Financial Management: Concepts and Applications

Part 1: Assessing and Managing Performance 1
1 Overview of Financial Management 1
1.1 Financial Management and the Cash Flow Cycle 1
Case Study: Advanced Micro Devices Inc.’s Cash Crunch 2
1.2 The Role of Financial Managers 5
In-Depth: Maximizing Shareholder Value: An Ethical Responsibility? 6
1.3 A Nonfinancial Perspective of Financial Management 7
In the News: Walmart’s Financial Challenges 8
1.4 Financial Management’s Relationship with Accounting and Other
Disciplines 9
1.5 Types of Firms 10
1.6 A Financial Management Framework 12
1.7 Relevance for Managers 16
Summary 16
Additional Readings and Information 17
Problems 17
2 Sizing-Up a Business: A Nonfinancial
Perspective 18
2.1 Sizing-Up the Overall Economy 20
In-Depth: Gathering Information for a Size-Up 20
2.1.1 GDP Components 21
2.1.2 Sector-Related Fluctuations 23
2.1.3 Inflation and Interest Rates 24
Case Study: Sector Performance and Business Cycles: Duke Energy
Corporation and Tiffany & Co. 24
2.1.4 Capital Markets 27
2.1.5 Economic Size-Up Checklist 28
2.2 Sizing-Up the Industry 29
2.2.1 Industry Life Cycles 29
2.2.2 The Competitive Environment 30
2.2.3 Opportunities and Risks 32
2.2.4 Industry Size-Up Checklist 332.3 Sizing-Up Operations Management and Supply Risk 33
2.4 Sizing-Up Marketing Management and Demand Risk 36
2.5 Sizing-Up Human Resource Management and Strategy 38
2.6 Sizing-Up Home Depot: An Example 40
2.7 Relevance for Managers 42
Summary 43
Additional Readings and Information 43
Problems 44
3 Understanding Financial Statements 45
3.1 Understanding Balance Sheets 45
3.1.1 Understanding Assets 47
3.1.2 Understanding Liabilities 49
3.1.3 Understanding Equity 51
In-Depth: Book Value of Equity versus Market Value of Equity 52
3.2 Understanding Income Statements 53
3.2.1 Understanding Revenues, Costs, Expenses, and Profits 53
In-Depth: EBIT versus EBITDA 55
3.2.2 Connecting a Firm’s Income Statement and Balance Sheet 57
3.3 Understanding Cash Flow Statements 58
3.3.1 Cash Flows Related to Operating Activities 59
3.3.2 Cash Flows from Investing Activities 61
3.3.3 Cash Flows from Financing Activities 61
In-Depth: U.S. versus International Accounting and Financial Statement
Presentation 62
3.4 Relevance for Managers 63
Summary 64
Additional Readings and Information 64
Problems 64
4 Measuring Financial Performance 65
4.1 Performance Measures 65
4.1.1 Return on Equity 66
Case Study: ROE Drivers across Industries: Tiffany and Kroger 69
4.1.2 Profitability Measures 69
4.1.3 Resource Management Measures 72
4.1.4 Liquidity Measures 75
4.1.5 Leverage Measures 76
4.1.6 Application: Home Depot 78
4.2 Reading Annual Reports 83
4.3 Relevance for Managers 84
Summary 85
Additional Readings and Information 85
Problems 86
5 Managing Day-to-Day Cash Flow 87
5.1 Cash Flow Cycles 87
5.2 Working Capital Management 92
5.2.1 Managing Inventory 92
In-Depth: Inventory Management Systems 92
5.2.2 Managing Accounts Receivable 93
In-Depth: Aging Schedules and Bad Debt 93
5.2.3 Managing Accounts Payable 94
5.2.4 Application: Home Depot 94
In-Depth: The Cost of Foregoing Discounts on Payables 94
In-Depth: Working Capital Management Ratios across Industries 98
5.3 Short-Term Financing 99
5.3.1 Bank Loans 99
5.3.2 Commercial Paper 100
5.3.3 Banker’s Acceptance 100
Case Study: Commercial Paper and the 2007–2009
Financial Crisis 101
5.4 Relevance for Managers 101
Summary 102
Additional Readings and Information 102
Problems 103
Part 2: Assessing Future Financial Needs 104
6 Projecting Financial Requirements and
Managing Growth 104
6.1 Generating Pro Forma Income Statements 105
6.1.1 Establishing Cost of Goods Sold and Gross Profit 106
6.1.2 Establishing Expenses 108
6.1.3 Establishing Earnings 108
6.2 Generating Pro Forma Balance Sheets 110
6.2.1 Establishing Assets 110
6.2.2 Establishing Liabilities and Equity 1116.3 Generating Pro Forma Cash Budgets 113
6.3.1 Establishing Cash Inflows 113
6.3.2 Establishing Cash Outflows 113
6.3.3 Establishing Net Cash Flows 114
6.4 Performing Sensitivity Analysis 115
6.4.1 Sales Sensitivity 116
6.4.2 Interest Rate Sensitivity 117
6.4.3 Working Capital Sensitivity 117
6.5 Understanding Sustainable Growth and Managing
Growth 118
Case Study: Home Depot’s Pro Forma Statements and
Sustainable Growth 121
6.6 Relevance for Managers 123
Summary 124
Additional Readings and Information 124
Problems 125
Appendix: Spreadsheet Analysis 125
7 Time Value of Money Basics and
Applications 129
7.1 Exploring Time Value of Money Concepts 129
7.1.1 Future Values 131
7.1.2 Present Values 133
7.1.3 Annuities 135
7.1.4 Perpetuities 136
In-Depth: Spreadsheet and Financial
Calculator Tips 137
7.2 Applying Time Value of Money Concepts to Financial
Securities 139
7.2.1 Bonds 139
In-Depth: Bond Prices and Yields: Home Depot Inc.
Example 143
7.2.2 Preferred Shares 143
In-Depth: Preferred Share Prices and Bond Yields: Kansas City
Railroad 145
7.2.3 Common Equity 146
In-Depth: Multistage Dividend Discount Model 148
7.3 Relevance for Managers 148
Summary 149
Additional Readings and Information 149
Problems 149
8 Making Investment Decisions 151
8.1 Understanding the Decision-Making Process 151
8.2 Capital Budgeting Techniques 153
8.2.1 Payback 154
8.2.2 Net Present Value 155
In-Depth: Real Options 157
8.2.3 Internal Rate of Return 158
8.3 Capital Budgeting Extensions 161
8.3.1 Profitability Index 161
8.3.2 Equivalent Annual Cost and Project Lengths 162
8.3.3 Mutually Exclusive Projects and Capital Rationing 163
8.4 Relevance for Managers 164
Summary 165
Additional Readings and Information 165
Problems 166
Part 3: Financing Long-Term Needs 167
9 Overview of Capital Markets: Long-Term
Financing Instruments 167
9.1 Bonds 168
9.1.1 Changing Bond Yields 168
9.1.2 Bond Features 169
In the News: The Libor Scandal 170
9.1.3 Bond Ratings 171
In-Depth: What Credit-Rating Agencies Do 172
9.2 Preferred Shares 173
9.3 Common Shares 174
9.3.1 Historical Returns 175
9.4 Capital Markets Overview 177
9.4.1 Private versus Public Markets 177
9.4.2 Venture Capital and Private Equity 178
Case Study: Private Placement Example—Sesac Inc. and the Music of
Bob Dylan and Neil Diamond 179
9.4.3 Initial Offerings versus Seasoned Issues 179
In Depth: SOX and the Cost of Being a Public Firm 181
Case Study: Google and Facebook IPOs 182
9.4.4 Organized Exchanges versus Over-the-Counter Markets 185
9.4.5 Role of Intermediaries 185
9.5 Market Efficiency 186
9.5.1 Weak Form 187
9.5.2 Semistrong Form 187
9.5.3 Strong Form 188
9.5.4 U.S. Stock Market Efficiency 188
9.6 Relevance for Managers 188
Summary 189
Additional Readings and Information 189
Problems 190
Appendix: Understanding Bond and Stock Investment
Information 191
Bond Information 191
Stock Information 191
10 Assessing the Cost of Capital: What
Return Investors Require 194
10.1 Understanding the Cost of Capital:
An Example 195
10.2 Understanding the Implications of the
Cost of Capital 197
10.3 Defining Risk 198
10.4 Estimating the Cost of Debt 201
10.5 Estimating the Cost of Preferred Shares 202
10.6 Estimating the Cost of Equity 204
10.6.1 Dividend Model Approach 204
10.6.2 Capital Asset Pricing Model 205
In-Depth: Investing in “the Market” 206
10.7 Estimating Component Weights 208
10.8 Home Depot Application 209
10.9 Hurdle Rates 211
10.10 Relevance for Managers 212
Summary 213
Additional Readings and Information 213
Problems 21411 Understanding Financing and Payout
Decisions 215
11.1 Capital Structure Overview 216
11.2 Understanding the Modigliani-Miller Argument: Why Capital
Structure Does Not Matter 218
11.3 Relaxing the Assumptions: Why Capital Structure Does Matter 221
11.3.1 Understanding the Impact of Corporate Taxes 222
11.3.2 Understanding the Impact of Financial Distress 223
In the News: Largest U.S. Bankruptcy 225
11.3.3 Combining Corporate Taxes and Financial Distress Costs 225
11.3.4 Impact of Asymmetric Information 226
11.4 Understanding Payout Policies 227
11.4.1 Paying Dividends 227
11.4.2 Repurchasing Shares 228
11.4.3 Do Dividend Policies Matter? 229
11.5 Relevance for Managers 230
Summary 231
Additional Readings and Information 231
Problems 232
Appendix: Why Dividend Policy Doesn’t Matter: Example 233
12 Designing an Optimal Capital
Structure 235
12.1 Factors Affecting Financing Decisions: The FIRST Approach 235
12.1.1 Maximizing Flexibility 235
Case Study: Ford Motor Company and Financial Flexibility Prior to the
Financial Crisis 237
12.1.2 Impact on EPS: Minimizing Cost 237
12.1.3 Minimizing Risk 241
12.1.4 Maintaining Shareholder Control 242
Case Study: Maintaining Control: Google Inc. and Dual Class
Shares 243
12.1.5 Optimal Timing 244
12.2 Tradeoff Assessment: Evaluating the FIRST Criteria 244
In-Depth: Optimal Amount of Debt at the Firm Level: Six Flags Inc.
Example 245
12.2.1 Example: Optimal Capital Structure and Minimizing the Cost of
Capital 247
Case Study: Changing Capital Structure: The Home
Depot Example 248
In-Depth: The Cost of Equity, Levered Betas, and the Target Capital
Structure 249
12.3 Relevance for Managers 250
Summary 252
Additional Readings and Information 252
Problems 253
Part 4: Creating Value 255
13 Measuring and Creating Value 255
13.1 An Overview of Measuring and Creating Value 256
13.2 Measuring Value: The Book Value Plus Adjustments
Method 258
13.2.1 Pros and Cons of the Book Value of Equity Plus Adjustments
Method 259
13.3 Measuring Value: The Discounted Cash Flow
Analysis Method 259
13.3.1 Estimating Free Cash Flows 260
In-Depth: Why Do We Add Back Noncash Items? 261
13.3.2 Estimating the Cost of Capital 262
13.3.3 Estimating the Present Value of Free Cash Flows 263
13.3.4 Estimating the Terminal Value 264
In-Depth: The Most Common DCF Estimation Mistakes 265
13.3.5 Estimating the Value of Equity 265
13.3.6 Pros and Cons of the Free Cash Flow to the
Firm Approach 267
13.4 Measuring Value: Relative Valuations and Comparable
Analysis 267
13.4.1 The Price-Earnings Method 267
13.4.2 Pros and Cons of the Price-Earnings Approach 269
In-Depth: The Price-Earnings Model and the Constant Growth Dividend
Discount Model 270
13.4.3 The Enterprise Value-to-EBITDA Method 270
13.4.4 Pros and Cons of the EV/EBITDA Approach 271
In-Depth: Comparing P/B, P/E, and EV/EBITDA
across Industries 272
13.5 Creating Value and Value-Based Management 273
13.6 Valuing Mergers and Acquisitions 276
13.6.1 Valuing Comparable M&A Transactions 277
13.7 Relevance for Managers 278
Summary 278
Additional Readings and Information 279
Problems 28014 Comprehensive Case Study: Wal-Mart Stores,
Inc. 281
14.1 Sizing-Up Walmart 283
14.1.1 Analyzing the Economy 283
14.1.2 Analyzing the Industry 284
14.1.3 Analyzing Walmart’s Strengths and Weaknesses in Operations,
Marketing, Management, and Strategy 286
14.1.4 Analyzing Walmart’s Financial Health 288
In-Depth: Target Corporation: ROIC 294
In-Depth: Target Corporation: ROE 295
14.2 Projecting Walmart’s Future Performance 295
14.2.1 Projecting Walmart’s Income Statement 295
14.2.2 Projecting Walmart’s Balance Sheet 297
14.2.3 Examining Alternate Scenarios 299
14.3 Assessing Walmart’s Long-Term Investing and Financing 300
14.3.1 Assessing Walmart’s Investments 300
14.3.2 Assessing Walmart’s Capital Raising and the Cost of Capital 301
In-Depth: Target Corporation: Cost of Capital 302
14.4 Valuing Walmart 302
14.4.1 Measuring Walmart’s Economic Value Added 302
In-Depth: Target Corporation: EVA 303
14.4.2 Estimating Walmart’s Intrinsic Value: The DCF Approach 304
14.4.3 Estimating Walmart’s Intrinsic Value: Comparable Analysis 304
In-Depth: Target Corporation: EV/EBITDA Analysis 306
14.4.4 Creating Value and an Overall Assessment of Walmart 306
14.5 Relevance for Managers and Final Comments 307
Additional Readings and Information 307
Problems 308