Preface

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About *Principles of Finance*

About the Authors

Introduction to Finance

Why It Matters

What Is Finance?

Definition of Finance

Finance is the study of the management, movement, and raising of money. The word *finance* can be used as a verb, such as when the First National Bank agrees to finance your home mortgage loan. It can also be used as a noun referring to an entire industry. At its essence, the study of finance is about understanding the uses and sources of cash, as well as the concept of risk-reward trade-off. Finance is also a tool that can help us be better decision makers.

Basic Areas in Finance

Finance is divided into three primary areas in the domestic market: business finance, investments, and financial markets and institutions (see [link]). We look at each here in turn.

Why We Study Finance

Finance is the lubricant that keeps our economy running smoothly. Issuing a mortgage can be profitable for a bank, but it also allows people to live in their own homes and to pay for them over time. Do MasterCard, Venmo, and PayPal make money when you use their product? Sure, but think how much more convenient and safer it is to carry a card or use an app instead of cash. In addition, these services allow you to easily track where and how you spend your money. A well-regulated and independent financial system is important to capital-based economies. Our smoothly functioning financial system has removed us from the days of strictly bartering to our system today, where transactions are as simple as a tap on your mobile phone.

Risk and Return in Finance

Finance tells us that an increase in risk results in an increase in expected return. The study of historical financial markets demonstrates that this relationship generally holds true and that riskier investments over time have provided greater returns. Of course, this is not true all the time and under all conditions; otherwise, where’s the risk?

The Role of Finance in an Organization

The Finance Function

Finance has many functions within an organization, and there are many job titles to reflect the varied job responsibilities. The comptroller, or more commonly a *controller*, in a for-profit business relies heavily on a knowledge of accounting. Controllers are in charge of financial reporting and the oversight of the accounting activities necessary to develop those reports. Controllers are concerned with payroll functions, accounts receivable, and accounts payable including taxes, inventory control, and any number of short-term asset and liability tracking and monitoring activities. They aid internal and external auditors and are responsible for monitoring and implementing the day-to-day financial operations of the firm.

Financial Planning

Financial planning is critical to any organization, large or small, private or public, for profit or not-for-profit. Financial planning allows a firm to understand the past, present, and future funding needs and distributions required to satisfy all interested parties. For-profit businesses work to maximize the wealth of the owners. These could be shareholders in a publicly traded corporation, the owner-managers of a “mom and pop” store, partners in a law firm, or the principal owners of any other number of business entities. Financial planning helps managers understand the firm’s current status, plan and create processes and contingencies to pursue objectives, and adjust to unexpected events. The more thoughtful and thorough the financial planning process, the more likely a firm will be able to achieve its goals and/or weather hard times. Financial plans typically consider the firm’s strategic objectives, ethical practices, and sources and costs of funds, as well as the development of budgets, scenarios, and contingencies. The financial plan Bacon Signs developed was thorough enough to anticipate when and how growth might occur. The plan that was presented to commercial banks allowed the firm to be guaranteed new financing at critical moments in the firm’s expansion.

Forecasting and Budgeting

Forecasting and budgeting are common practices for businesses, governmental agencies, not-for-profit firms, and individual households. As with many of the financial topics introduced in this chapter, these activities are valuable for individuals and businesses alike. Budgeting, or planning for the amount, sources, and uses of cash, occurs early in the planning process. It is common for businesses to have developed an annual budget well before the start of the year. With budgeting, a firm establishes objectives for the upcoming period by developing financial statements based on historical data and expectations, as well as aspirations for the future. The budgeting process helps the firm identify what actions need to be undertaken to achieve its objectives. However, no matter how strong the budgeting process, actual events can change the timing and magnitude of expected cash flows.

Importance of Data and Technology

Importance of Data

Financial data is important for internal and external analysis of business firms. More accurate and timely data leads to better business and financial decision-making. Financial budgeting and forecasting rely on the creation of several types of financial statements including income statements, the statements of cash flow, and balance sheets, as well as the notes and assumptions used to create the financial statements. Insiders such as executive and middle managers use financial data to evaluate and reevaluate decision-making. Having current and accurate data is key to making consistent value-adding decisions for a firm. Data helps inform managers about how and when to finance projects, which projects to undertake, and necessary changes to make regarding physical, financial, and human resource assets. “Gut feelings” and “seat-of-the-pants” decision-making tend to be inconsistent with value maximization.

Basic Data Types

Financial statements provide some of the data needed for decision-making. Firms summarize data and develop at least three essential financial statements or reports.

The Impact of Digitization

Data digitization makes the storage and transmission of data easier and more cost effective. Some data starts out as digital data, such as that from a Microsoft Suite product. The Excel files and Word documents we create are ubiquitous and easily stored and transmitted. Cloud storage and video conferencing are now the norm. Emails and Zoom meetings are quick, easy, and inexpensive ways to share and store information. Businesses now create an e-trail, or virtual paper trail, to document, verify, and share processes. Because data is now much easier to access, firms bear the added responsibility of ensuring that it is stored and secured properly so that individuals cannot inappropriately alter or delete information.

Uses of Data

Taken together and separately, the internally generated financial statements can provide managers with a wealth of information to enable superior decision-making. Harvard Business School identifies six ways managers can use financial statements.[footnote]

Catherine Cote. “How and Why Managers Use Financial Statements.” *Business Insights*. June 16, 2020. https://online.hbs.edu/blog/post/how-managers-use-financial-statements

Careers in Finance

Job Opportunities in Finance: Market Trends

There are many career opportunities in the field of finance. The Bureau of Labor Statistics (BLS) finds that as of May 2020, the median income for finance-related positions was \$72,250 versus the overall median income of only \$41,950. Further, the BLS predicts that close to an additional 500,000 new finance- and accounting-related jobs will be created by 2029.[footnote] These new employment opportunities are in addition to the many openings that will become available as baby boomers continue to retire and leave the workforce.

U.S. Bureau of Labor Statistics. *Occupational Outlook Handbook*. https://www.bls.gov/ooh/business-and-financial/home.htm

Financial Analyst Roles

Many executive-level finance officers worked their way up via the role of financial analyst. Job descriptions vary across firms, industries, and government organizations. However, the role of financial analyst usually includes market research, financial forecasting, modeling, cost analysis, and comparative valuations. Financial analysts gather data and produce financial reports in conjunction with multiple departments within a business or organization. They rely on marketing and production personnel to provide accurate sales forecasts, and they work with accountants to create accurate financial reports.

Business (or Management) Analyst Roles

The job description for a business analyst looks much like that for a financial analyst. However, the strong quantitative skills required for a financial analyst are less emphasized in favor of overall strategic thinking. A successful business analyst is able to evaluate business opportunities by using analytical thinking, industry best practices, process development, team building and organization, and information technology. They then communicate optimal courses of action to executive decision makers to maximize value in alignment with the vision and goals of the firm.

Markets and Participants

Primary and Secondary Markets

Simply put, the primary market is the market for “new” securities, and the secondary market is the market for “used” securities. Think of the primary market as equivalent to the sale of new cars and the secondary market as equivalent to the sale of used cars. In practice, many market locales trade both new and used securities. For example, the stock markets trade equity securities daily, and most of the trading takes place among individual and institutional investors who own shares in publicly traded companies. Trading a share of Amazon, Facebook, or Nike stock has little impact and no direct cash flow to the underlying firm. However, the information provided by such transactions is valuable, as it is a costly and public real-time statement by investors of their perceptions of firm’s value and a reflection of satisfaction and expectations.

Key Market Players

Key market players in finance include dealers, brokers, financial intermediaries, and you and me. Each of these players facilitates the exchange of products, information, and capital in different ways. The presence of these players makes financial transactions, easier, faster, and safer—essentially more efficient. You and your friends might engage in direct financial transactions, such as buying a coffee or borrowing money for a movie. These are typically small transactions. However, for transactions that are larger or more complicated, you need advanced financial entities with capital, expertise, and networks. The two segments of the secondary markets are broker markets and dealer markets, as [link] shows. The primary difference between broker and dealer markets is the way each executes securities trades.

Microeconomic and Macroeconomic Matters

Microeconomics

In the business setting, finance is the intersection of economics and accounting. Financial decision makers rely on economic theory and empirical evidence combined with accounting data to make informed decisions for their organization. Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and why of human and financial capital allocation to governments, businesses, and consumers.

Macroeconomics

Whereas microeconomics studies the decisions of individuals, macroeconomics examines the decisions of groups. Macroeconomic areas of study and concern include inflation, income, economic growth, and unemployment. When Bacon Signs developed a financial and operating plan to expand the business, the firm had to consider unemployment and inflation when estimating its price of labor and materials. Bacon Signs also had to consider interest rates when estimating the cost of borrowing money to expand the business.

Importance of Macroeconomic Variables in Financial Markets

To make financial forecasts, managers need good information to understand the relationship among several economic variables. Working from small to large, sales forecasts estimate the likely price and quantity of goods sold. In doing so, the forecaster will consider local, regional, state, national, and international economic conditions. Inflation is an important macroeconomic variable that influences prices. Every quarter, financial information hubs, such as the Wall Street Journal (WSJ), and government agencies and regulatory bodies, such as the Treasury Department and the Federal Reserve, release estimates about expected and current inflation. This information informs policy makers how to adjust the money supply to meet target objectives. Financial forecasters pay close attention to current and expected interest rates, as they have a fundamental impact on the cost of raising money and determining the required rate of return for investment.

Relationship between Microeconomics and Macroeconomics

In the parable, a group of blind people happen upon an elephant for the first time, and they each touch one part—but one part only—of the elephant. Subsequently, when they each describe what they have discovered, the descriptions are vastly different. The group's members become upset, accusing one another of inaccurate descriptions or worse. The parable demonstrates how individuals can make absolute truths from their own limited and subjective information. Financial decision makers run a similar risk, if they choose to recognize only their own findings and ignore other microeconomic or macroeconomic information and the interaction of these factors.

Financial Instruments

Money Markets and Instruments

The money market is the market for short-term, low-risk, highly liquid securities. “Short-term” refers to money market securities having maturities of less than one year–sometimes as short as overnight. “Low risk” specifically means that the probability of default by the issuer is very unlikely. Defaulting on money market instruments is not unheard of, but it is very rare. “High liquidity” means that money market instruments can generally be sold in a secondary market very quickly and at or near their current market value. Finally, money market securities are homogeneous, meaning that within an issue of securities, a single instrument is not unique. For example, if you purchase 13-week T-bills issued in the first week of January, each bill is identical to any other in the issue. Compare that to the purchase of physical assets such as a car or house, where each of the assets sold has some unique feature or measure of quality.

Capital Markets and Instruments

The capital market is the market for longer-term financial instruments. The capital market is similar to the money market. However, maturities are longer, default risk varies to a greater degree from low to high, and liquidity is less certain, as is the homogeneity of the financial instruments. Broadly, we separate capital market instruments into debt instruments traded in the bond markets and equity securities traded on the stock markets.

Concepts of Time and Value

Impact of Time on Saving and Spending

The choice to spend or save and invest is really a choice between consumption today versus consumption in the future. Economists, investment advisers, your friends, and mine love to discuss the trade-off of consumption now or later—even if not in those words. We have all heard conversations that go something like this: “Let’s go grab a beer—you can study for tomorrow’s exam in the morning.” Or “My father’s investment adviser told me that if I invest \$500 per month for the next 30 years and earn an annual rate of 10% on my investments, I will have invested \$180,000 over time but accumulated an investment portfolio worth over \$1.13 million!”

Definition of Economic Value

*Value* is a term used frequently in business and especially in economics, accounting, and finance. Accountants track, record, and display value in the form of financial statements and footnotes. The numbers they present are “book values” and represent what has occurred. Financial people like to speak in terms of “market values.” Market values are calculated using expected future cash flows discounted to today. Market values are the prices that consumers pay for a product. Economic value is what we believe consumers are actually willing to pay for a product, service, or experience. For example, the price of a movie ticket may be \$10, but there are individuals who are willing to pay far more for the experience of watching a movie on the big screen.

Corporate Structure and Governance

Why It Matters

Business Structures

The Most Common Types of Business Organization

The functions of most executive management teams are very similar for most businesses, and they will not differ in any significant manner based on how they may be structured or organized. However, the legal structure of any company will have a substantial impact on its operations, and it therefore deserves a significant amount of analysis and discussion. The four most common forms of business organizations are the following:

Sole Proprietorships

A proprietorship is typically defined as an unincorporated business owned by a single person. The process of forming a business as a sole proprietor is usually a simple matter. A business owner merely decides to begin conducting business operations, and that person is immediately off and running. Compared to other forms of business organizations, proprietorships have the following four important advantages:

Partnerships

A partnership is a business structure that involves a legal arrangement between two or more people who decide to do business as an organization together. In some ways, partnerships are similar to sole proprietorships in that they can be established fairly easily and without a large initial investment or cost.

Corporations

The most common type of organizational structure for larger businesses is the corporation. A corporation is a legal business entity that is created under the laws of a state. This entity operates separately and distinctly from its owners and managers. It is the separation of the corporate entity from its owners and managers that limits stockholders’ losses to the amount they originally invest in the firm. In other words, a corporation can lose all of its money and go bankrupt, but its owners will only lose the funds that they originally invested in the company.

Hybrids: Limited Liability Corporations and Partnerships

Another form of business organization is the limited liability corporation (LLC). This type of business structure has become a very popular type of organization. The LLC is essentially a hybrid form of business that has elements of both a corporation and a partnership. Another form of organizational structure is something called a limited liability partnership (LLP), which is quite similar to the LLC in structure and in use. It is very common to see LLPs used as the organizational form for professional services firms, often in such fields as accounting, architecture, and law. Conversely, LLCs are typically used by other forms of businesses.

Incorporating a Business

Many business owners decide to structure their business as a corporation. In order to begin the process of incorporation, an organization must file a business registration form with the US state in which it will be based and carry on its primary business activities. The document that must be used for this application is generally referred to as the articles of incorporation or a corporate charter. Articles of incorporation are the single most important governing documents of a corporation. The registration allows the state to collect taxes and ensure that the business is complying with all applicable state laws.

Relationship between Shareholders and Company Management

Stakeholders

A stakeholder is any person or group that has an interest in the outcomes of an organization’s actions. Stakeholders include employees, customers, shareholders, suppliers, communities, and governments. Different stakeholders have different priorities, and companies often have to make compromises to please as many stakeholders as possible.

Shareholders’ Roles and Composition

A shareholder or stockholder can be a person, company, or organization that holds stock in a given company. Shareholders typically receive dividends if the company does well and succeeds. They are entitled to vote on certain company matters and to be elected to a seat on the board of directors. One advantage of being a shareholder is that creditors cannot compel shareholders to pay for any of the company’s financial obligations or debts. However, being a shareholder includes responsibilities such as appointing the company’s directors, deciding on director compensation, setting limits on directors’ power, and monitoring and approving the company’s financial statements.

Role of Management

Corporations are run at the highest level by a group of senior managers referred to as the board of directors (BOD). The BOD is ultimately responsible for providing oversight and strategic direction as well as overall supervision of the organization at its highest managerial level. From an operational standpoint, the practical day-to-day management of a company comprises of a team of several mid-level managers, who are responsible for providing leadership to various departments in the company. Such managers may often have different functional roles in a business organization. The primary roles of any management group involve setting the objectives of the company; organizing operations; hiring, leading, and motivating employees; and overseeing operations to ensure that company goals are continually being met.

Role of the Board of Directors

Functions of a Board of Directors

A board of directors is a group of people who are elected to represent shareholders, and these directors are then ultimately responsible for running the company. Every public company is legally required to install a board of directors. Nonprofit organizations and many private companies often establish a board of directors as well, even if they are not legally required to do so.

Oversight: Corporate Governance

Corporate governance is a discipline that focuses on how a company conducts its business and the various controls that are implemented to ensure proper procedures and ethical behavior.

The Importance of Independence in Boards of Directors

An independent board of directors is composed of individuals who have no material interest in the company other than their directorship. They maintain their independence by only accepting compensation from the company for their BOD services. They also have their own information sources, instead of relying on information provided by senior management of the company. It is considered a corporate governance best practice to have independent members serve on boards of directors for both publicly and privately held companies.

The Importance of Diversity in Boards of Directors

As mentioned earlier, diversity can be an important quality for any board of directors. Increasingly over recent years, corporate management has begun to appreciate the value of diversity in boards of directors. This has resulted in a significant increase in the total number of women and people of color in boardrooms in the United States. However, many business observers believe that corporate governance practices have a long way to go in this respect. Increasing representation has now grown to become a high priority for most businesses and organizations around the world.

Agency Issues: Shareholders and Corporate Boards

Agency Problems and Issues

*Agency problems* refers to conflicts that occur when an agent (manager) who is entrusted with following the interests of the principal (shareholder or owner) of an organization abuses their position to further their own personal goals. In the field of corporate finance, agency problems are often related to a conflict of interest between the management of a company and its shareholders.

How to Resolve Agency Problems

Ultimately, agency problems result from the differences among the interests of a company’s management, other stakeholders of the firm, and its ownership or stockholders. When perpetuated, these differences may eventually result in lasting conflicts of interest. In order for companies to avoid such problems, it is imperative that they address the underlying problems of these differences. This will help ensure that normal business operations are not being adversely impacted by the agency problem.

Impact of ESG Ratings

In recent years, many publicly traded companies, as well as many that are privately owned, are being evaluated and rated according to environmental, social, and governance (ESG) factors. These ratings and evaluations are primarily conducted by third-party organizations. As a result, the investment community is using these reports and ratings to an ever-increasing degree in order to measure and assess corporate ESG factors and performance.

Interacting with Investors, Intermediaries, and Other Market Participants

Investor Relations

Within the general field of corporate public relations is a specific subdivision referred to as investor relations (IR). IR involves elements of communication, marketing, and finance and is designed to control the flow of information from the management of a public corporation to its investors and stakeholders.

Quarterly Earnings Conference Calls

As a result of the Securities Exchange Act of 1934, all publicly traded companies are required to file certain financial reports with the SEC. The underlying purpose of these requirements is to provide shareholders and the investment community with important operational and financial information on a regular basis and in a transparent manner. Reports filed with the SEC include the annual Form 10-K, quarterly Form 10-Qs, and current periodic Form 8-Ks, in addition to proxy reports and certain shareholder and affiliate reporting documents. Quarterly 10-Qs are an ongoing and regular reporting requirement of publicly traded companies and are to be filed within 45 days following the end of each fiscal quarter.

Investment Meetings and Conferences

Organizing the annual meeting of shareholders, investor roadshows, and investment conferences is no easy task for any corporation, though all of these audience-facing events are critical to maintaining strong relations with shareholders and the investment community. It is important to reach shareholders and investors on an almost personal basis by crafting a successful and interesting investment story. For effective investor relations, key messages supporting any ownership or potential investment case should be clear and consistent. These key messages should be embedded within the company’s materials and should form the basis of presentations, the corporate website, and annual reports. They should also be reinforced via concrete examples during annual meetings, roadshows, and investor presentations.

Purposes of Corporate Press Releases

Press releases have always been a vital tool in the communications toolkit of an IR professional. Various social media channels are also becoming increasingly popular for delivering company information and news. However, the press release remains a standard medium for most companies to communicate corporate news, results, and ideas.

Companies in Domestic and Global Markets

Important Differences among Domestic, International, and Global Organizations

If a company becomes global or multinational in scope, fundamental analysis of the organization by the investment community can become more complex. In order to better understand a company, it is important to determine what laws affect the company’s governance process and which set of accounting rules is used to fashion its financial reports.

Difference in Financial Reporting: GAAP versus IFRS

Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) were designed with similar objectives in mind: to provide a common and structured set of guidelines to assist in the preparation of accurate and unbiased financial reporting for public corporations.

SEC Reporting and EDGAR

EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) is the primary system for collecting and indexing documents submitted by companies to the SEC under the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, and the Investment Company Act of 1940.

Economic Foundations: Money and Rates

Why It Matters

Microeconomics

Demand

Microeconomics focuses on the decisions and actions of individual agents, such as businesses or customers, within the economy. The interactions of the decisions that businesses and customers make will determine the price and quantity of a good or service that is sold in the marketplace. Financial managers need a strong foundation in microeconomics. This foundation helps them understand the market for the company’s products and services, including pricing considerations. Microeconomics also helps managers understand the availability and prices of resources that are necessary for the company to create its products and services.

Supply

Supply is the quantity of a good or service that firms are willing to sell at various prices, during a given time period, ceteris paribus. [link] is a fictional example of a supply schedule for pizzas. In some cases, higher prices encourage producers to provide more of their product for sale. Thus, there is a positive relationship between the price and quantity supplied.

Equilibrium Price

Demand represents buyers, and supply represents sellers. In the market, these two groups interact to determine the price of a good and the quantity of the good that is sold. Because both the demand curve and the supply curve are graphed with price on the vertical axis and quantity on the horizontal axis, these two curves can be placed in the same graph, as is shown in [link].

Changes in Equilibrium Price

A price that is either too high (above the equilibrium price) or too low (below the equilibrium price) is not sustainable in a competitive market. Market forces pull prices to the equilibrium, where they stay until either supply or demand changes.

Macroeconomics

Inflation

Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation, unemployment, and growth of production. When the managers of an automotive company look at the market for steel and how the price of steel impacts the company’s production costs, they are looking at a microeconomic issue. Rather than being concerned about individual markets or products, macroeconomics is the branch of economic theory that considers the overall environment in which businesses operate.

Unemployment

Unemployment is a measure of people who are not working. For the individuals who find themselves without a job, unemployment causes financial hardship. From a macroeconomics standpoint, unemployment means that society has labor resources that are not being fully utilized.

Gross Domestic Product

Gross domestic product (GDP) is a measure of the size of an economy. A country’s GDP is the dollar value of all of the final goods and service produced within that country during a year. GDP measures the value of all of the automobiles produced, apples grown, heart surgeries performed, students educated, and all other new goods and services produced in a current year.

Business Cycles and Economic Activity

What Is the Business Cycle?

Although the US economy has grown significantly over time, as seen in [link], the growth has not occurred at a constant, consistent pace. At times, the economy has experienced faster-than-average growth, and occasionally the economy has experienced negative growth.

Stages of the Business Cycle

The business cycle consists of a period of economic expansion followed by a period of economic contraction. During the period of economic expansion, GDP rises. Employment expands as businesses produce more; conversely, unemployment falls. Other measures of economic growth may include increased new business starts and new home construction. The economy is said to be “heating up.” As the expansion continues, inflation often becomes a concern.

Historical Trends

The NBER has identified business cycle peaks and troughs in data going back to the mid-19th century. [link] lists each of these cycles, denoting the months of peaks and troughs. We see a repetition of the economic behavior—an expansion, a peak, a recession, and a trough, followed by yet another expansion, peak, recession, and trough. The cycles are events that repeatedly occur in the same order.

Interest Rates

Market for Loanable Funds

An interest rate is the rental price of money. The concepts of supply, demand, and equilibrium apply in this market just as they do in other markets. This market is referred to as the *market for loanable funds*.

Nominal Interest Rates

The nominal interest rate is the stated, or quoted, interest rate. If you want to borrow money to purchase a car and the bank quotes an interest rate of 5.5% on a four-year auto loan, the 5.5% is the nominal interest rate.

Real Interest Rates

Suppose you are deciding between saving your \$1,000 for the year and using it to purchase a flat-screen TV. The advantage of spending the money on the TV today is that you can enjoy watching programs on it over the next year. The advantage of saving the money is that you will earn 6% nominal interest; in one year, you will have \$1,060 to spend.

Risk Premiums

As we have discussed interest rates, we have talked about how the interest rate is determined by the demand and supply of loanable funds. This tells us the underlying interest rate in the economy. You will notice, however, if you look at the financial news, that there is more than one interest rate in the economy at any given time.

Foreign Exchange Rates

Spot Exchange Rate

An exchange rate is simply the price of a currency. If you live in the United States and are going on a trip to Mexico, you will need pesos to pay for your food, hotel, and other items. You will need to purchase pesos. Suppose that you go to your bank to purchase pesos. Suppose the bank tells you that it will cost \$0.0625 to purchase one Mexican peso. If you want to take 10,000 Mexican pesos with you on your trip, it will cost you \$625 to purchase the desired pesos.

Currency Appreciation

Just as the price of gasoline changes, resulting in it costing more to purchase gasoline on some visits to the gas station than on other visits, the price of a currency also changes. Currency appreciation occurs when it costs more to purchase a currency than it did before.

Currency Depreciation

Just as a currency can appreciate, it can depreciate. If the quote at the bank was $\mathrm{MXN}1=\mathrm{USD}0.0500$, it would only cost \$0.0500 to purchase a Mexican peso. When it costs fewer dollars to purchase a peso, the peso has depreciated. Either a decrease in demand for pesos or an increase in supply of pesos will cause the peso to depreciate.

Exchange Rate Risk

Businesses that engage in international business face currency exchange rate risk. As exchange rates change, a business can be impacted in a number of ways. One of these risks, transaction exposure, is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. A pottery-making business that has sold merchandise to a company in the United States for \$20,000, for example, will need to exchange the \$20,000 for pesos to be able to pay its workers and other expenses in pesos. How many pesos it will receive for \$20,000 will change depending on the exchange rate. If the exchange rate is $\mathrm{MXN}16=\mathrm{USD}1$, the company will receive 320,000 pesos for the \$20,000. If the exchange rate is $\mathrm{MXN}20=\mathrm{USD}1$, the company will receive 400,000 pesos for the \$20,000. Thus, as the peso depreciates (and the US dollar appreciates), the same number of dollars will provide more pesos. Conversely, as the peso appreciates (and the US dollar depreciates), the same number of dollars will provide fewer pesos.

Sources and Characteristics of Economic Data

FRED: Federal Reserve Economic Data

One of the largest sources of economic data is the Federal Reserve Economic Data (FRED) database.[footnote] This database is maintained by the Federal Reserve Bank of St. Louis and contains more than 765,000 economic time series. These time series are compiled by the Federal Reserve and come from a number of sources, including the Bureau of Labor Statistics and the US Census.

Federal Reserve Bank of St. Louis. Economic Resources & Data. Accessed October 25, 2021. https://www.stlouisfed.org/

Levels versus Percentage Changes

The same information can be presented in graphs several different ways. The particular format you choose will depend on how you are using the data.

Indexes

An index is created to track the performance of a particular aspect of the economy or the financial markets. An index helps compare the level of a variable at one point in time relative to another point in time. Indexes are often used when movement over time is more important than the absolute level of the variable at any one point in time.

Accrual Accounting Process

Why It Matters

Cash versus Accrual Accounting

Cash-Basis Accounting

In business, cash is certainly important. In fact, it’s so important that it dictates one of two ways we can account for our business transactions. The *cash method* is just as the name implies—it records transactions only when cash flows. We track cash inflows and outflows as they occur. This method is most commonly used by small businesses that deal primarily in cash transactions. The other method, called the *accrual method*, records transactions when they occur, rather than waiting for cash to be accumulated. Using the accrual method, we match cash inflows and the outflows required to generate them. We call this the *matching principle*. This method is used by most publicly traded companies. In this chapter, you’ll explore both methods, see how each impacts financial statements differently, note the role of timing in each method, and learn how and when to record capital and expense transactions.

Accrual-Basis Accounting

Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations. GAAP is a set of accounting standards created by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). It’s key to note that though they are similar in many areas, there are still key areas that differ between GAAP and IFRS. Therefore, when using financial statements, it’s important to be aware of the standards under which they were prepared. However, public or private companies using GAAP or IFRS must prepare their financial statements using the rules of accrual accounting. Accrual-basis accounting prescribes that revenues and expenses must be recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the revenue recognition principle and the expense recognition principle (also known as the matching principle).

Economic Basis for Accrual Accounting

Timing of Business Activity versus Cash Flow

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance *for a given period of time*. We already saw that Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. She categorized her business as a service entity and used the cash*-*basis method of accounting to record the initial operations for her business. Although Chris was using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance costs. So, on August 31, Chris realized she had only \$250 in her checking account.

Double-Entry Accounting

Accounting is based on a double-entry accounting system, which requires the following:

How Does a Company Recognize a Sale and an Expense?

Revenue Recognition

Revenue is the value of goods and services the organization sold or provided to customers for a given period of time. In our current example, Chris’s landscaping business, the “revenue,” or the value of services performed, for the month of August would be \$1,400. It is the value Chris received in exchange for the services provided to her clients. Likewise, when a business provides goods or services to customers for cash at the time of the service or in the future, the business classifies the amount(s) as revenue. Just as the \$1,400 revenues from a business made Chris’s checking account balance increase, revenues increase the value of a business. In accounting, revenue recognition involves recording sales or fees earned within the period earned. Just as earning wages from a business or summer job reflects the number of hours worked for a given rate of pay or payments from clients for services rendered, revenues (and the other terms) are used to indicate the dollar value of goods and services provided to customers for a given period of time.

Short-Term Revenue Recognition Examples

Two brief examples may help illustrate the difference between cash accounting and accrual accounting. Assume that a business sells \$200 worth of merchandise. In some businesses, there are two ways the customers pay: cash and credit (also referred to as “on account”). Cash sales include checks and credit cards and are paid at the time of the sale. Credit sales (not to be confused with credit card sales) allow the customer to take the merchandise but pay within a specified period of time, usually up to 45 days.

Expense Recognition

An expense is a cost associated with providing goods or services to customers. In our opening example, the expenses that Chris incurred totaled \$1,150 (consisting of \$100 for brakes, \$50 for fuel, and \$1,000 for insurance). You might think of expenses as the opposite of revenue, in that expenses reduce Chris’s checking account balance. Likewise, expenses decrease the value of the business and represent the dollar value of costs incurred to provide goods and services to customers for a given period of time.

When Should a Company Capitalize or Expense an Item?

What Is a Fixed Asset?

An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, be of material value, and not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets. It’s also key to note that companies will capitalize a fixed asset if they have material value. A \$10 stapler to be used in the office, for example, may last for years, but the value of the item is not significant enough to warrant capitalizing it.

What Is Depreciation?

When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used in the business’s operations. If a long-term asset is used in the business’s operations, it will belong in property, plant, and equipment or intangible assets. In this situation, the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life.

What Is “Profit” versus “Loss” for the Company?

Calculating Profit and Loss

Net income (net loss) is determined by comparing revenues and expenses. Net income is a result of revenues (inflows) being greater than expenses (outflows). A net loss occurs when expenses (outflows) are greater than revenues (inflows). In accounting it is common to present net income in the following format:

Profit versus Cash Flow

Knowing the difference between the cash basis and accrual basis of accounting is necessary to understand the need for the statement of cash flows. Stakeholders need to know the financial performance (as measured by the income statement—that is, net income or net loss) and financial position (as measured by the balance sheet—that is, assets, liabilities, and owners’ equity) of the business. This information is provided in the income statement, statement of owner’s equity, and balance sheet. However, since these financial statements are prepared using accrual accounting, stakeholders do not have a clear picture of the business’s cash activities. The statement of cash flows solves this inadequacy by specifically focusing on the cash inflows and cash outflows. It also helps better delineate the difference between revenues and cash flow in versus expenses and cash flow out. As mentioned in prior sections, revenue can occur without cash actually flowing. For example, a customer may buy a good on account. Revenues would be recorded, but cash would not yet be received. The same is true on the expenses side. An expense can be incurred, such as an electric bill, but cash may not have been paid out yet. Thus, an expense is recorded and recognized on the income statement, but cash has not yet been given up. The statement of cash flows helps reconcile the difference between net income (a result of recorded revenues and expenses) and actual cash flow.

Financial Statements

Why It Matters

The Income Statement

Functionality of the Income Statement

The income statement shows a firm’s performance over a specific period of time. The statement helps financial statement users understand the sales generated during the period and the expenses incurred to generate those sales. If the expenses are smaller than the sales, the net result is profitability, or net income, rather than a net loss.

Sales and Gross Profit

The first section of the income statement begins with sales. Though financial statements are required to follow a certain format, account names can differ slightly from one firm to another. You may see the first line, often referred to as *the top line*, called *sales*, *sales revenue*, *revenue*, *service revenues*, and other similar titles. All of these titles are meant to reflect the sales generated by selling product to customers in the day-to-day business. On Clear Lake’s income statement in [link], we see its top line referred to as Sales.

Income from Operations

Gross profit is a very helpful measure, but it is only the first of several provided by the income statement. After gross profit is calculated, other operating expenses are deducted in order to calculate the firm’s income from operations, also commonly called operating income. Common operating costs found in this section include building rent and utilities, property taxes, wages and salaries, and other overhead costs. In [link], we can see Clear Lake’s operating expenses. To sell its hunting and fishing equipment in the current year, Clear Lake Sporting Goods paid rent for its building (\$5,500) and utilities for its retail and warehouse spaces (\$2,500); recorded depreciation on equipment, buildings, and store furnishings (shelves, racks, etc.) (\$3,600); and paid salaries to its indirect employees in accounting, purchasing, and human resources (\$5,400). The company’s operating expenses are deducted from gross profit to arrive at operating income

Net Income

Finally, we move on to net income, or what is commonly referred to as *the bottom line*. Net income (or loss) reflects the net impact of all financial transactions for the firm, including those that are caused by events outside the normal course of business. The most common items deducted from operating income to arrive at net income include interest expense, gains/losses, and income tax expense. Remember, gains and losses are those that result from unusual transactions outside the normal course of business. Examples include selling a piece of old equipment or a loss on retiring debt.

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization)

Now that we have a full income statement, we can look at another commonly used measure of financial performance called EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Amortization is similar to depreciation. It is the spreading of the cost of an intangible asset over the course of its useful life. Intangible assets are long-term assets that lack physical substance, such as patents and copyrights.

The Balance Sheet

The Accounting Equation and the Classified Balance Sheet

Recall that the income statement shows the performance of a firm over the course of time. The classified balance sheet shows the financial state of a company as of a specific point in time. It is a key distinction between the two statements. The classified balance sheet is prepared in sections that align with the accounting equation.

Importance of the Balance Sheet

Now that we have gone to all the work to carefully assemble a classified balance sheet, what do we use it for? The answer lies within the accounting equation itself. Think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners. The balance sheet shows us what the firm has (its assets), who owns them (equity), and who the firm owes (its liabilities).

Limitations of the Balance Sheet

The balance sheet is indeed a very helpful financial statement, but it also poses challenges. First, assets on the balance sheet, under generally accepted accounting principles (GAAP), are recorded at historical cost. Historical cost is simply the cost paid for the item at the time it was purchased. Changes in market value of big-ticket items like land or buildings are not reflected in the balance sheet. Land remains at historical cost, and depreciable items like buildings are reflected at their current book value (historical cost less accumulated depreciation). If the asset has appreciated over time, the higher market value of the assets would not be seen on the balance sheet.

The Relationship between the Balance Sheet and the Income Statement

Net Income and Retained Earnings

As mentioned earlier, the financial statements are linked by certain elements and thus must be prepared in a certain order. The income statement was first since net income (or loss) is a required figure in preparing the balance sheet. During the period close process, all temporary accounts are closed to the income summary account, which is then closed to retained earnings. All revenue and expense accounts are closed since they are temporary. The net result is either net profit or net loss as the balance in the income summary account.

Expenses versus Payables

There is another key relationship between the income statement and the balance sheet can often be confusing to non-accountants: an expense versus a payable. The two are often assumed to be the same thing. However, it is important to note that the two are distinctly different.

The Statement of Owner’s Equity

What Is Equity?

Recall that the accounting equation can help us see what is owned (assets), who is owed (liabilities), and finally who the owners are (equity). The statement of owner’s equity addresses the last segment of the accounting equation in detail by laying out the equity elements of the firm and highlighting changes in these elements throughout the period.

Distributions to Owners

When firms earn a profit, they have two options as to what to do with their earnings. They can keep (retain) them and reinvest them back into the business, or they can pay them out to their shareholders in the form of dividends. Dividends are commonly in the form of cash, but dividends can be paid out in the form of stock or other assets as well.

Elements of the Statement of Owner’s Equity

Now that we have covered the basic elements of equity and know what dividends are, we have the basic pieces we need to create the statement of owner’s equity. The statement is broken out into columns, one for each element of equity: common stock, preferred stock, additional paid-in capital, retained earnings, and treasury stock.

The Statement of Cash Flows

Importance of the Statement of Cash Flows

Remember, most firms use accrual accounting. Revenues and expenses are recorded when they occur, not necessarily when cash moves. This can create timing differences between profits and cash flows. A firm can be profitable and still not have an adequate flow of cash. The opposite is also true: it can experience a net loss and still have cash on hand. Earning a profit is wonderful, but it is not the only goal an organization has. It must also have adequate cash flow to support daily operations. To support cash planning and to provide external financial statement users such as lenders and investors information about the firm’s cash flow, the statement of cash flows is prepared. Cash flow is also a crucial metric for determining the value of a company.

Operating Activities

To provide clear information about what areas of the business generated and used cash, the statement of cash flows is broken down into three key categories: operating, financing, and investing. The operating section reflects cash flows generated by and used by the day-to-day operations of the business. Investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). Finally, financing activities are those used to provide funds to run the business (loans, interest).

Investing Activities

As mentioned, investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). These are items that are capitalized (placed on the balance sheet and depreciated over time) and thus did not reduce net income. They did, however, cause an impact to cash flow (see [link]).

Financing Activities

Recall that financing activities are those used to provide funds to run the business. Common items in this section of the statement include the payment of dividends, issuance of common or preferred stock, and issuance or payment of notes payable (see [link]).

Analyzing Performance

The statement of cash flows can be used in a number of ways to assess firm performance by both internal and external financial statement users. Internal users can assess sources of and uses of cash in order to aid in adapting, as necessary, to ensure adequate future cash flows. External users also use the statement. Recall that comparing net income to operational cash flows can help assess the quality of earnings. In the next section you’ll explore operating cash flow and free cash flow to the firm, two key points of analysis in assessing cash flows.

Operating Cash Flow and Free Cash Flow to the Firm (FCFF)

Operating Cash Flow

Now that we have a statement of cash flows prepared, we can move on to a few key elements of the statement used to assess organizational cash management performance. Operating cash flow, or net cash flow from operating activities, is calculated in the first section of the statement of cash flows. It depicts the cash generated (or used by) the primary business activities. Remember, operating cash flow is calculated under the indirect method by adjusting net income for noncash expenses like depreciation and adjustments for changes in current asset and liability accounts (changes in net working capital).

Free Cash Flow

Free cash flow (FCF) is calculated by taking operating cash flows less capital expenditures. Free cash flow is an important measure, as it depicts the cash available to support the business’s operations and maintain its fixed assets. It is commonly used by investors as part of their overall evaluation of an investment, as it is a key measure of cash flow management practices and a firm’s ability to generate enough cash to cover operations and capital assets and it shows if there is any left over for other considerations such as dividend payments, debt repayment, and contributions to increase working capital for future growth.

Managing Cash Flow

Managing cash flow is not an easy task. A firm has a myriad of places that its cash flows from or to. However, there are a few key areas to place attention in order to manage or improve cash flows. First, consider where cash is coming from—customers. Managing terms and collection efforts with customers can have a significant impact on a firm’s cash flow. For example, a customer with terms of net 10 will likely yield payment quite quickly—10 days, give or take. A customer with terms of net 60, on the other hand, will require roughly 60 days to collect assuming they pay on time. The 50-day difference between these two examples means that the firm will go 50 additional days having expended the resources to provide the customer their good or service, but with no cash flow yet to cover it.

Common-Size Statements

Common-Size Income Statements

A common-size income statement is created by restating each line as a percentage of net sales. Expressing each item on the income statement as a percentage rather than in absolute dollars makes it much easier to make comparisons, particularly to other divisions or competitors of varying sizes. The formula to calculate each item on the income statement is:

Common-Size Balance Sheet

The common-size balance sheet functions much like the common-size income statement. Each line item on the balance sheet is restated as a percentage of total assets.

Analyzing Organizational Performance

Common-size financial statements facilitate the analysis of financial performance by converting each element of the statements to a percentage. This makes it easier to compare figures from one period to the next, compare departments within an organization, and compare the firm to other companies of any size as well as industry averages. On the income statement, analysts can see how much of sales revenue is spent on each type of expense. They can see this breakdown for each firm and compare how different firms function in terms of expenses, proportionally. They can also look at the percentage for each expense over time to see if they are spending more or less on certain areas of the business, such as research and development. On the balance sheet, analysts commonly look to see the percentage of debt and equity to determine capital structure. They can also quickly see the percentage of current versus noncurrent assets and liabilities.

Industry Comparison

Recall that a key benefit of common-size analysis is comparing the firm’s performance to the industry. Expressing the figures on the income statement and balance sheet as percentages rather than raw dollar figures allows for comparison to other companies regardless of size differences.

Reporting Financial Activity

Defining Accounting Periods

An accounting period can be any period of time, but the most common accounting periods are months, quarters, and a year. Accounting periods are important, particularly in accrual accounting, so there are clear cutoffs for recording transactions.

The Annual Report

An annual report is part of the 10-K filing that publicly traded firms must provide to the SEC and investors each year. The report details the firm’s operations and performance for the year and its current financial conditions. The report contains general company information, the firm’s financial statements, notes to the financial statements, various required disclosures pertaining to accounting policies, the management discussion and analysis (MD&A) statement, a letter from the CEO to the shareholders, and the firm’s audit report.

SEC Reporting Requirements

The Securities and Exchange Commission (SEC) requires publicly traded firms to regularly provide several reports. The two most common are the 10-K and quarterly report (10-Q). Certain unique events also require an additional filing called an 8-K. There are many events that might require reporting. A few key examples include changes to rights of shareholders, changes in control of the company, and amendments to the company charter or bylaws.

Measures of Financial Health

Why It Matters

Ratios: Condensing Information into Smaller Pieces

Importance of Ratios and Analysis

Financial ratios help internal and external stakeholders make informed decisions about actions like investing, becoming a supplier, making a loan, or altering internal operations, among other things. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main types of ratios: liquidity, solvency, efficiency, and profitability. While outcomes for some ratios may seem more ideal, the industry in which the business operates can change the influence of these outcomes on stakeholder decisions.

Limitation of Financial Statement Analysis

Though useful, it’s important to note that there are limitations to financial statement analysis as well. Stakeholders need to remember that past performance does not always predict future performance. Economic influences, such as inflation or a recession, could skew the data being analyzed. Additionally, the way a company reports information may change over time. For example, there could be changes in where and when certain transactions are recorded, and this may not be immediately evident to financial statement users. It is also key to note that though all publicly traded companies in the United States are required to follow Generally Accepted Accounting Principles (GAAP), there are many estimates and flexibility in how some standards are applied. This means that firms can still follow accounting standards appropriately but present some information differently from other firms.

Operating Efficiency Ratios

Accounts Receivable Turnover

For our discussion of financial statement analysis, we will look at Clear Lake Sporting Goods. Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells them to consumers) that sells hunting and fishing gear. [link] shows the comparative income statements and balance sheets for the past two years.

Total Asset Turnover

Total asset turnover measures the ability of a company to use its assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is

Inventory Turnover

Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is

Days’ Sales in Inventory

Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. The fewer the number of days, the more quickly the company can sell its inventory. The greater the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is

Liquidity Ratios

Current Ratio

The current ratio is closely related to working capital; it represents the current assets divided by current liabilities. The current ratio utilizes the same amounts as working capital (current assets and current liabilities) but presents the amount in ratio, rather than dollar, form. That is, the current ratio is defined as current assets/current liabilities. The interpretation of the current ratio is similar to working capital. A ratio of greater than one indicates that the firm has the ability to meet short-term obligations with a buffer, while a ratio of less than one indicates that the firm should pay close attention to the composition of its current assets as well as the timing of the current liabilities.

Quick Ratio

The quick ratio, also known as the *acid-test ratio*, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what it has on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is

Cash Ratio

Cash is the most liquid asset a company has, and cash ratio is often used by investors and lenders to asses an organization’s liquidity. It represents the firm’s cash and cash equivalents divided by current liabilities and is a more conservative look at a firm’s liquidity than the current or quick ratios. The ratio is reflected as a number, not a percentage. A cash ratio of 1.0 means the firm has enough cash to cover all current liabilities if something happened and it was required to pay all current debts immediately. A ratio of less than 1.0 means the firm has more current liabilities than it has cash on hand. A ratio of more than 1.0 means it has enough cash on hand to pay all current liabilities and still have cash left over. While a ratio greater than 1.0 may sound ideal, it’s important to consider the specifics of the company. Sitting on idle cash is not ideal, as the cash could be used to earn a return. And having a ratio less than 1.0 isn’t always bad, as many firms operate quite successfully with a ratio of less than 1.0. Comparing the company ratio with trend analysis and with industry averages will help provide more insight.

Solvency Ratios

Debt-to-Assets Ratio

The debt-to-assets ratio shows the relationship between debt and assets. It reflects how much of the assets of the business was financed through debt. It reflects the company’s leverage and is helpful to analysts in comparing how leveraged one company is compared to another.

Debt-to-Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. A key difference in debt and equity is the interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. The formula for the debt-to-equity ratio is

Times Interest Earned (TIE) Ratio

The times interest earned (TIE) ratio measures the company’s ability to pay interest expense on all debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is

Market Value Ratios

Earnings per Share (EPS)

Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock. An increasing earnings per share can drive up a stock price. Conversely, falling earnings per share can lower a stock’s market price. Earnings per share is also a component in calculating the price-to-earnings ratio (the market price of the stock divided by its earnings per share), which many investors find to be a key indicator of the value of a company’s stock.

Price/Earnings (P/E) Ratio

The price/earnings (P/E) ratio measures the current market share price of a company’s stock relative to its earnings per share (EPS). The ratio is helpful in comparing performance and stock price of a company to other companies. It’s also helpful in evaluating how much investors are willing to pay for earnings performance. Investors, in particular, use this ratio and rely on two key characteristics: past performance (trailing) and future estimates (forward). Trailing data can be calculated but is also easily found online, as it’s a common measure reported on financial sites. Investors will often look for P/E TTM, which is the price/earnings ratio for the trailing 12 months (last year worth of earnings data). This helps investors assess one day’s stock price relative to the earnings per share over the past 12 months. P/E ratio is widely used by investors to determine if a stock is over- or undervalued. It also helps them compare one firm to that of the industry average or index, such as the S&P 500.

Book Value per Share

Book value per share is often used hand in hand with market value per share. Investors compare the two in order to see if the stock is possibly over- or undervalued. Book value is derived from accounting practices and shows the value of the firm on paper. Market value, on the other hand, is determined by supply and demand, based on what investors are willing to pay for the stock. If the market value per share is higher than the book value, the stock is considered overvalued. If the market value is lower than the book value, it’s considered undervalued.

Profitability Ratios and the DuPont Method

Profit Margin

Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each \$1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is

Return on Total Assets

The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is

Return on Equity

Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders’ investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is

The DuPont Method

ROE in its basic form is useful; however, there are really three components of ROE: operating efficiency (profit margin), asset usage (total asset turnover), and leverage (equity ratio). This is known as the DuPont method. It originated in 1919 when the DuPont company implemented it for internal measurement purposes.[footnote] The DuPont method can be expressed using this formula:

Joshua Kennon. “What Is the DuPont Method Return on Equity, or ROE, Formula?” The Balance. December 16, 2020. https://thebalance.com/the-dupont-model-return-on-equity-formula-for-beginners-357494

Time Value of Money I: Single Payment Value

Why It Matters

Now versus Later Concepts

How and Why the Passage of Time Affects the Value of Money

The concept of the time value of money (TVM) is predicated on the fact that it is possible to earn interest income on cash that you decide to deposit in an investment or interest-bearing account. As times goes by, interest is earned on amounts you have invested (*present value*), which effectively means that time will add value (*future value*) to your savings. The longer the period of time you have your money invested, the more interest income will accrue. Also, the higher the rate of interest your account or investment is earning, again, the more your money will grow.

The Lump Sum Payment or Receipt

The most basic type of financial transaction involves a simple, one-time amount of cash, which can be either a receipt (inflow) or a payment (outflow). Such a one-time transaction is typically referred to as a lump sum. A lump sum consists of a one-off cash flow that occurs at any single point in time, present or future. Because it is always possible to dissect more complex transactions into smaller parts, the lump sum cash flow is the basis on which all other types of cash flow are treated. According to the general principle of adding value, every type of cash flow stream can be divided into a series of lump sums. For this reason, it is critical to understand the math associated with lump sums if you wish to have a greater appreciation, and a complete understanding, of more complicated forms of cash flow that may be associated with an investment or a capital purchase by a company.

Time Value of Money (TVM) Basics

Single-Period Scenario

Let us start with the following example. Your friend is considering putting money in a bank account that will pay 4% interest per year and is particularly interested in knowing how much money they will have one year from now if they deposit \$1,000 in this account. Your friend understands that you are studying finance and turns to you for help. By using the TVM principle of future value (FV), you can tell your friend that the answer is \$1,040. The additional \$40 that will be in the account after one year will be due to interest earned over that time. You can calculate this amount relatively easily by taking the original deposit (also referred to as the principal) of \$1,000 and multiplying it by the annual interest rate of 4% for one period (in this case, one year).

The Impact of Compounding

What would happen if your friend were willing to wait one more year to receive their lump sum payment? What would the future dollar value in their account be after a two-year period? Returning to our earlier example, assume that during the second year, your friend leaves the principal (\$1,000) and the earned interest (\$40) in the account, thereby reinvesting the entire account balance for another year. The quoted interest rate of 4% reflects the interest the account would earn each year, not over the entire two-year savings period. So, during the second year of savings, the \$1,000 deposit and the \$40 interest earned during the first year would both earn 4%:

Methods for Solving Time Value of Money Problems

Using Timelines to Organize TVM Information

A useful tool for conceptualizing present value and future value problems is a timeline. A timeline is a visual, linear representation of periods and cash flows over a set amount of time. Each timeline shows today at the left and a desired ending, or future point (maturity date), at the right.

Using a Financial Calculator to Solve TVM Problems

An extremely popular method of solving TVM problems is through the use of a financial calculator. Financial calculators such as the Texas Instruments BAII Plus™ Professional will typically have five keys that represent the critical variables used in most common TVM problems: N, I/Y, PV, FV, and PMT. These represent the following:

Using Excel to Solve TVM Problems

Excel spreadsheets can be excellent tools to use when solving time value of money problems. There are dozens of financial functions available in Excel, but a student who can use a few of these functions can solve almost any TVM problem. Special functions that relate to TVM calculations are as follows:

Applications of TVM in Finance

Single-Period Scenario

Let’s say you want to buy a new car next year, and the one you have your eye on should be selling for \$20,000 a year from now. How much will you need to put away today at 5% interest to have \$20,000 a year from now? Essentially, you are trying to determine how much \$20,000 one year from now is worth today at 5% interest over the year. To find a present value, we reverse the growth concept and lower or *discount* the future value back to the current period.

The Multiple-Period Scenario

There will often be situations when you need to determine the present value of a cash flow that is scheduled to occur several years in the future (see [link]). We can again use the formula for present value to calculate a value today of future cash flows over multiple time periods.

TVM, Inflation, Compounding Interest, Investing, Opportunity Costs, and Risk

The time value of money (TVM) is a critical concept in understanding the value of money relative to the amount of time it is held, saved, or invested. The TVM concept and its specific applications are frequently used by individuals and organizations that might wish to better understand the values of financial assets and to improve investing and saving strategies, whether these are personal or within business environments.

Nominal versus Real Interest Rates

One of the main problems of allowing inflation to determine interest rates is that current interest rates are actually nominal interest rates. Nominal rates are “stated,” not adjusted for the effects of inflation. In order to determine more practical real interest rates, the original nominal rate must be adjusted using an inflation rate, such as those that are calculated and published by the Bureau of Labor Statistics within the consumer price index (CPI).

Investing and Risk

Investing is usually a sound financial strategy if you have the money to do so. When investing, however, there are certain risks you should always consider first when applying the concepts of the time value of money. For example, making the decision to take \$1,000 and invest it in your favorite company, even if it is expected to provide a 5% return each year, is not a guarantee that you will earn that return—or any return at all, for that matter. Instead, as with any investment, you will be accepting the risk of losing some or even all of your money in exchange for the opportunity to beat inflation and increase your future overall wealth. Essentially, it is risk and return that are responsible for the entire idea of the time value of money.

Opportunity Costs

The concept of opportunity cost arises from the idea that there will always be possible options that are sacrificed with every option we decide on or for every choice that we make. For example, let’s consider the decision to go to college after you graduate from high school. This decision, as with just about any other, will involve evaluating opportunity costs. If you choose to go to college, this will result in your sacrificing four years of potential earnings that you could have had if you had decided to take a job instead of attending school. Also, in addition to the lost salary, you would be losing out on four years of work experience that could have had a positive impact on your résumé or your future earnings prospects.

Time Value of Money II: Equal Multiple Payments

Why It Matters

Perpetuities

What Is a Perpetuity?

A perpetuity is a series of payments or receipts that continues forever, or perpetually. One of the best ways to analyze the basics of an *annuity* (the stream of payments to be paid or received in the future) is by starting with a perpetuity. The most common examples of perpetuities in the author’s experience are college chair endowments and preferred stock.

How to Value a Perpetuity

Given these facts, how do we place a value on a perpetuity? Let’s keep the preferred stock example for Shaw Inc. in mind. The holder of one share will expect to receive a \$2.00 dividend for every share owned. Although a perpetuity may allow for growth of that dividend, we will hold that constant now. We must know one additional fact: the required rate of return. This is our random variable, which can cause fluctuation in the price of the preferred stock. Let’s assume that the required rate of return, which we’ll call *R*S, is 7%. This is the rate of return that the market expects in order to take on the risk of an investment such as Shaw.

Annuities

Calculating the Present Value of an Annuity

An annuity is a stream of fixed periodic payments to be paid or received in the future. Present or future values of these streams of payments can be calculated by applying time value of money formulas to each of these payments. We’ll begin with determining the present value.

Calculating the Present Value of an Annuity Due

Earlier, we defined an ordinary annuity*.* A variation is the annuity due. The difference between the two is one period. That’s all—just one additional period of interest. An ordinary annuity assumes that there is a one-period lag between the start of a stream of payments and the actual first payment. In contrast, an annuity due assumes that payments begin immediately, as in the lottery example above. We would assume that you would receive the first annual lottery check of \$120,000 immediately, not a year from now. In summary, whether calculating future value (covered in the next section) or present value of an annuity due, the one-year lag is eliminated, and we begin immediately.

Calculating Annuities Used in Structured Settlements

In addition to lottery payouts, annuity calculations are often used in structured settlements by attorneys at law. If you win a \$450,000 settlement for an insurance claim, the opposing party may ask you to accept an annuity so that they can pay you in installments rather than a lump sum of cash. What would a fair cash distribution by year mean? If you have a preferred discount rate (the percentage we all must know to calculate the time value of money) of 6% and you expect equal distributions of \$45,000 over 10 years, beginning one year from now, you can use the present value of an annuity formula to compare the alternatives:

Calculating the Future Value of an Annuity

In the previous section, we addressed discounting a periodic stream of payments from the future to the present. We are also interested in how to project the future value of a series of payments. In this case, an investment may be made periodically. Keeping with the definition of an annuity, if the amount of periodic investment is always the same, we may take a one-step shortcut to calculate the future value of that stream by using the formula presented below:

How Annuities Are Used for Retirement Planning

On a final note, how might annuities be used for retirement planning? A person might receive a lump-sum windfall from an investment, and rather than choosing to accept the proceeds, they might decide to invest the sum (ignoring taxes) in an annuity. Their intention is to let this invested sum produce annual distributions to supplement Social Security payments. Assume the recipient just received \$75,000, again ignoring tax effects. They have the chance to invest in an annuity that will provide a distribution at the end of each of the next five years, and that annuity contract provides interest at 3% annually. Their first receipt will be one year from now. This is an ordinary annuity.

Loan Amortization

Types of Loans

Funds can be loaned to businesses of any type, including corporations, partnerships, limited liability companies, and proprietorships. Bankers often refer to these lending structures as *facilities*, and they can be tailored to the specific needs of the borrower in a number of ways. Similarly, lenders develop loans and lines of credit for individuals. Whether for a business or an individual, the purpose of the loan, method of repayment, interest rate, specific terms, and time involved must all be tailored to the goals of the borrower and the lender. In this chapter, we will focus on fixed-rate loans, although other alternatives exist.

Calculating Loan Payments Using Simple Amortization

Loan amortization refers to a schedule of how and when a debt will be repaid with interest. As noted, we will focus on fixed-rate debts, such as auto loans, personal loans with installment payments, or mortgages. Before entering into a borrowing agreement, the borrower can use any of a number of tools to verify the terms being offered, such as the monthly payment on a car loan financed by the dealer. In many cases, this is accomplished by using the present value of an annuity formula:

Stated versus Effective Rates

The Difference between Stated and Effective Rates

If you look at the bottom of your monthly credit card statement, you could see language such as “The interest rate on unpaid balances is 1.5% per month.” You might think to yourself, “So, that’s 12 months times 1.5%, or 18% per year.” This is a fine example of the difference between *stated* and *effective* annual interest rates. The effective interest rate reflects compounding within a one-year period, an important distinction because we tend to focus on annual interest rates. Because compounding occurs more than once per year, the true annual rate is higher than appears. Please remember that if interest is calculated and compounded annually, the stated and effective interest rates will be the same. Keep in mind that the following principles work whether you are the debtor paying off an obligation or an investor hoping for more frequent compounding. The dynamics of the time value of money apply in either direction.

Effective Rates and Period of Compounding

Let’s remain with our example of a credit card statement that indicates an interest rate of 1.5% per month on unpaid balances. If you use this card only once, to make a \$1,000 purchase in January, and then fail to pay the bill when it comes due, the issuer will bill you \$15. Now you owe them \$1,015. Assume you completely ignore this bill and never pay it throughout the rest of the year. The monthly calculation of interest starts to compound on past interest assessments in addition to the \$1,000 initial purchase (see [link]).

Equal Payments with a Financial Calculator and Excel

Solving Time Value of Money Problems Using a Financial Calculator

Since the 1980s, many convenient and inexpensive tools have become available to simplify business and personal calculations, including personal computers with financial applications and handheld/desktop or online calculators with many of the functions we’ve studied already. This section will explore examples of both, beginning with financial calculators. While understanding and mastery of the use of time value of money equations are part of a solid foundation in the study of business and personal finance, calculators are rapid and efficient.

Solving Time Value of Money Problems Using Excel

Microsoft’s popular spreadsheet program Excel is arguably one of the most common and powerful numeric and data analysis products available. Yet while mastery of Excel requires extensive study and practice, enough basics can be learned in two or three hours to provide the user with the ability to solve problems quickly and conveniently, including extensive financial capability. Most of the calculations in this chapter were prepared with Excel.

Time Value of Money III: Unequal Multiple Payment Values

Why It Matters

Timing of Cash Flows

Multiple Payments or Receipts of Unequal Value: The Mixed Stream

At this point, you are familiar with the time value of money of single amounts and annuities and how they must be managed and controlled for business as well as personal purposes. If a stream of payments occurs in which the amount of the payments changes at any point, the techniques for solving for annuities must be modified. Shortcuts that we have seen in earlier chapters cannot be taken. Fortunately, with tools such as financial or online calculators and Microsoft Excel, the method can be quite simple.

Unequal Payments Using a Financial Calculator or Microsoft Excel

Using a Financial Calculator

A financial calculator provides utilities to simplify the analysis of uneven mixed cash streams (see [link]).

Using Microsoft Excel

Several of the exhibits already in this chapter have been prepared with Microsoft Excel. While full mastery of Excel requires extensive study and practice, enough basics can be learned in two or three hours to provide the user with the ability to quickly and conveniently solve problems, including extensive financial applications. Potential employers and internship hosts have come to expect basic Excel knowledge, something to which you are exposed in college.

Bonds and Bond Valuation

Why It Matters

Characteristics of Bonds

Bonds as Investments

One way to look at bond investments is to consider the fact that any investor who purchases a bond is essentially buying a future cash flow stream that the bond issuer (or borrower) promises to make as per agreement.

Basic Terminology

We need to know the following basic bond terms and pricing in order to apply the necessary time value of money equation to value this Apple, Inc. bond issue:

Types of Bonds

There are three primary categories of bonds, though the specifics of these different types of bond can vary depending on their issuer, length until maturity, interest rate, and risk.

The Global Bond Market versus the Global Stock Market

Bonds have long been a trusted investment vehicle for many investors. Though the global fixed-income debt market remains considerably larger than the global stock market, this is not an entirely fair comparison. Bond markets include sovereign bonds, or bonds that are issues by governments, while stock markets do not. Some experts believe that a more relevant comparison is between the value of corporate bond markets only (excluding sovereign bonds) and total stock market value.

The Two Sides of a Bond Investment

There are essentially two sides to a bond investment, meaning the bondholder will receive two types of cash inflow from the bond investment over its term. These are the payment of the par value at maturity (often referred to as payment of the face value of the bond at term end), and the periodic coupon payments (also called interest income) from the bond. These coupon payments are contractually determined and clearly indicated in the bond issue documentation received by the bondholder upon purchase.

The Relationship between Bond Prices and Interest Rates

Bond price and interest rate have an inverse relationship. When interest rates fall, bond prices rise, and vice versa (see [link]). If interest rates increase, the value of bonds sold at lower interest rates will decline. Similarly, if interest rates decline, the value of fixed-rate bonds will increase. An exception to this general rule is floating-rate bonds (often referred to as “floaters,” floating-rate notes, or FRNs).

Bond Valuation

Pricing a Bond in Steps

Why do we want to learn how to price a bond? The answer goes to the heart of finance: the valuation of assets. We need to ascertain what a given bond is worth to a willing buyer and a willing seller. What is its value to these interested parties? Remember that a bond is a financial asset that a company sells to raise money from willing investors. Whether you are the company selling the bond or the investor buying the bond, you want to make sure that you are selling or buying at the best available price.

Pricing a Bond Using a Financial Calculator

A financial calculator can also be used to solve common types of bond valuations. For example, what would be the current price (value) of a 4% coupon bond, paid semiannually, with a face value of \$1,000 and a remaining term to maturity of 15 years, assuming a required YTM rate of 5%? The steps to solve this problem are shown in [link] below.

Time Value Connection

As we have briefly discussed, bond valuation is determined by time value of money techniques, most notably present value calculations. This makes logical sense when one considers that an investment in a bond involves a series of future cash inflows, or payments from the bond issuer to the bondholder over the term of the bond’s maturity.

Yields and Coupon Rates

The two interest rates that we associate with a bond are often confusing to students when they first begin to work with bonds. The coupon rate is the interest rate printed on the bond; this is only used to determine the interest or coupon payments. The yield to maturity (YTM) is an interest rate that is used to discount the bond’s future cash flow. The YTM is derived from the marketplace and is based on the riskiness of future cash flows.

The Relationship of Yield to Maturity and Coupon Rate to Bond Prices

The value or price of any bond has a direct relationship with the YTM and the coupon rate.

Using the Yield Curve

Term Structure of Interest Rates

The expected yields of various bonds across different maturity periods are referred to as the *term structure of interest rates*. This is because they represent interest rates for different periods of time, maturities, or terms.

Why Is the Yield Curve Important?

Market technicians, brokers, and investment analysts will study the yield curve in great detail by keeping track of its many changes and movements. This is because of the overall importance of the yield curve as an economic indicator and how it can be representative of the ideas, attitudes, and bond market expectations of individuals as well as large institutional investors that exert significant influence on investment markets and the economy as a whole.

Risks of Interest Rates and Default

Bond Risks

As we touched on earlier, bonds are fixed-income investments, and because of this, they are subject to a number of risks that could have negative effects on their market value. The most common and best-known risks are interest rate risk and default risk, but other risks exist that should be understood. Among these risks are the following:

Bond Ratings and Rating Providers

It is important for investors to know the risks they are assuming when investing in bonds. Many investors will take advantage of information provided by bond rating services to assess the likelihood of borrowers (bond issuers) defaulting on the financial obligations of their bond issues.

Concepts of Bond Returns

Bond investors earn profits through two different means: collecting interest income and generating capital gains. These are important concepts for any investor who considers putting their money in fixed-income securities such as bonds.

Bond Laddering as an Investment Strategy

There are several successful strategies for successful bond investments, but perhaps one of the most common yet ingenious of these strategies is called *bond laddering*. Bond ladders help investors achieve diversity in their portfolios and reduce risk while helping maintain regular cash inflows in the form of coupon payments or interest. In a bond ladder, an investor will divide their total investment dollars among various bonds that mature at regular intervals, thereby balancing risk and return. An example of a bond ladder would be to purchase 10 different bonds that have maturities of one year, two years, three years, and so on, all the way through to 10 years.

Interest Rate Movements and Bond Prices

We now know that when investors buy bonds, either directly or through mutual funds, they are lending money to bond-issuing firms or governments. In turn, issuers promise to pay back the principal (par or face value) when the loan is due at the bond’s maturity date.

Using Spreadsheets to Solve Bond Problems

Calculating the Price (Present Value) of a Bond

The following examples illustrate how Microsoft Excel can be used to calculate common bond problems. Please be sure to refer to the chapters on the time value of money for examples of using spreadsheets to solve present value problems, as these same concepts are also used in solving bond problems.

Calculating the Yield to Maturity (Interest Rate) of a Bond

Use the following steps in Excel to determine the YTM (interest rate) of a bond. Assume that you want to find the YTM of a \$1,000, 3.5% bond with annual coupon payments that is selling for \$675.00 and will mature in 12 years.

Calculating the Maturity Period (Term) of a Bond

You can use the following steps in Excel to determine the maturity period or term of a bond. Assume that you are considering investing in a bond that is selling for \$820.00, has a face value of \$1,000, and has an annual coupon rate of 3%. If the YTM is 10%, how long will it be until the bond matures?

Calculating Coupon Rate and Interest (Coupon) Payments

Here is how you would determine the coupon or interest rate and coupon payment using Excel. Assume a \$1,000 face value bond is selling for \$595, has 20 years until it matures, and has a YTM of 6.5%. What are the coupon rate and the periodic coupon payment amount of the bond?

Stocks and Stock Valuation

Why It Matters

Multiple Approaches to Stock Valuation

The Price-to Earnings (P/E) Ratio

Experienced investors use a number of different methods to evaluate information on companies and their common stock before deciding on any potential purchase. One of the most popular techniques used by investors and analysts is to study a company’s financial statements in order to uncover basic fundamental information on the company. This involves calculating a number of financial ratios that help identify trends, bringing elements of operational performance to light and allowing for clearer analysis and evaluation.

The Price-to-Book (P/B) Ratio

Another financial ratio commonly used by investors and analysts is the price-to-book (P/B) ratio, also called the market-to-book (M/B) ratio. This is a financial metric used to evaluate a company’s current market value relative to its book value.

Alternative Multipliers

There are two main types of valuation metrics multiples used to value common stock. These are equity multiples and enterprise value (EV) multiples. Additionally, there are two primary methods by which to perform analysis using these multiples. These methods are comparable company analysis (comps) and precedent transaction analysis (precedents).

Dividend Discount Models (DDMs)

The Gordon Growth Model

The most common DDM is the Gordon growth model, which uses the dividend for the next year (*D*1), the required return (*r*), and the estimated future dividend growth rate (*g*) to arrive at a final price or value of the stock. The formula for the Gordon growth model is as follows:

Zero Growth Dividend Discount Model

The zero growth DDM assumes that all future dividends of a stock will be fixed at essentially the same dollar value forever, or at least for as long as an individual investor holds the shares of stock. In such a case, the stock’s intrinsic value is determined by dividing the annual dividend amount by the required rate of return:

Constant Growth Dividend Discount Model

As indicated by its name, the constant growth DDM assumes that a stock’s dividend payments will grow at a fixed annual percentage that will remain the same throughout the period of time they are held by an investor. While the constant growth DDM may be more realistic than the zero growth DDM in allowing for dividend growth, it assumes that dividends grow by the same specific percentage each year. This is also an unrealistic assumption that can present problems when attempting to evaluate companies such as Amazon, Facebook, Google, or other organizations that do not pay dividends. Constant growth models are most often used to value mature companies whose dividend payments have steadily increased over a significant period of time. When applied, the constant growth DDM will generate the present value of an infinite stream of dividends that are growing at a constant rate.

Variable or Nonconstant Growth Dividend Discount Model

Many experienced analysts prefer to use the variable (nonconstant) growth DDM because it is a much closer approximation of businesses’ actual dividend payment policies, making it much closer to reality than other forms of DDM. The variable growth model is based on the real-life assumption that a company and its stock value will progress through different stages of growth.

Two-Stage Dividend Discount Model

The two-stage DDM is a methodology used to value a dividend-paying stock and is based on the assumption of two primary stages of dividend growth: an initial period of higher growth and a subsequent period of lower, more stable growth.

Advantages and Limitations of DDMs

Some of the primary advantages of DDMs are their basis in the sound logic of present value concepts, their consistency, and the implication that companies that pay dividends tend to be mature and stable entities. Also, because the model is essentially a mathematical formula, there is little room for misinterpretation or subjectivity. As a result of these advantages, DDMs are a very popular form of stock evaluation that most analysts show faith in.

Some Final Thoughts on Dividend Discount Models

The dividend used to calculate a price is the expected future payout and expected future dividend growth. This means the DDM is most useful when valuing companies that have long, consistent dividend records.

Discounted Cash Flow (DCF) Model

Understanding How the DCF Model Differs from DDMs

The valuation of an asset is typically based on the present value of future cash flows that are generated by the asset. It is no different with common stock, which brings us to another form of stock valuation: the discounted cash flow (DCF) model. The DCF model is usually used to evaluate firms that are relatively young and do not pay dividends to their shareholders. Examples of such companies include Facebook, Amazon, Google, Biogen, and Monster Beverage. The DCF model differs from the dividend discount models we covered earlier, as DDM methodologies are almost entirely based on a stock’s periodic dividends.

Applying the DCF Model

We can apply the DCF model to an example to demonstrate this methodology and how the formula works. Calculate the value of Mayweather Inc. and its common stock based on the next six years of cash flow results. Assume that the discount rate (required rate of return) is 8%, Mayweather’s growth rate is 3%, and the terminal value (TCF) will be two and one-half times the discounted value of the cash flow in year 6.

Advantages and Limitations of the DCF Model

Due to several corporate accounting scandals in recent years, many analysts have given increasing credence to the use of cash flow as a metric for determining accurate corporate valuations. However, it should be noted that cash flow is not always the best means of measuring financial health. A company can always sell a large portion of its assets to generate a positive cash flow, even if it is operating at a loss or experiencing other financial difficulties. Additionally, investors prefer to see companies reinvesting their cash back into their businesses rather than sitting on excessive balances of idle cash.

Preferred Stock

Features of Preferred Stock

Preferred stock is a unique form of equity sold by some firms that offers preferential claims in ownership. Preferred stock will often feature a dividend that a company is obligated to pay out before it makes any dividend payments to common stockholders. In cases of bankruptcy and liquidation of the issuing company, preferred stockholders have priority claim to assets before common stockholders. Additionally, preferred stockholders are usually entitled to a set (or constant) dividend every period.

Determining the Intrinsic Value of Preferred Stock

We can apply a version of the present value of a perpetuity formula to value preferred stock, as in the following example. Oh-Well Heath Services Inc. has issued preferred stock that has a par value of \$1,000 and pays an annual dividend rate of 5%. If the market considers the risk of Oh-Well to warrant a 10% discount rate, what would be a fair market price for Oh-Well preferred stock?

Differences between Preferred and Common Stock

As we have discussed, preferred stock has important differences from common stock that apply to issuing firms and to investors. Some of the most important of these differences are listed in [link].

Efficient Markets

Efficient Markets

For the public, the real concern when buying and selling of stock through the stock market is the question, “How do I know if I’m getting the best available price for my transaction?” We might ask an even broader question: Do these markets provide the best prices and the quickest possible execution of a trade? In other words, we want to know whether markets are efficient. By **efficient markets**, we mean markets in which costs are minimal and prices are current and fair to all traders. To answer our questions, we will look at two forms of efficiency: operational efficiency and informational efficiency.

Operational Efficiency

Operational efficiency concerns the speed and accuracy of processing a buy or sell order at the best available price. Through the years, the competitive nature of the market has promoted operational efficiency.

Informational Efficiency

A second measure of efficiency is informational efficiency, or how quickly a source reflects comprehensive information in the available trading prices. A price is efficient if the market has used all available information to set it, which implies that stocks always trade at their fair value (see [link]). If an investor does not receive the most current information, the prices are “stale”; therefore, they are at a trading disadvantage.

Forms of Market Efficiency

Financial economists have devised three forms of market efficiency from an information perspective: weak form, semi-strong form, and strong form. These three forms constitute the efficient market hypothesis. Believers in these three forms of efficient markets maintain, in varying degrees, that it is pointless to search for undervalued stocks, sell stocks at inflated prices, or predict market trends.

Historical Performance of US Markets

Why It Matters

Overview of US Financial Markets

Money Markets

The money market is a multitrillion-dollar market. Features of money market securities include being short-term (with maturities of less than one year) and very low risk (rarely failing to make their required payments). Further, money market securities are also liquid, which means that they trade easily without losing value.

Bond Markets

Bond markets are financial markets that make payments to investors for a specific period of time. Investors decide how much to pay for a bond depending on how much they expect inflation to affect the value of the fixed payment. There are several types of bonds: government bonds, corporate bonds, and municipal bonds.

Equity Markets

An important goal of firm managers is to maximize owners’ wealth. For corporations, shares of stock represent ownership. A corporation could have 100 shares, one million shares, or even several billion shares of stock. Stocks are difficult to value compared to bonds. Bonds typically provide periodic interest payments and a principal payment at maturity. The bond indenture specifies the timing and the amount of payments. Stocks might have periodic dividend payments, and an investor can plan to sell the stock at some point in the future. However, no contract guarantees the size of the dividends or the time and resale price of the stock. Thus, the cash flows from stock ownership are more uncertain and risky.

Historical Picture of Inflation

Expected versus Actual Inflation

Inflation occurs when things cost more and your money buys less today than it did yesterday. It is understandable to dislike inflation and to be concerned over the prospect of rising prices. In fact, two of the primary policy objectives of the Federal Reserve are to work for price stability and moderate interest rates. However, is inflation necessarily good or bad? In practice, inflation can benefit some people and harm others at the same time. Consider the impact of differences in expected and actual realized inflation. Empirical evidence suggests that, on average, economists do a good job of developing inflation rate forecasts that match the actual rate of inflation. Estimated inflation is built into the interest rates investors require or are willing to pay for financial products, such as fixed-rate loans or bonds. When the actual rate of inflation exceeds the estimated rate on a product, such as a mortgage loan, this means borrowers are repaying the loan with less-valuable dollars and benefit from the increased inflation rate. Lenders, however, receive those inflation-impacted dollars and are harmed due to their unexpected decrease in purchasing power.

Inflation Impacts

Ultimately, inflation redistributes wealth. Lenders providing fixed-rate loans receive less-valuable dollars in return. Borrowers repay with those same less-valuable dollars. Workers receive less-valuable dollars, especially when their wage increases lag behind changes in prices. Modest inflation can benefit a consumer-driven economy like the United States if consumers are motivated to spend money before prices increase. However, too much inflation can cause frenzied buying, drive prices even higher, and outpace the rate of wage increases. Higher inflation raises the rates on new borrowing instruments and can slow the rate of business investment and economic growth. Inflation raises overall prices and may cause hardship for consumers on a fixed income.

Using Graphs and Charts to Plot Inflation Behavior

The CPI is a measure of how prices have changed for a basket of goods across the United States. [link] shows the eight major categories of expenditures included in the CPI.[footnote] Different regions of the country and population subgroups may experience different rates of inflation. Retired people may spend a greater portion of their income on healthcare than someone in their twenties.[footnote] Residents on the East and West Coasts spend a higher percentage of their earnings on housing than those living in the Midwest.[footnote] As such, there are several different measures of inflation based on geographic region or other factors.[footnote] It is worth noting that a basket of goods and services that cost \$100 in 1984 would cost approximately \$260 by the end of 2020, an increase of 160% (see [link])! Over that same period, the average annual rate of inflation as measured by the CPI was 2.55%. These numbers make it easy to see that even a relatively modest annual inflation rate, lower than the long-run annual US inflation rate of 3%, results in significant price increases.

US Bureau of Labor Statistics. “Consumer Price Index.” *US Bureau of Labor Statistics*. https://www.bls.gov/cpi/Chris Farrell. “The Truth About Health Care Costs in Retirement.” *Forbes.* June 28, 2018. https://www.forbes.com/sites/nextavenue/2018/06/28/the-truth-about-health-care-costs-in-retirement/US Department of Housing and Urban Development, Office of Policy Development and Research. “Rental Burdens: Rethinking Affordability Measures.” PD&R Edge. September 22, 2014. https://www.huduser.gov/portal/pdredge/pdr_edge_featd_article_092214.htmlKhan Academy. “How Changes in the Cost of Living Are Measured.” *Khan Academy*. https://www.khanacademy.org/economics-finance-domain/macroeconomics/macro-economic-indicators-and-the-business-cycle/macro-price-indices-and-inflation/a/how-changes-in-the-cost-of-living-are-measured-cnx

Historical Picture of Returns to Bonds

Federal Government Bond Behavior, Discussion, Charts, and Graphs

United States Treasury (sovereign) bonds are among the safest investments available. In fact, T-bonds often serve as the proxy for a risk-free investment in financial modeling. However, even though T-bonds may be essentially default-risk free, they do change value as interest rates change. Look at [link], showing annual T-bond returns from 1980 to 1999. None of these bonds defaulted, yet investors realized very different returns on their investments from year to year. The total returns reflect interest payments plus the change in price because of changes in interest rates.

Corporate Bond Behavior, Discussion, Charts, and Graphs

The performance of Baa bonds is very similar to T-Bonds over the four decades spanning 1980 to 2020 (see [link]). These bonds are not default-risk free and require a risk premium for investors. The average annual return of 12.07% from 1980 to 1999 topped T-bonds by 1.86%. The margin was greater in the period from 2000 to 2020 (see [link]), with Baa bonds (mid-tier corporate bonds) realizing an average annual premium of 2.30% over the default-risk free T-bonds.

Historical Picture of Returns to Stocks

Using Graphs and Charts to Plot Equity Market Behavior Stock Size Considerations

The Dow Jones Industrial Average (DJIA), also known as the Dow 30) and the S&P 500 Index are the most frequently quoted stock market indices among scholars, businesses, and the public in general. Both indices track the change in value of a group of large capitalization stocks. The changes in the two indices are highly correlated.

Statistical Analysis in Finance

Why It Matters

Measures of Center

Arithmetic Mean

The *average* of a data set is a way of describing location. The most widely used measures of the *center* of a data set are the mean (average), median, and mode. The arithmetic mean is the most common measure of the average. We will discuss the geometric mean later.

Median

To determine the median of a data set, order the data from smallest to largest, and then find the middle value in the ordered data set. For example, to find the median value of 50 portfolios, find the number that splits the data into two equal parts. The portfolio values owned by 25 people will be below the median, and 25 people will have portfolio values above the median. The median is generally a better measure of the average when there are extreme values or outliers in the data set.

Mode

Another measure of center is the mode. The mode is the most frequent value. There can be more than one mode in a data set as long as those values have the same frequency and that frequency is the highest. A data set with two modes is called *bimodal*. For example, assume that the weekly closing stock price for a technology stock, in dollars, is recorded for 20 consecutive weeks as follows:

Geometric Mean

The arithmetic mean, median, and mode are all measures of the *center* of a data set, or the *average*. They are all, in their own way, trying to measure the common point within the data—that which is “normal.” In the case of the arithmetic mean, this is accomplished by finding the value from which all points are equal linear distances. We can imagine that all the data values are combined through addition and then distributed back to each data point in equal amounts.

Weighted Mean

A weighted mean is a measure of the center, or average, of a data set where each data value is assigned a corresponding weight. A common financial application of a weighted mean is in determining the average price per share for a certain stock when the stock has been purchased at different points in time and at different share prices.

Measures of Spread

Standard Deviation

An important characteristic of any set of data is the variation in the data. In some data sets, the data values are concentrated close to the mean; in other data sets, the data values are more widely spread out. For example, an investor might examine the yearly returns for Stock A, which are 1%, 2%, -1%, 0%, and 3%, and compare them to the yearly returns for Stock B, which are -9%, 2%, 15%, -5%, and 0%.

Variance

Variance also provides a measure of the spread of data values. The variance of a data set measures the extent to which each data value differs from the mean. The more the individual data values differ from the mean, the larger the variance. Both the standard deviation and the variance provide similar information.

Relationship between Standard Deviation and Variance

In the formulas shown above for variance and standard deviation, notice that the variance is the square of the standard deviation, and the standard deviation is the square root of the variance.

Measures of Position

*z*-Scores

A *z*-score, also called a *z*-value, is a measure of the position of an entry in a data set. It represents the number of standard deviations by which a data value differs from the mean. For example, suppose that in a certain year, the rates of return for various technology-focused mutual funds are examined, and the mean return is 7.8% with a standard deviation of 2.3%. A certain mutual fund publishes its rate of return as 12.4%. Based on this rate of return of 12.4%, we can calculate the relative standing of this mutual fund compared to the other technology-focused mutual funds. The corresponding *z*-score of a measurement considers the given measurement in relation to the mean and standard deviation for the entire population.

Quartiles and Percentiles

If a person takes an IQ test, their resulting score might be reported as in the *87th percentile*. This percentile indicates the person’s relative performance compared to others taking the IQ test. A person scoring in the 87th percentile has an IQ score higher than 87% of all others taking the test. This is the same as saying that the person is in the top 13% of all people taking the IQ test.

Outlier Detection

Quartiles and the IQR can be used to flag possible outliers in a data set. For example, if most employees at a company earn about \$50,000 and the CEO of the company earns \$2.5 million, then we consider the CEO’s salary to be an outlier data value because is significantly different from all the other salaries in the data set. An outlier data value can also be a value much lower than the other data values, so if one employee only makes \$15,000, then this employee’s low salary might also be considered an outlier.

Statistical Distributions

Frequency Distributions

A frequency distribution provides a method to organize and summarize a data set. For example, we might be interested in the spread, center, and shape of the data set’s distribution. When a data set has many data values, it can be difficult to see patterns and come to conclusions about important characteristics of the data. A frequency distribution allows us to organize and tabulate the data in a summarized way and also to create graphs to help facilitate an interpretation of the data set.

Normal Distribution

The normal probability density function, a continuous distribution, is the most important of all the distributions. The normal distribution is applicable when the frequency of data values decreases with each class above and below the mean. The normal distribution can be applied to many examples from the finance industry, including average returns for mutual funds over a certain time period, portfolio values, and others. The normal distribution has two parameters, or numerical descriptive measures: the mean, *$\mu$*, and the standard deviation, $\sigma$. The variable *x* represents the quantity being measured whose data values have a normal distribution.

Exponential Distribution

The exponential distribution is often concerned with the amount of time until some specific event occurs. For example, a finance professional might want to model the time to default on payments for company debt holders.

Probability Distributions

Calculate Portfolio Weights

In many financial analyses, the **weightings** by asset category in a portfolio are a key index used to assess if the portfolio is meeting allocation metrics. For example, an investor approaching retirement age may wish to shift assets in a portfolio to more conservative and lower-volatility investments. Weightings can be calculated in several different ways—for example, based on individual stocks in a portfolio or on various sectors in a portfolio. Weightings can also be calculated based on number of shares or the value of shares of a stock.

Calculate and Interpret Expected Values

A probability distribution is a mathematical function that assigns probabilities to various outcomes. For example, we can assign a probability to the outcome of a certain stock increasing in value or decreasing in value. One application of a probability distribution function is determining expected value.

Apply the Normal Distribution in Financial Contexts

The normal, or bell-shaped, distribution can be utilized in many applications, including financial contexts. Remember that the normal distribution has two parameters: the mean, which is the center of the distribution, and the standard deviation, which measures the spread of the distribution. Here are several examples of applications of the normal distribution:

Data Visualization and Graphical Displays

Graphing Univariate Data

Data visualization refers to the use of graphical displays to summarize data to help to interpret patterns and trends in the data. *Univariate data* refers to observations recorded for a single characteristic or attribute, such as salaries or blood pressure measurements. When graphing univariate data, we can choose from among several types of graphs, such as bar graphs, time series graphs, and so on.

Graphing Bivariate Data

Bivariate data refers to paired data, where each value of one variable is paired with a value of a second variable. An example of paired data would be if data were collected on employees’ years of experience and their corresponding salaries. Typically, it is of interest to investigate possible associations or correlations between the two variables under analysis.

The R Statistical Analysis Tool

Commands and Vectors in R

R is a statistical analysis tool that is widely used in the finance industry. It is available as a free program and provides an integrated suite of functions for data analysis, graphing, and statistical programming. R is increasingly being used as a data analysis and statistical tool as it is an open-source language and additional features are constantly being added by the user community. The tool can be used on many different computing platforms and can be downloaded at the R Project website.

Graphing in R

There are many statistical applications in R, and many graphical representations are possible, such as bar graphs, histograms, time series plots, scatter plots, and others. The basic command to create a plot in R is the plot command, *plot(x, y)*, where *x* is a vector containing the *x*-values of the data set and *y* is a vector containing the *y*-values of the data set.

Regression Analysis in Finance

Why It Matters

Correlation Analysis

Calculate a Correlation Coefficient

In correlation analysis, we study the relationship between bivariate data, which is data collected on two variables where the data values are paired with one another.

Interpret a Correlation Coefficient

Once the value of *r* is calculated, this measurement provides two indicators for the correlation:

Test a Correlation Coefficient for Significance

The correlation coefficient, *r*, tells us about the strength and direction of the linear relationship between *x* and *y*. The sample data are used to compute *r*, the correlation coefficient for the sample. If we had data for the entire population (that is, all measurements of interest), we could find the population correlation coefficient, which is labeled as the Greek letter *ρ* (pronounced “rho”). But because we have only sample data, we cannot calculate the population correlation coefficient. The sample correlation coefficient, *r*, is our estimate of the unknown population correlation coefficient.

Linear Regression Analysis

Method of Least Squares and Residuals

Once the correlation coefficient has been calculated and a determination has been made that the correlation is significant, typically a regression model is then developed. In this discussion we will focus on linear regression, where a straight line is used to model the relationship between the two variables. Once a straight-line model is developed, this model can then be used to predict the value of the dependent variable for a specific value of the independent variable.

Assumptions for Linear Regression

Testing the significance of the correlation coefficient requires that certain assumptions about the data are satisfied. The premise of this test is that the data are a sample of observed points taken from a larger population. We have not examined the entire population because it is not possible or feasible to do so. We are examining the sample to draw a conclusion about whether the linear relationship that we see between *x* and *y* in the sample data provides strong enough evidence that we can conclude that there is a linear relationship between *x* and *y* in the population.

Best-Fit Linear Model

Calculate the Slope and *y*-Intercept for a Linear Regression Model Using Technology

Once a correlation has been deemed as significant, a best-fit linear regression model is developed. The goal in the regression analysis is to determine the coefficients *a* and *b* in the following regression equation:

Interpret and Apply the Slope and *y*-Intercept

The slope of the line, *b*, describes how changes in the variables are related. It is important to interpret the slope of the line in the context of the situation represented by the data. You should be able to write a sentence interpreting the slope in plain English.

Regression Applications in Finance

Regression Model for a Single Independent Variable

Regression analysis is used extensively in finance-related applications. Many typical applications involve determining if there is a correlation between various stock market indices such as the S&P 500, the Dow Jones Industrial Average (DJIA), and the Russell 2000 index.

Measures of Slope and Intercept from Regression Analysis

An important application of regression analysis is to determine the systematic risk for a particular stock, which is referred to as beta. A stock’s beta is a measure of the volatility of the stock compared to a benchmark such as the S&P 500 index. If a stock has more volatility compared to the benchmark, then the stock will have a beta greater than 1.0. If a stock has less volatility compared to the benchmark, then the stock will have a beta less than 1.0.

Predictions and Prediction Intervals

Predicting the Dependent Variable Using the Regression Model

A key aspect of generating the linear regression model is to use the model for predictions, provided the correlation is significant. To generate predictions or forecasts using the linear regression model, substitute the value of the independent variable (*x*) in the regression equation and solve the equation for the dependent variable (*y*).

Generating Prediction Intervals

One important value of an estimated regression equation is its ability to predict the effects on *y* of a change in one or more values of the independent variables. The value of this is obvious. Careful policy cannot be made without estimates of the effects that may result. Indeed, it is the desire for particular results that drive the formation of most policy. Regression models can be, and have been, invaluable aids in forming such policies.

Use of R Statistical Analysis Tool for Regression Analysis

Generate Correlation Coefficients Using the R Statistical Tool

R is an open-source statistical analysis tool that is widely used in the finance industry. R is available as a free program and provides an integrated suite of functions for data analysis, graphing, and statistical programming. R provides many functions and capabilities for regression analysis.

Generate Linear Regression Models Using the R Statistical Tool

To create a linear model in R, assuming the correlation is significant, the command *lm* (for linear model) will provide the slope and *y*-intercept for the linear regression equation.

How to Think about Investing

Why It Matters

Risk and Return to an Individual Asset

Measuring Historical Returns

*Risk* and *return* are often referred to as the two Rs of finance. Investors are interested in both risk and return because understanding one without the other is really meaningless. In terms of investment, the concept of *return* is fairly straightforward; return is the benefit, or profit, the investor expects from an expenditure. It is the reward for investing—the reason an investment is made in the first place. However, no investment is a sure thing. The return may not be what the investor was expecting. This uncertainty about what the return will be is referred to as *risk*.

Measuring Risk

Although the arithmetic average return for Delta Airlines (DAL) for 2011–2020 was 22.4%, there is not a year in which the return was exactly 22.4%. In fact, in some years, the return was much higher than the average, such as in 2013, when it was 132.61%. In other years, the return was negative, such as 2011, when it was −35.79%. Looking at the yearly returns in [link], the return for DAL varies widely from year to year. In finance, this volatility of returns is considered risk.

Risk and Return to Multiple Assets

Diversification

So far, we have looked at the return and the volatility of an individual stock. Most investors, however, own shares of stock in multiple companies. This collection of stocks is known as a portfolio. Let’s explore why it is wise for investors to hold a portfolio of stocks rather than to pick just one favorite stock to own.

Portfolio Size and Risk

As you add more stocks to a portfolio, the volatility, or standard deviation, of the portfolio decreases. The volatility of individual assets becomes less and less important. As we discussed earlier, the risk that is associated with events related to a particular company is called firm-specific risk, or unsystematic, risk. Examples of unsystematic risk would include a company facing a product liability lawsuit, a company inventing a new product, or accounting irregularities being detected. Holding a portfolio of stocks means that if one company you have invested in goes out of business because of poor management, you do not lose all your savings because some of your money is invested in other companies. Portfolio diversification protects you from being significantly impacted by unsystematic risk.

The Capital Asset Pricing Model (CAPM)

Risk-Free Rate

The capital asset pricing model (CAPM) is a financial theory based on the idea that investors who are willing to hold stocks that have higher systematic risk should be rewarded more for taking on this market risk. The CAPM focuses on systematic risk, rather than a stock’s individual risk, because firm-specific risk can be eliminated through diversification.

Risk Premium

You know that if you use your \$20,000 to invest in stock rather than in US Treasury bills, the outcome of the investment will be uncertain. Your investments may do well, but there is also a risk of losing money. You will only be willing to take on this risk if you are rewarded for doing so. In other words, you will only be willing to take the risk of investing in stocks if you think that doing so will make you more than you would make investing in US Treasury securities.

Beta

The risk premium represents how much an investor who takes on the market portfolio is rewarded for risk. Investors who purchase one stock—DAL, for example—experience volatility, which is measured by the standard deviation of that stock’s returns. Remember that some of that volatility, the volatility caused by firm-specific risk, can be diversified away. Because investors can eliminate firm-specific risk through diversification, they will not be rewarded for that risk. Investors are rewarded for the amount of systematic risk they incur.

CAPM Equation

Because DAL’s beta of 1.39 is greater than 1, DAL is riskier than the average stock in the market. Finance theory suggests that investors who purchase DAL will expect a higher rate of return to compensate them for this risk. DAL has 139% of the average stock’s systematic risk; therefore, investors in the stock should receive 139% of the market risk premium.

Applications in Performance Measurement

Sharpe Ratio

Investors want a measure of how good a professional money manager is before they entrust their hard-earned funds to that professional for investing. Suppose that you see an advertisement in which McKinley Investment Management claims that the portfolios of its clients have an average return of 20% per year. You know that this average annual return is meaningless without also knowing something about the riskiness of the firm’s strategy. In this section, we consider some ways to evaluate the riskiness of an investment strategy.

Treynor Measurement of Performance

Another reward-to-risk ratio measurement of investment performance is the Treynor ratio. The Treynor ratio is calculated as

Jensen’s Alpha

Jensen’s alpha is another common measure of investment performance. It is computed as the raw portfolio return minus the expected portfolio return predicted by the CAPM:

Using Excel to Make Investment Decisions

Average Return and Standard Deviation for a Single Stock

Excel can be used to calculate the average returns and the standard deviation of returns for both a single stock and a portfolio of stocks. It can also be used to calculate the beta for a stock. Historic stock price data for stocks you are interested in analyzing can easily be downloaded from sites such as Yahoo! Finance into Excel. The examples in this section use monthly stock data from December 2017 to December 2020 from Yahoo! Finance.

Average Return and Standard Deviation for a Portfolio

The Excel screenshot in [link] shows the return and standard deviation calculation for a portfolio. This sample four-stock portfolio contains AMZN, CVS, AAPL (Apple), and NFLX (Netflix). This portfolio is constructed as an equally weighted portfolio; because there are four stocks in this portfolio, each has a weight of 25%.

Calculating Beta

The standard deviation of a stock’s returns indicates the stock’s volatility. Remember that the volatility is caused by both firm-specific and systematic risk. Investors will not be rewarded for firm-specific risk because they can diversify away from it. Investors are, however, rewarded for systematic risk. To determine how much of a firm’s risk is due to systematic risk, you can use Excel to calculate the stock’s beta.

How Companies Think about Investing

Why It Matters

Payback Period Method

Payback Period Calculation

In order to purchase the embroidery machine, Sam’s Sporting Goods must spend \$16,000. During the first year, Sam’s expects to see a \$2,000 benefit from purchasing the machine, but this means that after one year, the company will have spent \$14,000 more than it has made from the project. During the second year that it uses the machine, Sam’s expects that its cash inflow will be \$4,000 greater than it would have been if it had not had the machine. Thus, after two years, the company will have spent \$10,000 more than it has benefited from the machine. This process is continued year after year until the accumulated increase in cash flow is \$16,000, or equal to the original investment. The process is summarized in [link].

Advantages

The principal advantage of the payback period method is its simplicity. It can be calculated quickly and easily. It is easy for managers who have little finance training to understand. The payback measure provides information about how long funds will be tied up in a project. The shorter the payback period of a project, the greater the project’s liquidity.

Disadvantages

Although it is simple to calculate, the payback period method has several shortcomings. First, the payback period calculation ignores the time value of money. Suppose that in addition to the embroidery machine, Sam’s is considering several other projects. The cash flows from these projects are shown in [link]. Both Project B and Project C have a payback period of five years. For both of these projects, Sam’s estimates that it will take five years for cash inflows to add up to \$16,000. The payback period method does not differentiate between these two projects.

Net Present Value (NPV) Method

Net Present Value (NPV) Calculation

Sam’s purchasing of the embroidery machine involves spending money today in the hopes of making more money in the future. Because the cash inflows and outflows occur in different time periods, they cannot be directly compared to each other. Instead, they must be translated into a common time period using time value of money techniques. By converting all of the cash flows that will occur from a project into present value, or current dollars, the cash inflows from the project can be compared to the cash outflows. If the cash inflows exceed the cash outflows in present value terms, the project will add value and should be accepted. The difference between the present value of the cash inflows and the present value of cash outflows is known as net present value (NPV).

Advantages

The NPV method solves several of the listed problems with the payback period approach. First, the NPV method uses the time value of money concept. All of the cash flows are discounted back to their present value to be compared. Second, the NPV method provides a clear decision criterion. Projects with a positive NPV should be accepted, and projects with a negative NPV should be rejected. Third, the discount rate used to discount future cash flows to the present can be increased or decreased to adjust for the riskiness of the project’s cash flows.

Disadvantages

The NPV method can be difficult for someone without a finance background to understand. Also, the NPV method can be problematic when available capital resources are limited. The NPV method provides a criterion for whether or not a project is a good project. It does not always provide a good solution when a company must make a choice between several acceptable projects because funds are not available to pursue them all.

NPV Profile

The NPV of a project depends on the expected cash flows from the project and the discount rate used to translate those expected cash flows to the present value. When we used a 9% discount rate, the NPV of the embroidery machine project was \$2,836. If a higher discount rate is used, the present value of future cash flows falls, and the NPV of the project falls.

Internal Rate of Return (IRR) Method

Internal Rate of Return (IRR) Calculation

The internal rate of return (IRR) is the discount rate that sets the present value of the cash inflows equal to the present value of the cash outflows. In considering whether Sam’s Sporting Goods should purchase the embroidery machine, the IRR method approaches the time value of money problem from a slightly different angle. Instead of using the company’s cost of attracting funds for the discount rate and solving for NPV, as we did in the first NPV equation, we set NPV equal to zero and solve for the discount rate to find the IRR:

Advantages

The primary advantage of using the IRR method is that it is easy to interpret and explain. Investors like to speak in terms of annual percentage returns when evaluating investment possibilities.

Disadvantages

One disadvantage of using IRR is that it can be tedious to calculate. We knew the IRR was about 14% for the embroidery machine project because we had previously calculated the NPV for several discount rates. The IRR is about, but not exactly, 14%, because NPV is not exactly equal to zero (just very close to zero) when we use 14% as the discount rate. Before the prevalence of financial calculators and spreadsheets, calculating the exact IRR was difficult and time-consuming. With today’s technology, this is no longer a major consideration. Later in this chapter, we will look at how to use a spreadsheet to do these calculations.

Alternative Methods

Profitability Index (PI)

The profitability index (PI) uses the same inputs as the NPV calculation, but it converts the results to a ratio. The numerator is the present value of the benefits of doing a project. The denominator is the present value of the cost of doing the project. The formula for calculating PI is

Discounted Payback Period

The payback period method provides a fast, simple approach to evaluating a project, but it suffers from the fact that it ignores the time value of money. The discounted payback period method addresses this flaw by discounting cash flows using the company’s cost of funds and then using these discounted values to determine the payback period.

Modified Internal Rate of Return (MIRR)

Financial analysts have developed an alternative evaluation technique that is similar to the IRR but modified in an attempt to address some of the weakness of the IRR method. This modified internal rate of return (MIRR) is calculated using the following steps:

Choosing between Projects

Choosing between Mutually Exclusive Projects

Earlier in this chapter, we saw that the embroidery machine that Sam’s Sporting Goods was considering had a positive NPV, making it a project that Sam’s should accept. However, another, more expensive embroidery machine may be available that is able to make more stitches per minute. Although the initial cost of this heavy-duty machine is higher, it would allow Sam’s to embroider and sell more items each year, generating more revenue. The two embroidery machines are mutually exclusive projects. Mutually exclusive projects compete with one another; purchasing one embroidery machine excludes Sam’s from purchasing the other embroidery machine.

Choosing between Projects with Different Lives

Suppose you are considering starting an ice-cream truck business. You find that you can purchase a used truck for \$50,000. You estimate that the truck will last for three years, and you will be able to sell enough ice cream treats to generate a cash inflow of \$40,000 during each of those years. Your cost of capital is 10%. The positive NPV of \$49,474 for the project makes this an acceptable project.

Choosing Projects When Resources Are Limited

Choosing positive NPV projects adds value to a company. Although we often assume that the company will choose to pursue all positive NPV projects, in reality, managers often face a budget that restricts the amount of capital that they may invest in a given time period. Thus, managers are forced to choose among several positive NPV projects. The goal is to maximize the total NPV of the firm’s projects while remaining within budget constraints.

Using Excel to Make Company Investment Decisions

Calculating NPV Using Excel

To calculate NPV using Excel, you would begin by placing each year’s expected cash flows in a sheet, as in row 5 in [link]. One approach to calculating NPV is to use the formula for discounting future cash flows, as is shown in row 6.

Calculating IRR Using Excel

Excel also provide a function for calculating IRR. This function is shown in [link], cell J8. The IRR function properly uses all the project’s cash flows, including the initial cash outflow at time 0, in its calculation, unlike the NPV function. This function will correctly return the IRR of 27.7% for the project. [link] shows the completed spreadsheet.

Using Excel to Create an NPV Profile

Firms often do not know exactly what their cost of attracting capital is, so they must use estimates in their decision-making. Also, the cost of attracting capital can change with economic and market conditions. Especially if markets are volatile, a company may use an NPV profile to see how sensitive their decisions are to changes in financing costs. Excel simplifies the creation of an NPV profile.

How Firms Raise Capital

Why It Matters

The Concept of Capital Structure

The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These items the company needs to conduct its operations are *assets*. They appear on the left-hand side of the balance sheet.

Attracting Capital

When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an *opportunity cost* to those who buy a company’s bonds or stock.

Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC).

The Costs of Debt and Equity Capital

Cost of Debt Capital

A company’s cost of debt is the interest rate it would have to pay to refinance its existing debt. Because a firm’s existing debt trades in the marketplace, its price changes according to market conditions. The overall credit environment can change due to changing macroeconomic conditions, causing a change in the price of debt securities. In addition, as there are changes in the overall riskiness of the firm and its ability to repay its creditors, the price of the debt securities issued by the firm will change.

Cost of Equity Capital

Companies can raise money by selling stock, or ownership shares, of the company. Stock is known as equity capital. The cost of common stock capital cannot be directly observed in the market; it must be estimated. Two primary methods for estimating the cost of common stock capital are the capital asset pricing model (CAPM) and the constant dividend growth model.

Calculating the Weighted Average Cost of Capital

WACC Equation

WACC is calculated using the equation

Calculating WACC in Practice

The equation for calculating WACC is straightforward. However, issues come up when financial managers calculate WACC in practice. Both the weights of the equity components and the cost of the equity components are needed to calculate the WACC. The WACC that financial managers derive will depend on the assumptions and models they use to determine what weights and capital costs to use.

Capital Structure Choices

The Unlevered Firm

Let’s begin our discussion of capital structure choices by exploring the financing decisions you would face if you were to start a T-shirt business. Suppose that your hometown will host an international cycling competition. The competition itself will last for a month; cyclists will arrive early to train in the local climate. News coverage will be significant, meaning a lot of media personnel will be visiting your area. In addition to fans attending the event, it is expected that tourism will increase over the next year as recreational cyclists will want to ride the route of the professional race. You decide to operate a business for one year that will sell T-shirts highlighting this event.

The Levered Firm

Next, consider borrowing some of the money that you will need to start this T-shirt business. Although the cash flows from the business are uncertain, suppose you are certain that the business will generate at least \$18,000. (Perhaps you have a guaranteed order from the cycling competition sponsors.) If you borrowed \$17,000 at the risk-free interest rate of 4%, you would owe to the lenders at the end of the year. Because you are certain that you will generate at least \$18,000 in cash, which is greater than \$17,680, you can borrow the \$17,000 without any risk of defaulting.

Leverage and the WACC

What happens to the WACC as leverage is used? To figure this out, we must calculate the weights of debt and equity in the capital structure:

The Impact of Taxes

In perfect capital markets, the choice of capital structure will not impact the value of the firm or the cost of the firm’s financing. In the real world, however, capital markets are not perfect. One of the important market imperfections is the presence of corporate taxes. Because the choice of capital structure can impact the taxes that a company pays, in the real world, capital structure can impact the cost of capital and the firm’s value.

Optimal Capital Structure

Debt and Financial Distress

The more debt a company uses in its capital structure, the larger the dollar value of the interest tax shield. Why, then, do we not see firms using a capital structure composed 100% of debt to maximize this interest tax shield?

Trade-Off Theory

Trade-off theory weighs the advantages and disadvantages of using debt in the capital structure. The advantage of using debt is the interest tax shield. The disadvantage of using debt is that it increases the risk of financial distress and the costs associated with financial distress.

Alternative Sources of Funds

Preferred Shares

Although our calculations of WACC thus far have assumed that companies finance their assets only through debt and common equity, we saw at the beginning of the chapter that the basic WACC formula is

Issuing New Common Stock

An existing firm can acquire equity capital to expand its assets in two ways: the retention of earnings or the sale of new shares of stock. Thus far in the chapter, the cost of equity capital calculations have assumed that the earnings were being retained for equity capital financing.

Convertible Debt

Some companies issue convertible bonds. These corporate bonds have a provision that gives the bondholder the option of converting each bond held into a fixed number of shares of common stock. The number of common shares the bondholder would receive for each bond is known as the conversion ratio.

Financial Forecasting

Why It Matters

The Importance of Forecasting

Financial Statement Foundations

In Financial Statements, you were introduced to a firm called Clear Lake Sporting Goods. You learned about the four key financial statements: the income statement, balance sheet, statement of stockholders’ equity, and statement of cash flows. Each one provides a different view of the firm’s financial health and performance.

Balance Sheet Analysis

Fully understanding the items that are on the balance sheet and how they relate to one another and to other financial statements will help you create a financial forecast. In Financial Statements, you learned that on the classified balance sheet, both assets and liabilities are broken down into current and noncurrent categories. You also know that the balance sheet must live up to its name—it must balance. This means that total assets (what the company owns) must equal total liabilities and equity (what the company owes).

Income Statement Analysis

Like balance sheet analysis, income statement analysis is also quite helpful in preparing for the forecasting process. In Financial Statements, you learned that the income statement is commonly broken down into a few sections. Cost of goods sold is deducted from net sales to arrive at gross margin. Gross margin refers to the profits earned solely on the sale of the product itself, without consideration for the expenses incurred to run the business. Next, operating expenses are deducted to reflect operating income. Operating income reflects the profits of the core business function. Finally, other items, such as interest expense, tax expense, and other gains and losses, are deducted to arrive at net income, a.k.a. the *bottom line*. Each segment of the income statement is helpful for assessing past performance and estimating future expenses for a forecast.

Forecasting Sales

Sales as the Driver

A significant portion of a business’s costs are driven by how much it sells. Thus, the sales forecast is the necessary first step in preparing a financial forecast. Common costs driven by sales include direct product costs, direct labor costs, and other key variable costs (i.e., costs that vary proportionately to sales), such as sales commissions.

Looking to the Past

Forecasting sales is not always an easy task, as no one knows the future. We can, however, use the information we do have to forecast future sales with the greatest accuracy possible. Most firms start by looking at the past. A firm may look at past sales from a variety of prior periods. It’s common to look at the past 12 months to estimate the coming 12 months. Looking at 12 consecutive months helps identify seasonality of sales trends, what time of year sales tend to drop off and when they increase, possible sales spikes that might reoccur, and any other trends that tend to appear over a 12-month period. In [link], we see Clear Lake’s sales by month for the past 12 months.

Changes for the Future

It’s important to note that the past is not always a reliable predictor of the future. Circumstances can often change to make the future quite different from the past. The business itself may change, the economy can change, the customer base may undergo a shift in demographics or a change in buying habits, new competition may emerge, and so on. So while past performance is helpful, it is only one step in the process of forecasting sales.

Pro Forma Financials

Purpose of a Forecast

As mentioned earlier in the chapter, forecasts serve different purposes depending on who is using them. Our focus here, however, is the world of finance. In this realm, the key purpose of pro forma (future-looking) financial statements is to manage a firm’s cash flow and assess the overall value that the firm is generating through future sales growth. Growing just for the sake of growing doesn’t always yield favorable income for the firm. A larger top-line sales figure that results in lower net income doesn’t make sense in the grand scheme of things. The same is true of profitable sales that don’t generate enough cash flows at the right time. The firm may make a profit, but if it doesn’t manage the timing of its cash flows, it could be forced to shut down if it can’t cover the costs of payroll or keep the lights on. Forecasting helps assess both cash flow and the profitability of future growth. Managers can forecast cash flow using data from forecasted financial statements; this allows them to identify potential gaps in cash and plan ahead in order to either alter collection and payment policies or obtain funding to cover the gap in the timing of cash flows.

Length of a Forecast

Forecasts can generally be for any length of time. The length generally depends on the user’s needs. A one-year forecast, broken down by month, is quite typical. A firm will often go through a formal budgeting process near the end of its calendar or fiscal year to project financial plans and goals for the coming year. Once that is done, a rolling financial forecast is then done monthly to adjust as time moves on, more information becomes available, and circumstances change.

Common-Size Financials

As we saw earlier in the chapter, common-size analysis involves using historical financial statements as a basis for future forecasts. Financial statements provide a great starting point for analysis, as we can see the relationships between sales and costs on the income statement and the relationships between total assets and line items on the balance sheet.

Select Variables to Use

A simple way to begin a full financial statement forecast might be to simply use the common-size statements and forecast every item using historical percentages. It’s a logical way to begin a very rough draft of the forecast. However, several variables should be taken into consideration. First, managers must address the cost of an account and determine if it’s a variable or fixed item. Variable costs tend to vary directly and proportionally with production or sales volume. Common examples include direct labor and direct materials. Fixed costs, on the other hand, do not change when production or sales volume increases or decreases within the relevant range. Granted, if production were to increase or decrease by a large amount, fixed costs would indeed change. However, in normal month-to-month changes, fixed costs often remain the same. Common examples of fixed costs include rent and managerial salaries.

Determine Potential Changes in Variables

So far, we have focused on using historical common-size statements to create a draft (not a final version) of the forecast. This is because the past isn’t always a perfect indicator of the future, and our finances don’t always follow a linear pattern. We use the past as a good starting point; then, we must assess what else we know to fine-tune and make adjustments to the forecast.

Generating the Complete Forecast

Forecast the Income Statement

To arrive at a fully forecasted income statement, we use historical income statements, common-size income statements, and any additional information we have about future sales and costs, such as the effects of the economy and competition. As we saw earlier in the chapter, we begin with forecasted sales because they are the basis for many of the forecasted costs.

Forecast the Balance Sheet

Now that we have a reasonable income statement forecast, we can move on to the balance sheet. The balance sheet, however, is entirely different from the income statement. It requires a bit more research and additional assumptions. Just like the income statement, it’s often a work in progress. A first draft is a good starting point, but adjustments must be made once it is created, and all the interrelationships between the statements, cash flow in particular, are taken into consideration.

Linkages between the Forecasted Balance Sheet and the Income Statement

Notice that in the discussion in the prior section on the balance sheet forecast, a lot of the information in the forecasted income statement was used to generate the forecasted balance sheet. The balance sheet accounts generally depend on activity reported in the income statement. For example, for many firms, the balance in their accounts receivable account is tied to their sales. Looking at historical balances in the accounts receivable account and how those relate to historical sales will help determine how to use the forecasted future sales to estimate the future balance of accounts receivable.

Forecasting Cash Flow and Assessing the Value of Growth

Create a Cash Flow Forecast

A cash flow forecast isn’t overly complex, yet it is not easy to assemble because it requires making many assumptions about the future. A cash forecast begins with the beginning cash balance, adds anticipated cash inflows, and deducts anticipated cash outflows. This identifies cash surpluses and shortages.

Using a Cash Forecast to Determine Additional Funds Needed

Finally, at the end of the cash flow forecast, cash outflows are subtracted from the cash inflows. This identifies whether a cash surplus (extra) or cash deficit (not enough) exists for each month. For example, in [link], we see that in March, Clear Lake is forecasting \$4,800 of cash inflows and \$17,800 of total cash outflows, which results in a cash deficit of \$13,000.

Assessing the Value of Growth

It’s a fairly common assumption that most, if not all, businesses want to grow. While it certainly can be good as a firm to grow in size, growth just for the sake of growth isn’t necessarily a good goal. A firm can grow in size based on customers, employees, locations, or simply sales. However, that doesn’t mean that the growth will increase profits. Growth may increase profits, but this is not a safe assumption. Scaling up operations takes careful planning, which includes monitoring the profitability of the sales and, of course, the cash flow it would require. Growing a business can require more inventory, more locations, more equipment, and more manpower, all of which cost money. Even if the forecasted growth is profitable, it may pose problems from a cash flow perspective. It’s important that the firm review not only its forecasted income statement and balance sheet but also its cash forecast, as this can reveal some serious gaps in funding depending on the extent, timing, and nature of the planned growth.

Scenarios in Forecasting

Forecasting is almost never a linear process. In other words, we don’t do one forecast and call it good. The first draft is completed using historical data, and then changes are made a bit at a time as all potential variables are assessed for their impact on the forecast. It’s quite common to then use the work-in-progress forecast to complete scenario analysis. This is particularly true when the forecast is completed in Excel or other budgeting or forecasting software. Elements of the forecast can be changed to see what the overall impact would be to the firm. Assuming the forecast is set up using formulas in Excel or other software, a change to one figure or one variable would then “ripple” through the forecast to reflect the overall impact.

Sensitivity Analysis in Forecasting

Sensitivity analysis will often look at the change in just one variable rather than the entire scenario. It examines how sensitive a particular output (commonly net income) will be to a change in a particular underlying input (sales or costs, for example). What if sales are 10% more or less than forecasted? What if the prices the firm can charge its customers are 10% more or less? What if the cost of goods sold increases by 10%? The purpose is to see which variables are crucial to “get right.” It isn’t worth spending a lot of research dollars to make sure you are accurately predicting a variable if that variable won’t notably change the outcome. However, a slight change in other variables may have significant impact.

Using Excel to Create the Long-Term Forecast

Using the “Sheet”

Creating a budget in Excel can be very simple or extremely complex, depending on the size and complexity of the business and the number of formulas and dependencies that are written into the Excel workbook.

Using Excel Functions to Balance

Once we get a draft of the forecasts outlined, then the tinkering starts. Additional information can be used to adjust the formulas, as we saw with the 2% reduction in January sales for the forecasted income statement. Because we have linked most (though not all) of our expenses, subtotals, and statements together using formulas, management can also use the forecast workbook to perform scenario and sensitivity analyses, essentially asking “what if?” and looking at the results. When completed, however, before finalizing the forecast, it’s important that the financial statements are in balance (particularly the *balance sheet*, just as the name implies).

The Importance of Trade Credit and Working Capital in Planning

Why It Matters

What Is Working Capital?

Goal of Working Capital Management

The goal of working capital management is to maintain adequate working capital to

Components of Working Capital Management

In contrast to net working capital, gross working capital is synonymous with current assets, particularly those current assets that are either cash or cash equivalents or that will be converted to cash within a short period of time (i.e., in less than one year).

What Is Trade Credit?

How Trade Credit Works

Trade credit is common in B2B (business to business) transactions and is analogous to consumer spending using a credit card. With a credit card, a consumer opens an account with a credit limit. Most trade credit is offered to a company with an open account that has a credit limit up to which the company can purchase goods or services without having to pay the cash up front. As long as the payments are made in accordance with the terms of the agreement (also called credit terms), no interest or additional fees are charged on the credit balance except possibly for a fee for late payment.

Trade Credit Terms

Trade credit arrangements often carry credit terms that offer an incentive, called a discount, for a company (the buyer) to pay its bill within a relatively short period of time. Net terms, also referred to as the full credit period, are the number of days that a business (purchaser) has before they must pay their invoice. A common net term is Net 30, with payment due in full within 30 days of the invoice.

Cost of Trade Credit

Trade credit is often referred to as a no-cost type of financing. Unlike with other credit arrangements (e.g., bank loans, lines of credit, and commercial paper), there is usually no interest expense associated with trade credit, and as long as your account does not become delinquent, there are no special fees. Some accounts payable arrangements specify an interest penalty or a late fee when the account goes delinquent, but as long as payments are made on time, trade credit is thought of as a low-cost source of working capital.

Cash Management

Cash Holdings

The cash holdings of a company are more than the currency and coins in the cash registers or the treasury vault. Cash includes currency and coins, but usually those amounts are insignificant compared to the cash holdings of checks to be deposited in the company’s bank account and the balances in the company’s checking accounts.

Receivables Management

Determining the Credit Policy

A company’s credit policy encompasses rules of credit granting and procedures for the collections of accounts. It’s how a company will process credit applications, utilize credit scoring and credit bureaus, analyze financial statements, make credit limit decisions, and conduct collection efforts when accounts become *delinquent* (still outstanding after their due date).

Establishing Credit Terms

Trade credit terms were discussed earlier. Recall that part of the terms and conditions of a sale are the credit terms—elements of a sales agreement (contract) that indicate when payment is due, possible discounts (for quick payments), and any late fee charges.

Monitoring Accounts Receivables

Financial managers monitor accounts receivables using some basic tools. One of those tools is the accounts receivable aging schedule (report). To prepare the aging schedule, a classifying of customer account balances is performed with age as the sorting attribute.

Accounts Receivables and Notes Receivable

An accounts receivable is an informal arrangement between a seller (a company) and customer. Accounts receivable are usually paid within a month or two. Accounts receivable don’t require any complex paperwork, are evidenced by an invoice, and do not involve interest payments. In contrast, a note receivable is a more formal arrangement that is evidence by a legal contract called a promissory note specifying the payment amount and date and interest.

Inventory Management

Inventory Cost

Controlling inventory costs minimizes working capital needs and, ultimately, the cost of goods sold. Inventory management impacts profitability; minimizing cost of goods sold means maximizing gross profit (Gross Profit = Net Sales Less Cost of Goods Sold).

Benefit of Holding Inventory

Brick-and-mortar stores need goods in stock so that the customer can see and touch the product and be able to acquire it when they need it. Customers are disappointed if they cannot see and touch the item or if they find out upon arrival at the store that it is out of stock.

Using Excel to Create the Short-Term Plan

Sample One-Year (Annual) Operating Budget

Preparing an annual operating budget can be a complex task. In essence, a company budget is a series of budgets, many of which are interrelated.

Sample Cash Budget

A cash budget is the last budget to be prepared and is often part of the financial budget (cash budget, budgeted income statement, and budgeted balance sheet). The purpose of the cash budget is to estimate cash flows, to help ensure sufficient cash balances are maintained during the planning period, and to plan for external financing during periods of cash deficits.

Risk Management and the Financial Manager

Why It Matters

The Importance of Risk Management

What Is Risk?

The job of the financial manager is to maximize the value of the firm for the owners, or shareholders, of the company. The three major areas of focus for the financial manager are the size, the timing, and the riskiness of the cash flows of the company. Broadly, the financial manager should work to

Risk and Firm Value

You would expect the managers of Starbucks Corporation to know a lot about coffee. They must also know a lot about risk. It is not surprising that the term *coffee* appears in the text of the company’s 2020 annual report 179 times, given that the company’s core business is coffee. It might be surprising, however, that the term *risk* appears in the report 99 times.[footnote] Given that the text of the annual report is less than 100 pages long, the word *risk* appears, on average, more than once per page.

Starbucks. *Starbucks Fiscal 2020 Annual Report*. Seattle: Starbucks Corporation, 2020. https://s22.q4cdn.com/869488222/files/doc_financials/2020/ar/2020-Starbucks-Annual-Report.pdf

Commodity Price Risk

Long-Term Contracts

One method of hedging the risk of volatile input prices is for a firm to enter into long-term contracts with its suppliers. Starbucks, for example, could enter into an agreement with a coffee farmer to purchase a particular quantity of coffee beans at a predetermined price over the next several years.

Vertical Integration

A common method of handling the risk associated with volatile input prices is vertical integration, which involves the merger of a company and its supplier. For Starbucks, a vertical integration would involve Starbucks owning a coffee bean farm. If the price of coffee beans rises, the firm’s costs increase and the supplier’s revenues rise. The two companies can offset these risks by merging.

Futures Contracts

Another method of hedging commodity price risk is the use of a futures contract. A commodity futures contract is designed to avoid some of the disadvantages of entering into a long-term contract with a supplier. A futures contract is an agreement to trade an asset on some future date at a price locked in today. Futures exist for a range of commodities, including natural resources such as oil, natural gas, coal, silver, and gold and agricultural products such as soybeans, corn, wheat, rice, sugar, and cocoa.

Exchange Rates and Risk

Exchange Rates

The costs to companies are impacted when the prices of the raw materials they use change. Very little coffee is grown in the United States. This means that all of those coffee beans that Starbucks uses in its espresso machines in Seattle, New York, Miami, and Houston were bought from suppliers outside of the United States. Brazil is the largest coffee-producing country, exporting about one-third of the world’s coffee.[footnote] When a company purchases raw materials from a supplier in another country, the company needs not just money but the money that is used in that country to make the purchase. Thus, the company is concerned about the exchange rate, or the price of the foreign currency.

Global Agricultural Information Network. *Brazil: Coffee Annual 2019*. GAIN Report No. BR19006. Washington, DC: USDA Foreign Agricultural Service, May 2019. https://apps.fas.usda.gov/newgainapi/api/report/downloadreportbyfilename?filename=Coffee%20Annual_Sao%20Paulo%20ATO_Brazil_5-16-2019.pdf

Exchange Rate Risks

Starbucks, like other firms that are engaged in international business, faces currency exchange rate risk. Changes in exchange rates can impact a business in several ways. These risks are often classified as transaction, translation, or economic risk.

Hedging

Just as companies may practice hedging techniques to reduce their commodity risk exposure, they may choose to hedge to reduce their currency risk exposure. The types of futures contracts that we discussed earlier in this chapter exist for currencies as well as for commodities. A company that knows that it will need Korean won later this year to purchase raw materials from a South Korean supplier, for example, can purchase a futures contract for Korean won.

Interest Rate Risk

Measuring Interest Rate Risk

Suppose that a company is supposed to pay a bill of \$1,000 in 10 years. The present value of this bill depends on the level of interest rates. If the interest rate is 5%, the present value of the bill is . If the interest rate rises to 6%, the present value of the bill is . The increase in the interest rate by 1% causes the present value of the expected cash flow to fall by .

Swap-Based Hedging

As the name suggests, a swap involves two parties agreeing to swap, or exchange, something. Generally, the two parties, known as counterparties, are swapping obligations to make specified payment streams.