Robert C. Higgins
Analysis for Financial Management E l e v en t h Ed i t i o n
Analysis for Financial Management
The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor
FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition Cornett, Adair, and Nofsinger M: Finance Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Eleventh Edition Kellison Theory of Interest Third Edition
Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition
INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Ninth Edition Bodie, Kane, and Marcus Investments Tenth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition
FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition
Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition
INTERNATIONAL FINANCE Eun and Resnick International Financial Management Seventh Edition
REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth Edition
FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Achieve Financial Literacy Fifth Edition Kapoor, Dlabay, and Hughes Personal Finance Eleventh Edition Walker and Walker Personal Finance: Building Your Future First Edition
Analysis for Financial Management
ROBERT C. HIGGINS Marguerite Reimers
Emeritus Professor of Finance The University of Washington
JENNIFER L. KOSKI John B. and Delores L. Fery
Faculty Fellow Associate Professor of Finance The University of Washington
TODD MITTON Ned C. Hill Professor of Finance Brigham Young University
ANALYSIS FOR FINANCIAL MANAGEMENT, ELEVENTH EDITION
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Higgins, Robert C. Analysis for financial management/Robert C. Higgins ; with Jennifer Koski and Todd Mitton.—
Eleventh edition. pages cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate)
ISBN 978-0-07-786178-0 (alk. paper) 1. Corporations–Finance. I. Title. HG4026.H496 2016 658.15’1—dc23
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In memory of my son
PART ONE Assessing the Financial Health of the Firm 1
1 Interpreting Financial Statements 3
2 Evaluating Financial Performance 39
PART TWO Planning Future Financial Performance 79
3 Financial Forecasting 81 4 Managing Growth 115
PART THREE Financing Operations 141
5 Financial Instruments and Markets 143
6 The Financing Decision 195
PART FOUR Evaluating Investment Opportunities 237
7 Discounted Cash Flow Techniques 239
8 Risk Analysis in Investment Decisions 289
9 Business Valuation and Corporate Restructuring 343
GLOSSARY 393 SUGGESTED ANSWERS TO
ODD-NUMBERED PROBLEMS 405 INDEX 437
PART ONE ASSESSING THE FINANCIAL HEALTH OF THE FIRM 1
Chapter 1 Interpreting Financial Statements 3 The Cash Flow Cycle 3 The Balance Sheet 6
Current Assets and Liabilities 11 Shareholders’ Equity 12
The Income Statement 12 Measuring Earnings 12
Sources and Uses Statements 17 The Two-Finger Approach 18
The Cash Flow Statement 19 Financial Statements and the
Value Problem 24 Market Value vs. Book Value 24 Economic Income vs. Accounting Income 27 Imputed Costs 28
Summary 31 Additional Resources 32 Problems 33
Chapter 2 Evaluating Financial Performance 39 The Levers of Financial Performance 39 Return on Equity 40
The Three Determinants of ROE 40 The Profit Margin 42 Asset Turnover 44 Financial Leverage 49
Is ROE a Reliable Financial Yardstick? 55 The Timing Problem 56 The Risk Problem 56
The Value Problem 58 ROE or Market Price? 59
Ratio Analysis 62 Using Ratios Effectively 62 Ratio Analysis of Stryker Corporation 63
Summary 71 Additional Resources 72 Problems 73
PART TWO PLANNING FUTURE FINANCIAL PERFORMANCE 79
Chapter 3 Financial Forecasting 81 Pro Forma Statements 81
Percent-of-Sales Forecasting 82 Interest Expense 88 Seasonality 89
Pro Forma Statements and Financial Planning 89
Computer-Based Forecasting 90 Coping with Uncertainty 94
Sensitivity Analysis 94 Scenario Analysis 95 Simulation 96
Cash Flow Forecasts 98 Cash Budgets 99 The Techniques Compared 102 Planning in Large Companies 103 Summary 105 Additional Resources 106 Problems 108
Chapter 4 Managing Growth 115 Sustainable Growth 116
The Sustainable Growth Equation 116 vii
Too Much Growth 119 Balanced Growth 119 Under Armour’s Sustainable Growth Rate 121 “What If” Questions 122
What to Do When Actual Growth Exceeds Sustainable Growth 122
Sell New Equity 123 Increase Leverage 125 Reduce the Payout Ratio 125 Profitable Pruning 126 Outsourcing 127 Pricing 127 Is Merger the Answer? 127
Too Little Growth 128 What to Do When Sustainable Growth
Exceeds Actual Growth 129 Ignore the Problem 130 Return the Money to Shareholders 130 Buy Growth 131
Sustainable Growth and Pro Forma Forecasts 132
New Equity Financing 132 Why Don’t U.S. Corporations Issue More
Equity? 135 Summary 136 Additional Resources 137 Problems 138
PART THREE FINANCING OPERATIONS 141
Chapter 5 Financial Instruments and Markets 143 Financial Instruments 144
Bonds 145 Common Stock 152 Preferred Stock 156
Financial Markets 158 Venture Capital Financing 158 Private Equity 160 Initial Public Offerings 162
Seasoned Issues 163 Issue Costs 168
Efficient Markets 169 What Is an Efficient Market? 170 Implications of Efficiency 172
Appendix Using Financial Instruments to Manage Risks 174
Forward Markets 175 Speculating in Forward Markets 176 Hedging in Forward Markets 177 Hedging in Money and Capital Markets 180 Hedging with Options 180 Limitations of Financial Market Hedging 183 Valuing Options 185
Summary 188 Additional Resources 189 Problems 191
Chapter 6 The Financing Decision 195 Financial Leverage 197 Measuring the Effects of Leverage on a
Business 201 Leverage and Risk 203 Leverage and Earnings 206
How Much to Borrow 208 Irrelevance 208 Tax Benefits 210 Distress Costs 211 Flexibility 215 Market Signaling 217 Management Incentives 220 The Financing Decision and Growth 221
Selecting a Maturity Structure 224 Inflation and Financing Strategy 225
Appendix The Irrelevance Proposition 225
No Taxes 226 Taxes 228
Summary 230 Additional Resources 231 Problems 232
PART FOUR EVALUATING INVESTMENT OPPORTUNITIES 237
Chapter 7 Discounted Cash Flow Techniques 239 Figures of Merit 240
The Payback Period and the Accounting Rate of Return 241
The Time Value of Money 242 Equivalence 247 The Net Present Value 248 The Benefit-Cost Ratio 250 The Internal Rate of Return 250 Uneven Cash Flows 254 A Few Applications and Extensions 255 Mutually Exclusive Alternatives and Capital
Rationing 259 The IRR in Perspective 260
Determining the Relevant Cash Flows 260
Depreciation 262 Working Capital and Spontaneous
Sources 264 Sunk Costs 265 Allocated Costs 266 Cannibalization 267 Excess Capacity 268 Financing Costs 270
Appendix Mutually Exclusive Alternatives and
Capital Rationing 272 What Happened to the Other
$578,000? 273 Unequal Lives 274 Capital Rationing 277 The Problem of Future Opportunities 278 A Decision Tree 279
Summary 280 Additional Resources 281 Problems 282
Chapter 8 Risk Analysis in Investment Decisions 289 Risk Defined 291
Risk and Diversification 293 Estimating Investment Risk 295
Three Techniques for Estimating Investment Risk 296
Including Risk in Investment Evaluation 297 Risk-Adjusted Discount Rates 297
The Cost of Capital 298 The Cost of Capital Defined 299 Cost of Capital for Stryker Corporation 301 The Cost of Capital in Investment Appraisal 308 Multiple Hurdle Rates 309
Four Pitfalls in the Use of Discounted Cash Flow Techniques 311
The Enterprise Perspective versus the Equity Perspective 312
Inflation 314 Real Options 315 Excessive Risk Adjustment 321
Economic Value Added 322 EVA and Investment Analysis 323 EVA’s Appeal 325
A Cautionary Note 326 Appendix Asset Beta and Adjusted Present
Value 326 Beta and Financial Leverage 327 Using Asset Beta to Estimate Equity
Beta 328 Asset Beta and Adjusted Present Value 329
Summary 332 Additional Resources 333 Problems 335
Chapter 9 Business Valuation and Corporate Restructuring 343 Valuing a Business 345
Assets or Equity? 346
Dead or Alive? 346 Minority Interest or Control? 348
Discounted Cash Flow Valuation 349 Free Cash Flow 350 The Terminal Value 351 A Numerical Example 354 Problems with Present Value Approaches to
Valuation 357 Valuation Based on Comparable Trades 357
Lack of Marketability 361 The Market for Control 362
The Premium for Control 362 Financial Reasons for Restructuring 364
The Empirical Evidence 372 The Cadbury Buyout 374 Appendix The Venture Capital Method of
Valuation 376 The Venture Capital Method—One
Financing Round 377
The Venture Capital Method—Multiple Financing Rounds 380
Why Do Venture Capitalists Demand Such High Returns? 382
Summary 384 Additional Resources 385 Problems 386
Glossary 393 Suggested Answers to
Odd-Numbered Problems 405 Index 437
Like its predecessors, the eleventh edition of Analysis for Financial Man- agement is for nonfinancial executives and business students interested in the practice of financial management. It introduces standard techniques and recent advances in a practical, intuitive way. The book assumes no prior background beyond a rudimentary, and perhaps rusty, familiarity with financial statements—although a healthy curiosity about what makes business tick is also useful. Emphasis throughout is on the managerial im- plications of financial analysis.
Analysis for Financial Management should prove valuable to individuals interested in sharpening their managerial skills and to executive program participants. The book has also found a home in university classrooms as the sole text in Executive MBA and applied finance courses, as a compan- ion text in case-oriented courses, and as a supplementary reading in more theoretical finance courses.
Analysis for Financial Management is my attempt to translate into another medium the enjoyment and stimulation I have received over the past four decades working with executives and college students. This experience has convinced me that financial techniques and concepts need not be abstract or obtuse; that recent advances in the field such as agency theory, market sig- naling, market efficiency, capital asset pricing, and real options analysis are important to practitioners; and that finance has much to say about the broader aspects of company management. I also believe that any activity in which so much money changes hands so quickly cannot fail to be interesting.
Part One looks at the management of existing resources, including the use of financial statements and ratio analysis to assess a company’s finan- cial health, its strengths, weaknesses, recent performance, and future prospects. Emphasis throughout is on the ties between a company’s oper- ating activities and its financial performance. A recurring theme is that a business must be viewed as an integrated whole and that effective financial management is possible only within the context of a company’s broader operating characteristics and strategies.
The rest of the book deals with the acquisition and management of new resources. Part Two examines financial forecasting and planning with par- ticular emphasis on managing growth and decline. Part Three considers the financing of company operations, including a review of the principal security types, the markets in which they trade, and the proper choice of security type by the issuing company. The latter requires a close look at fi- nancial leverage and its effects on the firm and its shareholders.
Part Four addresses the use of discounted cash flow techniques, such as the net present value and the internal rate of return, to evaluate invest- ment opportunities. It also deals with the difficult task of incorporating risk into investment appraisal. The book concludes with an examination of business valuation and company restructuring within the context of the ongoing debate over the proper roles of shareholders, boards of directors, and incumbent managers in governing America’s public corporations.
An extensive glossary of financial terms and suggested answers to odd- numbered, end-of-chapter problems follow the last chapter.
Changes in the Eleventh Edition Readers familiar with earlier editions of Analysis for Financial Management will notice a number of changes here. Most important, two talented young teachers and scholars have joined me in preparing the eleventh edition. Jennifer Koski, a colleague at the University of Washington, and Todd Mitton, at Brigham Young University, have done yeomen’s work ushering the book into the digital era. I much appreciate their many contributions. You should expect their responsibilities to grow in any future editions.
A second noteworthy change is the book’s partnership with McGraw- Hill’s Connect. As the following section explains in more detail, Connect is the lynchpin of the publisher’s digital initiative. Combining elements of computerized instruction and electronic publishing, it promises signifi- cant benefits to readers and instructors alike. I am anxious to watch McGraw-Hill turn this promise into reality. There will undoubtedly be bumps along the way, but I am confident we are on the right path.
Other more conventional changes and refinements in the eleventh edi- tion include:
• An introductory discussion of crowdfunding and its possible future. • A new treatment of present value calculations, gracefully introducing
computer spreadsheets as the principal means for solving present value problems, while eliminating reference to present value tables.
• Explicit discussion of present value problems involving uneven cash flows. • Enhanced ‘recommended resources’ at the end of each chapter,
including two-dimensional bar codes (QR codes) and recommended mobile apps for Android and iOS devices.
• Added discussion of payout policy, illustrated by Apple Inc.’s recent experience.
• Updated details on the impact of U.S. regulation on financial manage- ment, including the Dodd-Frank Act and the JOBS Act of 2012.
• Better integration of T-accounts and financial statements. • Use of Stryker Corporation, a leading medical technology company, as
an extended example throughout the book.
McGraw-Hill’s Connect connect.mheducation.com
McGraw-Hill’s Connect® is an online assess- ment solution that connects students with the
tools and resources they’ll need to achieve success. Connect allows faculty to create and deliver exams easily with selectable test bank items. Instruc- tors can also build their own questions into the system for homework or practice. Readers have access to the student resources that accompany this text, as well as McGraw-Hill’s adaptive self-study technology in Learn- Smart and Smartbook.
Connect supports this book in several important ways. The student re- sources include:
• Excel spreadsheets referenced in end-of-chapter problems. • Supplementary chapter problems and suggested answers. • Complimentary software programs described in Additional Resources
at the end of several chapters.
If you are not enrolled in a course using Connect, you can access these stu- dent resources with a free trial by following the instructions accompanying the access code acquired with the book. I encourage you to download these items now for later use. If you are enrolled in a Connect course, ask your instructor for your Connect course URL to access the course resources.
Intended primarily for instructor use, the Connect Instructor Library houses, among other things: • A test bank. • PowerPoint presentations. • An annotated list of suggested cases to accompany the book. • Suggested answers to even-numbered problems.
To access the Instructor Library, log in to your Connect course, select the “Library” tab, and then select “Instructor Resources.”
Connect’s adaptive learning resources, LearnSmart and Smartbook, promise to speed and enrich your mastery of the book by creating a per- sonalized, flexible program of study.
For more information about Connect, LearnSmart, or Smartbook, go to connect.mheducation.com, or contact a McGraw-Hill sales representative. For 24-hour support you can e-mail a Product Specialist or search Frequently Asked Questions at mhhe.com/support. Or for a human, call 800-331-5094.
A word of caution: Analysis for Financial Management emphasizes the ap- plication and interpretation of analytic techniques in decision making. These techniques have proved useful for putting financial problems into perspective and for helping managers anticipate the consequences of their
actions. But techniques can never substitute for thought. Even with the best technique, it is still necessary to define and prioritize issues, to mod- ify analysis to fit specific circumstances, to strike the proper balance be- tween quantitative analysis and more qualitative considerations, and to evaluate alternatives insightfully and creatively. Mastery of technique is only the necessary first step toward effective management.
I am indebted to Andy Halula of Standard & Poor’s for providing timely updates to Research Insight. The ability to access current Compustat data on CD continues to be a great help in providing timely examples of current practice. I also owe a large thank you to the following people for their in- sightful reviews of the 10th edition and their constructive advice. They did an excellent job; any remaining shortcomings are mine not theirs.
Bruce Campbell Franklin University Charles Evans Florida Atlantic University, Boca Raton Jaemin Kim San Diego State University, San Diego Inayat Ullah Mangla Western Michigan University, Kalamazoo
John Strong College of William & Mary Andy Terry University of Arkansas, Little Rock Marilyn Wiley University of North Texas Jaime Zender University of Colorado, Boulder
I appreciate the exceptional direction provided by Chuck Synovec, Noelle Bathurst, Melissa Caughlin, Dheeraj Chahal, and Mary Jane Lampe of McGraw-Hill on the development, design, and editing of the book. Bill Alberts, David Beim, Dave Dubofsky, Bob Keeley, Jack McDonald, George Parker, Megan Partch, Larry Schall, and Alan Shapiro have my continuing gratitude for their insightful help and support throughout the book’s evolu- tion. Thanks go as well to my daughter, Sara Higgins, for writing and editing the accompanying software. Finally, I want to express my appreciation to students and colleagues at the University of Washington, Stanford University, IMD, The Pacific Coast Banking School, The Koblenz Graduate School of Management, The Gordon Institute of Business Science, The Swiss International Business School ZfU AG, Boeing, and Microsoft, among others, for stimulating my continuing interest in the practice and teaching of financial management.