FINANCIAL MANAGEMENT AND POLICY VAN HORNE PDF
Fundamentals of financial management / James C. Van Horne, John M. Wachowicz. . l l l Part 6 The Cost of Capital, Capital Structure, and Dividend Policy. To My Family. Library of Congress Cataloging-in-Publication Data. Van Horne, James C. Financial management and policy / James C. Van Home. - 12th ed. Van Horne 12th edition - Ebook download as PDF File .pdf), Text File .txt) or read book online. Financial Management & Policy by James c. Van Horne 12th.
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Axel-Adam Müller, Lancaster Wachowicz Van Horne Authors: James C. Van Horne, the author of Financial Management and Policy, a Pearson Education text. -of-Financial-Management-By-James-C-Van-Horneth-Edition-pdf .. The board of directors sets company-wide policy and advises the CEO and other. Financial Management and Policy. Twelfth Edition. by. James C. Van Horne To view the Transparency Master (resourceone.info), you will need to download the FREE.
Request a copy. Download instructor resources. Additional order info. Buy this product. Highly respected for its effective integration of financial theory and practice, this classic text explores the rapidly evolving and exciting theory of finance as it relates to a corporation's investment in assets, financing, and dividends.
It explains the ways in which analytical techniques are brought to bear on financial decision making and supplies the institutional material necessary for a solid understanding of the environment in which financial decisions are made.
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Overview Features Contents Order Overview. NEW - Inclusion of marginal sidebars. Defines important terms and alternative explanations for students. Thus, the function of financial management can be broken down into three major decision areas: Yes, zero accounting profit while the firm establishes market position is consistent with the maximization of wealth objective.
Other investments where short-run profits are sacrificed for the long run also are possible. The goal of the firm gives the financial manager an objective function to maximize. The financial manager is involved in the acquisition, financing, and management of assets. These three functional areas are all interrelated e.
If managers have sizable stock positions in the company, they will have a greater understanding for the valuation of the company.
Moreover, they may have a greater incentive to maximize shareholder wealth than they would in the absence of stock holdings. However, to the extent persons have not only human capital but also most of their financial capital tied up in the company, they may be more risk averse than is desirable. If the company deteriorates because a risky decision proves bad, they stand to lose not only their jobs but have a drop in the value of their assets.
Excessive risk aversion can work to the detriment of maximizing shareholder wealth as can excessive risk seeking if the manager is particularly risk prone. Regulations imposed by the government constitute constraints against which shareholder wealth can still be maximized. It is important that wealth maximization remain the principal goal of firms if economic efficiency is to be achieved in society and people are to have increasing real standards of living.
The benefits of regulations to society must be evaluated relative to the costs imposed on economic efficiency. Where benefits are small Van Horne and Wachowicz: Presently there is considerable attention being given in Washington to deregulation.
Some things have been done to make regulations less onerous and to allow competitive markets to work.
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As in other things, there is a competitive market for good managers. A company must pay them their opportunity cost, and indeed this is in the interest of stockholders. To the extent managers are paid in excess of their economic contribution, the returns available to investors will be less. However, stockholders can sell their stock and invest elsewhere.
Therefore, there is a balancing factor that works in the direction of equilibrating managers' pay across business firms for a given level of economic contribution. In competitive and efficient markets, greater rewards can be obtained only with greater risk. The financial manager is constantly involved in decisions involving a trade-off between the two.
For the company, it is important that it do well what it knows best. There is little reason to believe that if it gets into a new area in which it has no expertise that the rewards will be commensurate with the risk that is involved. The risk-reward trade-off will become increasingly apparent to the student as this book unfolds. Corporate governance refers to the system by which corporations are managed and controlled. These relationships provide the framework within which corporate objectives are set and performance is monitored.
Boards review and approve strategy, significant investments, and acquisitions. The controller's responsibilities are primarily accounting in nature.
Cost accounting, as well as budgets and forecasts, would be for internal consumption. The treasurer's responsibilities fall into the decision areas most commonly associated with financial management: An ingenious device for obtaining individual profit without individual responsibility. The principal advantage of the corporate form of business organization is that the corporation has limited liability. The owner of a small family restaurant might be required to personally guarantee corporate borrowings or purchases anyway, so much of this advantage might be eliminated.
The wealthy individual has more at stake and unlimited liability might cause one failing business to bring down the other, healthy businesses. The liability is limited to the amount of the investment in both the limited partnership and in the corporation. However, the limited partner generally does not have a role in selecting the management or in influencing the direction of the enterprise.
On a pro rata basis, stockholders are able to select management and affect the direction of the enterprise. Also, partnership income is taxable to the limited partners as personal income whereas corporate income is not taxed unless distributed to the stockholders as dividends. With both a sole proprietorship and partnership, a major drawback is the legal liability of the owners.
It extends beyond the financial resources of the business to the owners personally. Fringe benefits are not deductible as an expense. Also, both forms of organization lack the corporate feature of "unlimited life.
The ownership is not liquid when it comes to planning for Van Horne and Wachowicz: Decision making can be cumbersome. An LLC generally lacks the feature of "unlimited life," and complete transfer of an ownership interest is usually subject to the approval of at least a majority of the other LLC members. Accelerated depreciation is used up to the point it is advantageous to switch to straight line depreciation.
A one-half year convention is followed in the first year, which reduces the cost recovery in that year from what would otherwise be the case. Additionally, a one-half year convention is followed in the year following the asset class. This pushes out the depreciation schedule, which is disadvantageous from a present value standpoint.
The double declining balance method is used for the first four asset classes, 3, 5, 7 and 10 years. The asset category determines the project's depreciable life. The immunity from each other's taxing power dates back to the early part of the 19th century.
It used to apply to salaries of government employees as well. Personal tax rates are progressive up to a point, then become regressive. With the differential taxation of ordinary income and capital gains, securities with a higher likelihood of capital gains are tax advantaged. These include low dividend common stocks, common stocks in general, discount bonds, real estate, and other investments of this sort.
Depreciation changes the timing of tax payments. The longer these payments can be delayed, the better off the business is. One advantage to Subchapter S occurs when investors have outside income against which to use losses by the company. Even with no outside income, stockholders still may find Subchapter S to be advantageous.
James C Van Horne Solutions
If dividends are paid, the stockholder under Subchapter S is subject only to taxation on the profits earned by the company. Under the corporate method, the company pays taxes on its profits and then the owners pay personal income taxes on the dividends paid to them. Tax incentives are the result of special interest groups influencing legislators. For example, exporters influenced the passage of DISCs. Doctors and attorneys influenced the passage of the Keogh pension plans.
Some of these incentives benefit society as a whole; others benefit only a few at the expense of the rest of society. It is hard to imagine all individuals placing the interest of the whole above their own interests. Therefore, it is difficult to perceive that tax incentives will be discontinued. Further, some incentives can be used to benefit large groups of people. The purpose of the carryback and carryforward provisions is to allow the cyclical company with large profit swings to obtain most of the tax benefits available to a company with more steady profits.
Also, the provision protects the company with a large loss in a given year. While if a company has steady losses it does not benefit from this provision, the marginal company with profit swings does. Financial markets allow for efficient allocation in the flow of savings in an economy to ultimate users.
In a macro sense, savings originate from savings-surplus economic units whose savings exceed their investment in real assets. The ultimate users of these savings are savings-deficit economic units whose investments in real assets exceed their savings. Efficiency is introduced into the process through the use of financial markets. Since the savings-surplus and savings-deficit units are usually different entities, markets serve to channel these funds at the least cost and inconvenience to both.
As specialization develops, efficiency increases. Loan brokers, secondary markets, and investment bankers all serve to expedite this flow from savers to users. Financial intermediaries provide an indirect channel for the flow of funds from savers to ultimate users. These institutions include commercial banks, savings and loan associations, life insurance companies, pension and profit-sharing funds and savings banks. Their primary function is the transformation of funds into more attractive packages for savers.
Services and economies of scale Van Horne and Wachowicz: Pooling of funds, diversifica- tion of risk, transformation of maturities and investment expertise are desirable functions that financial intermediaries perform. Differences in maturity, default risk, marketability, taxability, and option features affect yields on financial instruments. In general, the longer the maturity, the greater the default risk, the lower the marketability and the more the return is subject to ordinary income taxation as opposed to capital gains taxation or no taxation, the higher the yield on the instrument.
If the investor receives an option e. Conversely, if the firm issuing the security receives an option, such as a call feature, the investor must be compensated with a higher yield. Another factor -- one not taken up in this chapter -- is the coupon rate. The lower the coupon rate, the greater the price volatility of a bond, all other things the same, and generally the higher the yield.
The market becomes more efficient when the cost of financial intermediation is reduced. This cost is represented by the difference in interest rate between what the ultimate saver receives and what the ultimate borrower pays. Also, the inconvenience to one or both parties is an indirect cost.
When financial intermediation reduces these costs, the market becomes more efficient. The market becomes more complete when special types of financial instruments and financial processes are offered Van Horne and Wachowicz: For example, the new product might be a zero-coupon bond and the new process, automatic teller machines. These exchanges serve as secondary markets wherein the buyer and seller meet to exchange shares of companies that are listed on the exchange.
These markets have provided economies of time and scale in the past and have facilitated exchange among interested parties. If there are no disparities in savings pattern, the effect would fall on all financial markets. Prices would fall for these assets relative to fixed income securities until eventually the expected returns after taxes for all financial instruments were in equilibrium.
Interest rates would rise dramatically and it would be difficult for borrowers to find lenders willing to lend at a fixed interest rate. Disequilibrium would likely continue to occur until the rate of inflation reduced to a reasonable level. Answers to this question will differ depending on the financial intermediary that is chosen. Their presence improves the efficiency of financial markets in allocating savings to the most productive investment opportunities.
Money markets serve the short-term liquidity needs of investors. The usual line of demarkation is one year; money markets include instruments with maturities of less than a year while capital markets involve securities with maturities of more than one year.
However, both markets are financial markets with the same economic purpose so the distinction of maturity is somewhat arbitrary.
Money markets involve instruments that are impersonal; funds flow on the basis of risk and return. A bank loan, for example, is not a money-market instrument even though it might be short term. Transaction costs impede the efficiency of financial markets. The larger they are, the less efficient are financial markets. Financial institutions and brokers perform an economic service for which they must be compensated.
The means of compensation is transaction costs. If there is competition among them, transaction costs will be reduced to justifiable levels. The major sources are bank loans, bond issues, mortgage debt, and stock issues. Financial brokers, such as investment bankers in particular as well as mortgage bankers, facilitate the matching of borrowers in need of funds with savers having funds to lend. For this matching and servicing, the broker earns a fee that is determined by competitive forces.
In addition, security exchanges and the over-the-counter market improve the secondary market and hence the efficiency of the primary market where securities are sold originally. If sued, they could lose up to their full combined net worths. In contrast, the borrower suffers in having to pay a higher real return than expected. In other words, the loan is repaid with more expensive dollars than anticipated. No specific solution is recommended. The student should consider default risk, maturity, marketability, and any tax effects.
Henry is responsible for all liabilities, book as well as contingent. He still could lose all his net assets because Kobayashi's net worth is insufficient to make a major dent in the lawsuit: As the two partners have substantially different net worths, they do not share equally in the risk. Henry has much more to lose. Under the corporate form, he could lose the business, but that is all. Depreciation charges for the equipment: Therefore, to just break even, the firm must set rates so that at least a 2 percent difference exists between the deposit interest rate and the mortgage rate.
In addition, market conditions dictate that 3 percent is the floor for the deposit rate, while 7 percent is the ceiling for the mortgage rate. Suppose that Wallopalooza wished to increase the current deposit rate and lower the current mortgage rate by equal amounts while earning a before-tax return spread of 1 percent.
It would then offer a deposit rate of 3. Of course, other answers are possible, depending on your profit assumptions.
The premium attributable to maturity is 7. In this case, default risk is held constant and marketability, for the most part, is also held constant. Simple interest is interest that is paid earned on only the original amount, or principal, borrowed lent. With compound interest, interest payments are added to the principal and both then earn interest for subsequent periods.
Hence interest is compounded. The greater the number of periods and the more times a period interest is paid, the greater the compounding and future value. The answer here will vary according to the individual. Common answers include a savings account and a mortgage loan.
An annuity is a series of cash receipts of the same amount over a period of time. It is worth less than a lump sum equal to the sum of the annuities to be received because of the time value of money.
Interest compounded continuously. It will result in the highest terminal value possible for a given nominal rate of interest. In calculating the future terminal value, we need to know the beginning amount, the interest rate, and the number of periods. In calculating the present value, we need to know the future value or cash flow, the interest or discount rate, and the number of peri- ods.
Thus, there is only a switch of two of the four variables. They facilitate calculations by being able to multiply the cash flow by the appropriate discount factor. Otherwise, it is necessary to raise 1 plus the discount rate to the nth power and divide.
Prior to electronic calculators, the latter was quite laborious. With the advent of calculators, it is much easier and the advantage of present-value tables is lessened. Interest compounded as few times as possible during the five years. Realistically, it is likely to be at least annually. Compounding more times will result in a lower present value. For interest rates likely to be encountered in normal business situations the "Rule of 72" is a pretty accurate money doubling rule.
Since it is easy to remember and involves a calculation that can be done in your head, it has proven useful.
Decreases at a decreasing rate. The denominator of the present value equation increases at an increasing rate with n. Therefore, present value decreases at a decreasing rate. A lot. Turning to FVIF Table in the chapter and tracing down the 3 percent column to 25 years, we see that he will increase his weight by a factor of 2.
This translates into a weight of about pounds at age It is particularly important when the interest rate is high, as evidenced by the difference in solutions between Parts 1. The comparison illustrates the desirability of early cash flows. Therefore, the note has an implied interest rate of almost 7 percent.
Therefore, the implicit interest rate is slightly more than 7 percent. Thus, it will take approximately 9 years of payments before the loan is retired. So, we need to then subtract three future values from our "trial" ending balance: After collecting terms, we get the following: There are many ways to solve this problem correctly.
Here are two: Cash withdrawals at the END of year Answers to Alt. You are faced with determining the present value of an annuity due. For approximate answers, we can make use of the "Rule of 72" as follows: Future terminal value of each cash flow and total future value of each stream are as follows using Table I in the end-of-book Appendix: Present value of each cash flow and total present value of each stream using Table II in the end-of-book Appendix: In Table I in the Appendix at the end of the book, the interest factor for 6 years at 12 percent is 1.
Interpolating, we have 2. A man who knows the price of everything and the value of nothing. The market value of a firm is the market price at which the firm trades in an open marketplace.
This value is often viewed as being the higher of the firm's liquidation value i. The intrinsic value or economic value of a security could differ from its market value or price.
Even in a market that is reasonably efficient and informed, the market price of a security will fluctuate about its intrinsic value. The less efficient and informed the market may be, the greater the likelihood that intrinsic value will differ from market value. Both bonds and preferred stocks are fixed-income securities. The interest payment or dividend is fixed at the time of issuance, is contractual, and occurs at regular intervals.
Thus, we apply the same general approach to valuing bonds and preferred stock -- that is, we determine the present value of a fixed payment stream. The longer the maturity, the less important the principal payment, and the more important the interest payments in the bond's valuation.
As a result, the principal payment acts less as a buffer against the effect of changes in yield on market price. The lower coupon bond will suffer the greater proportional market decline. Its income stream is further in the future than that for the higher coupon bond, and hence subject to more volatility. Dividends are all that investors as a whole receive.
As shown in the chapter, a dividend capitalization model does not preclude consideration of capital gains. In fact, it embodies market price changes. The stock would be worth zero. There must be the prospect for an ultimate cash payment to someone for an investment to have value.
As companies grow larger, growth becomes more difficult. Unless there is some competitive advantage or monopolistic position, most large companies grow roughly in keeping with growth in the economy.
A company can of course grow at an increasing rate for a while, but increasing rates become increasingly harder to sustain in a competitive economy. If increasing rates of growth could be sustained for a number of years, the value of the stock would explode and approach infinity.
This can be illustrated with the perpetual growth model where "g" is greater than "k. A company could grow at this rate for a while, but not forever. At the end of 25 years, it would be over times larger. Obviously this cannot go on forever in real terms or the company will end up owning the world. The real rate of growth of the economies of the world is single digit.
Eventually the growth of this company must taper off. She is right. Current price: Both result in the same market price per share. If the students work with present-value tables, they should still be able to determine an approximation of the yield to call by making use of a trial-and-error procedure. The use of a computer provides a precise semiannual YTM figure of 3. With everything the same except for maturity, the longer the maturity, the greater the price fluctuation associated with a given change in market required return.
The closer in time that you are to the relatively large maturity value being realized, the less important are interest payments in determining the market price, and the less important is a change in market required return on the market price of the security. Rounding error incurred by use of tables may sometimes cause slight differences in answers when alternative solution methods are applied to the same cash flows. The yield to maturity is higher than the coupon rate of 8 percent because the bond sells at a discount from its face value.
The nominal annual yield to maturity as reported in bond circles is equal to 2 x semiannual YTM. The problem is set up as follows: The value of this type of bond is based on simply discounting to the present the maturity value of each bond.
We have already done that in answering Part a and those values are: That is quite different from being rash. Virtually none of the concepts presented would hold. Risk would not be a dimension of concern to the risk-neutral investor. The only concern would be with expected return, and market equilibrium would be in relation to seeking the highest expected return. If investors were risk seekers, increased risk would provide positive utility and would be sought along with higher expected returns.
Obviously there would be no risk-return tradeoff of the type described. The characteristic line depicts the expected relationship between excess returns in excess of the risk-free rate for the security involved and for the market portfolio.
The beta is the slope of the characteristic line. It should be zero in theory, but may be positive or negative in practice.
Beta measures the responsiveness of changes in excess returns for the security involved to changes in excess returns for the market portfolio. It tells us how attuned fluctuations in returns for the stock are with those for the market. A beta of one indicates proportional fluctuation and systematic risk; a beta greater than one indicates more than proportional fluctuation; and a beta less than one indicates less than proportional fluctuation relative to the market.
The security market line SML can vary with changes in interest rates, investor psychology, and perhaps with other factors. If you limit yourself to only common stock, you would seek out defensive stocks -- where returns tend to go up and down by less than those for the overall market. Therefore, the betas would be less than 1. However, it is important to recognize that there are few stocks with betas of less than 0. Most have betas of 0.
The undervalued stock would lie above the security market line, thereby providing investors with more expected return than required for the systematic risk involved.
Investors would buy the stock and cause it to rise in price. The higher price will result in a lower expected return. Equilibrium is achieved when the expected return lies along the security market line. Also, by inspection we see that the distribution is skewed to the left. Turning to Table V at the back of the book, 1. These standard deviations correspond to areas under the curve of. Interpolating for 1. As the graph will be drawn by hand with the characteristic line fitted by eye, they will not all be the same.
However, students should reach the same general conclusions. Excess Return Markese Characteristic. This indicates that excess returns for the stock fluctuate less than excess returns for the market portfolio. The stock has much less systematic risk than the market as a whole.
It would be a defensive investment. Perhaps the best way to visualize the problem is to plot expected returns against beta. This is done below. A security market line is then drawn from the risk-free rate through the expected return for the market portfolio which has a beta of 1. Stock 3 is priced so that its expected return exactly equals the return required by the market; it is neither overpriced nor underpriced.
It is important to stress that the relationships are expected ones. Also, with a change in the risk-free rate, the betas are likely to change. Solution to Appendix A Problem: Turning to Table V in the Appendix at the back of the book, 1. This is the same as in our first instance involving a zero return or less, except that it is to the right, as opposed to the left, of the mean. For the first and last terms, the correlation coefficients for these weighted-variance terms are 1. The purpose of a balance sheet is to present a picture of the firm's financial position at one moment in time.
The income statement, on the other hand, depicts a summary of the firm's profitability over time. By analyzing trends, one is able to determine whether there has been improvement or deterioration in the financial condition and performance of a firm.
This is particularly useful in the prediction of insolvency and the taking of remedial steps before insolvency can occur. Receivables and inventories undoubtedly dominate the current asset position of the firm.
Moreover, the collection period is probably slow and there may be some hidden bad debts. Also, inventory turnover may be slow, indicating inefficiency and excessive investment in inventory.
This question points to the fact that the current ratio is a very crude indicator of liquidity and that one must analyze the specific current assets. A firm may generate a high return and still be technically insolvent for many reasons. Most frequently, the profitable firm is growing at a rate that cannot be supported by internal sources of funds, and external sources of funds beyond a point are unavailable. Both measures relate a balance sheet figure, which was the result of the last month, or so, of sales, to annual income statement figures.
Comparing a "stock" balance sheet item to a "flow" income statement item might involve a mismatch of variables. The stock item may not be representative of how this variable looked over the period during which the flow occurred.
Therefore, where appropriate, we may need to use an "average" balance sheet figure in order to better match the income statement flow item with a balance sheet stock figure more representative of the entire period.
A long-term creditor is interested in liquidity ratios because short-term creditors may force bankruptcy, imposing some substantial costs on the long-term creditor. The ratio of debt-to-equity and long-term debt to total capitalization both historically and in comparison with other companies.
Coverage ratios give some indication of the firm's ability to service debt. With all of these ratios, comparisons with other companies in the industry as well as over time add additional insight. Such a situation could come about if the company had invested its profits in large, slow-moving inventory, an addition to fixed assets, or in increased accounts receivable.
A slow-moving inventory would be visible in a low inventory turnover ratio and in a below average quick or acid-test ratio. An addition to fixed assets would be visible in the fixed asset turnover ratio. An increase in accounts receivable would be reflected in a lengthening average collection period and, possibly, in a stretching of the receivable aging schedule. In addition, if the firm has recently suffered a decline in the market value of its securities carried at cost on the balance sheet, the firm could find itself in difficulty when attempting to sell out to pay maturing obligations.
Yes, it could. By increasing the turnover the company is really reducing its investment in excessive stocks of inventory carrying a low or zero rate of return. The resulting inventory is said to be more liquid or more readily convertible into cash. However, if the Van Horne and Wachowicz: The use of cost of goods sold in the ratio allows the analyst to separate the effects of an increased gross margin resulting from an increase in selling price or a decrease in costs from the effects of a more efficient inventory management per se high volume of sales for a given level of inventory investment.
The appropriate standard varies by industry. What is a good ratio for one industry may not be so for another. Also, no one financial ratio tells the whole story.
Only by analyzing multiple ratios can one get a reasonably complete picture of a firm's financial condition and performance. Both firms are equally profitable. An example of Firm B might be a retail department store. Short-term creditors look at balance sheet assets as a loan safety margin for repayment in the event of default.
The income statement is ignored because the impact of future earnings on this safety margin is small over short time periods. Yet for that portion of short-term credit renewed on a more or less permanent basis, the "earning power" of the firm represents the real margin of credit risk over the long-term regardless of initial asset strength.
The use of index analysis allows one to go behind some of the trends that are evident in a trend analysis of financial ratios. Apparently, sales did not keep up with asset expansion or sales decreased while assets did not. In either case, fixed costs would command a larger percentage of the sales dollar, causing profitability on sales to decrease. The lower profitability on sales and lower asset turnover resulted in lower return on investment.
Current assets increased relative to sales as is indicated by the inventory turnover and collection period.
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The current ratio and the acid-test ratio, however, decreased. This indicates a substantial increase in current liabilities. Interest on each issue: While net fixed assets jumped in 20X4, changes were only modest in 20X2 and 20X3. The basic problem is that retained earnings have grown at only a very slow rate, almost all of which occurred in 20X3. This is due to inadequate profitability, excessive dividends, or both. While the company increased its long-term debt in 20X2, it has not done so since.
The question would be whether payables are past due and whether employees are being paid on time.
It is clear that the company cannot continue to expand its assets without increasing its equity base in a significant way. This indicates that interest, Van Horne and Wachowicz: This increase also explains why the return on equity 8 has been rising while the return on assets 9 has been falling.
The impact of the increase in debt and overall decline in profitability is also shown by the reduction in coverage The overall reduction in liquidity, together with the large amount involved and the lengthy terms, would argue against granting the credit. Of course, this argument would have to be balanced against the importance to the vendor of this sale and possible repeat sales. The student should be especially concerned with this ratio.
There would appear to be little advantage in granting the loan. The student should at least be aware of the multitude of fundamentally negative factors involved. Current assets decline, and there is no change in current liabilities. Current assets and current liabilities each increase by the same amount. Neither current assets nor current liabilities are affected.
Current assets decline and current liabilities increase by the same amount. Receivables are growing at a slower rate, although the average collection period is still very Van Horne and Wachowicz: Inventory turnover is slowing as well, indicating a relative buildup in inventories. The increase in receivables and inventories, coupled with the fact that shareholders' equity has increased very little, has resulted in the total debt-to-equity ratio increasing to what would have to be regarded on an absolute basis as quite a high level.
The current and acid-test ratios have fluctuated, but the current ratio is not particularly inspiring. The lack of deterioration in these ratios is clouded by the relative buildup in both receivables and inventories, evidencing a deterioration in the liquidity of these two assets.
Both the gross profit and net profit margins have declined substantially. The relationship between the two suggests that the company has reduced relative expenses in 20X3 in particular. The buildup in inventories and receivables has resulted in a decline in the asset turnover ratio, and this, coupled with the decline in profitability, has resulted in a sharp decrease in the return on assets ratio.
Net fixed assets surged in 20X2, but then fell back as a percentage of the total to almost the 20X1 percentage.
The absolute amounts suggest that the company spent less than its depreciation on fixed assets in 20X3. With respect to financing, shareholders' equity has not kept up, so the company has had to use somewhat more debt percentage-wise.
It appears to be leaning more on trade credit as a financing source as payables increased percentage-wise. Bank loans and long-term debt also increased sharply in 20X2, no doubt to finance the bulge in net fixed assets. The Van Horne and Wachowicz: Profit after taxes slipped slightly as a percentage of sales over the 3 years.
In 20X2, this decline was a result of the cost of goods sold and interest expense, as other expenses and taxes declined as a percentage of sales. In 20X3, cost of goods sold declined as a percentage of sales, but this was more than offset by increases in other expenses and taxes as percentages of sales.
Index analysis shows much the same picture. Cash declined faster than total assets and current assets, and receivables increased faster than these two benchmarks.
Inventories fluctuated, but were about the same percentage-wise to total assets in 20X3 as they were in 20X1. Net fixed assets increased more sharply than total assets in 20X2 and then fell back into line in 20X3. The sharp increase in bank loans in 20X2 and 20X3 and the sharp increase in long-term debt in 20X2, along with the accompanying increases in interest expenses, are evident. The percentage increases in shareholders' equity were less than those for total assets, so debt increased by a larger percentage than for either of the other two items.
With respect to profitability, net profits increased less than sales, for the reasons indicated earlier. Flow of funds sources and uses statements provide the analyst with information generally being about year-to-year changes in assets and how these changes are financed.
It is important to recognize that these sources and uses of funds are changes in the balance sheet that occur from one point in time to another without revealing any information about the interim time period. Also, the sources and uses of funds statement does not represent cash movements. The cash budget, on the other hand, represents the flow of cash and is usually short-run month-to-month in nature.
A statement of cash flows reports a firm's cash inflows and outflows during a period of time segregated into three categories: When used with other financial statements and disclosures, the statement of cash flows should help the analyst to: The variable that most directly affects the cash budget is sales since the cash inflow is proportional to sales and cash outflow is proportional to production, which is determined by sales.
Cash planning can lower the cost of borrowing for two reasons. By knowing ahead of time how much financing is required, the financial manager can bargain for funds. Also, the quality of cash planning can convince lenders to lower their risk perceptions of the firm and, therefore, charge a lower interest rate. Cash is an asset item. If it decreases it is by definition a source of funds.
The increase in any asset cash included is by definition a use of funds. The decrease in inventory is a source that is automatically applied as a use to finance the resulting increase in accounts receivable.
The purpose of accounting statements is to provide information to creditors and investors so that they may make a correct assessment of the risk and return characteristics of the firm. The statement of cash flows may provide insights not apparent in studying either the income statement or balance sheet. The statement of cash flows reports the firm's cash inflows and outflows, during the year, segregated into three categories: Some managers prefer the flow of funds statement over the more complex cash flow statement because: Whether or not depreciation is a source of funds has been debated for many years by accountants and financial analysts.
Accountants argue that depreciation is an accounting entry that does not affect cash flows. People in finance argue that whether the funds from operations are determined by restating the income statement on a cash basis or by adding back to earnings after tax all the noncash deductions, the result is the same.
Thus, the argument is nothing more than a discussion of semantics. Obviously, if a firm incurs losses, depreciation does not provide funds. An insight is gained with respect to the use of the funds provided by the banker as well as the source that will enable the firm to pay off the banker's loan.
The cash budget deals with inflows and outflows of cash and not necessarily accounting flows. The cash flow is short run in nature. The sources and uses of funds statement deals with accounting flows and not necessarily cash flows. The financial manager should concentrate on accurate projections of sales as well as the projection of collections on credit sales. The other important estimate that must be accurate is the cost of production.
Probably the cash budget is a better measure of liquidity. The current ratio and quick ratio are historical "pictures" of account balances as of a particular day.
The cash budget is concerned with events in the future rather than historical events. Virtually everything in the cash budget depends on sales: It is truly the cornerstone on which the cash budget is built and must come first in the preparation of the cash budget. Forecast statements are projections of expected future income statements and balance sheets.
The principal purpose is that they allow us to study the composition of future financial statements. If the firm is interested in staying within certain financial ratios, as is required under a loan agreement, the forecast balance sheet allows this determination.
Forecast statements are quarterly, or annual, and the balance sheet is not given by a cash budget. The two principal ways by which to prepare forecast statements are through a cash budget and by direct estimates of the items.
The latter involves projections, usually on the basis of historical financial ratios. The base starting point is projected sales. Answers to Appendix Questions: A sustainable growth rate is the maximum percentage growth in sales that can occur consistent with target operating, debt, and dividend ratios.
With sustainable growth modeling, one can determine whether the sales growth objectives of the firm are consistent with its operating characteristics and its financial objectives. When the marketing, operations, and finance objectives are not mutually consistent, this will be shown. A change in one or more of the targets will need to occur. Such modeling is essential for effective planning. Steady-state modeling assumes that balance sheet and performance ratios do not change over time.
The future is like the past, and the firm grows in a steady, consistent manner over time. No external equity financing is assumed. Growth is entirely through earnings retention coupled with debt. When changing assumptions are invoked, the ratios need not be constant over time.
Moreover, equity financing is allowed. The input variables are beginning sales and beginning equity. Target variables are the ratio of assets-to-sales, the net profit margin, debt-to-equity, the amount of dividends, and the amount of new stock financing.
These are in addition to the growth rate in sales. In general, the assets-to-sales ratio and the debt-to- equity ratio have the greatest influence on the sustainable growth rate. Net income Increase, accounts payable Additions to fixed assets Decrease in short-term bank borrowings Interest paid Dividends paid Cost of Goods Mfd. Cash Disbursements for Cost of Goods Mfd.
Cost of goods sold 1, Gross profit Rent Interest Depreciation Receivables Inventory Prepaid taxes 0. Accounts payable Common stock and retained earnings The change in debt ratio affects the level of overall assets, not just the growth component.
Sources and uses of funds statement for Dana-Stallings, Inc. This growth has far outstripped the growth in retained earnings. To finance this growth, the company has reduced its marketable securities to zero, has leaned heavily on trade credit accounts payable , and has increased its accrued expenses and bank borrowings.
All of this is short-term financing of mostly long-term buildups in assets. Statement of cash flows for Dana-Stallings, Inc. Increase in short-term bank borrowings By and large, the cash flow statement prepared using the indirect method gives you much the same information gathered from an analysis of the sources and uses of funds statement. In March, substantial collections are made on the prior month's billings, causing a large net cash inflow sufficient to pay off the additional borrowings.
All of these things permit a high rate of growth in sales next year. Unless further changes in these directions occur, the SGR will decline. Working capital management encompasses the administration of the firm's current assets -- namely, cash and marketable securities, receivables, and inventory -- and the financing especially, current liabilities needed to support current assets. The funda- mental decisions underlying this management involve the level of investment in current assets and the appropriate mix of short-term and long-term financing used to support this investment in current assets.
Such decisions are governed by the important financial principle of a trade-off between risk and profitability. Usually, increased profitability is only possible with the addition of risk. In broad terms, the profitability and risk associated with current assets are a function of the level, composition, and financing of these assets.
As the level of current assets increases a movement to a more "conservative" working capital strategy , the riskiness of the firm generally decreases -- but, so too does the firm's profitability. See Question 8 for an exception to this "rule". The difference in the industries that accounts for the level of current assets in each is that utilities cannot store their product for future consumption.
Therefore, the inventory held by utilities is limited to parts and supplies for their plant and equipment. There is no finished product inventory. The retail trade industry Van Horne and Wachowicz: All their product first goes to inventory.
When we speak of working capital, we mean current assets. Therefore, "temporary" working capital is the amount of current assets that varies with a firm's seasonal needs. If a firm adopts a hedging maturity matching approach to financing, each asset would be offset with a financing instrument of the same approximate maturity.
Temporary or seasonal variations in current assets would be financed with short-term debt. The permanent component of current assets would be financed with long-term debt or equity.
In general, short-term debt carries a lower explicit cost of capital. The decision to finance the permanent component of working capital with short-term debt may result in higher reported earnings per share. If stockholders do not perceive a higher risk characteristic for the firm as a result of higher proportions of short-term debt, the financial manager may be exploiting an imperfection in the capital market to maximize the wealth of stockholders.
However, the existence of this imperfection is doubtful. The use of permanent financing for short-term needs may result in inefficient operation of the firm.
During periods of slow operation in the seasonal cycle, the firm will be unable to reduce its asset volume. Consequently, the firm will be paying for capital when it is not needed.
Further, the explicit cost of long- term funds is usually higher than the cost of short-term financing. Thus, the firm is paying a higher cost of capital in exchange for a reduction in the risk characteristic of the firm. The reduction may be insignificant in relation to the cost paid for it. Increasing the level of current assets past some level may actually increase risk as a result of the increasing risk of obsolescence of inventory, the increasing risk of uncollectible accounts, and the increasing risk of loss of purchasing power of money assets.
While short-term rates exceeding long-term rates makes the long- term financing method more attractive at the particular moment involved, it does not necessarily make it more attractive over a period of time. The above phenomenon is usually associated with times when interest rates are high and expected to fall. Over a period of ten years, the interest cost might be lower by financing on a short-term basis and refinancing at each maturity as opposed to long-term debt financing.
This occurs because short-term rates fall sufficiently below the present long-term rate so that the Van Horne and Wachowicz: Another reason the firm might not wish to entirely use long-term debt is that if there are seasonal funds requirements it would be borrowing at certain times when the funds were not needed. An increase in the risk of the firm occurs from several sources. First, if sinking fund or amortization payments are required for the debt, the larger amortization payments of a shortened debt schedule consume a larger and larger percentage of the period's expected net cash flow.
Increasingly, as the debt maturity is shortened, smaller and smaller adverse deviations from the expected cash flow can send the firm into technical insolvency. The reduced safety margin against adverse net cash flow fluctuations results in an increased risk level for the firm. Second, if no amortization payments are required i. The firm faces the risk of not being able to refinance the maturing debt and the risk of being forced to pay higher interest payments on any refinancing available.
Increasing the firm's liquidity increases the safety margin against adverse cash flow fluctuations increases the probability of interest and principal repayment and thus reduces all the risks outlined above. Too large an investment in working capital lowers the firm's profitability without a corresponding reduction in risk.
In fact, risk might actually increase - - see answer to Question 8. Too small a level of working capital could also lower profitability due to stockouts and too few credit sales because of an overly strict credit policy.
A margin of safety to offset uncertainty can be provided by increasing the level of current assets of the firm, by increasing the maturity schedule of its debt, or by some combination of the two.
In all cases the increased safety comes at a cost of lower profitability. One can visualize situations where sales are lost as a result of stockouts and costs may increase as more lost time in production is caused by shortages of materials. Finance fixed assets with common stock and retained earnings. Finance the temporary working capital with short- term debt. Alternative 1 is lowest in cost because the company borrows at a lower rate, 12 percent versus There is a risk consideration in that if things turn bad the company is dependent on its bank for continuing support.
There is risk of loan renewal and of interest rates changing. Alternative 2 involves borrowing the expected increase in permanent funds requirements on a term basis. As a result, only the expected seasonal component of total needs would be financed with short-term debt. Alternative 3, the most conservative financing plan of the three, involves financing on a term basis more than the expected build-up in permanent funds requirements.
In all three cases, there is the risk that actual total funds requirements will differ from those that are expected. Also, more lenient credit terms may lead to increased sales and profits. A hidden cost is that part of the debt capacity of the firm is used up by virtue of financing increased levels of current assets with debt. Cash management involves the efficient collection and disbursement of cash and any temporary investment of cash while it resides with the firm. The general idea is that the firm will benefit by "speeding up" cash receipts and "slowing down" cash payouts.
Concentration banking involves the movement of cash from lock-box or field banks into the firm's central cash pool residing in a concentration bank. This process is needed to:One involves the development of 10 discount record stores in Chicago.
Be part of the conversation. A group-specific required return is for a division or some other subgroup of the firm where there is an aggregation of assets of roughly the same risk. But for now, our focus is on the time value of money and the ways in which the rate of interest can be used to adjust the value of cash flows to a single point in time. Financial analysis is a necessary condition, or prerequisite, for making sound financial decisions; we examine the tools of analysis in Part IV.
The rate on commercial paper is lower than the prime rate since the high quality borrower, who is able to issue commercial paper, can get the prime rate at the bank. It emphasizes short-term cash flows that are important for small growing concerns.