The proformas are dynamic financial statements that recalculate based on your decisions.

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

FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition Cornett, Adair, and Nofsinger M: Finance Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Eleventh Edition Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Ninth Edition Bodie, Kane, and Marcus Investments Tenth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition

INTERNATIONAL FINANCE Eun and Resnick International Financial Management Seventh Edition

REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth Edition

FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Achieve Financial Literacy Fifth Edition Kapoor, Dlabay, and Hughes Personal Finance Eleventh Edition Walker and Walker Personal Finance: Building Your Future First Edition

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.