Instructor Manual for Foundations of Financial Management 18E by Stanley Block, Geoffrey Hirt & Bart

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INSTRUCTORS MANUAL

2023

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COMPLETE Elaborated Instructor Manual for Foundations of Financial Management 18th Edition Stanley Block Geoffrey Hirt Bartley Danielsen 2023

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Foundations of Financial Management 18th Edition - by Stanley Block, Geoffrey Hirt & Bartley Danielsen ISBN-10 032358196X ISBN-13 978-0323581967 Instructor Manual for Foundations of Financial Management 18th Edition - by Stanley Block, Geoffrey Hirt & Bartley Danielsen

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TABLE OF CONTENTS PART 1 INTRODUCTION 1 The Goals and Activities of Financial Management

PART 2 FINANCIAL ANALYSIS AND PLANNING 2 Review of Accounting 3 Financial Analysis 4 Financial Forecasting 5 Operating and Financial Leverage

PART 3 WORKING CAPITAL MANAGEMENT 6 Working Capital and the Financing Decision 7 Current Asset Management 8 Sources of Short-Term Financing

PART 4 THE CAPITAL BUDGETING PROCESS 9 The Time Value of Money 10 Valuation and Rates of Return 11 Cost of Capital 12 The Capital Budgeting Decision 13 Risk and Capital Budgeting

PART 5 LONG-TERM FINANCING 14 Capital Markets 15 Investment Banking 16 Long-Term Debt and Lease Financing 17 Common and Preferred Stock Financing 18 Dividend Policy and Retained Earnings

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19 Convertibles, Warrants, and Derivatives

PART 6 EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE 20 External Growth through Mergers 21 International Financial Management

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

The Goals and Activities of Financial Management

1

Author’s Overview The major thrust of this chapter is to establish the objectives of financial management and the importance of the financial manager to the organization. The introduction focuses on the financial decisions that a company like 3M makes and allows the instructor to bring the real world into the classroom immediately. Although the financial crisis might not be at the forefront of the student’s mind, it provides a good example of the risk that management and investors face.

The Dodd-Frank Act can be used to discuss legislative reaction to the behavior of financial institutions and to talk about the unintended consequences that often come out of such regulations. The various forms of organizations should be developed, and the Finance in Action Box “The Endangered Public Company” points out the problems of public companies and discusses state owned enterprises (SOEs) found in many foreign countries. This provides a good place to start the discussion of the various forms of organization. The instructor should highlight the importance of owner wealth maximization as a goal and briefly relate it to valuation concepts associated with risk and return. In addition, the role and functions of the financial markets in allocating capital should be emphasized as well as the pressures of institutional investors on financial managers. The student should also be directed to the shortfalls of profit maximization as the ultimate goal of the firm. A short discussion of social responsibility and its relationship to the financial objectives of the firm can engage students in a discussion of how wealth maximization and social responsibility can co-exist. The Finance in Action box on the 3M Company is a good example of this co-existence. We end the chapter with a short discussion of the impact of internationalization and information technology on financial markets.

Chapter Concepts LO 1-1

List some of the concepts that the field of finance covers.

LO 1-2

Recognize that a firm can have many different forms of organization.

LO 1-3

Describe how the relationship of risk to return is a central focus of finance.

LO 1-4

Explain the primary goal of financial managers.

LO 1-5

Recall that financial managers attempt to achieve wealth maximization through daily activities such as credit and inventory management and through longer-term decisions related to raising funds.

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LO 1-6

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Explain future and present value and how they relate to the time value of money.

Annotated Outline and Strategy I.

II.

III.

The Field of Finance A.

Finance is a link between accounting, economics, and other related fields of study. A financial manager must understand the Federal Reserve System, the commercial banking system, and the interrelationships between various sectors of the economy.

B.

Finance is so closely tied to economics than many of the best-known winners of the Nobel Prize for Economics were financial economists.

C.

The financial manager must know how to interpret and use financial statements in assessing the firm’s performance and allocating the firm’s financial resources to generate the best return possible in the long run.

D.

The demand for financial management skills exists in many sectors of our society including corporate management, financial institutions, consulting, and even nonprofit organizations.

Investments vs. Corporate Finance A.

Corporations like Apple sell stocks and bonds to raise capital for expansion.

B.

Investors determine the value of these bonds and stocks and buy them to add to a portfolio of securities of various companies.

C.

Financial managers must be familiar with the workings of financial markets where securities are bought and sold and where they raise capital.

The Value of Studying Finance A.

Careers in finance include financial officer, banker, stockbroker, wealth manager, financial analyst, portfolio manager, investment banker, financial consultant or financial planner.

B.

One thing in common for all these jobs, is the management of risk and return tradeoffs. Maximizing return while minimizing risk is a common goal.

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IV.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

C.

It is estimated that about 20 percent of all chief executive officers (CEOs) of publicly traded companies in the United States and in the United Kingdom were Chief Financial Officers (CFO) before being promoted to CEO.

D.

You will be faced with financial decisions your whole life. You may buy a house or condominium and borrow money to finance the purchase. You may have to manage your retirement plan or your household budget.

Activities of Financial Management. A financial manager is responsible for the proper allocation of funds between current and fixed assets, for achieving the best

PPT

Functions of the Financial Manager (Figure 1-1)

mix of financing alternatives, and for developing an appropriate dividend policy within the context of the firm’s objectives.

A.

Daily financial management activities 1.

2.

3.

4.

B.

Less routine or occasional activities 1.

2.

3.

4.

C.

Monitor cash balances Credit management Inventory control Receipt and disbursement of funds

Negotiations with banks for loans to finance business operations.

Sale of stocks and bonds Capital budgeting Dividend decisions

Forms of organization: The finance function may be carried out within a number of different forms of organizations.

1.

Sole proprietorship a.

Single ownership b.

Simplicity of decision making c.

Low organizational and operating costs d.

Unlimited liability e.

Earnings are taxed as personal earnings of the individual owner

2.

Partnership

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

a. b. c.

d. e.

V.

Two or more partners Usually formed by articles of partnership agreement Unlimited liability for all partners unless a limited partnership is formed which provides limited liability for one or more partners.

At least one partner must be a general partner.

Earnings are taxed as personal earnings of partners Special forms of partnerships such as the limited partnership and the limited liability partnership can be used to circumvent the liability issue of partnerships.

3.

Corporation a.

Most important form of business in terms of revenue and profits b.

Legal entity c.

Formed by articles of incorporation d.

Stockholders (owners) have limited liability e.

Easy divisibility of ownership f.

Managed by the board of directors g.

Double taxation of earnings: Earnings of the corporation are subject to the corporate income tax; dividends (distributed net income) are subject to personal taxation h.

The 2017 Tax Cuts and Jobs Act cut the U.S. corporate tax rate from 35% to 21%. i.

Subchapter S corporations, however, avoid the double taxation disadvantage. S corporations are limited to 100 shareholders.

4.

Limited Liability Company (LLC) a.

Popular for its highly flexible structure b.

Provides limited liability for the owners c.

Not technically a corporation d.

Can be taxed many different ways elected by the owners

Corporate Governance.

A.

Enron and other failures of corporate governance are discussed.

B.

During the last decade much attention has been devoted to the relationship between the owners of the firm and the managers of the firm. In large corporations, the hired management acts as agents for owners. The study of the relationship between owners and managers as well as other agent relationships is referred to as agency theory.

C.

The Sarbanes-Oxley Act of 2002 imposed greater accountability on corporate

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

executives and independent auditors. It has also created additional compliance burdens on publicly traded companies.

VI.

VII.

D.

The financial crisis of 2007-2009 exposed the inability of corporate boards to understand risk management. In response Congress passed the Dodd-Frank Act, officially known as the Wall Street Reform and Consumer Protection Act of 2010.

E.

Institutional investors such as pension funds and mutual funds have more and more impact on decisions made by corporate boards of directors because they often own a significant percentage of a company’s common stock.

F.

Dodd-Frank Act, also known as the Wall Street Reform and Consumer Protection Act of 2010 was the first major financial regulatory change in the U.S. since the Great Depression. The act assigns regulatory responsibility, actual rulemaking and implementation are charged to different agencies for enforcement.

The Time Value of Money A.

Time value of money is perhaps the most important concept in finance. It is the knowledge that a dollar today is worth more than a dollar received in the future.

B.

This is true because a dollar can be invested to earn a positive return or given that we live with inflation, the purchasing power of future dollar will buy less than a dollar spent today.

C.

We cover this topic in detail in Chapter 9 where you will learn how to calculate the future value, the present value, the future value of an annuity and the present value of an annuity.

Goals of Financial Management.

A.

The integration of the external investor point of view with the internal management orientation is evidenced by the goal of financial management: To make those decisions and engage in those activities that will maximize the overall value of the firm for the benefit of the stockholders.

B.

The goal of maximizing profits is not the same as maximizing shareholder wealth.

C.

The valuation approach to wealth maximization focuses on how investors value the future earnings stream.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

D.

Shareholder wealth maximization is a long-term goal. Changing investor expectations and emphasis may influence its achievability.

E.

While not all managements focus on maximizing shareholder wealth, ignoring wealth maximization for publicly traded firms can result in hostile takeovers or institutional investor pressure on the board of directors.

G.

The goal of maximizing shareholder wealth cannot ignore corporate responsibility to social issues and cannot operate without ethical standards.

Socially desirable actions such as pollution control, equitable hiring practices, and firm pricing standards may at times be inconsistent with achieving maximum valuation in the market, absent government mandates.

H.

Insider trading occurs when someone uses information that is not available to the public to profit from trading in a company’s publicly traded securities. This is illegal and protected by the SEC.

Finance in Action: The Purpose of the Corporation In 2019 the Business Roundtable an organization of over 200 chief executive officers backtracked on the goal of financial management. They expanded the role of the corporation to include all stakeholders – customers, employees, communities, and shareholders. In other words, they stand behind the idea that you can’t maximize value and ignore stakeholders.

VIII. The Role of Financial Markets. Wealth maximization depends on the perception and expectations of the market. Through daily price changes in the common stock of each publicly traded company, the market provides managers with a performance report card.

A.

Structure and Functions of the Financial Markets. Money markets (Chapter 7) and capital markets (Chapter 14) are more fully presented in later chapters, but the students may find that some current examples from the Wall Street Journal will create a sense of realism about this course.

B.

Allocation of Capital. Students need to understand how the market price reflects risk and return expectations and how a company’s ability to raise funds is influenced by its financial performance and corporate behavior.

C.

Internationalization of the Financial Markets. Emphasize the globalization of the capital markets and the worldwide pool of capital available to many companies.

Use the international companies highlighted in the text to get across the point that the search for capital is global.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

VIII. Format of the Text: The text is divided into the following parts: 1. Introduction: This section examines the goals and objectives of financial management with emphasis on decision-making and risk management. Discussion includes an update of significant events influencing the study of finance.

2. Financial Analysis and Planning: Includes a review the basic principles of accounting, which is required for understanding major financial topics.

3. Working Capital Management: A discussion of the short-term assets and liabilities of the firm and the related analysis of risk-return issues.

4. The Capital Budgeting Process: This section begins with a discussion of “time value of money” and continues on to cover the valuation of bonds and stocks, emphasizing the traditional dividend valuation model. The text then covers capital budgeting decisions including the use of risk-return analysis in capital budgeting.

5. Long-Term Financing: This section discusses the U.S. financial markets as they relate to corporate financial management. The student will consider sources and

Perspective 1-3: Mention that U.S. and foreign firms often trade on each other’s financial markets. uses of funds, the role of the investment banker, and leasing as a form of debt.

6. Expanding the Perspective of Corporate Finance: This section addresses corporate mergers and external growth strategies. It describes the growth of international financial markets, the rise of multinational business, and the related effects on corporate financial management.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

2

Review of Accounting Author’s Overview

As already discussed, finance is a blend of accounting, economics, and other disciplines. This chapter will prove invaluable in establishing the relationship between accounting and finance, whether the student has already taken accounting or not. Though it is assumed that every student taking the introductory course in managerial finance has had course work in accounting, many students are in need of a review. By explicitly covering this review material early in the course, the student is able to grasp later material more easily and the instructor does not have to continually close the “accounting gaps” during the course. The instructor must, of course, decide whether to lecture on this material or merely assign it as reading. Some may choose to forego it altogether. Our experience as professors is that the introductory accounting curriculum has changed over the years and does not always cover the relationship between the balance sheet, income statement, and statement of cash flows. Before covering the financial analysis material in the next chapter, understanding Chapter 2 is a necessity. Also, cash flow generation is necessary for understanding capital budgeting decisions.

Chapter Concepts LO1. Explain what an income statement measures.

LO2. Recall the price-earnings ratio indicates the relative valuation of earnings.

LO3. Understand that the balance sheet shows assets and the financing of those assets with debt and equity.

LO4. Explain what the statement of cash flows indicates.

LO5. Recognize that depreciation provides a tax reduction benefit that increases cash flow.

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Perspective 2-1: P/E ratios provide a new concept and can be of benefit to the student.

Students tend to respond enthusiastically to stock market considerations in valuation.

They can get a feel for P/E ratios and how they change over time in Table 2-3.

Annotated Outline and Strategy I.

The Income Statement PPT

Kramer Corporation—Income Statement (Table 2-1)

A.

The income statement begins with the total amount of sales (revenues) that are generated within a specific period of time.

B.

The various expenses that occur in generating the sales are subtracted in stair-step fashion to arrive at the net income for the defined period.

C.

The separation of the expense categories such as cost of goods sold, selling and administrative expenses, depreciation, interest, and taxes enables the management to assess the relative importance and appropriateness of the expenditures in producing each level of sales.

D.

The “bottom line” value, net income, is the aggregate amount available to the owners.

E.

Net income is converted from an aggregate value to an earnings per share (EPS) value by dividing net income by the number of shares of outstanding stock.

F.

The EPS is a measurement of the return available to providers of equity capital to the firm. The return to the providers of debt capital, interest, appears earlier in the income statement as a tax-deductible expense.

PPT

Kramer Corporation—Statement of Retained Earnings (Table 2-2)

G.

The earnings per share may be converted to a measure of current value through application of the price-earnings (P/E) ratio.

H.

The P/E ratio is best used as a relative measure of value because the numerator, price, is based on the future and the denominator, earnings, is a current measure.

PPT

Price-earnings ratios for selected U.S. companies (Table 2-3)

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II.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

I.

There are limitations associated with the income statement. For example, the income statement reflects only income occurring to the individual or business firm from verifiable transactions as opposed to the economists’ definition of income, which reflects changes in real worth. Furthermore, flexibility in the application of Generally Accepted Accounting Principles may cause similar events to be recorded and reported differently.

J.

The statement of retained earnings, a supplement to the income statement, indicates the disposition of earnings.

Balance Sheet PPT

Kramer Corporation—Balance Sheet (Table 2-4)

A.

Whereas the income statement provides a summary of financial transactions for a specific time period, the balance sheet portrays the cumulative results of transactions at a point in time. The balance sheet may present the position of the firm as a result of transactions for six months, 25 years, or other periods.

B.

The balance sheet is divided into two broad categories. The assets employed in the operations of the firm compose one category while the other, liabilities and net worth, is composed of the sources of financing for the employed assets.

C.

Within the asset category, the assets are listed in their order of liquidity.

1.

2.

3.

4.

5.

6.

7.

D.

Cash (including demand deposits) – current assets Marketable securities: investments of temporarily excess cash in highly liquid securities Accounts receivable Inventory Prepaid expenses: future expense items that have already been paid Investments: investments in securities and other assets for longer than one operating cycle Plant and equipment adjusted for accumulated depreciation

The various sources of financing of a firm are listed in their order of maturity.

Those sources that mature earliest, current liabilities, are listed first. The more permanent debt and equity sources follow.

1.

2.

3.

Accounts payable Notes payable Accrued expenses: an obligation to pay is incurred but payment has not

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

4.

5.

6.

been made Long-term debt: all or a majority of the principal will be paid beyond the current period Preferred stock Common stock accounts: a. b. c.

E.

Confusing balance sheet–related terms 1.

2.

3

F.

Common stock (par value) Capital paid in excess of par Retained earnings

Retained earnings is the account used to measure the accumulation of earnings over the life of the firm. It includes “all the income the firm ever made minus all the dividends the firm ever paid.” It is not a bucket of money that can be reinvested, but the annual increase in retained earnings is one of the sources of funds that make up the existing investment level.

Net worth or book value of the firm is composed of the various common equity accounts and represents the net contributions of the owners to the business plus the earnings retained by the firm (Retained Earnings—see above).

Book value is a historical value and does not necessarily coincide with the market value of the owner’s equity.

Limitations of the balance sheet: Values are recorded at cost. Replacement cost of some assets, particularly plant and equipment, may greatly exceed their recorded value. Research and development are a valuable asset to some of the world’s most valuable companies like Apple, Google, and Amazon. However, standard accounting practice is to deduct these costs on the income statement as incurred resulting on R&D investments never shown on the firm balance sheets.

Perspective 2-2: Illustrate the substantial differences that may exist between market definitions of value and accounting definitions.

PPT Comparison of Market Value to Book Value per Share in January 2021 (Table 2-5) III.

Statement of Cash Flows A.

In November 1987, the accounting profession replaced the statement of changes in financial position (and the sources and uses of funds statement) with the Statement

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

of Cash Flows as a required financial statement.

B.

The new statement emphasizes the critical nature of cash flow to the operations of the firm.

C.

The three primary sections of the statement of cash flows are: 1.

2.

3.

Cash flows from operating activities.

Cash flows from investing activities.

Cash flows from financing activities.

PPT Illustration of concepts behind the statement of cash flows (Figure 2-1) D.

Income from operations may be translated from an accrual basis to a cash basis in two ways to obtain cash flow from operations.

1.

2.

Direct method: each and every item on the income statement is adjusted from accrual accounting to cash accounting.

Indirect method: a less tedious process than the direct method is usually preferred. Net income is used as the starting point and adjustments are made to convert net income to cash flows from operations. Beginning with net income, a.

b.

Add depreciation for the current period, decreases in individual current asset accounts (other than cash), and increases in current liabilities.

Subtract increases in current asset accounts (other than cash) and decreases in current liabilities.

Perspective 2-3: The steps necessary for computing cash flow from operations are illustrated in Figure 2-2. The actual numerical material can be found in Tables 2-1, 2-6, and 2-7.

PPT

Steps in Computing Net Cash Flows from Operating Activities Using the Indirect Method (Figure 2-2)

PPT

Kramer Corporation—Comparative Balance Sheets (Table 2-6)

PPT

Cash Flows from Operating Activities (Table 2-7)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

E.

Cash flow from investing is found by summing the changes of investment in securities and plant and equipment. Increases are uses of funds and decreases are sources of funds.

F.

Cash flow from financing activities is found by summing the sale or retirement of corporate securities and dividends. The sale of securities is a source of funds and the retirement of securities and payment of dividends are uses of funds.

G.

Cash flows from operations, cash flows from investing, and cash flows from financing are combined to arrive at the net cash flows. The net increase or decrease shown in the statement of cash flows will be equal to the change in the cash balance on the balance sheet.

PPT

Cash Flows from Investing Activities (Table 2-8)

PPT

Cash Flows from Financing Activities (Table 2-9)

Perspective 2-4: The three sections of the statement of cash flows are brought together in Table 2-10. In the example, highlight how the cash flows from operating activities are funding investing and financing activities.

Perspective 2-5: The Finance in Action Box discusses some of the major differences between international accounting standards (IFRS) and U.S. generally accepted accounting principles (GAAP) and is a good example of how the global economy is impacting financial reporting.

PPT

Kramer Corporation—Statement of Cash Flows (Table 2-10)

Finance in Action: International Accounting Standards vs. U.S. GAAP Economies and capital markets have moved to a global platform, creating the need for a uniform reporting standard. This led to the formation of International Financial Reporting Standards (IFRS) by the International Accounting Standards Board (IASB), which was adopted by many countries except the United States. In the U.S., the Financial Accounting Standards Board (FASB) developed reporting standards know as Generally Accepted Accounting Principles (GAAP). Many standards have been aligned; however, significant differences remain between IFRS and U.S. GAAP. IV.

Depreciation and Funds Flow A.

Depreciation is an attempt to allocate an initial asset cost over its life.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

B.

Depreciation is an accounting entry and does not involve the movement of funds.

C.

As indicated in the statement of cash flows, depreciation is added back to net income to arrive at cash flow.

Perspective 2-6: To illustrate how the initial purchase of an asset and the subsequent write-off of depreciation affects cash flow, refer to Table 2-11.

PPT

Comparison of accounting and cash flows (Table 2-11)

Finance in Action Ethics: Taxes a Strategic Tool for Competition between Countries and States.

Switzerland is only one example of a European country with lower tax rates than the U.S., and it demonstrates why some corporations have moved their headquarters out of the United States. In response to this exodus, Congress lowered the federal corporate tax rate from 35 percent to 21 percent beginning in 2018, substantially reducing incentives to relocate overseas.

V.

VI.

Free Cash Flow A.

Free cash flow is equal to cash flow from operating activities: Minus: Capital expenditures (required to maintain the productive capacity of the firm) Minus: Dividends (needed to maintain the necessary payout on common stock and to cover any preferred stock obligation)

B.

The amount of free cash flow is often a determining factor as to whether a leveraged buyout is possible.

C.

When management suspects its stock is undervalued, a special financing activity may take the form of a leveraged buyout.

Income Tax Considerations A.

Personal taxes at varying rates apply to the earnings of proprietors and partners.

B.

Starting December 2017, a major tax bill passed by Congress changed the corporate tax rate from as high as 35 percent to a flat rate of 21 percent. Some state and foreign taxes may still apply to increase the overall rate higher than 21 percent.

C.

The aftertax cost of a tax-deductible business expense can be calculated by taking

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

the (expense)  (1 – tax rate).

D.

Although depreciation is a noncash expense, it does affect cash flow by reducing taxes. Tax reduction in cash outflow for taxes resulting from depreciation charges may be computed by multiplying the (depreciation expense)  (tax rate).

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

3

Financial Analysis Author’s Overview

The student should be directed to view the thirteen ratios as an overall package that can be used to evaluate any firm. The use of the Saxton Company analysis provides continuity to the discussion. The authors like to stress that ratios are easier to remember than students think. For example, emphasize that net income is the numerator for the profitability ratios, sales is the numerator for most asset utilization ratios, and that the debt ratios essentially define themselves.

Though the student must be familiar with the calculation and meaning of each individual ratio, the primary emphasis is on the interrelationship between the ratios (such as that stressed by the DuPont system of analysis). The discussion of inflation/disinflation and distortions in financial reporting represents an important lesson for the student: do not automatically accept the bottom line.

Chapter Concepts LO1. Recognize that ratio analysis provides a meaningful comparison of a company to its industry.

LO2. Explain what ratios can be used for and what they measure.

LO3. Recall that the DuPont system of analysis identifies the true sources of return on assets and return to stockholders.

LO4. Detail what trend analysis shows.

LO5. Explain why reported income must be further evaluated.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Annotated Outline and Strategy I.

Ratio analysis: Like painting a picture; one ratio (color) does not reveal much by itself, but when several ratios are taken together, the analyst gets a better picture of the firm.

Ratio analysis provides a basis for evaluating the performance of the firm and facilitates comparison with other firms, using data from sources such as Bloomberg, Standard & Poor’s, Value Line Investment Survey, etc.

Perspective 3-1: Ratios give additional meaning to absolute values. Show how we use ratios in everyday life such as miles per gallon, baseball batting averages, etc.

A.

Classification System: There are 13 basic ratios presented in the text. We break them down into four categories:

PPT

Ratio Analysis and Classification System 1.

Profitability ratios: Measures of returns on sales, total assets, and invested capital a. b. c.

Profit margin = Net income/Sales Return on assets (investment) = Net income/Total assets Return on equity = Net income/Stockholders’ equity = Return on assets ÷ (1 – Debt/Assets)

PPT

Saxton Company— Financial statement for ratio analysis (Table 3-1)

PPT

The Analysis—Profitability Ratios

PPT

DuPont Analysis (Figure 3-1)

Perspective 3-2: The DuPont system of analysis carries insights into the relationship between profitability ratios. Use Figure 3-1 and Table 3-2 to explain this system.

PPT Return on Equity: Walmart vs. Target Using the DuPont Method of Analysis, 2020 (Table 3-2)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Name Walmart Stores Inc. Target

A

B

A×B

C

D = (1 – C)

(A × B)/D

Profit Margin

Asset Turnover

Return on Assets

Debt/Assets

1 – Debt/ Assets

Return on Equity

3.83%

1.62

6.21%

65.12%

34.88%

17.80%

4.58%

1.29

5.90%

73.71%

26.30%

22.43%

2.

Asset utilization ratios: Measures how well the firm is managing its accounts receivable, inventories, and long-term assets. a. b. c. d. e.

PPT

Receivable turnover = Sales/Receivables Average collection period = Accounts receivable/Average daily credit sales Inventory turnover = Sales/Inventory or COGS/Inventory Fixed asset turnover = Sales/Fixed assets Total asset turnover = Sales/Total assets

The Analysis—Asset Utilization Ratios

Perspective 3-3: This is an excellent opportunity to explain how asset utilization ratios relate to profitability ratios.

3.

Liquidity ratios: Measures of the firm's ability to pay off short-term obligations as they come due a.

PPT

The Analysis—Liquidity Ratios b.

4.

Quick ratio = Current assets minus Inventory/Current liabilities

Debt Utilization Ratios: Measures the prudence of the firm’s debt management policies. a. b. c.

PPT

Current ratio = Current assets/Current liabilities

Debt to total assets Times interest earned Fixed charge coverage

The Analysis—Debt Utilization Ratios

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5.

II.

Users focus on different ratios to assess performance of different aspects of the business.

Trend Analysis: Compares company performance over a period of time and is just as important as industry comparisons PPT

Ratio Analysis (Table 3-3)

PPT

Trend Analysis (Figure 3-2)

Perspective 3-4: Figure 3-2 and Figure 3-3 illustrate the importance of trends.

Trend Analysis in the Computer Industry – AMD vs. Intel (Figure 3-3)

PPT

Finance in Action: Are Ratios Good Predictors of a Company’s Value In this section we discuss the complexity of valuing a company’s market value. Ratios are helpful in determining profitability, financial risk, business risk but more than ratio analysis goes into market value. A critical factor is the growth of earnings, sales and cash flow as well as how long that growth will last. Every market student understands SWAT analysis and competitive advantage. Valuation integrates all know information and is subject to a financial analyst’s interpretation.

III.

Impact of Inflation on Financial Analysis A.

Impact on Profits 1.

2.

3.

B.

First-in, first-out (FIFO) inventory valuation during inflation periods “understates” cost of goods sold and causes “inventory profits.”

The use of replacement cost accounting reduces income and interest coverage during inflationary periods.

A leveling off of prices referred to as disinflation may cause a reduction in profits.

Impact on Asset Value 1.

2.

3.

Assets on the balance sheet are recorded at cost.

In inflationary periods, the replacement cost of long-term assets may greatly exceed the reported values.

The use of replacement cost accounting increases asset values during inflationary periods. This increase lowers the debt to asset ratio but does not necessarily enhance the firm’s ability to service its debt.

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PPT

STEIN Corporation - Net Income for 202020 (Table 3-4)

PPT

STEIN Corporation - Net Income for 2021 (Table 3-65

PPT Comparison of Replacement Cost Accounting and Historical Cost Accounting (Table 3-6) C.

Raising capital 1.

2.

3.

IV.

Investors generally require higher rates of return during periods of inflation.

Although earnings may drop because of disinflation, the declining rate of return demanded by investors may cause the value of a firm’s securities to increase.

The movement away from financial assets (stocks and bonds) into tangible assets (gold, silver, etc.) by investors during periods of inflation makes it difficult and more expensive for firms to raise capital. Likewise, the reverse trend during periods of disinflation enhances a firm’s ability to issue securities.

Other Elements of Distortion in Reported Income PPT A.

An Illustration Recognition of revenue 1.

2.

A conservative firm may recognize long-term installment sales revenues when payments are received, whereas other firms report the full amount of the sale as soon as possible.

Firms may use different inventory write-off policies to influence profits.

B.

Differences in inventory valuation (LIFO versus FIFO) may cause incomparable differences between companies.

C.

Extraordinary losses are reported in total as deductions from operating income by some firms but shown as deductions (net of taxes) from net income by others.

D.

The financial analyst should make every attempt to adjust financial reports to a consistent format for proper analysis.

PPT

Income Statements (Table 3-7)

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Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 1, Harrod’s Sporting Goods (ratio analysis) Case 2, Chem-Med Company (ratio analysis case)

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Financial Forecasting

4

Author’s Overview Developing pro forma statements is a fairly involved process. However, the rewards to students are high in terms of understanding the interaction of accounting data and financial forecasting. The development of pro forma financial statements is an integrative exercise, so there is little reward for a halfway approach. The use of an integrated Excel spreadsheet makes this process a little more manageable. It should be emphasized than any student intending to start up a small business will be required to prepare this type of statement for a bank loan or business plan. Often management students see no reason to master this painstaking exercise, but, if they hope to become entrepreneurs, it will be good for them to know it because a lender or investor will want to see their proforma statements for any chance of a loan or investment.

The percent-of-sales method, presented at the end of the chapter, is a second approach to financial forecasting. It is easily understood and quickly mastered, but it has many weaknesses and does not have the full validity of developing pro forma statements. Choosing whether and how to present the percent-of-sales method is really a matter of instructor preference.

Chapter Concepts LO1. Recognize that financial forecasting is essential to the strategic growth of the firm.

LO2. List the three financial statements for forecasting.

LO3. Know the percent-of-sales method may also be used for forecasting on a less precise basis.

LO4. Explain why the various methods of forecasting enable the firm to determine the amount of new funds required in advance.

LO5. Understand the process of forecasting forces the firm to consider seasonal and other effects on cash flow.

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Annotated Outline and Strategy I.

II.

Introduction A.

Financial planning helps managers arrange increased funding requirements to finance additional assets needed to support changes in marketing strategies and growth.

B.

Profit alone is insufficient to finance significant growth.

C.

Financial forecasts are used to evaluate performance by comparing planned outcomes against actual results.

D.

Lenders frequently require evidence of planning prior to making funds available.

E.

Financial planning is necessary, not only for success, but for survival as well.

Constructing Pro Forma Statements: The most comprehensive means of financial planning is through the development of pro forma financial statements, namely the pro forma income statement, the cash budget, and the pro forma balance sheet.

PPT

Development of Pro Forma Statements (Figure 4-1)

Perspective 4-1: Indicate how the pro forma income statement and cash budget are used to develop the pro forma balance sheet as presented in Figure 4-1. Then a more detailed coverage of other tables and schedules can be given.

III.

Pro Forma Income Statement: A projection of how much profit a firm will make over a specific time period 1.

PPT

Establish a sales projection a.

Forecast economic conditions b.

Survey sales personnel Projected Wheel and Caster Sales (Table 4-1)

Perspective 4-2: Many steps are necessary to convert the sales forecast into production requirements, cost of goods sold, and gross profit. Tables 4-1 through 4-7 are all brought together into one table (Table 4-8) to show all the relationships at once in the pro forma income statement.

2.

Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at gross profit.

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PPT

Stock of Beginning Inventory (Table 4-2)

Finance in Action: Tesla’s Sales Forecasts: Where Marketing and Finance Come Together Students need to understand that many of the numbers financial managers use in their analysis are provided by other functional areas in the firm. Sales forecasts are usually generated by the marketing function, and projected sales for wheels and casters in Table 4-1 are derived outside of the finance area. Tesla Motors is given as an example in this box.

PPT

Production Requirements for Six Months (Table 4-3) a.

Determine units to be produced + Projected unit sales + Desired ending inventory – Beginning inventory = Production requirements

b.

Determine the cost of producing the units (1) (2)

Unit cost = materials + labor + overhead Total costs = number of units to be produced  unit cost

PPT

Unit Costs (Table 4-4)

PPT

Total Production Costs (Table 4-5) c.

Compute cost of goods sold (1) (2)

d.

Estimate unit sales Cost of goods sold = unit sales × unit cost (FIFO or LIFO)

Compute gross profit

PPT

Allocation of Manufacturing Cost and Determination of Gross Profits (Table 4-6)

PPT

Value of Ending Inventory (Table 4-7)

3.

Compute other expenses a.

General and administrative b.

Interest expense

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c. d.

4.

Taxes Dividends

Determine profit by completing the actual pro forma statement + Sales revenue – Cost of goods sold = Gross profit – General and administrative expenses = Operating profit (EBIT) – Interest expense = Earnings before taxes (EBT) – Taxes = Earnings after taxes (EAT) – Common stock dividends = Increase in retained earnings

PPT IV.

Income Statement (Table 4-8)

Cash Budget: A summary of expected cash receipts and disbursements for a specific period of time 1.

Estimate cash sales and collection timing of credit sales

PPT

Monthly Sales Pattern (Table 4-9)

PPT

Monthly Cash Receipts (Table 4-10)

PPT

Component Costs of Manufactured Goods (Table 4-11)

2.

Forecast cash payments a. b. c. d. e. f. g. h.

PPT

Payments for materials purchased according to credit terms Wages General and administrative expenses Capital expenditures Principal payments Interest payments Taxes Dividends

Average Monthly Manufacturing Costs (Table 4-12)

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PPT

Summary of All Monthly Cash Payments (Table 4-13)

3.

Determine monthly cash flow (receipts minus payments)

PPT

Monthly Cash Flow (Table 4-14)

PPT

Cash Budget with Borrowing and Repayment Provisions (Table 4-15)

4.

Construct cash budget + Total receipts (for each month, week, etc.)

– Total payments (for each month, week, etc.) = Net cash flow (for the period) + Beginning cash balance = Cumulative cash balance Note: The beginning cash balance for each period of the cash budget is equal to the cumulative cash balance of the previous period in the absence of borrowing or investing of cash balances.

5.

Determine cash excess or need for borrowing + Desired cumulative cash balance – Cumulative cash balance (at end of period) +/– Loan required or cash excess = Ending cash balance

V.

Pro Forma Balance Sheet: An integrated projection of the firm’s financial position based on its existing position, forecasted profitability (from pro forma income statement), anticipated cash flows (cash budget), asset requirements, and required financing 1.

Construction of pro forma balance sheet a.

Current Assets (source of information) (1) (2) (3) (4)

Cash (cash budget) Marketable securities (previous balance sheet and cash budget) Accounts receivable (sales forecast, cash budget) Inventory (COGS computation for pro forma income statement)

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(5)

b.

Plant and equipment (previous balance sheet + purchases – depreciation)

Liabilities and Stockholders’ Equity (1) (2) (3) (4) (5)

Accounts payable (cash budget worksheet) Notes payable (previous balance sheet and cash budget) Long-term debt (previous balance sheet plus new issues) Common stock (previous balance sheet plus new issues) Retained earnings (previous balance sheet plus projected addition from pro forma income statement)

Perspective 4-3: Use Figure 4-2 to reinforce the pattern used to arrive at the pro forma balance sheet.

PPT

Development of a Pro Forma Balance Sheet (Figure 4-2)

PPT

Balance Sheet December 31, 2021 (Table 4-16)

PPT

Pro Forma Balance Sheet June 30, 2022 (Table 4-17)

Perspective 4-4: Table 4-17 is the last piece in the puzzle in that it represents the actual pro forma balance sheet. The amounts in the 10 accounts in the table can be clarified in the explanations following the table in the text.

Finance in Action: Pro Forma Financial Statements: A Critical Tool for Entrepreneurs This box reemphasizes what we have stated in the overview and provides some important reasons why pro forma financial statements are important. A point often overlooked by entrepreneurs is that a firm can only grow if it has enough money available to increase its current and fixed assets.

VI.

Percent-of-Sales Method: Shortcut, less exact alternative for determining financial needs 1.

Assumes that balance sheet accounts maintain a given relationship to sales Assets = % of sales Current Sales

PPT

Balance Sheet and Percentage-of-Sales Table for Howard Corporation (Table 4-18)

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Perspective 4-5: Table 4-18 can be tied in with Formula 4-1 to demonstrate the percent-ofsales method.

2.

Project asset levels on basis of forecasted sales (percent of sales of each asset  forecasted sales)

3.

Project spontaneous financing: Some financing is provided spontaneously when asset levels increase; for example, accounts payable increase when a firm buys additional inventory on credit.

4.

Project internal financing from profit = profit margin  forecasted sales  dividend payout ratio.

5.

Determine external financing = required new assets to support sales – spontaneous financing – the change in retained earnings. The relationship is expressed as follows:

A Required new funds =

S

(S) −

L S

(S) − PS 2 (1− D)

Where: A/S = percentage relationship of variable assets to sales S = change in sales L/S = percentage relationships of variable liabilities to sales P = profit margin S2 = new sales level D = dividend payout ratio

Perspective 4-6: Students often get confused about companies operating at full capacity and those operating at less than full capacity. Be sure to emphasize the point that when at full capacity, a company cannot increase output without adding more fixed costs. However, when operating at less than full capacity, the firm can produce more goods without making additional investments in plant and equipment.

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Operating and Financial Leverage

5

Author’s Overview Though the student has probably covered break-even analysis in other courses, the material in Chapter 5 offers an opportunity to more fully explore the financial effects of all forms of leverage on the firm. The contrast between aggressive and conservative approaches should be emphasized, particularly through the useful technique of computing degrees of leverage. This chapter also serves as a good basis for much of the later discussion in the text on the cost of capital. The student begins to appreciate the positive benefits of debt, but also realizes that unlimited use of debt increases the financial risk of the firm and perhaps the cost of various other sources of financing.

Chapter Concepts LO1. Define leverage.

LO2. Explain break-even analysis and why it is used.

LO3. Describe operating leverage.

LO4. Explain what financial leverage shows.

LO5. Recall that combined leverage takes into account the use of both fixed assets and debt.

LO6. Recognize that by increasing leverage, the firm not only increases its profit potential, but also its risk of failure.

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Annotated Outline and Strategy Perspective 5-1: The introduction emphasizes the airline industry as an industry that has both high operational leverage and high financial leverage. The bankruptcy of most U.S. air carriers should get across the point that leverage has its risk and that this chapter is very important for anyone who intends to be a financial analyst or stock investor.

I.

II.

Leverage in a Business: The use of fixed charge obligations with the intent of magnifying the potential return to the firm.

A.

Fixed operating costs: Those operating costs, such as rent, depreciation, property taxes, and executive salaries, that remain relatively constant regardless of the volume of operations.

B.

Fixed financial costs: The interest costs arising from debt financing that must be paid regardless of the level of sales or profits.

Operating Leverage: The extent to which fixed assets and associated fixed costs are utilized in the business.

A.

Break-even analysis: A numerical and graphical technique used to determine at what point the firm will break even.

1.

2.

Break-even point: the unit sales where total revenue = total costs Contribution margin per unit is sales price (per unit) minus variable costs per unit.

Formula for break-even point in units:

3.

BE =

Fixed costs Fixed costs FC = = Contribution margin Price – Variable cost per unit P – VC

PPT

Classification of Costs (Table 5-1)

PPT

Break-Even Chart: Leveraged Firm (Figure 5-1)

Perspective 5-2: Establish factors related to break-even analysis by illustrating the operations of a highly leveraged firm versus a conservative firm by using Figures 5-1 and 5-2 and Tables 5-2 and 53.

PPT

Volume-Cost-Profit Analysis: Leveraged Firm (Table 5-2)

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B.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

A More Conservative Approach: A firm not willing to accept the additional risk of a higher degree of operating leverage will only commit to a lower level of fixed costs, and thus will operate further away from the break-even point. Profits will grow at a slower rate, but if volume shrinks, there is more room to decline before hitting the break-even point and beginning to show losses.

PPT

Break-Even Chart: Conservative Firm (Figure 5-2)

PPT

Volume-Cost-Profit Analysis: Conservative Firm (Table 5-3)

C.

The Risk Factor: The risk factor in using financial leverage depends on the firm’s operations relative to its break-even point and its operating leverage. How close to break-even volume is the firm’s actual operating volume? Management’s willingness to take risks is also a function of its view of future economic conditions.

D.

Cash Break-Even Analysis 1.

2.

Deducting noncash fixed expenses such as depreciation in the break-even analysis enables one to determine the break-even point on a cash basis.

Cash break-even point formula:

Cash BE = 3.

E.

Fixed costs – (Noncash fixed costs) Price – Variable cost per unit

Although cash break-even analysis provides additional insight, the emphasis in the chapter is on the more traditional accounting data–related break-even analysis.

Degree of Operating Leverage: A reflection of the extent fixed assets and fixed costs are utilized in the business firm. The employment of operating leverage causes operating profit to be more sensitive to changes in sales.

1.

2.

3.

4.

The use of operating leverage increases the potential return but it also increases potential losses.

The amount of leverage employed depends on anticipated economic conditions, nature of the business (cyclical or noncyclical), and the risk aversion of management.

The sensitivity of a firm’s operating profit to a change in sales as a result of the employment of operating leverage is reflected in its degree of operating leverage.

Degree of operating leverage (DOL) is defined as the ratio of percentage change in operating income in response to percentage change in units sold.

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DOL = % change in operating income % change in unit volume 5.

The DOL may also be computed using the formula: DOL =

where: Q = P = VC = FC = CM = EBIT = 6.

PPT

Q(P − VC) CM = Q(P − VC) − FC EBIT

quantity at which DOL is computed price per unit variable cost per unit fixed costs contribution margin earnings before interest and taxes

DOL and other measures of leverage always apply to the starting point for the range used in the computation.

Operating Income or Loss (Table 5-4)

Perspective 5-3: DOL can easily be computed from the summary data on the leveraged and conservative firm. Summary data are presented in Table 5-4 and are drawn from Tables 5-2 and Table 5-3.

F.

Limitations of Analysis: The normal assumption in doing break-even analysis is that a linear function exists for revenues and costs as volume changes. This is probably reasonable over a relevant range. However, for more extreme levels of operations, some nonlinearity may exist, resulting in revenue weakness and cost overruns.

PPT III.

Nonlinear Break-Even Analysis (Figure 5-3)

Financial Leverage: A measure of the amount of debt used in the capital structure of the firm. While operating leverage primarily pertains to the left-hand side of the balance sheet (assets and associated costs), financial leverage deals with the right-hand side of the balance sheet (liabilities and net worth).

A.

Impact on Earnings: 1.

Two firms may have the same operating income but greatly different net incomes due to the magnification effect of financial leverage. The higher the financial leverage, the greater the profits or losses at high or low levels of operating profit, respectively.

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2.

B.

Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a higher rate of return than the interest rate on the borrowed amount. The extent of a firm’s use of financial leverage may be measured by computing its degree of financial leverage (DFL).

Degree of Financial Leverage: DFL is the ratio of the percentage change in earnings per share in response to a percentage change in EBIT. 1.

The DFL may also be computed utilizing the following formula:

DFL =

% change in EPS % change in EBIT

Or, more simply DFL =

EBIT EBIT– I

Where: EBIT = Earnings before interest and taxes 2.

3

The DFL is associated with a specific level of EBIT and changes as EBIT changes.

The purpose of employing financial leverage is to increase return to the owners, but its use also increases their risk.

Perspective 5-4: The impact of financial leverage can also be viewed in Figure 5-4.

PPT

Impact of Financial Plan on Earnings per Share (Table 5-5)

PPT

Financing Plans and Earnings per Share (Figure 5-4)

C.

Limitations to Use of Financial Leverage: 1.

2.

IV.

As the firm becomes more highly leveraged and creditors take on more risk, they will demand higher interest rates that countermand the benefits of financial leverage.

As the risk to the stockholders increases with leverage, their required rate of return increases and stock prices may decline.

Combining Operating and Financial Leverage A.

Combining operating and financial leverage provides maximum magnification of

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returns, but it also magnifies the risk.

B. PPT

The combined leverage effect can be illustrated through the income statement.

Income Statement (Table 5-6)

Perspective 5-5: Operating income is the end result of operating leverage and the beginning factor for financial leverage (in the form of earnings before interest and taxes). These relationships are further enforced through Figure 5-5.

PPT Combining Operating and Financial Leverage (Figure 5-5) PPT Operating and Financial Leverage (Table 5-7) V.

Degree of Combined Leverage A.

The degree of combined leverage (DCL) is a measure of the effect on net income as a result of a change in sales. The DCL is computed similarly to DOL or DFL. DCL =

B.

% change in EPS % change in sales

The DCL may also be computed as follows:

DCL =

Q(P − VC) CM = Q(P − VC) − FC − I EBT

Perspective 5-6: Reinforce the interactive nature of the various forms of leverage. Many firms in the Japanese economy use both high operating and financial leverages. Because of their high combined leverage, they are hesitant to lose volume and therefore are extremely competitive in pricing.

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Finance in Action: Give Shareholders a Slice of the Apple and Leverage Rises The Apple Computer company example illustrates the rise of cash that resulted from a series of blockbuster product sales (i.e., iPod and iPhone). Apple was able to grow its cash flow from operations from just over $80 million in 2002 to over $80 billion in 2015. Between 2012 and 2020, Apple paid dividends amounting to $103 billion and repurchased $378 billion in stock.

This was titled their “capital return program.” Prior to beginning this program, Apple’s debt-toasset ratio was less than 33%, but by 2020 had risen to 79%.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 3, Glen Mount Furniture Company (financial leverage) Case 4, Genuine Motor Products (combined leverage)

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Working Capital and the Financing Decision

6

Author’s Overview The chapter introduces the student to the topic of working capital management. The emphasis is on the buildup of current assets and how they can best be financed. Examples of Harley Davidson, Target, and Macy’s are used to show that seasonal earning and sales go hand in hand. Companies in cyclical or seasonal industries have a more challenging job of managing their current assets. Such key topics as the impact of production on financing needs and the differences between temporary and permanent assets are considered. Also, the relative costs and volatility of short- and long-term financing are evaluated, with an emphasis on the term structure of interest rates. The chapter provides the framework from which to move into the next two chapters, which cover the management of specific short-term assets and sources of short-term financing.

Chapter Concepts LO1. Explain how working capital management involves financing and controlling the current assets of the firm.

LO2. Recall that management must distinguish between current assets that are easily converted to cash and those that are more permanent.

LO3. Recognize the financing of an asset should be tied to how long the asset is likely to be on the balance sheet.

LO4.

Explain why long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates.

LO5. Recall risk, as well as profitability, determines the financing plan for current assets.

LO6. Illustrate why expected value analysis may sometimes be employed in working capital management.

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Annotated Outline and Strategy I. Introduction A.

Working capital management involves the financing and management of the current assets of the firm.

B.

It is the financial manager’s most time-consuming function.

C.

Success in managing current assets in the short run is critical for the firm’s long-run existence.

Finance in Action: The Future of Commerce - Shopify Online shopping mushroomed during the pandemic and Shopify created an online digital commerce engine that includes website design, photography payment systems, product sourcing, inventory management and shipping. Shopify has made it easier for small entrepreneurs to compete with Amazon and other large on-line retailers.

II.

The Nature of Asset Growth A.

Changes in current assets may be “temporary” (seasonal) or “permanent.”

1.

2.

3.

Current assets by definition are those expected to become cash in one operating cycle, but the level of the current assets may be “permanent” or “temporary.”

Businesses subject to cyclical sales may have temporary fluctuations in the level of current assets, such as inventory. These temporary current assets are “self-liquidating.” Their use (or sale) will generate sufficient cash to pay back the funds borrowed to obtain them.

Businesses experiencing permanent growth will see a permanent increase in current assets, such as accounts receivable. The average balance in accounts receivable will go up and stay up as long as sales are high.

PPT The Nature of Asset Growth (Figure 6-1) III.

Controlling Assets—Matching Sales and Production A.

When a firm produces more than it sells, inventory rises. When sales rise faster than production, inventory declines and receivables rise.

B.

Level production (matching production and sales over an entire cycle) may cause large buildups in current assets (inventory) when sales are slack. These buildups drop

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rapidly during peak demand periods when sales exceed the level production output.

C.

Figure 6-2 demonstrates the quarterly sales and earnings per share for Harley Davidson while Figure 6-3 illustrates the same principle for Target and Macy’s. In both cases, as sales grow over time, these permanent increases in associated working capital have to be financed.

PPT Quarterly Sales and Earnings Per Share for Harley Davidson (Figure 6-2) PPT Quarterly Sales and Earnings Per Share, Target and Macy’s (Figure 6-3)

Perspective 6-1: The Yawakuzi example brings into focus the relationship among level production, varying levels of sales, and current asset financing. Tables 6-1 through 6-5 and Figure 64 are essential to the presentation.

PPT Yawakuzi Sales Forecast (in units) (Table 6-1) PPT Yawakuzi’s Production Schedule and Inventory (Table 6-2) PPT Sales Forecasts, Cash Receipts and Payments, and Cash Budget (Table 6-3) PPT Total Current Assets, First Year ($ millions) (Table 6-4) PPT Cash Budget and Assets for Second Year with No Growth in Sales ($ millions) (Table 6-5) PPT The Nature of Asset Growth (Yawakuzi) (Figure 6-4) IV.

Patterns of Financing: Flexible based on management’s willingness to accept risk.

A.

Ideally, temporary increases in current assets are financed by short-term funds and permanent current assets are financed with long-term sources.

PPT Matching Long-Term and Short-Term Needs (Figure 6-5) B.

Matching short-term funds with short-term assets allows the company to increase and decrease sources and uses of funds as the company’s sales fluctuate.

C.

Many firms, however, choose or are forced to use plans that do not match financing

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with asset needs.

D.

Financing a high percentage of short-term assets with long-term funds means the firm will have to pay interest costs on the excess funds even when the funds are not needed.

PPT Using Long-Term Financing for Part of Short-Term Needs (Figure 6-6) E.

Financing permanent current assets and some long-term assets with short-term funds is quite risky. Short-term funds will be permanently needed and thus cost is highly volatile. Also, sources of short-term funds are not always available in tight credit markets.

PPT Using Short-Term Financing for Part of Long-Term Needs (Figure 6-7) V.

The Financing Decision A.

Figure 6-8 presents a decision-tree diagram that illustrates the various sources of financing that can be used by a corporation.

B.

The term structure of interest rates indicates the relative costs of short- and long-term financing and is important to the financing decision.

Perspective 6-2: The discussion of the term structure of interest rates provides a good opportunity to relate the cost of financing to the working capital decision.

C.

The relationship of interest rates at a specific point in time for securities of equal risk but different maturity dates is referred to as the term structure of interest rates.

D.

There are three theories describing the shape of the yield curve.

1.

2.

3.

Liquidity premium theory: presumes that long-term rates should be higher than short-term rates because long-term securities are less liquid and more price sensitive.

Market segmentation theory: postulates that the yield curve is “shaped” by the maturity preferences of the various investors. Some institutions such as commercial banks are primarily interested in short-term securities. Others such as insurance companies manifest a preference for much longer-term securities.

Expectations hypothesis: maintains that long-term rates reflect the average of expected short-term rates over the time period that the long-term security is

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outstanding. Table 6-6 demonstrates how the expectations theory can be used to calculate long-term rates given the expectations of future one-year rates.

PPT E.

Expectations Theory (Table 6-6)

The term structure of interest rates is depicted by yield curves shown in Figure 6-9.

Types of yield curves 1.

2.

3.

VI.

Upward sloping: normal shape; shorter maturities have lower required yields.

Inverted, downward sloping: short-term rates are higher than intermediate or long-term rates.

Yield curves shift upward and downward in response to changes in anticipated inflation rates and other conditions of uncertainty.

PPT

Treasury Yield Curve (Figure 6-9)

PPT

Long- and Short-Term Annual Interest Rates (Figure 6-10)

A Decision Process A.

The composition of a firm’s financing of working capital is made within the riskreturn framework.

B.

Short-term financing is generally less costly but more risky than long-term financing.

During tight money periods, short-term financing may be unavailable or very expensive.

PPT

Alternative Financing Plans (Table 6-7)

PPT

Impact of Financing Plans on Earnings (Table 6-8)

C.

By applying the probabilities of the occurrence of various economic conditions, an expected value of alternative financing strategies may be computed and used as a decision basis.

PPT Expected Returns under Different Economic Conditions (Table 6-9)

PPT

Expected Returns for High-Risk Firm (Table 6-10)

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VII.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Toward an Optimum Policy A.

An aggressive firm will borrow short term and maintain relatively low levels of liquidity. Panel 1 in Table 6-11 represents the aggressive firm.

B.

The conservative firm (Panel 4) will maintain high liquidity and utilize more longterm financing.

C.

Moderate firms compensate for short-term financing with highly liquid assets (Panel 2) or balance low liquidity with long-term financing (Panel 3).

PPT

Asset Liquidity and Financing Assets (Table 6-11)

D.

Risk versus return considerations also affect the composition of the left-hand side of the balance sheet.

E.

A firm may compensate for high risk on the financing side with high liquidity on the asset side or vice versa.

Finance in Action: Working Capital Problems in a Small Business The solution to seasonal working capital problems that plague small businesses is sufficient flexible planning to ensure that profits produced during the peak season are available to cover losses during the off-season. This is true because small firms have trouble finding sources of funds for seasonal needs. This can be tied back into financial markets and the changing structure of banking.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 5, Gale Force Surfing working capital—Level vs. seasonal production

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Current Asset Management

7

Author’s Overview The instructor should stress the profitability-liquidity trade-offs to be found in the current asset accounts. The student should think of the less liquid current assets as representing a competitive investment for capital. The four different topics for discussion in the chapter are all worthy of detailed coverage. The material on cash management has real contemporary importance and is usually of interest to the student who has struggled with his or her own cash management. The management of accounts receivable and inventories represents an excellent opportunity to cover decision-making tools that are an important part of financial management.

Chapter Concepts LO1. Recall that current asset management involves the management of cash, marketable securities, accounts receivable, and inventory.

LO2. Explain what is involved in cash management.

LO3. Explain what is involved in the management of marketable securities.

LO4. Detail the requirement of accounts receivable management.

LO5. Determine the level of inventory necessary to enhance sales and profitability.

LO6. Understand that the less liquid an asset is, the higher the required return.

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Annotated Outline and Strategy I.

Introduction: A.

The financial manager must anticipate economic conditions and consumer preferences to effectively allocate resources among current assets.

1.

2.

3.

4.

II.

The primary concern in managing cash and marketable securities is safety and liquidity, then profitability.

The focus of managing accounts receivable and inventory should face the same profitability criteria as any other decision.

We use the retail sector in the introduction as an example of the unpredictability of sales that impacts inventory and receivables management.

Early 2020 saw a halt in the economy from the COVID-19 pandemic. Much of the U.S. population worked from home and Congress sent out stimulus checks and enhanced unemployment benefits as many industries were impacted.

Cash Management: Cash is a necessary but low-earning asset. Financial managers attempt to minimize cash balances and yet maintain sufficient amounts of cash to meet obligations in a timely manner.

A.

The three main reasons for holding cash are for: 1.

2.

3.

B.

Transactions balances Compensating balances for banks Precautionary needs

The cash flow cycle can be used to describe how funds move in and out of the firm.

PPT

The Cash Flow Cycle (Figure 7-1)

PPT

Expanded Cash Flow Cycle (Figure 7-2) C.

III.

E-commerce sales impact cash flow because they typically involve credit cards.

Credit card companies typically advance payment to the vendor within 7–10 days.

Temporarily, excess cash balances are transferred into interest-earning marketable securities.

Collections and Disbursements

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A.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

The dynamics of check payment processing have significantly reduced the time delay between mailing a check and the transfer of funds.

Finance in Action: The Cloud, B2B and Working Capital Management The cloud refers to large data storage facilities that allow companies to use remote computing power and analytics. The cloud has affected corporate practices and profitability especially the business-to-business (B2B) industry supply exchanges. Covisint and Ariba are examples of leading companies in the (B2B) world helping companies automate with their suppliers.

B.

Float: Using the difference in the cash balances shown on the bank’s records and those shown on the firm’s records.

1.

2.

3.

4.

C.

The company’s books reflect a different cash balance than the bank’s books.

Float results because it takes time for checks to move through the mail and through the banking system.

The Check Clearing for the 21st Century Act allows for electronic check processing so that float is significantly reduced.

Increasing use of electronic funds transfers will eventually eliminate float altogether.

Improving collections 1.

2.

Decentralized collection centers speed collection of accounts receivable by reducing mailing time.

Lockbox system—customers mail payment to a post office box serviced by a local bank in their geographical area. Checks are cleared locally and balances transferred by wire to a central location.

D.

Extended disbursement to take advantage of slower clearing of checks. The primary benefits of speeding up inflows or slowing outflows are the earnings generated from the freed-up balances. The benefits must be weighed against the cost.

E.

Cost-benefit analysis

PPT

Cash Management Network (Figure 7-3)

Perspective 7-1: Use Figure 7-3 to illustrate how funds are freed up. Apply a potential rate of return on these funds and relate that to the maximum cost that should be incurred. Also stress that electronic funds transfers will eventually reduce float in the financial system.

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F.

Electronic funds transfers take place domestically through automated clearinghouses (ACHs) and internationally through SWIFT (Society for Worldwide Interbank Financial Telecommunications). The fastest growing area is person-to-person or P2P transfers.

G.

International cash management 1.

2.

3.

PPT IV.

Multinational firms shift funds from country to country daily, maximizing returns and balancing foreign exchange risk.

Disparate time zones, banking systems, culture, taxes, interest rates, and other differences create a nonuniform system in some cases.

Over 11,353 financial institutions in 200 countries use SWIFT for standardized interbank electronic funds transfers. Figure 7-4 shows the high annual growth of international electric funds transfers. Each SWIFT message represents a cash transfer from one account to another.

Eleven-Year SWIFTNet FIN Message Traffic (Figure 7-4)

Marketable Securities A.

Because marketable securities normally represent funds held in reserve, the maturity should be kept reasonably short to avoid interest rate risk.

B.

There is a wide array of securities from which to choose.

1.

2.

3.

Federal government securities Federal agency securities Nongovernment securities a. b. c. d. e. f. g.

PPT

Certificates of deposit Commercial paper Banker’s acceptances Eurodollar certificates of deposit Passbook savings accounts Money market funds Money market accounts

An Examination of Yield and Maturity Characteristics (Figure 7-5)

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Perspective 7-2: Use Table 7-1 to highlight the attributes of the various securities and instruments, stressing the ever-changing nature of the market and competition between financial institutions. It is instructive to compare the high interest rate environment of 1980 (before your students were born) to the historically low interest rates that have existed since 2003. The year 2000 might be an example of more normal rates. The definitions of each type of security are in the text.

V.

PPT

Types of Short-Term Investments (Table 7-1)

PPT

Financing Growth in Accounts Receivable (Figure 7-6)

Management of Accounts Receivable: Accounts receivable as a percentage of total assets have been increasing due to increasing sales, inflation, and extended credit terms during recessions.

A.

Accounts receivable as an investment 1.

Investment in accounts receivable should generate a return equal to or in excess of the return available on alternative investments.

Perspective 7-3: Discuss a credit decision relating the sales function to the credit created by the new accounts. Emphasize that the emphasis should be on rate of return and not on the level of sales.

B.

Credit policy administration: There are three primary factors to consider: 1.

Credit standards a. b. c.

The firm screens credit applicants on the basis of prior records of payment, financial stability, current net worth, and other factors.

5 Cs of Credit: character, capital, capacity, conditions, collateral Dun & Bradstreet Information Services (DBIS) (1) (2) (3)

d.

PPT

Business Information Report Commercial Credit Scoring Report Industry Credit Score Report (See Table 7-2)

D-U-N-S Data Universal Number System is a unique nine-digit code used globally as a business identification number. See Figure 7-7.

D-U-N-S Numerical Tracking System (Figure 7-7)

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2.

3.

Terms of trade Collection policy: Some measures used to assess collection efficiency are: a. b. c.

Average collection period Ratio of bad debts to sales Aging of accounts receivable

Perspective 7-4: The section titled “An Actual Credit Decision” brings together the issues discussed under credit policy administration, with a focus on incremental income from additional sales as well as an analysis on the marginal rate of return.

VI.

Inventory Management A.

Inventory is the least liquid of current assets.

B.

A firm’s level of inventory is largely determined by the cyclical nature of sales and whether it follows a seasonal or level production schedule. The production decision is based on the trade-off of cost savings of level production versus the additional inventory carrying costs.

C.

Rapid price movements complicate the inventory level decision.

D.

There are two basic costs associated with inventory: 1.

Carrying costs: a. b. c. d. e.

2.

Interest on funds tied up in inventory Warehouse space costs Insurance Material handling expenses Risk of obsolescence (implicit cost)

Ordering and processing costs

E.

Carrying costs vary directly with average inventory levels.

F.

Total carrying costs increase as the order size increases.

G.

Total ordering costs decrease as the order size increases.

H.

The first step toward achieving minimum inventory costs is determination of the optimal order quantity. This quantity may be derived by use of the economic order

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

quantity formula: EOQ =

2SO C

where: S = sales in units O = the cost to process an order C = annual carrying costs per unit in dollars

Perspective 7-5: Combine the EOQ formula with Figure 7-8 to clearly illustrate the impact of selecting the optimum order size.

PPT Determining the Optimum Inventory Level (Figure 7-8) PPT Inventory Usage Pattern (Figure 7-9) PPT Total Costs for Inventory (Table 10-2) I.

Assumptions of the basic EOQ model: 1.

2.

3.

Inventory usage is at a constant rate.

Order costs per order are constant.

Delivery time of orders is consistent, and order arrives as inventory reaches zero.

J.

Minimum total inventory costs will result if the assumptions of the model are applicable and the firm’s order size equals the economic ordering quantity.

K.

Safety stock provides a cushion against late delivery or unexpected sales. This will increase the cost of holding inventory but prevent inventory being out of stock.

Finance in Action: NASA Experiments with Inventory Tracking on the International Space Station (ISS) This box illustrates how the use of technology can save time and reduce costs. NASA is experimenting with RFID chips on the ISS to track supplies and to help astronauts find everything from personal supplies to scientific equipment. Since supplies are stocked infrequently in space, it is very important for the astronauts to know their precise needs. The new adaptations to RFID technology deal with the concept of microgravity and will replace the previously used handheld devices.

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K.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Just-in-Time Inventory Management (JIT) 1.

2.

3.

4.

5.

Began in Japan and now used in the U.S. Suppliers are located near manufacturers who are able to make orders in small lot sizes because of short delivery time.

Lower inventory means lower costs The downside of JIT is that any glitch in delivery can shut down the whole production process. In 2011 the tsunami in Japan and the floods in Thailand were good examples of unexpected events that can cause huge problems for companies using just-in-time inventory systems. The worldwide COVID-19 pandemic has caused supply chain problems that still existed at the beginning of 2022.

The COVID-19 of 2020-2021 caught the world by surprise and created a shortage of medical supplies. Worldwide shortages created competition among countries for the limited medical supplies and personal protective equipment.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 6, Modern Kitchenware Co. (cash discount) Case 7, Landis Apparel Co. Case 8, Fresh & Fruity Foods, Inc. (current asset management); this case can also be used after Chapter 8 in the text.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Sources of Short-Term Financing

8

Author’s Overview The instructor has the opportunity to cover the various sources of short-term financing with an eye toward the borrower’s size and the relative cost of doing business. Since banking is such a rapidly changing area, the instructor may wish to highlight some of the changes that are taking place. The student should also get some exposure to the various considerations in computing interest costs.

Throughout the chapter, there are ample opportunities to indicate the advantages and drawbacks of trade credit, bank credit, commercial paper, foreign borrowing, and collateralized borrowing arrangements.

Chapter Concepts LO1. Remember trade credit from suppliers is normally the most available form of short-term financing.

LO2. Recall that bank loans are usually short term and should be paid off from funds from the normal operations of the firm.

LO3. Define commercial paper.

LO4. Discuss how using accounts receivable and inventory as collateral for a loan, the firm may be able to borrow larger amounts.

LO5. Define hedging and explain why it is used.

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Annotated Outline and Strategy I.

Trade Credit A.

Trade credit is usually the largest source of short-term financing

B.

It is a spontaneous source of funds that changes as sales expand or contract

C.

The credit period is set by terms of credit, but firms may be able to “stretch” the payment period.

D.

Cash discount policy 1.

2.

Suppliers may provide a cash discount for early payment.

Foregoing discounts can be very expensive. The cost of failing to take a discount is computed as follows:

Cost of failing

=

to take a cashdiscount

3.

E.

Whether a firm should take a discount depends on the relative costs of alternative sources of financing.

Net Credit Position 1.

2.

II.

360 Discount percent  100 percent − Discount percent Final due date − Discount period

The relationship between a firm’s level of accounts receivable and its accounts payable determines its net trade credit position.

If the firm’s average accounts receivable exceeds average accounts payable, it is a net provider of credit. If payables exceed receivables, the firm is a net user of trade credit.

Bank Credit

Perspective 8-1: Discuss how financial institutions have changed over time. The Gramm-LeachBliley Act in 1999 allowed banks and investment banks to merge and created a more competitive marketplace but also created institutions that were “too big to fail.” The financial crisis of 2007– 2008 that resulted in the Dodd-Frank Act in 2011 impacted the way banks are regulated and has changed the way banks are managing their risk assets.

A. B.

Banks prefer short-term, self-liquidating loans Bank loan terms and concepts

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

1.

Prime rate: The interest rate charged to the most creditworthy borrowers. a. b. c.

PPT

The prime rate serves as a base in determining the interest rate for various risk classes of borrowers.

The prime rate of New York banks receives much attention from government officials in managing the economy.

The prime rate has been more volatile in the last couple of decades than in previous decades.

The Prime Rate versus the London Interbank Offered Rate on U.S. Dollar Deposits (Figure 8-1) d.

The London Interbank Offer Rate (LIBOR) on U.S. dollar deposits is being used worldwide as a base lending rate on dollar loans.

Perspective 8-2: The Finance in Action box “What Will Replace LIBOR?” is a good lesson in ethics because LIBOR would not be changing if it had not been for illegal and unethical conduct among the market makers in the LIBOR market. LIBOR will be phased out by December 31, 2021 and replaced with the Sterling Overnight Index Average (SONIA).

2.

Compensating balances a.

b. c.

3.

Maturity provisions a. b.

4.

As a loan condition, a borrower may be required to maintain a minimum average account balance in the bank equal to a percentage of loans outstanding or a percentage of future bank commitments, and/or pay a fee for services.

Compensating balances raise the cost of a loan and compensate the bank for its services.

If a compensating balance is required, the borrower must borrow more than the amount needed.

Most bank loans are short term and mature within a year.

In the last decade more banks have extended intermediate-term loans (one to seven years) that are paid in installments.

Costs of commercial bank financing—The effective interest rate on a loan depends on the loan amount, interest paid, length of the loan, and method of repayment.

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Perspective 8-3: Review Formulas 8-2 through 8-6, including a comparison of the effective costs of a loan under varying assumptions.

C.

Annual percentage rate 1.

2.

D.

The Truth in Lending Act enacted by Congress in 1968 requires that the annual percentage rate (APR) be given to the borrower. The thrust of the legislation was to protect unwary individuals from paying more than the stated rate without their knowledge.

The APR requires the use of the actuarial method of compounded interest and corresponds to the effective rate used throughout the text.

The Credit Crunch Phenomenon 1.

2.

Credit crunches seem to appear every 3–5 years.

The pattern of the credit crunch has been as follows: a. b. c. d. e.

f.

III.

The Federal Reserve tightens the money supply to fight inflation.

Lendable funds shrink, interest rates rise.

Business loan demand increases due to price-inflated inventories and receivables.

Depositors withdraw savings from banks to seek higher return elsewhere, further reducing bank credit availability.

In the early 1990s, the U.S. saw a different kind of credit crunch from too many bad loans. The supply of funds dwindled and caused record bankruptcies for banks and savings and loans.

During the 2020-2021 pandemic, bank balance sheets were healthy, and money was available for loans. Congress passed the CARES Act which guaranteed bank loans focusing on small businesses.

Financing through Commercial Paper A.

Short-term, unsecured promissory notes issued to the public in minimum units of $25,000.

B.

Issuers 1.

2.

3.

Finance companies such as General Motors Acceptance Corporation (GMAC) that issue paper directly. Such issues are referred to as finance paper or direct paper.

Industrial or utility firms issue paper indirectly through a dealer. This type of issue is called dealer paper.

Asset-backed commercial paper was primarily bundled mortgage-backed

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securities that increased in popularity until the banking crises in 2007.

C.

There has been very rapid growth in the commercial paper market in the last few decades. Using Figure 8-2, emphasize how the commercial paper market collapsed in 2007 and continued on a downhill slide until it stabilized beginning in 2012. Only nonfinancial paper has returned close to its previous peak set in 2001.

PPT

Total Commercial Paper Outstanding (Figure 8-2)

D.

Traditionally, commercial paper has been a paper certificate issued to the lender to signify the lender’s claim to be repaid. There is a growing trend among companies that sell and buy commercial paper to handle the transaction electronically. Actual paper certificates are not created. Documentation of the transactions is provided by computerized book-entry transactions and transfers of money are accomplished by wiring cash between lenders and commercial paper issuers.

E.

Advantages 1.

2.

3.

F.

Limitations 1.

2.

PPT

IV.

Commercial paper may be issued at below the prime interest rate at commercial banks.

No compensating balances are required, though lines of credit are necessary.

Prestige.

The primary limitation is the possibility that the commercial paper market might “dry up” unexpectedly, as it does whenever an investment grade company has its credit rating lowered by Standard & Poor’s, Moody’s, or Fitch.

A credit crisis like the one of 2007–2009 might cause the market to stop functioning for a period of time.

Comparison of Commercial Paper Rate to Prime Rate (annual rate*) (Table 8-1)

Foreign Borrowing A.

Loans from foreign banks are an increasing source of funds for U.S. firms.

B.

Foreign loans denominated in U.S. dollars are called Eurodollar loans. These loans are usually short to intermediate term in maturity.

C.

A possibly cheaper alternative to borrowing Eurodollars is the borrowing of foreign

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

currencies that are converted to dollars and forwarded to the U.S. parent company.

V.

VI.

Use of Collateral in Short-Term Financing A.

The lending institution may require collateral to be pledged when granting a loan.

B.

Lenders lend on the basis of the cash flow capacity of the borrower. Collateral is an additional but secondary consideration.

Accounts Receivable Financing 1.

Pledging accounts receivable as collateral a. b. c. d. e.

PPT

Convenient means of financing. Receivable levels are rising as the need for financing is increasing.

May be relatively expensive and preclude use of alternative financing sources.

Lender screens accounts and loans a percentage (60 to 80 percent) of the acceptable amount.

Lender has full recourse against borrower.

The interest rate, which is usually well in excess of the prime rate, is based on the frequently changing loan balance outstanding.

Receivables Loan Balance (Table 8-2) 2.

Factoring Receivables a. b. c.

Receivables are sold, usually without recourse, to a factoring firm.

A factor provides a credit-screening function by accepting or rejecting accounts.

Factoring costs.

(1) (2)

3.

Commission of 1 to 3 percent of factored invoices Interest on advances

Asset-backed public offerings of receivables a. b.

Public offerings of securities backed by receivables as collateral are a means of short-term financing.

Several problems exist: (1)

Historically, firms that sold receivables were considered to be in financial trouble.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

(2)

VII.

The receivables might not be paid in the case of a recession or credit crisis.

Inventory Financing A.

The collateral value of inventory is based on several factors.

1.

Marketability a. b.

2.

3.

4.

Raw materials and finished goods are more marketable than goodsin-process inventories.

Standardized products or widely traded commodities qualify for higher percentage loans.

Price Stability Perishability Physical Control a. b.

c.

Blanket inventory liens: Lender has general claim against inventory of borrower. No physical control.

Trust receipts: Also known as floor planning; the borrower holds specifically identified inventory and proceeds from sales in trust for the lender.

Warehousing: Goods are physically identified, segregated, and stored under the direction of an independent warehousing company.

Inventory is released from warehouse openly upon presentation of warehouse receipt controlled by the lender.

(1) (2)

Public warehouse—facility on the premises of the warehousing firm.

Field warehouse—independently controlled facility on the premises of borrower.

B.

Inventory financing and the associated control methods are standard procedures in many industries.

C.

Appraisal of inventory control devices 1.

Field warehousing is popular in grain storage and food canning. Wellmaintained control measures involve substantial expense and raise cost of borrowing. Cost of inventory may run 15% or higher.

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Finance in Action: How About Going to the Internet to Borrow Money?

This article discusses a form of Internet social lending that shows promise as a source of financing.

To avoid high interest rates from traditional lenders, borrowers are finding lower-rate loans on the Internet through loan brokerage sites such as Prosper.com or LendingClub. Like eBay or other auction sites, borrowers register their loan needs, including the amount needed, the length of time the funds will be needed, and the interest rate they are willing to pay. Lenders register the amount they have to loan, starting with as little as $50 and the rate they want to receive. Loans can then be consolidated from several small lenders so the risk to any one lender is minimized.

VIII. Hedging to Reduce Borrowing Risk A.

Firms that continually borrow to finance operations are exposed to the risk of interest rate changes.

B.

Hedging activities in the financial futures market reduce the risk of interest rate changes.

C.

Hedging involves entering into a contract to buy or sell treasury bonds in the future, at a price negotiated in the present. Changes in the interest rate will drive changes in the future purchase price of the investment and result in a profit or loss.

Perspective 8-4: Hedging and the use of derivative products is one of the hottest topics in finance.

This example helps explain the general concept of hedging.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 9, Pierce Control System (bank financing)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

The Time Value of Money

9

Author’s Overview This is one of the most important chapters in the book as far as student comprehension is concerned. The instructor should first determine how much prior knowledge of time value of money the students have acquired from accounting or lower mathematics. While most students are generally familiar with the concepts of future value and present value, they often lack the ability to identify and categorize the nature of the problem before them.

The material in this chapter will serve as a springboard to the remaining chapters in this section on valuation, cost of capital, and capital budgeting–related topics. A good background in time value of money will ease the transition. The authors suggest a liberal use of homework problems and a quiz to reinforce the importance of this material.

This chapter uses color-coordinated figures to explain the relationships between present value and future value, present value and the present value of annuities, and future value and the future value of annuities. These color-coded figures are helpful to those more visually oriented students who may not understand the mathematical relationships between these time value calculations.

For faculty who want to emphasize Excel spreadsheets and calculator keystrokes, this chapter provides an excellent opportunity to develop both skills. Using spreadsheets with time-value exercises can be especially instructive in understanding the concept of how higher discount rates generate lower cash flows and vice versa.

Chapter Concepts LO1. Explain the time value of money and how a dollar received today is worth more than a dollar received in the future.

LO2. Recognize that future value is based on the number of periods over which the funds are to be compounded at a given interest rate.

LO3. Recognize that present value is based on the current value of funds to be received.

LO4. Calculate yield on investment (rate of return), annuity due, and payments required.

LO5. Recall that compounding or discounting may take place on a less-than-annual basis such as © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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semiannually or monthly.

Author’s Note: In previous editions of Foundations of Financial Management, the authors have emphasized the use of time value tables in the text. This has presented several problems. With the advent of computer-generated problem sets, the tables were not precise and caused students who used calculators and spreadsheets much frustration because of rounding errors created by truncating the table values. This also caused difficulty for instructors because students could get different answers using the tables than with calculators or spreadsheets. In later editions, we have revamped this chapter to introduce calculator and Excel spreadsheets as the primary way to calculate time value problems. Because many of our users like to use tables, we have kept that pedagogy, but now it is found at the end of the chapter.

Annotated Outline and Strategy I.

Relationship to the Capital Outlay Decision: Capital budgeting involves the analysis of whether funds invested today will be more than offset by the value of the funds received from the investment in the future.

II.

Future Value—Single Amount A.

In determining future value, we measure the value of an amount that is invested now and allowed to grow at a given interest rate over a specified period of time.

FV = PV(1+ i)n

B.

The relationship may be expressed by the following table formula: FV = PV  FVIF

The FVIF term is found using the calculator keystrokes. We use a $1,000 example rather than $1 (also see Appendix 9A).

PPT C.

Future Value of $1, FVIF =(1+i)n (Table 9A-1)

Using a financial calculator to derive the future value of a single payment, enter the known values for the following:

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

N enter the number of interest periods I/Y enter the annual interest rate PV enter the present value amount PMT enter zero FV leave blank Then press the CPT key and then the FV key (The resulting value will appear as a negative number.)

Perspective 9-1: One or two numerical examples using the Excel spreadsheet are helpful.

III.

Present Value—Single Amount A.

The present value of a future sum is the investment required today that will equal the future sum at a specified time at a given interest rate.

PPT PPT

Present Value of $1, FVIF =(1+i)n (Table 9A-2) Relationship of Present Value and Future Value (Figure 9-1)

Perspective 9-2: Use Figure 9-1 to demonstrate the relationship between present and future value.

B.

The relationship may be expressed in the following formula: PV = FV

C.

1 (1+ i)n

The formula may be restated as: PV = FV PVIF

The PVIF term is found using calculator keystrokes. We use $1,000 rather than $1 in our example (also see Appendix 9B).

D.

Using a financial calculator to derive the present value of a single future payment, enter the known values for the following: N enter the number of interest periods I/Y enter the annual interest rate PV leave blank PMT enter zero FV enter the future value amount Then press the CPT key and then the PV key (The resulting value will appear as a negative number.)

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PPT

Excel example of Present Value Calculation – page 258.

Perspective 9-3: We would suggest using the Excel spreadsheet example on page 258 to show the relationship of the present value to the discount rate and time period.

IV.

Interest Rate—Single Amount A.

When we know the future value, the present value, and the time period, we can solve for the interest rate or the rate of return on an investment.

B.

Using Formula 9-3 we find that: 1

 FV n i =  −1  PV  C.

We can use calculator keystrokes or the Excel spreadsheet to solve for the interest rate.

PPT

V.

VI.

Excel example of Interest Rate Calculation – page 259.

Number of Periods—Single Amount A.

Following up on the interest rate example, we can use Formula 9-4 to solve for the number of periods it takes to grow (compound) $1,000 to $1,464.10 if we know the rate of return is 10%.

B.

Once again, using the spreadsheet example on page 259 or the calculator keystrokes, you can demonstrate how many years it takes to compound $1,000 to $1,464.10.

Future Value—Annuity A.

An annuity represents consecutive payments or receipts of equal amounts over equal time intervals.

B.

The annuity value is normally assumed to take place at the end of each period.

C.

The future value of an annuity represents the sum of the future value of the individual flows.

PPT

Compounding Process for Annuity (Figure 9-2)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

PPT

Future Value of an Annuity of $1, FVIFA = [(1 + i)n – 1]/i (Table 9A-3)

Perspective 9-4: While we have reduced the emphasis on the tables, they are a good visual way to show the students how the numbers progress.

D.

The formula for the future value for an annuity is given in Formula 9-5:

The FVIFA term is found using the calculator keystrokes or the Excel spreadsheet on page 261 (also see Appendix C).

E.

Using a financial calculator to derive the future value of an annuity, enter the known values for the following: N enter the number of interest periods I/Y enter the annual interest rate PV enter zero PMT enter the periodic payment FV leave blank Then press the CPT key and then the FV key (The resulting value will appear as a negative number.)

F.

Use the Spreadsheet on page 261 to demonstrate the future value of an annuity.

Finance in Action: Powerball Jackpot Decisions The odds of winning are now 1 in 292 million after Powerball changed the number of choices for the white and red numbers, and many students will be quite familiar with the $768. million Powerball prize won in March of 2019. However, the purpose of the box is to demonstrate the impact that present value has on an annuity prize taken as a lump sum payout. As a sidebar, you might want to bring in what taxes do the lump sum payout.

VII.

Present Value—Annuity A.

The present value of an annuity represents the sum of the present value of the individual cash flows.

B.

The formula for the present value of an annuity is presented in Formula 9-6 (also see Appendix D for PVIFA)

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C.

Using a financial calculator to derive the present value of an annuity, enter the known values for the following: N enter the number of interest periods I/Y enter the annual interest rate PV leave blank PMT enter the periodic payment FV enter zero Then press the CPT key and then the PV key (The resulting value will appear as a negative number.)

D.

The annuity value associated with a present value is often associated with withdrawal of funds from an initial deposit or the repayment of a loan.

Perspective 9-5: An example that might ring true with the students is to have them use the Excel spreadsheet on page 263 to calculate their annual or monthly student loan repayment once they graduate from college and have a job. It might be an eye-opening exercise.

VIII. Graphical Presentation of Time Value Relationships A.

Use Figures 9-3 and 9-4 to show that present value and future value are inversely related.

B.

Use Figures 9-5 and 9-6 to demonstrate how annuities are the sums of single period values.

PPT

Future Value of $0.68 at 10%

(Figure 9-3)

PPT

Present Value of $1.00 at 10%

(Figure 9-4)

PPT

Present Value of $1.00 at 10%

(Figure 9-5)

PPT

Future Value of $0.68 at 10%

(Figure 9-6)

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IX.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Determining the Annuity Value (The amount of the periodic payment that would grow to the requisite future value or be discounted to the requisite present value) A.

Annuity equaling a future value 1.

The formula for the future value for an annuity is found in Formula 9-7: A=

PPT

FVA (1+ i)n −1   i  

Relationship of Present Value to Annuity (Table 9-1)

Perspective 9-5: Demonstrate how annuities work in everyday situations.

PPT 2.

B.

Payoff Table for Loan (Amortization Table) (Table 9-2) Using a financial calculator to derive the annuity value required to achieve a future amount, enter the known values for the following: N enter the number of interest periods I/Y the periodic interest rate PV enter zero PMT leave blank FV enter the future value amount Then press the CPT key and then the PMT key (The resulting annuity value will appear as a negative value.)

Annuity equaling a present value 1.

The formula for the present value of an annuity is presented in Formula 9-8: A =  PVA 1− 1   (1+ i)n    i    

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X.

XI.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

2.

Using a financial calculator to derive the annuity value required to achieve a present amount, enter the known values for the following: N enter the number of interest periods I/Y the periodic interest rate PV enter the present value amount PMT leave blank FV enter zero Then press the CPT key and then the PMT key (The resulting annuity value will appear as a negative value.)

3.

Finding annuity payments using Excel’s PMT function: The PMT function assumes that each payment is at the end of a period. Either the PV or FV argument must be entered. See the example on page 269-270.

Finding Interest Rates and the Number of Payments A.

Finding annuity interest rates using calculator keystrokes or Excel: See discussion on page 270.

B.

Finding the number of annuity payments using calculator keystrokes or Excel: See discussion on page 271.

Compounding over Additional Periods A.

Compounding semiannually requires us to cut the annual interest rate in half and to multiply the number of periods by two. Consequently, quarterly compounding divides the interest rate by four and multiplies the periods by four. See Case 1 and Case 2 on pages 271.

B.

Patterns of payment with a deferred annuity: Sometimes an annuity does not start being received until several years in the future, and under these conditions, we need to calculate the present value of each payment. There are several ways to do the calculation. See examples on pages 272 and 273.

C.

Annuities due: Annuities that start at the beginning of the period rather than at the end of the period. Use the Excel spreadsheet on page 275 to demonstrate both present value and future values of annuities due.

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XII.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Alternative Calculations: Using TVM Tables—Appendix 9A & B, Pages 284–290 A.

Future value of a single amount 1.

In determining future value, we measure the value of an amount that is invested now and allowed to grow at a given interest rate over a specified period of time.

FV = PV(1+ i)n

2.

The relationship may be expressed by the following formula: FV = PV FVIF

B.

Present value of a single amount 1.

C.

The present value of a future sum is the investment required today at a given interest rate that will equal the future sum at a specified point in time.

2.

The relationship may be expressed in the following formula: 1 PV = FV n (1+ i) Future value of an annuity 1.

2.

3.

4.

An annuity represents consecutive payments or receipts of equal amounts over equal time intervals.

The annuity value is normally assumed to take place at the end of each period.

The future value of an annuity represents the sum of the future value of the individual flows.

The formula for the future value for an annuity is: FVA = A  FVIFA

D.

Present value of an annuity 1.

2.

The present value of an annuity represents the sum of the present value of the individual cash flows.

The formula for the present value of an annuity is: PVA = A  PVIFA

XIII.

Appendix 9 C Using Calculators for Financial Analysis pages 290-298 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 10, Allison Boone, M.D. (time value of money) Case 11, Billy Wilson, All American (time value of money) Case 12, Sarah Gilbert, Retiree (time value of money)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Valuation and Rates of Return

10

Author’s Overview The student can clearly see that the material covered in the previous chapter on time value of money is now being applied. The recurring theme throughout the chapter is that valuation is based on the present value of benefits to be received in the future. The instructor should establish this point at the outset and then repeatedly demonstrate it in the evaluation of bonds, preferred stock, and common stock. The instructor should also emphasize the relationship of the discount rate in present value analysis to the required rate of return demanded by security holders. The authors suggest that the instructor go through the process of defining the investor’s required return in terms of a real rate of return, an inflation premium, and a risk premium. The instructor can then vary one of these components and show the impact on overall required return and valuation.

Not all professors wish to use an example of supernormal growth, so we have included Appendix 10A to cover this topic. This model is good at demonstrating that Ke (the required rate of return on equity) has to be greater than g (the expected growth rate) in order to use the constant divided growth model. When growth is greater than the required rate of return, the supernormal growth model is appropriate. This appendix will help solidify the concepts of uneven cash flow before getting into the capital budgeting section.

Chapter Concepts LO1. Know the valuation of a financial asset is based on the present value of future cash flows.

LO2. Recognize that the required rate of return in valuing an asset is based on the risk involved.

LO3. Recall that bond valuation is based on the process of determining the present value of interest payments plus the present value of the principal payment at maturity.

LO4. Explain the basis of preferred stock valuation.

LO5. Explain how stock valuation is determined.

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Annotated Outline and Strategy PPT

I.

II.

The Relationship between Time Value of Money, Required Return, Cost of Financing, and Investment Decisions (Figure 10-1)

Valuation Concepts A.

The value of an asset is the present value of the expected cash flows associated with the asset. To compute the present value of an asset, an investor must know or estimate the amount of expected cash flows, the timing of expected cash flows, and the risk characteristics of the expected flows.

B.

The price (present value) of an asset will be based on the collective assessment of the asset’s cash flow characteristics by the many capital market participants.

Valuation of Bonds A.

The value of a bond is derived from cash flows composed of periodic interest payments and a principal payment at maturity.

B.

The present value (price) of a bond is equal to the present value of the interest payments plus the present value of the principal (Face Value or Par Value) payment.

It is given in Formula 10-1 as follows: = Pb

n

It

(1+ Y )t t =1

where: Pb = It = Pn = t = n = Y = 1.

+

Pn (1+ Y )n

price of the bond interest payments principal payment at maturity period from 1 to n total number of periods yield to maturity (required rate of return)

The present value of interest payments can be calculated using Formula 9-6 from the previous chapter.

1− PVA = A

1 (1+ i)n i

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2.

The present value of the principal payment (par value) at maturity may be computed by applying Formula 9-2 from the previous chapter.

PV = FV 

3.

1 (1+ i)n

The present value (price) of the bond will be the sum of the present value of the interest payments plus the present value of the principal.

Perspective 10-1: Sometimes it is instructive to have the students calculate the present value of the interest payments and principal independently rather than just the final bond price. This can be valuable in showing how a change in required return or maturity can cause the two cash flows to change. This is most easily demonstrated using a calculator or an Excel spreadsheet.

C.

Bond valuation using a financial calculator, or an Excel spreadsheet is presented on page 302-303 of the text. The Excel spreadsheet is a very instructive way to do sensitivity testing by varying the years to maturity and the required rate of return.

PPT D.

Use the Excel Example on page 303 to calculate a Bond Price Concept of yield to maturity 1.

Three factors influence an investor’s required rate of return on a bond. a.

b. c.

The required real rate of return: the rate of return demanded for giving up current use of funds on a no-risk, non-inflation-adjusted basis.

An inflation premium: a premium to compensate the investor for the effect of inflation on the value of the dollar.

Risk premium: all financial decisions are made within a risk-return framework. An astute investor will require compensation for risk exposure. There are two types of risk associated with the required rate of return (yield to maturity) on a bond: (1) (2)

E.

Business risk is the possibility of a firm not being able to sustain its competitive position and growth in earnings.

Financial risk is the possibility that a firm will be unable to meet its debt obligations as they come due.

Changing the yield to maturity and the impact on bond valuation 1.

Bond prices are inversely related to required rates of return. A change in the required rate of return will cause a change in the bond price in the opposite direction.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

PPT

Bond Prices Given Various Yields to Maturity (20-year bond, 10% coupon) (Table 10-1)

Perspective 10-2: Table 10-1 illustrates the impact of differences between yield to maturity and coupon rates on bond prices and reinforces the inverse relationship between bond prices and required yield to maturity.

2.

PPT

The impact of the change in required rate of return on the bond price is dependent upon the remaining time to maturity. The impact will be greater as the time to maturity increases.

Impact of Time to Maturity on Bond Prices (Table 10-2)

Perspective 10-3: Table 10-2 shows the critical effect of time to maturity on bond price sensitivity. The longer the time to maturity, the bigger the change in bond price.

PPT

Relationship between Time to Maturity and Bond Price* (Figure 10-2) 3.

*The relationship in the graph is not symmetrical

Perspective 10-4: The critical effect of time to maturity on bond price sensitivity is further supported by this figure.

F.

Determining yield to maturity from the bond price 1.

If the bond price, interest rate on the bond, and number of years to maturity are known, the yield to maturity (market-determined required rate of return) can be computed.

2.

The yield to maturity can most easily be found using a financial calculator.

The keystrokes are as follows: N Number of years to maturity PV Present value of the bond (current bond price) PMT Interest payment (annuity) FV Future value (par value at maturity) Function CPT I/Y The example in the text gives a yield of 12 percent

3.

The yield to maturity can also be found by using the Goal Seek function in Excel. The Goal Seek function can be found in the most recent version of Excel on the Data tab, in the Data Tools group under What-If Analysis.

Examples of this spreadsheet are found on page 314 in the text.

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PPT

Excel Functions for YTM (Table 10-3)

PPT

Finding the Goal Seek Function in Excel (Figure 10-3)

G.

Semiannual interest and bond prices: Often interest payments are made more frequently than once a year. Semiannual interest payments are common. To compute the price of such a bond, we divide the annual amount of interest and the yield to maturity by two and multiply the number of years to maturity by two. For example, 10 years would be 20 semiannual periods. Annual coupon payments of $60 would be semiannual payments of $30, and an annual yield to maturity of 8 percent would become a semiannual yield to maturity of 4 percent.

Perspective 10-5: Students have the opportunity to use both the annual and semiannual approaches in working problems at the back of the chapter.

III.

Valuation and Preferred Stock Dp Dp Dp Dp P p= (1+ K )1+ (1+ K )2 + (1+ K )3 + .... + (1 + K )n p

p

p

A.

Preferred stock is usually valued as a perpetual stream of fixed dividend payments where: Pp = the price of preferred stock Dp = the annual dividend for preferred stock (a constant value) Kp = the required rate of return (discount rate) applied to preferred stock dividends

B.

Since the dividend stream is a perpetuity, the preferred stock valuation formula can be reduced to a more usable form Pp =

Dp Kp

C.

If Kp changes after preferred stock is issued, Pp will change in an inverse fashion.

Since preferred stock theoretically has a perpetual life, it is highly sensitive to changes in the required rate of return (Kp).

D.

If the market price of preferred stock and the annual dividend are known, the marketdetermined required rate of return can be computed by using the valuation equation and solving for Kp.

Pp =

Dp Kp

then

K p=

Dp Pp

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IV.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Valuation of Common Stock A.

The value of a share of common stock is the present value of an expected stream of future dividends

D1 P0 = ( 1+ K e ) +

D2 ( 1+ K e )

2

D3

+

( 1+ K e )

3

+ .....+

Dn ( 1+ K e )

n

where: P0 = price of the stock at time zero (today) D = dividend for each year Ke = the required rate of return for common stock (discount rate_ B.

Unlike dividends on most preferred stock, common stock dividends may vary. The valuation formula may be applied, with modification, to three different circumstances: no growth in dividends, constant growth in dividends, and variable growth in dividends.

1.

No Growth in Dividends. Common stock with constant (no growth) dividends is valued in the same manner as preferred stock.

P0 =

D0 Ke

where: P0 D1 Ke 2.

= price of common stock today = current annual dividend on common stock (a constant value) = required rate of return for common stock

Constant Growth in Dividends. The price of common stock with constant growth in dividends is the present value of an infinite stream of growing dividends. Fortunately, in this circumstance the basic valuation equation can be reduced to the more usable form below if the discount rate (Ke) is assumed to be greater than the growth rate.

P0 =

D1 (K e − g)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

where: P0 = price of stock today D1 = dividend expected at the end of the first year = D0(1 + g) Ke = required rate of return for common stock (discount rate) g = constant growth rate in dividends a.

b.

3.

The above formula can also be thought to represent the present value of dividends for a period of time (such as n = 3) plus the present value of the stock price after a period of time (such as P3). Since P3 represents the present value of dividends from D4 through Dn, P0 will still represent the present value of all future dividends.

The value of P0 is quite sensitive to any change in the required rate of return (Ke) and the growth rate (g).

Rearrangement of the constant growth equation allows the calculation of the required rate of return, Ke, when P0, D1, and g are given.

Ke =

D1 +g P0

The first term represents the dividend yield that the stockholder expects to receive, and the second term represents the anticipated growth in dividends, earnings, and stock price.

4.

PPT

The price-earnings ratio concept and valuation. Stock valuation may also be linked to the concept of price-earnings ratios discussed in Chapter 2.

Although this is a less theoretical, more pragmatic approach than the dividend valuation models, the end results may be similar because of the common emphasis on risk and growth under either approach.

Quotations from finance.yahoo.com (Figure 10-4)

Perspective 10-6: Figure 10-4 from finance.yahoo.com illustrates how P/E ratios are shown in the financial press. Coca-Cola is used as an example, and dividend yield and price changes can also be mentioned to stimulate interest.

5.

Variable growth in dividends. The most likely variable growth case is one of supernormal growth followed by constant growth. a.

Value can be found through taking the present value of the dividends during the supernormal growth period plus the price of the stock at end of the supernormal growth period. Since growth is then constant, Formula 10-8 can be used for the terminal value.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Finance in Action: An Important Question—What’s a Small Business Really Worth?

This box presents some of the practical issues faced in valuing a small business and serves as a contrast to the formulas presented in the text. b.

c.

Another type of variable growth is where the firm is assumed to pay no dividends for a period of time and then begins paying dividends.

In this case, the present value of deferred dividends can be computed as a representation of value.

If no dividends are ever intended, then valuation may rest solely on the present value of future earnings and the present value of a future stock price.

Perspective 10-7: Appendix 10A Valuation of a Supernormal Growth Firm is optional and is found on pages 334–336.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 13, Gilbert Enterprises (Stock Valuation)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Cost of Capital

11 Author’s Overview

Chapter 11 on “Cost of Capital” naturally follows Chapter 10 on “Valuation and Rates of Return.”

The instructor should emphasize at the outset that investors’ required rate of return translates into the cost of financing for the firm. There should be a dual emphasis on properly determining the aftertax cost for each type of financing and on determining the appropriate weights to be assigned to the various sources of financing.

The cost of debt and the cost of preferred stock are reasonably straightforward, but additional guidance is required in determining the cost of common equity. The instructor should indicate the firm’s ability to acquire equity capital through retained earnings or through new common stock and the associated cost of each. The cost of retained earnings should be explained as an opportunity cost for the use of the stockholders’ funds. For that reason, it is assumed the stockholders can earn as much on these funds, if distributed, as they are currently earning in the firm. Thus, the cost of retained earnings is also equal to Ke (the firm’s return on common equity).

After the various costs are computed, the instructor can direct more attention to the weighting scheme given to the components in the capital structure. The instructor may wish to refer to the authors’ example in which the increased use of debt initially decreases the cost of capital, but then ultimately increases it. The interdependent nature (of costs and weights) should be stressed in discussing the optimal capital structure.

The instructor has the option of introducing the student to the capital asset pricing model in the text and more fully in Appendix 11A. There the concepts of regression analysis, the beta coefficient, and the security market line are introduced and related to previously discussed material on the cost of capital. This chapter as well as subsequent chapters is fully comprehensible without the use of this material. The appendix is available, however, for those instructors who wish to go over the capital asset pricing model in detail.

Chapter Concepts LO1. Recall that the cost of capital represents the weighted average cost of the source of financing to the firm.

LO2. Understand the cost of capital is normally the discount rate to use in analyzing an investment. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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LO3. Recognize that the cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds, preferred stock, and common stock.

LO4. Explain how a firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

LO5. Recall that the cost of capital may eventually increase as larger amounts of financing are utilized.

Annotated Outline and Strategy I.

The Overall Concept A.

A business firm must strive to earn at least as much as the cost of the funds that it uses.

B.

The cost of a firm’s funds is called its cost of capital.

C.

A firm usually has several sources of funds, and each source will most likely have a different cost.

D.

The overall cost of the funds employed is a proportionate average of the various sources.

E.

There are several steps in measuring a firm’s cost of capital.

1.

2.

3.

PPT II.

Compute the cost of each source of capital.

Assign weights to each source.

Compute the weighted average of the component costs.

Cost of Capital—Baker Corporation (Table 11-1)

Cost of Debt A.

The basic cost of debt to the firm is the effective yield to maturity. The yield to maturity is a market-determined rate and can be found by examining the relationships of security price, periodic interest payments, maturity value, and length of time to maturity. The yield to maturity for a corporate bond may be found by solving for YTM in the following calculator keystrokes:

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

N PV PMT FV CPT I/Y

Number of periods to maturity Current price of the bond Periodic coupon payment Maturity value of bond (usually $1000) Function Yield to maturity

Table 11-2 on page 339 uses an Excel spreadsheet to calculate the yield to maturity using the RATE function.

PPT

Yield to Maturity (Table 11-2)

B.

Since interest is tax-deductible, the actual cost of debt to the firm is less than the yield to maturity.

C.

The aftertax cost of debt is: Kd = Y (1− T ) (Formula 11-1)

where: Y= Yield to maturity T= Firm’s effective tax rate Thus, the aftertax cost to a firm for bonds issued at par paying $100 annually in interest would be 7.05 percent if the firm's marginal tax rate were 25 percent.

Kd = Y(1 – T) = 9.40%(1 – 0.25) = 9.40%(0.75) = 7.05% D.

PPT

The example of Coca-Cola Company in Table 11-3 on page 340 presents the opportunity for the professor to expose the students to the information found in Standard & Poor’s Capital IQ Net Advantage.

Excerpt from S&P Capital IQ Net Advantage (Table 11-3)

Perspective 11-1: Explain that since the cost of preferred stock and common stock is calculated on an aftertax basis, the cost of debt is adjusted for taxes, so all three sources of capital are on an aftertax cost basis.

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III.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Cost of Preferred Stock A.

The cost of preferred stock like the cost of debt is that a constant annual payment is made, but dissimilar in that there may be no maturity date on which a principal payment must be made.

B.

The cost of preferred stock may be determined by examining the relationship of its annual (usually fixed) dividend and its market-determined price. Preferred stock usually has no maturity, and therefore the dividends are expected to be perpetual.

C.

The cost of preferred stock Kp is computed by dividing the annual dividend payment by the net proceeds received by the firm in the sale of preferred stock.

Kp =

Dp

(Formula 11-2)

(Pp − F )

where: Kp Dp Pp F IV.

= Cost of preferred stock = The annual dividend on preferred stock = The price of preferred stock = Flotation, or selling cost

Cost of Common Equity A.

The basis of computation of the price of common stock is the dividend valuation model.

P0 =

P0 = D1 = Ke = g = B.

D1 (Formula 10-8) (K e − g)

Price of the stock today Dividend at the end of the first year (or period) Required rate of return Constant growth rate in dividends

Assuming constant growth, the dividend valuation model can be manipulated to represent the required rate of return: D1 + g (Formula 11-3) Ke = Po

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

C.

The equation for the cost of common equity Ke is equal to the total of the dividend yield rate plus capital gains on the original investment. D1/P0 represents the dividend yield. Since the original investment must grow at the same rate as the dividends, the capital gains on the investment is achieved by adding g, the dividend growth rate.

D.

Required return on common stock using the capital asset pricing model (CAPM).

The CAPM provides an alternative calculation of the required return on common stock. See Perspective 11-2.

1.

Under the CAPM, the required return for common stock can be described by the following formula:

K j = Rf +  (Km − Rf ) where: Kj Rf

2.

3.

= =

Required return on common stock Risk-free rate of return; usually the current rate on Treasury bill securities  = Beta coefficient. The beta measures the historical volatility of an individual stock’s return relative to a stock market index.

A beta greater than 1 indicates greater volatility (price movements) than the market, while the reverse would be true for a beta less than 1.

Km = Return expected in the market as measured by an appropriate index Both Kj and Ke should be equal under the case of market equilibrium.

Appendix 11A presents the capital asset pricing model in more detail for those who wish to expand the textbook coverage on this concept.

Perspective 11-2: It is helpful to point out that the Kj in the capital asset pricing model is often used in the dividend valuation model because if you plug Ke from Formula 11-3 into the dividend valuation model, you will always get the current price of the stock as the value. By developing Ke (Kj) independently from the dividend valuation model, you eliminate using a circular reference.

E.

Cost of retained earnings: Common stock financing is available through the retention of earnings belonging to current stockholders or by issuing new common stock.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

1.

The cost of retained earnings is equivalent to the rate of return on the firm’s common stock. This is the opportunity cost. Thus, the cost of common equity in the form of retained earnings is: Ke =

D1 + g P0

where: Ke = D1 = P0 = g = F.

Cost of common equity in the form of retained earnings Dividend at the end of the first year Price of the stock today Constant growth rate in dividends

Cost of new common stock: The sale of new common stock has a higher cost than the cost of retained earnings because the firm’s proceeds from the sale of the new stock are reduced by the flotation costs (F) paid to the investment banker. The cost of new common stock, Kn is: Kn =

D1 (P0 − F )

+ g (Formula 11-6)

where: Kn = D1 = P0 = g = F= V.

Required rate of return on new common shares Expected dividend at the end of the first year Price per share of stock at the beginning of the first year Constant growth rate in dividends Flotation costs per share

Optimum Capital Structure—Weighting Costs A.

The firm should seek to minimize its cost of capital by employing the optimal mix of capital financing.

B.

Weighted average cost of capital can be calculated by the summation of the product of each element of capital multiplied by its relative weight or mix.

C.

The Baker Corporation example on pages 345 and 346 demonstrates the concept of weighted average cost of capital numerically, while Figure 11-1 does so graphically.

PPT

Cost of Capital Curve

(Figure 11-1)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

D.

Although debt is the cheapest source of capital, there are limits to the amount of debt capital that lenders will provide (recall the Debt/Equity (D/E) relationships discussed in Chapter 3). The cost of both debt and equity financing rises as debt becomes a larger portion of the capital structure.

E.

Traditional financial theory maintains that the weighted average cost of capital declines as lower costing debt is added to the capital structure. The optimum mix of debt and equity corresponds to the minimum point on the average cost of capital curve.

F.

The optimal debt-to-equity mix varies among industries. The more cyclical the business, the lower the D/E ratio that would be required.

PPT

2018 and 2021 Long-Term Debt as a Percentage of Debt + Equity (MV) (Table 11-4)

Perspective 11-3: You can relate Table 11-4 back to ratio analysis and use this to explain the risk of bankruptcy and the fact the cost of capital and especially the cost of debt goes up as the ratio of long-term debt as a percentage of equity goes up.

G.

VI.

The weights applied in computing the weighted average cost should be market-value weights.

Capital Acquisition and Investment Decision Making A.

The discount rate used in evaluating capital projects should be the weighted average cost of capital.

B.

If the cost of capital is earned on all projects, the residual claimants of the earnings stream, the owners, will receive their required rate of return. If the overall return of the firm is less than the cost of capital, the owners will receive less than their desired rate of return because providers of debt capital must be paid.

C.

For most firms, the cost of capital is fairly constant within a reasonable range of debt-equity mixes (flat portion of curve in Figure 11-2). Changes in money and capital market conditions (supply and demand for money), however, cause the cost of capital for all firms to vary upward and downward over time.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Perspective 11-4: Discuss the impact of economic cycles on the cost of capital. The shifts that occur in costs of capital demonstrate that companies raise capital in an uneven fashion, often raising capital before it is all needed in anticipation of rising costs. The low cost of debt between the years 2008–2013 and again during the pandemic in 2020-2021 is a good example of a low interest rate environment.

PPT D.

Cost of Capital over Time (Figure 11-2) Cost of Capital in the Capital Budgeting Decision 1.

2.

3.

It is the current cost of each source of funds that is important.

The cost of each source of capital will vary with the amount of capital derived from that source.

The required rate of return or discount rate for capital budgeting decisions will be the weighted average cost of capital.

Perspective 11-5: Use Table 11-5 and Figure 11-3 together to show that not all projects can be accepted and that only those projects with expected rates of return greater than the cost of capital can be accepted as viable capital budgeting projects.

VII.

PPT

Investment Projects Available to the Baker Corporation (Table 11-5)

PPT

Cost of Capital and Investment Projects for the Baker Corporation (Figure 11-3)

Marginal Cost of Capital A.

The marginal cost of debt (the cost of the last amount of debt financing) will rise as more debt financing is used. The marginal cost of equity also rises when the shift from retained earnings to external (common stock) equity financing is necessary.

Finance In Action: Do Green Bonds Have a Lower Cost of Capital Green bonds are bonds sold to finance specific environmental projects and they have grown in popularity as the world recognizes global warming is a real issue. However, green bonds do not have a lower cost of capital than any other bonds of equal risk.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Perspective 11-5: Compare Table 11-6 and Table 11-7 to show how the cost of capital rises as the Baker Corp. raises its first $39 million, its next $11 million, and then the rising cost of funds raised over the $50 million threshold. Figure 11-4 brings these tables together to show that as the marginal cost of capital rises, project E is now eliminated.

PPT PPT

Costs of Capital for Different Amounts of Financing (Table 11-6) and Cost of Capital for Increasing Amounts of Financing (Table 11-7)

PPT

Marginal Cost of Capital and Baker Corporation Projects (Figure 11-4)

PPT

Cost of Components in the Capital Structure (Table 11-8)

VIII. Appendix 11A: Cost of Capital and the Capital Asset Pricing Model A.

The Capital Asset Pricing Model (CAPM) relates the risk-return tradeoffs of individual assets to market returns.

B.

The CAPM encompasses all types of assets but is most often applied to common stock.

C.

The basic form of the CAPM is a linear relationship between returns on individual stocks and the market over time. Using least squares regression analysis, the return on an individual stock Kj is: K j = +  K m + e

where: Kj =  =  = Km = e = PPT

Return on individual common stock of company Alpha, the intercept on the y-axis Beta, the coefficient Return on the stock market (an index of stock returns is used, usually the Standard & Poor’s 500 Index) Error term of the regression equation

Performance of PAI and the Market (Table 11A-1)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

PPT

Linear Regression of Returns between PAI and the Market (Figure 11A-1)

D.

Using historical data, the beta coefficient is computed. The beta coefficient is a measurement of the return performance of a given stock versus the return performance of the market.

E.

The CAPM is an expectational model. There is no guarantee that historical data will be repeated.

F.

The CAPM evolved into a risk premium model.

1.

Investors expect higher returns if higher risks are taken.

2.

The minimum return expected by investors will never be less than can be obtained from a riskless asset (usually considered to be U.S. Treasury bills).

The relationship is expressed as follows:

K j = R f + (Km – R f ) where: Rf = Risk-free rate of return  = Beta coefficient from Formula 11A-1 Km = Return on the market index Km – Rf = Premium or excess return of the market versus the risk-free rate (since the market is riskier than Rf, the assumption is that the expected Km will be greater than Rf) (Km - Rf) = Expected return above the risk-free rate for the stock of Company j, given the level of risk 3.

Beta measures the sensitivity of an individual security's return relative to the market. a. b.

By definition, the market beta = 1.0 A security with a beta = 1.0 is expected to have returns equal to and as volatile as the market. One with a beta of 2.0 is twice as volatile (up or down).

4. Beta measures the impact of an asset on an individual’s portfolio of assets.

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G.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

A risk-return graph can be derived from the risk premium model. The graphed relationship between risk (measured by beta) and required rates of return is called the security market line (SML).

PPT H.

PPT

The Security Market Line (SML) (Figure 11A-2) Cost of capital considerations 1.

If required returns rise, prices of securities fall to adjust to the new equilibrium return level, and as required returns fall, prices rise.

2.

A change in required rates of return is represented by a shift in the SML. The Security Market Line and Changing Interest Rates (Figure 11A-3) a. b.

c.

PPT

The new SML will be parallel to the previous one if investors attempt to maintain the same risk premium over the risk-free rate.

If investors attempt to maintain purchasing power in an inflationary economy, the slope of the new SML may be greater than before due to an inflation premium.

An investor’s required rate of return and thus a firm’s cost of capital will also change if investors risk preferences change. The slope of the SML would change even if the risk-free rate remained the same.

The Security Market Line and Changing Investor Expectations (Figure 11A-4)

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 16, Berkshire Instruments, (Cost of Capital) Case 17, Galaxy Systems, Inc. (Divisional Cost of Capital)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

The Capital Budgeting Decision

12

Author’s Overview While early comments on administrative procedures and accounting considerations are helpful, the major thrust of Chapter 12 is on the various methods for ranking investment proposals. The basic selection methods are established, mutually exclusive versus non–mutually exclusive events are compared, and the reinvestment assumption, capital rationing, and the net present value profile are presented.

The chapter continues with a comprehensive discussion of procedures for depreciation write-off and integrates the resultant cash flow determination with the capital budgeting decision. There is also a presentation of a replacement decision that examines the process of selling an old piece of equipment and replacing it with a new version. The tax consequences of replacement are carefully examined and included in the example presented.

Chapter Concepts LO1. Show how a capital budgeting decision represents a long-term investment decision.

LO2. Recognize that cash flow rather than earnings is used in the capital budgeting decision.

LO3. Understand that the payback method considers the importance of liquidity but fails to consider the time value of money.

LO4. Recall that the net present value and the internal rate of return are generally the preferred methods of capital budgeting analysis.

LO5. Recognize that the discount or cutoff rate is normally the cost of capital.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Annotated Outline and Strategy I.

Introduction A.

Capital expenditures are outlays for projects with lives extending beyond one year and perhaps for as many as 25 years for utilities and oil and gas companies.

B.

Extensive planning is required.

C.

Capital expenditures usually require initial cash flows, often large, with the expectation of future cash inflows. The differing time periods of inflows and outflows require present-value analysis.

D.

The longer the time horizon associated with a capital expenditure, the greater the uncertainty. Areas of uncertainty are: 1.

2.

3.

4.

5.

II.

Administrative Considerations PPT

III.

Annual costs and inflows Product life Interest rates Economic conditions Technological change

Capital Budgeting Procedures (Figure 12-1)

A.

Search and discovery of investment opportunities

B.

Collection of data

C.

Evaluation and decision making

D.

Reevaluation and adjustment

Accounting Flows versus Cash Flows A.

PPT PPT

The capital budgeting process focuses on cash flows rather than income. Income figures do not reflect the cash available to a firm due to the deduction of noncash expenditures such as depreciation.

Cash flow for Alston Corporation (Table 12-1) Revised cash flow for Alston Corporation (Table 12-2)

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B.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Accounting flows are not totally disregarded in the capital budgeting process.

1.

2.

IV.

Investors’ emphasis on earnings per share may, under certain conditions, require use of income rather than cash as the decision criterion.

Top management may elect to glean the short-term personal benefits of an income effect rather than the long-run cash-flow effects that are more beneficial from the owner’s viewpoint.

Methods of Ranking Investment Proposals A.

Payback Method 1.

The payback period is the length of time necessary for the sum of the expected annual cash inflows to equal the cash investment. A cutoff period is established for comparison. Capital proposals with a payback in excess of the cutoff are rejected.

2.

Deficiencies of the method a. b.

3.

Inflows after the payback period are ignored.

The pattern of cash flows is ignored; therefore, time value of money is not considered.

Though not conceptually sound, the payback method is frequently used. a. Easy to understand b. Emphasizes liquidity c. Quick return is important to firms in industries characterized by rapid technological development.

PPT

Investment alternatives (Table 12-3)

Perspective 12-1: During periods of high inflation, a quick payback on a project indicates a rapid return of funds for reinvestment at perhaps even higher inflated returns, which some companies prefer over the superior IRR and NPV methods.

B.

Net Present Value (NPV) 1.

2.

In this method, the cash inflows are discounted at the firm’s cost of capital or some variation of that measure.

If the present value of the cash inflows equals or exceeds the present value of the cash investment, the capital proposal is acceptable.

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

3.

We use the NPV function of Excel to demonstrate the difference in net present value between Investments A and B. The use of Excel provides the opportunity to use sensitivity testing with various discount rates to demonstrate the change in NPV.

Finance in Action: Capital Budgeting Practices Utilized by Smaller, Privately Held Businesses: This article discusses why small privately owned businesses use the payback method rather than discounted cash flow techniques. Most small business owners are not as sophisticated financially as Fortune 500 companies, and they don’t really have to be. Their projects are small and often have short lives. Additionally, they don’t have stockholders to hold them accountable for their rate of return decisions, only bankers who want to know how they will repay the loan.

PPT C.

Calculating Net Present Value for Investments A and B (Table 12-4) Internal Rate of Return (IRR) 1.

2.

3.

4.

5.

6.

7.

PPT

The IRR method requires calculation of the rate that equates the cash investment with the cash inflows.

The calculation procedure is the same as the yield to maturity computation presented in Chapter 9.

An investment option where the IRR exceeds the minimum return on investment (usually the firm’s cost of capital or some variation of that measure) is a candidate for approval.

To fully comprehend the meaning of the internal rate of return, the student needs to understand how IRR relates to NPV, and so it is important to show that the IRR is the discount rate (interest rate) that makes NPV = 0.

We use the IRR function of Excel to demonstrate the difference between the rates of return for Investments A and B. You can show that the “Goal Seek” function in Excel that was used in Chapter 10 to calculate the yield to maturity can also be used to calculate an IRR, since the yield to maturity on a bond is nothing more than the bond’s internal rate of return.

A financial calculator can also be used to determine the IRR for both annuities and uneven cash flows. We demonstrate the keystrokes needed to solve for IRR with uneven cash flows.

Calculating IRR for Investments A and B (Table 12-5)

Perspective 12-2: Please see the Excel examples for NPV and IRR calculations in Tables 12-4 and 12-5, as well as the calculator keystrokes in the margins on pages 382 and 384.

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PPT Capital budgeting results (Table 12-6) V.

Selection Strategy A.

All non–mutually exclusive projects having an NPV >= 0 (which also means IRR >= cost of capital) should be accepted under normal conditions. If the NPV = 0, it means that the company will earn its cost of capital on the project.

B.

The NPV method and the IRR method always agree on the “accept” or “reject” decision on non–mutually exclusive projects.

C.

A disagreement may arise between the NPV and IRR methods when a choice must be made between mutually exclusive proposals or when all acceptable proposals cannot be taken due to capital rationing.

1.

2.

PPT

D.

The reinvestment assumption—IRR and NPV ($10,000 investment) (Tables 12-7 and 12-8) Modified internal rate of return is an alternative calculation to the IRR and NPV methods.

1.

2.

3.

4.

PPT

The primary cause of disagreement is the differing reinvestment assumptions.

The NPV method inherently assumes reinvestment of cash inflows at the cost of capital. The IRR method assumes reinvestment of cash inflows at the internal rate of return.

The more conservative net present value technique is usually the recommended approach when a conflict in ranking arises.

All cash outflows are discounted to the present at the firm’s cost of capital.

All cash inflows are converted to a terminal value by compounding them at the firm’s cost of capital out to the end of the project.

The discount rate that equates the future value of the inflows growing at the cost of capital with the amount invested is the MIRR. Table 12-9 demonstrates the method for calculating MIRR using the RATE function on Excel.

Calculating MIRR for Investment B (Table 12-9)

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VI.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Capital Rationing A.

Management may implement capital rationing by artificially constraining the amount of investment expenditures.

B.

Under capital rationing, some acceptable projects may be declined due to management’s fear of growth or hesitancy to use external financing.

C.

Under capital rationing, projects are ranked by NPV and accepted until the rationed amount of capital is exhausted.

D.

The NPV profile is particularly useful in comparing projects when they are mutually exclusive or under conditions of capital rationing.

E.

The NPV profile demonstrates that the IRR method is not an acceptable decision criterion when the WACC lies to the left of the crossover point of two mutually exclusive investment proposals.

PPT

Capital rationing (Table 12-10)

VIII. Combining Cash Flow Analysis and Selection Strategy A.

IX.

Tax law changes in 2017 have changed how depreciation is calculated for tax purposes. Companies can temporarily take 100 percent bonus depreciation in the first year that an asset is placed in service. This will phase out in 2023 and expire in 2027.

The modified accelerated cost recovery system, often referred to as MACRS, also remains in place.

PPT

Categories for depreciation write-off (Table 12-11)

PPT

Depreciation percentages (expressed in decimals) (Table 12-12)

PPT

Depreciation schedule (Table 12-13)

Actual Investment Decision: This section includes an example of calculating the NPV of an investment proposal, which includes the use of MACRS depreciation that results in an uneven cash flow stream and the calculation of the aftertax cash flow.

PPT

Cash flow related to the purchase of machinery (Table 12-14)

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PPT X.

Net present value of cash flow at 10% discount rate (Table 12-15)

The Replacement Decision PPT

A. PPT

B. PPT XI.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Net present value of cash flow considering proceeds from sale of old equipment. (Table 12-16) Sale of Old Asset Accumulated depreciation on the old machine and tax on the sale.

(Tables 12-17 and 12-18) Incremental Depreciation Incremental depreciation calculations (Table 12-19)

Elective Expensing: Businesses can write off tangible property such as equipment, furniture, tools, and computers in the year they are purchased for up to $1 million. This tax deduction is superior to the previous depreciating asset when the write-off takes place over a number of years. A tax provision, called Section 179 elective expensing, is primarily beneficial to small businesses because the allowance is phased out dollar for dollar when the total property purchases exceed $2.5 million in a year. The 100 percent bonus depreciation deduction will begin to phase out in 2023.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 18, Aerocomp, Inc. (Methods of Investment Evaluation) Case 19, Phelps Toy Company (Capital Budgeting and Cash Flow)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Risk and Capital Budgeting

13

Author’s Overview Though risk is discussed throughout the text, Chapter 13 provides the most explicit portrayal of its impact on the decision-making process of the firm. The actual measurement of risk through the computation of the mean, standard deviation, and coefficient of variation is presented in detail. The introduction of the risk-adjusted discount rate brings together the key material in Chapter 12 and this chapter. Simulation analysis also is introduced to emphasize how complicated decision variables can be reduced to a more manageable scale through examining, in advance, outcomes and probabilities of outcomes. Decision trees are introduced after simulation models to path dependent outcomes combined with probability estimates. Finally, the portfolio effect of an investment is introduced. The coefficient of correlation is defined in a general sense that should prove quite workable to the student.

An example of the efficient frontier is demonstrated in Figure 13-2 titled “Risk-return trade-off.”

Chapter Concepts LO1. Explain the concept of risk and how it is measured.

LO2. Recognize that most investors are risk-averse, which means they dislike uncertainty.

LO3. Explain why investors will require higher rates of return from risky projects.

LO4. Use simulation models and decision trees to assess the risk of an investment.

LO5. Assess the impact of a given investment on the total risk of the firm.

Annotated Outline and Strategy I.

Definition of Risk in Capital Budgeting A.

Management’s ability to achieve the goal of owner’s wealth maximization will largely depend on success in dealing with risk.

B.

Definition: Variability of possible outcomes. The wider the distribution of possible outcomes for a particular investment, the greater is its risk.

PPT

Variability and risk (Figure 13-1)

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The Concept of Risk-Averse A.

Risk aversion is a basic assumption of financial theory. Investors require a higher expected return the riskier an investment is perceived to be.

Perspective 13-1: We provide statistics briefly, but most students should not have to spend too much time on the statistics. Instead, focus on applying these measures to financial decision-making.

PPT III.

Risk-return trade-off (Figure 13-2)

Actual Measurement of Risk A.

The basic risk measurement is the standard deviation, which is a measure of dispersion around an expected value.

1.

The expected value is a weighted average of the possible outcomes of an event times their probabilities.

D (expected value) = DP 2.

The formula for computing the standard deviation is:

 (standard deviation) =

PPT B.

 (D − D) P 2

Probability distribution of outcomes (Table 13-1) The Coefficient of Variation 1.

The standard deviation is limited as a risk measure for comparison purposes.

Two projects, A and B, may both be characterized by a standard deviation of $600, but A may have an expected value of $6,000 and B $600.

2.

The size problem is eliminated by employing the coefficient of variation, V, which is the ratio of the standard deviation of an investment to its expected value. The higher the coefficient of variation, the higher the risk. $190 $600 = .10 = = .317 V VA = B $6,000 $600 Coefficient of variation (V ) =

 D

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PPT

Probability distributions with equal expected values and different degrees of risk (Figure 13-3)

PPT

Probability distributions with different expected values and standard deviations. (Figure 13-4)

C.

Beta () is another measure of risk that is widely used in portfolio management. Beta measures the volatility of returns on an individual stock relative to a stock market index of returns. (See Appendix 11A for a thorough discussion.)

PPT

Average betas for a five-year period (Table 13-2)

Perspective 13-2: Table 13-2 allows for a good discussion of industry/company factors that may cause risk and the fact that betas are not stable over time for all companies. We highlight the significant changes in red and green.

IV.

Risk and the Capital Budgeting Process A.

The expected inflows from capital projects are usually risky and uncertain.

B.

Cash flows of projects bearing a normal amount of risk undertaken by the firm should be discounted at the cost of capital.

C.

As the risk of a proposal increases, the rate of return required by lenders and investors increases.

D.

The cost of capital is composed of two components: the risk-free rate (the inflationadjusted real rate of return) plus a risk premium (risk associated with usual projects of a business).

E.

Adjustments must be made in the evaluation process for projects bearing other than (more or less) normal risk levels.

1.

2.

Risk-adjusted discount rate approach: The discount rate is adjusted upward for more risky projects and downward for projects bearing less than normal risk.

A firm may establish a risk-adjusted discount rate for each of the various categories of investment such as new equipment, new market, etc.

Risk-adjusted discount rates may be based on several measures of risk such as the standard deviation, coefficient of variation, or beta.

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PPT

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Relationship of risk to discount rate (Figure 13-5)

Perspective 13-3: Discuss foreign projects and how they are evaluated based on risk. International capital budgeting often has higher risks associated with emerging market systems or political instability.

F.

PPT G.

Increasing risk over time: Our ability to forecast diminishes as we forecast farther out in time.

Risk over time (Figure 13-6) Qualitative measures may mean that management makes up various risk classes for projects having similar characteristics.

Finance in Action: Energy: A High-Risk Industry The focus of the discussion should be on the risk assigned by energy companies to the many variables that affect cash flow such as the uncertainty of oil prices, the adoption of alternative energy sources, government regulations, political turmoil in the Middle East, oil spills, and dry wells.

Perspective 13-4: Tables 13-4 and 13-5 bring back investments A and B from Chapter 12 and demonstrate how a different decision would be made if Investment B had been adjusted for risk.

V.

PPT

Risk categories and associated discount rates (Table 13-3)

PPT

Capital budgeting analysis (Table 13-4)

PPT

Capital budgeting decision adjusted for risk (Table 13-5)

Simulation Models A.

The uncertainty associated with a capital budgeting decision may be reduced by projecting and preparing for the various possible outcomes resulting from the decision.

Simulation models and decision trees enhance management’s initial capital budget decision efforts and also expedite intermediate decisions (whether to continue, revise, or even cancel investment plans) once the initial decision has been made.

B.

Simulation models—various values for economic and financial variables affecting the capital budgeting decision are randomly selected and used as inputs in the simulation model. Although the process does not ensure that a manager’s decision will be correct

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(in terms of actual events), decisions can be made with a greater understanding of possible outcomes.

PPT C.

PPT VI.

Simulation flow chart (Figure 13-7) Decision trees—the sequential pattern of decisions and resulting outcomes and associated probabilities (managerial estimates based on experience and statistical processes) are tracked along the branches of the decision tree. Tracing the sequence of possible events in this fashion is a valuable analytical tool in the decision-making process.

Decision trees (Table 13-6)

The Portfolio Effect A.

A risky project may reduce the total risk of the firm through the portfolio effect.

B.

Projects that move in opposite directions in response to the same economic stimulus are negatively correlated. Since the movement of negatively correlated projects is in opposite directions, the total deviation is less than the deviations of the projects individually.

C.

The relationship between project movements is expressed by the coefficient of correlation that varies from the extremes of –1 (perfectly negative) to +1 (perfectly positive) correlation. Noncorrelated projects have a correlation coefficient of zero.

PPT D.

Portfolio considerations in evaluating risk

(Figure 13-8)

Although projects with correlation coefficients of –1 are seldom found, some risk reduction will occur, however minor, when projects are negatively correlated or have low positive correlation.

PPT

Measures of correlation

(Table 13-7)

PPT

Levels of risk reduction as measured by the coefficient of correlation (Figure 13-9)

PPT

Rates of return for Conglomerate Inc. and two merger candidates (Table 13-8)

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Perspective 13-5: Table 13-8 is a good example of how negatively correlated projects can reduce risk when combined.

E.

The firm should strive to achieve two objectives in combining projects according to their risk-return characteristics.

1.

2.

F.

PPT

Achieve the highest possible return at a given risk level.

Provide the lowest possible risk at a given return level.

The various optimal combinations of projects are located along a risk-return line referred to as the “efficient frontier.”

Risk-return trade-offs (Figure 13-10)

Finance in Action: Real Options Add a New Dimension to Capital Budgeting This article discusses real options not considered under traditional capital budgeting decisions.

These real options include intermittent decision points throughout the project. These decision points provide the opportunity for the firm to continue or revise project plans or abandon the project altogether. This sophisticated technique is not widely used but is expected to increase in the future.

VII.

The Share Price Effect A.

Higher earnings do not necessarily contribute to the firm's goal of owner's wealth maximization. The firm's earnings may be discounted at a higher rate because investors perceive that the firm is pursuing riskier projects to generate the earnings.

B.

The risk aversion of investors is verified in the capital market. Firms that are very sensitive to cyclical fluctuations tend to sell at lower P/E multiples.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 20, Global Resources. (Risk-Adjusted Discount Rates) Case 21, Inca, Inc. (Capital Budgeting with Risk)

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Capital Markets

14 Author’s Overview

This chapter on capital markets is basic to the understanding of the flow of funds through the economy and the relationship of capital markets to corporate bonds, stocks, and preferred stock.

Students often view bonds as uninteresting and unimportant securities, so special emphasis has been placed on them to show their dominant positions as a source of external capital. The instructor may wish to emphasize that corporations operate in competitive capital markets with government units.

Although much of this chapter is descriptive, it reinforces the concepts of risk and return and wealth maximization by describing the markets that create wealth and either reward or penalize the investor for assuming risk. The allocation of capital in a capitalistic economy is crucial to the understanding of our economic system, and the instructor should explore the market’s role in the allocation process.

Markets are now dominated by electronic communication networks (ECNs) rather than traditional floor trading. Changes in our market structure will continue to be motivated by competition and technology and striving for low-cost leadership and transaction speed between competitive markets.

We have taken the opportunity to include a section on market efficiency. There is a discussion of efficiency in the more traditional sense of liquidity, stability, and continuity, and this is linked with the concept of the efficient market hypothesis in the weak, semi-strong and strong forms. The important matter of securities market regulation is also covered in the chapter.

Chapter Concepts LO1. Recognize that capital markets, both domestic and foreign, are made up of securities that have a life of one year or longer (often much longer).

LO2. Identify the primary participants raising funds in domestic capital markets.

LO3. Recall that the United States is a three-sector economy in which households, corporations, and governmental units allocate funds among themselves.

LO4. Describe the securities markets.

LO5. List the characteristics of efficient security markets.

LO6. Explain the objectives of security legislation.

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Annotated Outline and Strategy Perspective 14-1: Though this is a descriptive chapter, the institutional relationships are important to students who have had limited experience with capital markets.

I.

II.

Introduction A.

COVID-19 impact on the U.S. stock market and work from home companies.

B.

Money market: Short-term market for securities maturing in a year or less.

C.

Capital market: Long-term market for securities with maturities greater than one year.

D.

More often, companies search all capital markets, including world markets, for capital at the lowest cost.

International Capital Markets A.

Competition for low-cost funding is worldwide.

B.

Important developments in international capital markets include NAFTA (1994) which was renegotiated and is now called the US-Mexico-Canada Agreement (2018); creation of the European Union (1993) and European Central Bank (1998); the growth of the World Trade Organization (WTO) with the admission of Russia in 2012 as one of the 160 member countries; and the rise of China as the world’s second largest economic power.

C.

The economic development of emerging markets has increased the size of these markets as a percentage of the world’s publicly traded capital.

D.

Money flows between countries include U.S. investment abroad and foreign investments in the U.S.

E.

Large amounts of long-term capital in the United States have been supplied by foreigners. Foreign investors have been attracted by the relatively high interest rates and political stability available in the United States.

PPT

Domestic market capitalization (millions of USD) (Figure 14-1)

PPT

World Federation of Exchanges members (2021) (Table 14-1)

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Competition for Funds in the U.S. Capital Markets

Perspective 14-2: Explain that finding financial capital is a competitive game. Companies compete among themselves, the federal government, and state governments.

A.

Government Securities 1.

2.

3.

B.

Corporate Securities 1.

2.

3.

4.

PPT

IV.

The U.S. Treasury borrows both long-term and short-term debts to cover budget deficits. When budget surpluses exist, as they did in 1998, the government reduces its net borrowing.

Federally sponsored credit agencies, charged with funding the large numbers of federal programs, issue securities in the capital markets. Agencies include the Federal National Mortgage Association, the Federal Home Loan Banks, and the Farm Credit Banks.

State and local municipalities are usually required by law to balance their budgets, so their borrowing is often short-term, or project related. The interest paid on these issues is exempt from federal income tax.

New issues of corporate securities have been predominantly bonds in recent years. Bonds are more widely used to raise capital when interest rates are low.

Though very similar to debt, the lack of the tax deductibility of preferred stock dividends has constrained the popularity of preferred stock issues.

New issues of common stock occur when a company needs to raise more new capital than can be provided by retained earnings.

The majority of internally generated funds are not included in reported earnings. Depreciation tax shields provide a substantial source of internal funding. The percentage relationship between retained earnings and depreciation varies over time based on profits and capital spending patterns, but depreciation is usually a very substantial source of internally generated funds.

Internally generated funds—corporate profits, dividends, and retained earnings (Figure 14-2 Panels A & B)

The Supply of Capital Funds PPT

Flow of funds through the economy (Figure 14-3)

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Finance in Action: The World’s Biggest Exchange: Hatched from an Egg? This box describes the formulation and evolution of the futures market. What began as a marketing technique to guarantee prices on eggs and butter has become the largest exchange in the world (the CME Group), trading around $1 quadrillion each year.

A.

Business and government have been net demanders of funds and the household sector the major supplier of funds in our three-sector economy.

B.

Household sector savings are usually channeled to the demanders of funds through financial institutions such as commercial banks, mutual savings banks, and credit unions. See Figure 14-3 on p. 457 for the flow of funds through the economy.

C.

Other intermediaries in the flow-of-funds process include mutual funds, pension plans, and insurance firms.

D.

The Role of the Security Markets 1.

2.

Securities markets aid the allocation of capital among the sectors of the economy and the financial intermediaries.

Security markets enable the demanders of capital to issue securities by providing the necessary liquidity for investors in two ways: a. b.

Corporations can sell new issues of securities rapidly at fair competitive prices.

The markets allow the purchaser of securities to convert the securities to cash with relative ease, within one to three days.

Perspective 14-3: Explain that financial markets are continually changing over time as technology advances.

V.

The Organization of the Security Markets A.

In addition to the traditional national and regional securities exchanges that provide a centrally located auction market for buyers and sellers, the globalization of markets and investments is fueling the need for electronic communication networks (ECNs) to improve efficiency and lower trading costs.

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B.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Traditional Organized Exchanges 1.

2.

3.

C.

The Major Exchanges

PPT

Competing exchanges headquartered in the U.S. (Table 14-2) 1.

2.

3.

4.

D.

ICE, The Intercontinental Exchange started out as a futures market and was one of the first exchanges to become publicly traded which allowed it to use it’s common stock to acquire the New York Stock Exchange and other futures markets.

CBOE, was originally the Chicago Board Options Exchange and it merged with the Chicago Mercantile Exchange to become the biggest exchange for options and futures.

NASDAQ Markets, originally referred to as the National Association of Securities Dealers Automated Quotations because it was one of the first exchanges to trade electronically. Now it has acquired options markets, Canadian, Nordic and Baltic exchanges and its automated trading systems run several other markets around the work.

When you examine Table 14-2, you can see that all these markets trade equities, options and all have expanded outside the United States.

Numerous stock exchanges operate outside the United States. These exchanges trade stocks of companies in their own domestic market, as well as stocks of large U.S. companies. Many foreign stocks are also traded in U.S. markets.

1.

PPT

The primary U.S. exchanges are the New York Stock Exchange (NYSE) and NASDAQ. Regional exchanges of lesser importance include the Chicago and Cincinnati exchanges acquired by the NYSE, and the Boston and Philadelphia exchanges, acquired by NASDAQ. Ninety percent of the volume on these regional exchanges is from dually traded stocks on the NYSE. All exchanges have listing requirements that companies must meet in order to have their common stock traded on that exchange.

Foreign exchanges are shown in Table 14-1 on p. 453. World markets by geographic region are shown in Table 14-3 on page 463.

World markets by geographic region (Table 14-3)

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E.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Other Financial Exchanges 1.

2.

F.

Electronic Communications Networks (ECNs) 1.

2.

3.

VI.

Consist mostly of futures, commodity, and options exchanges.

Electronic Communication Networks (ECNs) were briefly discussed early in the chapter, but we bring them up again to emphasize that trading has become electronic around the world and while some markets like the NYSE might maintain a trading floor, most of the volume is through ECNs.

Electronic trading systems that use computers to automatically match buy and sell orders.

ECNs lower the cost of trading by creating better execution and more price transparency and by employing “after hours trading.” Most ECNs have been granted “Exchange” status by the Securities and Exchange Commission.

Once thought to be in competition with the traditional exchanges, many are now owned by the established exchanges.

Market Efficiency A.

Criteria of efficiency 1.

2.

3.

Rapid adjustment of prices to new information Continuous market; successive prices are close The market is able to absorb large dollar amounts of securities without destabilizing the price

B.

The more certain the income stream, the less volatile price movements will be and the more efficient the market will be.

C.

Screen-based trading systems versus floor trading are becoming a trend that most observers would agree increase market efficiency.

D.

Beginning in August 2000, U.S. security markets started trading in decimals rather than fractions. Market makers generally prefer the wider spreads guaranteed with fractions, but investors appear to have benefited from decimalization.

E.

The efficient market hypothesis has three forms.

1.

2.

Weak form: Past price information is unrelated to future prices; trends cannot be predicted and taken advantage of by investors.

Semistrong form: Prices reflect all public information.

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3.

Strong form: Prices reflect all public and private information.

F.

A fully efficient market, if it exists, precludes insiders and large institutions from making profits from security transactions in excess of the market in general.

G.

The efficiency of the market is debatable, but most would agree that the movement is toward greater efficiency.

Finance in Action: Dark Pools—Market Efficiency or a Question of Ethics This box discusses a dark pool where trading occurs between institutional investors, usually in blocks of 10,000 to 100,000 shares. Dark pools work much like ECNs, but the trades do not show up on the consolidated tape for other market makers to observe. These are not public exchanges and so critics complain they lack transparency or price discovery. Hedge funds and mutual fund managers use these dark pools to hide their trades from competitors.

VII.

Regulation of the Security Markets A.

Organized securities markets are regulated by the Securities and Exchange Commission (SEC) and through self-regulation. The OTC market is regulated by the National Association of Securities Dealers (NASD).

B.

Major laws govern the sale and trading of securities as well as reporting standards.

1.

Securities Act of 1933 was a response to abuses present in the securities markets during the Wall Street “crash” era. Its purpose was to provide full disclosure of all pertinent investment information on new corporate security issues.

2.

The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) and empowered it to regulate the securities markets.

3.

The Securities Acts Amendments of 1975 directed the SEC to supervise the development of a national securities market, prohibited fixed commissions on public transactions, and prohibited financial institutions and insurance companies from buying stock exchange memberships to save commission costs.

4.

The Sarbanes-Oxley Act of 2002 authorized an independent private-sector board to oversee the accounting profession. The act was in response to the many accounting frauds perpetrated on investors by companies such as Enron, World Com, and Tyco.

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5.

In 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. This is the most comprehensive financial reform legislation since the Great Depression. This act impacts banks, hedge funds, derivatives, credit cards, mortgages, and other financial products. It is an extremely complex law, so we can expect that regulatory agencies will continue crafting and implementing regulations for several years.

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Investment Banking: Public and Private Placement

15

Author’s Overview This chapter presents a detailed account of the functions of the investment banker. By making maximum use of material covered under “Distribution Process,” the instructor can present a good picture of the marketing channels and pricing mechanisms that are frequently utilized in a public distribution. Such topics as the underwriter spread, pricing of the security, market stabilization, and aftermarket considerations are usually interesting to the student. We highlight the Facebook IPO and its subsequent price collapse and rebound.

We have included many examples of real firms with their IPOs and data that show how the investment bankers like Morgan Stanley, Goldman Sachs and other share the IPO and Merger Acquisition pie. These examples highlight the investment banking process with real firms and the concentration and competition within the investment banking market.

We also introduce the phenomenon of SPACs or Special Purpose Acquisition Companies as an alternative to the traditional initial public offering.

The advantages and disadvantages of going public is an area worthy of consideration. While it seems that the ultimate goal of every small firm is to grow large enough to one day be public, there are some very sound reasons to challenge this objective.

The continuing importance of private placement and its impact on traditional investment banking can be considered. Also, the instructor should cover the phenomenon of the leveraged buyout, a significant development of the 1980s that has continued to this day.

Chapter Concepts LO1. Describe how investment bankers are intermediaries between corporations in need of funds and the investing public.

LO2. Recognize that investment bankers, rather than corporations, normally take the risk of successfully distributing corporate securities, and for this there are costs involved.

LO3. Conclude that the distribution of new securities may involve dilution in earnings per share.

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LO4. Infer that corporations turn to investment bankers when making the critical decision about whether to go public (distribute their securities in the public markets) or stay private.

LO5. Understand leveraged buyouts rely heavily on debt in the restructuring of a corporation.

Annotated Outline and Strategy I.

Introduction: The late 1990s was a hot IPO market for tech stocks without earnings and is called the dot-com era for investment banking. During this time, record numbers of companies from Amazon.com to eBay went public. But initial public offerings move up and down with investor sentiment and good and bad markets. Table 15-1 presents examples of IPOs from 2014 through the early part of 2021 and includes a variety of issues, ranging from the $25 billion issue from Alibaba to the $287 million offering of Trivago.

PPT

Examples of global equity IPOs 2014–2021 (Table 15-1)

While the IPO markets are exciting for the big winners, we also emphasize that buying IPOs is no guaranteed way to make a profit for investors. Additionally, the IPO by Google featured in the last Finance in Action Box can create some interest in this chapter.

II.

III.

The Role of Investment Banking A.

The role of investment banking has been to act as the middleman between investors with money and companies in need of capital.

B.

Investment bankers have been merging and the industry has consolidated to the point where the top 10 investment bankers controlled 43.8 percent of the global market in 2020, up from 39.85 percent in 2019.

PPT

Global ranking of investment bankers, 2019 vs. 2020 (Table 15-2)

Enumeration of Functions A.

Underwriter: The risk-taking function. The underwriter bears the risk of fluctuations in the selling price of the security issue. The investment banker may handle the issues of unknown corporations on a non–risk-bearing “best-efforts” basis only.

B.

Market maker: The investment banker may engage in buying and selling of a security to ensure a liquid market.

C.

Advisor: Corporations may seek an investment banker’s advice on the size, timing,

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and marketability of security issues. Advice is also rendered pertaining to merger and acquisition decisions, leveraged buyouts, and corporate restructuring.

D.

Agency functions: As an agent, the investment banker assists in the private placement of security issues and in the negotiating process of merger and acquisition transactions.

E.

Note in Tables 15-3 and 15-4 the diverse areas where investment bankers make their money. Competition is keen among investment bankers and many limit themselves to specific segments where their reputation and expertise is highest. Table 15-3 indicates that JPMorgan and Goldman Sachs dominate the categories.

PPT

Banking leaders based on fees for the year ended December 29, 2020 (Table 15-3)

PPT

Global underwriting fees and number of deals by quarter and product (Table 15-4)

Perspective 15-1: Further explain that these Wall Street firms are financial conglomerates providing a variety of services such as those listed in the table as well as brokerage, mutual fund management, wealth management for individuals and pension funds, and more.

IV.

The Distribution Process A.

The managing investment banker forms an underwriting syndicate of investment bankers to increase marketability of the issue and spread the risk.

B.

Syndicate members, acting as wholesalers, sell the securities to brokers and dealers who eventually sell the securities to the public.

PPT C.

Distribution process in investment banking (Figure 15-1) The spread is the difference in the price of a security to the public and the amount paid to the issuing firm and represents the compensation of those participating in the distribution.

1.

2.

The spread is divided among the distribution participants. The lower a party falls in the distribution hierarchy, the lower the portion of the spread received.

Usually, the larger the dollar value of an issue, the smaller the spread is as a

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3.

4.

V.

percentage of the offering price.

The spread on equity issues is greater than on debt issues because of the greater price uncertainty.

The actual numbers in Tables 15-5 and 15-6 are not static and change with market conditions. Main takeaway is that cost decrease as the size of the offering increases. Bond offerings are cheaper than equity offerings.

PPT

Allocation of underwriting spread (Figure 15-2)

PPT

Underwriting compensation as a percentage of proceeds (Table 15-5)

PPT

Total costs to issue stock (percentage of total proceeds) (Table 15-6)

Pricing the Security A.

Several factors must be considered by the managing investment banker when negotiating the issue price of a security of a first-time issuer.

1.

2.

3.

4.

5.

Experience of the firm in the market.

Financial position of the issuing firm.

Expected earnings and dividends.

P/E multiples of firms in the same industry.

Anticipated public demand.

Finance in Action: SPACs: Special Purpose Acquisition Companies SPACs are also referred to as blank-check funds and are designed as merger funds. They raise money with no special purpose in mind except to acquire a company and eventually take it public.

SPACs have been around for a long time, but they have mushroomed as fund raising vehicles in 2020 and 2021. There were 248 SPACs in 2020 and more in 2021.

Perspective 15-2: Because investment bankers take price risks, they are motivated to price issues conservatively to sell out the issue. Corporations want the highest price possible. This potential conflict may create interesting situations and is worthy of discussion.

B.

Comparing debt versus equity offerings is always a surprise to students because so much emphasis in the news is on the stock market; but it is important to point out that debt IPOs were more than eight times the size of equity offerings in 2019 and 2020. Table 15-7 gets this point across.

PPT Global debt and equity capital markets bookrunner rankings (Table 15-7) © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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C.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

The issue price of securities of firms with existing securities outstanding is usually determined by “underpricing.”

1.

2.

Price is set slightly below current market value.

Underpricing is partially a result of the dilutive effect of spreading earnings over a greater number of shares of stock.

D.

Dilution: When new common stock is sold, the new shares issued immediately cause earnings per share to decline until the earnings can be increased from the investment of new funds.

E.

Market Stabilization: The managing investment banker seeks to stabilize the market (keep the sales price up) by repurchasing securities while at the same time selling them. Note that the SEC recognizes that underwriter price support is a form of market manipulation, but the practice is allowed as a justifiable element of smoothly functioning IPO markets. The Facebook example demonstrates the risk investment bankers take with equity offerings, illustrating one of the reasons that underwriting fees are more expensive than debt.

PPT

Facebook share price on the first day of trading (Figure 15-3)

PPT

Facebook closing quotes on May 18, 2012 (Figure 15-4)

Perspective 15-3: The stabilization process for the Facebook IPO is highlighted by Figures 15-3 and 15-4.

F.

Aftermarket: Research has indicated that initial public offerings often do well in the immediate aftermarket. However, average long run returns for IPOs appear to be relatively poor.

G.

Shelf registration 1.

2.

Large companies are permitted to file one comprehensive registration statement and then wait (hold securities on a shelf) until market conditions are favorable before issuing securities without further SEC approval.

Previously, a registration statement had to be filed for each security issue.

Shelf registration has been used primarily for debt issues.

A greater concentration of business among the stronger firms in the investment banking industry has resulted from the shelf registration process.

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H.

VI.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

In 1999 Congress passed the Gramm-Leach-Bliley Act that repealed the GlassSteagall Act. The Glass-Steagall Act required that commercial banks and investment banks operate independently of each other. While the investment banking market was already competitive, Gramm-Leach-Bliley allows combinations between investment banks and commercial banks.

Public versus Private Financing A.

Advantages of being public 1.

2.

3.

4.

5.

B.

Disadvantages of being public 1.

2.

3.

4.

5.

6.

VII.

Greater availability of funds Prestige Higher liquidity for stockholders Established price of public issues aids a stockholder’s estate planning Enables a firm to engage in merger activities more readily

Company information must be made public through SEC and state filings Accumulating and disclosing information is expensive in terms of dollars and time Short-term pressure from security analysts and investors Embarrassment from public failure High cost of going public Sarbanes-Oxley requirements have added additional burdens

Public Offerings A.

A classic example: Rosetta Stone goes public 1.

2.

PPT

Table 15-8 shows the costs of issuance including the following fees: SEC registration fee, FINRA filing fee, initial NYSE listing fee, legal fees and expenses, accounting fees and expenses, printing expenses, transfer agent and registrar fees and expenses, and miscellaneous expenses.

Figure 15-6 demonstrates what often happens after an IPO. Large shareholders decide to sell more shares after the IPO. The increased supply of shares and the negative signal that large shareholders are exiting the stock sends the price down.

Rosetta Stone’s prospectus (Figure 15-5)

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PPT

Out-of-pocket costs for Rosetta Stone IPO (Table 15-8)

PPT

2009 stock returns for Rosetta Stone and S&P 500 Index (Figure 15-6)

VIII. Private Placement. Private placement refers to selling securities directly to insurance companies, pension funds, and others rather than going through security markets. Private placement is used more for debt than equity issues.

A.

Advantages and disadvantages of private placements 1.

Advantages a. b. c.

2.

Eliminates the lengthy, expensive registration process with the SEC Greater flexibility in negotiating terms of issue Costs of issue are less

The usually higher interest cost on a privately placed debt instrument is a disadvantage.

Perspective 15-4: Discuss the consequences for public markets if the trend to utilize private placement increases.

B.

Going private and leveraged buyouts 1.

Firms that elect to go private are usually small companies that are seeking to avoid large auditing and reporting expenses. In the 1980s, 1990s, and mid2000s however, large firms went private to avoid the pressure of pleasing analysts in the short term. There are two basic ways to go private. The public firm can be purchased by a private firm, or the company can repurchase all publicly traded shares from the stockholders.

2.

Many firms have gone private through leveraged buyouts. Management or some external group borrows the needed cash to repurchase all the shares of the company. Frequently the management of the private firm must sell off assets in order to reduce the heavy debt load.

3.

Several firms that have gone private during the 1980s have restructured and returned to the public market at an increased market value. In some cases, the firm was divided, and the divisions were sold separately. The “breakup value” of some firms such as Beatrice and Uniroyal were substantially higher than the market value of the unified entity. In 2021 General Electric and

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Johnson and Johnson announced that they will break up their companies into three separate business units. You may be able to have your students analyze this process to see if stockholders really benefited from the breakup.

Finance in Action Managerial: Tulip Auctions and the Google IPO This box describes how Google went public using a Dutch auction rather than the standard methods discussed in this chapter. Google’s decision was driven, at least in part, by a desire to avoid underpricing its stock in the offering. Dutch auctions are used extensively for Treasury auctions, but IPOs are rarely priced in this manner. Google’s IPO was underpriced anyway.

However, underwriter fees were only 2.8 percent, which is certainly less than a traditional IPO would have cost the firm. Also, Dutch auctions appear to remove at least some to the disadvantages faced by small investors in the traditional IPO process.

IX.

International Investment Banking Deals A.

Privatization: Beginning in the 1980s and continuing today, many governments around the world are selling state-owned companies to individual and institutional investors. At one time, China was probably the current leader in this activity as the communist country tries to create large publicly owned companies that can become more efficient through the pressure of being compared to other publicly traded companies in their competitive industries. In recent years China has pushed back on Chinese tech and social media companies that have become too powerful and influential. Markets do have a way of rewarding successful companies and penalizing underperforming ones.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 22, Robert Boyle & Associates, Inc. (Going Public and Investment Banking) Case 23, Glazer Drug Co. (Initial Public Offering)

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Long-Term Debt and Lease Financing

16

Author’s Overview This chapter covers a broad range of debt topics including secured versus unsecured debt, sinking fund provisions, bond prices, yields, ratings, and conversion and call features. The student gets a good indoctrination into the various influences on bond prices, which can be strongly reinforced by problems at the back of the chapter.

The bond refunding decision is covered from the approach of a capital budgeting problem, and leasing is examined as a special form of debt, rather than as a separate type of financing. Studies and pronouncements by the accounting profession have taken the authors in this direction. However, the reasons for a lease arrangement are clearly enumerated.

Financial alternatives for distressed times are covered in Appendix 16A, with a discussion of out-ofcourt and in-court settlements. Disposal of assets under liquidation are also examined in this appendix.

Chapter Concepts LO1. Explain why analyzing long-term debt requires consideration of the collateral pledged and the method of repayment.

LO2. Explain the importance of bond yields in bond analysis and how bonds ratings are determined.

LO3. Determine whether to call in and reissue debt (refund the obligation) when interest rates decline.

LO4. Identify the similarities between long-term lease obligations and debt.

LO5. Recall that when a firm fails to meet its financial obligations, it may be subject to bankruptcy.

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Annotated Outline and Strategy I.

The Expanding Role of Debt

Perspective 16-1: The expanding role of debt is not just an issue for corporations but also for federal and state governments and consumers.

A.

Corporate debt has expanded dramatically in the last three decades.

B.

The rapid expansion of corporate debt is the result of: 1.

2.

3.

4.

5.

C.

PPT

II.

Rapid business expansion.

Inflation.

At times, inadequate funds generated from the internal operations of business firms.

Repurchase of common stock with cheap debt.

Low interest rates.

Corporations suffered a decline in interest coverage until 2008 and then remained relatively stable. Macy’s took advantage of the low interest rates to increase leverage and borrow longer-term debt. Although the financial crisis had a dramatic affect on financial institutions, most corporations suffered a temporary decline in earnings. As earnings rebounded and they refinanced debt at low interest rates, their earnings coverage ratios rebounded to record levels.

Earnings before interest and taxes and times interest earned for Macy’s Inc. 1999–2021 (Figure 16-1)

The Debt Contract A.

Par value: the face value of a bond

B.

Coupon rate: the actual interest rate on a bond; annual interest/par value

C.

Maturity date: the final date on which repayment of the debt principal is due

D.

Indenture: lengthy, legal agreement detailing the issuer’s obligations pertaining to a bond issue. The indenture is administered by an independent trustee.

E.

Security provisions 1.

Secured debt: specific assets are pledged to bondholders in the event of default.

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2.

3.

4.

F.

Mortgage agreement: real property is pledged as security for loan.

Senior claims require satisfaction in liquidation proceedings prior to junior claims.

New property may become subject to a security provision by an “afteracquired property clause.”

Unsecured debt 1.

2.

PPT

Debenture: an unsecured, long-term corporate bond Subordinated debenture: an unsecured bond in which payment will be made to the bondholder only after the holders of designated senior debt issues have been satisfied.

Priority of claims (Figure 16-2)

Perspective 16-2: The example of General Motors bankruptcy is a wonderful example of the priority of claims and of government intervention in the markets.

G.

Methods of Repayment 1.

2.

3.

4.

5.

PPT

Lump: sum payment at maturity Serial payments: bonds are paid off in installments over the life of the issue; each bond has a predetermined maturity date.

Sinking-fund provision: the issuer is required to make regular contributions to fund under the trustee’s control. The trustee purchases (retires) bonds in the market with the contributions.

Conversion: retirement by converting bonds into common stock; this is the option of the bond holder, but it may be forced. (See Chapter 19.)

Call feature: an option of the issuing corporation allowing it to retire the debt issue prior to maturity. It requires payment of a call premium over par value of 5 percent to 10 percent to the bondholder. The call is usually exercised by the firm when interest rates have fallen.

Eli Lilly’s bond offering (Table 16-1)

Finance in Action: Soccer Bonds Bounce Back The Football Club Internazionale Milano S.p.A (also known as “Inter Milan”) became one of the most recent sports franchises to issue bonds. The bonds carry an interesting twist in that they encourage the bondholders to cheer on the team. The team may have learned from Leeds United F.C., which borrowed heavily when on a winning streak. However, after several injuries and poor plays, the team was forced out of the top tier English Premier League. In 2003, the team was demoted to a lower league and forced to sell its stadium and training ground in 2004. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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III.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Bond Prices, Yields, and Ratings A.

Bond prices are largely determined by the relationship of their coupon rate to the going market rate and the number of years until maturity.

1.

2.

3.

If the market rate for the bond exceeds the coupon rate, the bond will sell below par value. If the market rate is less than the coupon rate, the bond will sell above par value.

The more distant the maturity date of a bond, the farther below or above par value the price will be given the coupon rate and market rate relationship.

Table 16-2 features an Excel spreadsheet that demonstrates years to maturity and changing bond prices as market rates change.

PPT

Interest rates and bond prices (face value is $1,000 and annual coupon rate is 12%) (Table 16-2)

PPT

Long-term yields on debt (Figure 16-3)

Perspective 16-3: It is important for students to understand the difference between the various bond yields. The most important yield is the yield to maturity, which is a function of price change as well as annual cash flow.

B.

Bond yields are quoted on three different bases. Assume a $1,000 par value bond pays $100 per year interest for 10 years. The bond is currently selling at $900 in the market.

1.

2.

3.

Coupon rate (nominal yield): Stated interest payment divided by par value, $100/$1,000 = 10% Current yield: Stated interest payment divided by the current price of the bond, $100/$900 = 11.11% Yield to Maturity: the interest rate that will equate future interest payments and payment at maturity to current market price (the internal rate of return).

The yield to maturity may be computed approximately by the following formula found in Footnote 2 on page 513.

Perspective 16-4: You may want to refer to the material on page 310 in Chapter 10 that demonstrates the calculation of yield to maturity using an Excel spreadsheet or calculator keystrokes. The approximate yield to maturity calculation demonstrates the impact on YTM when the bond sells at a premium or discount.

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Perspective 16-5: With spreadsheets and calculators, approximation formulas are not necessary, but the calculation is instructive in terms of examining the impact on yield to maturity when a bond sells at a discount or premium. While the Excel examples give the right answer they are not always as instructive. The denominator is 60-40 rather than 50-50 to make up for the curvilinear nature of the bond price over time (see Figure 10-2) on page 308. The formula is no longer in the book but is included below for reference.

Approximate = Yield to Maturity(Y ')

C.

Bond ratings 1.

2.

3.

D. PPT IV.

Principal payment – Price of the bond Number of years to maturity 0.6 (Price of the bond) + 0.4 (Principal payment)

Annual interest payment +

There are two major bond -rating agencies: Moody’s Investor Service and Standard & Poor’s Corporation.

The higher the rating, the lower the interest rate that must be paid.

The ratings are based on the: a. firm’s ability to make interest payments. b. consistency of performance. c. firm size. d. debt/equity ratio. e. firm’s working capital position. f. and other factors.

Examining actual bond ratings: See Table 16-3 and discussion.

Outstanding bond issues (Table 16-3)

The Refunding Decision A.

The process of calling outstanding bonds and replacing them with new ones is termed refunding. This action is most likely to be pursued by businesses during periods of declining interest rates.

B.

Interest savings from refunding can be substantial over the life of a bond but the costs of refunding can also be very large.

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Perspective 16-6: Compare the refunding decision with paying off a high-cost mortgage early and refinancing it at a lower rate with all the resultant costs of financing, points, closing fees, lawyers, etc. Notice that all present value examples have calculator keystroke solutions in the margin.

C.

A refunding decision is nothing more than a capital budgeting problem. The refunding costs constitute the investment. The net reduction in annual cash expenditures are the inflows. A major difference in evaluating a capital expenditure for refunding is that the discount rate applied is the aftertax cost of debt rather than the cost of capital because the annual savings are known with greater certainty.

D.

Step A – Identification of Cash Inflows and Outflows

E.

1.

Outflow considerations: a.

The payment of the call premium b.

The underwriting cost on the new issue less the PV of the future tax savings (on the new underwriting cost)

2.

Inflow considerations: a.

The present value of the aftertax savings on the difference in the interest rates b.

Accelerated tax benefits from the immediate write-off of the remaining unamortized underwriting cost of the old issue. (The difference between immediate write-off of remaining value and the PV of annual write-off times the tax rate.)

3.

Net present value: Inflows minus outflows equals Net Present Value.

Step B – Calculating Each Cash Flow 1.

2.

3.

4.

5.

Aftertax Interest Savings – Table 16-4 Aftertax Call Premium Cost – Table 16-5 New Underwriting Costs and Tax Benefits of Amortization – Table 16-6 Accelerated Tax Benefits from Unamortized Underwriting Cost on Original Bond – Table 16-7.

Loss of Amortization Tax Benefits from the Original Bond Underwriting – Table 16-8

PPT

Annual interest savings (Table 16-4)

PPT

Call premium aftertax cost (Table 16-5)

PPT

Tax benefit of underwriting costs (Table 16-6)

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PPT

Tax benefit from unamortized underwriting cost (Table 16-7)

PPT

Lost tax benefits of old amortization (Table 16-8)

F. Step C - Net Present Value of Combined Cash Flows – Table 16-9 PPT V.

Net present value of proposed refunding (Table 16-9)

Other Forms of Bond Financing A.

Zero-coupon rate bonds 1.

2.

3.

4.

5.

6.

PPT B.

Do not pay interest; sold at deep discounts from face value.

These bonds provide immediate cash inflow to the corporation (sell bonds) without any outflow (interest payments) until the bonds mature.

Since the difference between the selling price and the maturity value is amortized for tax purposes over the life of the bond, a tax reduction benefit occurs without a current cash outflow.

Allows investor to “lock in” a multiplier of the initial investment.

Most investors in these bonds are tax-exempt because the annual increase in bond value is taxed as ordinary income even though no payment is received.

Brokerage houses are marketing future interests in government securities, which are a variation of the zero-coupon rate bond.

Zero-coupon bonds (Table 16-10)

Floating Rate Bonds 1.

2.

The interest rate varies with market conditions.

Unless market rates move beyond floating rate limits, the price of the floating rate bond should not change; therefore, the investor is assured (within limits) of the market value of his investment.

Finance in Action: Negative Interest Rates Give Lenders Less Than They Pay For A negative interest rate actually means that instead of earning a return on your money you are paying a fee to have a financial institution hold your money. Central banks often reduce rates to stimulate spending and if you are earning a negative rate of return on your money you are not likely to hold a lot of money. When the European Central Bank (ECB) held rates at -0.5% in 2020, that was their goal—spend your money and help the economy recover from COVID-19.

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VI.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Advantages and Disadvantages of Debt A.

Benefits of debt 1.

Tax-deductibility of interest. (Corporate tax 25%, effective aftertax cost of interest is only 75%) 2.

The financial obligation is specific and fixed (with the exception of floating rate bonds).

3.

In an inflationary economy, debt may be repaid with “cheaper dollars.”

4.

Prudent use of debt may lower the cost of capital.

B.

Drawbacks of debt 1.

Interest and principal payments must be met when due regardless of the firm’s financial position.

2.

Burdensome bond indenture restrictions.

3.

Imprudent use of debt may depress stock prices.

C.

Eurobond market 1.

Usually denominated in dollars but not always.

2.

Disclosure less stringent than U.S. Securities and Exchange Commission.

3.

Not able to rely on rating agencies.

4.

See examples in Table 16-11.

PPT VII.

Examples of Eurobonds (Table 16-11)

Leasing as a Form of Debt A.

A long-term, noncancelable lease has similar characteristics to a debt obligation.

B.

The release of Accounting Standards Update 2016-02 requires that all leases, with the exception of short-term leases of less than 12 months, be included as an asset and a liability on the balance sheet.

PPT

Balance sheet ($ millions) (Table 16-12)

PPT

Revised balance sheet ($ millions) (Table 16-13)

C.

Leases that substantially transfer all the benefits and risks of ownership from the owner to the lessee must be capitalized. A finance lease is required whenever any one of the following conditions exists.

1.

Ownership of the property is transferred to the lessee by the end of the lease term.

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2.

3.

4.

5.

D.

A lease that does not meet any of the five criteria is an operating lease.

1.

2.

3.

4.

E.

Usually short-term.

Often cancelable at the option of the lessee.

The lessor frequently provides maintenance.

Capitalization and presentation on the balance sheet are not required.

Impact of finance lease on the income statement 1.

2.

F.

The lease contains a purchase price (sure to be purchased) at the end of the lease.

The lease term is for a major part of the remaining economic life of the asset.

The present value of all payments exceeds the asset’s fair value.

The asset is of a specialized nature and so has no alternative use to lessor at end of term.

The intangible leased property under finance lease (asset) amount is amortized and written off over the life of the lease.

The obligation under finance lease (liability) is written off through amortization with an “implied” interest expense on the remaining balance.

Advantages of leasing 1.

2.

3.

4.

5.

6.

7.

Lessee may not have sufficient funds to purchase or borrowing capability.

Provisions of lease may be less restrictive.

May be no down payment.

Expert advice of leasing (lessor) company.

Creditor claims on certain types of leases are restricted in bankruptcy and reorganization procedures.

Certain retail malls or retail complexes only available for lease.

Tax considerations a. b.

8.

Obtain maximum benefit of tax advantages.

Tax-deductibility of lease payments for land.

Infusion of capital through a sale-leaseback.

VIII. Appendix 16A: Financial Alternatives for Distressed Firms A.

Financial distress 1.

Technical insolvency—firm has positive net worth but is unable to pay its bills as they come due.

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2.

B.

Out-of-court settlement 1.

2.

3.

4.

C.

Bankruptcy—a firm’s liabilities exceed the value of its assets—negative net worth.

Extension—creditors allow the firm more time to meet its financial obligations.

Composition—creditors agree to accept a fractional settlement on their original claim.

Creditor committee—a creditor committee is established to run the business in place of the existing management.

Assignment—a liquidation of the firm’s assets without going through formal court action.

In-court settlements—formal bankruptcy 1.

2.

3.

Bankruptcy proceedings may be initiated voluntarily by the firm or forced by the creditors—involuntary bankruptcy.

The decisions of a court-appointed referee who arbitrates the bankruptcy proceedings are final, subject only to court review.

Reorganization—a fair and feasible plan to reorganize the bankrupt firm. a.

b.

4.

Internal reorganization necessitates an evaluation of existing management and policies. An assessment and possible redesign of the firm’s capital structure is also required.

External reorganization—a financially strong and managerially competent merger partner is found for the bankrupt firm.

Liquidation—if reorganization of the firm is determined to be infeasible; the assets of the firm will be sold to satisfy creditors. The priority of claims is: a. b. c. d. e. f. g.

Bankruptcy administrative costs (legal fees) Wages of workers earned within 3 months of bankruptcy declaration Federal, state, and local taxes Secured creditors—designated assets General creditors—there is a priority within this category also Preferred stockholders Common stockholders

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Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 24, Leland Industries (Debt Financing) Case 25, Warner Motor Oil Co. (Bond refunding)

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Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Common and Preferred Stock Financing

17

Author’s Overview The first part of the chapter gives the student a clear view of the changing nature of stock ownership through increasing institutional participation and the declining importance of individual stock ownership. The residual nature of common stock as compared to other securities is examined as well as cumulative voting and rights offerings. We also stress the various classes of common stock that exist, such as voting and nonvoting and founders’ stock.

Preferred stock should be introduced as a hybrid form of security. The unusual tax features of preferred stock are compared to debt by highlighting the non–tax deductibility of preferred dividends to the paying corporation and the partial tax-exempt nature of preferred dividends to corporate owners. The cumulative nature of preferred stock is also important to the discussion, with lesser recognition given to the conversion, call, and participating features (some of these topics have been covered under the discussion of debt).

Chapter Concepts LO1. Recognize that common stockholders are the owners of the corporation and therefore have a claim to undistributed income, the right to elect the board of directors, and other privileges.

LO2. Conclude that cumulative voting provides minority stockholders with the potential for some representation on the board of directors.

LO3. Recall that a rights offering gives current stockholders a first option to purchase new shares.

LO4. Explain why poison pills and other similar provisions may make it difficult for outsiders to take over a corporation against management’s wishes.

LO5. Describe how preferred stock compares to debt and common stock.

Annotated Outline and Strategy I.

Introduction A. B.

Although management has daily control of the corporation, ultimate control of the firm resides in the hands of the stockholders.

Common stockholders poses three key rights: the residual claim to income, the right

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to vote and elect the board of directors, and the right to purchase new shares to maintain their ownership percentage.

Perspective 17-1: The introduction tells a story of TowerJazz headquartered in Israel and the journey of losses and fundraising through common stock sales. It emphasizes the importance of common stock and access to capital markets and is a good introduction to risk taking by investors in small firms.

II.

Common Stockholders’ Claim to Income A.

Common stockholders have a residual claim on the income stream; the amount remaining after creditors and preferred stockholders have been satisfied belongs to the owners (common stockholders) whether paid in dividends or retained.

B.

Institutional investors such as pension, mutual funds, exchange traded funds, insurance companies, and bank managed trust funds control a large share of the voting power.

C.

A corporation may have several classes of common stock that differ in regard to voting rights and claim on the earnings stream.

PPT III.

Institutional ownership of U.S. companies (Table 17-1)

The Voting Right A.

Owners of common stock have the right to vote on all major issues including election of the board of directors.

Perspective 17-2: The voting right is important, and the Ford family provides an interesting example of “founders’ stock” for students. Other examples include Facebook (Meta), Alphabet and Palantir.

B.

Majority voting: holders of majority of stock can elect all directors.

C.

In some firms such as Ford Motor Company, different classes of stock are entitled to elect a specified percentage of the board of directors.

D.

Cumulative voting makes it possible for minority stockholders who own less than 50 percent of the stock to elect some of the directors.

1.

The stockholder can cast one vote for each share of stock owned times the number of directors to be elected.

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2.

The following formula may be employed to determine the number of shares needed to elect a given number of directors under cumulative voting.

Number of Total number of  Shares directors desired shares outstanding = +1 required Total number of directors to be elected + 1

3.

Restated, if we know the number of minority shares outstanding under cumulative voting and wish to determine the number of directors that can be elected, we use the formula:

Number of directors that can be elected

=

(Shares owned − 1)  (Number of directors to be elected + 1) Total number of shares outstanding

PPT

Shares required to elect a given number of directors (Equation 17-1)

PPT

Number of directors that can be elected with a given number minority shares (Equation 17-2)

Finance in Action: Corporate Governance and Capital Allocation –Apple and Facebook Inc. This box illustrates that corporate governance refers to the way a company is managed by the board of directors. Good governance includes information transparency so that stockholders and employees know the actions taken by the board. In the situation of Facebook, Mark Zuckerberg is not only the chairman of the board, but also the CEO and controlling stockholder. Tim Cook at Apple is Chairman of the Board, but not CEO and does not have controlling interest in Apple.

Morningstar rates Facebook and Apple on four standards: (1) Capital Allocation; (2) Environment; (3) Social); and (4) Governance. Both Facebook (Meta) and Apple are rated laggard for Governance and standard for Capital Allocation. Apple gets an average grade for the Environment while Facebook is given a Leader Rating. Apples gets an average rating on Social while Facebook gets rated a laggard.

IV.

The Right to Purchase New Shares A.

PPT

The stockholder may have the right to maintain his percentage of ownership, voting power, and claim to earnings through the preemptive right provision which requires that existing stockholders be given the first option to purchase new shares. Rights offerings are more common in European markets than in the U.S. Rights offerings big and small

(Table 17-2)

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Perspective 17-3: The T-Mobile offering in June of 2002 is an example of a major rights offering in the U.S. while the Banco Santander SA rights offering in 2017 in a good example of a European offering. See Table 17-2 for other examples.

B.

The Use of Rights in Financing 1.

2.

3.

Even if the preemptive right provision is not required, the corporation may finance through a rights offering.

Each stockholder receives one right for each share of stock owned and is allowed to buy new shares of stock at a reduced price (below market value) plus the required number of rights/share.

The number of rights required to purchase a new share equals the ratio of shares outstanding to the new shares issued.

Number of rights required to purchase one new share

4.

=

Number of shares outstanding Number of shares to be issued

Rights have market value since they entitle the holder to purchase shares of stock at less than market price. a.

Rights required: Initially, after the rights offering announcement, stock trades "rights-on." The formula for the value of a right during the rights-on period is: R= M0 = S = N =

b.

(M 0 − S ) ( N + 1)

Market value of stock, rights-on Subscription price Number of rights required to purchase a new share of stock

Monetary value of a right: After a certain period, the right no longer trades with the stock but may be bought and sold separately. On the “ex-rights” date the stock price falls by the theoretical value of a right. The ex-rights value of a right is: R= Me =

(Me − S) N

Market value of stock, ex-rights

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Perspective 17-4: Rights provide a first option to purchase new shares but do not make the stockholder wealthier.

5.

6.

Existing stockholders usually do not have a monetary gain from a rights offering. The gain from purchasing shares at less than market price is eliminated by dilution of previously owned shares.

A stockholder has three options when presented with a rights offering. a. b. c.

C.

Exercise the rights; no net gain or loss Sell the rights; no net gain or loss Allow the rights to lapse; a loss will be incurred due to the dilution of existing shares that is not offset by value of unsold or unexercised rights.

Desirable features of rights offerings 1.

2.

3.

4.

Protects stockholders' voting position and claim on earnings Existing stockholders provide a built-in market for new issues; distribution costs are lower May create more interest in stock than a straight offering Lower margin requirements

Finance in Action: HSBC Holdings Plc. Rights Offering HSBC Holdings Plc., also known as Hong Kong Shanghai Banking Corporation, is Europe’s biggest bank with a worldwide presence. This box describes how they used a $17.7 billion rights offering in March of 2009 to bail themselves out of the financial crisis. This is one of the largest rights offerings in history.

D.

Poison pills 1.

2.

V.

A “poison pill” is a rights offering made to existing shareholders of a company with the sole purpose of thwarting an acquisition attempt by another company. The increased number of shares may dilute the ownership percentage of the firm pursuing the takeover.

Some investors feel that a poison pill strategy is contrary to the goal of maximizing the wealth of the owners.

American Depository Receipts (ADRs) A.

ADRs are shares of foreign stock held in trust by U.S. banks that issue a claim on these trust receipts. There are over 3725 ADRs or GDRs (global deposit receipts)

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listed on U.S. exchanges and over-the-counter markets. See Table 17-3 for the American Depository Shares (Receipts) for nine regions in February 2021.

B.

ADRs allow foreign companies to raise funds in U.S. markets and provide investors with English annual reports using U.S. GAAP accounting.

C.

The example of ADRs gives the professor yet another chance to emphasize how important international markets are to both U.S. and foreign firms.

Depository receipts – Foreign company listings on U.S. exchanges and over-the-counter (Table 17-3)

PPT

VI.

Preferred Stock Financing A.

Characteristics of preferred stock 1.

2.

VII.

Stipulated that dividends must be paid before dividends on common stock but are not guaranteed or required.

Dividends are not tax-deductible to the corporation and are paid after taxes just like common stock dividends.

B.

Preferred stock contributes to capital structure balance by expanding the capital base without diluting common stock or incurring contractual obligations.

C.

Primary purchasers of preferred stock are corporate investors, insurance companies, and pension funds. One advantage these investors have is that 70 percent of dividend income received by corporations is exempt from taxation whereas interest received is fully taxable.

Provisions Associated with Preferred Stock 1.

2.

3.

4.

5.

6.

7.

Cumulative dividends Conversion feature Call feature Participation provision Floating rate Auction rate preferred stock Par value

VIII. Comparing Features of Common and Preferred Stock and Debt: As the level of risk increases, so does the return.

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PPT

Features of alternative security issues (Table 17-4)

PPT

Risk and expected return for various security classes (Figure 17-1)

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 26, Midsouth Exploration Company (Preferred Stock) Case 27, Alpha Biogenetics (Poison Pill)

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Dividend Policy and Retained Earnings

18

Author’s Overview The key initial question to be asked is: How does a corporation determine the amount of dividends to be paid? The discussion should move to the marginal principle of retained earnings with the associated emphasis on dividends as a passive variable in the decision-making process. The corporate life cycle curve is included to relate growth to dividend policy. Because few students would accept the theory that a corporation sets its dividend payment entirely on the basis of whether the corporation or stockholder can make a higher return on the funds, the passive approach to dividends is seen as a good but incomplete theory that must be supplemented with further considerations. The instructor can then cover other relevant functions of dividends such as resolution of uncertainty and information content and integrate the marginal principle of retained earnings with considerations of investor preferences. Other influences on dividend policy such as legal requirements, cash position of the firm, access to capital markets, and the like are presented.

Additional material is also provided on dividend payment procedures and dividend reinvestment plans. Tax rates on dividends and capital gains are also presented with the changes under the Tax Cuts and Jobs Act of 2017. Additionally, stock repurchase as an alternative to the cash dividend has received increasing attention in the literature and in the popular press and makes a good ending discussion point.

Chapter Concepts LO1. Explain how the board of directors and corporate management decide what to do with the firm’s annual earnings: pay them out in dividends or retain them for reinvestment in future projects.

LO2. Summarize the information that is derived from dividends and how dividend policy provides

information about where the firm is on its life cycle curve.

LO3. Identify the factors that influence dividend policy.

LO4. Assess the value of stock dividends and stock splits to their shareholders.

LO5. Explain why some firms decide to repurchase their shares in the market rather than increase dividends.

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Annotated Outline and Strategy I.

The Marginal Principle of Retained Earnings A.

Life cycle growth and dividends 1.

2

The corporate growth rate in sales and earnings is a major influence on dividends.

A firm’s dividend policy will usually reflect the firm’s stage of development. a. b.

c.

d.

PPT

Stage I—small firm, initial stage of development—no dividends.

Stage II—successful firm, growing demand for products and increasing sales, earnings, and assets—stock dividends followed later by small cash dividends.

Stage III—cash dividends rise as asset expansion slows and external funds are more readily available—stock dividends and stock splits also common.

Stage IV—the firm reaches maturity and maintains a stable sales growth rate, and cash dividends tend to be 35 to 40 percent of earnings depending on the industry.

Life cycle growth and dividend policy (Figure 18-1)

Perspective 18-1: The life cycle curve is important. The impact of growth on cash flow ties back to cash forecasting in Chapter 4, and external and internal funds in Chapter 14. Be sure to emphasize the accelerating, decelerating, and constant growth areas.

B.

Dividends as a passive variable—according to the passive residual theory of dividends, earnings should be retained as long as the rate earned is expected to exceed a stockholder’s rate of return on the distributed dividend.

C.

An incomplete theory—the residual dividend theory assumes a lack of preference for dividends by investors.

D.

Arguments for the relevance of dividends—much disagreement exists as to investors’ preference for dividends or retention of earnings. Arguments for the relevance of dividends ignore investor preferences but include: 1.

2.

3.

Resolves investor uncertainty about receiving dividends.

Information content: “The firm must be doing well because it paid a dividend.”

A bird in the hand is worth two in the bush. In other words, a known dividend

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is better than an unknown capital gain.

PPT

Corporate dividend policy (Table 18-1)

Finance in Action: Being an Aristocrat Is Pretty Good This box highlights companies that have been able to raise their dividends over 25 consecutive years; these companies are referred to as Dividend Aristocrats because there are not many companies that can make that claim. We include a box of companies like 3M, Coca-Cola, Johnson & Johnson, and a few others who have managed this feat for 50 or more consecutive years.

II.

Dividend Stability A.

Firms with high growth rates usually pay relatively low dividends. See Table 18-1.

B.

Mature firms follow a relatively high payout policy.

C.

The average payout of U.S. corporations since WWII has been 40 to 50 percent of aftertax earnings.

D.

The stable dividend policy followed by U.S. corporations indicates that corporate management feels that stockholders have a preference for dividends.

Perspective 18-2: Figure 18-2 highlights the volatility of earnings and the stability of dividends. Even when earnings collapse in recessions, companies are unwilling to cut dividends in reaction to what they think is temporary because it sends the wrong message to shareholders.

PPT

Standard & Poor’s 500 Index Quarterly Earnings and Dividends (Figure 18-2)

III.

Other Factors Influencing Dividend Policy A.

PPT

Legal rules—most states have enacted laws protecting corporate creditors by forbidding distribution of the firm’s capital in the form of dividends.

Dividend policy considerations

(Table 18-2)

B.

Cash position of the firm—must have cash available regardless of the level of past or current earnings in order to pay dividends.

C.

Access to capital markets—the easier the access to capital markets, the more able the

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firm is to pay dividends rather than retain earnings.

D.

Desire for control 1.

2.

E.

Tax position of shareholders 1.

2.

3.

PPT IV.

High tax-bracket stockholders may prefer retention of earnings because they can choose when to sell and pay taxes on their capital gain. They may also prefer retention of earnings over dividends when tax rates on dividends are higher than long-term capital gains taxes.

Lower tax-bracket individuals, corporations receiving dividends, and tax-free institutional investors such as pension funds may prefer higher dividend payout ratios.

See Table 18-3 for the new tax rates on dividends and capital gains under the Tax Cuts and Jobs Act of 2017. Notice that the table distinguishes between ordinary dividends and qualified dividends.

Tax Cuts and Jobs Act of 2017 (2021 tax rates)

(Table 18-3)

Dividend Payment Procedures A.

Dividends are usually paid quarterly.

1.

2.

B.

Dividend Yield = Annual dividend per share ÷ Current stock price.

Dividend Payout Ratio = Annual dividend per share ÷ Earnings per share

Three key dividend dates: 1.

2.

3.

V.

Small, closely held firms may limit dividends to avoid restrictive borrowing provisions or the need to sell new stock.

Established firms may feel pressure to pay dividends to avoid stockholders’ demand for change of management.

Holder-of-record date—the date the corporation examines its books to determine who is entitled to a cash dividend.

Ex-dividend date—two business days prior to the holder-of-record date. If an investor buys a share of stock after the third day prior to the holder-of-record date, the investor's name would not appear on the firm’s books.

Payment date—approximate date of mailing of dividend checks.

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PPT

XYZ Corporation’s financial position before stock dividend (Table 18-4)

PPT

XYZ Corporation’s financial position after stock dividend (Table 18-5)

A.

An accounting transfer is required at fair market from retained earnings. The par value of the stock dividend is transferred to the common stock account and the remainder (if any) is added to the capital in excess of par account.

B.

Unless total cash dividends increase, the stockholder does not benefit from a stock dividend.

C.

Use of stock dividends 1.

2.

VI.

Stock Split—A distribution of stock that increases the total shares outstanding by 20 to 25 percent or more.

PPT

VII.

Informational content—retention of earnings for reinvestment Camouflage inability to pay cash dividends

XYZ Corporation before and after stock split (Table 18-6)

A.

Accounting transfer from retained earnings is not required. Par value of stock is reduced, and the number of shares increases proportionately.

B.

Benefits to stockholders, if any, are difficult to identify.

C.

Primary purpose is to lower stock price into a more popular trading range.

D.

Reverse stock splits have an opposite impact: to lower the number of shares outstanding (as well as earnings per share) but to increase stock price.

Repurchase of Stock as an Alternative to Dividends A.

Alternative to payment of dividends 1.

2.

Most often used when the firm has excess cash and inadequate investment opportunities.

With the exception of a lower capital gains tax (preferential tax treatment of

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capital gains was eliminated by the tax Reform Act of 1986) the stockholder would be as well off with a cash dividend.

B.

Other reasons for repurchase 1.

2.

3.

Management may deem that stock is selling at a very low price and is the best investment available.

Use for stock options or as part of a tender offer in a merger or acquisition.

To reduce the possibility of being “taken over.”

PPT

Financial data of Morgan Corporation (Table 18-7)

PPT

Billion-dollar stock repurchases (Table 18-8)

VIII. Dividend Reinvestment Plans A.

Begun during the 1970s, plans provide investors with an opportunity to buy additional shares of stock with the cash dividend paid by the company.

B.

Types of plans 1.

2.

C.

The company sells treasury stock or authorized but unissued shares. The stock is often sold at a discount since no investment banking or underwriting fees have to be paid. This plan provides a cash flow to the company.

The company’s transfer agent buys shares of stock in the market for the stockholder. This plan does not provide a cash flow to the firm but is a service to the stockholder.

Plans usually allow stockholders to supplement dividends with cash payments up to $1,000 per month in order to increase purchase of stock

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 28, Montgomery Corporation (Dividend Policy) Case 29, Orbit Chemical Co. (Dividend Policy; This case also considers stock repurchases and stock options)

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Convertibles, Warrants, and Derivatives

19

Author’s Overview Because the material in the chapter can be viewed from both a corporate finance and investments perspective, the student’s interest in the chapter is usually quite high. The student is given an indepth exposure to convertibles, with primary attention devoted to valuation procedures. There is also material on the usefulness, advantages, and disadvantages of convertibles to the corporation. The advantage to the corporation is usually a disadvantage to the investor, and the disadvantage to the corporation is an advantage to the investor. Many real-world examples are included in the text and can be woven into the lecture.

The discussion of warrants parallels many of the points considered under convertibles. The topic of leverage, as it applies to warrants, also is appropriately introduced at this point and provides valuable background material for the student who progresses to subsequent courses in investments.

We provide a brief introduction to options and futures in a corporate finance context. We discuss put and call options and focus on employee stock options, which may be of interest to those students entering the job market. Futures are presented in combination with corporate hedging activities using oil and currency futures.

Chapter Concepts LO1. Recall that convertible securities can be converted to common stock at the option of the owner.

LO2. Recognize that securities that are converted to common stock may move with the value of common stock.

LO3.

Explain convertible bond valuation.

LO4.

Compare warrants to convertibles and detail how they are similar.

LO5. Explain why accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement.

LO6. Recall that derivative securities such as options and futures can be used by corporate financial managers for hedging activities.

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Annotated Outline and Strategy I.

Convertible Securities A.

A convertible security is a fixed income security, bond, or preferred stock that can be converted at the option of the holder into common stock. (The chapter focuses on convertible bonds.)

1.

2.

B.

Value of the convertible bond 1.

2.

3.

4.

5.

6

PPT

Conversion ratio: number of shares of common stock into which the security may be converted Conversion price: par value of bond divided by the conversion ratio

Conversion value: conversion ratio times the market price per share of common stock Conversion premium: market value of convertible bond minus the conversion value Pure bond value: the value of the convertible bond as a straight bond (nonconvertible bond); the present value of the annual interest payment and maturity payment discounted at the market rate of interest Investors pay a conversion premium if the price of the convertible security exceeds the value if the conversion were exercised.

If the market price of the common stock exceeds the conversion price, the market value of the bond will rise above its par value to the conversion value or higher. This gives the convertible bond downside risk because if the stock price declines, the bond value will also decline.

The convertible bond’s value is limited on the downside by its pure bond value, which is considered the “floor value."

Price movement pattern for a convertible bond (Figure 19-1)

Perspective 19-1: Students often get confused about where the data come from for plotting these lines. The instructor should emphasize the relationship between common stock value and conversion value and the meaning of pure bond value. The conversion value line is easy to draw; you start at zero and pick any stock price then multiply by the conversion ratio and connect the two points. The pure bond value is a horizontal line representing the bond value without conversion features.

PPT Pricing patterns for convertible bonds outstanding, prices on February 23, 2021 (Table 19-1)

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Perspective 19-2: Use Table 19-1 to discuss discounts and premium to the pure bond value when the convertible bond is selling at a premium to par value, close to par value, and at a discount to par value. Comparisons can also be made between coupon rates and yields to maturity. Additionally, you can use the table to examine the concept of downside risk if the stock price should fall to the pure bond value.

C.

Is this fool’s gold? Disadvantages to the investor 1.

2.

3.

4.

D.

Advantages and disadvantages to the corporation 1.

2.

3.

4.

5.

PPT E.

All downside risk is not eliminated. When the conversion value is very high, the investor is subject to significant downward price movement.

The pure bond value will fall if interest rates rise.

Interest rates on convertibles are less than on nonconvertible straight bonds of the same risk.

Convertibles are usually subject to the call provision.

Lower interest rate than a straight bond May be only means for the company to gain access to the capital market Enables the sale of stock at higher than market price The size of the convertible bond market is relatively small.

Firms that use convertibles are usually smaller companies experiencing rapid growth and low dividend yields with low credit ratings and high risk.

Largest convertible bond issues of 2020 (Table 19-2)

Forcing Conversion 1.

2.

Conversion may be forced if the company calls the convertible when the conversion value exceeds the call price.

Conversion is encouraged by a “step-up” provision in the conversion price.

Perspective 19-3: After covering the advantages and disadvantages of convertibles from both the investor and the corporate viewpoint, examine the trade-offs that are made by both parties. Probe students’ understanding of why a security like this exists and how it affects the capital structure and the cost of capital.

PPT

Bonds trading significantly above par value (Table 19-3)

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Perspective 19-4: Use Table 19-3 to show that companies do not always force conversion even when they could do so. The reasons usually focus on the fact that interest is tax-deductible while dividends are not. So, the company will consider whether the increased dividend payments that would occur with conversion are more costly than paying the interest on the bond.

F.

Accounting considerations with convertibles 1.

2.

Prior to 1969 the possible dilution effect of convertible securities on earnings per share was not required to be reflected in financial reports.

Currently earnings per share must be reported in two ways: Basic earnings per share =

Earnings after taxes Shares of common stock

where convertible securities include warrants, other options, and any convertible securities that create common stock.

PPT

XYZ Corporation (Table 19-4) Diluted earnings per share =

II.

Adjusted earnings after taxes Shares outstanding + All convertible securities

Financing through Warrants A.

A warrant is an option to buy a stated number of shares of stock at a specified price over a given period.

1.

Sweetens a debt issue by lowering the interest rate on the bond 2.

Usually detachable from the bond 3.

Speculative: the value is dependent on the market movement of the stock 4.

A warrant that is out-of-the-money indicates that the exercise price is above the current stock price.

5.

A warrant that is in-the-money indicates that the stock price is about the exercise price and has a positive intrinsic value.

6.

A warrant can multiply the gain on a stock several times through leverage.

PPT

Market price relationships for a warrant (Figure 19-2)

PPT

Leverage in valuing warrants (Table 19-5)

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PPT

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Occidental Petroleum common stock price and warrant price (Figure 19-3)

Perspective 19-5: Use Figure 19-3 to show a real example of how the warrant follows the stock price up and down. When Occidental’s stock price is above the exercise price you have an in-themoney-warrant. But because there is so much time before expiration (August 2027), even when the warrant is out-of-the-money, it still has speculative value. This warrant will still be outstanding when you cover this chapter, and you could have your students update the graph or at least calculate the intrinsic value and speculative premium.

Finance in Action: Enticing Investors through Convertibles and Warrants Convertibles and warrants are features used by a company to provide incentives above and beyond the rate of return. This article discusses how one company overcame low demand for its common stock by sweetening the deal through offering warrants attached to the bond. This way the investors can avoid the risk of full ownership if the stock value declines but have the option to jump on board at prearranged prices if the company does well.

B.

Valuation of warrants I = (M − E)  N

1.

Applying this formula, the minimum value of a warrant may be found

where:

2.

3.

C.

I= intrinsic value of a warrant M = market value of a common stock (stock price) E= exercise price of a warrant N= number of shares each share entitles the holder to purchase The actual price of the warrant may substantially exceed the formula value due to the speculative nature of warrants.

Table 19-5 demonstrates the speculative use of warrants to magnify a change in the stock price.

Use of warrants in corporate finance 1.

2.

3.

4.

Enhances a debt issue by giving the bondholder an option to buy the company’s stock at a set price.

Add-on in a merger or acquisition Cannot be forced with a call, but option price is sometimes “stepped-up.”

Equity base expands when warrants are exercised but the underlying debt remains.

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D.

III.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Accounting considerations with warrants—Potential dilution of earnings per share upon exercise of warrants must be disclosed in financial reports. There is a required calculation to compute the dilution and it involves using the proceeds of the cash inflow to retire and equal dollars worth of common stock shares.

Derivative Securities A.

Call options are similar to employer stock options in that they are an option to buy securities at a set price for a specified period of time.

B.

A put option is the opposite of a call option. A put allows the put holder to sell shares to the put writer at a set price for a specified period of time.

C.

Futures contracts impose on both parties the obligation to complete a purchase or sale transaction at a later date.

D.

Derivatives can be used for speculation as well as hedging. Corporations generally use derivatives to hedge risk.

Perspective 19-5: The instructor should emphasize that the use of derivatives is one of the most important developments in finance and that they can be used to hedge almost any type of risk.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 30, Hamilton Products (Convertibles) Case 33, Security Software, Inc. (Convertibles)

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External Growth through Mergers

20

Author’s Overview The discussion of mergers and acquisitions brings together a number of topics discussed earlier in the text. The instructor is able to take a second look at earnings per share growth, price-earnings ratios, stockholder wealth maximization, and portfolio considerations. These topics are considered in the present existing merger environment. Most students enjoy hearing about unfriendly takeovers, proxy battles, white knights, and various defensive strategies.

A central consideration in the chapter is the effect of differential P/E ratios on postmerger earnings per share. Once this concept is understood, the student should be encouraged to consider why P/E ratios may differ for the acquiring firm and the merger candidate. At least one major variable affecting P/E ratios is the possibility of differential future growth rates. Through numerical analysis, the student begins to see that the short-term impact on earnings per share can be very different from the long-term effect. Of greater importance, the student is forced to consider what the impact of these short- and long-term effects will be on the postmerger valuation. Another important consideration is the portfolio effect associated with the merger.

The price movement pattern associated with mergers is also worthy of consideration. Not only is the material of interest to students who relate well to investment-oriented subjects, but it is also an important consideration to corporate financial management. The premium offered and the associated price movement may determine management’s strategy with regard to accepting or fighting a proposal. This is particularly relevant in the latest merger movement, in which unfriendly offers for undervalued assets are commonplace.

We introduce the chapter with the example of Warren Buffet’s acquisition of H.J. Heinz Company.

Berkshire Hathaway made the biggest purchase in their company’s history in 2009 by purchasing the remaining 77.4 percent of Burlington Northern Santa Fe (BNSF) railway. Additionally, we present the U.S. Airways and American Airlines merger, which was really the “shark” (U.S. Airways) eating the “whale” (American Airlines). Not to ignore biotech, we also present Bristol Myer’s purchase of Celegene Corp. in 2019 and consolidation in the energy industry. This leads us to Table 20-1, where we present the largest mergers and acquisitions worldwide.

Chapter Concepts LO1. Recognize that firms engage in mergers for financial motives and to increase operating efficiency. Tax benefits and other factors must also be considered.

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LO2. Recall that companies may be acquired through cash purchases or by one company exchanging its shares for another company’s shares.

LO3. Understand how a merger can impact earnings per share and stock valuation.

LO4. Know that a merger may have a diversification benefit, but it may also create a less focused firm.

LO5. Recognize that some buyouts are unfriendly and are strongly opposed by the potential candidates.

Annotated Outline and Strategy

I.

PPT

Largest mergers and acquisitions worldwide (Table 20-1)

PPT

Mergers and acquisitions: North America (Figure 20-1)

Motives for Business Combinations A.

Business combinations may be either mergers or consolidations.

1.

2.

B.

Merger: A combination of two or more companies in which the resulting firm maintains the identity of the acquiring company.

Consolidation: Two or more companies are combined to form an entirely new entity.

Financial Motives: It is often cheaper to acquire market share than it is to develop it.

1.

Portfolio Effect a.

Risk reduction as a result of the portfolio effect b.

Lower required rate of return by investors. c.

Higher value of the firm.

2.

Access to Financial Markets a.

Greater access to financial markets to raise debt and equity capital. b.

Attract more prestigious investment bankers to handle financing. c.

Strengthen cash position and/or improve debt-equity ratio.

3.

Tax Inversions a.

U.S. companies buying foreign companies and changing their domicile to that lower-tax country to lower their overall tax rate.

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b.

c.

4.

The U.S., in recent years, unlike most other developed countries, had one of the highest tax rates on corporate earnings (35 percent) in the world.

Fortunately, the 2017 Tax Cuts and Jobs Act rectified the situation by setting the corporate tax rates to 21 percent and putting corporations on a territorial tax system.

Obtain a tax loss carryforward to offset future income.

Finance In Action: Are Diversified Firms Winners or Losers?

This is an interesting presentation about the merits of buying a diversified company or creating an equal portfolio. What does the stock market see in the benefits or penalties of diversification?

C.

Nonfinancial Motives 1.

2.

3.

D.

Expand management and marketing capabilities.

Acquire new products.

Synergy: 2 + 2 = 5.

Motives of Selling Stockholders 1.

2.

3.

4.

Desire to receive acquiring firm’s stock, which may have greater acceptability in the market.

Provides opportunity to diversify their holdings.

Gain on sale of stock at an attractive price.

Avoid the bias against smaller businesses.

Perspective 20-1: Mergers provide an opportunity to reexamine valuation models, cost of capital, and capital budgeting techniques from previous chapters. Concepts of growth and value are relevant, as are future benefits derived from the acquired company.

II.

Terms of Exchange A.

Cash purchases 1.

2.

Capital budgeting decision: Net present value of purchasing a going concern equals the present value of cash inflows, including anticipated synergistic benefits minus cash outlays and including adjustment for tax shield benefit from any tax loss carryforward.

Many firms were purchased for cash in the 1970s and 1980s at a price below the replacement costs of their assets, but the rising stock market of the 1990s

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made this difficult to duplicate. Even after the stock market retreat in 2000– 2001 and again in 2008–9, companies were still selling well above replacement costs. The bull market of 2020 and 2021 had companies selling way above their replacement costs but companies also had highly valued common stock to use in mergers or acquisition. This is where a high P/E firm had the advantage in buying a low P/E firm.

B.

Stock-for-Stock Exchange 1.

2.

3.

PPT

Emphasizes the impact of the merger on earnings per share.

If the P/E ratio of the acquiring firm is greater than the P/E ratio of the acquired firm, there will be an immediate increase in earnings per share.

Stockholders of the acquired firm are usually more concerned with market value exchanged than earnings, dividends, or book value exchanged.

Financial data on potential merging firms (Table 20-2)

4.

5.

6.

7.

In addition to the immediate impact on earnings per share, the acquiring firm must be concerned with the long-run impact of the merger on market value.

An acquired firm may have a low P/E ratio because its future rate of growth is expected to be low. In the long run, the acquisition may reduce the acquiring firm’s earnings per share and its market value.

The acquisition of a firm with a higher P/E ratio causes an immediate reduction in earnings per share. In the long run, however, the higher growth rate of the acquired firm may cause earnings per share and the market value of the acquiring company to be greater than if the merger did not take place.

Determinants of earnings per share impact of a merger a. b. c.

Exchange ratio Relative growth rates Relative size of the firms

PPT

Postmerger earnings per share (Table 20-3)

PPT

Risk-reduction portfolio benefits (Figure 20-2)

C.

Portfolio Effect 1.

2.

If the risk assessment of the acquiring firm is decreased by a merger, its market value will rise even if the earnings per share remain constant.

Two types of risk reduction may be accomplished by a merger.

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a. b.

Business risk reduction may result from acquiring a firm that is influenced by an opposite set of factors in the business cycle.

Financial risk reduction may result from a lower use of debt in the postmerger financial structure of the acquiring firm.

Perspective 20-2: The portfolio effect pertaining to mergers reinforces concepts learned in Chapter 13. Issues of earnings correlation and synergy can be discussed and, if possible, you might present a current merger situation with potential benefits and drawbacks.

III.

Accounting Considerations in Mergers and Acquisitions A.

Prior to 2001, a merger was treated as either a pooling of interests or a purchase of assets on the books of the acquiring firm. After June 2001, pooling of interests was no longer allowed.

B.

Criteria for pooling of interests treatment before 2001.

1.

2.

3.

4.

C.

Purchase of assets 1.

2.

3.

IV.

The acquiring firm issues only common stock, with rights identical to its old outstanding voting stock, in exchange for substantially all the voting stock of the acquired company.

The acquired firm’s stockholders maintain an ownership position in the surviving firm.

The merged firm does not intend to dispose of a significant portion of the assets of the combined companies within two years.

The combination is effected in a single transaction.

Necessary when the tender offer is in cash, bonds, preferred stock, or common stock with restricted rights.

Any excess of purchase price over book value is recorded as goodwill and written off over a maximum period of 40 years (with some exceptions).

Before the accounting change, goodwill had to be written off over a maximum of 40 years. This caused a negative effect on postmerger earnings.

Under the new rules, goodwill does not have to be written off unless there is a verifiable decrease in the value of the acquired firm.

Negotiated versus Tender Offers PPT

Mergers and acquisitions: Hostile takeovers (Figure 20-3)

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A.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

Friendly versus unfriendly mergers 1.

2.

B.

Unfriendly takeover attempts have resulted in additions to the Wall Street vocabulary 1.

2.

3.

C.

Most mergers are friendly, and the terms are negotiated by the officers and directors of the involved companies.

Takeover tender offers occur when proposed mergers are opposed by the management of candidate firms.

Saturday night special—a surprise offer made right before the market closes for the weekend.

White knight — a third firm that management of the target firm calls upon to help avoid the initial, unwanted tender offer.

Leveraged takeover—the acquiring firm negotiates a loan based on the target company’s assets (particularly a target company with large cash balances).

Actions by target companies to avoid unwanted takeovers.

1.

2.

3.

4.

5.

6.

7.

8.

White knight arrangements.

Moving corporate offices to states with protective provisions against takeovers.

Buying up company’s own stock to reduce amount available for takeover.

Encouraging employees to buy stock under corporate pension plan.

Increasing dividends to keep stockholders happy.

Staggering election of members of the board of directors.

Buying other firms to increase size.

Avoiding large cash balances, which encourage leveraged takeover attempts.

Finance in Action: SPACs: The Merger Choice of 2020 and 2021 SPACs are special purpose acquisition funds where investors contribute money to the fund, not know exactly what the fund will buy with the money. Many private companies prefer to be acquired by a SPAC rather than go through the time-consuming and expensive process of an IPO. SPACs have been around for a long time and used to be frowned upon as a way for highly risky companies to go public but in the market boom of 2020-2021 they have attained respectability but some distain from investment bankers who would rather make IPO fees than advisory fees.

V.

Premium Offers and Stock Price Movements: The acquiring firm typically pays a merger premium which changes according to market behavior. In the 2014-2016 market, premiums averaged about 38%. But in the 2017-2019 market the average premium was 55%. This supports the rule of thumb that premiums range between 40 and 60 percent over the premerger market price of the firm being acquired. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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PPT

M&A takeover premiums for U.S. and non-U.S. deals (2014-19) (Figure 20-4)

PPT

Stock movements of potential acquirees (Table 20-4)

Perspective 20-3: Table 20-4 demonstrates the stock movement of potential acquirees. This is a good example showing the premium between the preannouncement price and the day after announcement and the subsequent collapse of the stock price to below the preannouncement price.

There is risk in speculating on mergers.

VI.

Two-Step Buyout A.

The acquiring firm attempts to gain control by offering a very high cash price for 51 percent of the outstanding shares of the target firm. Simultaneously, a second lower price is announced that will be paid, either in cash, stock, or bonds, at a subsequent point in time.

B.

One problem with merger premiums is they usually disappear if the merger is called off.

C.

The procedure provides a strong incentive for stockholders of the target firm to quickly react to the offer. Also, the two-step buyout enables the acquiring firm to pay a lower total price than if a single offer is made.

D.

The SEC is keeping a close watch on the two-step buyout because of fears that the less sophisticated stockholders may be at a disadvantage when competing against arbitragers and institutional investors.

E.

The discussion of the 3M acquisition of Ceradyne shows how a company can technically avoid a two-step buyout and create the same price for all tendering stockholders.

Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 31, Acme Alarm Systems (Merger Terms and Stock Price) Case 34, National Brands versus A-1 Holdings (Merger Analysis) Case 35, KFC and the Colonel (Overall Business Considerations)

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International Financial Management

21

Author’s Overview The instructor should stress the importance of international financial management (and international trade) to the class. The students can easily appreciate the everyday events that bring the world closer together. An important point is that international finance has the same elements as domestic financial management, only the issues tend to be more involved. The firm must not only make a profit on a transaction but convert that profit into the appropriate currency in a satisfactory manner. With the U.S. becoming a mature economy, it is increasingly important that students understand how to conduct business across international borders. The rise of the euro as a world currency has changed the way Europe does business. With 164 member countries in the World Trade Organization, international trade will continue, with the WTO trying to maintain an even playing field.

While we have attempted to integrate international material throughout the book, this chapter concentrates only on international issues and is a good introduction to the complexities of international financial decision-making for those instructors wanting more depth in this area.

Chapter Concepts LO1. Describe a multinational company.

LO2. Recognize that a company operating in many foreign countries must consider the effect of exchange rates on its profitability and cash flow.

LO3. Understand that foreign exchange risk can be hedged or reduced.

LO4. Assess the political risk in making a foreign investment decision.

LO5. List the potential ways for financing international operations and recognize they are much greater than for domestic operations.

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Annotated Outline and Strategy I.

Introduction A.

Many factors have contributed to greater economic interaction among the world’s nations.

1.

2.

3.

4.

5.

B.

II.

Advances in communication and transportation.

Adaptation of political systems. a.

Post–World War II rebuilding programs b.

Eurozone c.

The United States-Mexico-Canada Agreement (USMCA) formerly NAFTA d.

BREXIT (Britain’s exit from the European Union International flows of capital and technology.

International currency: U.S. dollar vs. the euro.

Interdependence for scarce resources.

International business operations are complex and risky and require special understanding.

PPT

One U.S. dollar to the British pound and euro (Figure 21-1)

PPT

International sales of selected companies (Table 21-1)

The Multinational Corporation (MNC): Nature and Environment A.

Basic forms of MNC 1.

2.

3.

4.

B.

Exporter: exportation to foreign markets of domestically produced products.

Licensing Agreement: granting of a license to an independent local (in the foreign country) firm to use the “exporting” firm’s technology.

Joint Venture: cooperative business operation with a firm (or firms) in the foreign country.

Fully Owned Foreign Subsidiary

International Environment versus Domestic Environment 1.

More risky: in addition to normal business risks, the MNC is faced with foreign exchange risk and political risk. The portfolio risk of the parent company, however, may be reduced if foreign and domestic operations are

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2.

3.

not correlated.

Potentially more profitable.

More complex: the laws, customs, and economic environment of the host country may vary in many respects: a. b. c. d. e.

III.

Rates of inflation Tax rules Structure and operation of financial institutions Financial policies and practices Work habits and wages of laborers

Foreign Exchange Rates A.

To facilitate international trade, currencies must be exchanged. For example, an exporter will usually desire payment in the currency of his home country. The importer must swap his domestic currency for the currency desired by the exporter in order to pay his bill.

1.

2.

Examine Figure 21-2 and some of the currencies versus the dollar.

Currencies are not stable over time.

Perspective 21-1: Use Figure 21-2 to show how currencies move up and down over time.

PPT

Exchange rates to the dollar (Figure 21-2)

Finance in Action: Taking a Bite out of Purchasing Power Parity with the Big Mac Purchasing power parity assumes that in long run, exchange rates should move towards the rate that would equalize the price of identical basket of goods in any two countries. Sometimes economists like to par down the basket of goods to one good and in 1986 the Big Mac from McDonalds was used to compare exchange rates across countries. Afterall, many ingredients go into a Big Mac, and you can find a McDonalds in almost any major city in the world.

B.

Factors affecting exchange rates 1.

2.

3.

4.

5.

6.

7.

Supply of and demand for the currencies of the various countries.

The degree of central bank intervention.

Inflation rate differentials (Purchasing Power Parity Theory) Interest rate differentials (Interest Rate Parity Theory) Balance of payments Government policies Other factors

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a. b. c.

Capital market movements Changes in supply of and demand for the products and services of individual countries Labor disputes

C.

Many variables affect currency exchange rates. The importance of each variable or set of variables will change as economics and political conditions change throughout the world.

D.

Spot Rates, Forward Rates, and Cross Rates

Perspective 21-2: There are a number of easily understood examples in the text on spot and forward rates as well as cross rates.

1.

2.

3.

PPT

IV.

Spot rate: the exchange rate between currencies with immediate delivery Forward rate: the rate of exchange between currencies when delivery will occur in the future.

Cross rates: the exchange rate between currencies such as the Swiss franc and British pounds based on their exchange rate with another currency such as U.S. dollars.

Foreign exchange cross rates of major world currencies (Table 21-2)

Managing Foreign Exchange Risk A.

Three types of foreign exchange risk exposure 1.

2.

3.

Accounting or translation exposure: depends upon accounting rules established by the parent company’s government. Under SFAS 52, all foreign currency–denominated assets and liabilities are converted at the rate of exchange in effect on the date of balance sheet preparation.

Transaction exposure: in the U.S., foreign exchange gains and losses are reflected in the income statement for the current period—this increases the volatility of earnings per share.

Economic exposure to different countries’ GDP performance.

Perspective 21-3: The instructor might wish to discuss the different ways foreign exchange risk can be reduced.

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B.

Instructors Manual-Foundations of Financial Management 18E(Block/Hirt/Danielsen)

There are three strategies used to minimize transaction exposure: 1.

2.

3.

PPT

Hedging in the forward exchange market: the recipient (seller) of foreign currency in an international transaction sells a forward contract to assure the amount that will be received in domestic currency.

Hedging in the money market: the recipient borrows foreign currency in the amount to be received and then immediately converts to domestic currency.

When the receivable is collected, the loan is paid off.

Hedging in the currency futures market: futures contracts in foreign currencies began trading in the International Monetary Market (IMM) of the Chicago Mercantile Exchange on May 16, 1972, and on the London International Financial Futures Exchange (LIFFE) in September 1982.

Currency futures hedging (Table 21-3)

Finance in Action: Coca-Cola Manages Currency Risk As a large MNC, Coca-Cola, with about $69 billion in sales, must manage billions of dollars in currency risk. Coke operates in 200 countries so you can imagine how many currencies it must hedge. The company uses derivatives to manage these risks. This box demonstrates that the primary use of derivatives is to reduce risk exposures, rather than to speculate.

V.

Foreign Investment Decisions A.

Reasons for U.S. firms to invest in foreign countries 1.

2.

3.

4.

5.

6.

PPT B.

Fear of import tariffs (in foreign countries) Lower production costs, particularly with regard to labor costs Ease of entry because of advanced American technology Tax advantages Strategic considerations—competition International diversification Risk reduction from international diversification (Figure 21-3)

Foreign firms are expanding their investment in the United States 1.

2.

Foreign investments in the United States provide employment for millions of people.

Reasons for foreign expansion in the U.S. a.

International diversification b.

Strategic considerations

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c. d. e. f. g. h. i.

Increasing labor costs Saturated markets Shortage of land for development Large market in U.S. Labor restrictions overseas Access to advanced technology Political stability

Perspective 21-4: This is a good place to talk about current political risk.

C.

VI.

Analysis of Political Risk 1.

The structure of the foreign government and/or those in control may change many times during the lengthy period necessary to recover an investment.

“Unfriendly” changes may result in: a.

Foreign-exchange restrictions b.

Foreign-ownership limitations c.

Blockage of repatriation of earnings d.

Expropriation of foreign subsidiary’s assets

2.

Safeguards against political risk a.

A thorough investigation of the country’s political stability prior to investment. b.

Joint ventures with local (foreign) companies c.

Joint ventures with multiple companies representing multiple countries. d.

Insurance through the federal government agency U.S. International Development Finance Corporation. (DFC).

Financing International Business Operations A.

Letters of credit: in order to reduce the risk of nonpayment, an exporter may require an importer to furnish a letter of credit. The letter of credit is normally issued by the importer’s bank and guarantees payment to the exporter upon delivery of the merchandise if the specified conditions are met.

B.

Funding of transactions 1.

2.

Export-Import Bank (Eximbank): facilitates the financing of U.S. exports through several programs.

Loans from the parent company or sister affiliate. See Figure 21-4.

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a.

b.

Parallel loans: an arrangement where two parent firms in different countries each make a loan to the affiliate of the other parent. The procedure eliminates foreign exchange risk.

Fronting loans: loans from a parent firm to a foreign subsidiary via a bank located in the foreign country. See Figure 21-5.

PPT

A parallel loan arrangement (Figure 21-4)

PPT

A fronting loan arrangement (Figure 21-5) 3.

Eurodollar loans: loans from foreign banks that are denominated in dollars. a.

b. c.

d.

4.

Eurobond market: long-term funds may be secured by issuing Eurobonds.

These bonds are sold throughout the world but are denominated primarily in U.S. dollars. a. b. c. d.

5.

There are many participants in the Eurodollar market from throughout the world, particularly the U.S., Canada, Western Europe, and Japan.

Lower borrowing costs and the absence of compensating balance requirements are significant incentives for U.S. firms.

The lending rate is based on the London Interbank Offered Rate (LIBOR). As of this printing, LIBOR was still in use but in the U.S. it most likely be replaced by SONIA, the Sterling Overnight Index Average.

Lending in the Eurodollar market is almost exclusively done by commercial banks. Large Euro-currency loans are frequently syndicated and managed by a lead bank.

Disclosure requirements are less stringent.

Registration costs are lower than in U.S. Some tax advantages exist.

Caution must be exercised because of the exposure to foreign exchange risk.

International equity markets: selling common stock to residents of a foreign country provides financing and also reduces political risk.

Perspective 21-5: The instructor may wish to indicate the importance of international equity markets in the current age of the MNC. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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a.

b.

c. d.

6.

International Finance Corporation (IFC): the IFC was established in 1956 and is a unit of the World Bank. Its objective is to promote economic development in the 189 member countries of the World Bank that own it. a. b. c.

VII.

Multinational firms list their shares on major stock exchanges around the world. Half the stocks listed on the Amsterdam stock exchange are foreign.

Marketing securities internationally requires firms to adjust their procedures. For example, commercial banks have a dominant role in the securities business throughout Europe.

About 500 foreign companies are listed on the NYSE. American Depository Receipts (ADRs) are a common way for foreign firms to list shares in the U.S.

A multinational firm may be able to raise equity capital by selling partial ownership to the IFC. The IFC decides to participate in the venture on the basis of profitability and the potential benefit to the host country.

Once the venture is well established, the IFC frees up its capital by selling its ownership interest.

Some Unsettled Issues in International Finance A.

The complexity of the multinational business environment generates questions for which there are no easy answers.

1.

2.

B.

Should a foreign affiliate design a capital structure similar to that of the parent firm or one that fits the acceptable pattern of the host country?

Who should determine the dividend policy of a foreign affiliate—the affiliate management or the parent management?

Successful participation in the international business environment requires cohesive, coordinated financial management.

VIII. Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision

Perspective 21-6: The appendix represents a reasonably complicated consideration of a foreign investment decision by a corporation. Because adequate coverage requires an hour or more, it is relegated to the appendix.

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A.

Cash Flow Analysis

B.

Tax Factors

C.

Foreign Exchange Considerations

D.

Present Value Analysis

E.

The Risk Factor

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