in the past cannot be
guaranteed to happen in the future. A forward looking hurdle rate is important, because hurdle rates are used to
evaluate the future cash flows from investments. It is possible to avoid a guileless dependence on the past by making
predictions of future opportunity costs. However, this approach is subject to the same degree of uncertainty as a
naive reliance on historical figures. Because of these problems, firms look increasingly to other methods.
Whereas an opportunity cost definition reflects a judgment made within a firm, the cost of capital generally is
set by external forces. The capital markets price their funds on the basis of the future risk that they see within a
firm. Financial theorists have defined the kinds of risks that investors face, and for which they require compensation.
One form of risk is operational risk. This risk is associated with a company's ability to produce and market its
products. Another form of risk is the risk of illiquidity: while an investor's capital is employed in one place, a
better opportunity may arise in another. The investor's illiquidity, or lack of access to funds, will prevent
participation in the better investment. Another kind of risk is financial. Financial risk has been previously defined
as the uncertainty associated with a firm's ability to translate EBIT into earnings per share. Financial risk increases
with financial leverage. Investors require greater compensation as these risks increase. The compensation that
investors require therefore reflects a firm's risk.
Individual investor opinions about a firm's risk are not more accurate than a company's projected opportunity
costs. However, in total, the combined assessments of hundreds of market analysts are more reliable. Furthermore,
the capital markets represent the primary source of funds that firms use to finance new assets. Whether or not the
firm approves of its perceived risk, the capital markets set prices based on their perceptions.
49
For the equity markets, financial theorists have offered an "efficient market" theory to explain how the market
is able to accurately reflect a firm's risk. The efficient market theory holds that, at any given moment, the prices of
securities reflect all that is or can be known about a company's future. This circumstance exists because there are
hundreds of sophisticated investors and arbitrageurs who are trying to find "values" to exploit. The free market
forces which are in effect move security as a firm's prospects change. Free equity market forces react to
developments which affect the firm's operational and financial risk, and dividends.
Debt markets also price their funds on the basis of the risks that they perceive in a firm. They set their return
requirements based on the firm's operational and financial risk, and on the term of the loan, which establishes the
risk of illiquidity. A long-term loan presents an investor with a higher probability that a better opportunity will arise
while his funds are occupied.
A firm's cost of capital, then, represents the market's definition of a firm's risk. Firms accept this proxy for use
as an average hurdle rate, because they have no alternative that is more objective. For another equally pragmatic
reason, it is prudent for companies to evaluate investment in a way that is consistent with the markets' view the
markets react to a firm's investment decisions.
Using the cost of capital as an average hurdle rate does not violate the rule that asset purchase decisions must
be considered independently of their financings. In the next section you will see that the cost of capital is not a
particular interest rate or equity issue cost that is available to a firm. Rather, the cost of capital is a composite figure,
based on the proportion of debt and equity that is in a company's capital structure. The cost of capital is used as a
proxy for an average hurdle rate, because it is the best obtainable indication of the risk of a firm.
THE COST OF CAPITAL

There are many definitions of the cost of capital. Generally, the cost of capital is the weighted cost, expressed
as a percentage, that a company has paid for the funds in its capital structure. The weighted average is determined
by the proportion of debt and equity on the financing side of the balance sheet. The cost of capital can be expressed
by the following formula:
Cost of Capital = (% Debt x Cost of Debt) + (% Equity x Cost of Equity)
To solve this equation, an analyst first refers to the balance sheet, where the percentages of debt and equity can be
found. These percentages are multiplied by the costs, and the result is the firm's current cost of capital. A
refinement of this procedure, and one which results in a more accurate figure, is the calculation of the target cost
of capital.
The only difference in a target cost of capital derivation is the manner in which the percentages are defined. In
a target cost of capital calculation, the percentages on the balance sheet are altered to reflect the addition of a
financing under consideration, or the future percentages that the company intends to maintain. For example, a firm
may have fifty percent debt and fifty percent equity in its capitalization. Its best choice for financing a new project
may be equity. The target capital structure would include the amount of equity that will be necessary to finance the
project, and in this case, could raise the equity percentage to 55%, for example. If this target structure does not
reflect the capitalization percentages that the firm intends to maintain during the life of the asset, then the "planned"
ratio can be used.
50
One further refinement of the target cost of capital, which is based on the prices that are reflected in the current
capital structure, is the marginal cost of capital. The margin cost of capital also uses "target" capitalization
proportions, but its costs are based on the prices which exist in the current market. In other words, the costs which
were incurred in the firm's existing capital structure are prices that it paid in the past. The marginal cost of capital
is based on the prices that a company will have to pay, to re-create that target structure, in the current marketplace.
With these explanations complete, we can turn to the problem of calculating the first element in the general
equation.
THE COST OF DEBT

Debt is of two dominant forms: loans and bonds. The marginal cost of debt is calculated in the same way for
each form. The cost of all types of debt is calculated after taxes: interest payments are a tax deductible expense.
Investors that provide debt funds require returns, in the form of interest. In addition to operational and financial
risk, debt investors are exposed to a risk of illiquidity. Illiquidity is generally a greater risk for loan issuers than it
is for equity holders, because there is no convenient market where one can sell traditional loans. Therefore, longterm loans require higher interest rates than do short-term loans, in normal circumstances. Before we turn to the
marginal cost of debt, you should be familiar with the kinds of debt that are available.
Loans come in many forms. Loans can be short or long term. Lines of credit may also be classified as loans.
Generally, a company pays for the use of loan funds through interest payments. This interest can be a fixed amount,
or it can be related to the amount of principal which remains to be paid. Interest rates can also vary with an agreed
upon reference point, such as the prime rate. Naturally, the principal must also be repaid. Most loans are predicated
upon agreements between the lender and borrower. These agreements, called covenants, most often place
limitations on the borrower's freedom to do things which could jeopardize its repayment of the loan. For example,
a lender may require that a company maintain a certain current ratio or dividend policy. If a borrower violates the
loan covenants, then the lender may declare that the loan is in default, and may take whatever actions are necessary
to recover its investment. Loan covenants are more restrictive for high-risk borrowers.
Bonds are a long-term security which a firm issues to investors in return for their capital. the most common unit
of issue is $1,000, so that 1000 bonds would be issued for a $1,000,000 financing. Firms which issue bonds pay the
investors interest on the original value of their bonds, for as long as they hold them, or until the bonds mature.
Bonds mature at the time that the issuer agrees to repurchase them from the holders. Average maturities range from
five to thirty years. The interest, or coupon rate, remains fixed throughout the life of the issue. When the bonds
mature, the firm purchases the outstanding ones at their original or par value. There is a market which continuously
trades existing, as well as new issues of bonds.
Several circumstances may influence the price that any investor, including the firm, pays to purchase bonds
before they mature. While the coupon rate remains constant, the value of the bonds does not. The forces of supply
and demand heavily influence the bond market. These forces are driven by interest rates in the debt market as a
whole. If general interest rates fall, for example, the market will place a premium on bonds which have coupon
rates that are higher than the new interest rate. Coupon rates, you remember, are constant. This increased demand
drives the prices of those bonds upward, until the advantage of owning them no longer exists, and equilibrium is
realized. The opposite occurs if general interest rates increase. Bond holders with low coupon rates discover that
their bonds are in disfavor, and must be sold at discounts. Eventually the prices are driven down to the point that
they offer the market's preferred return.
51
The return that is earned on a bond is referred to as its yield to maturity (YTM). Investors require yields that
are commensurate with the risk of the bond issuer. Risk profiles are divided into nine classes. Firms with the best
credit rating are classified "Aaa", and these bonds have the lowest yield. In return for this low yield, an investor
receives the highest likelihood that the firm will repay its debt. At the other end of the spectrum are "C" bonds,
which have very high yields. These high yields are offset by the distinct possibility that they may not be repurchased
at maturity. So-called "junk bonds" are those with high yields and high risk.
To determine a bond's yield to maturity, an internal rate of return must be calculated. Consider the case of a
bond issue with a 10% coupon rate, a par value of $1,000,000, and a maturity of five years. The YTM is calculated
from the investor's perspective.
End of Year
0
Cash Flows ($000s)
Bond Purchase
(1,000)
Coupon Payments
Bond Sale
100
100
100
100
100
1,000
The IRR = YTM = 10%.
You may check this IRR by performing an NPV calculation, using 10% as a hurdle rate. You will find that the
resulting NPV is equal to zero. This calculation has pointed out an interesting fact. A bond which is valued at par
has a YTM which is equal to its coupon rate. Notice that the coupon rate, 10%, results in annual coupon payments
of $100,000, which is 10% of the par value of the original issue, $1,000,000. If 1000 bonds were issued, each bond
will receive a coupon payment of $100. This bond is somewhat unusual because its coupon payments are annual.
Most bonds pay interest semiannually.
Supply and demand moves the market value of bonds. If the prevailing return on debt of the same risk as this
bond issue were to fall, the holders of these bonds would find that their securities would be in high demand. Let us
suppose that general interest rates fell on the day after these bonds were issued. Since the demand for these bonds
would increase, an original holder might be able to sell one of the bonds for $1050. The yield to maturity, will have
been altered to the following rate:
0
Cash Flows ($000s)
Bond Purchase
Coupon Payments
Bond Sale
100
100
100
100
100
1,000
(1,050)
The IRR = YTM = 8.72%.
An NPV calculation for this investment using the YTM (8.72%) as a hurdle rate yields a result of zero. As you can
see, the higher purchase value results in a lower YTM, which is consistent with the direction that general interest
rates went in this example.
52
If a bond's YTM remains constant, then the timing of a purchase does not affect the purchase price: it remains
at par value until the YTM changes. An important fact for you to remember is that changing YTM's do not change
the value of a bond. Market forces change the value, and this in turn changes the YTM. There are, however,
characteristics of bonds which influence the market's behavior.
Just as lenders incorporate covenants into loan agreements, bond issuers include certain provisions in their
issues. One common condition is a call provision. A call provision permits a firm to repurchase bonds at either
their market or par value, if the market value of a bond reaches a certain point. If a bond appreciates to a certain
value above par, then this means that its YTM has decreased below the level yielded at the time of issue. This
indicates that the debt market's required return, for forms of comparable risk, has declined. Therefore, new funds
are available to the firm at a lower rate than they are currently paying. In these circumstances, firms may naturally
wish to refinance their debt at the new rate. They can do this through a call provision, which allows them to buy
back the old bonds when they have appreciated to a certain point. The call provision establishes the price at which
the company can do this. Naturally, a company waits until the bonds have appreciated beyond this call price before
they repurchase them. The call price is also referred to as a strike price. Call provisions often have time limitations.
Generally, a certain length of time must pass before they can be exercised. Investors may experience a call either
voluntarily, or involuntarily. When involuntary call provisions are present in the terms of a bond issue, market
forces resist valuing the bonds above the strike price. Market forces may or may not succeed in achieving this.
Firms retire bonds in many ways. Most bond agreements require the company to begin retiring bonds after a
certain time has passed. In order to do this, schedules of payments known as sinking funds, are arranged in advance
of the issue. Firms with exceptionally strong credit ratings may be allowed to forego sinking funds, and repurchase
the bonds at maturity with a single balloon payment.
Bonds are exceedingly diverse instruments of debt. They vary with respect to their seniority, the manner in
which they are secured, the provisions which accompany their issue, and in the manner in which they are retired. A
more detailed discussion is beyond the scope of this text.
The cost of debt, in whatever form, is calculated by a company in the same way. The cost of debt is equal to its
after tax cost. Since sinking fund and other principal payments are after tax cash flows, only interest or coupon
payments are considered to be the cost of debt. (An exception to this rule is the case of loans which require that
compensating balances be maintained. In this case the "unproductive" compensating amount would effectively
increase the cost of the funds actually received.) The specific cost is determined by the loan's interest rate or the
bond's yield to maturity. The formula for this term in the cost of capital equation is:
Cost of Debt = (1 - Tax Rate) x Interest Rate
Since we are concerned only with the marginal cost of debt, it is unnecessary to establish the various interest
rates that a company is currently paying for all of the forms of debt in its capital structure. You need be concerned
only with the interest cost of the most attractive form of debt that is available to the firm in the current market. In
other words, apprise yourself of the best interest rate for debt that is available in sufficient quantity to cover a firm's
financing needs. This rate, when multiplied by the target percentage of debt in the company's capital structure, will
yield the debt component of a firm's cost of capital. If a firm's best debt alternative is a 10% loan and the firm is in
a 40% tax bracket, then the firm's cost of debt is:
Cost of Debt = (1 - .40) x .1 = .060 = 6.0%
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To include this in the cost of capital equation, this cost of debt would have to be multiplied by the percentage of
debt in the firm's target capitalization. As you can see, the cost of debt is a straightforward calculation. The cost of
equity is another matter.
THE COST OF EQUITY

You may recall that there are only two sources of equity. A firm may generate equity through earnings, or
through issues of stock. With the exception of the fees that must be paid to issue new stock, the cost of equity is
equal to the cost of retained earnings. A company's cost of equity is equal to the return that its equity holders expect
in return for the use of their capital. In general, there are two methods for quantifying the returns that equity investors
expect: dividend discounts and risk premium assessments.
Dividend Discount Methods

Dividend payments are cash flows which accrue to investors in return for the use of their funds. Even where
firms are retaining all of their earnings for reinvestment, shareholders expect that at some point in the future dividend
payments will begin. With this assumption in mind, an investor can view all of a firm's earnings as future dividend
payments. This viewpoint is supported by one of the corollaries to the value creation theory: when a firm has no
foreseeable attractive investment opportunities, it must begin returning investor capital.
Dividend discount models presume that a stock's market value is determined by the present value of future
dividend payments. The fundamental assumption underlying dividend discount models is this: the maximum price
that investors are willing to pay for a stock is the present value of the future dividends that they will receive. This
assumption seems to agree with a firm's view of the cost of equity: dividends represent the "cost" of having
shareholders in the firm. If a ratio of the present value of dividend payments to a stock price is constructed, then a
cost of equity according to this method will be defined. Dividend discount methods vary in their complexity.
The most naive form views a firm's earnings per share as a future dividend, without allowing for the time which
will expire before it is paid. This simple version is the opposite of the price-earnings ratio (P/E) discussed earlier.
Intuitively, this simple dividend discount method makes a good deal of sense. P/Es, by definition, represent the
market's expectation of a firm's future prospects. Next year's projected earnings, divided by a current stock price
which has been defined in an "efficient market", would seem to indicate a fair assessment of the market's expected
return on an investment in a firm. This method is widely used as an initial "rough" estimate by many analysts. A
projected EPS of $3.00 divided by a current share price of $24.00 yields a cost of equity of 12.5%. Notice that,
unlike debt, the cost of equity makes no allowance for a tax shield. Dividend payments are paid with after-tax
dollars.
It has been noted that the P/E inversion disregards the length of time which may pass before future earnings may
be returned to the investor. More complex methods attempt to allow for this, as well as a rate of growth in the firm
which may differ from the frozen status that is implied in the simple model.
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The next most complex dividend discount method requires the analyst to predict a firm's rate of growth. The
underlying assumption of this formula is that dividend payments will increase at the same rate that the firm grows.
This formula is
Where: Growth Rate = (1 - Payout %) x ROE

This formula, as the P/E inversion, is predicated on the belief that the stock price reflects the present value of all
future dividends. It is less naive than the P/E inversion in that it has substituted next year's projected dividend for
EPS. It also attempts to predict the growth of the dividends. However, despite its considerable simplicity, it has
several disadvantages: it cannot be used if the firm pays no dividends; it assumes that a firm's growth rate is constant.
Nevertheless, this method is widely used. As an example, assume that a firm will pay a $4.00 dividend next year
on a 25% payout. Its projected ROE will average 10% for as many years as can be foreseen. The firm's stock
currently trades for $40.00 per share. The firm's current cost of equity is:
There are more complex dividend discount models, which require the analyst to predict dividends for a number of
years into the future. Others allow for different growth rates in discrete future time periods. The "increased
accuracy" of these complex formulas should probably be viewed with as much skepticism as the simple models.
Despite the shortcomings of dividend discount methods, they are popular. The simplicity and beauty of the
premise that stock prices are equal to the present value of future dividend payments is alluring. However, some
analysts prefer to approach the problem from another view point.
Risk Premium Assessments
Risk premiums are the returns that investors require in excess of the returns that are available in risk-free
investments. You may not be aware that risk-free investments exist. Your intuition is correct. There are, however,
investments which are considered to be so safe that they are virtually risk-free. Such investments are those in U.S.
government securities, such as Treasury Bills and Bonds. Financial theorists believe that investors are always aware
of the risk-free returns that are available, and that there must be some additional return to entice them to invest in
other than risk-free investments. This additional return is known as a risk premium. If an analyst can determine the
risk premium that equity holders in the firm require, then the company's cost of equity will have been defined.
Theoretically, the return required by investors in any firm is:
Total Required Return = Risk Free Rate + Risk Premium
The first term of the equation is readily available in the newspaper listings of government securities. It is the risk
premium that is difficult to define.
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The simplest way to define a risk premium is to guess. Since that method is not very scientific, other methods
have been developed. One of the most widely used is a formula known at the Capital Asset Pricing Model
(CAPM). The Capital Asset Pricing Model quantifies a company's risk premium by relating the historical returns
of that company, or the industry in which it competes, to the performance of the market as a whole.
Many dedicated research teams, most notably Ibbotson and Sinquefield of the Financial Analysts Research
Foundation, have tracked the historical performance of the stock market through several decades. To derive CAPM,
statistical techniques have been employed to relate the performances of various industries and individual firms to
the market as a whole. Specifically, a variable known as a "beta" was calculated in each of the relationships. A
beta measures the magnitude of covariance in stock performance between a firm and the total stock market. The
covariance in performance between a stock and the market in general is a measure of the amount and direction that
an individual stock's value changes for a given change in the market's composite performance.
The CAPM formula simply applies the covariance measure to the "total required return" formula highlighted
previously. The CAPM formula is:
Cost of Equity = Risk Free Rate + Beta (Market Return - Risk Free Rate)
In this formula, the risk premium is defined by the covariance term. The underlying assumption of CAPM is that
investors require a higher return from stocks than they do from risk-free investments, and this higher return is equal
to the potential that a stock has to exceed the performance of the market.
The only variable that is difficult to obtain for this formula is the beta. Many stock research concerns have
calculated them, however. Where a beta has not been calculated, or where there is insufficient historical data to
derive one, an estimate has to be made. Analysts use the following guidelines to do this:
1. A company whose risk is equal to the average stock in the market has a beta of 1, meaning its performance
conforms exactly to the market.
2. A company whose risk is less than the average stock in the market has a beta less than 1. A beta less than
1 indicates that the stock value will move in the same direction as the total market, only it will not
move as far.
3. A company whose risk is greater than the market as a whole has a beta greater than 1. This indicates
that the stock's value will change in the same direction as the market index, but that it will change
more.
The beta of a utility company might be .6, and the beta of a high technology growth company might be 2 or greater.
As the guidelines suggest, a very low risk firm has a low beta. A high risk firm has a beta greater than 1. The
CAPM formula ensures that high risk firms are compensated with high returns, and vice versa, because of the
multiplying effect of the beta. You may want to reexamine the formula and confirm this.
Having obtained a beta and the risk-free rate, an analyst may be in a quandary over which number to use as a
proxy for the "market return". There are two solutions to this problem. An estimate can be made, or the historical
performance of the market can be used. Neither is completely satisfactory, and often the answer is determined by
individual judgment. We are of the opinion that the historical return on the market is the best choice, because it is
a known quantity. For your information, the average nominal return on common stocks has exceeded the risk free
rate by about 8 percentage points during the last 5 decades.
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Once these judgments have been made, CAPM is solved quite easily. Assume that the risk-free rate on T-Bills
is 7.4%, and a company has a beta of 1.2. Using the historical market return which is in excess of the risk-free rate,
the company's cost of equity is:
Cost of Equity = .074 + 1.2 (.08)
= .17 or 17%
CAPM is widely used to define the return required by investors, and therefore a company's cost of securing investors.
While it requires the considerable use of judgment, its results are usually derived with more certainty than those that
result from dividend discount models. However, dividend discount models can still be useful. There are situations
where an analyst is more comfortable in predicting a company's dividends and growth rate, than trying to assign a
beta to a particular firm.
We have now explored some of the methods that can be used to value the costs of the most basic kinds of capital.
There are other hybrid financial instruments which share the characteristics of both debt and equity. You should be
aware of some of these financial instruments, and how their costs are derived.
Cost of Hybrids
Preferred stock and convertibles are two popular financial instruments which share characteristics of debt and
equity.
Preferred stock is classified as equity, although it shares many qualities with bonds. Preferred stock provides
its holders with ownership in a firm, without exposure to many of the risks that common shareholders experience.
Preferred stockholders receive dividends that are a fixed percentage of the par value of their shares. In this way,
preferred dividends are similar to coupon payments. A difference is that preferred dividends are not an expense that
firms may deduct from their taxable income. Preferred dividends are attractive to some investors, because they
provide a relatively safe and predictable return. Also, firms consider preferred shareholders to be senior to common
shareholders in liquidation claims and in the receipt of dividends. Preferred stock has grown in popularity largely
as a result of the income tax system. Corporations investing in the stock of other corporations are allowed to exclude
from taxation a certain percentage (historically this has been 85%) of the dividends they receive.
In return for regular, known dividends, preferred stockholders forfeit ceratin opportunities. Preferred dividends
are subordinate to the obligations a firm may have to debt holders. Preferred stockholders frequently do not have
voting rights, as do common shareholders. Finally, although preferred shareholders are protected by fixed dividends
from the downside risks confronting common stockholders, they typically cannot benefit from the high returns
which may accrue to common stockholders in a profitable year. Preferred dividends are fixed, but management
retains the right to withhold them, if necessary, in a particular year. Preferred stock, like many financial instruments,
can be issued with a variety of terms and characteristics. The features that have been mentioned apply to most
preferred stocks. Companies are free, however, to issue preferred stock which has the right to vote or participate in
the company profits, in excess of regular preferred dividends.
The cost of preferred equity is easily calculated:
Notice that there is no need to allow for a tax shield. Preferred dividends are paid with after-tax funds.
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In addition to preferred stock, there are many convertible financial instruments. Convertibles are instruments
which can be converted to common stock. This conversion may occur at the company's discretion, and may occur
with or without the investor's approval. Conversions which require the investor's consent are referred to as
voluntary; those which do not are involuntary. Most convertibles are either bonds or preferred stock.
Convertibles are accompanied by call provisions. As previously mentioned, call provisions can be enacted when
the par value of the bond increases to a certain value, known as a call or strike price. Bonds may have call provisions
which pertain to their repurchase or to their conversion to common stock. In the case of preferred stock, which can
also be repurchased or converted, call provisions are related to the price of common shares. When a common share
has appreciated to the point that the cost of issuing common stock is less than or equal to the cost of preferred equity,
the company will want to call in the preferred shares. Call provisions provide the price that the company will pay
(usually above par), or state the number of common shares that the preferred can be converted to. Convertible
options are usually time constrained.
The cost of convertible instruments is surprisingly easy to calculate. If the instrument has not been converted,
its value is calculated in the same way as it is for debt or equity. An unconverted convertible bond is treated as debt.
An unconverted convertible preferred share is treated as preferred stock.
In addition to these special cases, firms incur costs when they issue new securities. When a firm issues new
equity or bonds, it must pay for the services of several third parties, in order to facilitate the deal. Fees must be paid
to the SEC, attorneys, and investment bankers, to name a few. These fees can be expressed as a percentage of the
issue. To calculate the issue costs on a firm's cost of capital, the following formulas are used:
In the case of new equity, the formula is nearly identical to the dividend discount model. The exception is that the
issue fees are converted to a percentage per share and are included in the denominator. In the case of new debt, the
numerator represents the total dollar figure of annual interest payments. The denominator is the net amount of funds
that the company receives after the fees have been deducted.
We are now ready to return to the general cost of capital formula.
The Weighted Average Cost of Capital
As you have seen, the cost of capital means many things. Managers who are evaluating investments are
interested in determining their firm's marginal cost of capital. Since the cost of capital is a weighted average of the
various kinds of financial instruments in the firm's capitalization, it is frequently referred to as the marginal
weighted average cost of capital. If there are special securities in the firm's capital structure, then their costs must
be calculated separately, and weighted according to their proportions of the whole. A formula which encompasses
all of these possibilities is:
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The components of the capital structure should be considered as percentages of the total.
In this chapter, you have been exposed to several methods of calculating the costs of the various capital
components. As with ranking investments, where several methods are available, it is always prudent to use several
of the methods and compare the results. For instance, in calculating the cost of equity, you would be wise to use a
dividend discount method along with CAPM, and compare both to the naive P/E inversion. When these methods
yield significantly different results, an inquiry about the cause must be made. Very frequently, a cost is an average
of several close results.
The cost of capital is an extremely useful tool for managers to employ. It provides a basis for hurdle rate
selections. It allows managers to assess financing alternatives on the basis of cost. Most importantly, it enables
managers to create value within their firms.
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Learning Objectives
Chapter 6- Assessing Merger and Acquisition Targets
Defined the term mergers and acquisitions.
Value a firm using the dilution method and the relevant cash flow method.
State and define the minimum price to be paid for the proposed
investment.
State and define the maximum price to be paid for the proposed
investment.
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Chapter 6
Assessing Merger and Acquisition Targets
In Chapter 4, you were introduced to capital budgeting as a means to evaluate investments.
Capital
budgeting is usually associated with project evaluation. When a firm is considering an acquisition or merger with
another company, many of the same techniques apply. Mergers are nothing more than complex projects.
The terms merger and acquisition are often used interchangeably, and "merger" typically refers to any
business combination. This practice is harmless, unless an accounting or legal distinction is desired. Technically,
for legal and accounting purposes, a merger is a business combination which occurs when two firms combine their
balance sheets and the "acquired" company ceases to exist as a separate entity. An acquisition, on the other hand,
may be an investment in all or part of another company. There are two other legal forms of business combinations:
two firms may consolidate by combining their balance sheets and evolving into a firm with a new name; another
kind of combination occurs when one firm acquires greater than a twenty percent share in another, and thereby
creates a parent-subsidiary relationship. For our discussion, "merger" and "acquisition" will refer to a situation
where one firm is absorbed by another, and the target firm ceases to exist.
An acquisition is a complex project because it involves more than cash flow projections. Unlike single asset
purchases, which are typically market-valued, companies can be valued in several ways. The results of several
valuations provide a "price negotiating range" between the acquiror and the target. To complicate this range further,
two companies may be worth more together than they are worth as separate entities. This added value, which results
from a combination of firms, is referred to as synergy. Firms which are shopping in the acquisitions market search
for other firms which will provide synergies. Synergy may result from any of the following circumstances:
Vertical Integration a situation where the target (acquired) firm lies upstream or downstream in the
production or marketing chain of the products which the acquiring firm produces. Vertical integration can
provide lower production costs or more efficient distribution. Both benefit the acquiring firm's earnings or
cash flows.
Horizontal Integration a situation where the target firm produces similar products, and has unused and
compatible production resources or a marketing capability that the acquiring company could use. Both
benefits can reduce production costs and/or increase sales.
Financing Capability the target firm may have unused debt capacity which could be beneficial to the
acquiror.
Enhanced Cash Flow the target firm may produce attractive annual cash flows, or it may have large
cash reserves on its balance sheet.
Diversification the acquiror may be seeking to reduce its operational risk through the purchase of an
unrelated but profitable business.
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Market Undervaluation the market may have discounted a target firm's worth, or may not have foreseen
the value which could be created if the target firm were to be acquired.
Excess Cash an acquiror may have large cash reserves which need to be employed to enhance earnings
or reduce the threat of becoming a target itself.
In general, synergies enhance an acquiror's earnings or cash flows. Synergies are not always readily
apparent. It is the skill that is required to identify them which makes a merger a more complex problem than a
simple capital investment.
In addition to possible synergies, the tax implications of mergers are extensive. Frequently, the legal form
of a business combination is determined more by tax considerations than it is by the valuations which may occur.
Nevertheless, firms must ascribe values to potential targets. The results of valuations determine whether the
business combination should be undertaken; the tax considerations determine what the legal structure of the
investment should be. Further discussion of business combinations and tax considerations will not be conducted in
this text. Our task is to learn how companies value their acquisition targets, and by so doing, determine whether or
not a business combination should occur.
TARGET VALUATION
The valuation of acquisition candidates conforms to the evaluation and ranking stage of capital budgeting.
There are methods which rely on discounted cash flows, and those which do not enter the realm of present value.
In reviewing these methods, remember that there are usually two values which delineate the price negotiation range.
There is a maximum price that an acquiror is willing to pay, and a minimum price that the target is willing to accept.
Finally, there is a price that the acquiror believes is a fair one, and is referred to as the justifiable price. Typically,
the acquiror establishes the justifiable price, and compares that figure to the maximum price that could be paid
without diluting the firm's earnings per share. Then the acquiror approaches the negotiating table, and compares
these values to the minimum price that the target is willing to accept. We turn now to the methods of target valuation
that do not rely on present value.
Simple Valuation Methods
One indicator of a firm's worth can be found on its balance sheet. The book value, or net worth, is equal to
the figure obtained by subtracting a firm's total liabilities from its total assets. This figure is also known as net
assets, and happens to be equal to the firm's owners' equity. The book value of a firm is often considered the
minimum value that the target is willing to accept. However, acquirors are wary of this value because accounting
methods vary among firms. The economic value of a firm may differ considerably, depending upon depreciation
methods, inventory valuation, or the nature of the assets themselves.
A refinement of this valuation is the liquidation value of the firm. Appraisers can be retained and instructed
to estimate the value of a firm's assets on the open market. The liquidation value of the firm is the appraised asset
value, less the firm's liabilities. A liquidation value is also frequently viewed as a minimum value by a target firm.
Acquirors also view this computation with suspicion, although less so than a target's book value.
Another asset-based valuation is determined by the replacement cost of the target's assets. Replacement
costs are based on current market prices. This estimate is often difficult, and if used, is considered to be the
maximum price that a target could hope to obtain, based strictly on the firm's assets.
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The last simple method of estimating a target's worth can only be performed for publicly traded companies.
The acquiror simply learns the current market price of the target's securities and multiplies that value times the
number of outstanding shares. This value, the market capitalization, can fall anywhere on the negotiating
continuum. A company which has enjoyed a profitable recent history will be trading at a relatively high P/E. If the
opposite has occurred, then the stock will be trading at a low P/E. Despite the efficacy of the efficient market theory,
the market does not always correctly foresee the future.
Earnings Valuations
In the valuation just mentioned, the analyst uses the value that the stock market has attributed to the target
without the addition of synergies from a merger. Earnings valuations call for the analyst to predict what the target's
post-merger P/E will be. When this estimate is made, the predicted P/E is multiplied by the target's EPS for the
previous four quarters. This results in a post-merger value per share, which can be multiplied by the number of
shares outstanding to arrive at a value for the firm.
The estimation of a target's P/E after an acquisition is no mean task. Since a P/E is one estimate of a firm's
future prospects, analysts can judge how a merger will change the target's future, and thereby guess in which
direction the P/E will change. While the direction of change is not often difficult to predict, the magnitude is.
The difficulty in predicting P/Es can be offset by calculating the implied price earnings ratio. The implied P/E is:
As you see, this calculation brings us back to present value. The appropriate cash flows and discount factors will
be introduced in the next section. This formula has a foundation in the premise that a stock's value is equal to the
present value of its future cash flows (dividends). The P/E which results from this calculation may differ
significantly from the market's current estimation. This divergence between the current and the implied P/E can
arise if predicted cash flows or assessments of the target's risk differ, as they would in a merger.
The prices that are derived from earnings valuations can fall at any point in the negotiating range. However,
a target rarely accepts a tender offer which is below its current market value. Earnings estimates are not only used
to value potential targets. An acquiring firm frequently uses it predictions of earnings dilution to establish a
maximum price that it is willing to pay for an acquisition.
The dilution method of establishing a maximum acquisition price is firmly based in the philosophy of value
creation. Specifically, an acquisition will create value only if a firm's current shareholders experience a positive
return as a result of the decision. Since earnings per share can be viewed by shareholders as future dividends, a
merger which improves EPS is beneficial to the original shareholders. The dilution method of establishing a
maximum acquisition price solves for the breakeven point. The process is summarized in Figure 6.1.
Figure 6.1
Dilution Method
1.
Forecast the acquiror's net income for the next year, without the merger.
2.
Forecast the target's net income for the next year, with the merger (include synergies).
3.
Add the two net incomes from steps 1 and 2.
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4.
Calculate the acquiror's EPS for the next year, without the merger.
5.
Divide the combined earnings from step 3 by the acquiror's projected EPS as found in step 4.
6.
Subtract the number of shares that the acquiror has outstanding from the number calculated in 5.
This figure is the number of shares that the acquiror can issue without diluting EPS.
7.
Multiply this number of issuable shares by the acquiror's current share price. This is equal to the
maximum price that the acquiror should be willing to pay for the target.
This calculation simply solves for the number of shares that a firm could offer in exchange for another company
without diluting its earnings per share. If the target will not accept this value, then a "friendly" deal will not be
possible. The acquiring firm can rarely create value if it pays more than this price.
The dilution method is heavily dependent on an analyst's prediction of the target's postmerger earnings.
Results should be subjected to sensitivity analysis.
All earnings-related valuations rely on the assumption that a firm's reported earnings are a true indicator of
the firm's earning power. This assumption may not always be a reliable one. It has already been noted that
accounting methods can distort a company's financial statements. Accounting methods also determine how a
company reports its earnings during periods of rapidly changing general price levels. Inflated earnings can
substantially overstate a company's economic worth. Nevertheless, earnings-based valuations are useful checks on
other valuation methods which can be employed. These methods also relate the merger to forces which are
important in the capital markets.
To avoid the distortions which can arise in simple or earnings valuations, many analysts turn to cash flow
methods. These methods rely on present value calculations, and require the use of considerable judgment. As with
all methods of evaluating investments, the use of sensitivity analysis is critical. The analyst should also recall the
lessons learned about capital budgeting and cost of capital appraisals, which suggested that no single method is
absolutely reliable. Several methods should be used for mutual verification.
Relevant Cash Flow Valuations
The increasing importance of cash flow in financial analysis has also found a place in corporate valuations.
The present value of a target's cash flows is therefore considered to be the justifiable price for the acquisition. If
an acquiring firm establishes that a target's justifiable price exceeds the maximum price that it is willing to pay, then
the deal will probably not be pursued.
There are several cash flow valuation methods. Cash flows can be measured before interest and taxes, or
net of them. The most straightforward method is to assess the target's relevant cash flows. A firm's relevant annual
cash flow is equal to:
Net Income + Depreciation - Change in Working Capital - Capital Investments
Notice the difference between this cash flow and operating cash flow. Operating cash flow does not allow for the
investment in working capital or capital equipment that is necessary to maintain the firm as a going concern. Notice
also that the interest payments to debt holders are included in relevant cash flows. Since debt obligations are
provided for, relevant cash flows are discounted with a firm's cost of equity, as opposed to the weighted average
cost of capital. You may have noticed that the retirement of debt is not provided for. In relevant cash flow valuations,
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it is conventionally assumed that sinking funds can be financed yearly with short-term debt. Therefore, it is assumed that debt
retirement obligations can be "rolled over" from year to year.
To perform this kind of valuation, one simply collects the appropriate data, arranges the cash flows as in a simple
capital budgeting problem, and discounts those flows by the correct factor. Naturally, several critical judgments must be made.
Pro forma income statements must be prepared, and subjected to sensitivity analysis. Using implied growth rates, the
sustainable growth formula is employed to determine changes that must occur in the firm's working capital to support that
growth. Estimates must be made on the level of capital investment which will be necessary to support the company operations.
This involves an assessment of the economic life of the company's assets. The economic life of the target determines the
overall horizon of the analysis. If necessary, a terminal value must be assigned to the target firm.
Although all of the previous estimates are crucial, terminal values often play an especially significant role. As with
simple capital budgeting, the terminal value of the investment should not sway decision makers to opt for a marginal
acquisition. The assignment of terminal values for companies is frequently more subjective than it is for single assets: there
are fewer established markets for the resale of companies. Analysts have several methods of assigning terminal values to
businesses. Future book or liquidation values are often estimated. Another popular method is appropriate if it can be assumed
that the target firm's growth rate will have stabilized by the end of the investment evaluation horizon. If such can be safely
assumed, then the residual value of a firm is equal to:
Relevant Cash Flow in Last Year

Targets Cost of Equity
This method of determining residual value applies to any asset, and is referred to as cash flow in perpetuity.
After the relevant cash flows for the target firm are determined, they are discounted by a factor equal to the cost of
equity of the target firm. This may appear to be inappropriate to some readers. Since the target firm is an investment, should
the target's cash flows be discounted by the acquiring firm's cost of equity? Or shouldn't the target's cash flows be discounted
by the acquired firm's cost of equity? Or shouldn't the targets cash flows be discounted by the weighted cost of equity that will
result in the post-merger firm? The answers to both of these questions is a subject of vigorous debate among financial analysts.
It is our belief that a target firm should have only one justifiable price. If a firm is for sale, its price should not change
to reflect the costs of equity for every firm considering its acquisition. Furthermore, the risk of the target firm should not
change simply because it has been acquired. Its risk may well be altered by managerial decisions that are made subsequent to
the acquisition, but not by the act of acquisition alone. For these two reasons, the target's cost of equity is the appropriate
discount factor for relevant cash flow valuations.
A firm's justifiable price is equal to its pre-merger cash flows discounted by its cost of equity. The maximum
justifiable price is equal to its post-merger cash flows, with synergies included, discounted by its cost of equity. The justifiable
price is usually the minimum value that a target will accept, unless that value is exceeded by its liquidation, replacement, or
market value. The maximum justifiable price is the most that an acquiror will pay, unless that value exceeds the price that
would dilute its post-merger earnings per share. If this occurs, the acquiring firm must do some soul-searching. Is it better to
sacrifice short-term EPS performance for long-term value creation? A zealous adherence to the principles of value creation
would suggest that it is. Such reflections bring us to the thought processes which accompany price negotiations.
Merger Price Negotiations
The object of all the valuations previously discussed is to define the price negotiation range. The price that
is paid for an acquisition depends on the strengths of the teams that are involved in the negotiations.
Naturally, the target firm seeks the highest possible price, and the acquiror seeks the lowest. It is not difficult
for the target firm to decide upon a minimum acceptable price. The target determines its liquidation value and the
present value of its relevant stand-alone cash flows, and selects the higher value. The acquiror determines the
65
maximum price that it can pay without post-merger earnings per share dilution, and the present value of the target's
enhanced (with synergy) cash flows, and begins the negotiation. Figure 6.2 summarizes the negotiators' positions.
Figure 6.2
Defining the Negotiating Range
In this example, there is a chance that the acquiror will have the unhappy task of choosing between EPS dilution
and value creation for the firm. It is just as likely that another situation will not provide this dilemma. In situations
where this choice arises, many firms bow to market pressures and allow the fear of earnings dilution to drive their
decisions. However, managers who subscribe to the value creation theory will pay a higher price. The enhanced
cash flows are based on present value, and any acquisition cost which is beneath that ceiling will create value for
the acquiror.
Although there is a degree of discussion between firms in "hostile takeovers", the range illustrated in Figure
6.2 is applied primarily to "friendly" situations. In an unfriendly tender offer, the acquiror usually appeals directly
to the target's stockholders.
The subject of mergers and acquisitions encompasses far more than valuations. It has already been suggested
that legal and accounting matters are of tremendous importance. As with any investment, decisions should also rest
on considerations beyond the return on the investment. The qualitative matters discussed in the capital budgeting
chapter are even more significant in a merger. It is qualitative analysis that enables an analyst to identify the
synergies which will make a merger worthwhile.
66
Learning Objectives
Chapter 7- Financing Investments
Discuss FRICTO analysis.
Calculate the cost of a bond issue.
Calculate the cost of a stock issue.
Describe and illustrate breakeven EBIT.
67
Chapter 7
Financing Investments
In Chapter 3, you were introduced to the concept of the creation of value. Since that introduction, we have
explored the ways in which value can be created on the asset side of a firm's balance sheet. We must now address
the issue of how those assets can be financed.
You will recall that a financial manager has several choices in financing assets. Debt may be chosen, or
new equity. A firm's sources of equity include retained earnings and stock issues. To the traditional sources one
may add preferred stock and convertible securities. It has been previously implied that value can be created through
financing by choosing the least expensive alternative. There are several factors which can properly influence
managers to create value in their firms by choosing other than the least expensive sources.
Managers often find that financing choices are limited by unalterable circumstances. Examine the diagram
below for a moment.
Common Stock + Retained Earnings
Net Income - Dividends

If any of the terms on the three tiers of the right side of this equation are fixed, then financing choices have been
limited. For example, a set dividend policy limits the amount of equity that can be raised through retained earnings.
If the company's stock is trading at a very low relative P/E, then a stock issue may be out of the question. On the
remaining tier, if the company has arrived at the maximum percentage of debt that is believed to be prudent, then
debt may be eliminated as an alternative.
In every financing decision, three questions are addressed: (1) How much funding is needed? (2) What is
the firm's capitalization policy? (3) What is the firm's dividend policy?
Each of the three issues have strategic and tactical characteristics. The amount of funding that a firm requires
depends on the industry in which the firm competes, the age of the firm's assets, and the marketing strategy that the
firm has chosen to pursue. The ability of the firm to generate cash also determines the funding that will be required.
A company's capitalization policy determines the target debt/equity ratios that were discussed in the cost-of-capital
chapter. Capitalization policy is determined by factors within and outside of the firm. Internal factors include
management's risk tolerance, the significance of management's ownership in the firm, and control of ownership in
68
the firm. The greatest external force is the capital markets. The markets establish acceptable percentages of debt
in a firm's capital structure, for example, by reacting to the perceived level of risk. Dividend policy is established
by the firm's board of directors. While internal matters influence their policies significantly, few boards act without
considering the scope and the composition of the firm's shareholders. Boards are especially wary when there are
shareholders who own large blocks of the company's stock.
An analytical framework has been designed to assist managers, once they have established dividend and
capitalization policies, and after they have determined the amount of funding that is required. This framework,
known as a "FRICTO" analysis, enables managers to systematically address the important issues of an asset
financing. A manager who adheres to the steps of a FRICTO analysis addresses the most important tactical valuecreation issues in a financing, and also tests the important underlying strategic principles that have been established
by the firm.
FRICTO ANALYSIS
"FRICTO" is an acronym which represents each of the six steps in a FRICTO analysis. The six issues in
the analysis are flexibility, risk, income, control, timing, and other. Each issue can be as important as another,
and the relative importance of each varies among industries and companies, and within the same firm over time.
The relative importance of each issue is established by management.
Flexibility
Prudent managers try to envision the worst imaginable set of developments for their firms so that they can
prepare for them. An assessment of the firm's flexibility enables an analyst to predict how effectively the firm could
weather the financial consequences of a "disastrous occurrence". The reserves that a firm sets aside for flexibility
crises come in the form of debt capacity and insurance. It is important to understand that a flexibility crisis is a rare,
unpredictable event, with which the firm's managers have had no recent experience, and which could threaten the
survival of the firm. Examples of such events might be a serious economic downturn on the order of the Great
Depression, or the sudden obsolescence of a major product line, or serious product liability. Such events could
diminish a company's income to the point of interrupting production, causing the firm to default on outstanding
loans, or other developments which could cause the firm to cease to exist. If a firm maintains the flexibility to have
ready access to funds, then it has done all that it can do to prepare for such events. It is left to a firm's managers to
predict the amount of funding that would be required.
Since debt can provide funds more quickly than new equity, firms ordinarily allow some debt capacity in
their capital structures for flexibility crises. However, managers occasionally overlook the need to maintain this
capacity when the economy is doing well or when interest rates are particularly low, or when the firm's stock is not
doing well enough to warrant an equity issue. In the flexibility step of this analysis, the analyst ensures that the
company does not forget this important strategic issue. It is probably not surprising that the flexibility portion of a
FRICTO analysis leans away from the selection of debt for financing.
Risk
Not all unfortunate developments which befall companies are rare, unpredictable, or colossal. Most
managers realize that business cycles are recurrent, that unions strike, and that record sales cannot be realized every
year. But these kinds of occurrences can be prepared for: a company's managers have likely experienced previous
recessions, and most companies have hard data on how the company performed during the last trough in the cycle.
69
It is likely that other similar data may exist for the other kinds of setbacks. With this information, managers can
discern how the firm behaved, and what the most pressing requirements will likely be during the next such situation.
Managers should look to the most pressing short-term needs to prepare for these lesser magnitude
"disasters". Short-term needs are ordinarily limited to working capital and cash requirements. Capital investments
can be postponed, if necessary, until the storm has passed.
Temporary expanding working capital needs are ordinarily met through additional short-term debt. The
availability of such funding is all too often assumed by managers to be a "given". If a manager has overlooked the
company's probable liquidity during a second order setback, and it proves to be low, then not only will the firm be
unable to meet its contractual obligations (interest payments, sinking funds, etc.), but it will be unable to find a
short-term lender.
To prevent this situation, two things must be done. First, the company's cash generating ability during a
predictable setback must be forecast. This step involves all of the measures recommended for any kind of financial
forecast. The second item of preparation is to restrict the company's contractual obligations to a level that could be
comfortably met during crises of the kind that have been addressed in this section. By doing these things, a firm's
managers can ensure that short-term funding will be available when it is most needed: short-term lenders like to
lend when they know that they will get their money back.
The quantitative method that most often serves as an indicator of a firm's ability to meet contractual
obligations is a coverage ratio calculation. There are many variations of coverage ratios; while we believe that the
cash-oriented ones are most relevant, perhaps the best ones are those that are used by the company's potential sources
of short-term debt. Coverage ratios, in general, are equal to the firm's annual funds flow divided by its annual
contractual obligations. If an obligation requires after tax dollars, then that allowance should be made. The
following is an example of a comprehensive coverage ratio:
Where:
SF = Sinking Fund Obligations
DIVS = Dividends
Variations on coverage ratios include those which consider only debt service (omitting dividend requirements), and
those which only consider interest coverage (assuming that sinking funds can be covered with short-term debt).
Others use earnings instead of cash flow in the numerator.
To assess the impact of a financing alternative in a FRICTO analysis, you simply compare the coverage
ratios that result under the different financing choices that are available. Like the flexibility analysis, the risk step
in this analysis favors financing assets with funds other than debt. Additional debt raises contractual obligations;
higher dividends which may accompany new equity are discretionary payments.
70
Income
The analysis of the impact of a financing choice on a firm's income is a step that favors choices which benefit
earnings per share and the firm's stock price. Earnings per share can be improved by choosing alternatives which
are least expensive, or those which are least dilutive. Stock prices can be improved through increased P/Es or higher
earnings per share.
The income step of the FRICTO analysis addresses each of these considerations: explicit costs, EPS
dilution, and implicit costs for each of the financing alternatives.
The explicit cost of an alternative is found by using many of the methods introduced in Chapter 5:
Calculating the Cost of Raising Capital. Explicit costs are always based on the costs associated with new issues; a
FRICTO analysis is, after all, used to select new financing. To refresh your memory, the formulas for determining
the explicit costs of various securities are summarized in Figure 7.1:
Figure 7.1
Explicit Cost Calculations
The "net proceeds" of a debt issue are those funds which remain after the necessary fees have been deducted; the
cost of equity used for FRICTO purposes is equivalent to the P/E inversion method. However, the significant
difference is that the projected EPS, after investment is producing income, is used rather than the current EPS.
The next step in the income analysis is the assessment of a financing decision's impact on dilution of the
company's earnings. This appraisal is carried out through EBIT analysis. In an EBIT analysis, the alternatives are
arranged in a chart so that the characteristics of each can be readily seen. All of the factors which influence EPS
are considered for each alternative. At least two sets of comparisons should be made for each alternative. The
preferred comparison is between the company with its current earnings, and the company with its projected earnings
after the new asset is producing additional income.
The best way to gain an understanding of an EBIT analysis is to proceed through an example. Suppose that
the following facts apply to Firm "Z":
Shares of common stock outstanding: 250,000
Current share value: $40.00
Current EBIT: $1,500,000; EPS = $2.90
Projected Earnings (with new asset): $2,000,000
Funding needed: $1,800,000
71
Financing Alternative I: $2 million bond issue

Coupon: 11%; due in 10 years
Issue fees: $100,000
Financing Alternative II: $2 million common stock issue
Fees: $100,000
Average selling price per share: $38.00
Projected number of shares to issue: 52,630
The two financing alternatives should be analyzed as follows:
Bond Issue
Common shares outstanding
Pre-Investment Earnings
New Interest Payments
Tax 46%*
Net Earnings
EPS
Dilution From $2.90
250,000
$ 1,500,000
220,000
588,800
691,200
302,630
$ 1,500,000
690,000
810,000
$ 2.76
% (4.8)
$ 2.68
% (7.6)
Avg Post-Investment Earnings $ 2,000,000

New Interest Payments
220,000
Tax 46%
818,800
New Earnings
$ 961,200
EPS
Stock Issue
$ 3.84
$ 2,000,000
$ 920,000
$ 1,080,000
$ 3.57
*A 46% tax rate (not 40%) is used in this example because it clearly demonstrates the dilution.
As you can see from this analysis, the tax shelter of interest payments and the fewer number of outstanding shares
which accompany a debt issue ordinarily restrict earnings dilution to a greater extent than equity sales. A debt issue
is necessarily accompanied with new interest obligations, whereas an equity issue is not. The new interest payments
are a tax-reducing expense and reduce net income, but this disadvantage is offset by the fact that the equity
alternative requires issuance of new shares. The new shares dilute net income to a greater extent than new interest
reduces. This relationship holds true until exhorbitant interest payments overwhelm debt's typical advantage. If a
financing alternative involves a convertible security, then a complete EBIT analysis includes a column for the
security before and after conversion. Notice that only interest charges that the company will incur as a result of a
financing choice are included; existing interest obligations are not. The reasoning behind that methodology is that
the company will incur existing obligations, regardless of the alternative that is chosen.
For every financing alternative, a breakeven point exists where the dilutive effect on EPS of issuing new
shares would be matched exactly by the dilution resulting form interest payments on new debt. A handy formula
for arriving at the breakeven point is
72
A breakeven EBIT for Firm Z's financing decision would be calculated as follows:
(Debt)
(Equity)
(EBIT - 220) x (1 - .46)
(EBIT - 0) x (1 - .46)
=
250
302.63
302.63 (EBIT - 220)
250 (EBIT)
302.63 EBIT - 66,578.6
250 EBIT
52.63 EBIT
66,578.6
1,265.03, or $1,265,000.
Breakeven EBIT
This calculation tells us that for EBIT levels below $1,265,000, the interest cost of the debt overwhelms the
advantage of issuing fewer shares and that an equity issue would cause less dilution. The lower dilution in this case
would be not the result of fewer shares outstanding, but the result of higher pre-tax income the equity issue
requires no interest payments. Beyond the breakeven EBIT, the combined tax shelter and lower number of income
diluting shares makes debt the superior choice.
Having derived this breakeven, it is left to a firm's managers to decide whether the new asset will provide
earnings beyond the breakeven level. That judgment determines which financing alternative is superior from the
dilution perspective.
The third and final consideration of the income impact of a financing decision concerns the implicit costs of
a financing decision. To determine implicit costs, the analyst must predict the capital market's reaction to a financing
decision.
You will remember that the capital markets react whenever they perceive that the risk of a firm has changed.
They react to events which change the risk of the firm on both sides of the balance sheet. The risk changes on either
side of the firm's balance sheet are not always in the same direction for a given investment decision. For example,
the positive effects of a company's investment may be offset by a poor accompanying financing decision.
Presumably, if an investment decision creates value for the firm, then the markets will react favorably and
the price earnings ratio for the stock will rise. The company's financing decision will either augment or offset this
favorable reaction. If an investment is perceived as a poor one, the financing decision can probably only further
damage the firm's P/E. The capital markets do not like poor investment decisions, even if they are financed
intelligently. This is not to say that it is possible for a financial restructuring alone to affect the market value of a
stock; managers are always free to recapitalize their firms without investing additional funds.
A manager concerned with the impact of a financing decision should examine the capitalization statistics for
firms in the same industry, of similar size. By selecting firms which have experienced similar earnings
performances, you can infer when a company may have crossed the boundary of the market's acceptable debt limit
for firms in that industry. All other qualities being roughly equivalent, companies which are in the market's
73
estimation optimally capitalized, will enjoy higher P/Es. Unfortunately, this kind of inference is, at best, a poor one.
It is far more likely that a manager using this kind of approach will guess the direction of a P/E's change than its
magnitude. Nevertheless, it is better to perform this analysis than it is to ignore the possible ramifications of a
financing decision in the marketplace. One should not allow the results of this inference to outweigh the need to
provide for flexibility. It is within the market's awareness that different companies in the same industry have varying
managerial talent; exposure to flexibility crises therefore differs in firms and this variance causes predictions of
optimal capitalizations to be so inaccurate.
It is often useful to calculate the P/E at which two financing decisions would result in an equivalent share
price. To perform this appraisal, you need the perspective that would be engendered by an inference of the kind
discussed in the last paragraph. For instance, if you were a manager in a firm which already has a high
debt/capitalization ratio, then you might suspect that an addition of debt would cause the market to react negatively.
Given the earnings per share that you derived in your EBIT analysis, how far would your firm's P/E have to fall in
order to make an equity issue more favorable than the debt issue? The important assumption here is the value of
the P/E that the firm will experience if it chooses the financing alternative that the market prefers. It is often
reasonable to assume that the preferred decision will be accompanied by the firm's historical P/E. The following
figures are available from the Firm Z example, after the new earnings have begun to be enjoyed.
(Market Preference)
Debt Issue
Equity Issue
Projected EPS
$3.84
Projected P/E
Resulting Stock Price
-
$ 3.57
13.0
$46.41
To find the breakeven P/E, simply divide the projected market price of the stock under the preferred alternative by
your projected EPS for the alternative you wish to pursue. In this example, Firm Z's breakeven P/E is
$46.41 or 12.
3.84
Depending on the firm's past experience, a P/E less than or equal to 12 could be a distinct possibility. Unlike the
previous steps in the income module of this FRICTO analysis, this implicit cost assessment seems to suggest that
an equity issue may be best. Realize that it is equally probable in any given situation that the implicit costs will
favor a debt issue, convertible, or any other security. The results are entirely dependent on a firm's existing
capitalization.
Control
If the other steps have been biased toward one form of financing over another, control issues are on average,
neutral. Control is a relatively sensitive issue to managers, and one that stockholders may or may not be concerned
with. Specifically, control issues are those which determine what the composition of the company's board of
direction may be. Managers ordinarily like the security that is afforded by steady work. Shareholders like stock
appreciation and dividends. It is a company's board of directors which appoints the Chief Executive and which sets
the company's dividend policy. Both decisions on the part of the board indirectly affect the company's stock price.
The board of directors is, of course, elected by the shareholders.
The issue of control is related to the composition and scope of the firm's ownership. Control becomes a live
issue whenever an equity issue is considered to be a financing alternative. The size of the proposed issue is also
important.
74
Managers become concerned when an issue could change the balance of power in the firm's equity
ownership. An issue can be of virtually any size and affect this change. The size of an issue which could do this
depends on the scope and composition of the stockholders it takes a relatively larger issue to affect the control
of a firm as the number of stockholders increases and the size of their average holdings decreases. If there are a few
stockholders with large blocks of the company's stock, then a very small number of shares could swing the balance
of control.
There are no rules of thumb for assessing control issues. Managers should always be aware of the kind of
stockholders in the firm and who the large stockholders are. This knowledge is important for other than control
reasons. Generally, if a stock issue will endanger the status quo, then managers try to avoid selling equity to the
market. If an equity issue is absolutely unavoidable, then there are a few measures which can be undertaken to
dilute the size of the acquisitions of the new equity. Unfortunately for managers, there are only a few legal methods
through which this end can be achieved, and none are absolutely effective. Laws have been designed to protect
shareholders from managers that build fortresses around themselves.
Timing
There are two timing issues which surround every financing decision. The first involves the sequencing of
financial alternatives, given that future financial requirements are known. The second issue is the status of the
capital markets at the time that funding is needed.
The sequencing of financial choices is very important. Managers must learn to look forward to the coming
years and determine what the firm's funding needs will be. If, for example, a firm needs only a moderate amount
of financing next year, but a very large amount in the year beyond that, then that could have important consequences
for the present financing choice. This sequencing is especially important when the firm's current capitalization is
compared to the target capitalization. A firm which is just below the target percentage of debt, and requires funds
which will carry it above that level in the current year, should consider the amount of funding it will require the next
time it approaches the capital markets. It may be better to opt for a large equity issue now, to be followed by a
smaller debt issue later. It is generally easier for firms to obtain large amounts of funding, relative to the size of
their capital structure, through equity issues than it is to acquire the same amount through an issue of debt.
The sequencing of capital decisions should also be heavily influenced by the status of the capital markets.
If interest rates are currently much higher than those which are expected in the distant future, then equity or shortterm debt or a convertible security should be considered for immediate needs. If the company's stock price is at a
record low, then it is probably not the best time to issue common stock. One bugaboo which continually besets
managers is the chronic resistance to issuing equity. They seem to be more readily sensitive to the prospect of
higher interest rates than they are to lower stock prices. It is difficult to resist the belief that interest rates will surely
go higher, but one cannot explain why managers believe that their stock prices will not fall.
The sequencing of financing and the status of the markets should blend together in a financing choice.
Common sense should be a manager's guide in timing issues, but frequently it is not. About the best preparation
that a manager can make is to be aware of the propensity to avoid stock issues. Individual companies could profit
by preparing a set of decision rules in advance of the heat of the fray. It is far wiser to act in the manner that was
prescribed in a reflective moment of objectivity, then it is to make decisions when the ship is already going down.
Other Issues
In an ideal FRICTO analysis, there are not "other" issues. A firm's managers objectively examine the results
of each step, and act according to the preponderance of the evidence. In reality, however, there are several issues
75
which may be categorized under the "other" rubric. They are generally those issues which cause one of the previous
steps in the FRICTO analysis to be considered more important than the others. There are certainly an infinite
number of scenarios which can cause this situation to arise. Frequently, management can completely and correctly
lend greater weight to one of the five steps. Often these other important factors are related to the risk tolerances of
the firm's managers. A few of these special circumstances will be illustrated here.
A company which is experiencing a low stock price and low trading activity may wish to stimulate the
market through a stock issue. Managers who are determined to stimulate market activity in their stock may "believe"
that the importance of flexibility outweighs the disadvantage of earnings dilution. They may believe that the market
activity will stimulate their stock to the point that a higher P/E will offset the lower earnings per share.
Another less justifiable reason for selecting one financing alternative over another is related to the speed
with which the company can obtain the needed funds. This reason is frequently offered in unstable markets.
Managers may believe, for example, that it is better to lock in a moderately high interest rate loan now than it is to
absorb the costs which the company could incur in a bond issue whose value could decline considerably during the
forty-five day period that the issue would take place. The likelihood of such an unfavorable occurrence is probably
less important than the managers' risk adversity in such a situation. There are many scenarios where market
instability can stampede managers into rash decisions. It may be just as probable that managers can be justified
through such courses of action in many cases.
These other issues are significant in that they underscore an important theme in this text. Judgment has far
more influence on events in corporate finance than all of the analytical techniques combined. It is rare when the
future of a company balances on the judgment of one individual. Collective judgment is as much a product of
corporate culture as it is the external business reality.
As far as individual judgment is concerned, there are no courses that one can take to improve one's
objectivity. We can only prepare ourselves with the acquisition of as many facts as possible, and then let experience
by our guide.
76
ILLUSTRATIONS
77
= = = = = = = = = = = = = = = ILLUSTRATION 1.1 = = = = = = = = = = = = = = =
XYZ Corporation
Statement of Income
Year Ended June 30, 2001
(millions)
Sales (Less Returns, Discounts, etc.)
Less: Cost of Goods Sold
$ 140
100
Gross Profit
40
Less Operating Expenses:

Selling, General and Administrative
Depreciation
Interest
20
3
2
Profit Before Tax

Income Taxes
15
9
Net Profit
78
= = = = = = = = = = = = = = = ILLUSTRATION 1.2 = = = = = = = = = = = = = = =
XYZ Corporation
Statement of Financial Position
As of June 30
2001
2000
(millions)
ASSETS
Cash
Accounts Receivable
Inventories
Property, Plant and Equipment
3
25
10
30
2
20
12
28
Total Assets
$ 68
$ 62
Notes Payable
Current Portion - Long Term Debt
Accounts Payable and Accrued Expenses
Long-Term Debt
2
3
2
12
3
2
3
8
Total Liabilities
19
16
Common Stock (1,000,000 shares outstanding)

Retained Earnings
21
28
21
25
$ 68
$ 62
LIABILITIES AND OWNERS EQUITY
Total Liabilities and Owners Equity
79
= = = = = = = = = = = = = = = ILLUSTRATION 1.3 = = = = = = = = = = = = = = =
XYZ Corporation
Statement of Cash Flows
Year Ended June 30, 2001
Cash Flow from Operating Activities

Net Income
Adjustment to Reconcile Net Income to
Cash provided by Operating Activities:
Depreciation
Changes in Current Assets & Liabilities
Accounts Receivable (increase) decrease
Inventory (increase) decrease
Other Current Assets (increase) decrease
Accounts Payable and Accrued
Expenses increase (decrease)
Taxes Payable increase (decrease)
Cash Provided by Operating Activities
Cash Flow from Investing Activities
Acquisition of Property, Plant & Equipment
Cash Provided by Investing Activities
Cash Flow from Financing Activities
Issuance of Long-Term Debt
Cash Dividends Paid
Cash Provided (Used) by Financing Activities
Net Increase (Decrease) in cash
80
= = = = = = = = = = = = = = = ILLUSTRATION 1.4 = = = = = = = = = = = = = = =
Coleman Cash Flow Statement
2001
Part I
I.
Net Income
Add: Depreciation
Add: Other noncash expenses
Subtract: Noncash revenues
Net income before depreciation and other
non-cash expenses and revenues
II. This could have represented cash inflow except that the
company:
A. Collected more than (less than) it billed customers, as shown in
a decrease (increase) in Receivables
B. Bought and manufactured less than (more than) the cost of goods
shipped, as shown in a decrease (increase) in Inventories
C. Paid out less (more than) costs incurred, as shown in an increase
(decrease) in Payables and Accruals
D. Paid out less than (more than) the costs incurred, as shown in
an increase (decrease) in Income Tax Payable
Total Working Capital adjustments
Cash internally generated
81
= = = = = = = = = = = = = = = ILLUSTRATION 1.4 = = = = = = = = = = = = = = =
Coleman Cash Flow Statement
2001
Part II
III. There are discretionary outlays of cash for:
Acquisition of property, plant and equipment
(in excess of dispositions)
Dividends to stockholders
Total discretionary outflows
IV. Financing and other cash inflows and outflows were:
Issuance of Common Stock
Net increase (decrease) in Long-Term Debt
The net change in cash is an increase (decrease) of
= = = = = = = = = = = = = = = ILLUSTRATION 1.5 = = = = = = = = = = = = = = =
Ratio
Abbrev.
To Calculate
Significance
Return
ROS
On
Sales
Gross
GM %
Margin
%
Return
ROA
on
Assets
Asset
A/T
Turnover
Return on ROE
Equity
Net Income
Net Sales
Gross Margin
Net Sales
Ability to
generate profit
from sales
Average markup
on sales
Net Income
Avg. Total Assets
Earnings power
of assets
Net Sales
Avg. Total Assets
[Net Income - Pfd.
Divs]
Avg. Owners
Equity
Productivity of
assets
Return on
owners
investment
82
Firm
A
Firm
B
= = = = = = = = = = = = = = = ILLUSTRATION 1.5 cont. = = = = = = = = = = = = = = =

Ratio
Abbrev.
To Calculate
Significance
Earnings
per
Share
Price to
Earnings
EPS
Net Income
Avg. Shares
Outstanding
Market Price
EPS
Earnings trend
Payout
PO
Cash Dividends
Net Income
Times
Interest
Earned
X/I
EBIT
Interest Charges
P/E
Firm
A
Firm
B
Markets
opinion of
firms
prospects
Share of
earnings
distributed to
owners
Productivity of
assets
= = = = = = = = = = = = = = = ILLUSTRATION 1.6 = = = = = = = = = = = = = = =
Liquidity Ratios
Ratio
Current
Ratio
Quick
Ratio
Abbrev
.
CUR.
QUICK
Receivables
Turnover
R/T
Days Sales
Outstanding
DSO
Inventory
Turnover
I/T
To Calculate
Significance
Current Assets
Current
Liabilities
Cur. Assets Inventory
Current
Liabilities
Net Sales
Average
Receivables
Days in Period
Receivables
Turnover
Cost of Goods
Sold
Average
Inventory
Short-term debt
paying ability
83
Short-term debt
paying ability
Credit policy
indicator
Credit policy
indicator
Inventory
management
indicator
Firm
A
Firm
B

Liquidity Ratios
Ratio
Days
Inventory
Abbr
ev.
D/I
Accounts
Payable
Turnover
AP/T
Days
Payable
D/P
Operating
Cycle
OC
To Calculate
Significance
Days in Period
Inventory Turnover
Inventory
management
indicator
Creditworthiness
& working capital
management
(COGS + Change in
Inv)
Avg. Accounts
Payable
Days in Period
Accts. Payable
Turnover
Days Sales
Outstanding
+
Days Inventory
Firm
A
Firm
B
Creditworthiness
& working capital
management
Inventory-to-cash
time period
= = = = = = = = = = = = = = = ILLUSTRATION 1.7 = = = = = = = = = = = = = = = =
Financial Strength Ratios
Ratio
Abbrev.
To Calculate
Significance
Debt to
Assets
D/A
Total Liabilities
Total Assets
Equity
to
Assets
Debt to
Equity
E/A
Total Equity
Total Assets
R/T
Total Liabilities
Total Equity
Debt to
Capitalization
DSO
Long-Term Debt
(Equity + LT Debt)
Percent of assets
financed by
lenders
Percent of assets
financed by
lenders
Degree of
financial
leverage
Degree of
financial
leverage
84
Firm
A
Firm
B
= = = = = = = = = = = = = = = ILLUSTRATION 1.8 = = = = = = = = = = = = = = =
FIRM A
Balance Sheet and Share Data
Total Assets
Owners Equity
Shares Outstanding
Market Price Per
Share
Dividends Paid
(000)
Income Statement
2001
2000
$
3,100
$
1,300
100,00
0
$ 18
$
2,950
$
1,220
100,00
0
$ 13
$ 70
$ 70
2001
Net Sales
Cost of Sales
$
2,500
1,600
Gross Margin
900
Operating Expenses
650
EBIT
250
Interest Charges
EBT
Income Tax
Net Income
26
224
74
150
FIRM B
Balance Sheet and Share Data
Total Assets
Owners Equity
Shares Outstanding
Market Price Per
Share
Dividends Paid
(000)
Income Statement
2001
2000
$
2,750
$
1,400
85,000
$ 63
$
2,300
$
1,150
85,000
$ 55
$ 50
$ 50
85
2001
Net Sales
Cost of Sales
$
4,000
2,400
Gross Margin
Operating Expenses
1,600
1,110
EBIT
490
Interest
EBT
Income Tax
Net Income
43
447
147
300
= = = = = = = = = = = = = = = ILLUSTRATION 1.9 = = = = = = = = = = = = = = =
HORIZONTAL (PERCENT CHANGE FROM PREVIOUS YEAR)
20XU 20XV 20XW
20XX 20XY
FIRM A
Sales
Cost of Goods Sold
Operating Expenses
Selling &
Administrative
R&D
Other
Net Income
(20)
(22)
(10)
12
5
8
(28)
13
15
18
12
12
0
3
(37)
10
15
17
(8)
10
5
7
(28)
10
7
12
10
6
20
5
0
(1)
10
0
17
50
53
75
100
45
48
(17)
100
25
23
47
25
18
40
FIRM B
Sales
Cost of Goods Sold
Operating Expenses
Selling &
Administrative
R&D
Other
Net Income
86
= = = = = = = = = = = = = = = ILLUSTRATION 1.9 = = = = = = = = = = = = = = =
VERTICAL ANALYSIS (COMPONENTS AS A PERCENTAGE OF SALES)
20XU 20XV 20XW
20XX 20XY
1,800
58 %
12
9
1,887
60 %
8
10
2,170
61 %
8
9
2,174
63 %
5
10
2,500
64 %
4
11
10
6
5
10
6
6
10
6
6
10
6
6
10
5
6
Sales ($ 000s)
Cost of Goods Sold
1,840
59 %
Operating Expenses
Selling &
Administrative
R&D
Other
Net Income
6
8
2,760
59
%
7
10
4,000
60
&
4
14
17
2
8
14
2
8
13
1
8
FIRM A
Sales ($ 000s)
Cost of Goods Sold
Operating Expenses
Selling &
Administrative
R&D
Other
Net Income
FIRM B
87
= = = = = = = = = = = = = = = ILLUSTRATION 2.1 = = = = = = = = = = = = = = =
Questionable Ventures, Inc.
Assumption - Income Statement
1.
Sales have grown at an average rate of 10% per year for the last three
years and could be expected to continue at the same pace fro the
foreseeable future.
2.
Cost of goods sold has ranged between 58 % and 61 % of sales. For

purposes of projections, a COGS percentage of 60 % seems reasonable.
3.
Operating expenses appear to have some fixed components and some that
vary directly with sales. Of the 2000 operating expenses, $150,000 were
fixed and will be subject to a projected annual inflation rate of 4 %. The
remainder will fluctuate directly with sales.
4..
Interest expense will increase directly with growth in sales. This assumes
that the duPont formula relationship holds steady, and interest rates are
unchanged.
5.
Tax rate is 40 %.
88
WORKSHEET 2.1
Income Statement
Period Ending July 31, 2000
(000s of $)
Actual
2000
Sales
Cost of Goods Sold
1,000
580
Gross Margin
Operating Expenses
(including $100
depreciation)
420
Earnings Before Interest &

Taxes
Interest Expense
120
Earnings Before Taxes

Income Taxes
Pro Forma
2001
2002
300
60
60
24
Net Income
36
89
= = = = = = = = = = = = = = = ILLUSTRATION 2.2 = = = = = = = = = = = = = = =
Assumptions - Balance Sheet
1.
The 2000 cash balance of $40,000 is adequate to cover the Companys

short-term obligations for the foreseeable future.
2.
Accounts receivable and inventory, which compromise 80% of the value of

other current assets, will increase directly with a growth in sales. (You
should recall that sales are projected to increase 10% per year.) The
remaining current assets will not change.
3.
The company plans to add $120,000 to its plant and equipment in 2001.
The projected income statement shows depreciation expense of $60,000 in
2001 and 2002. No expenditures are planned for 2002.
4.
Accounts payable will increase at an annual rate of 10%. Other liabilities

will remain constant.
5.
No stock issuances are planned.
6.
Net income from the projected income statement is $32,000 in 2001 and
$41,000 in 2002. Dividends have averaged $10,000 for the last several
years. No increase or decrease is planned.
90
WORKSHEET 2.2

Balance Sheet
July 31, 2000
(000s of $)
Actual
2000
Pro Forma
2001
Assets
Cash
Other Current Assets
Noncurrent Assets
40
200
400
Total Assets
640
Liabilities & Owners Equity
Notes Payable
Accounts Payable
Other Current
Liabilities
Noncurrent Liabilities
Common Stock
Retained Earnings
Total Liabs & Ownerss
Equity
10
100
100
100
130
200
640
91
2002
= = = = = = = = = = = = = = = ILLUSTRATION 2.3 = = = = = = = = = = = = = = =
Enter the input data in this section

Company Name............Scranton Technologies
Data Entered In...................Millions
Most Recent Year...............2002
YEAR
2002
2001
2000
Cash & Securities

Accounts Receivable
Inventories
Net Fixed Assets
Total Assets
247
482
346
1,084
684
2,103
220
434
334
993
578
8,585
257
365
316
940
461
1,668
Accounts Payable
Notes Payable
Taxes Payable
Current Liabilities
Long-term Debt
Total Equity
201
117
20
473
506
913
167
109
43
359
500
820
147
87
10
282
495
736
46,395
61
46,395
51
2002
2001
2000
2,724
1,895
497
88
40
277
165
71
2,496
1,775
426
71
31
249
151
67
2,246
1,599
372
63
26
125
141
62
Shares Outstanding (000s)

Market Price Per Share
YEAR
Net Revenue
Cost of Goods Sold
Selling, General & Administrative
Depreciation & Amortization
Interest Expense
Earnings Before Tax
Net Income
Dividends
22,753
57
92

Balance Sheet Analysis
Percent
Percent
|----Percentage of---|
Change
Change
Total Assets
2002
2001
2000 2002 2001 2000
ASSETS
Cash & Securities
Accounts Receivable
Inventories
Other Current Assets
$247 12%
482 11%
346
4%
9 80%
1,084 9%
Fixed Assets
Other Noncurrent Assets
Total Assets
684 18% 578

335 17% 287
2,103 13% 1,858
Liabilities & Equity

Accounts Payable
Notes Payable
Taxes Payable
Other Current Liabilities
Total Current Liabilities
Long Term Debt
Other LT Debt
Total Owners Equity
Total Liabilities & Equity
220
434
334
5
993
201 20% 167

117 7% 109
20 -53% 43
135 238% 40
473 32%
359
506 1% 500
211 18% 179
913 11%
820
2,103 13% 1,858
93
-14%
18%
6%
150%
6%
257
366
315
2
940
11.7
22.9
16.4
.5
51.5
11.8
23.4
1 8.0
0.3
53.5
15.4
21.9
18.9
0.1
56.3
25%
461 32.6
31.1 27.6
7%
267 15.9
15.4 16.1
11% 1,668 100.0 100.0 100.0
14%
25%
330%
5%
27%
147
87
10
38
282
1% 495
15% 155
11% 736
11% 1,668
9.6
5.6
1.0
6.3
22.5
24.1
10.0
43.4
100.0
9.0
5.8
2.3
2.2
19.3
8.8
5.2
0.6
2.3
16.9
26.9 29.7
9.6
9.3
44.2 44.1
100.0 100.0
Income Statement Analysis

Percent
Percent
Change
Change
2002
2001
2000
|-------Percentage of------|
Total Assets
2002
2001
2000
Net Revenue
Cost of Goods Sold
2,724 9.1% 2,496 11.1% 2,246 100.0% 100.0% 100.0%

1,895 6.8% 1,775 11.0% 1,559 69.6% 71.1% 71.2%
Gross Margin
Selling, General & Admin.
Depreciation
Interest Expense
Other
829
497
88
40
* 62
16.7%
23.9%
29.0%
10.7%
Earnings Before Tax

Income Taxes
266
* 101
165
71
Net Income
Dividends
721
426
71
31
56
30.4%
18.2%
3.2%
1.5%
2.3%
28.9%
17.1%
2.8%
1.2%
2.2%
28.8%
16.6%
2.8%
1.2%
-2.7%
6.8%
3.1%
249 99.2% 125 9.8%

98 -712.5% (16) 3.7%
10.0%
3.9%
5.8%
-0.7%
9.3%
6.0%
151
67
6.0%
2.7%
6.3%
2.8%
* Derived Figure
94
647
14.5% 372
12.7%
63
19.2%
26
-191.8% (61)
7.1%
8.1%
141
62
6.1%
2.6%

Ratio Analysis
2002
2001
2000
TURNOVER RATIOS
Asset Turnover
Average Turnover
Average Inventory Turns/Yr
1.30
61.4
5.6
1.34
58.4
5.5
1.35 Sales/Assets
NA 365*Average Receivables/Revenues
NA Cost of Goods Sold/Average Inventories
PROFITABILITY RATIOS
Return on Sales
Return on Assets
Return on Equity
6.1%
7.8%
18.1%
6.0%
8.1%
18.4%
$7.25
7.86
0.43
$3.25
18.74
0.44
CAPITALIZATION RATIOS
Financial Leverage
Long-term Debt/Capital
Total Debt/Assets
Long-term Debt/Equity
2.30
0.36
0.47
0.55
2.27
0.38
0.46
0.61
2.27
0.40
0.47
0.67
LIQUIDITY RATIOS
Current Ratio
Quick Ratio
2.29
1.56
2.77
1.84
3.33 Current Assets/Current Liabilities

2.21 [Current Assets-Inventories/Current Liabilities
Earnings Per Share

Price/Earnings Ratio
Dividend Payout Ratio
6.3% Net Income/Sales

8.5% Net Income/Assets
19.2% Net Income/Equity
$3.04 1000*Net Income/Shares Outstanding(End ofYr.)
16.78 Market Price Per Share/Earnings Per Share
0.44 Dividends/ Net Income
95
Assets/Equity
LT Debt/(LT Debt + Equity)
[Current Liabs + LT Debt]/Total Assets
Long-term Debt/Equity

Cash Flow Analysis
2002
165.0
88.0
253.0
2001
151.0
71.0
222.0
(Inc.) Dec. in Receivables

(Inc.) Dec. in Inventory
Inc. (Dec.) in Accounts Payable
Inc. (Dec.) in Taxes Payable
Subtotal
(48.0)
(12.0)
34.0
(23.0)
(49.0)
(69.0)
(18.0)
20.0
33.0
(34.0)
Cash Internally Generated
204.0
188.0
(194.0)
(71.0)
(265.0)
(188.0)
(67.0)
(255.0)
(61.0)
(67.0)
(4.0)
(48.0)
(1.0)
103
38.0
88.0
(3.0)
(20.0)
0.0
24
29.0
30.0
Net Income
Add: Depreciation and Amortization
Net Income Adjusted for Noncash Items
Changes in Receivables, Inventories,
Accounts Payable and Taxes Payable:
Discretionary Outflows:
(Inc.) Dec. in Fixed Assets
Dividends
Total Discretionary Items
Cash Internally Generated Less D.O.
Financing and Other:
(Inc.) Dec. in Other Current Assets
(Inc.) Dec. in Other Assets
Other Changes in Equity
Inc. (Dec.) in Other Current Liabs.
Inc. (Dec.) in LT Debt & Other Liabs.
Total Financing and Other
Net Change in Cash
27.0
96
37.0
= = = = = = = = = = = = = = = ILLUSTRATION 3.1 = = = = = = = = = = = = = = =
Scenario 1
A firm with $100 million in assets needs to finance an additional $15 million of assets growth. It has
enough debt capacity to cover the new funding needed, but that is all it could reasonable hope to afford. The
firms stock price is near a record high. The current dividend policy calls for a payout of 10%, and the firms
most recent annual earnings were $10 million. The company expects to experience rapid growth during the next
5 years.
= = = = = = = = = = = = = = = ILLUSTRATION 3.2 = = = = = = = = = = = = = = =
Scenario 2
A firm with $18 million in assets needs to finance $5 million for a new plant in the Sunbelt, which is the
location of its biggest market. 75% of the firm is owned equally by the companys three most senior officers.
Interest rates are moderately high, and the firms stock is currently trading at an historical record P/E. The firm
has improved its earnings per share every year it has been in existence. Its current long-term debt to total
capitalization is 60%, with $9 million in outstanding long-term loans. The firm has $3 million in current liabilities
and its managers expect earnings to grow from the present level of $3 million by 10% per year for the next few
years. The current payout ratio is 40%.
= = = = = = = = = = = = = = = ILLUSTRATION 3.3 = = = = = = = = = = = = = = =
1.
Any decision which improves EPS will also improve the stock price.
2.
If the risk of the firm remains constant, then the dividend/stock price ratio will remain
constant.
3.
If the risk of the firm increases, then an adjustment will have to be made to the ratio to
improve the investors percentage return.
4.
If the risk of the firm decreases, then an adjustment will occur which reduces the
investors percentage return.
5.
Dividend Yield = Dividend $ / Stock Price $.
97
WORKSHEET 4.1
Investment A
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cash Flows
(20,000)
8,000
7,000
7,000
7,000
8,000
Cumulative
Cash Flows
Present
Values
Cumulative
P.V.
.
Cumulative
Cash Flows
Present
Values
Cumulative
P.V.
.
__________
__________
_________
_________
___________
___________
Payback Years
Net Present Value
Present Value Index
Present Value Payback
Internal Rate of Return
Investment B
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cash Flows
(50,000)
12,000
25,000
25,000
5,000
5,000
Payback Years
Net Present Value
Present Value Index
Present Value Payback
Internal Rate of Return
__________
__________
__________
__________
98
= = = = = = = = = = = = = = = ILLUSTRATION 5.1 = = = = = = = = = = = = = = =
COST OF DEBT:
After tax interest charge for marginal debt

Principal
COST OF EQUITY:
Earnings Per Share
P/E Inversion =
Market Price
Dividend Per Share
Dividend Discount =
Market Price
+ (1-Payout %) * ROE
CAPM = Risk Free Rate + Beta(Market Return-Risk Free Rate)

COST OF PREFERRED:
___ Preferred Dividends______
Preferred Equity in Capital Structure
WEIGHTED AVERAGE COST OF CAPITAL:
Cost of Debt * Total Debt
Cost of Equity * Total Equity
Total Capital
Total Capital
+ Cost of Hybrid Securities * Total Hybrid Capital

Total Capital
99
= = = = = = = = = = = = = = = ILLUSTRATION 5.2 = = = = = = = = = = = = = = =
Firm
Cost of Debt
9.5
9.
13.
Cost of Equity
15.
13.
18.
Cost of preferred
11.
10.5
n/a
Debt/Capitalization
23.
42.
17.
Equity/Capitalization
70.
45.
83.
Preferred/Capitalization
7.
13.
Debt/Capitalization
25.
45.
38.
Equity/Capitalization
75.
45.
62.
Preferred/Capitalization
10.
Marginal tax rate
42.
36.
40.
Before Tax
Existing
Target
100
WORKSHEET 7.1
Debt
Preferred
Common
Common Shares Out.
________
EBIT Projection
_________
Less: New Interest
_________
EBT
_________
Less: Income Tax
_________
Less: Preferred Divs
_________
Net Earnings
_________
EPS
_________
% Dilution
_________
= = = = = = = = = = = = = = = ILLUSTRATION 7.1 = = = = = = = = = = = = = = =
Fluco anticipates a cash need of $10 million in the next year. If Fluco does not raise the additional funds
to invest in the R & D project, projected earnings are $4.25 per share, which translates to an EBIT for the year of
$11 million. The benefits of the R & D project are expected to add 25% to Flucos EBIT in the first year. The
firm currently has 1.2 million shares outstanding and is in a 50% marginal tax bracket.
The debt alternative calls for a $10 million debenture with a coupon of 11%. It would likely be issued at
par. The second alternative calls for 100,000 shares of $100 par preferred stock to be issued , bearing a 12%
annual dividend. The third option calls for a common stock offering of $10 million. With an issue of that size,
it is expected that Flucos stock price would fall to $40.
101

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Understanding Corporate Finance

Analyzing Financial Statements

The Financial Position at Period's End

The Cash Flows for the Period

The Balance Sheet

Total Current Assets

Total Current Liabilities

The Income Statement

Less Operating Expenses

Operating Income Before Taxes

Statement of Owners' Equity

Balance December 31, 2014

Balance December 31, 2015

Cash Flow From Investing Activities

Cash Flow from Financing Activities

Cash Dividends Paid

Cash Balance at End of Year

Operating Performance Ratios

Clever Toy's profit margin for 2015 is $164,000 or 4.8%.

Return on Assets = Profit Margin x Asset Turnover

The quick ratio for Clever Toy in 2015 is

Financial Strength Ratios

The debt to assets ratio for Clever Toy is

The equity to assets ratio for Clever Toy is

Clever Toy's ratio is

The duPont Formula

Cost of Goods Sold

Projecting Earnings and Cash Flow

Forecasting is perhaps the world's second oldest profession.

From the court astrologers of the ancient

II. Sales Influences

Projecting the Statements

1100 1210 1331 1464

Earnings Before Taxes

ABC Company will maintain its current working capital policy.

No dividends will be paid.

Creating Value for Stockholders

Common Stock + Retained Earnings

Net Income - Dividends

An Introduction to Present Value

26.91 .1038 x $1000.00

($10,000) 5,000 6,250 5,250

Based on these results, our investor should choose Investment X.

Total Present Value = $909 + 2,479 + 2,254 + 1,366 + 1,242

Discount Rate = 15%

Year End Payment:

Present Value, Investment A = $10,015

THE CAPITAL BUDGETING PROCESS

No degree of quantitative sophistication in evaluating alternatives is as important as generating the

Quantifying the Alternatives

1. Cash proceeds from sale of old asset

1. Acquisition costs, not necessarily price

225 225 225 225 225 225 225

(90) (90) (90) (90) (90) (90) (90)

Incremental Net Income 135 135 135 135 135

Yearly Cash Flow(220)150 150 150 110 150

Notes and Assumptions:

Old asset sold at book value.

Ranking the Alternatives

Nonpresent Value Methods

Present Value Methods

THE COST OF CAPITAL

THE COST OF DEBT

The IRR = YTM = 10%.