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STUDY UNIT FIVEFINANCE

5.1 Long-Term Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35.2 Short-Term Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85.3 Optimal Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115.4 Cash Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185.5 Marketable Securities Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215.6 Receivables Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225.7 Valuation and Pricing Business Combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235.8 Derivative Financial Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245.9 Statement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295.10 Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345.11 Study Unit 5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

The emphasis of this study unit is on the financing of an enterprise. Sources of funds may beinternal or external, short-term or long-term, and debt or equity. Selecting the appropriate types andamounts of available financing sources is necessary to minimize the firm’s cost of capital andmaximize shareholder value.

Core Concepts■ The ordinary (common) shareholders are the owners of the corporation.■ Preference (preferred) shares are a hybrid of debt and equity.■ Bonds are long-term debt instruments. They are similar to term loans except that they are usually

offered to the public and sold to many investors.■ Share rights evidenced by warrants are options that are distributed with debt or preference

(preferred) shares.■ Both the issuance of rights and a conversion feature offer a corporation a means of delayed equity

financing when market prices are unfavorable.■ Intermediate-term financing refers to debt issues having approximate maturities of greater than 1

but less than 10 years.■ Short-term credit is debt scheduled to be repaid within 1 year.■ Capital structure consists primarily of long-term debt, preference (preferred) stock, and ordinary

(common) equity.■ Leverage is the relative amount of the fixed cost of capital, principally debt, in a firm’s capital

structure.■ The cost of capital is a weighted average of the various debt and equity components.■ The cost of debt equals the interest rate times one minus the marginal tax rate.■ The cost of retained earnings is an opportunity cost. It is the rate that investors can earn

elsewhere on investments of comparable risk.■ The cost of preference (preferred) stock equals the preference (preferred) dividend divided by the

net issuance price.■ Standard financial theory states than an optimal capital structure exists.■ The Capital Asset Pricing Model (CAPM) adds the risk-free rate to the product of the beta

coefficient and the difference between the market return and the risk-free rate.■ According to the dividend growth model, the required rate of return on retained earnings is the sum

of the dividend payout ratio and the dividend growth rate.■ The efficient markets hypothesis states that current share prices immediately and fully reflect all

relevant information.

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■ The cash budget details projected receipts and disbursements, preferably to plan thesynchronization of inflows and outflows.

■ Cash collections should be expedited. Slowing cash disbursements increases available cash.■ The amount of cash on hand should be determined by cost benefit analysis.■ A firm’s excess cash should be placed in an investment with the highest return consistent with low

risk.■ Short-term marketable securities are sometimes held as substitutes for cash but are more likely to

be acquired as temporary investments.■ The objective of managing accounts receivable is to have both the optimal amount of receivables

outstanding and the optimal amount of bad debt.■ Receivables management should maximize the accounts receivable turnover ratio, that is, shorten

the average time receivables are held.■ The most fundamental approach to valuing a business combination is capital budgeting analysis.

If the net present value (NPV) is positive, the combination is financially sound for the acquirer.■ A derivative is a financial instrument whose value changes with the change in the underlying (a

specified interest rate, security price, foreign currency exchange rate, price index, commodityprice, etc.).

■ A call option is the most common type of option. It gives the owner the right to purchase theunderlying asset at a fixed price.

■ A put option gives the owner the right to sell the underlying asset for a fixed price.■ A forward contract is an executory (unperformed) contract.■ A futures contract is a specific kind of forward contract. It is a definite agreement that allows a

trader to purchase or sell an asset at a fixed price during a specific future month.■ Swaps are contracts to hedge risk by exchanging cash flows.■ The essence of financial statement analysis is the calculation of financial ratios. These ratios

establish relationships among financial statement accounts at a moment in time or for a givenaccounting period.

■ Liquidity (solvency) ratios measure the short-term viability of the business, i.e., its ability tocontinue in the short term by paying its obligations. Asset management ratios measure theentity’s ability to generate income. Leverage ratios measure the use of debt to finance assetsand operations. Profitability ratios measure profit or loss on a relative basis. Growth ratiosmeasure the changes in the entity’s economic status over a period of years. Valuation ratiosreflect the basic principle that management’s goal is to maximize shareholder value.

■ Basic earnings per share (BEPS) equals (a) profit (loss) attributable to ordinary (common) equityholders divided by (b) the weighted-average of outstanding ordinary (common) shares.

■ Calculation of diluted earnings per share (DEPS) requires adjustments of the BEPS numerator anddenominator for the effects of dilutive potential ordinary (common) shares.

■ The study of business cycles focuses on the periodic cycles in the economy, most of which arecharacterized by changes in price levels and in rates of employment. A cycle’s stages are trough,recovery, peak, and recession.

■ Economic indicators are variables that in the past have been highly correlated with economicactivity.

■ Businesses have life cycles. These cycles interact with business cycles and product cycles.

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5.1 LONG-TERM FINANCING

1. A firm may have long-term funding requirements that it cannot, or does not want to, meetusing retained earnings. It must therefore issue equity or debt securities. Certain hybridforms also are used for long-term financing, e.g., convertible securities.

2. The principal considerations when reviewing financing choices are cost, risk, and thelender’s (the investor’s) view of the financing device.

3. Ordinary (common) shares. The ordinary (common) shareholders are the owners of thecorporation, and their rights as owners, although reasonably uniform, depend on the lawswhere the firm is incorporated. Equity ownership involves risk because holders of ordinary(common) shares are not guaranteed a return and are last in priority in a liquidation. Equityprovides the cushion for creditors if any losses occur on liquidation.

a. Advantages of ordinary (common) shares to the issuer

1) Dividends are not fixed. They are paid from profits when available.2) There is no fixed maturity date for repayment of the capital.3) The sale of ordinary (common) shares increases the creditworthiness of the

firm by providing more equity.4) Ordinary (common) shares are frequently more attractive to investors than debt

because they grow in value with the success of the firm.

a) The higher the ordinary (common) share value, the more advantageousequity financing is over debt financing.

b. Disadvantages of ordinary (common) shares to the issuer

1) Control (voting rights) of existing ordinary (common) shareholders may bediluted as more ordinary (common) shares are sold.

2) New ordinary (common) shares dilute earnings available to existingshareholders because of the greater number of shares outstanding.

3) Underwriting costs are typically higher for ordinary (common) share issues.4) Too much equity may raise the average cost of capital of the firm above its

optimal level.5) Ordinary (common) share cash dividends may not be deductible as an expense

and are after-tax cash deductions to the firm.c. Ordinary (common) shareholders ordinarily have preemptive rights.

1) Preemptive rights give ordinary (common) shareholders the right to purchaseany additional issuances in proportion to their current ownership.

2) If applicable law or the corporate charter does not provide preemptive rights, thefirm may nevertheless sell to the ordinary (common) shareholders in a rightsoffering. Each shareholder is issued a certificate or warrant that is an optionto buy a certain number of shares at a fixed price within a given time.

a) Until the rights are actually issued, the shares trade rights-on. The sharesand the rights are not separable. After the rights are received, the sharestrade ex-rights because the rights can be sold separately. The price of ashare right sold rights-on is

If: P = value of a share rights-onS = subscription price of a shareN = number of rights needed to buy a share

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4. Preference (preferred) shares are a hybrid of debt and equity. They have a fixed chargeand increase leverage, but payment of dividends is not a legal obligation. They are lessrisky for investors than ordinary (common) shares but more risky than bonds. Debt holdershave priority over preference (preferred) shareholders in liquidation.

a. Advantages of preference (preferred) shares to the issuer

1) They are a form of equity and therefore build the creditworthiness of the firm.2) Control is still held by ordinary (common) shareholders.3) Superior earnings of the firm are usually still reserved for the ordinary

(common) shareholders.b. Disadvantages of preference (preferred) shares to the issuer

1) Preference (preferred) share cash dividends paid are not tax deductible in mostcountries. The result is a substantially greater cost relative to bonds.

2) In periods of economic difficulty, accumulated (past) dividends may createmajor managerial and financial problems for the firm.

c. Typical provisions of preference (preferred) share issues

1) Par value. Par value is the liquidation value, and a percentage of par equals thepreference (preferred) dividend.

2) Priority in assets and earnings. If the firm goes bankrupt, the preference(preferred) shareholders have priority over ordinary (common) shareholders.

3) Accumulation of dividends. If preference (preferred) dividends in arrears arecumulative, they must be paid before any ordinary (common) dividends can bepaid.

4) Convertibility. Preference (preferred) share issues may be convertible intoordinary (common) shares at the option of the shareholder.

5) Participation. Preference (preferred) shares may participate with ordinary(common) in excess earnings of the company. For example, 8% participatingpreference (preferred) shares might pay a dividend each year greater than 8%when the corporation is extremely profitable. But nonparticipating preference(preferred) shares will receive no more than is stated on the face of the share.

6) Redeemability. Some preference (preferred) shares may be redeemed at agiven time or at the option of the holder or otherwise at a time not controlled bythe issuer. This feature makes preference (preferred) shares more nearly akinto debt, particularly in the case of transient preference (preferred) stock,which must be redeemed within a short time (e.g., 5 to 10 years).

7) Voting rights. These may be conferred if preference (preferred) dividends arein arrears for a stated period.

8) Callability. The issuer may have the right to repurchase the shares. Forexample, the shares may be noncallable for a stated period after which theymay be called if the issuer pays a call premium.

9) Maturity. Preference (preferred) shares may have a sinking fund that allows forthe purchase of a given annual percentage of the outstanding shares.

d. Holding preference (preferred) shares rather than bonds may provide corporations atax advantage. A portion of dividends received from preference (preferred) sharesmay be tax deductible, whereas all bond interest received ordinarily is taxable.

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5. Bonds are long-term debt instruments. They are similar to term loans except that they areusually offered to the public and sold to many investors.

a. Advantages of bonds to the issuer

1) Basic control of the firm is not shared with the debtholder.2) Cost of debt is limited. Bondholders usually do not participate in the superior

earnings of the firm.3) Ordinarily, the expected yield of bonds is lower than the cost of shares.4) Interest paid on debt is usually tax deductible.5) Debt may add substantial flexibility in the financial structure of the corporation

through the use of call provisions.b. Disadvantages of bonds to the issuer

1) Debt has a fixed charge. If the earnings of the firm fluctuate, the risk ofinsolvency is increased by the fixed interest obligation.

2) Debt adds risk to a firm. Shareholders will consequently demand highercapitalization rates on equity earnings, which may result in a decline in themarket price of shares.

3) Debt usually has a maturity date.4) Debt is a long-term commitment, a factor that can affect risk profiles. Debt

originally appearing to be profitable may become a burden and drive the firminto bankruptcy.

5) Certain managerial powers are usually surrendered in the contractualrelationship defined in the bond indenture.

a) For example, specific ratios may have to remain above a certain levelduring the term of the loan.

6) The amount of debt financing available to the individual firm is limited.Generally accepted standards of the investment community will usually dictatea certain debt-equity ratio for a firm. Beyond this limit, the cost of debt mayrise rapidly, or debt financing may not be available.

c. The bond indenture is the contractual arrangement between the issuer and thebondholders. It contains restrictive covenants intended to prevent the issuer fromtaking actions contrary to the interests of the bondholders. A trustee, often a bank, isappointed to ensure compliance.

1) Call provisions give the corporation the right to redeem bonds. If interest ratesdecline, the company can call high-interest bonds and replace them withlow-interest bonds.

2) Bonds are putable or redeemable if the holder has the right to exchange themfor cash. This option is usually activated only if the issuer takes a stated action,for example, greatly increasing its debt or being acquired by another entity.

3) Sinking fund requirements provide for the firm to retire a certain portion of itsbonds each year or to set aside money for repayment in the future. Such termsincrease the probability of repayment for bondholders but require the use ofcapital by the firm.

4) The issuer may be required to maintain its financial ratios, e.g., times-interest-earned, at specified levels.

5) Dividends may be limited if earnings do not meet specified requirements.6) The amount of new bonds issued may be restricted to a percentage of bondable

property (fixed assets).

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d. Types of bonds

1) A mortgage bond is a pledge of certain assets for a loan. It is less risky forinvestors than a debenture because it is usually secured by real property as acondition of the loan. A first mortgage bond has priority over a secondmortgage bond.

2) A debenture is a long-term bond not secured by specific property. Onlycompanies with the best credit ratings can issue debentures because holderswill be general creditors. They will have a status inferior to that of securedparties and creditors with priorities in bankruptcy.

3) Subordinated debentures normally have a higher yield than secured bondsbecause they are riskier for investors. They are subordinated (inferior) to theclaims of other general creditors, secured parties, and persons with priorities inbankruptcy. The bond indenture specifies the claims (senior debt) to whichthese bonds are subordinate. They are usually issued only when the companyhas some debt instrument outstanding that prohibits the issuance of additionalregular bonds.

4) An income bond pays interest only if the issuer has earnings. Such bonds areriskier for investors than other bonds. They are correspondingly less risky forthe issuer.

5) Serial bonds have staggered maturities. These bonds permit investors tochoose the maturity dates that meet their needs.

6) Registered bonds are issued in the name of the owner. Interest payments aresent directly to the owner. When the owner sells registered bonds, the bondcertificates must be surrendered and new certificates issued.

a) They differ from coupon (bearer) bonds, which can be freely transferredand have a detachable coupon for each interest payment.

7) Participating bonds participate in excess earnings of the debtor as defined inthe indenture.

8) Indexed bonds (purchasing power bonds) pay interest that is indexed to ameasure of general purchasing power.

9) Zero-coupon bonds pay no periodic interest. However, they sell at a deepdiscount from their face amount.

a) The need to reinvest the periodic payments from normal bonds makestheir final return uncertain because future reinvestment rates areuncertain. But investors know the exact return on a zero-coupon bond.Investors might therefore be willing to pay a premium for them, which inturn might lead firms to issue them.

b) The lack of interest payments means the firm faces no additionalinsolvency risk from the issue until it matures.

10) Junk bonds are very high-risk, high-yield securities issued to finance leveragedbuyouts and mergers. They also are issued by troubled companies. Issuers ofjunk bonds exploit the large tax deductions for interest paid by entities with highdebt ratios.

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11) Convertible bonds may be exchanged by the holder for equity shares asdetermined by the bond indenture

a) Bonds also may be issued with warrants. Warrants are usuallydetachable. They are options to purchase equity securities that areseparately accounted for. A capital gain results if the share price risesabove the option price. The bonds remain outstanding if the warrants areexercised.

12) International bonds exist in two forms. Foreign bonds are denominated in thecurrency of the nation in which they are sold. Eurobonds are denominated in acurrency other than that of the nation where they are sold.

6. Share rights and convertibility are among the common financing arrangements used toincrease investor interest in corporate securities. The objective is a lower interest rate onbonds or a higher selling price for shares.

a. Share rights evidenced by warrants are options that are distributed with debt orpreference (preferred) shares. They permit a holder to share in an issuing company’sprosperity through a future purchase of shares at a special low price. They differfrom put and call options.

1) A put option is a right traded in the shares market to sell shares at a given pricewithin a specified period.

2) A call option is a right to purchase shares at a given price within a specifiedperiod.

3) Neither a put nor a call is issued by the company whose shares are the subjectof the option.

b. Convertibility. Bonds or preference (preferred) shares may be exchangeable (by theinvestor) into ordinary (common) shares under certain conditions.

c. Both the issuance of rights and a conversion feature offer a corporation a means ofdelayed equity financing when market prices are unfavorable. When the marketprice rises above the conversion price, holders will presumably exercise the rights orconvert the securities.

7. Intermediate-term financing refers to debt issues having approximate maturities of greaterthan 1 but less than 10 years. The principal types of intermediate-term financing are termloans and lease financing. Major lenders under term agreements are commercial banks,life insurance companies, and, to some extent, pension funds.

a. Term loans. One possible feature of term loans is tying the interest payable on theloan to a variable rate. This floating rate is usually stated as some percentage overthe prime rate (the rate charged by a bank to its largest, most creditworthy clients).It may result in extremely high borrowing costs.

1) Risk tradeoffs

a) The need of the firm to obtain the loanb) The flexibility inherent in term borrowingc) The ability of the firm to borrow in the capital marketd) Other available types of debt financinge) The amount of privacy desired

2) Term loans are private contracts between private firms. Long-term debtsecurities usually involve governmental regulation, often including disclosure.

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3) Variable or floating rate loans are advantageous to lenders because theypermit better matching of interest costs and revenues. The market values ofthese loans also tend to be more stable than those for fixed-rate loans.

a) The disadvantages include (1) a heightened risk of default, (2) losses ofexpected revenues if interest rates decline or if market rates rise abovethe ceiling specified in the agreement, and (3) the difficulty of working witha more complex product.

4) Borrowers may benefit from the lower initial costs of these loans. However,they must accept (a) increased interest rate risk, (b) the difficulty of forecastingcash flows, (c) a possible loss of creditworthiness if interest rates are expectedto rise, and (d) the burden of more complex financing arrangements.

5) If the interest rate is variable but the monthly loan payment is fixed, anincrease in the rate means that the interest component of the payment and thetotal interest for the loan term will be greater.

a) The term of the loan also will be extended, and the principal balance willincrease because amortization is diminished. Indeed, negativeamortization may occur if the interest rate increase is great enough.

b. Lease financing offers tax and other benefits. If leases are not accounted for asinstallment purchases, they provide off-balance-sheet financing. Thus, under anoperating lease, the lessee need not record an asset or a liability, and rent expenserather than interest is recognized.

8. Maturity matching (equalizing the life of an asset acquired with the debt instrument used tofinance it) is an important factor in choosing the source of funds. Financing long-termassets with long-term debt allows the company to generate sufficient cash flows from theassets to satisfy obligations as they mature.

9. Venture capital. Venture capital firms invest in new enterprises that might not be able toobtain funds in the usual capital markets due to the riskiness of new products. Placementsof securities with venture capital firms are usually private placements and not subject togovernment regulation.

a. Venture capitalists accept low liquidity for their investments and high risk.b. The payoff may be substantial if the company does succeed.c. Venture capital is usually sought during the rapid growth stage of the firm’s

development.

5.2 SHORT-TERM FINANCING

1. Short-term credit is debt scheduled to be repaid within 1 year. Three main sources of thiscredit are trade credit, commercial banks, and commercial paper, but many other sourcesare available.

a. The terms of trade credit are set by suppliers.

1) EXAMPLE: If 2/10, net/30 were the method of payment, the buyer has 10 daysto take a 2% discount. If it is not taken, the full price must be paid within30 days. Advantages of this arrangement are that trade credit may be the onlysource of financing available and that the first 10 days of credit are free. Thedisadvantage is that the 20 additional days of credit are costly.

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2) Payments should be made within discount periods if the cost of not takingdiscounts exceeds the firm’s cost of capital.

a) The cost of not taking discounts is approximately

i) In this example, the cost of not taking the discount is

b) A more accurate calculation of the cost of not taking discounts considersthe effects of compounding. In this example, annualizing this costmeans that 18 payments are deemed to occur during the year. Theannual effective rate is

b. Commercial banks have traditionally offered savings (time deposit) and checking(demand deposit) accounts and served as lenders for a variety of purposes. Thus,they have been instrumental in governmental efforts to manage the money supply.However, other financial institutions have emerged that perform such functions.Furthermore, commercial banks have expanded their operations to include stockbrokerage, insurance, and other services.

1) Commercial bank lending is very significant to firms needing sources ofshort-term and intermediate-term financing. It is second only to trade credit asa source of financing.

a) The majority of lending by commercial banks is on a short-term basis.Many short-term loans are written for a term of 90 days.

b) The loan is obtained by signing a promissory note. Repayment is madein a lump sum at the maturity date, or installments are paid.

c) A line of credit may be extended to a borrowing firm. An amount iscredited to the borrower’s checking account for business use. At thematurity date, the checking account is charged the amount constitutingrepayment, usually principal and interest.

i) A revolving credit agreement (committed line of credit) imposes alegal obligation on the bank, but the borrower pays a commitmentfee.

d) Commercial banks typically require compensating balances in checkingaccounts equal to some percentage of the loan. The result is an increasein the effective interest rate.

e) The interest rate at which the bank will lend to a firm will depend on thefirm’s financial strength. The interest rate may be anywhere from theprime interest rate to 2 or 3 points above it. It is traditionally the lowestrate charged by banks. However, in recent years, banks have beenmaking loans at still lower rates in response to competition from thecommercial paper market.

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f) The cost of a bank loan may be determined in several ways. Simpleinterest is based on the borrowed amount and is paid at the end of theloan term. Discounted interest is based on the borrowed amount but ispaid in advance. The add-on interest rate for an installment loan equalsthe interest divided by the average balance. Compounding (periodicallyadding interest to the carrying amount) increases the effective rate, andthe more frequent the compounding, the higher the rate.

i) Simple interest rate for a 1-year loan:

ii) Discounted interest rate for a 1-year loan:

iii) Add-on installment interest rate for a 1-year loan:

iv) The present value and future value formulas with whichaccountants should be very familiar illustrate compounding.However, they are not repeated here.

2) Considerations in choosing a commercial lender

a) The bank’s policy toward risk.b) The additional services and counseling the bank provides to customers.c) The support a bank will provide in times of financial distress. Will the bank

pressure a firm to repay its loans on time or negotiate extensions?d) The degree of loan specialization provided by a bank. For example, a

bank may specialize in loans to companies in a given line of business.e) The size of the bank and its lending capacity. Thus, given that a bank

cannot lend more than 15% of its capital to one customer, a largecompany ordinarily will choose a large bank.

f) The financial strength of the bank.c. Commercial paper consists of short-term, unsecured, notes payable. They are

issued in large denominations by large companies with high credit ratings to othercompanies and institutional investors, such as pension funds, banks, and insurancecompanies. The maturity date of commercial paper is normally less than 270 days.Commercial paper is traded in money markets and thus is highly liquid. Commercialpaper is a lower cost source of funds than bank loans. It is usually issued at belowthe prime rate.

1) Advantages are that it affords broad and efficient distribution, provides largesums (at a given cost), and avoids costly financing arrangements.

2) Disadvantages are that it trades in an impersonal market and that the amountavailable is limited to the excess liquidity of big corporations.

d. Many other types of short-term financing are in use.

1) Bankers’ acceptances are drafts drawn on deposits at a bank. The acceptanceby the bank is a guarantee of payment at maturity.

2) Repurchase agreements involve sales by a dealer in government securitieswho agrees to repurchase at a given time for a specific price. Maturities maybe very short-term. This arrangement is in essence a secured loan.

3) Pledging or assigning receivables involves securing loans with receivables. Abank will often lend up to 80% of outstanding receivables. Receivables mayalso be factored (sold).

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4) Money-market mutual funds invest in portfolios of short-term securities.5) Warehouse financing uses inventory as security for the loan. A third party, for

example, a public warehouse, holds the collateral and serves as the creditor’sagent. The creditor receives the warehouse receipts evidencing rights in thecollateral. Security for inventory financing also may be in other forms.

a) A blanket (floating) lien against all inventory of the debtor permits sale ofthe inventory. Thus, the value of the collateral may be reduced.

b) A trust receipt is an instrument in which the debtor acknowledges that theinventory is held in trust for the creditor. Proceeds of sale of the specifiedgoods are remitted promptly to the creditor. Dealer financing of anautomobile purchase uses this method.

c) A field warehousing arrangement provides for on-site control andsupervision of specified goods by a third party.

6) Agency securities are issued by government agencies. Agency securities maybe long- or short-term.

7) National governments may issue long- and short-term debt.8) Local governmental entities issue short-term securities that may be exempt

from taxation.9) Chattel mortgages are loans secured by movable personal property (e.g.,

equipment or livestock).

5.3 OPTIMAL CAPITALIZATION

1. The financial structure of a firm encompasses the right-hand side of the balance sheet,which describes how the firm’s assets are financed. Capital structure is the permanentfinancing of the firm and is represented primarily by

a. Long-term debt

1) Most firms renew (roll over) their long-term obligations. Thus, long-term debt isoften effectively permanent.

b. Preference (preferred) stockc. Ordinary (common) equity

1) Ordinary (common) stock2) Additional paid-in capital3) Retained earnings

2. The following factors influence financial structure:

a. Growth rate and stability of future salesb. Competitive structures in the industryc. Asset makeup of the individual firmd. Attitude of owners and management toward riske. Control position of owners and managementf. Lenders’ attitudes toward the industry and a particular firmg. Tax considerations

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3. Leverage is the relative amount of the fixed cost of capital, principally debt, in a firm’s capitalstructure. Leverage, by definition, creates financial risk, which relates directly to thequestion of the cost of capital. The more leverage, the higher the financial risk, and thehigher the cost of debt capital.

a. Earnings per share ordinarily will be higher if debt is used to raise capital instead ofequity, provided that the firm is not over-leveraged. The reason is that the cost ofdebt is lower than the cost of equity because interest is tax deductible. However,the prospect of higher EPS is accompanied by (1) greater risk to the firm resultingfrom required interest costs, (2) creditors’ liens on the firm’s assets, and (3) thepossibility of a proportionately lower EPS if sales volume fails to meet projections.

b. The degree of financial leverage (DFL) is the percentage change in earningsavailable to ordinary (common) shareholders that is associated with a givenpercentage change in net operating income. The second formula below can bederived from the first (the derivation is not given).

c.

1) Net income means earnings available to ordinary (common) shareholders.2) Operating income equals earnings before interest and taxes (EBIT).3) I equals interest expense. If the company has preference (preferred) stock, the

second formula is further modified as follows [if P = preference (preferred)dividends and T is the tax rate]:

4) The greater the DFL, the riskier the firm.d. If the return on assets exceeds the cost of debt, additional leverage is favorable.e. Operating leverage is the extent to which fixed costs are used in the production

process. A company with a high percentage of fixed costs is more risky than one inthe same industry that relies more on variable costs to produce.

1) The degree of operating leverage (DOL) is the percentage change in netoperating income associated with a given percentage change in sales. Thesecond formula below can be derived from the first (the derivation is not given).

2)

a) EXAMPLE: If operating income increases 20% with a 10% increase insales, DOL is 2.0.

f. The degree of total leverage (DTL) combines the DFL and the DOL. It equals thedegree of financial leverage times the degree of operating leverage. Thus, it alsoequals the percentage change in net income that is associated with a givenpercentage change in sales.

1)

a) EXAMPLE: If net income increases 15% with a 5% increase in sales, DTLis 3.0.

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2) Firms with a high degree of operating leverage do not usually employ a highdegree of financial leverage and vice versa. One of the most importantconsiderations in the use of financial leverage is operating leverage.

a) EXAMPLE: A firm has a highly automated production process. Becauseof automation, the degree of operating leverage is 2. If the firm wants adegree of total leverage not exceeding 3, it must restrict its use of debt sothat the degree of financial leverage is not more than 1.5. If the firm hadcommitted to a production process that was less automated and had alower DOL, more debt could be employed, and the firm could have ahigher degree of financial leverage.

4. Cost of capital. Managers must know the cost of capital in making investment (long-termfunding) decisions because investments with a return higher than the cost of capital willincrease the value of the firm (shareholders’ wealth). The theory underlying the cost ofcapital applies to new, long-term funding because long-term funds finance long-terminvestments. Short-term funds are used to meet working capital and other temporaryneeds. Cost of capital is of less concern for short-term funding.

a. The cost of capital is a weighted average of the various debt and equity components.The weighted-average cost of capital weights the percentage cost of eachcomponent by the percentage of that component in the financial structure. TheWACC is the weighted cost of each new monetary unit of capital raised. It is amarginal cost, not the average cost of amounts raised in the past or in the currentperiod. The primary use of WACC is for capital budgeting. For this purpose, amarginal cost is needed.

1) The marginal cost of debt equals the interest rate on new debt times oneminus the marginal tax rate because interest is a tax deduction. Hence, anincrease in the tax rate decreases the cost of debt. If kd is the interest rate onnew debt, and T is the marginal tax rate, the formula is

kd(1 – T)

2) The cost of retained earnings is an opportunity cost. It is the rate thatinvestors can earn elsewhere on investments of comparable risk. The cost ofinternally generated funds is an imputed cost.

3) The cost of new external ordinary (common) equity is higher than the cost ofretained earnings because of stock flotation costs.

a) Providers of equity capital are exposed to more risk than lenders becausethe firm is not obligated to pay them a return. Also, in case of liquidation,creditors are paid before equity investors. Thus, equity financing is moreexpensive than debt because equity investors require a higher return tocompensate for the greater risk assumed.

4) The cost of preference (preferred) stock equals the preference (preferred)dividend divided by the net issuance price. No tax adjustment is necessarybecause preference (preferred) dividends paid are not deductible.

b. Standard financial theory states that an optimal capital structure exists.

1) The optimal capital structure minimizes the weighted average cost of capitaland thereby maximizes the value of the firm’s stock.

a) The optimal capital structure does not maximize EPS. Greater leveragemaximizes EPS but also increases risk. Thus, the highest stock price isnot reached by maximizing EPS.

2) The optimal capital structure usually involves some debt, but not 100% debt.

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3) The relevant relationships are depicted below.

a) D ÷ E represents the lowest weighted-average cost of capital and istherefore the firm’s optimal capital structure.

4) Ordinarily, firms cannot identify this optimal point precisely. Thus, they shouldattempt to find an optimal range for the capital structure.

c. The required rate of return on equity capital (R) can be estimated as follows.

1) The Capital Asset Pricing Model (CAPM) adds the risk-free rate (determinedby government securities) to the product of the beta coefficient (a measure ofthe firm’s risk) and the difference between the market return and the risk-freerate. Below is the basic equilibrium equation for the CAPM.

a) The market risk premium (RM – RF) is the amount above the risk-free raterequired to induce average investors to enter the market.

b) The beta coefficient (β) of an individual stock is the correlation betweenthe volatility (price variation) of the stock market and the volatility of theprice of the individual stock.

i) EXAMPLE: If an individual stock rises 10% and the stock marketrises 10%, the beta coefficient is 1.0. If the stock rises 15% and thestock market only rises 10%, beta is 1.5.

c) EXAMPLE: Assuming a beta of 1.20, a market rate of return ofapproximately 17%, and an expected risk-free rate of 12%, the requiredrate of return on equity capital is .12 + 1.20 (.17 – .12), or 18%.

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d) The graph of the basic CAPM equation (with interest rates plotted on thevertical axis and betas on the horizontal axis) is the Security MarketLine. The slope of the SML equals the market risk premium, and they-intercept is the risk-free rate.

e) The risk premium is the difference in expected rates of return on a riskyasset and a less risky asset.

2) R also may be estimated by adding a percentage to the firm’s long-term cost ofdebt.

a) A 3% to 5% premium is frequently used.3) The economic value of the firm is expressed by the formula

If: V is value, CF is net cash flow, k is the discount rate (cost of capital), andt is time.

4) The dividend growth model (also known as the constant growth model or theGordon model) estimates the cost of retained earnings using the dividendsper share, the expected growth rate, and the market price. To justify retentionof earnings, management must expect a return at least equal to the dividendyield plus a growth rate.

a) The formula is

If: P0 = current priceD1 = next dividendR = required rate of returnG = growth rate in dividends per share (but the model assumes

that the dividend payout ratio, retention rate,and therefore the EPS growth rate are constant).

i) EXAMPLE: If a company’s dividend is expected to be $4 while themarket price is $50 and the dividend is expected to grow at aconstant rate of 6%, the required rate of return would be $4 ÷ $50 +.06, or 14%.

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b) To determine the cost of new ordinary (common) stock (externalequity), the model is altered to incorporate the flotation cost. As theflotation cost rises, R increases accordingly.

c) The dividend growth model also is used for stock price evaluation. Theformula can be restated in terms of P0 as follows:

d) The stock price is affected by the dividend payout ratio because someinvestors may want capital gains, but others may prefer current income.Thus, investors will choose stocks that give the proper mix of capital gainsand dividends.

e) A concept relevant to securities valuation is the efficient marketshypothesis (EMH). It states that current share prices immediately andfully reflect all relevant information. Hence, the market is continuouslyusing new information to correct pricing errors, and securities prices arealways in equilibrium. The reason is that securities are intenselyanalyzed by many highly trained individuals. These analysts work forinstitutions with the resources to take very rapid action when newinformation is available.

i) The EMH states that abnormal returns cannot be obtainedconsistently with either fundamental or technical analysis.Fundamental analysis evaluates a security’s future price basedupon sales, internal developments, industry trends, the generaleconomy, and expected changes in each factor. Technicalanalysis evaluates a security’s future price based on the salesprice and number of shares traded in recent transactions.

ii) Under the EMH, the expected return of each security equals thereturn required by the marginal investor given its risk. The priceequals its fair value as perceived by investors.

iii) Under the strong form of the EMH, all public and private informationis instantaneously reflected in securities’ prices. Thus, insidertrading is assumed not to result in abnormal returns. Thesemistrong form states that all publicly available data are reflectedin security prices, but private or insider data are not immediatelyreflected. Accordingly, insider trading can result in abnormalreturns. The weak form states that current prices reflect all recentpast price data, so technical analysis will not provide a basis forabnormal returns.

iv) Empirical data have refuted only the strong form of the EMH.v) The price of a security reflects the present value of its future cash

flows. If that price is accurate, the net present value of theinvestment is zero. Thus, if all prices are accurate, every securityhas an NPV of zero, and all securities are therefore perfectsubstitutes.

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d. The marginal cost of capital (MCC). The MCC is a weighted average of the costs ofthe different financing sources. If the cost of any source of financing increases, theMCC curve will rise. The MCC curve is upward sloping because the lowest costfinancing sources are assumed to be used first. Thus, as cumulative debt increases,the cost of debt also increases. (The curve below has been smoothed. To reflect thebreaks or jumps that occur at points beyond which new capital becomes more costly,the curve also may be drawn in steps.)

e. The investment opportunity schedule (IOS). The return on an additional unit ofcapital investment decreases because the most profitable investments are madeinitially. (The curve below also has been smoothed.)

f. Combining the MCC and IOS schedules (graphs) determines the corporate cost ofcapital, the hurdle rate used in the capital budgeting process. It also determines theoptimal capital budget.

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5. To ensure short-term and long-term survival, firms must recognize the need for budgetingand financial forecasts. Additional funds needed (AFN) must be calculated to avoidshortages of working capital and provide for adequate funds required to complete plans forcapital expansion. Working capital is required for sales growth. Furthermore, a firmnearing full capacity production must be responsive to fixed asset requirements. If a firmcannot supply the expansion capital through retained earnings, it must seek externalcapital, which will result in an increase of debt or equity. The following graph is an exampleof the visual depiction of a firm’s additional financing needs.

5.4 CASH MANAGEMENT

1. The cash budget details projected receipts and disbursements, preferably to plan thesynchronization of inflows and outflows.

a. It is based on the projected sales and credit terms, collection percentages, andestimated purchases and payment terms.

b. Cash outflows are budgeted based on the level of sales.c. Cash budgeting is an ongoing, cumulative activity.

1) Budgets must be for a specified period of time, and the units of time must beshort enough to assure that all cash payments can be made.

2. Holding cash is done for the following reasons:

a. As a medium of exchange. Cash is still needed for some business transactions.b. As a precautionary measure. Cash or a money-market fund can be held for

emergencies. Normally, investment in high-grade, short-term securities is a betteralternative to holding cash.

1) Years ago, in face of cash shortages, money was literally held, as a precautionagainst bank closings.

2) Today, if the banks fail, paper money will be worthless; thus, there is noprecautionary reason to hoard paper currency.

c. For speculation. Cash may be held to take advantage of bargain-purchaseopportunities. However, for this purpose too, short-term, highly liquid securities arepreferable.

d. As a compensating balance in exchange for a bank’s services or loans.

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3. Cash collections should be expedited.

a. Invoices should be mailed promptly.b. Credit terms must be competitive but geared to encourage prompt payment.c. A lockbox system may be used to expedite the receipt of funds. A company

maintains mailboxes, often in numerous locations around the country, to whichcustomers send payments. A bank checks these mailboxes several times a day.Funds received are immediately deposited to the company’s account without firstbeing processed by the company’s accounting system, thereby hastening availabilityof the funds. In addition, having several lockboxes throughout the country reducesthe time a payment is in the postal system.

1) Concentration banking may be useful in this context. Regional concentrationbanks may serve as centers for the transfer of lockbox receipts. Adisbursement account at the regional center will then expedite the use of thereceipts for payments in that region. Such use might be delayed if all receiptswere transmitted to a national central bank.

d. Transfer of monies by wire expedites cash management. A wire transfer is anyelectronic funds transfer by means of a two-way system.

e. Electronic Data Interchange (EDI) is the communication of electronic documentsdirectly from one computer to another. Electronic funds transfer (EFT) andcustomer debit cards are applications of EDI that expedite cash inflows. With therecent widespread growth of electronic commerce (the buying and selling ofproducts and services over the Internet) by individuals, the use of electronic fundstransfer has mushroomed. Companies such as PayPal enable individuals to transferfunds to each other at little or no cost.

f. Automated clearing houses (ACHs) are electronic networks that facilitate thereading of data among banks.

4. Slowing cash disbursements increases available cash.

a. Payment beyond normal credit terms, however, creates vendor ill will and may incurinterest charges.

b. Payments should be made within discount periods if the cost of not taking adiscount exceeds the firm’s cost of capital.

c. Payment by draft (a three-party instrument in which the drawer orders the drawee topay money to the payee) is a means of slowing cash outflows.

1) A check is the most common draft. Check float arises from the delay betweenan expenditure or receipt by check and the clearing of the check.

a) The effect is an interest-free loan to the payor.b) Accordingly, companies try to maximize disbursements float (the period

from when checks are written to when they are subtracted from the bankbalance). They try to minimize collections float (the sum of the timechecks are in the mail, internal processing time, and the time required forclearing through the banking system).

2) Payable through drafts (PTDs) also are drafts. They differ from checksbecause they are not payable on demand, and the drawee is the payor, not abank. After presentment to a bank, a PTD must be presented to the issuer. Ifthe issuer chooses to accept the instrument, it will deposit the necessary funds.Consequently, use of PTDs allows a firm to postpone the deposit of funds andtherefore to maintain lower cash balances.

a) The drawbacks of PTDs are that suppliers prefer checks. Furthermore,banks impose greater charges for processing PTDs.

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d. When a compensating balance is negotiated with a bank, use of an averagebalance frees most of the balance for use as a contingency fund.

1) The flexible compensating balance can be used as a cushion for the days whencash demands are greatest and deposits fail to materialize.

2) The effective interest rate on loans requiring compensating balances equalstotal interest cost divided by total principal.

a)

b) Total principal is reduced by the account’s ordinary balance, and totalinterest cost is reduced by the amount of interest that the company wouldearn on its ordinary balance.

e. Zero-balancing checking accounts are disbursement accounts (for example,payroll) offered by some banks. The account balance is maintained at zero until acheck comes in. The resulting overdraft is covered by a transfer from a master(parent) account earning interest.

1) The disadvantages are that the bank may charge a fee for this service and theamount needed in the master account still needs to be estimated.

5. The amount of cash on hand should be determined by cost-benefit analysis.

a. The reduction in average cash times the interest rate (cost of capital or investmentyield rate) is the benefit.

b. Costs of having insufficient cash include incremental personnel cost, lost discounts,and lost vendor goodwill.

c. The economic order quantity (EOQ) model is applicable to cash management.

1) It can be stated in terms of the following assumptions:

a) A known demand for cashb) A given carrying (interest) costc) The flat amount (cost) of converting other assets to cash, such as the

broker’s fee for sale of marketable securities (assumed to be constantregardless of the transaction size)

2) One such EOQ-type model is the Baumol Cash Management Model. Itminimizes the total of the costs of securities transactions and the opportunitycosts of holding cash (the return forgone by not investing in marketablesecurities or the cost of borrowing cash). If OC is the optimal cash level, b isthe cost per transaction (a fixed amount per transaction), i is the interest rate onmarketable securities or the cost of borrowing cash, and T is the total cashdemand for the period, the formula is

3) The Baumol model, like the EOQ model, is deterministic and relies on simplifyingassumptions. For example, the demand for cash must be known. If suchinformation is not known, the Miller-Orr Cash Management Model can beused. The Miller-Orr model assumes uncertain cash flows that are random inamount and direction and are normally distributed as the number of periodsincreases. It provides for cost efficient cash balances by determining an upperlimit and lower limit for cash balances. The target cash balance is betweenthese two limits. As long as cash is between the two limits, no transaction toreplenish or invest the cash balance occurs.

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a) The diagram below illustrates the Miller-Orr Model. The objective of themodel is to minimize the expected cost of holding cash by choosingappropriate values for two variables: the upper limit (H) and the returnpoint (Z). The lower limit (L) is given. When the cash balance reaches H,sufficient cash is invested to reduce the balance to Z. When the balancefalls to L, sufficient assets are sold to increase the balance.

6. A firm’s excess cash should be placed in an investment with the highest return consistentwith low risk, such as those listed below.

a. Short-term debt securities may be guaranteed explicitly by a government and exemptfrom local taxation. They may be sold on a discount basis.

b. Certificates of deposit are a form of savings deposit that cannot be withdrawn beforematurity without a high penalty. However, negotiable CDs are subject to governmentsecurities regulation.

c. Money-market accounts are similar to checking accounts but pay higher interest.d. High-grade commercial paper consists of unsecured, short-term notes issued by

large companies that are very good credit risks. However, commercial paper mayyield a higher return than CDs because it is riskier.

e. A firm with excessive cash might tend to be an attractive takeover target.

7. Interest rate expectation theory states that long-term interest rates are usually a geometricaverage of expected future short-term interest rates.

5.5 MARKETABLE SECURITIES MANAGEMENT

1. Short-term marketable securities are sometimes held as substitutes for cash but are morelikely to be acquired as temporary investments.

a. Most firms avoid large cash balances and prefer borrowing to meet short-term needs.b. As temporary investments, marketable securities may be purchased with maturities

timed to (1) meet seasonal fluctuations, (2) pay off a bond issue, (3) make taxpayments, or (4) otherwise satisfy anticipated needs.

2. Marketable securities should be chosen with a view to the risk of default (financial risk).

3. Interest-rate risk should be minimized given the reasons for holding marketable securities.

a. Short-term securities are less likely to fluctuate in value because of changes in thegeneral level of interest rates.

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4. Changes in the general price level (inflation) determine the purchasing power of paymentson investments (principal and interest) and thus the types of securities chosen and therates charged.

5. The degree of marketability of a security determines its liquidity, that is, the ability to resellat the quoted market price.

6. The firm’s tax position will influence its choice of securities. For example, a firm with netloss carryforwards may prefer a higher-yielding taxable security to a tax-exempt municipalbond.

7. Short-term marketable securities are usually chosen for reasons that make high-yield,high-risk investments unattractive. Hence, a higher return may be forgone in exchange forgreater safety. Given the various options available, a company should have aninvestment policy statement to provide continuing guidance to management regardingthe risk-return trade-off.

a. Thus, speculative tactics, such as selling short (borrowing and selling securities inthe expectation that their price will decline by the time they must be replaced) andmargin trading (borrowing from a broker to buy securities) are avoided.

5.6 RECEIVABLES MANAGEMENT

1. The objective of managing accounts receivable is to have both the optimal amount ofreceivables outstanding and the optimal amount of bad debts.

a. This balance requires a trade-off between the benefits of credit sales, such as moresales, and the costs of accounts receivable, such as collection, interest, and baddebt costs. The appropriate policy does not seek merely to maximize sales or tominimize default risk.

b. Thus, a firm should extend credit until the marginal benefit (profit) is zero(considering opportunity costs of alternative investments).

2. Credit terms, collection policies, etc., are frequently determined by competitors. A firmmust match such inducements to make sales. Firms often use a statistical technique calledcredit scoring to determine whether to extend credit to a specific customer. Credit scoringassigns numerical values to the elements of credit worthiness, e.g., income, length of timeemployed in the same job, occupation, and home ownership.

3. Receivables management should maximize the accounts receivable turnover ratio, that is,shorten the average time receivables are held.

a. The accounts receivable turnover ratio equals net credit sales divided by averageaccounts receivable.

b. A common analytical tool is an aging schedule developed from a company’saccounts receivable ledger. It stratifies the accounts depending on how long theyhave been outstanding.

c. The number of days of receivables equals the number of days in the year (365, 360,or 300) divided by the receivables turnover ratio. This ratio can be compared with theseller’s credit terms to determine whether most customers are paying on time.

1) It is the average number of days to collect a receivable (collection period).2) It also may be computed as average accounts receivable divided by average

daily sales (net credit sales ÷ days in a year).d. Average gross receivables is calculated by multiplying average daily sales by the

average collection period.

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4. The following are different types of credit instruments used in receivables management:

a. An invoice is a bill issued by a company that has provided goods or services to acustomer. It includes the prices, terms, and types of goods. In asset-based lending(such as factoring), an invoice means an account receivable.

b. A promissory note is a two-party negotiable instrument that contains an unconditionalpromise to pay a fixed sum of money at a definite time.

c. A conditional sales contract is a financing method often used by sellers ofequipment. The buyer receives possession and use of the goods. The seller initiallyreceives a promissory note but retains title until the installment debt is paid.Retention of title facilitates repossession.

5. Other tools of credit such as bank charge cards should be evaluated as an alternative tocharge accounts.

a. Banks charge a fee equal to a percentage charge sales.b. Charge tickets can be deposited at a bank in the same way as customer checks.c. Money is instantly available to the seller.

5.7 VALUATION AND PRICING BUSINESS COMBINATIONS

1. The most fundamental approach to valuing a business combination is capital budgetinganalysis. If the net present value (NPV) is positive, that is, if the present value of theestimated incremental cash flows from the combination exceeds the present value of theamounts to be paid for the acquired firm, the investment is financially sound for theacquirer. The shareholders of the acquired firm should perform a similar analysis andcompare the result with the NPV of remaining an independent entity. Accordingly, theanalysis must emphasize

a. Accurate estimates of expected cash flowsb. The effect on the cost of capital and the optimal capital structure of the acquirerc. How the combination will be financedd. The price to be paid

1) A combination should be synergistic or otherwise result in the creation of newvalue. In that case, a premium can be paid to the shareholders of the acquiredfirm while still permitting the shareholders of the acquiring firm to benefit.However, most of the gain in value usually is paid to the acquired firm’sshareholders as an inducement to sell.

2. Crucial aspects of valuation analysis are the estimates of the incremental cash flows fromthe combination and the required rate of return (cost of capital). This rate is the discountrate to be used in calculating the NPV.

a. Projecting incremental cash flows from the combination becomes relatively moredifficult when the firms’ operations are to be merged or if the acquired firm’soperations are to be changed.

1) The cash flow analysis should also consider the transaction costs involved.b. In comparison with the usual capital budgeting analysis, a combination often requires

consideration of more complex debt arrangements. The debt acquired will havedifferent rates from that held by the acquiring firm, debt may be issued to finance thecombination, and new debt may be issued to finance expansion of the acquired firm.Accordingly, the projected cash flow analysis should incorporate interest. Becausethe net cash flows will be calculated after subtraction of interest, the valuation willreflect the equity residual, i.e., the value to the acquiring firm.

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c. The forecast of the incremental cash flows available to the acquiring firm should bebased on analyses of the sensitivity of the NPV to changes in the crucial variables.It also should consider the range of the probable values of these variables based ontheir probability distributions. Consequently, a computer simulation may be auseful technique for evaluating the combination, assuming probabilities can beestimated for the components of the projected cash flows.

d. If the net incremental cash flows to the acquiring firm are to be calculated, thediscount rate used should be the cost of equity capital. Moreover, this rate shouldreflect the risk associated with the use of funds rather than their source. The ratetherefore should not be the cost of capital of the acquiring firm but rather the cost ofequity of the combined firm after the combination. This calculation requires a newestimate of beta to be used in the Capital Asset Pricing Model.

e. Estimating the value of the combination using discounted cash flows should not ignorethe market prices of comparable investments. If the market is efficient, marketprices should equal the values of those investments. This analysis should include theP-E ratio, price-to-book-value ratio, and price-to-sales ratio.

f. The nature of the bid for the acquired firm (cash, stock, debt, or a combination) hasimportant effects on

1) The combined firm’s capital structure2) The tax position of the acquiring company and the shareholders of the acquired

company3) Whether the acquired firm’s shareholders will benefit from postcombination

gains by the combined firm4) The extent of governmental regulatory involvement

5.8 DERIVATIVE FINANCIAL INSTRUMENTS

1. A derivative is a financial instrument commonly used in hedging activities. Its valuechanges with the change in the underlying (a specified interest rate, security price, foreigncurrency exchange rate, price index, commodity price, etc.). It requires little or no initialnet investment compared with contracts having similar responses to changing marketconditions, and it is settled in the future.

a. An embedded derivative is one that is combined with a host contract so that somecash flows of the instrument vary in the same way as those of a stand-alonederivative.

2. Options and futures are derivative securities. They are not claims on business assets,such as those represented by equity securities. Instead, they are created by the partieswho trade in them.

a. An American option is a contractual arrangement that gives the owner the right tobuy or sell an asset at a fixed price at any moment in time before or on a specifieddate. A European option is exercisable only at the expiration date.

b. Exercise of an option is the act of buying or selling the asset underlying the optioncontract. An open interest is the total number of option or futures contracts thathave not expired, been exercised, or been fulfilled by delivery.

c. An option is a right of the owner, not an obligation.

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d. The exercise or strike (striking) price is the price at which the owner can purchasethe asset underlying the option contract. The option price, also called optionpremium, is the amount paid to acquire an option.

1) The bid-ask spread is the difference between what a buyer is willing to bid andwhat a seller is asking.

e. An option usually has an expiration date after which it can no longer be exercised.f. The longer the time before expiration, the more valuable the option. The reason is

the increased time available for the asset’s price to rise or fall.g. A covered option is written against stock held in the option writer’s portfolio.h. A naked (uncovered) option does not have the backing of stock.i. A call option is the most common type of option. It gives the owner the right to

purchase the underlying asset at a fixed price. Thus, it represents a long positionbecause the owner gains from a price increase. The profit is the difference betweenthe price paid and the value at the closing date, minus the brokerage fee.

1) Call options usually involve ordinary (common) stock as the underlying asset.However, any type of asset may underlie an option.

2) If the value of the asset underlying a call option is less than the exercise price ofthe option, the option is out-of-the-money, or not worth exercising. If the valueof the asset underlying the option is greater than the sum of the call premiumand the exercise price, it is in-the-money and can earn the owner a profit.

3) A call option’s expiration value equals the excess of the current price of theasset over the exercise price. If the exercise price exceeds the current price,the option is worthless.

j. A put option gives the owner the right to sell the underlying asset for a fixed price. Itrepresents a short position because the owner benefits from a price decrease.

1) If the value of the asset underlying a put option is greater than its exerciseprice, the put is out of the money.

2) If the value of the asset underlying the put option is less than the exercise priceof the put option, the put is in the money. Intrinsic value is the differencebetween the exercise price and the market price of the underlying security.

3) A put option’s expiration value equals either zero or the excess of the exerciseprice over the current market price.

k. A stock option is an option to buy a specific stock at some future time. An indexoption is an option whose underlying security is an index. If exercised, settlement ismade by cash payment because physical delivery is not possible. Long-TermEquity Anticipation Securities (LEAPS) are examples of long-term stock options orindex options, with expiration dates up to three years away. Foreign currencyoptions give the holder the right to buy a specific foreign currency at a designatedexchange rate.

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l. The value of a call option may be viewed as based on its exercise price, its expirationdate, the price of the underlying asset, the variability of that asset, and the risk-freeinterest rate. The well-known Black-Scholes Option-Pricing Model uses thesefactors.

1) If C is the current value of a call option with time t in years until expiration, S isthe current stock price, N(di) is the cumulative probability that a deviation lessthan di will occur in a standardized normal distribution [N(di) is an area to theleft of di under the curve for the standard normal distribution], E is the call’sexercise price, e is a constant (approximately 2.7183), r is the annualizedcontinuous risk-free rate of return, ln(S/E) is the natural logarithm of S/E, andσ2 is the variance of the continuous rate of return on the stock, theBlack-Scholes formula is

a) In effect, the first term of the equation for C is the expected present valueof the final stock price, and the second term is the present value ofthe exercise price.

3. A forward contract is simply an executory (unperformed) contract. The parties agree to theterms of a purchase and sale, but performance, i.e., payment by the buyer and delivery bythe seller, is deferred. A futures contract is a specific kind of forward contract. It is adefinite agreement that allows a trader to purchase or sell an asset at a fixed price during aspecific future month. Futures contracts for agricultural commodities, metals, oil, andfinancial assets are traded on numerous exchanges.

a. One characteristic of a futures contract is that it may be highly leveraged. The initialmargin paid may be a very small percentage of the price. Thus, the risk of eithergain or loss to a speculator may be great.

b. A futures contract differs from a forward contract in part because it is traded on anexchange. The result is a liquid market in futures that permits buyers and sellers tonet out their positions. For example, a party who has sold a contract can net outhis/her position by buying a futures contract.

c. Because futures contracts are for delivery during a given month, not a specific day,they are more flexible arrangements than forward contracts. The seller notifies theexchange clearinghouse when delivery is to be made. It then randomly matchesthe seller with a buyer who has purchased a contract for the same month.

d. Another distinguishing feature of futures contracts is that their prices are marked tomarket at the close of every day. Thus, the market price is posted at the close ofbusiness each day. A mark-to-market provision minimizes a futures contract’schance of default because profits and losses on the contracts must be received orpaid each day through a clearinghouse. This requirement of daily settlement isnecessary because futures contracts are sold on margin.

1) Cover is the cancelation of a short position in any futures contract by thepurchase of an equal quantity of the same futures contract. It is a means ofclosing out a futures position.

2) Another means of closing a futures position is delivery. It is the tender andreceipt of the actual commodities or, in the case of agricultural commodities,warehouse receipts covering such commodities, in settlement of a futurescontract. Some contracts settle in cash (cash delivery), in which case openpositions are marked to market on the last day of the contract based on thecash market close.

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e. A futures contract is entered into as either a speculation or a hedge. A financialmanager can protect a company against adverse changes in prices and interest ratesby hedging in the futures market. Hedging is the process of using offsettingcommitments to minimize or avoid the impact of adverse price movements.

1) Long hedges are futures purchased to protect against price increases.2) Short hedges are futures sold to protect against price declines.3) EXAMPLE: In the commodities market, a company might have a contract with

a farmer to buy soybeans at a future date. The price is agreed upon as thecurrent price. The company would lose money if the soybean prices declinedbefore the beans were delivered. To avoid any loss (or gain), the companycould sell soybeans in the future at today’s price. If the price of soybeansdeclines before the delivery date, the company will lose money on the beansbought from the farmer. However, it will gain money on the beans sold throughthe futures contract by buying cheap beans in the future to cover the delivery.

a) Because commodities can be bought and sold on margin, considerableleverage is involved. This high degree of leverage is most beneficial tothe speculator who is looking for large returns and is willing to bear therisk to get them. For hedgers, however, the small margin requirement isuseful only because the risk can be hedged without tying up a largeamount of cash.

4) The delta or hedge ratio is the change in price of a call option for everyone-point movement in the price of the underlying security. It is equal to N(d1)in the Black-Scholes Option-Pricing Model. Gamma is a measurement of howfast delta changes, given a unit change in the underlying futures price.

f. Interest rate futures contracts involve risk-free bonds.

1) The quantity traded is either $100,000 or $1,000,000, depending on whichmarket is used.

2) EXAMPLE: If a corporation wants to borrow money in six months for a majorproject, but the lender refuses to commit itself to an interest rate, the interestrate futures market can be used to hedge the risk that interest rates mightincrease in the interim. The company agrees to sell government bonds in sixmonths. If interest rates increase over the period, the value of thegovernment bonds will decline. The company can buy government bonds in sixmonths and use them to cover the delivery that it had promised in the futurescontract. Because the price of bonds declined over the period, the companywill make a profit on their delivery. The interest rates that the company willhave to pay on the upcoming loan will be higher, however. It has cost thecompany money to wait six months for the loan. The profit from the futurescontract should approximately offset the loss resulting from the higher interestloan. If interest rates had declined, the company would have had the benefit ofa lower interest loan but would have lost money on the bonds. The goal of anysuch hedging operation is to break even on the change in interest rates.

a) By hedging, the financial manager need not worry about fluctuations ininterest rates.

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g. Swaps are contracts to hedge risk by exchanging cash flows. The simplest form,sometimes called a plain vanilla swap, is an exchange of interest rates without anychange in the initial debt arrangement.

1) In an interest-rate swap, one firm exchanges its fixed interest payments for aseries of payments based on a floating rate. Such contracts are highlycustomized. If a firm has debt with fixed charges, but its revenues fluctuatewith interest rates, it may prefer to swap for cash outflows based on a floatingrate. The advantage is that revenues and the amounts of debt service will thenmove in the same direction, and interest-rate risk will be reduced. Thespecified dollar amount on which the exchanged interest payments are based iscalled the notional principal amount.

a) The steps to valuation of swaps include

i) Identifying the cash flows over time.ii) Constructing the swap curve, obtained from the government yield

curve and the swap spread curve.iii) Constructing a zero-coupon curve from the swap curve.iv) Determining the present value of the cash flows using the

zero-coupon rates.b) The swap spread is obtained from market makers. It is the market-

determined additional yield that compensates counter-parties who receivefixed payments in a swap for the credit risk involved in the swap. Theswap spread will differ with the creditworthiness of the counter-party.

c) Most swaps are priced to be at-the-money at inception, meaning that thevalue of the floating rate cash flows is the same as the value of the fixedrate cash flows at the inception of the deal. Naturally, as interest rateschange, the relative value may shift. Receiving the fixed-rate flow willbecome more valuable than receiving the floating rate flow if interest ratesdrop or if credit spreads tighten.

d) Investment banks and commercial banks are the market makers for mostswaps. The market makers generally warehouse the risk in portfolios,managing the residual interest rate risk of the cash flows.

2) A currency swap is an exchange of an obligation to pay out cash flowsdenominated in one currency for an obligation to pay in another. For example,a British firm with revenues in euros has to pay suppliers and workers inpounds, not euros. To minimize exchange-rate risk, it might agree to exchangeeuros for pounds held by a firm that needs euros. The exchange rate will bean average of the rates expected over the life of the agreement.

3) A swaption is an option on a swap, usually on an interest-rate swap. It providesthe holder with the right to enter into a swap at a specified future date atspecified terms (freestanding option on a swap) or to extend or terminate thelife of an existing swap (embedded option on a swap).

h. Arbitrage is the simultaneous purchase and sale of identical or equivalent financialinstruments or commodity futures to benefit from a discrepancy in their pricerelationship. This sometimes involves selling in one market while simultaneouslybuying in another market.

i. Program trading, also known as index arbitrage or computer-assisted trading,exploits the price discrepancies between indexes of stocks and futures contracts byusing sophisticated computer models to hedge positions. Program trading arose withthe advent of telecommunication technology that permits transactions in differentmarkets to be monitored simultaneously.

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j. An interest rate cap is an option that limits the risk of interest rate increases. Ifinterest rates rise above a certain level, the cap holder receives the excess of theactual interest rate over a designated interest rate (the strike or cap rate) based onthe notional principal amount. The cap holder’s loss is limited to the premium paid tothe cap writer. The cap writer has unlimited risk from potential increases in interestrates above the specified rate.

k. An interest rate floor is an option that limits the risk of interest rate decreases. Ifrates fall below a specified level, the floor holder receives cash payments equal tothe excess of a designated rate (the strike or floor rate) over the actual rate based onthe notional principal amount. The floor holder pays the floor writer a premium toreceive this right. The floor writer faces significant risk from potential decreases inrates below the specified rate.

l. A collar is an option that combines the strategies of a cap and a floor. The buyeracquires a cap and writes a floor. The writer writes a cap and buys a floor. Collarsfix the rate a variable-rate lender will receive or a borrower will pay between the capand floor rate levels. Collars help reduce the cost of buying outright a cap or floor.Because a borrower or lender is usually only interested in protecting againstmovements in interest rates in one direction, the premium received for writing a capor floor serves to reduce the cost of the cap or floor purchased.

5.9 STATEMENT ANALYSIS

1. The essence of financial statement analysis is the calculation of financial ratios. Theseratios establish relationships among financial statement accounts at a moment in time orfor a given accounting period. Once calculated, the entity’s ratios can be compared withits historical data and with its projections for the future. Moreover, ratios also may beevaluated by comparison with those for other entities or with industry averages.However, users must be aware of the limitations of ratio analysis, for example, thosearising from differences in the nature of the entities being compared, changes in accountingpolicies, and the effects of changing price levels. Moreover, ratios must be evaluated interms of broad economic and strategic factors and from the unique perspectives ofparticular users.

2. Liquidity ratios measure the short-term viability of the business, i.e., its ability to continue inthe short term by paying its obligations.

a. Current ratio

1) If the current ratio is less than 1.0, a transaction that results in equal increases(decreases) in the numerator and denominator increases (decreases) the ratio.However, if the current ratio is more than 1.0, equal increases (decreases) inthe numerator and denominator decrease (increase) the ratio.

b. Acid test or quick ratio

1) A more conservative computation limits the numerator to certain financial assets,such as those held for trading, net receivables, and cash equivalents.

c. Working capital

1) Working capital identifies the relatively liquid portion of the capital of the entityavailable for meeting obligations within the operating cycle.

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3. Asset management ratios measure the entity’s ability to generate income.

a. Inventory turnover

1) A high turnover implies that the entity does not hold excessive stocks ofinventories that are unproductive (obsolete or not marketable) and lessen itsprofitability.

b. Number of days of inventory (inventory conversion period)

1) The days in a year may be 365, 360 (a banker’s year), or 300 (business days).c. Accounts receivable turnover

d. Number of days of receivables (receivables collection period)

e. Operating cycle

1) An alternative, more accurate concept is the cash conversion cycle. It equalsthe inventory conversion period, plus the receivables collection period, minusthe payables deferral period (average time between resource purchases andpayment of cash for them).

f. Total assets turnover

g. Fixed assets turnover

4. Leverage ratios measure the use of debt to finance assets and operations.

a. Trading on the equity (leverage) is the financial strategy in which fixed-chargesecurities, such as debt or preference (preferred) shares, are used to finance assetswith the hope that the return on the assets will be greater than the fixed charges.

b. Debt-to-equity ratio

c. Debt ratio

d. Times-interest-earned ratio

1) If profit or loss declines sufficiently, no income tax expense will be recognized.

e. Fixed-charge coverage

f. Leverage factor (equity multiplier)

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5. Profitability ratios measure profit or loss on a relative basis.

a. Profit margin on sales

b. Return on investment (ROI) equals profit or loss divided by invested capital. Thedenominator may be defined in various ways, e.g., total assets available, assetsemployed, working capital plus other assets, and equity. One problem with thisdefinition of the resource base is that, although it has the advantage of emphasizingreturn to owners, it reflects decisions at different levels of the entity: short-termliabilities incurred by the responsibility center (operating decisions) and long-termliabilities controlled at the corporate level (long-term financing decisions).

c. The basic Du Pont equation relates the return on average total assets, the totalassets turnover, and the profit margin on sales.

d. If the basic Du Pont equation is multiplied by the leverage factor, the result is thereturn on ordinary (common) equity [after adjustment for any preference(preferred) dividends].

1) The leverage factor and return on equity also may be calculated for total equity.

6. Growth ratios measure the changes in the entity’s economic status over a period of years.Entities compare their growth in sales, operating profit, profit or loss, EPS, and dividendsper share with the results of competitors and the economy as a whole.

a. IAS 33, Earnings per Share, must be applied by public entities and by others thatchoose to disclose EPS.

b. Basic earnings per share (BEPS)

1) Ordinary (common) shares are subordinate to all other equity instruments.2) A BEPS amount also is calculated with a numerator equal to profit or loss from

continuing operations (if presented) attributable to ordinary (common) equityholders.

3) The numerator is adjusted for after-tax preference (preferred) dividends andother effects of preference (preferred) shares treated as equity.

4) The denominator includes shares from the time consideration is receivable,e.g., when cash is receivable or interest on convertible debt no longer accrues.

a) Adjustments are made for events [other than conversion of potentialordinary (common) shares] that change ordinary (common) sharesoutstanding without an increase in resources, e.g., a share split or acapitalization or bonus issue (a stock dividend).

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c. Diluted earnings per share (DEPS)

1) Calculation of DEPS amounts requires adjustments of the BEPS numeratorand denominator for the effects of dilutive potential ordinary (common) shares.

a) Potential ordinary (common) shares (POSs) are contracts that mayentitle holders to ordinary (common) shares.

b) A POS is dilutive if it reduces (increases) EPS (loss per share) as a resultof assuming the conversion of convertible instruments, exercise of optionsor warrants, or issue of ordinary (common) shares when conditions aresatisfied. A POS is antidilutive if it increases (reduces) EPS (loss pershare).

2) The BEPS numerators are adjusted for after-tax effects of

a) Dividends or other items associated with dilutive POSs that weresubtracted in arriving at the BEPS numerator,

b) Recognized interest on dilutive POSs, andc) Other changes in income or expense associated with conversion of POSs.

3) The BEPS denominator is adjusted for the weighted-average number ofordinary (common) shares assumed to have been issued upon conversion of alldilutive POSs.

a) Conversion is assumed to have occurred at the earlier of the beginning ofthe period or issue date of the POSs.

b) The assumed proceeds of options and warrants are deemed to be froman issuance at the average market price of ordinary (common) sharesfor the period. Options and warrants are dilutive if issued at less thanaverage market price. The difference between the shares assumedissued at the option or warrant price and the number assumed issued atthe average market price is regarded as an issue for no consideration.Thus, if the average market price for the period is greater than the optionprice, the number of ordinary (common) shares deemed to be issuedfor no consideration is added to the BEPS denominator. They have noeffect on the numerator. The shares assumed issued at the averagemarket price are not dilutive or antidilutive and are excluded from theDEPS denominator.

4) Convertible preference (preferred) shares or convertible debt instrumentsare antidilutive when the dividend or interest, respectively, per ordinary(common) share obtainable exceeds BEPS.

5) Contingently issuable ordinary (common) shares are included in BEPS andDEPS when the conditions have been met. If the conditions have not beenmet, the number of issuable shares included in DEPS is the issuable number ifthe contingency period were the end of the current period.

6) Contracts to be settled in cash or ordinary (common) shares

a) At the entity’s option are presumed to be settled in shares. These POSsare included in DEPS if dilutive.

b) At the holder’s option are presumed to be settled at the more dilutive ofthe alternatives for DEPS purposes.

7) Purchased puts and calls held by the entity (options on its shares) areexcluded from DEPS. Their effect is antidilutive.

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8) A written put option or forward purchase contract [obligations of the entity torepurchase its ordinary (common) shares] is included in DEPS if dilutive. If it isin the money, potential dilution is determined by

a) Assuming ordinary (common) shares will be issued at the beginning of theperiod at the average market price (lower than the in-the-money price) toobtain sufficient proceeds to perform the contract,

b) Using these assumed proceeds for the repurchase, andc) Including in the DEPS denominator the excess of shares assumed issued

over the shares assumed repurchased.d. Retrospective adjustments are made to BEPS and DEPS for all periods presented

to reflect a capitalization, bonus issue, share split, or reverse split. Error correctionsand changes in accounting policies also result in retrospective adjustments.

e. Presentation. The parent presents BEPS and DEPS (with equal prominence) on theface of the income statement for profit or loss from continuing operations and forprofit or loss for each class of ordinary (common) shares. If a discontinuedoperation is reported, BEPS and DEPS for it are presented on the face of theincome statement or in the notes.

f. Cash flow per share

g. Dividend payout ratio for ordinary (common) shares

h. Dividend yield

7. Valuation ratios reflect the basic principle that management’s goal is to maximizeshareholder value.

a. Book value per ordinary (common) share

1) Assets available to ordinary (common) shareholders are assets, minus liabilities,minus assets required to redeem preference (preferred) shareholders’ shares.

b. Price-earnings ratio

1) P-E ratios tend to be higher for growth companies.

8. Limitations of Ratio Analysis

a. Development of ratios for comparison with industry averages is more useful forentities that operate within a particular industry than for conglomerates.

b. Inflation misstates the balance sheet and income statement because of the effects onfixed assets, depreciation, inventory, long-term debt, and profitability.

c. Seasonal factors affect results. For example, inventory and receivables may varywidely, and year-end balances may not reflect the periodic averages.

d. An entity’s management has an incentive to window dress financial statements.e. Comparability of financial statement amounts and the ratios derived from them is

impaired if different entities choose different accounting policies.f. The ratios that are strong indicators of an entity’s financial position may vary from

one industry, entity, or division to another.

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g. Ratios are constructed from accounting data subject to estimation.h. Trends may be misinterpreted absent sufficient years of analysis.i. Ratio analysis may be distorted by failing to use an average or weighted average.j. Misleading conclusions may result if improper comparisons are selected.k. Whether a certain level of a ratio is favorable depends on the underlying

circumstances.l. Different ratios may yield opposite conclusions about an entity’s financial health.

Thus, the net effects of a set of ratios should be analyzed.m. Industry averages may include data from capital-intensive and labor-intensive entities

and from entities with divergent policies about leverage.n. Some data may be presented either before or after taxes.o. Comparability among entities may be impaired if they have different fiscal years.p. The geographical locations of entities may affect comparability because of

differences in labor markets, price levels, regulation, taxation, etc.q. Size differentials among entities affect comparability because of differences in

access to and cost of capital, economies of scale, and width of markets.

9. Comparative analysis includes horizontal (trend) analysis that compares analytical dataover time and vertical analysis that makes comparisons among one year’s data.

a. Comparing an entity’s performance with respect to its industry may identify itsstrengths and weaknesses. Horizontal analysis of the industry may identifyindustrywide trends and practices.

b. Common-size financial statements compare entities of different sizes by expressingitems as percentages of corresponding base-year figures. The base amount isassigned the value of 100%.

1) The horizontal form evaluates trends. The amounts for subsequent years arestated in percentages of a base-year amount.

2) Vertical common-size analysis presents figures for one year expressed aspercentages of a base amount on the balance sheet (e.g., total assets) and onthe income statement (e.g., sales).

5.10 BUSINESS CYCLES

1. The study of business cycles focuses on the periodic cycles in the economy, most of whichare characterized by changes in price levels and in rates of employment.

a. As shown in the following graph, a business cycle has four stages: trough, recovery,peak, and recession.

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b. A trough is marked by low levels of economic activity and underuse of resources.Sales and profits of most firms are depressed.

c. Recovery is marked by increasing economic activity. Sales and profits of most firmsrise.

d. The peak is that period when economic activity is booming. Sales and profits are atthe maximum for most firms.

e. Recession means economic activities and employment levels contract. Sales andprofits decline.

1) During the recessionary phase of a business cycle, society’s resources areunderused. Because of the underuse of resources, potential national incomewill exceed actual national income.

f. A depression is a major, long-lasting downturn in the economy. Conditions aresimilar to that of a recession, but more severe and less easily adjusted.

1) If businesses cut back their spending too severely and too quickly, their suppliersare forced to lay off employees in large numbers. If unemployment becomeswidespread, it creates a cycle leading to more unemployment.

2) Causes of a depression include (a) overextension of credit during prosperity,(b) inventories in excess of consumer demand, (c) overspeculation in stocksand commodities, and (d) failure of new investments to match savings.

g. Business cycles are considered a natural phenomenon, at least under classicaleconomic theory. In recent decades, fiscal and monetary policy have been used totemper the extent of business cycles.

1) Although the specific causes of cycles have never been definitively identified,consumer confidence seems to be one factor. When consumers becomepessimistic about future economic events, they spend less. The result is anincrease in inventory levels. Businesses respond to the increase in inventoryby cutting back production and laying off workers.

2. Economic indicators. Economists use economic indicators to forecast turns in thebusiness cycle. They are variables that in the past have had a high correlation withaggregate economic activity. The best known are the composite indexes calculated by TheConference Board, a private research group with many corporate and other membersworldwide. Indicators may lead, lag, or coincide with economic activity. A leading indicatoris a forecast of future economic trends, and a lagging indicator changes after the economicactivity has occurred.

a. Leading indicators include

1) Average workweek for production workers2) Prices of the ordinary (common) shares of 500 companies3) Average weekly initial unemployment insurance claims4) New orders for consumer goods and materials5) New orders for nondefense capital goods6) Building permits for homes7) Vendor performance (slower deliveries diffusion index)8) Money supply9) Index of consumer expectations10) Interest rate spread

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b. Lagging indicators include

1) Average duration of unemployment in weeks2) Change in index of labor cost per unit of output3) Average prime rate charged by banks4) Ratio of manufacturing and trade inventories to sales5) Commercial and industrial loans outstanding6) Ratio of consumer installment credit outstanding to personal income7) Change in consumer price index for services

c. Coincident indicators include

1) Employees on nonagricultural payrolls2) Personal income minus transfer payments3) Industrial production (based on value added and physical output)4) Manufacturing and trade sales

3. Investment expenditure is often used by economists to explain business cycles.

a. The accelerator theory gives a model for volatility of investment and the subsequenteffects on gross domestic product (GDP), the broadest measure of national economicactivity.

1) The accelerator theory states that capital investment is related to the rate ofchange in GDP.

2) It assumes a particular level of capital equipment needed to produce a givenlevel of output.

b. Given an economy producing at capacity and a subsequent increase in productdemand, an increase in capital investment is required to meet the increaseddemand. The demand for capital goods then creates an additional increase indemand, which in turn requires an additional investment in capital goods. In thisfashion, the process of investing to meet demand continues to accelerate.

c. A positive net investment occurs when the additions to capital goods exceed theamount of depreciation on existing capital goods.

1) Negative net investment occurs when depreciation exceeds the additions tocapital stock.

4. The product life cycle is useful in understanding other cycles. It has the following stages:

a. Precommercialization. The strategy is to innovate by conducting R&D, marketingresearch, and production tests. During product development, the firm has no sales,but it has high investment costs.

b. In the introduction stage, the growth rate and profits are low. The reason is the highcost of promotion and selective distribution to generate product awareness andencourage customers to try it. Competitors are few, basic versions of the productare produced, and higher-income customers (innovators) are usually targeted.Cost-plus prices are charged. They may initially be high to permit cost recoverywhen unit sales are low. The strategy is to (1) infiltrate the market, (2) plan forfinancing to cope with losses, (3) build supplier relations, (4) increase production andmarketing efforts, and (5) plan for competition.

c. In the growth stage, (1) sales and profits increase rapidly, (2) cost per customerdecreases, (3) customers are early adopters, (4) new competitors enter an expandingmarket, (5) new product models and features are introduced, and (6) promotionspending declines or remains stable. The firm enters new market segments anddistribution channels and attempts to build brand loyalty and achieve the maximumshare of the market. Thus, prices are set to penetrate the market, distributionchannels are extended, and the mass market is targeted through advertising. Thestrategy is to advance by these means and by achieving economies of productivescale.

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d. In the maturity stage, sales peak but growth declines. Competitors are mostnumerous but may begin to decline in number, and per-customer cost is low. Profitsare high for large market-share firms. For others, profits may fall because ofcompetitive price-cutting and increased R&D spending to develop improvedversions of the product. The strategy is to defend market share and maximize profitsthrough diversification of brands and models to enter new market segments. The firmalso engages in still more intensive distribution, cost cutting, and advertising toencourage brand switching. Customer service is emphasized.

1) Some writers identify a separate stage between growth and maturity. During theshakeout period, the overall growth rate falls, price cutting occurs, and weakerfirms leave the market.

e. During the decline stage, sales and profits drop as prices are cut, and some firmsleave the market. Customers include late adopters (laggards), and per-customer costis low. Weak products and unprofitable distribution media are eliminated, and adver-tising budgets are reduced to the level needed to retain the most loyal customers.The strategy is to withdraw by reducing production, promotion, and inventory.

5. Businesses have life cycles. These cycles interact with business cycles and productcycles. For example, successful new product introductions may increase sales and profitsduring a recession.

a. In the formative stage, the emerging firm most likely relies on the personal resourcesof its owners, assistance from governmental agencies, and trade credit for itsfinancing needs.

b. If the firm is successful and enters the stage of rapid growth, internal financingbecomes feasible, and trade credit continues to be used. Moreover, the firm’sperformance may enable it to secure bank credit to meet seasonal needs andintermediate-term loans. Such a firm also may attract equity financing from venturecapitalists.

1) If the firm is extremely successful, it may be able to issue securities that arepublicly traded. Thus, the firm may enter the formal capital and moneymarkets. These markets provide financing at lower cost than venturecapitalists.

c. The firm must consider the limitations of the product life cycle. Absent thedevelopment of new products, growth will not continue, and the firm will enter theproduct maturity and decline stage. The financing pattern at this stage usuallyincludes internal financing, diversification, share repurchases, and mergers.

d. Another perspective on life cycles compares the firm’s growth rate with theeconomy’s.

1) Thus, during the early stages of the cycle, the firm’s rate is much greater thanthat of the economy. Later, the rates tend to be about the same. In the declinestage, the firm’s growth rate is lower than the economy’s.

2) Accordingly, its earnings, dividends, and stock price fall. Firms with growth ratesthat do not approximate the economy’s growth rate are nonconstant growthfirms. Calculations using the dividend growth model are more complicatedfor such firms.

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5.11 STUDY UNIT 5 SUMMARY

1. The ordinary (common) shareholders are the owners of the corporation, and their rights asowners, although reasonably uniform, depend on the laws where the firm is incorporated.Ordinary (common) shareholders ordinarily have preemptive rights.

2. preference (preferred) shares are a hybrid of debt and equity. They have a fixed charge andincrease leverage, but payment of dividends is not a legal obligation.

3. Bonds are long-term debt instruments. They are similar to term loans except that they areusually offered to the public and sold to many investors. The bond indenture is thecontractual arrangement between the issuer and the bondholders. It contains restrictivecovenants intended to prevent the issuer from taking actions contrary to the interests of thebondholders. A trustee, often a bank, is appointed to ensure compliance. Types of bondsare (a) mortgage bonds, (b) debentures, (c) subordinated debentures, (d) income bonds,(e) serial bonds, (f) registered bonds, (g) coupon bonds, (h) participating bonds, (i) indexedbonds, (j) zero-coupon bonds, (k) junk bonds, and (l) international bonds.

4. Share rights and convertibility are among the common financing arrangements used toincrease investor interest in corporate securities. The objective is a lower interest rate onbonds or a higher selling price for shares. Share rights evidenced by warrants are optionsthat are distributed with debt or preference (preferred) shares. Both the issuance of rightsand a conversion feature offer a corporation a means of delayed equity financing whenmarket prices are unfavorable. When the market price rises above the conversion price,holders will presumably exercise the rights or convert the securities.

5. Intermediate-term financing refers to debt issues having approximate maturities of greaterthan 2 but less than 10 years. The principal types of intermediate-term financing are termloans and lease financing. Major lenders under term agreements are commercial banks,life insurance companies, and, to some extent, pension funds.

6. Short-term credit is debt scheduled to be repaid within 1 year. Three main sources of thiscredit are trade credit, commercial banks, and commercial paper, but many other sourcesare available.

7. The financial structure of a firm encompasses the right-hand side of the balance sheet,which describes how the firm’s assets are financed. Capital structure is the permanentfinancing of the firm and is represented primarily by long-term debt, preference (preferred)stock, and ordinary (common) equity.

8. Leverage is the relative amount of the fixed cost of capital, principally debt, in a firm’s capitalstructure. Leverage, by definition, creates financial risk, which relates directly to thequestion of the cost of capital. The more leverage, the higher the financial risk, and thehigher the cost of debt capital.

9. Interest is tax deductible, so EPS ordinarily is higher if debt capital is raised instead ofequity, assuming the firm is not over-leveraged.

10. The degree of financial leverage (DFL) is the percentage change in earnings available toordinary (common) shareholders that is associated with a given percentage change in netoperating income.

11. The degree of operating leverage (DOL) is the percentage change in net operating incomeassociated with a given percentage change in sales.

12. The degree of total leverage (DTL) combines the DFL and the DOL.

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13. The cost of capital is a weighted average of the various debt and equity components. Theweighted-average cost of capital weights the percentage cost of each component by thepercentage of that component in the financial structure. The cost of debt equals theinterest rate times one minus the marginal tax rate because interest is a tax deduction.Hence, an increase in the tax rate decreases the cost of debt. The cost of retainedearnings is an opportunity cost. It is the rate that investors can earn elsewhere oninvestments of comparable risk. The cost of internally generated funds is an imputed cost.The cost of new external ordinary (common) equity is higher than the cost of retainedearnings because of stock flotation costs. The cost of preference (preferred) stock equalsthe preference (preferred) dividend divided by the net issuance price. No tax adjustment isnecessary because preference (preferred) dividends paid are not deductible.

14. Standard financial theory states that an optimal capital structure exists. The optimal capitalstructure minimizes the weighted average cost of capital and thereby maximizes the valueof the firm’s stock.

15. The Capital Asset Pricing Model (CAPM) adds the risk-free rate (determined by governmentsecurities) to the product of the beta coefficient (a measure of the firm’s risk) and thedifference between the market return and the risk-free rate. Below is the basic equilibriumequation for the CAPM.

16. The dividend growth model estimates the cost of retained earnings using the dividends pershare, the expected growth rate, and the market price. To justify retention of earnings,management must expect a return at least equal to the dividend yield plus a growth rate.

17. A concept relevant to securities valuation is the efficient markets hypothesis (EMH). It statesthat current share prices immediately and fully reflect all relevant information. Hence, themarket is continuously using new information to correct pricing errors, and securities pricesare always in equilibrium.

18. The cash budget details projected receipts and disbursements, preferably to plan thesynchronization of inflows and outflows. It is based on the projected sales and credit terms,collection percentages, and estimated purchases and payment terms.

19. Cash collections should be expedited. For this purpose, a lockbox system, concentrationbanking, wire transfers, and EDI are helpful.

20. Slowing cash disbursements increases available cash. Payment beyond normal creditterms, however, creates vendor ill will and may incur interest charges. Payments should bemade within discount periods if the cost of not taking a discount exceeds the firm’s cost ofcapital.

21. The amount of cash on hand should be determined by cost-benefit analysis. The reductionin average cash times the interest rate (cost of capital or investment yield rate) is thebenefit. Costs of having insufficient cash include incremental personnel cost, lostdiscounts, and lost vendor goodwill.

22. A firm’s excess cash should be placed in an investment with the highest return consistentwith low risk, such as T-bills, CDs, money-market accounts, or high-grade commercialpaper.

23. As temporary investments, marketable securities may be purchased with maturities timed to(a) meet seasonal fluctuations, (b) pay off a bond issue, (c) make tax payments, or(d) otherwise satisfy anticipated needs. Marketable securities should be chosen with aview to the risk of default (financial risk). Interest-rate risk should be minimized given thereasons for holding marketable securities.

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24. The objective of managing accounts receivable is to have both the optimal amount ofreceivables outstanding and the optimal amount of bad debts. The balance requires atrade-off between the benefits of credit sales, such as more sales, and the costs ofaccounts receivable, such as collection, interest, and bad debt costs. The appropriatepolicy does not seek merely to maximize sales or to minimize default risk.

25. Receivables management should maximize the accounts receivable turnover ratio, that is,shorten the average time receivables are held. The accounts receivable turnover ratioequals net credit sales divided by average accounts receivable.

26. The most fundamental approach to valuing a business combination is capital budgetinganalysis. If the net present value (NPV) is positive, that is, if the present value of theestimated incremental cash flows from the combination exceeds the present value of theamounts to be paid for acquired firm, the investment is financially sound for the acquirer.The shareholders of the acquired firm should perform a similar analysis and compare theresult with the NPV of remaining an independent equity.

27. A derivative is a financial instrument whose value changes with the change in the underlying(a specified interest rate, security price, foreign currency exchange rate, price index,commodity price, etc.). It requires little or no initial net investment compared with contractshaving similar responses to changing market conditions, and it is settled in the future. Anembedded derivative is one that is combined with a host contract so that some cash flowsof the instrument vary in the same way as those of a stand-alone derivative.

28. A call option is the most common type of option. It gives the owner the right to purchase theunderlying asset at a fixed price. Thus, it represents a long position because the ownergains from a price increase. The profit is the difference between the price paid and thevalue at the closing date, minus the brokerage fee. A put option gives the owner the rightto sell the underlying asset for a fixed price. It represents a short position because theowner benefits from a price decrease.

29. The value of a call option may be viewed as based on its exercise price, its expiration date,the price of the underlying asset, the variability of that asset, and the risk-free interest rate.The well-known Black-Scholes Option-Pricing Model uses these factors.

30. A forward contract is simply an executory (unperformed) contract. The parties agree to theterms of a purchase and sale, but performance, i.e., payment by the buyer and delivery bythe seller, is deferred. A futures contract is a specific kind of forward contract. It is adefinite agreement that allows a trader to purchase or sell an asset at a fixed price during aspecific future month. Futures contracts for agricultural commodities, metals, oil, andfinancial assets are traded on numerous exchanges. One characteristic of a futurescontract is that it may be highly leveraged. It is also marked to market daily.

31. Hedging is the process of using offsetting commitments to minimize or avoid the impact ofadverse price movements. Long hedges are futures purchased to protect against priceincreases. Short hedges are futures sold to protect against price declines.

32. Swaps are contracts to hedge risk by exchanging cash flows. The simplest form, sometimescalled a plain vanilla swap, is an exchange of interest rates without any change in the initialdebt arrangement.

33. The essence of financial statement analysis is the calculation of financial ratios. Theseratios establish relationships among financial statement accounts at a moment in time or fora given accounting period. Once calculated, the entity’s ratios can be compared with itshistorical data and with its projections for the future. Moreover, ratios also may beevaluated by comparison with those for other entities or with industry averages. However,users must be aware of the limitations of ratio analysis, for example, those arising fromdifferences in the nature of the entities being compared, changes in accounting policies,and the effects of changing price levels. Moreover, ratios must be evaluated in terms ofbroad economic and strategic factors and from the unique perspectives of particular users.

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34. Liquidity (solvency) ratios measure the short-term viability of the business, i.e., its ability tocontinue in the short term by paying its obligations. These include the current and quickratios and working capital.

35. Asset management ratios measure the entity’s ability to generate income, e.g., inventoryturnover, accounts receivable turnover, and the operating cycle.

36. Leverage ratios measure the use of debt to finance assets and operations, e.g., thedebt-to-equity, debt, and times-interest-earned ratios.

37. Probability ratios measure profit or loss on a relative basis, e.g., profit margin on sales,return on total assets, and the DuPont equation.

38. Growth ratios measure the changes in the entity’s economic status over a period of years,e.g., basic EPS, diluted EPS, cash flow per share, the dividend payout, and the dividendyield.

39. Basic earnings per share (BEPS) equals (a) profit (loss) attributable to ordinary (common)equity holders divided by (b) the weighted-average of outstanding ordinary (common)shares. The numerator is adjusted for after-tax preference (preferred) dividends and othereffects of preference (preferred) shares treated as equity. The denominator includesshares from the time consideration is receivable, e.g., when cash is receivable or intereston convertible debt no longer accrues. Adjustments are made for events [other thanconversion of potential ordinary (common) shares] that change ordinary (common) sharesoutstanding without an increase in resources, e.g., a share split or a capitalization or bonusissue (a stock dividend).

40. Calculation of diluted earnings per share (DEPS) requires adjustments of the BEPSnumerator and denominator for the effects of dilutive potential ordinary (common) shares.Potential ordinary (common) shares (POSs) are contracts that may entitle holders toordinary (common) shares. A POS is dilutive if it reduces (increases) EPS (loss per share)as a result of assuming the conversion of convertible instruments, exercise of options orwarrants, or issue of ordinary (common) shares when conditions are satisfied.

41. Valuation ratios reflect the basic principle that management’s goal is to maximizeshareholder value, e.g., book value per ordinary (common) share and the price-earningsratio.

42. The study of business cycles focuses on the periodic cycles in the economy, most of whichare characterized by changes in price levels and in rates of employment. A cycle’s stagesare trough, recovery, peak, and recession. A trough is marked by low levels of economicactivity and underuse of resources. Sales and profits of most firms are depressed.Recovery is marked by increasing economic activity. Sales and profits of most firms rise.The peak is that period when economic activity is booming. Sales and profits are at themaximum for most firms. Recession means economic activities and employment levelscontract. Sales and profits decline.

43. Economists use economic indicators to forecast turns in the business cycle. They arevariables that in the past have had a high correlation with aggregate economic activity. Thebest known are the composite indexes calculated by The Conference Board, a privateresearch group with many corporate and other members worldwide. Indicators may lead,lag, or coincide with economic activity. A leading indicator is a forecast of future economictrends, and a lagging indicator changes after the economic activity has occurred.

44. The stages of the product life cycle are (a) precommercialization, (b) introduction, (c) growth,(d) maturity, (e) shakeout, and (f) decline.

45. Businesses have life cycles. These cycles interact with business cycles and product cycles.For example, successful new product introductions may increase sales and profits during arecession. Another perspective on life cycles compares the firm’s growth rate with theeconomy’s.

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