The ______ measure of returns ignores compounding

Robert C. Higgins

Analysis for Financial Management E l e v en t h Ed i t i o n

Analysis for Financial Management

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate

Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

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Analysis for Financial Management

Eleventh Edition

ROBERT C. HIGGINS Marguerite Reimers

Emeritus Professor of Finance The University of Washington

with

JENNIFER L. KOSKI John B. and Delores L. Fery

Faculty Fellow Associate Professor of Finance The University of Washington

and

TODD MITTON Ned C. Hill Professor of Finance Brigham Young University

ANALYSIS FOR FINANCIAL MANAGEMENT, ELEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Higgins, Robert C. Analysis for financial management/Robert C. Higgins ; with Jennifer Koski and Todd Mitton.—

Eleventh edition. pages cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate)

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In memory of my son

STEVEN HIGGINS

1970–2007

vi

Preface xi

PART ONE Assessing the Financial Health of the Firm 1

1 Interpreting Financial Statements 3

2 Evaluating Financial Performance 39

PART TWO Planning Future Financial Performance 79

3 Financial Forecasting 81 4 Managing Growth 115

PART THREE Financing Operations 141

5 Financial Instruments and Markets 143

6 The Financing Decision 195

PART FOUR Evaluating Investment Opportunities 237

7 Discounted Cash Flow Techniques 239

8 Risk Analysis in Investment Decisions 289

9 Business Valuation and Corporate Restructuring 343

GLOSSARY 393 SUGGESTED ANSWERS TO

ODD-NUMBERED PROBLEMS 405 INDEX 437

Brief Contents

Preface xi

PART ONE ASSESSING THE FINANCIAL HEALTH OF THE FIRM 1

Chapter 1 Interpreting Financial Statements 3 The Cash Flow Cycle 3 The Balance Sheet 6

Current Assets and Liabilities 11 Shareholders’ Equity 12

The Income Statement 12 Measuring Earnings 12

Sources and Uses Statements 17 The Two-Finger Approach 18

The Cash Flow Statement 19 Financial Statements and the

Value Problem 24 Market Value vs. Book Value 24 Economic Income vs. Accounting Income 27 Imputed Costs 28

Summary 31 Additional Resources 32 Problems 33

Chapter 2 Evaluating Financial Performance 39 The Levers of Financial Performance 39 Return on Equity 40

The Three Determinants of ROE 40 The Profit Margin 42 Asset Turnover 44 Financial Leverage 49

Is ROE a Reliable Financial Yardstick? 55 The Timing Problem 56 The Risk Problem 56

The Value Problem 58 ROE or Market Price? 59

Ratio Analysis 62 Using Ratios Effectively 62 Ratio Analysis of Stryker Corporation 63

Summary 71 Additional Resources 72 Problems 73

PART TWO PLANNING FUTURE FINANCIAL PERFORMANCE 79

Chapter 3 Financial Forecasting 81 Pro Forma Statements 81

Percent-of-Sales Forecasting 82 Interest Expense 88 Seasonality 89

Pro Forma Statements and Financial Planning 89

Computer-Based Forecasting 90 Coping with Uncertainty 94

Sensitivity Analysis 94 Scenario Analysis 95 Simulation 96

Cash Flow Forecasts 98 Cash Budgets 99 The Techniques Compared 102 Planning in Large Companies 103 Summary 105 Additional Resources 106 Problems 108

Chapter 4 Managing Growth 115 Sustainable Growth 116

The Sustainable Growth Equation 116 vii

Contents

viii Contents

Too Much Growth 119 Balanced Growth 119 Under Armour’s Sustainable Growth Rate 121 “What If” Questions 122

What to Do When Actual Growth Exceeds Sustainable Growth 122

Sell New Equity 123 Increase Leverage 125 Reduce the Payout Ratio 125 Profitable Pruning 126 Outsourcing 127 Pricing 127 Is Merger the Answer? 127

Too Little Growth 128 What to Do When Sustainable Growth

Exceeds Actual Growth 129 Ignore the Problem 130 Return the Money to Shareholders 130 Buy Growth 131

Sustainable Growth and Pro Forma Forecasts 132

New Equity Financing 132 Why Don’t U.S. Corporations Issue More

Equity? 135 Summary 136 Additional Resources 137 Problems 138

PART THREE FINANCING OPERATIONS 141

Chapter 5 Financial Instruments and Markets 143 Financial Instruments 144

Bonds 145 Common Stock 152 Preferred Stock 156

Financial Markets 158 Venture Capital Financing 158 Private Equity 160 Initial Public Offerings 162

Seasoned Issues 163 Issue Costs 168

Efficient Markets 169 What Is an Efficient Market? 170 Implications of Efficiency 172

Appendix Using Financial Instruments to Manage Risks 174

Forward Markets 175 Speculating in Forward Markets 176 Hedging in Forward Markets 177 Hedging in Money and Capital Markets 180 Hedging with Options 180 Limitations of Financial Market Hedging 183 Valuing Options 185

Summary 188 Additional Resources 189 Problems 191

Chapter 6 The Financing Decision 195 Financial Leverage 197 Measuring the Effects of Leverage on a

Business 201 Leverage and Risk 203 Leverage and Earnings 206

How Much to Borrow 208 Irrelevance 208 Tax Benefits 210 Distress Costs 211 Flexibility 215 Market Signaling 217 Management Incentives 220 The Financing Decision and Growth 221

Selecting a Maturity Structure 224 Inflation and Financing Strategy 225

Appendix The Irrelevance Proposition 225

No Taxes 226 Taxes 228

Summary 230 Additional Resources 231 Problems 232

Contents ix

PART FOUR EVALUATING INVESTMENT OPPORTUNITIES 237

Chapter 7 Discounted Cash Flow Techniques 239 Figures of Merit 240

The Payback Period and the Accounting Rate of Return 241

The Time Value of Money 242 Equivalence 247 The Net Present Value 248 The Benefit-Cost Ratio 250 The Internal Rate of Return 250 Uneven Cash Flows 254 A Few Applications and Extensions 255 Mutually Exclusive Alternatives and Capital

Rationing 259 The IRR in Perspective 260

Determining the Relevant Cash Flows 260

Depreciation 262 Working Capital and Spontaneous

Sources 264 Sunk Costs 265 Allocated Costs 266 Cannibalization 267 Excess Capacity 268 Financing Costs 270

Appendix Mutually Exclusive Alternatives and

Capital Rationing 272 What Happened to the Other

$578,000? 273 Unequal Lives 274 Capital Rationing 277 The Problem of Future Opportunities 278 A Decision Tree 279

Summary 280 Additional Resources 281 Problems 282

Chapter 8 Risk Analysis in Investment Decisions 289 Risk Defined 291

Risk and Diversification 293 Estimating Investment Risk 295

Three Techniques for Estimating Investment Risk 296

Including Risk in Investment Evaluation 297 Risk-Adjusted Discount Rates 297

The Cost of Capital 298 The Cost of Capital Defined 299 Cost of Capital for Stryker Corporation 301 The Cost of Capital in Investment Appraisal 308 Multiple Hurdle Rates 309

Four Pitfalls in the Use of Discounted Cash Flow Techniques 311

The Enterprise Perspective versus the Equity Perspective 312

Inflation 314 Real Options 315 Excessive Risk Adjustment 321

Economic Value Added 322 EVA and Investment Analysis 323 EVA’s Appeal 325

A Cautionary Note 326 Appendix Asset Beta and Adjusted Present

Value 326 Beta and Financial Leverage 327 Using Asset Beta to Estimate Equity

Beta 328 Asset Beta and Adjusted Present Value 329

Summary 332 Additional Resources 333 Problems 335

Chapter 9 Business Valuation and Corporate Restructuring 343 Valuing a Business 345

Assets or Equity? 346

x Contents

Dead or Alive? 346 Minority Interest or Control? 348

Discounted Cash Flow Valuation 349 Free Cash Flow 350 The Terminal Value 351 A Numerical Example 354 Problems with Present Value Approaches to

Valuation 357 Valuation Based on Comparable Trades 357

Lack of Marketability 361 The Market for Control 362

The Premium for Control 362 Financial Reasons for Restructuring 364

The Empirical Evidence 372 The Cadbury Buyout 374 Appendix The Venture Capital Method of

Valuation 376 The Venture Capital Method—One

Financing Round 377

The Venture Capital Method—Multiple Financing Rounds 380

Why Do Venture Capitalists Demand Such High Returns? 382

Summary 384 Additional Resources 385 Problems 386

Glossary 393 Suggested Answers to

Odd-Numbered Problems 405 Index 437

xi

Preface

Like its predecessors, the eleventh edition of Analysis for Financial Man- agement is for nonfinancial executives and business students interested in the practice of financial management. It introduces standard techniques and recent advances in a practical, intuitive way. The book assumes no prior background beyond a rudimentary, and perhaps rusty, familiarity with financial statements—although a healthy curiosity about what makes business tick is also useful. Emphasis throughout is on the managerial im- plications of financial analysis.

Analysis for Financial Management should prove valuable to individuals interested in sharpening their managerial skills and to executive program participants. The book has also found a home in university classrooms as the sole text in Executive MBA and applied finance courses, as a compan- ion text in case-oriented courses, and as a supplementary reading in more theoretical finance courses.

Analysis for Financial Management is my attempt to translate into another medium the enjoyment and stimulation I have received over the past four decades working with executives and college students. This experience has convinced me that financial techniques and concepts need not be abstract or obtuse; that recent advances in the field such as agency theory, market sig- naling, market efficiency, capital asset pricing, and real options analysis are important to practitioners; and that finance has much to say about the broader aspects of company management. I also believe that any activity in which so much money changes hands so quickly cannot fail to be interesting.

Part One looks at the management of existing resources, including the use of financial statements and ratio analysis to assess a company’s finan- cial health, its strengths, weaknesses, recent performance, and future prospects. Emphasis throughout is on the ties between a company’s oper- ating activities and its financial performance. A recurring theme is that a business must be viewed as an integrated whole and that effective financial management is possible only within the context of a company’s broader operating characteristics and strategies.

The rest of the book deals with the acquisition and management of new resources. Part Two examines financial forecasting and planning with par- ticular emphasis on managing growth and decline. Part Three considers the financing of company operations, including a review of the principal security types, the markets in which they trade, and the proper choice of security type by the issuing company. The latter requires a close look at fi- nancial leverage and its effects on the firm and its shareholders.

Part Four addresses the use of discounted cash flow techniques, such as the net present value and the internal rate of return, to evaluate invest- ment opportunities. It also deals with the difficult task of incorporating risk into investment appraisal. The book concludes with an examination of business valuation and company restructuring within the context of the ongoing debate over the proper roles of shareholders, boards of directors, and incumbent managers in governing America’s public corporations.

An extensive glossary of financial terms and suggested answers to odd- numbered, end-of-chapter problems follow the last chapter.

Changes in the Eleventh Edition Readers familiar with earlier editions of Analysis for Financial Management will notice a number of changes here. Most important, two talented young teachers and scholars have joined me in preparing the eleventh edition. Jennifer Koski, a colleague at the University of Washington, and Todd Mitton, at Brigham Young University, have done yeomen’s work ushering the book into the digital era. I much appreciate their many contributions. You should expect their responsibilities to grow in any future editions.

A second noteworthy change is the book’s partnership with McGraw- Hill’s Connect. As the following section explains in more detail, Connect is the lynchpin of the publisher’s digital initiative. Combining elements of computerized instruction and electronic publishing, it promises signifi- cant benefits to readers and instructors alike. I am anxious to watch McGraw-Hill turn this promise into reality. There will undoubtedly be bumps along the way, but I am confident we are on the right path.

Other more conventional changes and refinements in the eleventh edi- tion include:

• An introductory discussion of crowdfunding and its possible future. • A new treatment of present value calculations, gracefully introducing

computer spreadsheets as the principal means for solving present value problems, while eliminating reference to present value tables.

• Explicit discussion of present value problems involving uneven cash flows. • Enhanced ‘recommended resources’ at the end of each chapter,

including two-dimensional bar codes (QR codes) and recommended mobile apps for Android and iOS devices.

• Added discussion of payout policy, illustrated by Apple Inc.’s recent experience.

• Updated details on the impact of U.S. regulation on financial manage- ment, including the Dodd-Frank Act and the JOBS Act of 2012.

• Better integration of T-accounts and financial statements. • Use of Stryker Corporation, a leading medical technology company, as

an extended example throughout the book.

xii Preface

McGraw-Hill’s Connect connect.mheducation.com

McGraw-Hill’s Connect® is an online assess- ment solution that connects students with the

tools and resources they’ll need to achieve success. Connect allows faculty to create and deliver exams easily with selectable test bank items. Instruc- tors can also build their own questions into the system for homework or practice. Readers have access to the student resources that accompany this text, as well as McGraw-Hill’s adaptive self-study technology in Learn- Smart and Smartbook.

Connect supports this book in several important ways. The student re- sources include:

• Excel spreadsheets referenced in end-of-chapter problems. • Supplementary chapter problems and suggested answers. • Complimentary software programs described in Additional Resources

at the end of several chapters.

If you are not enrolled in a course using Connect, you can access these stu- dent resources with a free trial by following the instructions accompanying the access code acquired with the book. I encourage you to download these items now for later use. If you are enrolled in a Connect course, ask your instructor for your Connect course URL to access the course resources.

Intended primarily for instructor use, the Connect Instructor Library houses, among other things: • A test bank. • PowerPoint presentations. • An annotated list of suggested cases to accompany the book. • Suggested answers to even-numbered problems.

To access the Instructor Library, log in to your Connect course, select the “Library” tab, and then select “Instructor Resources.”

Connect’s adaptive learning resources, LearnSmart and Smartbook, promise to speed and enrich your mastery of the book by creating a per- sonalized, flexible program of study.

For more information about Connect, LearnSmart, or Smartbook, go to connect.mheducation.com, or contact a McGraw-Hill sales representative. For 24-hour support you can e-mail a Product Specialist or search Frequently Asked Questions at mhhe.com/support. Or for a human, call 800-331-5094.

A word of caution: Analysis for Financial Management emphasizes the ap- plication and interpretation of analytic techniques in decision making. These techniques have proved useful for putting financial problems into perspective and for helping managers anticipate the consequences of their

Preface xiii

actions. But techniques can never substitute for thought. Even with the best technique, it is still necessary to define and prioritize issues, to mod- ify analysis to fit specific circumstances, to strike the proper balance be- tween quantitative analysis and more qualitative considerations, and to evaluate alternatives insightfully and creatively. Mastery of technique is only the necessary first step toward effective management.

I am indebted to Andy Halula of Standard & Poor’s for providing timely updates to Research Insight. The ability to access current Compustat data on CD continues to be a great help in providing timely examples of current practice. I also owe a large thank you to the following people for their in- sightful reviews of the 10th edition and their constructive advice. They did an excellent job; any remaining shortcomings are mine not theirs.

Bruce Campbell Franklin University Charles Evans Florida Atlantic University, Boca Raton Jaemin Kim San Diego State University, San Diego Inayat Ullah Mangla Western Michigan University, Kalamazoo

John Strong College of William & Mary Andy Terry University of Arkansas, Little Rock Marilyn Wiley University of North Texas Jaime Zender University of Colorado, Boulder

I appreciate the exceptional direction provided by Chuck Synovec, Noelle Bathurst, Melissa Caughlin, Dheeraj Chahal, and Mary Jane Lampe of McGraw-Hill on the development, design, and editing of the book. Bill Alberts, David Beim, Dave Dubofsky, Bob Keeley, Jack McDonald, George Parker, Megan Partch, Larry Schall, and Alan Shapiro have my continuing gratitude for their insightful help and support throughout the book’s evolu- tion. Thanks go as well to my daughter, Sara Higgins, for writing and editing the accompanying software. Finally, I want to express my appreciation to students and colleagues at the University of Washington, Stanford University, IMD, The Pacific Coast Banking School, The Koblenz Graduate School of Management, The Gordon Institute of Business Science, The Swiss International Business School ZfU AG, Boeing, and Microsoft, among others, for stimulating my continuing interest in the practice and teaching of financial management.

I envy you learning this material for the first time. It’s a stimulating intellectual adventure.

Robert C. (Rocky) Higgins Marguerite Reimers Emeritus Professor of Finance

Foster School of Business University of Washington

rhiggins@uw.edu

xiv Preface

P A R T O N E

Assessing the Financial

Health of the Firm

C H A P T E R O N E

Interpreting Financial Statements

Financial statements are like fine perfume; to be sniffed but not swallowed. Abraham Brilloff

Accounting is the scorecard of business. It translates a company’s diverse activities into a set of objective numbers that provide information about the firm’s performance, problems, and prospects. Finance involves the in- terpretation of these accounting numbers for assessing performance and planning future actions.

The skills of financial analysis are important to a wide range of people, including investors, creditors, and regulators. But nowhere are they more important than within the company. Regardless of functional specialty or company size, managers who possess these skills are able to diagnose their firm’s ills, prescribe useful remedies, and anticipate the financial conse- quences of their actions. Like a ballplayer who cannot keep score, an op- erating manager who does not fully understand accounting and finance works under an unnecessary handicap.

This and the following chapter look at the use of accounting information to assess financial health. We begin with an overview of the accounting prin- ciples governing financial statements and a discussion of one of the most abused and confusing notions in finance: cash flow. Two recurring themes will be that defining and measuring profits is more challenging than one might ex- pect, and that profitability alone does not guarantee success, or even survival. In Chapter 2, we look at measures of financial performance and ratio analysis.

The Cash Flow Cycle

Finance can seem arcane and complex to the uninitiated. However, a comparatively few basic principles should guide your thinking. One is that a company’s finances and operations are integrally connected. A company’s

activities, method of operation, and competitive strategy all fundamentally shape the firm’s financial structure. The reverse is also true: Decisions that appear to be primarily financial in nature can significantly affect company operations. For example, the way a company finances its assets can affect the nature of the investments it is able to undertake in future years.

The cash flow–production cycle shown in Figure 1.1 illustrates the close interplay between company operations and finances. For simplicity, suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets, and is now ready to begin operations. To do so, the company uses cash to purchase raw mate- rials and hire workers; with these inputs, it makes the product and stores it temporarily in inventory. Thus, what began as cash is now physical in- ventory. When the company sells an item, the physical inventory changes back into cash. If the sale is for cash, this occurs immediately; otherwise, cash is not realized until some later time when the account receivable is collected. This simple movement of cash to inventory, to accounts receiv- able, and back to cash is the firm’s operating, or working capital, cycle.

4 Part One Assessing the Financial Health of the Firm

FIGURE 1.1 The Cash Flow–Production Cycle

Cash

Ch ang

es in

equ ity

Ch ang

es in

lia bil

itie s

Ta xes

Int ere

st

Di vid

end s

Inventory

Accounts receivable

Fixed assets

Cash salesP ro

du cti

on

Collection of credit sales

D epreciation

In ve

stm ent

Cre dit

sa les

Another ongoing activity represented in Figure 1.1 is investment. Over a period of time, the company’s fixed assets are consumed, or worn out, in the creation of products. It is as though every item passing through the business takes with it a small portion of the value of fixed assets. The accountant rec- ognizes this process by continually reducing the accounting value of fixed assets and increasing the value of merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity and to fi- nance additional growth, the company must invest part of its newly received cash in new fixed assets. The object of this whole exercise, of course, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that started the journey.

We could complicate Figure 1.1 further by including accounts payable and expanding on the use of debt and equity to generate cash, but the fig- ure already demonstrates two basic principles. First, financial statements are an important window on reality. A company’s operating policies, production techniques, and inventory and credit-control systems fundamentally de- termine the firm’s financial profile. If, for example, a company requires payment on credit sales to be more prompt, its financial statements will reveal a reduced investment in accounts receivable and possibly a change in its revenues and profits. This linkage between a company’s operations and its finances is our rationale for studying financial statements. We seek to understand company operations and predict the financial consequences of changing them.

The second principle illustrated in Figure 1.1 is that profits do not equal cash flow. Cash—and the timely conversion of cash into inventories, ac- counts receivable, and back into cash—is the lifeblood of any company. If this cash flow is severed or significantly interrupted, insolvency can occur. Yet the fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency. To illustrate, suppose a company loses control of its accounts receivable by allowing customers more and more time to pay, or suppose the company consistently makes more mer- chandise than it sells. Then, even though the company is selling mer- chandise at a profit in the eyes of an accountant, its sales may not be generating sufficient cash soon enough to replenish the cash outflows re- quired for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. As another example, suppose the company is managing its inventory and receivables carefully, but rapid sales growth is necessitating an ever-larger investment in these assets. Then, even though the company is profitable, it may have too little cash to meet its obligations. The company will literally be “growing broke.” These brief examples illustrate why a manager must be concerned at least as much with cash flows as with profits.