Interpreting the Cash Cycle

Our examples show that the cash cycle depends on the inventory, receivables, and payables periods. The cash cycle increases as the inventory and receivables periods get longer. It decreases if the company is able to defer payment of payables and thereby lengthen the payables period. Unlike Amazon.com, most firms have a positive cash cycle, and they thus require financing for inventories and receivables. The longer the cash cycle, the more financing is required. Also, changes in the firm's cash...

Temporary Cash Surpluses

Firms have temporary cash surpluses for various reasons. Two of the most important are the financing of seasonal or cyclical activities of the firm and the financing of planned or possible expenditures. Seasonal or Cyclical Activities Some firms have a predictable cash flow pattern. They have surplus cash flows during part of the year and deficit cash flows the rest of the year. For example, Toys 51 Us, a retail toy firm, has a seasonal cash flow pattern influenced by Christmas. A firm such as...

Summary And Conclusions

This chapter has covered the basics of credit and inventory policy. The major topics we 1. The components of credit policy. We discussed the terms of sale, credit analysis, and collection policy. Under the general subject of terms of sale, the credit period, the cash discount and discount period, and the credit instrument were described. 2. Credit policy analysis. We developed the cash flows from the decision to grant credit and showed how the credit decision can be analyzed in an NPV setting....

Indirect Bankruptcy Costs

Because it is expensive to go bankrupt, a firm will spend resources to avoid doing so. When a firm is having significant problems in meeting its debt obligations, we say that it is experiencing financial distress. Some financially distressed firms ultimately file for bankruptcy, but most do not because they are able to recover or otherwise survive. For example, in late 2000, analysts were speculating that one of the best-known technology companies in the world, Xerox, was headed for bankruptcy...

Value of Stock Splits and Stock Dividends

The laws of logic tell us that stock splits and stock dividends can (1) leave the value of the firm unaffected, (2) increase its value, or (3) decrease its value. Unfortunately, the issues are complex enough that one cannot easily determine which of the three relationships holds. The Benchmark Case A strong case can be made that stock dividends and splits do not change either the wealth of any shareholder or the wealth of the firm as a whole. In our preceding example, the equity had a total...

Some Details on Stock Splits and Stock Dividends

Stock splits and stock dividends have essentially the same impacts on the corporation and the shareholder they increase the number of shares outstanding and reduce the value per share. The accounting treatment is not the same, however, and it depends on two things (1) whether the distribution is a stock split or a stock dividend and (2) the size of the stock dividend if it is called a dividend. By convention, stock dividends of less than 20 to 25 percent are called small stock dividends. The...

Stock Dividends And Stock Splits

Another type of dividend is paid out in shares of stock. This type of dividend is called a stock dividend. A stock dividend is not a true dividend because it is not paid in cash. The effect of a stock dividend is to increase the number of shares that each owner holds. Because there are more shares outstanding, each is simply worth less. A stock dividend is commonly expressed as a percentage for example, a 20 percent stock dividend means that a shareholder receives one new share for every five...

Tax and Legal Benefits from High Dividends

Earlier, we saw that dividends were taxed unfavorably for individual investors. This fact is a powerful argument for a low payout. However, there are a number of other investors who do not receive unfavorable tax treatment from holding high-dividend yield, rather than low-dividend yield, securities. Corporate Investors A significant tax break on dividends occurs when a corporation owns stock in another corporation. A corporate stockholder receiving either common or preferred dividends is...

An Illustration of the Irrelevance of Dividend Policy

A powerful argument can be made that dividend policy does not matter. We illustrate this by considering the simple case of Wharton Corporation. Wharton is an all-equity firm that has existed for 10 years. The current financial managers plan to dissolve the firm in two years. The total cash flows the firm will generate, including the proceeds from liquidation, will be 10,000 in each of the next two years. Current Policy Dividends Set Equal to Cash Flow At the present time, dividends at each date...

Does Dividend Policy Matter

To decide whether or not dividend policy matters, we first have to define what we mean by dividend policy. All other things being the same, of course dividends matter. Dividends are paid in cash, and cash is something that everybody likes. The question we will be discussing here is whether the firm should pay out cash now or invest the cash and pay it out later. Dividend policy, therefore, is the time pattern of dividend payout. In particular, should the firm pay out a large percentage of its...

More on the ExDividend Date

The ex-dividend date is important and is a common source of confusion. We examine what happens to the stock when it goes ex, meaning that the ex-dividend date arrives. To illustrate, suppose we have a stock that sells for 10 per share. The board of directors declares a dividend of 1 per share, and the record date is set to be Tuesday, June 12. Based on our previous discussion, we know that the ex date will be two business (not calendar) days earlier, on Friday, June 8. If you buy the stock on...

Cash Dividends And Dividend Payment

The term dividend usually refers to cash paid out of earnings. If a payment is made from sources other than current or accumulated retained earnings, the term distribution, rather than dividend, is used. However, it is acceptable to refer to a distribution from earnings as a dividend and a distribution from capital as a liquidating dividend. More generally, any direct payment by the corporation to the shareholders may be considered a dividend or a part of dividend policy. Dividends come in...

Dividends and Dividend Policy

In December 1999, General Electric Company (better known as GE) announced a broad plan to reward stockholders for the recent success of the firm's business. Under the plan, GE would (1) boost its quarterly dividend by 17 percent from 35 cents per share to 41 cents per share, (2) expand its plans to buy back its common stock by as much as 5 billion, and (3) undertake a three-for-one stock split, meaning that each existing common share would be replaced with three new ones. Investors cheered,...

Dubious Reasons for Leasing

Leasing and Accounting Income Leasing can have a significant effect on the appearance of the firm's financial statements. If a firm is successful at keeping its leases off the books, the balance sheet and, potentially, the income statement can be made to look better. As a consequence, accounting-based performance measures such as return on assets, or ROA, can appear to be higher. 888 PART EIGHT Topics in Corporate Finance For example, because an operating lease does not appear on the balance...

Info

Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition VII. Short-Term Financial Planning and Management CHAPTER 19 Short-Term Finance and Planning Assume that Wildcat can borrow any needed funds on a short-term basis at a rate of 3 percent per quarter, and can invest any excess funds in short-term marketable securities at a rate of 2 percent per quarter. Prepare a short-term financial plan by filling in the following schedule. What is the net cash cost (total interest...

Residual Dividend Approach

Earlier, we noted that firms with higher dividend payouts will have to sell stock more often. As we have seen, such sales are not very common, and they can be very expensive. Consistent with this, we will assume that the firm wishes to minimize the need to sell new equity. We will also assume that the firm wishes to maintain its current capital structure. Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition VI. Cost of Capital and Long-Term Financial Policy CHAPTER 18...

Evaluating a Proposed Credit Policy

To illustrate how credit policy can be analyzed, we will start with a relatively simple case. Locust Software has been in existence for two years, and it is one of several successful firms that develop computer programs. Currently, Locust sells for cash only. Locust is evaluating a request from some major customers to change its current policy to net one month (30 days). To analyze this proposal, we define the following P Price per unit v Variable cost per unit Q Current quantity sold per month...

Financial Planning Model The Ingredients

Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for a large number of other variables. Models can vary quite a bit in terms of their complexity, but almost all will have the elements that we discuss next. Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the driver, meaning that...

Establishing A Dividend Policy

How do firms actually determine the level of dividends they will pay at a particular time As we have seen, there are good reasons for firms to pay high dividends, and there are good reasons to pay low dividends. We know some things about how dividends are paid in practice. Firms don't like to cut dividends. Consider the case of The Stanley Works, maker of Stanley tools and other building products. As of 2001, Stanley had paid dividends for 124 years, longer than any other industrial company...

What Can Planning Accomplish

Because the company is likely to spend a lot of time examining the different scenarios that will become the basis for the company's financial plan, it seems reasonable to ask what the planning process will accomplish. Examining Interactions As we discuss in greater detail in the following pages, the financial plan must make explicit the linkages between investment proposals for the different operating activities of the firm and the financing choices available to the firm. In other words, if the...

Why Does Underpricing Exist

Based on the evidence we've examined, an obvious question is, Why does underpricing continue to exist As we discuss, there are various explanations, but, to date, there is a lack of complete agreement among researchers as to which is correct. We present some pieces of the underpricing puzzle by stressing two important caveats to our preceding discussion. First, the average figures we have examined tend to Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition VI. Cost...

The Tax Shield Approach

The third variation on our basic definition of OCF is the tax shield approach. This approach will be very useful for some problems we consider in the next section. The tax shield definition of OCF is OCF (Sales - Costs) X (1 - T) + Depreciation X T 10.3 where T is again the corporate tax rate. Assuming that T 34 , the OCF works out to be OCF ( 1,500 - 700) X .66 + 600 X .34 528 + 204 732 This approach views OCF as having two components. The first part is what the project's cash flow would be if...

Venture Capital

The term venture capital does not have a precise meaning, but it generally refers to financing for new, often high-risk ventures. For example, before it went public, Netscape Communications was VC financed. Individual venture capitalists invest their own money so-called angels are usually individual VC investors, but they tend to specialize in smaller deals. Venture capital firms specialize in pooling funds from various sources and investing them. The underlying sources of funds for such firms...

Credit Evaluation and Scoring

There are no magical formulas for assessing the probability that a customer will not pay. In very general terms, the classic five Cs of credit are the basic factors to be evaluated 1. Character. The customer's willingness to meet credit obligations. 2. Capacity. The customer's ability to meet credit obligations out of operating cash flows. 3. Capital. The customer's financial reserves. 4. Collateral. An asset pledged in the case of default. 5. Conditions. General economic conditions in the...

Questions and Problems

Use the following information to work Problems 1 through 6 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner leasing is a very common practice with expensive, high-tech equipment . The scanner costs 2,000,000, and it would be depreciated straight-line to zero over four years. Because of radiation contamination, it will actually be completely valueless in four years. You can lease it for 600,000 per year for four years. 1. Lease or Buy Assume that the...

Concepts Review and Critical Thinking Questions

Dividend Policy Irrelevance How is it possible that dividends are so important, but, at the same time, dividend policy is irrelevant 2. Stock Repurchases What is the impact of a stock repurchase on a company's debt ratio Does this suggest another use for excess cash 3. Dividend Policy What is the chief drawback to a strict residual dividend policy Why is this a problem How does a compromise policy work How does it differ from a strict residual policy 4. Dividend Chronology On Tuesday,...

Selling Securities To The Public The Basic Procedure

There are many rules and regulations surrounding the process of selling securities. The Securities Act of 1933 is the origin of federal regulations for all new interstate securities issues. The Securities Exchange Act of 1934 is the basis for regulating securities already outstanding. The Securities and Exchange Commission, or SEC, administers both acts. There is a series of steps involved in issuing securities to the public. In general terms, the basic procedure is as follows 1. Management's...

Relevant Cash Flows

What is a relevant cash flow for a project The general principle is simple enough a relevant cash flow for a project is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project. Because the relevant cash flows are defined in terms of changes in, or increments to, the firm's existing cash flow, they are called the incremental cash flows associated with the project. The concept of incremental cash flow is central to our...

What Is The Price Per Share Of Equity Under Plan I

EBIT and Leverage Control, Inc., has no debt outstanding and a total market value of 100,000. Earnings before interest and taxes, EBIT, are projected to be 6,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Control is considering a 40,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500...

Dilution

Dilution A subject that comes up quite a bit in discussions involving the selling of securities is Loss in existing dilution. Dilution refers to a loss in existing shareholders' value. There are several kinds shareholders' value, in terms of either book value, or EPS. 9Robert S. Hansen, The Demise of the Rights Issue, Review of Financial Studies 1 Fall 1988 , pp. 289-309. Ross et al. Fundamentals VI. Cost of Capital and 16. Raising Capital of Corporate Finance, Sixth Long-Term Financial...

Cash Discounts

As we have seen, cash discounts are often part of the terms of sale. The practice of granting discounts for cash purchases in the United States dates to the Civil War and is widespread today. One reason discounts are offered is to speed up the collection of receivables. This will have the effect of reducing the amount of credit being offered, and the firm must trade this off against the cost of the discount. Notice that when a cash discount is offered, the credit is essentially free during the...

Dividend Payouts Use The Annual Financial Statements For General Mills Gis Boston Beer Sam And Us Steel X To Find The

PART SIX Cost of Capital and Long-Term Financial Policy Suppose the only owners of stock are corporations. Recall that corporations get at least a 70 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporation's income and capital gains tax rates are both 35 percent, what does this model predict the ex-dividend share price will be What does this problem tell you about real-world tax considerations and the...

Standard

Bond Ratings Look up Coca-Cola KO , Gateway GTW , Callaway Golf ELY , and Navistar International NAV . For each company, follow the Financial Highlights link and find the bond rating. Which companies have an invest- SPOOR'S ment grade rating Which companies are rated below investment grade Are any - unrated When you find the credit rating for one of the companies, click on the S amp P Issuer Credit Rating link. What are the three considerations listed that Standard amp Poor's uses to issue a...

The Goal Of Financial Management

Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it in order to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions. If we were to consider possible financial goals, we might come up with some ideas like the...

Easily Identifiable Debt-equity Ratio That Will Maximize The Value Of A Firm

PART SIX Cost of Capital and Long-Term Financial Policy that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm A 3. Optimal Capital Structure Is there an easily identifiable debt-equity ratio that will maximize the value of a firm Why or why not 4. Observed Capital Structures Refer to the observed capital structures given in Table 17.7 of the text. What do you notice about the types of industries with respect to their average debt-equity ratios...

Part Seven

Short-Term Financial Planning and Management 637 19.1 Tracing Cash and Net Working Capital 640 19.2 The Operating Cycle and the Cash Cycle 641 Defining the Operating and Cash Cycles 642 The Operating Cycle 642 The Cash Cycle 643 The Operating Cycle and the Firm's Organizational Chart 644 Calculating the Operating and Cash Cycles 644 The Operating Cycle 645 The Cash Cycle 646 Interpreting the Cash Cycle 647 19.3 Some Aspects of Short-Term Financial Policy 648 The Size of the Firm's Investment in...

Homemade Dividends

There is an alternative and perhaps more intuitively appealing explanation of why dividend policy doesn't matter in our example. Suppose individual investor X prefers dividends per share of 100 at both Dates 1 and 2. Would she be disappointed if informed that the firm's management was adopting the alternative dividend policy dividends of 110 and 89 on the two dates, respectively Not necessarily, because she could easily reinvest the 10 of unneeded funds received on Date 1 by buying some more...

Ocf T X D

Use the expression in part a to find the cash, accounting, and financial break-even points for the Wettway sailboat example in the chapter. Assume a 38 percent tax rate. c. In part b , the accounting break-even should be the same as before. Why Verify this algebraically. Operating Leverage and Taxes Show that if we consider the effect of taxes, the degree of operating leverage can be written as DOL 1 FC X 1 - T - T X OCF Notice that this reduces to our previous result if T words Scenario...

Spreadsheet Strategies

Using a Spreadsheet for Time Value of Money Calculations More and more, businesspeople from many different areas and not just finance and accounting rely on spreadsheets to do all the different types of calculations that come up in the real world. As a result, in this section, we will show you how to use a spreadsheet to handle the various time value of money problems we presented in this chapter. We will use Microsoft Excel , but the commands are similar for Ross et al. Fundamentals of...

Forecasting Risk

The key inputs into a DCF analysis are projected future cash flows. If the projections are seriously in error, then we have a classic GIGO garbage in, garbage out system. In such a case, no matter how carefully we arrange the numbers and manipulate them, the resulting answer can still be grossly misleading. This is the danger in using a relatively sophisticated technique like DCF. It is sometimes easy to get caught up in number crunching and forget the underlying nuts-and-bolts economic...

What Are The Implications Of Wacc For A Company

M amp M and Taxes In the previous question, suppose the corporate tax rate is 35 percent. What is EBIT in this case What is the WACC Explain. Calculating WACC Nopay Industries has a debt-equity ratio of 2. Its WACC is 11 percent, and its cost of debt is 11 percent. The corporate tax rate is 35 percent. a. What is Nopay's cost of equity capital b. What is Nopay's unlevered cost of equity capital c. What would the cost of equity be if the debt-equity ratio were 1.5 What if it were 1.0 What if it...

The Percentage Of Sales Approach

A financial planning method in which accounts are varied depending on a firm's predicted sales level. In the previous section, we described a simple planning model in which every item increased at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowing, it probably is not, because the amount of long-term borrowing is something set by management, and it does not necessarily relate directly to the level of sales. In this section, we...

Octagon Declares

If Octagon stock currently sells for 20 per share and a 10 percent stock dividend is declared, how many new shares will be distributed Show how the equity accounts would change. b. If Octagon declared a 25 percent stock dividend, how would the accounts change Stock Splits For the company in Problem 2, show how the equity accounts will change if a. Octagon declares a five-for-one stock split. How many shares are outstanding now What is the new par value per share b. Octagon declares a...

Mm Propositions I And Ii With Corporate Taxes

Debt has two distinguishing features that we have not taken into proper account. First, as we have mentioned in a number of places, interest paid on debt is tax deductible. This is good for the firm, and it may be an added benefit of debt financing. Second, failure to meet debt obligations can result in bankruptcy. This is not good for the firm, and it may be an added cost of debt financing. Since we haven't explicitly considered either of these two features of debt, we realize that we may get...

Financial Markets And The Corporation

We've seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance. The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The arrows in Figure 1.2 trace...

Chapter Review and Self Test Problems

8.1 Dividend Growth and Stock Valuation The Brigapenski Co. has just paid a cash dividend of 2 per share. Investors require a 16 percent return from investments such as this. If the dividend is expected to grow at a steady 8 percent per year, what is the current value of the stock What will the stock be worth in five years 8.2 More Dividend Growth and Stock Valuation In Self-Test Problem 8.1, what would the stock sell for today if the dividend was expected to grow at 20 percent per year for the...

For Each Of The Following Scenarios Discuss Whether Profit Opportunities Exist From Trading In The Stock Of The Firm

Efficient Markets Hypothesis For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that 1 the market is not weak form efficient, 2 the market is weak form but not semistrong form efficient, 3 the market is semistrong form but not strong form efficient, and 4 the market is strong form efficient. a. The stock price has risen steadily each day for the past 30 days. b. The financial statements for a company...

Project Analysis Mcgilla Golf

Project Analysis McGilla Golf has decided to sell a new line of golf clubs. Intermediate The clubs will sell for 600 per set and have a variable cost of 240 per set. The continued company has spent 150,000 for a marketing study that determined the company will sell 50,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced clubs. The high-priced clubs sell at 1,000 and have variable costs of 550. The company will...

Why Evaluate Financial Statements

As we have discussed, the primary reason for looking at accounting information is that we don't have, and can't reasonably expect to get, market value information. It is important to emphasize that, whenever we have market information, we will use it instead of accounting data. Also, if there is a conflict between accounting and market data, market data should be given precedence. Financial statement analysis is essentially an application of management by exception. In many cases, such analysis...

The Pure Play Approach

We've seen that using the firm's WACC inappropriately can lead to problems. How can we come up with the appropriate discount rates in such circumstances Because we cannot observe the returns on these investments, there generally is no direct way of coming up with a beta, for example. Instead, what we must do is examine other investments outside the firm that are in the same risk class as the one we are considering and use the market-required returns on these investments as the discount rate. In...

The Mechanics of a Rights Offering

To illustrate the various considerations a financial manager faces in a rights offering, we will examine the situation faced by the National Power Company, whose abbreviated initial financial statements are given in Table 16.7. As indicated in Table 16.7, National Power earns 2 million after taxes and has one million shares outstanding. Earnings per share are thus 2, and the stock sells for 20, or 10 times earnings that is, the price-earnings ratio is 10 . To fund a planned expansion, the...

The Capital Structure Weights

We will use the symbol E for equity to stand for the market value of the firm's equity. We calculate this by taking the number of shares outstanding and multiplying it by the price per share. Similarly, we will use the symbol D for debt to stand for the market value of the firm's debt. For long-term debt, we calculate this by multiplying the market price of a single bond by the number of bonds outstanding. If there are multiple bond issues as there normally would be , we repeat this calculation...

Assume That You Have Several Thousand Dollars To Invest. When You Get Home From Class Tonight You Find That Your

The investment rule he followed was to submit a purchase order for every firm commitment initial public offering of oil and gas exploration companies. There were 22 of these offerings, and he submitted a purchase order for approximately 1,000 in stock for each of the companies. With 10 of these, no shares were allocated to this assistant professor. With 5 of the 12 offerings that were purchased, fewer than the requested number of shares were allocated. The year...

An All Equity Firm Is Considering The Following Projects

Finding the WACC Titan Mining Corporation has 8 million shares of common stock outstanding, .5 million shares of 6 percent preferred stock outstanding, and 100,000 9 percent semiannual bonds outstanding, par value 1,000 each. The common stock currently sells for 32 per share and has a beta of 1.15, the preferred stock currently sells for 67 per share, and the bonds have 15 years to maturity and sell for 91 percent of par. The market risk premium is 10 percent, T-bills are yielding 5...

For The Cash Flows In The Previous Problems Suppose The Firm Uses The Npv Decision Rule. At A Required Return 10

Calculating NPV For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept this project What if the required return was 21 percent 9. Calculating NPV and IRR A project that provides annual cash flows of 1,200 for nine years costs 6,000 today. Is this a good project if the required return is 8 percent What if it's 24 percent At what discount rate would you be indifferent between accepting the project and...

Long Term Solvency Measures

Long-term solvency ratios are intended to address the firm's long-run ability to meet its obligations, or, more generally, its financial leverage. These are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations. Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is 'For many of these ratios that involve average...

Standardized Financial Statements

The next thing we might want to do with Prufrock's financial statements is to compare them to those of other, similar, companies. We would immediately have a problem, however. It's almost impossible to directly compare the financial statements for two companies because of differences in size. For example, Ford and GM are obviously serious rivals in the auto market, but GM is much larger in terms of assets , so it is difficult to compare them directly. For that matter, it's difficult to even...

Overview Of Corporate Finance

CHAPTER 1 Introduction to Corporate Finance Chapter 1 describes the role of the financial manager and the goal of financial management. It also discusses some key aspects of the financial management environment. CHAPTER 2 Financial Statements,Taxes, and Cash Flow Chapter 2 describes the basic accounting statements used by the firm. The chapter focuses on the critical differences between cash flow and accounting income it also discusses why accounting value is generally not the same as market...

Introduction to Valuation The Time Value of Money

On December 2, 1982, General Motors Acceptance Corporation GMAC , a subsidiary of General Motors, offered some securities for sale to the public. Under the terms of the deal, GMAC promised to repay the owner of one of these securities 10,000 on December 1, 2012, but investors would receive nothing until then. Investors paid GMAC 500 for each of these securities, so they gave up 500 on December 2, 1982, for the promise of a 10,000 payment 30 years later. Such a security, for which you pay some...

Common Size Statements

To get started, a useful way of standardizing financial statements is to express each item on the balance sheet as a percentage of assets and to express each item on the income statement as a percentage of sales. The resulting financial statements are called common-size statements. We consider these next. Common-Sfze Balance Sheets One way, though not the only way, to construct a common-size balance sheet is to express each item as a percentage of total assets. Prufrock's 2001 and 2002...

Working with Financial Statements

On May 11, 2001, the price of a share of common stock in AOL-Time Warner closed at about 54. At that price, The Wall Street Journal reported AOL-Time Warner had a price-earnings PE ratio of 99. That is, investors were willing to pay 99 for every dollar in income earned by AOL-Time Warner. At the same time, investors were willing to pay only 48, 26, and 10 for each dollar earned by Enron, 3M, and Sears, respectively. At the other extremes were Voicestream and Yahoo, both relative newcomers to...

The Profitability Index

Another tool used to evaluate projects is called the profitability index PI , or benefit-cost ratio. This index is defined as the present value of the future cash flows divided by the initial investment. So, if a project costs 200 and the present value of its future cash flows is 220, the profitability index value would be 220 200 1.1. Notice that the NPV for this investment is 20, so it is a desirable investment. More generally, if a project has a positive NPV, then the present value of the...

As A Shareholder Of A Firm That Is Contemplating A New Project Would You Be More Concern With The Accounting Break Even

Marginal Cash Flows A co-worker claims that looking at all this marginal this and incremental that is just a bunch of nonsense, and states Listen, if our average revenue doesn't exceed our average cost, then we will have a negative cash flow, and we will go broke How do you respond 4. Operating Leverage At one time at least, many Japanese companies had a no layoff' policy for that matter, so did IBM . What are the implications of such a policy for the degree of operating leverage a company...

Future Value for Annuities

On occasion, it's also handy to know a shortcut for calculating the future value of an annuity. As you might guess, there are future value factors for annuities as well as present value factors. In general, the future value factor for an annuity is given by Annuity FV factor Future value factor - 1 r To see how we use annuity future value factors, suppose you plan to contribute 2,000 every year to a retirement account paying 8 percent. If you retire in 30 years, how much will you have The...

Getting Started Pro Forma Financial Statements

Pro forma financial statements are a convenient and easily understood means of summarizing much of the relevant information for a project. To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital. To illustrate, suppose we think we can sell 50,000 cans of shark attractant per year at a...

Salsman Inc. Recently Issued New Securities

PART SIX Cost of Capital and Long-Term Financial Policy applies an adjustment factor of 2 percent to the cost of capital for such risky projects. Under what circumstances should Sallinger take on the project 21. Flotation Costs Salsman, Inc., recently issued new securities to finance a new TV show. The project cost 1.4 million and the company paid 105,000 in flotation costs. In addition, the equity issued had a flotation cost of 10 percent of the amount raised, whereas the debt issued had a...

Cost Of Capital And Longterm Financial Policy

CHAPTER 15 Cost of Capital The discount rate used in capital budgeting is often the project's weighted average cost of capital. This chapter identifies the components to be used in a project's cost of capital, the method used to determine the cost of each component, and how the component costs are combined into a weighted average cost of capital. CHAPTER 16 Raising Capital Chapter 16 examines the process of raising capital.Two of the most interesting subjects covered deal with firms that are...

Financial Policy and Growth

Based on our discussion just preceding, we see that there is a direct link between growth and external financing. In this section, we discuss two growth rates that are particularly useful in long-range planning. The Internal Growth Rate The first growth rate of interest is the maximum growth rate that can be achieved with no external financing of any kind. We will call this the internal growth rate because this is the rate the firm can maintain with internal financing only. In Figure 4.1, this...

The Efficient Markets Hypothesis

The efficient markets hypothesis EMH asserts that well-organized capital markets, such as the NYSE, are efficient markets, at least as a practical matter. In other words, an advocate of the EMH might argue that although inefficiencies may exist, they are relatively small and not common. Ross et al. Fundamentals I V. Risk and Return I 12. Some Lessons from I I The McGraw-Hill of Corporate Finance, Sixth Capital Market History Companies, 2002 CHAPTER 12 Some Lessons from Capital Market History...

Supreme Court Decision Substantially Broadens Producer Liability For Injuries Suffered By Product Users

Concepts Review and Critical Thinking Questions Diversifiable and Nondiversifiable Risks In broad terms, why is some risk diversifiable Why are some risks nondiversifiable Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk Information and Market Returns Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2 percent in the coming year, as compared to 5...

Cash Flow from Assets

Cash flow from assets involves three components operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm's day-to-day activities of producing and selling. Expenses associated with the firm's financing of its assets are not included because they are not operating expenses. As we discussed in Chapter 1, some portion of the firm's cash flow is reinvested in the firm. Capital spending refers to the net spending...

1

Reward-to-Risk Ratios Stock Y has a beta of 1.45 and an expected return of 17 percent. Stock Z has a beta of .85 and an expected return of 12 percent. If the risk-free rate is 6 percent and the market risk premium is 7.5 percent, are these stocks correctly priced 20. Reward-to-Risk Ratios In the previous problem, what would the risk-free rate have to be for the two stocks to be correctly priced 21. Portfolio Returns Using information from the previous chapter on capital market history,...

Answer to Chapter Review and Self Test Problem

2.1 In preparing the balance sheets, remember that shareholders' equity is the residual. With this in mind, Mara's balance sheets are as follows Ross et al. Fundamentals I I. Overview of Corporate I 2. Financial Statements, I I The McGraw-Hill of Corporate Finance, Sixth Finance Taxes, and Cash Flow Companies, 2002 CHAPTER 2 Financial Statements, Taxes, and Cash Flow

Chapter Review and Self Test Problem

2.1 Cash Flow for Mara Corporation This problem will give you some practice working with financial statements and figuring cash flow. Based on the following information for Mara Corporation, prepare an income statement for 2002 and balance sheets for 2001 and 2002. Next, following our U.S. Corporation examples in the chapter, calculate cash flow from assets, cash flow to creditors, and cash flow to stockholders for Mara for 2002. Use a 35 percent tax rate throughout. You can check your answers...

Some Common Misconceptions about the EMH

No other idea in finance has attracted as much attention as that of efficient markets, and not all of the attention has been flattering. Rather than rehash the arguments here, we will be content to observe that some markets are more efficient than others. For example, financial markets on the whole are probably much more efficient than real asset markets. Having said this, however, we can also say that much of the criticism of the EMH is misguided because it is based on a misunderstanding of...

Long Term Financial Planning and Growth

Boston Chicken Inc., operator and franchiser of Boston Market restaurants, was one of the great success stories of the early 1990s. The firm added restaurants at a staggering rate resulting in an increase in sales from 42.5 million in 1993 the year it first became a publicly traded corporation to 462.4 million in 1997, for an average growth rate of 82 percent per year. Unfortunately, the firm's recipe for growth turned out to be a disaster by 1998 because the firm grew too fast to maintain the...

Calculating and Comparing Effective Annual Rates

To see why it is important to work only with effective rates, suppose you've shopped around and come up with the following three rates Bank A 15 percent compounded daily Bank B 15.5 percent compounded quarterly Bank C 16 percent compounded annually Which of these is the best if you are thinking of opening a savings account Which of these is best if they represent loan rates To begin, Bank C is offering 16 percent per year. Because there is no compounding during the year, this is the effective...

Project Cash Flows

To develop the cash flows from a project, we need to recall from Chapter 2 that cash flow from assets has three components operating cash flow, capital spending, and changes in net working capital. To evaluate a project, or minifirm, we need to arrive at estimates for each of these. Once we have estimates of the components of cash flow, we will calculate cash flow for our minifirm just as we did in Chapter 2 for an entire firm Project cash flow Project operating cash flow - Project change in...

Suppose The Average Inflation Rate Over This Time Period Was 3.5 Percent And The Average T-bill Rate Over The Period

Risk Premiums Refer to Table 12.1 in the text and look at the period from Basic 1970 through 1975. continued a. Calculate the average returns for large-company stocks and T-bills over this time period. b. Calculate the standard deviation of the returns for large-company stocks and T-bills over this time period. c. Calculate the observed risk premium in each year for the large-company stocks versus the T-bills. What was the average risk premium over this period What was the standard deviation...

Some Lessons from Capital Market History

With the Nasdaq stock market index down almost 40 percent, 2000 was not a good year overall for stock market investors, particularly those who concentrated on technology stocks. In fact, it was an especially bad year for companies such as Yahoo , which lost almost 90 percent of its value. Of course, some stocks do well even in a bad year. Juniper Networks gained 122.5 percent, and OSI Pharmaceuticals was up by an amazing 909.4 percent These examples illustrate that there were tremendous...

Setting the Bid Price

Early on, we used discounted cash flow analysis to evaluate a proposed new product. A somewhat different and very common scenario arises when we must submit a competitive bid to win a job. Under such circumstances, the winner is whoever submits the lowest bid. There is an old saw concerning this process the low bidder is whoever makes the biggest mistake. This is called the winner's curse. In other words, if you win, there is a good chance you underbid. In this section, we look at how to go...

Example

Valuation of Future I 8. Stock Valuation I I The McGraw-Hill of Corporate Finance, Sixth Cash Flows Companies, 2002 248 PART THREE Valuation of Future Cash Flows The only tricky thing here is that the next dividend, D is given as 4, so we won't multiply this by 1 g . With this in mind, the price per share is given by Po Di R - g 4 .16 - .06 4 .10 40 Because we already have the dividend in one year, we know that the dividend in four years is equal to D1 x 1 g 3 4...

Just Dew It Balance Sheet

Total liabilities and owners' equity Prepare the 2001 and 2002 Prepare the 2002 common- 13. Preparing Standardized Financial Statements common-size balance sheets for Just Dew It. 14. Preparing Standardized Financial Statements base year balance sheet for Just Dew It. 15. Preparing Standardized Financial Statements Prepare the 2002 combined common-size, common-base year balance sheet for Just Dew It. 16. Sources and Uses of Cash For each account on this company's balance sheet, show the change...

Partial Amortization or Bite the Bullet

A common arrangement in real estate lending might call for a 5-year loan with, say, a 15-year amortization. What this means is that the borrower makes a payment every month of a fixed amount based on a 15-year amortization. However, after 60 months, the borrower makes a single, much larger payment called a balloon or bullet to pay off the loan. Because the monthly payments don't fully pay off the loan, the loan is said to be partially amortized. Suppose we have a 100,000 commercial mortgage...

Table

In general, the price today of a share of stock, P0, is the present value of all of its future dividends, D1, D2, D3, . . . If the dividend grows at a steady rate, g, then the price can be written as This result is called the dividend growth model. If the dividend grows steadily after t periods, then the price can be written as P0 D . . . D _Pl_ 1 R 1 1 R 2 1 R ' 1 R ' The required return, R, can be written as the sum of two things where D1 P0 is the dividend yield and g is the capital gains...

Can The Goal Of Maximizing The Value Of The Stock Conflict With Other Goals Such As Avoiding Unethical Or Illegal

Agency relationship exists in the corporate form of organization In this context, what kinds of problems can arise 7. Primary versus Secondary Markets You've probably noticed coverage in the financial press of an initial public offering IPO of a company's securities. Is an IPO a primary-market transaction or a secondary-market transaction 8. Auction versus Dealer Markets What does it mean when we say the New York Stock Exchange is an auction market How are auction markets different from dealer...

18 Percent Over The Following Year And Then 8 Percent Per Year Indefinitely

PART THREE Valuation of Future Cash Flows paying dividends forever. If the required return on this stock is 11 percent, what is the current share price 8. Valuing Preferred Stock Sowell, Inc., has an issue of preferred stock outstanding that pays an 8.50 dividend every year, in perpetuity. If this issue currently sells for 124 per share, what is the required return 9. Stock Valuation Smashed Pumpkin Farms SPF just paid a dividend of 3.00 on its stock. The growth rate in dividends is expected to...

Smolira Golf Corp.

Du Pont Identity Construct the Du Pont identity for Smolira Golf Corp. Calculating the Interval Measure For how many days could Smolira Golf Corp. continue to operate if its cash inflows were suddenly suspended Statement of Cash Flows Prepare the 2002 statement of cash flows for Smolira Golf Corp. Market Value Ratios Smolira Golf Corp. has 1,250 shares of common stock outstanding, and the market price for a share of stock at the end of 2002 was 63. What is the price-earnings ratio What are the...

This Problem Is Useful For Testing The Ability Of Financial Calculators And Computer Software. Consider The Following

Multiple IRRs This problem is useful for testing the ability of financial calculators and computer software. Consider the following cash flows. How many different IRRs are there hint search between 20 percent and 70 percent When These end-of-chapter activities show students how to use and learn from the vast amount of financial resources available on the Internet. See examples in Chapter 1, page 22 Chapter 4, page 126. Growth Rates Go to quote.yahoo.com and enter the ticker symbol IP for...

Other Types of Bonds

Many bonds have unusual or exotic features. So-called disaster bonds provide an interesting example. In 1996, USAA, a big seller of car and home insurance based in San Antonio, announced plans to issue 500 million in act of God bonds. The way these work is that USAA will pay interest and principal in the usual way unless it has to cover more than 1 billion in hurricane claims from a single storm over any single one-year period. If this happens, investors stand to lose both principal and...

Preferred Stock Features

Preferred stock differs from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that the holders of the preferred shares must receive a dividend in the case of an ongoing firm before holders of common shares are entitled to anything. Preferred stock is a form of equity from a legal and tax standpoint. It is important to note, however, that holders of preferred stock...

Lifehouse Software Has 10percent Coupon Bonds On The Market With 7 Years To Maturity. The Bonds Make Semiannual

Bond Price Movements Bond X is a premium bond making annual payments. The bond pays a 9 percent coupon, has a YTM of 7 percent, and has 13 years to maturity. Bond Y is a discount bond making annual payments. This bond pays a 7 percent coupon, has a YTM of 9 percent, and also has 13 years to maturity. If interest rates remain unchanged, what do you expect the price of these bonds to be one year from now In three years In eight years In 12 years In 13 years What's going on here Illustrate your...

The Moulon Rouge Corporation

PART THREE Valuation of Future Cash Flows c. What is the relationship between the current yield and YTM for premium bonds For discount bonds For bonds selling at par value 23. Interest on Zeroes HSD Corporation needs to raise funds to finance a plant expansion, and it has decided to issue 20-year zero coupon bonds to raise the money. The required return on the bonds will be 9 percent. a. What will these bonds sell for at issuance b. Using the IRS amortization rule, what interest deduction can...

The Discounted Payback

We saw that one of the shortcomings of the payback period rule was that it ignored time value. There is a variation of the payback period, the discounted payback period, that fixes this particular problem. The discounted payback period is the length of time until the sum of the discounted cash flows is equal to the initial investment. The discounted payback rule would be Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified...

Estimating Net Present Value

Imagine we are thinking of starting a business to produce and sell a new product, say, organic fertilizer. We can estimate the start-up costs with reasonable accuracy because we know what we will need to buy to begin production. Would this be a good investment Based on our discussion, you know that the answer depends on whether or not the value of the new business exceeds the cost of starting it. In other words, does this investment have a positive NPV This problem is much more difficult than...

Average versus Marginal Tax Rates

In making financial decisions, it is frequently important to distinguish between average and marginal tax rates. Your average tax rate is your tax bill divided by your taxable income, in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the rate of the extra tax you would pay if you earned one more Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition 2. Financial Statements, Taxes, and Cash Flow CHAPTER 2 Financial...

Dimensions of Financial Planning

It is often useful for planning purposes to think of the future as having a short run and a long run. The short run, in practice, is usually the coming 12 months. We focus our attention on financial planning over the long run, which is usually taken to be the coming two to five years. This time period is called the planning horizon, and it is the first dimension of the planning process that must be established. In drawing up a financial plan, all of the individual projects and investments the...

Present versus Future Value

What we called the present value factor is just the reciprocal of that is, 1 divided by the future value factor Future value factor 1 r ' Present value factor 1 1 r ' In fact, the easy way to calculate a present value factor on many calculators is to first calculate the future value factor and then press the 1 x key to flip it over. If we let FV' stand for the future value after ' periods, then the relationship between future value and present value can be written very simply as one of the...

But It Unfortunately Ran A Bit Over Budget. All Is Not Lost. You Just Received An Offer In The Mail To Transfer Your 5

PART THREE Valuation of Future Cash Flows 1,000 X 1.143 1,000 X 1.48154 1,481.54. Now, Judy recognizes that coming up with 1,481.54 all at once might be a strain, so she lets you make low, low monthly payments of 1,481.54 36 41.15 per month, even though this is extra bookkeeping work for her. Is this a 14 percent loan Why or why not What is the APR on this loan What is the EAR Why do you think this is called add-on interest 66. Calculating Annuity Payments This is a classic retirement problem....

Calculating Present Value Of A Perpetuity Given An Interest Rate Of 6.5 Percent

PART THREE Valuation of Future Cash Flows 48. Calculating Present Value of Annuities Congratulations You've just won the 15 million first prize in the Subscriptions R Us Sweepstakes. Unfortunately, the sweepstakes will actually give you the 15 million in 375,000 annual installments over the next 40 years, beginning next year. If your appropriate discount rate is 11 percent per year, how much money did you really win 49. Present Value and Multiple Cash Flows What is the present value of 1,000...