Student: Stanley

Read the Case Study documents.

Resources: Gale Force Surfing , Berkshire Instruments KFC and the Colonel , and Harrod's Sporting Goods Read the Case Study documents. Select a case study that resonates with you from a professional perspective. Post a 90- to 175-word discussion message sharing which case you chose and why it was chosen. Include at least one point from the case that stood out to you and why it did. Submit the assignment. 3 Financial Analysis LEARNING OBJECTIVES LO 3-1 Ratio analysis provides a meaningful comparison of a company to its industry. LO 3-2 Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization. LO 3-3 The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders. LO 3-4 Trend analysis shows company performance over time. LO 3-5 Reported income must be further evaluated to identify sources of distortion. If you’re in the market for dental products, look no further than Colgate-Palmolive. The firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection, whitening enhancement), as well as every shape and size of toothbrush. While you’re getting ready for the day, also consider its soaps, shampoos, and deodorants (Speed Stick, Lady Speed Stick, etc.). For those of you who decide to stay home and clean your apartment or dorm room, Colgate-Palmolive will provide you with Ajax, Fab, and a long list of other cleaning products. All this is somewhat interesting, but why mention these subjects in a finance text? Well, Colgate-Palmolive has had some interesting profit numbers over the last three years. Its profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While these numbers are higher than those of the average company, the 2014 number that blows analysts away is its return on stockholders’ equity of 167.8 percent (the norm is 15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list the number as not meaningful (NMF). The major reason for this abnormally high return is its high debt-to-total-asset ratio of 81 percent. This means that the firm’s debt represents 81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity. In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on stockholders’ equity, partially because it is heavily financed by stockholders’ equity at 66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This kind of analysis will be found in the financial ratios discussion in this chapter. In Chapter 2, we examined the basic assumptions of accounting and the various components that make up the financial statements of the firm. We now use this fundamental material as a springboard into financial analysis—to evaluate the financial performance of the firm. The format for the chapter is twofold. In the first part we use financial ratios to evaluate the relative success of the firm. Various measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends. Page 57 In the second part of the chapter we explore the impact of inflation and disinflation on financial operations. You will begin to appreciate the impact of rising prices (or at times, declining prices) on the various financial ratios. The chapter concludes with a discussion of how other factors—in addition to price changes—may distort the financial statements of the firm. Terms such as net income to sales, return on investment, and inventory turnover take on much greater meaning when they are evaluated through the eyes of a financial manager who does more than merely pick out the top or bottom line of an income statement. The examples in the chapter are designed from the viewpoint of a financial manager (with only minor attention to accounting theory). Ratio Analysis Ratios are used in much of our daily life. We buy cars based on miles per gallon; we evaluate baseball players by earned run and batting averages, basketball players by field goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significance of the resultant number. Financial ratios are used to weigh and evaluate the operating performance of the firm. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may appear satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio analysis. For example, are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10 percent “profit margin” ratio), that might be quite satisfactory—whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this “number-crunching” process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, corporate governance, sustainability, and numerous other factors. Many libraries and universities subscribe to financial services such as Bloomberg, Standard & Poor’s Industry Surveys and Corporate Reports, the Value Line Investment Survey, Factset, and Moody’s Corporation. Standard & Poor’s also leases a computer database called S&P IQ to banks, corporations, investment organizations, and universities. Compustat contains financial statement data on over 16,000 companies for a 20-year period. Ratios can also be found on such websites as finance.yahoo.com. These data can be used for countless ratios to measure corporate performance. The ratios used in this text are a sample of the major ratio categories used in business, but other classification systems can also be constructed. Classification System We will separate 13 significant ratios into four primary categories. A. Profitability ratios 1. Profit margin 2. Return on assets (investment) 3. Return on equity Page 58 B. Asset utilization ratios 4. Receivable turnover 5. Average collection period 6. Inventory turnover 7. Fixed asset turnover 8. Total asset turnover C. Liquidity ratios 9. Current ratio 10. Quick ratio D. Debt utilization ratios 11. Debt to total assets 12. Times interest earned 13. Fixed charge coverage The first grouping, the profitability ratios, allows us to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital. Many of the problems related to profitability can be explained, in whole or in part, by the firm’s ability to effectively employ its resources. Thus the next category is asset utilization ratios. Under this heading, we measure the speed at which the firm is turning over accounts receivable, inventory, and longer-term assets. In other words, asset utilization ratios measure how many times per year a company sells its inventory or collects all of its accounts receivable. For long-term assets, the utilization ratio tells us how productive the fixed assets are in terms of generating sales. In category C, the liquidity ratios, the primary emphasis moves to the firm’s ability to pay off short-term obligations as they come due. In category D, debt utilization ratios, the overall debt position of the firm is evaluated in light of its asset base and earning power. The users of financial statements will attach different degrees of importance to the four categories of ratios. To the potential investor or security analyst, the critical consideration is profitability, with secondary consideration given to such matters as liquidity and debt utilization. For the banker or trade creditor, the emphasis shifts to the firm’s current ability to meet debt obligations. The bondholder, in turn, may be primarily influenced by debt to total assets—while also eyeing the profitability of the firm in terms of its ability to cover debt obligations. Of course, the experienced analyst looks at all the ratios, but with different degrees of attention. Ratios are also important to people in the various functional areas of a business. The marketing manager, the head of production, the human resource manager, and many of their colleagues must all be familiar with ratio analysis. For example, the marketing manager must keep a close eye on inventory turnover; the production manager must evaluate the return on assets; and the human resource manager must look at the effect of “fringe benefits” expenditures on the return on sales. The Analysis Page 59 Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Saxton Company, as presented in Table 3-1. The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry. Table 3-1 Financial statement for ratio analysis SAXTON COMPANY Income Statement For the Year Ended December 31, 2015 Sales (all on credit) $4,000,000 Cost of goods sold 3,000,000 Gross profit $1,000,000 Selling and administrative expense* 450,000 Operating profit $ 550,000 Interest expense 50,000 Extraordinary loss 200,000 Net income before taxes $ 300,000 Taxes (33%) 100,000 Net income $ 200,000 *Includes $50,000 in lease payments. Balance Sheet As of December 31, 2015 Assets Cash $ 30,000 Marketable securities 50,000 Accounts receivable 350,000 Inventory 370,000 Total current assets $ 800,000 Net plant and equipment 800,000 Net assets $1,600,000 Liabilities and Stockholders’ Equity Accounts payable $ 50,000 Notes payable 250,000 Total current liabilities $ 300,000 Long-term liabilities 300,000 Total liabilities $ 600,000 Common stock 400,000 Retained earnings 600,000 Total liabilities and stockholders’ equity $1,600,000 A. Profitability Ratios We first look at profitability ratios. The appropriate ratio is computed for the Saxton Company and is then compared to representative industry data. Page 60 In analyzing the profitability ratios, we see the Saxton Company shows a lower return on the sales dollar (5 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 12.5 percent exceeds the industry norm of 10 percent. There is only one possible explanation for this occurrence—a more rapid turnover of assets than that generally found within the industry. This is verified in Ratio 2b, in which sales to total assets is 2.5 for the Saxton Company and only 1.5 for the industry. Thus Saxton earns less on each sales dollar, but it compensates by turning over its assets more rapidly (generating more sales per dollar of assets). Return on total assets as described through the two components of profit margin and asset turnover is part of the Du Pont system of analysis. Return on assets (investment) = Profit margin × Asset turnover The Du Pont company was a forerunner in stressing that satisfactory return on assets may be achieved through high profit margins or rapid turnover of assets, or a combination of both. We shall also soon observe that under the Du Pont system of analysis, the use of debt may be important. The Du Pont system causes the analyst to examine the sources of a company’s profitability. Since the profit margin is an income statement ratio, a high profit margin indicates good cost control, whereas a high asset turnover ratio demonstrates efficient use of the assets on the balance sheet. Different industries have different operating and financial structures. For example, in the heavy capital goods industry the emphasis is on a high profit margin with a low asset turnover—whereas in food processing, the profit margin is low and the key to satisfactory returns on total assets is a rapid turnover of assets. Equally important to a firm is its return on equity or ownership capital. For the Saxton Company, return on equity is 20 percent, versus an industry norm of 15 percent. Thus the owners of Saxton Company are more amply rewarded than are other shareholders in the industry. This may be the result of one or two factors: a high return on total assets or a generous utilization of debt or a combination thereof. This can be seen through Ratio 3b, which represents a modified or second version of the Du Pont formula. Page 61 Note that the numerator, return on assets, is taken from Ratio 2b, which represents the initial version of the Du Pont formula (Return on assets = Net income/Sales × Sales/Total assets). Return on assets is then divided by [1 − (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Saxton Company, the modified version of the Du Pont formula shows: Actually the return on assets of 12.5 percent in the numerator is higher than the industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Please see Ratio 3b to confirm these facts. Both the numerator and denominator contribute to a higher return on equity than the industry average (20 percent versus 15 percent). Note that if the firm had a 50 percent debt-to-assets ratio, return on equity would go up to 25 percent.1 This does not necessarily mean debt is a positive influence, only that it can be used to boost return on equity. The ultimate goal for the firm is to achieve maximum valuation for its securities in the marketplace, and this goal may or may not be advanced by using debt to increase return on equity. Because debt represents increased risk, a lower valuation of higher earnings is possible.2 Every situation must be evaluated individually. You may wish to review Figure 3-1, which illustrates the key points in the Du Pont system of analysis. Figure 3-1 Du Pont analysis Page 62 As an example of the Du Pont analysis, Table 3-2 on the next page compares two well-known retail store chains, Walmart and Abercrombie & Fitch. In 2014, Abercrombie was more profitable in terms of profit margins (4.2 percent versus 3.3 percent). However, Walmart had a 19.5 percent return on equity versus 10.5 percent for Abercrombie. Why the reversal in performance? It comes back to the Du Pont system of analysis. Walmart turned over its assets 3.62 times a year versus a slower 2.15 times for Abercrombie. Walmart was following the philosophy of its late founder Sam Walton: Give the customer a bargain in terms of low prices (and low profit margins) but move the merchandise quickly. Walmart was able to turn a low return on sales (profit margin) into a good return on assets. Furthermore, its higher debt ratio (37.7 percent for Walmart versus 13.4 percent for Abercrombie) allowed Walmart to turn its higher return on assets into an even higher relative return on equity (19.5 percent versus 10.5 percent). For some firms, a higher debt ratio might indicate additional risk, but for stable Walmart, this is not the case. Finally, as a general statement in computing all the profitability ratios, the analyst must be sensitive to the age of the assets. Plant and equipment purchased 15 years ago may be carried on the books far below its replacement value in an inflationary economy. A 20 percent return on assets purchased in the early 1990s may be inferior to a 15 percent return on newly purchased assets. B. Asset Utilization Ratios The second category of ratios relates to asset utilization, and the ratios in this category may explain why one firm can turn over its assets more rapidly than another. Notice that all of these ratios relate the balance sheet (assets) to the income statement (sales). The Saxton Company’s rapid turnover of assets is primarily explained in Ratios 4, 5, and 6. Saxton collects its receivables faster than does the industry. This is shown by the receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by the average collection period of 32 days, which is 4 days faster than the industry norm. The average collection period suggests how long, on average, customers’ accounts stay on the books. The Saxton Company has $350,000 in accounts receivable and $4,000,000 in credit sales, which when divided by 360 days yields average daily credit sales of $11,111. We divide accounts receivable of $350,000 by average daily credit sales of $11,111 to determine how many days credit sales are on the books (32 days). Page 63 Table 3-2 Return on Equity: Walmart vs. Abercrombie & Fitch using the Du Pont Method of Analysis, 2014 Data: December 31, 2014 In addition, the firm turns over its inventory 10.8 times per year as contrasted with an industry average of 7 times.3 This tells us that Saxton generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efficient inventory-ordering and cost-control methods. The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry (5 versus 5.4) as shown above. This is a relatively minor consideration in view of the rapid movement of inventory and accounts receivable. Finally, the rapid turnover of total assets is again indicated (2.5 versus 1.5). C. Liquidity Ratios After considering profitability and asset utilization, the analyst needs to examine the liquidity of the firm. The Saxton Company’s liquidity ratios fare well in comparison with the industry. Further analysis might call for a cash budget to determine if the firm can meet each maturing obligation as it comes due. D. Debt Utilization Ratios The last grouping of ratios, debt utilization, allows the analyst to measure the prudence of the debt management policies of the firm. Page 64 Debt to total assets of 37.5 percent as shown in Ratio 11 is slightly above the industry average of 33 percent, but well within the prudent range of 50 percent or less.4 Ratios for times interest earned and fixed charge coverage show that the Saxton Company debt is being well managed compared to the debt management of other firms in the industry. Times interest earned indicates the number of times that income before interest and taxes covers the interest obligation (11 times). The higher the ratio, the stronger is the interest-paying ability of the firm. The figure for income before interest and taxes ($550,000) in the ratio is the equivalent of the operating profit figure presented in the upper part of Table 3-1. Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. In the present case, the Saxton Company has lease obligations of $50,000 as well as the $50,000 in interest expenses. Thus the total fixed charge financial obligation is $100,000. We also need to know the income before all fixed charge obligations. In this case, we take income before interest and taxes (operating profit) and add back the $50,000 in lease payments. Income before interest and taxes $550,000 Lease payments 50,000 Income before fixed charges and taxes $600,000 The fixed charges are safely covered 6 times, exceeding the industry norm of 5.5 times. The various ratios are summarized in Table 3-3. The conclusions reached in comparing the Saxton Company to industry averages are generally valid, though exceptions may exist. For example, a high inventory turnover is considered “good” unless it is achieved by maintaining unusually low inventory levels, which may hurt future sales and profitability. Page 65 Table 3-3 Ratio analysis In summary, the Saxton Company more than compensates for a lower return on the sales dollar by a rapid turnover of assets, principally inventory and receivables, and a wise use of debt. You should be able to use these 13 measures to evaluate the financial performance of any firm. Page 66 Trend Analysis Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one year may not present an accurate picture of the firm. Therefore we look at the trend analysis of performance over a number of years. However, without industry comparisons even trend analysis may not present a complete picture. For example, in Figure 3-2 on the next page, we see that the profit margin for the Saxton Company has improved, while asset turnover has declined. This by itself may look good for the profit margin and bad for asset turnover. However, when compared to industry trends, we see the firm’s profit margin is still below the industry average. With asset turnover, Saxton has improved in relation to the industry even though it is in a downward trend. Similar data could be generated for the other ratios. By comparing companies in the same industry, the analyst can examine and compare trends over time. In looking at the computer industry data in Table 3-4 on page 67, it is apparent that profit margins and returns on equity have changed over time for IBM and Apple. This is primarily due to intensified competition within the industry. IBM began to feel the squeeze on profits first, beginning in 1991, and actually lost money in 1993. By 1994, Lou Gerstner took over as chairman and chief executive officer at IBM and began turning the company around; by 1997, IBM was back to its old levels of profitability and hitting all-time highs for return on stockholders’ equity. This continued until the recession of 2001–2002. During the next decade, IBM engaged in financial engineering. It kept repurchasing shares of stock in the market, reducing its share count from 29.7 billion shares in 2004 to 17.2 billion shares in 2014. During the same years, its revenues decreased from $96.3 billion to $94.5 billion. Figure 3-2 Trend analysis A. Profit margin B. Total asset turnover In 2003, Apple Computer began its amazing run over the next 10 years, creating the iPod, annual versions of the iPhone, the iPad, and iPad mini, and new versions of its MacBook and iMac computers. Note that even though Apple’s profit margin far exceeds that of IBM, IBM still has a higher return on equity. This takes us back to the Du Pont model. IBM has a debt-to-asset ratio of 72.5 percent in its capital structure while Apple has a 24 percent debt-to-asset ratio. In addition, IBM has been buying back billions of dollars of stock in the market over the last 10 years and has reduced stockholders’ equity on its balance sheet. Both the debt and stock repurchases have inflated IBM’s return on equity. Apple was debt free until 2013 when, under pressure from institutional stockholders, the company agreed to sell a total of $35.3 billion of debt and use the proceeds to raise its dividends as well as buy back some stock. In contrasting the two companies, we should point out that while IBM’s revenues were stagnant from 2004 to 2014, Apple grew its revenues from $8.2 billion in 2004 to $182.795 billion, almost doubling IBM’s revenues of $94.5 billion. Page 67 Table 3-4 Trend analysis in the computer industry What will be the trends for these two companies for the rest of the decade? Technology is changing so quickly that no one can say. Both are likely to remain lean in operating expenses but highly innovative in new product development. Impact of Inflation on Financial Analysis Before, coincident with, or following the computation of financial ratios, we should explore the impact of inflation and other sources of distortion on the financial reporting of the firm. As illustrated in this section, inflation causes phantom sources of profit that may mislead even the most alert analyst. Disinflation also causes certain problems, and we shall consider these as well. The major problem during inflationary times is that revenue is almost always stated in current dollars, whereas plant and equipment or inventory may have been purchased at lower price levels. Thus profit may be more a function of increasing prices than of satisfactory performance. Although inflation has been moderate since the early 1990s, it tends to reappear so you should be aware of its consequences. One of the major concerns of many economists is that the United States will suffer from an inflationary spiral before 2020 because of all the money that the Federal Reserve has pumped into the economy to help pull the country out of its financial crisis. So far there is no sign of rising inflation, but it pays to be vigilant. Page 68 Finance in ACTION Managerial Are Financial Analysts Friends or Foes to Investors? Reader Beware! Financial analysis is done not only by managers of the firm but by outside analysts as well. These outside analysts normally supply data to stock market investors. One of the problems that was detected after the great bull market of the 1990s was that analysts were not always as objective as they should be. This unfortunate discovery helped intensify the bear market of the early 2000s. The reason that many analysts lack objectivity is that they work for investment banking–brokerage firms that not only provide financial analysis for investors, but also underwrite the securities of the firms they are covering. Underwriting activity involves the distribution of new securities in the public markets and is highly profitable to the investment banker. For example, Goldman Sachs, a major Wall Street investment banking firm, may not only be doing research and financial analysis on General Electric or Eastman Kodak, but also profiting from investment banking business with these firms. Since the fees from investment banking activities contribute heavily to the overall operations of the investment banker, many analysts for investment banking firms “relaxed their standards” in doing financial analysis on their clients in the 1990s. As an example, Goldman Sachs, Merrill Lynch, and other Wall Street firms often failed to divulge potential weaknesses in the firms they were investigating for fear of losing the clients’ investment banking business. Corporations that were being reported upon were equally guilty. Many a corporate chief officer told an investment banker that “if you come out with a negative report, you will never see another dollar’s worth of our investment banking business.” Morgan Stanley, a major investment banker, actually had a written internal policy for analysts never to make negative comments about firms providing investment banking fees. Pity the poor investor who naively followed the advice of Morgan Stanley during the mid-1990s. After the market crash of the early 2000s, the SEC and federal legislators began requiring investment bankers to either fully separate their financial analysis and underwriting business or, at a minimum, fully divulge any such relationships. For example, Merrill Lynch now states in its research reports, “Investors should assume that Merrill Lynch is seeking or will seek investing banking or other business relationships with the companies in this report.” The government is also requiring investment bankers to provide independent reports to accompany their own in-house reports. These independent reports are done by fee-based research firms that do not engage in underwriting activities. Independent firms include Standard & Poor’s, Value Line, Morningstar, and other smaller firms. They tend to be totally objective and hard-hitting when necessary. Some independent research firms know more about a company than it knows about itself. Take the example of Sanford C. Bernstein & Co. and Cisco Systems in late 2000. Bernstein analyst Paul Sagawa downgraded Cisco for investment purposes even though Cisco Chief Executive Officer John T. Chambers respectfully disagreed. The astute independent analyst anticipated the end of the telecom boom and knew the disastrous effect it would have on Cisco because the company would lose key telecom customers. When the disaster finally occurred, CEO Chambers told investors that “No one could have predicted it. It was like a 100-year flood.” Apparently he forgot about the Sagawa report he had read and dismissed only a few months before. www.goldmansachs.com www.ml.com Page 69 An Illustration The Stein Corporation shows the accompanying income statement for 2015 in Table 3-5. At year-end the firm also has 100 units still in inventory at $1 per unit. Table 3-5 Stein Corporation Income Statement for 2015 STEIN CORPORATION Net Income for 2015 Sales $200 (100 units at $2) Cost of goods sold 100 (100 units at $1) Gross profit $100 Selling and administrative expense 20 (10% of sales) Depreciation 10 Operating profit $ 70 Taxes (40%) 28 Aftertax income $ 42 Assume that in the year 2016 the number of units sold remains constant at 100. However, inflation causes a 10 percent increase in price, from $2 to $2.20. Total sales will go up to $220 as shown in Table 3-6, but with no actual increase in physical volume. Further, assume the firm uses FIFO inventory pricing, so that inventory first purchased will be written off against current sales. In this case, 2015 inventory will be written off against year 2016 sales revenue. In Table 3-6, the company appears to have increased profit by $11 compared to that shown in Table 3-5 (from $42 to $53) simply as a result of inflation. But not reflected is the increased cost of replacing inventory and plant and equipment. Presumably, replacement costs have increased in an inflationary environment. Table 3-6 Stein Corporation Income Statement for 2016 STEIN CORPORATION Net Income for 2016 Sales $220 (100 units at 2000 price of $2.20) Cost of goods sold 100 (100 units at $1.00) Gross profit $120 Selling and administrative expense 22 (10% of sales) Depreciation 10 Operating profit $ 88 Taxes (40%) 35 Aftertax income $ 53 Page 70 As mentioned in Chapter 2, inflation-related information was formerly required by the FASB for large companies, but this is no longer the case. It is now purely voluntary. What are the implications of this type of inflation-adjusted data? From a study of 10 chemical firms and eight drug companies, using current cost (replacement cost) data found in the financial 10K statements these companies filed with the Securities and Exchange Commission, it was found that the changes shown in Table 3-7 occurred in their assets, income, and selected ratios.5 Table 3-7 Comparison of replacement cost accounting and historical cost accounting The comparison of replacement cost and historical cost accounting methods in the table shows that replacement cost reduces income but at the same time increases assets. This increase in assets lowers the debt-to-assets ratio since debt is a monetary asset that is not revalued because it is paid back in current dollars. The decreased debt-to-assets ratio would indicate the financial leverage of the firm is decreased, but a look at the interest coverage ratio tells a different story. Because the interest coverage ratio measures the operating income available to cover interest expense, the declining income penalizes this ratio and the firm has decreased its ability to cover its interest cost. Disinflation Effect As long as prices continue to rise in an inflationary environment, profits appear to feed on themselves. The main problem is that when price increases moderate (disinflation), there will be a rude awakening for management and unsuspecting stockholders as expensive inventory is charged against softening retail prices. A 15 or 20 percent growth rate in earnings may be little more than an “inflationary illusion.” Industries most sensitive to inflation-induced profits are those with cyclical products, such as lumber, copper, rubber, and food products, and also those in which inventory is a significant percentage of sales and profits. A leveling off of prices is not necessarily bad. Even though inflation-induced corporate profits may be going down, investors may be more willing to place their funds in financial assets such as stocks and bonds. The reason for the shift may be a belief that declining inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lessening inflation means the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current valuation. Page 71 None of this happens with a high degree of certainty. To the extent that investors question the permanence of disinflation (leveling off of price increases), they may not act according to the script. That is, lower rates of inflation will not necessarily produce high stock and bond prices unless reduced inflation is sustainable over a reasonable period. Whereas financial assets such as stocks and bonds have the potential (whether realized or not) to do well during disinflation, such is not the case for tangible (real) assets. Precious metals, such as gold and silver, gems, and collectibles, that boomed in the highly inflationary environment of the late 1970s fell off sharply a decade later, as softening prices caused less perceived need to hold real assets as a hedge against inflation. The shifting back and forth by investors between financial and real assets may occur many times over a business cycle. Deflation There is also the danger of deflation, actual declining prices in which everyone gets hurt from bankruptcies and declining profits. This happened in Russia, Asia, and other foreign countries in 1998, and it has become a worry in Russia and Europe in 2015. One of the negative consequences is that debt has to be repaid with more expensive currency rather than with cheaper money under inflationary conditions. The same phenomenon happened in the United States from 2007 to 2009 and is a continuing concern of the Federal Reserve Board. Monetary authorities would rather have a low-inflation economy than a deflationary economy. Other Elements of Distortion in Reported Income The effect of changing prices is but one of a number of problems the analyst must cope with in evaluating a company. Other issues, such as the reporting of revenue, the treatment of nonrecurring items, and the tax write-off policy, cause dilemmas for the financial manager or analyst. We can illustrate this point by considering the income statements for two hypothetical companies in the same industry as shown in Table 3-8 on the next page. Both firms had identical operating performances for 2015—but Company A is very conservative in reporting its results, while Company B has attempted to maximize its reported income. If both companies had reported income of $280,000 in the prior year of 2014, Company B would be thought to be showing substantial growth in 2015 with net income of $700,000, while Company A is reporting a “flat” or no-growth year in 2015. However, we have already established that the companies have equal operating performances. Explanation of Discrepancies Let us examine how the inconsistencies in Table 3-8 could occur. Emphasis is given to a number of key elements on the income statement. The items being discussed here are not illegal but reflect flexibility in financial reporting. Sales Company B reported $200,000 more in sales, although actual volume was the same. This may be the result of different concepts of revenue recognition. For example, certain assets may be sold on an installment basis over a long period. A conservative firm may defer recognition of the sales or revenue until each payment is received, while other firms may attempt to recognize a fully effected sale at the earliest possible date. Similarly, firms that lease assets may attempt to consider a long-term lease as the equivalent of a sale, while more conservative firms recognize as revenue each lease payment only when it comes due. Although the accounting profession attempts to establish appropriate methods of financial reporting through generally accepted accounting principles, reporting varies among firms and industries. Page 72 Table 3-8 INCOME STATEMENTS For the Year 2015 Conservative Firm A High Reported Income Firm B Sales $4,000,000 $4,200,000 Cost of goods sold 3,000,000 2,700,000 Gross profit $1,000,000 $1,500,000 Selling and administrative expense 450,000 450,000 Operating profit $ 550,000 $1,050,000 Interest expense 50,000 50,000 Extraordinary loss 100,000 — Net income before taxes $ 400,000 $1,000,000 Taxes (30%) 120,000 300,000 Net income $ 280,000 $ 700,000 Extraordinary loss (net of tax) — 70,000 Net income transferred to retained earnings $ 280,000 $ 630,000 Cost of Goods Sold The conservative firm (Company A) may well be using LIFO accounting in an inflationary environment, thus charging the last-purchased, more expensive items against sales, while Company B uses FIFO accounting—charging off less expensive inventory against sales. The $300,000 difference in cost of goods sold may also be explained by varying treatment of research and development costs and other items. Extraordinary Gains/Losses Nonrecurring gains or losses may occur from the sale of corporate fixed assets, lawsuits, or similar nonrecurring events. Some analysts argue that such extraordinary events should be included in computing the current income of the firm, while others would leave them off in assessing operating performance. Unfortunately, nonrecurring losses are treated inconsistently despite attempts by the accounting profession to ensure uniformity. The conservative Firm A has written off its $100,000 extraordinary loss against normally reported income, while Firm B carries a subtraction against net income only after the $700,000 amount has been reported. Both had similar losses of $100,000, but Firm B’s loss is shown net of tax implications at $70,000. Extraordinary gains and losses happen among large companies more often than you might think. General Motors has had “nonrecurring” losses four times in the last decade. This, in part, led to its decline as a major corporation. In the current age of mergers, tender offers, and buyouts, understanding the finer points of extraordinary gains and losses becomes even more important. Page 73 Sustainability, ROA, and the “Golden Rule” Finance in ACTION Ethics Perhaps “sustainability” isn’t the first word that comes to mind when someone thinks about the garbage business. However, today’s waste industry leaders not only develop sanitary landfills with synthetic liners and ground water monitoring wells, but they are often at the forefront of community recycling and renewable energy efforts. When Lonnie Poole started Waste Industries in 1970, he didn’t know that the company would grow to be one of the country’s largest waste companies, but like most entrepreneurs, he did believe that he could build a business for the long haul. Focused on a commitment to service, Poole knew that his company had to find ways to offer service options that were both economically viable and environmentally sustainable. Sometimes projects provided an adequate near-term return on assets (ROA), and they also made sense from a sustainability perspective. Other times, doing the right thing from a long-term sustainability perspective meant Waste Industries needed to find a way to overcome short-term financial considerations. Take the company’s recycling effort as an example. Waste Industries has been engaged in recycling since the 1970s. From an ROA perspective, it was hard to justify the firm’s recycling efforts. At first, there was no market for the recyclables. Instead of selling recycled paper, the firm had to pay paper companies to haul recycled paper away. Over time, Waste Industries’ investments in sustainability began to pay off. Due to their early investments, today an infrastructure has developed to recycle more waste at lower costs. Based purely on a short-run ROA, the firm’s long-term commitment was not justified, but Poole’s commitment to recycling and other sustainable practices were part of a wider corporate culture focused on treating customers, employees, and the broader community with respect. Now business researchers are finding that Poole may have simply been ahead of his time. When Harvard researchers examined the impact of corporate sustainability initiatives on long-term firm performance, they discovered both higher ROA and higher ROE (return on equity) for firms whose executives promoted sustainability within their firms. Philosophers and religious leaders have long touted the “golden rule” as a basic ethical code, which states one should do to others what they would wish done to themselves. Like many successful business people, Poole believed sustainability meant making a positive difference in the communities his company served, enriching the lives of employees, and forging meaningful relationships with vendors and suppliers. In the long run, these values paid off. Perhaps this is why a basic rule for ethical behavior is called “golden.” Source: R.G. Eccles, I. Ioannou, and G. Serafeim, “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance,” NBER Working Paper No. 17950, 2012. Net Income Firm A has reported net income of $280,000, while Firm B claims $700,000 before subtraction of extraordinary losses. The $420,000 difference is attributed to different methods of financial reporting, and it should be recognized as such by the analyst. No superior performance has actually taken place. The analyst must remain ever alert in examining each item in the financial statements, rather than accepting bottom-line figures. Page 74 SUMMARY Ratio analysis allows the analyst to compare a company’s performance to that of others in its industry. Ratios that initially appear good or bad may not retain that characteristic when measured against industry peers. There are four main groupings of ratios. Profitability ratios measure the firm’s ability to earn an adequate return on sales, assets, and stockholders’ equity. The asset utilization ratios tell the analyst how quickly the firm is turning over its accounts receivable, inventory, and longer-term assets. Liquidity ratios measure the firm’s ability to pay off short-term obligations as they come due, and debt utilization ratios indicate the overall debt position of the firm in light of its asset base and earning power. The Du Pont system of analysis first breaks down return on assets between the profit margin and asset turnover. The second step shows how this return on assets is translated into return on equity through the amount of debt the firm has. Throughout the analysis, the analyst can better understand how return on assets and return on equity are derived. Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one year may not present an accurate picture of the firm. Therefore we look at the trend analysis of performance over a period of years. A number of factors may distort the numbers accountants actually report. These include the effect of inflation or disinflation, the timing of the recognition of sales as revenue, the treatment of inventory write-offs, the presence of extraordinary gains and losses, and so on. The well-trained financial analyst must be alert to all of these factors. LIST OF TERMS profitability ratios 58 profit margin return on asset return on equity asset utilization ratios 58 receivable turnover average collection period inventory turnover fixed asset turnover total asset turnover liquidity ratios 58 current ratio quick ratio debt utilization ratios 58 debt to total assets times interest earned fixed charge coverage Du Pont system of analysis 60 trend analysis 65 inflation 67 replacement costs 69 disinflation 70 deflation 71 LIFO 72 FIFO 72 DISCUSSION QUESTIONS 1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, which ratios would each group be most interested in, and for what reasons? (LO3-2) 2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. (LO3-3) 3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period? (LO3-2) 4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned? (LO3-2) Page 75 5. Is there any validity in rule-of-thumb ratios for all corporations, such as a current ratio of 2 to 1 or debt to assets of 50 percent? (LO3-2) 6. Why is trend analysis helpful in analyzing ratios? (LO3-4) 7. Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions. (LO3-5) a. Return on investment b. Inventory turnover c. Fixed asset turnover d. Debt-to-assets ratio 8. What effect will disinflation following a highly inflationary period have on the reported income of the firm? (LO3-5) 9. Why might disinflation prove favorable to financial assets? (LO3-5) 10. Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why? (LO3-2) PRACTICE PROBLEMS AND SOLUTIONS Profitability ratios (LO3-2) 1. Barnes Appliances has sales of $10,000,000, net income of $450,000, total assets of $4,000,000, and stockholders’ equity of $2,000,000. a. What is the profit margin? b. What is the return on assets? c. What is the return on equity? d. The debt-to-assets ratio is currently 50 percent. If it were 60 percent, what would the return on equity be? To answer this question, use Ratio 3b in the text. All 13 ratios (LO3-2) 2. The Gilliam Corp. has the following balance sheet and income statement. Compute the profitability, asset utilization, liquidity, and debt utilization ratios. Page 76 GILLIAM CORPORATION Balance Sheet December 31, 20X1 Assets Current assets: Cash $ 70,000 Marketable securities 40,000 Accounts receivable (net) 250,000 Inventory 200,000 Total current assets $ 560,000 Investments 100,000 Net plant and equipment 440,000 Total assets $1,100,000 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 130,000 Notes payable 120,000 Accrued taxes 30,000 Total current liabilities $ 280,000 Long-term liabilities: Bonds payable $ 200,000 Total liabilities $ 480,000 Stockholders’ equity Preferred stock, $100 par value $ 150,000 Common stock, $5 par value 50,000 Capital paid in excess of par 200,000 Retained earnings 220,000 Total stockholders’ equity $ 620,000 Total liabilities and stockholders’ equity $1,100,000 GILLIAM CORPORATION Income Statement For the Year Ending December 31, 20X1 Sales (on credit) $2,400,000 Less: Cost of goods sold 1,600,000 Gross profit $ 800,000 Less: Selling and administrative expenses 560,000* Operating profit (EBIT) $ 240,000 Less: Interest expense 30,000 Earnings before taxes (EBT) $ 210,000 Less: Taxes 75,000 Earnings after taxes (EAT) $ 135,000 * Includes $40,000 in lease payments. Solutions 1. a. b. c. d. 2. Profitability ratios 1. Page 77 2. 3. Asset utilization ratios 4. 5. 6. 7. 8. Liquidity ratios 9. 10. Debt utilization ratios 11. 12. Note: Income before interest and taxes equals operating profit, $240,000. 13. Income before fixed charges and taxes = Operating profit + Lease payments* $240,000 + $40,000 = $280,000 Page 78 Fixed charges = Lease payments = Interest $40,000 + $30,000 = $70,000 PROBLEMS Selected problems are available with Connect. Please see the preface for more information. Basic Problems Profitability ratios (LO3-2) 1. Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of $156,000 on sales of $2,010,000. Division B is able to make only $28,800 on sales of $329,000. Based on the profit margins (returns on sales), which division is superior? Profitability ratios (LO3-2) 2. Database Systems is considering expansion into a new product line. Assets to support expansion will cost $380,000. It is estimated that Database can generate $1,410,000 in annual sales, with an 8 percent profit margin. What would net income and return on assets (investment) be for the year? Profitability ratios (LO3-2) 3. Polly Esther Dress Shops Inc. can open a new store that will do an annual sales volume of $837,900. It will turn over its assets 1.9 times per year. The profit margin on sales will be 8 percent. What would net income and return on assets (investment) be for the year? Profitability ratios (LO3-2) 4. Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns over its assets 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit margin (return on sales)? Profitability ratios (LO3-2) 5. Elizabeth Tailors Inc. has assets of $8,940,000 and turns over its assets 1.9 times per year. Return on assets is 13.5 percent. What is the firm’s profit margin (returns on sales)? Profitability ratios (LO3-2) 6. Dr. Zhivago Diagnostics Corp.’s income statement for 20X1 is as follows: Sales $2,790,000 Cost of goods sold 1,790,000 Gross profit $1,000,000 Selling and administrative expense 302,000 Operating profit $ 698,000 Interest expense 54,800 Income before taxes $ 643,200 Taxes (30%) 192,960 Income after taxes $ 450,240 a. Compute the profit margin for 20X1. b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold increases by 20 percent. The firm is able to keep all other expenses the same. Assume a tax rate of 30 percent on income before taxes. What is income after taxes and the profit margin for 20X2? Page 79 Profitability ratios (LO3-2) 7. The Haines Corp. shows the following financial data for 20X1 and 20X2: 20X1 20X2 Sales $3,230,000 $3,370,000 Cost of goods sold 2,130,000 2,850,000 Gross profit $1,100,000 $ 520,000 Selling & administrative expense 298,000 227,000 Operating profit $ 802,000 $ 293,000 Interest expense 47,200 51,600 Income before taxes $ 754,800 $ 241,400 Taxes (35%) 264,180 84,490 Income after taxes $ 490,620 $ 156,910 For each year, compute the following and indicate whether it is increasing or decreasing profitability in 20X2 as indicated by the ratio: a. Cost of goods sold to sales. b. Selling and administrative expense to sales. c. Interest expenses to sales. Profitability ratios (LO3-2) 8. Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of debt. It reports net income of $200,000. a. What is the firm’s return on assets? b. What is its return on stockholders’ equity? c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin (return on sales)? Profitability ratios (LO3-2) 9. Network Communications has total assets of $1,500,000 and current assets of $612,000. It turns over its fixed assets three times a year. It has $319,000 of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity? Profitability ratios (LO3-2) 10. Fondren Machine Tools has total assets of $3,310,000 and current assets of $879,000. It turns over its fixed assets 3.6 times per year. Its return on sales is 4.8 percent. It has $1,750,000 of debt. What is its return on stockholders’ equity? Profitability ratios (LO3-2) 11. Baker Oats had an asset turnover of 1.6 times per year. a. If the return on total assets (investment) was 11.2 percent, what was Baker’s profit margin? b. The following year, on the same level of assets, Baker’s assets turnover declined to 1.4 times and its profit margin was 8 percent. How did the return on total assets change from that of the previous year? Du Pont system of analysis (LO3-3) 12. AllState Co. has the following ratios compared to its industry for last year: AllState Trucking Industry Return on sales 3% 8% Return on assets 15% 10% Explain why the return-on-assets ratio is so much more favorable than the return-on-sales ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required. Page 80 Du Pont system of analysis (LO3-3) 13. Front Beam Lighting Company has the following ratios compared to its industry for last year: Front Beam Lighting Industry Return on assets 12% 5% Return on equity 16% 20% Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required. Du Pont system of analysis (LO3-3) 14. Gates Appliances has a return-on-assets (investment) ratio of 8 percent. a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity? b. If the firm had no debt, what would the return-on-equity ratio be? Intermediate Problems Du Pont system of analysis (LO3-3) 15. Using the Du Pont method, evaluate the effects of the following relationships for the Butters Corporation: a. Butters Corporation has a profit margin of 7 percent and its return on assets (investment) is 25.2 percent. What is its assets turnover? b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm’s return on equity be? c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35 percent? Du Pont system of analysis (LO3-3) 16. Jerry Rice and Grain Stores has $4,780,000 in yearly sales. The firm earns 4.5 percent on each dollar of sales and turns over its assets 2.7 times per year. It has $123,000 in current liabilities and $349,000 in long-term liabilities. a. What is its return on stockholders’ equity? b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities. Interpreting results from the Du Pont system of analysis (LO3-3) 17. Assume the following data for Cable Corporation and Multi-Media Inc. Cable Corporation Multi-Media Inc. Net income $ 31,200 $ 140,000 Sales 317,000 2,700,000 Total assets 402,000 965,000 Total debt 163,000 542,000 Stockholders’ equity 239,000 423,000 a. Compute the return on stockholders’ equity for both firms using Ratio 3a. Which firm has the higher return? Page 81 b. Compute the following additional ratios for both firms: Net income/Sales Net income/Total assets Sales/Total assets Debt/Total assets c. Discuss the factors from part b that added or detracted from one firm having a higher return on stockholders’ equity than the other firm as computed in part a. Average collection period (LO3-2) 18. A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is $285,000. What is the average collection period? (Use a 360-day year.) Average daily sales (LO3-2) 19. Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales? Inventory turnover (LO3-2) 20. Perez Corporation has the following financial data for the years 20X1 and 20X2: 20X1 20X2 Sales $8,000,000 $10,000,000 Cost of goods sold 6,000,000 9,000,000 Inventory 800,000 1,000,000 a. Compute inventory turnover based on Ratio 6, Sales/Inventory, for each year. b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year. c. What conclusions can you draw from part a and part b? Turnover ratios (LO3-2) 21. Jim Short’s Company makes clothing for schools. Sales in 20X1 were $4,820,000. Assets were as follows: Cash $ 163,000 Accounts receivable 889,000 Inventory 411,000 Net plant and equipment 520,000 Total assets $1,983,000 a. Compute the following: 1. Accounts receivable turnover. 2. Inventory turnover. 3. Fixed asset turnover. 4. Total asset turnover. Page 82 b. In 20X2, sales increased to $5,740,000 and the assets for that year were as follows: Cash $ 163,000 Accounts receivable 924,000 Inventory 1,063,000 Net plant and equipment 520,000 Total assets $2,670,000 Once again, compute the four ratios. c. Indicate if there is an improvement or decline in total asset turnover, and based on the other ratios, indicate why this development has taken place. Overall ratio analysis (LO3-2) 22. The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000, with 90 percent of sales sold on credit. Compute the following ratios: a. Current ratio. b. Quick ratio. c. Debt-to-total-assets ratio. d. Asset turnover. e. Average collection period. Debt utilization ratios (LO3-2) 23. The Lancaster Corporation’s income statement is given below. a. What is the times-interest-earned ratio? b. What would be the fixed-charge-coverage ratio? LANCASTER CORPORATION Sales $246,000 Cost of goods sold 122,000 Gross profit $124,000 Fixed charges (other than interest) 27,500 Income before interest and taxes $ 96,500 Interest 21,800 Income before taxes $ 74,700 Taxes (35%) 26,145 Income after taxes $ 48,555 Page 83 Debt utilization and Du Pont system of analysis (LO3-3) 24. Using the income statement for Times Mirror and Glass Co., compute the following ratios: a. The interest coverage. b. The fixed charge coverage. The total assets for this company equal $80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e. c. Profit margin. d. Total asset turnover. e. Return on assets (investment). TIMES MIRROR AND GLASS COMPANY Sales $126,000 Less: Cost of goods sold 93,000 Gross profit $ 33,000 Less: Selling and administrative expense 11,000 Less: Lease expense 4,000 Operating profit* $ 18,000 Less: Interest expense 3,000 Earnings before taxes $ 15,000 Less: Taxes (30%) 4,500 Earnings after taxes $ 10,500 *Equals income before interest and taxes. Debt utilization (LO3-2) 25. A firm has net income before interest and taxes of $193,000 and interest expense of $28,100. a. What is the times-interest-earned ratio? b. If the firm’s lease payments are $48,500, what is the fixed charge coverage? Advanced Problems Return on assets analysis (LO3-2) 26. In January 2007, the Status Quo Company was formed. Total assets were $544,000, of which $306,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation of $30,600 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $29,000 per year each of the last 10 years. Other assets have not changed since 2007. a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016. (Use $29,000 in the numerator for each year.) b. To what do you attribute the phenomenon shown in part a? c. Now assume income increased by 10 percent each year. What effect would this have on your preceding answers? (A comment is all that is necessary.) Page 84 Trend analysis (LO3-4) 27. Jolie Foster Care Homes Inc. shows the following data: a. Compute the ratio of net income to total assets for each year and comment on the trend. b. Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b. Trend analysis (LO3-4) 28. Quantum Moving Company has the following data. Industry information also is shown. As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of the following? a. Net income/Total assets. b. Debt/Total assets. Analysis by divisions (LO3-2) 29. The Global Products subsidiaries. a. Which division has the lowest return on sales? b. Which division has the highest return on assets? c. Compute the return on assets for the entire corporation. d. If the $8,760,000 investment in the heavy machinery division is sold off and redeployed in the medical supplies subsidiary at the same rate of return on assets currently achieved in the medical supplies division, what will be the new return on assets for the entire corporation? Page 85 Analysis by affiliates (LO3-1) 30. Omni Technology Holding Company has the following three affiliates: a. Which affiliate has the highest return on sales? b. Which affiliate has the lowest return on assets? c. Which affiliate has the highest total asset turnover? d. Which affiliate has the highest return on stockholders’ equity? e. Which affiliate has the highest debt ratio? (Assets minus stockholders’ equity equals debt.) f. Returning to question b, explain why the software affiliate has the highest return on total assets. g. Returning to question d, explain why the personal computer affiliate has a higher return on stockholders’ equity than the foreign operations affiliate even though it has a lower return on total assets. Inflation and inventory accounting effect (LO3-5) 31. The Canton Corporation shows the following income statement. The firm uses FIFO inventory accounting. CANTON CORPORATION Income Statement for 20X1 Sales $272,800 (17,600 units at $15.50) Cost of goods sold 123,200 (17,600 units at $7.00) Gross profit $149,600 Selling and administrative expense 13,640 Depreciation 15,900 Operating profit $120,060 Taxes (30%) 36,018 Aftertax income $ 84,042 a. Assume in 20X2 the same 17,600-unit volume is maintained, but that the sales price increases by 10 percent. Because of FIFO inventory policy, old inventory will still be charged off at $7 per unit. Also assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute aftertax income for 20X2. b. In part a, by what percent did aftertax income increase as a result of a 10 percent increase in the sales price? Explain why this impact took place. c. Now assume that in 20X3 the volume remains constant at 17,600 units, but the sales price decreases by 15 percent from its year 20X2 level. Also, because of FIFO inventory policy, cost of goods sold reflects the inflationary conditions of the prior year and is $7.50 per unit. Further, assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute the aftertax income. Page 86 Using ratios to construct financial statements (LO3-2) 32. Construct the current assets section of the balance sheet from the following data. (Use cash as a plug figure after computing the other values.) Yearly sales (credit) $420,000 Inventory turnover 7 times Current liabilities $80,000 Current ratio 2 Average collection period 36 days Current assets: $ Cash ___________ Accounts receivable ___________ Inventory ___________ Total current assets ___________ Using ratios to construct financial statements (LO3-2) 33. The Griggs Corporation has credit sales of $1,200,000. Given these ratios, fill in the following balance sheet. Total assets turnover 2.4 times Cash to total assets 2.0% Accounts receivable turnover 8.0 times Inventory turnover 10.0 times Current ratio 2.0 times Debt to total assets 61.0% Using ratios to determine account balances (LO3-2) 34. We are given the following information for the Pettit Corporation. Sales (credit) $3,549,000 Cash 179,000 Inventory 911,000 Current liabilities 788,000 Asset turnover 1.40 times Current ratio 2.95 times Debt-to-assets ratio 40% Receivables turnover 7 times Current assets are composed of cash, marketable securities, accounts receivable, and inventory. Calculate the following balance sheet items. a. Accounts receivable. b. Marketable securities. Page 87 c. Fixed assets. d. Long-term debt. Using ratios to construct financial statements (LO3-2) 35. The following information is from Harrelson Inc.’s financial statements. Sales (all credit) were $28.50 million for last year. Sales to total assets 1.90 times Total debt to total assets 35% Current ratio 2.50 times Inventory turnover 10.00 times Average collection period 20 days Fixed asset turnover 5.00 times Fill in the balance sheet: Comparing all the ratios (LO3-2) 36. Using the financial statements for the Snider Corporation, calculate the 13 basic ratios found in the chapter. Page 88 SNIDER CORPORATION Balance Sheet December 31, 20X1 Assets Current assets: Cash $ 52,200 Marketable securities 24,400 Accounts receivable (net) 222,000 Inventory 238,000 Total current assets $536,600 Investments 65,900 Plant and equipment $615,000 Less: Accumulated depreciation (271,000) Net plant and equipment $344,000 Total assets $946,500 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 93,400 Notes payable 70,600 Accrued taxes 17,000 Total current liabilities $181,000 Long-term liabilities: Bonds payable $153,200 Total liabilities $334,200 Stockholders’ equity: Preferred stock, $50 per value $100,000 Common stock, $1 par value 80,000 Capital paid in excess of par 190,000 Retained earnings 242,300 Total stockholders’ equity $612,300 Total liabilities and stockholders’ equity $946,500 SNIDER CORPORATION Income statement For the Year Ending December 31, 20X1 Sales (on credit) $2,064,000 Less: Cost of goods sold 1,313,000 Gross profit $ 751,000 Less: Selling and administrative expenses 496,000* Operating profit (EBIT) $ 255,000 Less: Interest expense 26,900 Earnings before taxes (EBT) $ 228,100 Less: Taxes 83,300 Earnings after taxes (EAT) $ 144,800 *Includes $36,100 in lease payments. Ratio computation and analysis (LO3-2) 37. Given the financial statements for Jones Corporation and Smith Corporation shown here: a. To which one would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering. b. In which one would you buy stock? Why? Page 89 JONES CORPORATION Sales (on credit) $1,250,000 Cost of goods sold 750,000 Gross profit $ 500,000 Selling and administrative expense† 257,000 Less: Depreciation expense 50,000 Operating profit $ 193,000 Interest expense 8,000 Earnings before taxes $ 185,000 Tax expense 92,500 Net income $ 92,500 *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments. SMITH CORPORATION Sales (on credit) $1,000,000 Cost of goods sold 600,000 Gross profit $ 400,000 Selling and administrative expense† 224,000 Depreciation expense 50,000 Operating profit $ 126,000 Interest expense 21,000 Earnings before taxes $ 105,000 Tax expense 52,500 Net income $ 52,500 †Includes $7,000 in lease payments. COMPREHENSIVE PROBLEM Lamar Swimwear (Trend analysis and industry comparisons) (LO3) Bob Adkins has recently been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products. Page 90 Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year. There was a steady real growth of 3 to 4 percent in gross domestic product during the period under study. Exhibit 1 Exhibit 2 Page 91 Exhibit 3 The stock in the corporation has become available due to the ill health of a current stockholder, who is in need of cash. The issue here is not to determine the exact price for the stock, but rather whether Lamar Swimwear represents an attractive investment situation. Although Mr. Adkins has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has no fast and firm rules about required return on investment, but rather wishes to analyze the overall condition of the firm. The firm does not currently pay a cash dividend, and return to the investor must come from selling the stock in the future. After doing a thorough analysis (including ratios for each year and comparisons to the industry), what comments and recommendations do you offer to Mr. Adkins? COMPREHENSIVE PROBLEM Sun Microsystems (Trends, ratios, stock performance) (LO3) Sun Microsystems is a leading supplier of computer-related products, including servers, workstations, storage devices, and network switches. In 2009, Sun Microsystems was acquired by Oracle Corporation. In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G. McNealy offered the following remarks: Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still, we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good indication that Sun continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively brought costs down—even as they continued to bring exciting new products to market. Page 92 The statement would not appear to be telling you enough. For example, McNealy says the year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can delve further by examining the income statement in Exhibit 4. Also, for additional analysis of other factors, consolidated balance sheet(s) are presented in Exhibit 5. 1. Referring to Exhibit 4, compute the annual percentage change in net income per common share-diluted (second numerical line from the bottom) for 1998–1999, 1999–2000, and 2000–2001. 2. Also in Exhibit 4, compute net income/net revenue (sales) for each of the four years. Begin with 1998. 3. What is the major reason for the change in the answer for Question 2 between 2000 and 2001? To answer this question for each of the two years, take the ratio of the major income statement accounts to net revenues (sales). Cost of sales Research and development Selling, general and administrative expense Provision for income tax 4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 4 and 5. Exhibit 4 Page 93 Exhibit 5 Page 94 5. Analyze your results in Question 4 more completely by computing Ratios 1, 2a, 2b, and 3b (all from this chapter) for 2000 and 2001. Actually the answer to Ratio 1 can be found as part of the answer to Question 2, but it is helpful to look at it initially. What do you think was the main contributing factor to the change in return on stockholders’ equity between 2000 and 2001? Think in terms of the Du Pont system of analysis. 6. The average stock prices for each of the four years shown in Exhibit 4 were as follows: 1998 11¼ 1999 16¾ 2000 28½ 2001 9½ a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown above and divide by net income per common stock-dilution from Exhibit 4. b. Why do you think the P/E has changed from its 2000 level to its 2001 level? A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio Applied to Earnings per Share in Chapter 2. 7. The book values per share for the same four years discussed in the preceding question were: 1998 $1.18 1999 $1.55 2000 $2.29 2001 $3.26 a. Compute the ratio of price to book value for each year. b. Is there any dramatic shift in the ratios worthy of note? WEB EXERCISE 1. IBM was mentioned in the chapter as having an uneven performance. Let’s check this out. Go to its website, www.ibm.com, and follow the steps below. Under “Information for” at the bottom of the page, select “Investors.” Select “Financial Snapshot” on the next page. 2. Click on “Stock Chart.” How has IBM’s stock been doing recently? 3. Click on “Financial Snapshot.” Assuming IBM’s historical price-earnings ratio is 18, how does it currently stand? 4. Assuming its annual dividend yield is 2.5 percent, how does it currently stand? Page 95 5. Assuming IBM’s historical “LT” (long-term) debt/equity is 100 percent, how does it currently stand? Generally speaking, is that good or bad? 6. Assuming its historical return on assets is 10 percent, how does it currently stand? Generally speaking, is that good or bad? Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for. 1The return could be slightly different than 25 percent because of changing financial costs with higher debt. 2Further discussions of this point are presented in Chapter 5, “Operating and Financial Leverage,” and Chapter 10, “Valuation and Rates of Return.” 3This ratio may also be computed by using “Cost of goods sold” in the numerator. While this offers some theoretical advantages in terms of using cost figures in both the numerator and denominator, Dun & Bradstreet and other credit reporting agencies generally show turnover using sales in the numerator. 4From the Du Pont system of analysis discussed earlier in the chapter, we used total debt to total assets. There are also other important debt measures used for different purposes, such as long-term debt to equity. 5Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study of the Chemical and Drug Industry for Years 1976 through 1978.” Replacement cost is but one form of current cost. Nevertheless, it is often used as a measure of current cost. *Lease payments are in a footnote on the income statement (middle of page 64). Copyright © 2017 by University of Phoenix. All rights reserved. Week 2 Case Study FIN/486 Version 6 1 Gale Force Surfing During mid-September 2015, the top managers of the Gale Force Corporation, a leading manufacturer of windsurfing equipment and surfboards, were gathered in the president’s conference room reviewing the results of the company’s operations during the past fiscal year (which runs from October 1 to September 30). “Not a bad year, on the whole,” remarked the president, 32-year-old Charles (“Chuck”) Jamison. “Sales were up, profits were up, and our return on equity was a respectable 15 percent. In fact,” he continued, “the only dark spot I can find in our whole annual report is the profit margin, which is only 2.25 percent. Seems like we ought to be making more than that, don’t you think, Tim?” He looked across the table at the vice president for finance, Timothy Baggit, age 28. “I agree,” replied Tim, “and I’m glad you brought it up, because I have a suggestion on how to improve that situation.” He leaned forward in his chair as he realized he had captured the interest of the others. “The problem is, we have too many expenses on our income statement that are eating up the profits. Now, I’ve done some checking, and the expenses all seem to be legitimate except for interest expense. Look here, we paid over $250,000 last year to the bank just to finance our short-term borrowing. If we could have kept that money instead, our profit margin ratio would have been 4.01 percent, which is higher than any other firm in the industry.” “But, Tim, we have to borrow like that,” responded Roy (“Pop”) Thomas, age 35, the vice president for production. “After all, our sales are seasonal, with almost all occurring between March and September. Since we don’t have much money coming in from October to February, we have to borrow to keep the production line going.” “Right,” Tim replied, “and it’s the production line that’s the problem. We produce the same number of products every month, no matter what we expect sales to be. This causes inventory to build up when sales are slow and to deplete when sales pick up. That fluctuating inventory causes all sorts of problems, including the excessive amount of borrowing we have to do to finance the inventory accumulation.” (See Tables 1 through 5 for details of Gale Force’s current operations based on equal monthly production.) Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2017 by University of Phoenix. All rights reserved. Week 2 Case Study FIN/486 Version 6 2 Table 1 Sales Forecast (in units) First Quarter Second Quarter Third Quarter Fourth Quarter October 2014 ..... 150 January ...................... 0 April ......................... 500 July.......................... 1,000 November .......... 75 February .................... 0 May .......................... 1,000 August ..................... 500 December ........... 25 March ........................ 300 June .........................1,000 September ............... 250 Table 2 Production Schedule and Inventory (equal monthly production) Production Inventory Beginning This End ($2,000 Inventory Month Sales Inventory per unit) October 2014 .............. 400 + 400 - 150 = 650 $1,300,000 November ................... 650 400 75 975 1,950,000 December .................... 975 400 25 1,350 2,700,000 January ........................ 1,350 400 0 1,750 3,500,000 February ...................... 1,750 400 0 2,150 4,300,000 March .......................... 2,150 400 300 2,250 4,500,000 April ............................. 2,250 400 500 2,150 4,300,000 May ............................. 2,150 400 1,000 1,550 3,100,000 June ............................. 1,550 400 1,000 950 1,900,000 July .............................. 950 400 1,000 350 700,000 August ......................... 350 400 500 250 500,000 September................... 250 400 250 400 800,000 Table 3 Sales Forecast, Cash Receipts and Payments, and Cash Budget October 2014 November December January February March Sales Forecast Sales (units) ................................. 150 75 25 0 0 300 Sales (unit price: $3,000) ............. $ 450,000 $ 225,000 $ 75,000 0 0 $ 900,000 Cash Receipts Schedule 50% cash ..................................... $ 225,000 $ 112,500 $ 37,500 $ 450,000 50% from prior month’s sales* ... $ 375,000 $ 225,000 $ 112,500 $ 37,500 0 0 Total cash receipts ................ $ 600,000 $ 337,500 $ 150,000 $ 37,500 0 $ 450,000 Cash Payments Schedule Production in units ...................... 400 400 400 400 400 400 Production costs (each = $2,000) $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 Overhead .................................... $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 Dividends and interest ................ 0 0 0 0 0 0 Taxes ........................................... $ 150,000 0 0 $ 150,000 0 0 Total cash payments ............. $ 1,150,000 $ 1,000,000 $ 1,000,000 $ 1,150,000 $ 1,000,000 $ 1,000,000 Cash Budget; Required Minimum Balance is $125,000 Cash flow..................................... $ –550,000 –662,500 –850,000 –1,112,500 –1,000,000 –550,000 Beginning cash ............................ 125,000 125,000 125,000 125,000 125,000 125,000 Cumulative cash balance ............. –425,000 –537,500 –725,000 –987,500 –875,000 –425,000 Monthly loan or (repayment)...... $ 550,000 $ 662,500 $ 850,000 $ 1,112,500 $ 1,000,000 $ 550,000 Cumulative loan .......................... $ 550,000 $ 1,212,500 $ 2,062,500 $ 3,175,000 $ 4,175,000 $ 4,725,000 Ending cash balance .................... $ 125,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2017 by University of Phoenix. All rights reserved. *September sales assumed to be $750,000. Week 2 Case Study FIN/486 Version 6 3 “Now, here’s my idea,” said Tim. “Instead of producing 400 items a month, every month, we match the production schedule with the sales forecast. For example, if we expect to sell 150 windsurfers in October, then we only make 150. That way we avoid borrowing to make the 250 more that we don’t expect to sell, anyway. Over the course of an entire year the savings in interest expense could really add up.” “Hold on, now,” Pop responded, feeling that his territory was being threatened. “That kind of scheduling really fouls up things in the shop where it counts. It causes a feast or famine environment—nothing to do for one month, then a deluge the next. It’s terrible for the employees, not to mention the supervisors who are trying to run an efficient operation. Your idea may make the income statements look good for now, but the whole company will suffer in the long run.” Chuck intervened. “OK, you guys, calm down. Tim may have a good idea or he may not, but at least it’s worth looking into. I propose that you all work up two sets of figures, one assuming level production and one matching production with sales. We’ll look at them both and see if Tim’s idea really does produce better results. If it does, we’ll check it further against other issues Pop is concerned about and then make a decision on which alternative is better for the firm.” Table 3 (continued) April May June July August September Sales Forecast Sales (units) ................................. 500 1,000 1,000 1,000 500 250 Sales (unit price: $3,000) ............. $1,500,000 $3,000,000 $3,000,000 $3,000,000 $1,500,000 $ 750,000 Cash Receipts Schedule 50% cash ...................................... $ 750,000 $1,500,000 $1,500,000 $1,500,000 $ 750,000 $ 375,000 50% from prior month’s sales ...... $ 450,000 $ 750,000 $1,500,000 $1,500,000 $1,500,000 $ 750,000 Total cash receipts ................. $1,200,000 $2,250,000 $3,000,000 $3,000,000 $2,250,000 $ 1,125,000 Cash Payments Schedule Production in units ...................... 400 400 400 400 400 400 Production costs (each = $2,000) $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 Overhead ..................................... $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 Dividends and interest ................. 0 0 0 0 $1,000,000 0 Taxes ........................................... $ 150,000 0 0 $ 300,000 0 0 Total cash payments .............. $1,150,000 $1,000,000 $1,000,000 $1,300,000 $2,000,000 $1,000,000 Cash Budget; Required Minimum Balance is $125,000 Cash flow ..................................... 50,000 1,250,000 2,000,000 1,700,000 250,000 125,000 Beginning cash ............................. 125,000 125,000 125,000 125,000 400,000 650,000 Cumulative cash balance ............. 175,000 1,375,000 2,125,000 1,825,000 650,000 775,000 Monthly loan or (repayment) .......... ($ 50,000) ($1,250,000) ($2,000,000) ($1,425,000) 0 0 Cumulative loan........................... $4,675,000 $3,425,000 $1,425,000 0 0 0 Ending cash balance .................... $ 125,000 $ 125,000 $ 125,000 $ 400,000 $ 650,000 $ 775,000 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2017 by University of Phoenix. All rights reserved. Week 2 Case Study FIN/486 Version 6 4 Table 4 Total Total Current Assets Accounts Current First Year Cash Receivable* Inventory Assets October ............. $125,000 + $225,000 + $1,300,000 = $1,650,000 November ......... 125,000 112,500 1,950,000 2,187,500 December ......... 125,000 37,500 2,700,000 2,862,500 January ............. 125,000 0 3,500,000 3,625,000 February ........... 125,000 0 4,300,000 4,425,000 March ............... 125,000 450,000 4,500,000 5,075,000 April .................. 125,000 750,000 4,300,000 5,175,000 May ................... 125,000 1,500,000 3,100,000 4,725,000 June .................. 125,000 1,500,000 1,900,000 3,525,000 July .................... 400,000 1,500,000 700,000 2,600,000 August ............... 650,000 750,000 500,000 1,900,000 September ........ 775,000 375,000 800,000 1,950,000 * Equals 50 percent of monthly sales Table 5 Cumulative loan balance and interest expense (1% per month) October November December January February March Cumulative loan balance .................... $ 550,000 $1,212,500 $2,062,500 $3,175,000 $4,175,000 $4,725,000 Interest expense at (prime, 8.0%, + 4.0%) 12.00% ............ $ 5,500 $ 12,125 $ 20,625 $ 31,750 $ 41,750 $ 47,250 April May June July August September Cumulative loan balance .................... $4,675,000 $3,425,000 $1,425,000 0 0 0 Interest expense at $ 46,750 $ 34,250 $ 14,250 0 0 0 (prime, 8.0%, + 4.0%) 12.00% ............ Total interest expense for the year: $254,250 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright © 2017 by University of Phoenix. All rights reserved. Week 2 Case Study FIN/486 Version 6 5 Required Activities: 1. Reference tables 1 through 5 to complete the following: A. Reproduce these tables if Tim’s suggestion were implemented; that is, change the Production This Month column in Table 2 from 400 each month to 150, 75, 25, and so on, to match Sales in the next column. B. Recompute the remainder of Table 2, and Tables 3, 4, and 5 based on the new production numbers. Note: Beginning inventory is still 400 units. Beginning cash is still $125,000 and that remains the minimum required balance. C. Write a one paragraph summary of what the new computations reflect and what you would suggest as a result of your findings. 2. Reference table 5 to calculate how much Tim’s suggestion would save in interest expense in a year. A. Use your recomputed figures in Table 5 from question 1 to summarize what the change would offer as a savings from the total interest expense. Justify your perspective on whether those findings would be a positive point for Tim’s suggestion or a positive point for Roy (“Pop”). 3. Assume that there is an added expense for each sales dollar of .5 percent (.005). Based on this fact and the information computed in question 2, is seasonal production justified? A. Compute the total sales using table 3 ( original or recomputed table can be sued) B. Apply the added expense and identify what the expense amount will do (increase/decrease and by how much). C. Compare the rate of the added expense burden to the interest savings computed in question 2 of table5. D. Write a one paragraph summary of your findings. Include if you feel the seasonal production plan is justified or not and why you are making the formal recommendation to implement the change or not. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10 Valuation and Rates of Return LEARNING OBJECTIVES LO 10-1 The valuation of a financial asset is based on the present value of future cash flows. LO 10-2 The required rate of return in valuing an asset is based on the risk involved. LO 10-3 Bond valuation is based on the process of determining the present value of interest payments plus the present value of the principal payment at maturity. LO 10-4 Preferred stock valuation is based on the dividend paid and the market required return. LO 10-5 Stock valuation is based on determining the present value of the future benefits of equity ownership. Valuation appears to be a fickle process to stockholders of some corporations. For example, if you held The Coca-Cola Company common stock in February 2015, you would be pleased to see that stockholders were valuing your stock at 26 times earnings. Certainly there was some justification for such a high valuation. Coca-Cola is sold in more than 200 countries, and it is the best-known brand in the world. But keep in mind that the company’s earnings were only 5 percent higher in 2014 than they had been in 2009, although dividends were up 50 percent from $0.88 to $1.32 per share. If stockholders of Coca-Cola were happy with the firm’s strong P/E (price-earnings ratio) valuation in February 2015, those who invested in ExxonMobil were not. The corporate giant was trading at a P/E ratio of 11 even though both its earnings and dividends had grown more rapidly than Coke’s (69 percent and 64 percent, respectively). Keep in mind ExxonMobil is one of the largest companies in the world in terms of revenue (almost $400 billion per year). It is a dominant player among integrated oil companies (those that not only discover oil but also sell it at the retail level). Furthermore, the stock has outperformed the popular market averages over the last 10-, 20-, and 30-year time periods. Thus ExxonMobil stockholders probably were not pleased with a low P/E ratio of 11. The question then becomes, why are P/E ratios so different and why do they change so much? Informed investors care about their money and vote with their dollars. The factors that influence valuation are many and varied, and you will be exposed to many of them in this chapter. Page 296 In Chapter 9, we considered the basic principles of the time value of money. In this chapter, we will use many of those concepts to determine how financial assets (bonds, preferred stock, and common stock) are valued and how investors establish the rates of return they demand. In the next chapter, we will use material from this chapter to determine the overall cost of financing to the firm. We merely turn the coin over. Once we know how much bondholders and stockholders demand in rates of return, we will observe what the corporation is required to pay them to attract their funds. The cost of corporate financing (capital) is subsequently used in analyzing whether a project is acceptable for investment. These relationships are depicted in Figure 10-1. Figure 10-1 The relationship between time value of money, required return, cost of financing, and investment decisions Valuation Concepts The valuation of a financial asset is based on determining the present value of future cash flows. Thus we need to know the value of future cash flows and the discount rate to be applied to the future cash flows to determine the current value. The market-determined required rate of return, which is the discount rate, depends on the market’s perceived level of risk associated with the individual security. Also important is the idea that required rates of return are competitively determined among the many companies seeking financial capital. For example, Microsoft, due to its low financial risk, relatively high return, and strong market position, is likely to raise debt capital at a significantly lower cost than can United Airlines, a firm with high financial risk. This implies that investors are willing to accept low return for low risk, and vice versa. The market allocates capital to companies based on risk, efficiency, and expected returns—which are based to a large degree on past performance. The reward to the financial manager for efficient use of capital in the past is a lower required return for investors than that of competing companies that did not manage their financial resources as well. Throughout the balance of this chapter, we apply concepts of valuation to corporate bonds, preferred stock, and common stock. Although we describe the basic characteristics of each form of security as part of the valuation process, extended discussion of each security is deferred until later chapters. Valuation of Bonds As previously stated, the value of a financial asset is based on the concept of the present value of future cash flows. Let’s apply this approach to bond valuation. A bond provides an annuity stream of interest payments and a $1,000 principal payment at maturity.1 These cash flows are discounted at Y, the yield to maturity. The value of Y is determined in the bond market and represents the required rate of return for bonds of a given risk and maturity. More will be said about the concept of yield to maturity in the next section. Page 297 The price of a bond is thus equal to the present value of regular interest payments discounted by the yield to maturity added to the present value of the principal (also discounted by the yield to maturity). The following timeline depicts a bond’s cashflows: This relationship can be expressed mathematically as follows: where Pb = Price of the bond It = Interest payments Pn = Principal payment at maturity t = Number corresponding to a period; running from 1 to n n = Number of periods Y = Yield to maturity (or required rate of return) The first term in the equation says to take the sum of the present values of the interest payments (It); the second term directs you to take the present value of the principal payment at maturity (Pn). The discount rate used throughout the analysis is the yield to maturity (Y). The answer derived is referred to as Pb (the price of the bond). The analysis is carried out for n periods. Let’s look at an example: In this timeline, each interest payment (It) equals $100; Pn (principal payment at maturity) equals $1,000; Y (yield to maturity) is 10 percent; and n (total number of periods) equals 20. We could say that Pb (the price of the bond) equals: Page 298 We take the present value of the interest payments and then add this value to the present value of the principal payment at maturity. Present Value of Interest Payments In this case, we determine the present value of a $100 annuity for 20 years.2 The discount rate is 10 percent. We can use Formula 9-6 to find the following: Present Value of Principal Payment (Par Value) at Maturity This single value of $1,000 will be received after 20 years. Note the term principal payment at maturity is used interchangeably with par value or face value of the bond. We discount $1,000 back to the present at 10 percent. We can use Formula 9-2 to find the following: The current price of the bond, based on the present value of interest payments and the present value of the principal payment at maturity, is $1,000. Present value of interest payments $ 851.40 Present value of principal payment at maturity 148.64 Total present value, or price, of the bond $1,000.00 The price of the bond in this case is essentially the same as its par, or stated, value to be received at maturity of $1,000. This is because the annual interest rate is 10 percent (the annual interest payment of $100 divided by $1,000) and the yield to maturity, or discount rate, is also 10 percent. When the interest rate on the bond and the yield to maturity are equal, the bond will trade at par value. Later we will examine the mathematical effects of varying the yield to maturity above or below the interest rate on the bond. Bond Valuation Using a Financial Calculator Page 299 Bond values can be found using the PV function on a financial calculator. The first calculator solution box in the margin shows the present value of the twenty $100 coupon payments. The calculator keystrokes are identical to those used to find the present value of an annuity. Notice that the PMT value is entered as a negative number. As we found earlier, the present value of the coupon payment annuity stream is $851.36. The second calculator solution shows the present value of the $1,000 principal payment that will be received at the end of 20 years. The calculator keystrokes are identical to those used to find the present value of a single amount. If the FV value is entered as a negative number, the present value of the principal will be $148.64. This is the value found using the present value equation earlier. Of course, the value of the bond ($1,000) is the sum of the present values in Panel A and Panel B. Finally, the third calculator solution demonstrates how we calculate the bond value when entering the principal and coupon payments simultaneously. Again, the coupon amounts are entered as a negative value using the PMT key, and the principal is entered as a negative value using the FV key. The value of the bond is $1,000. FINANCIAL CALCULATOR PV of Interest Payments Value Function 20 N 10 I/Y 0 FV −100 PMT Function Solution CPT PV 851.36 Using Excel’s PV Function to Calculate a Bond Price FINANCIAL CALCULATOR PV of Principal Value Function 20 N 10 I/Y −1000 FV 0 PMT Function Solution CPT PV 148.64 Excel’s PV function can calculate the price of a bond. In order to produce a positive bond price, the coupon payment annuity amount is input as a negative value for the pmt argument. The principal payment (−1000) is entered as the fv argument. The function in cell D1 references the arguments in cells B1 to B4. The function in cell D5 uses hardcoded numerical values. In both cases, the bond values produced by the PV function are identical to the calculator solution. FINANCIAL CALCULATOR Bond Price Value Function 20 N 10 I/V −1000 FV −100 PMT Function Solution CPT PV 1000.00 Concept of Yield to Maturity In the previous example, the yield to maturity that was used as the discount rate was 10 percent. The yield to maturity, or discount rate, is the rate of return required by bondholders. The bondholder, or any investor for that matter, will allow three factors to influence his or her required rate of return: 1. The required real rate of return—This is the rate of return the investor demands for giving up the current use of the funds on a noninflation-adjusted basis. It is the financial “rent” the investor charges for using his or her funds for one year, five years, or any given period. Although it varies from time to time, historically the real rate of return demanded by investors has been about 2 to 3 percent. Page 300 2. Inflation premium—In addition to the real rate of return discussed above, the investor requires a premium to compensate for the eroding effect of inflation on the value of the dollar. It would hardly satisfy an investor to have a 3 percent total rate of return in a 5 percent inflationary economy. Under such circumstances, the lender (investor) would be paying the borrower 2 percent for use of the funds, or in other words, losing 2 percent in purchasing power. This would represent an irrational action. No one wishes to pay another party to use his or her fund. The inflation premium added to the real rate of return ensures that this will not happen. The size of the inflation premium will be based on the investor’s expectations about future inflation. In the last two decades, the inflation premium has been 2 to 4 percent. In the late 1970s, it was in excess of 10 percent. If one combines the real rate of return (part 1) and the inflation premium (part 2), the risk-free rate of return is determined. This is the rate that compensates the investor for the current use of his or her funds and for the loss in purchasing power due to inflation, but not for taking risks. As an example, if the real rate of return were 3 percent and the inflation premium were 4 percent, we would say the risk-free rate of return is 7 percent.3 3. Risk premium—We must now add the risk premium to the risk-free rate of return. This is a premium associated with the special risks of a given investment. Of primary interest to us are two types of risk: business risk and financial risk. Business risk relates to the inability of the firm to hold its competitive position and maintain stability and growth in its earnings. Financial risk relates to the inability of the firm to meet its debt obligations as they come due. In addition to the two forms of risk mentioned above, the risk premium will be greater or less for different types of investments. For example, because bonds possess a contractual obligation for the firm to pay interest to bondholders, they are considered less risky than common stock where no such obligation exists.4 The risk premium of an investment may range from as low as zero on a very-short-term U.S. government–backed security to 10 to 15 percent on a gold mining expedition. The typical risk premium is 2 to 6 percent. Just as the required real rate of return and the inflation premium change over time, so does the risk premium. For example, high-risk corporate bonds (sometimes referred to as junk bonds) normally require a risk premium of about 5 percentage points over the risk-free rate. However, in September 1989 the bottom fell out of the junk bond market as Campeau Corp., International Resources, and Resorts International began facing difficulties in making their payments. Risk premiums almost doubled. The same phenomenon took place in the fall of 2008 in reaction to the U.S. financial crisis and in the spring of 2010 in reaction to the debt crisis in Greece, Portugal, Ireland, Italy, and Spain. As is emphasized in many parts of the text, there is a strong correlation between the risk the investor is taking and the return the investor demands. Supposedly, in finance as in other parts of business, “There is no such thing as a free lunch.” As you take more risk hoping for higher returns, you also expose yourself to the possibility of lower or negative returns on the other end of the probability curve. Page 301 We shall assume that in the investment we are examining the risk premium is 3 percent. If we add this risk premium to the two components of the risk-free rate of return developed in parts 1 and 2, we arrive at an overall required rate of return of 10 percent. + Real rate of return 3% + Inflation premium 4 = Risk-free rate 7% + Risk premium 3 = Required rate of return 10% In this instance, we assume we are evaluating the required return on a bond issued by a firm. If the security had been the common stock of the same firm, the risk premium might be 5 to 6 percent and the required rate of return 12 to 13 percent. Finally, in concluding this section, you should recall that the required rate of return on a bond is effectively the same concept as required yield to maturity. Changing the Yield to Maturity and the Impact on Bond Valuation In the earlier bond value calculation, we assumed the interest rate was 10 percent ($100 annual interest on a $1,000 par value bond) and the yield to maturity was also 10 percent. Under those circumstances, the price of the bond was basically equal to par value. Now let’s assume conditions in the market cause the yield to maturity to change. Increase in Inflation Premium For example, assume the inflation premium goes up from 4 to 6 percent. All else remains constant. The required rate of return would now be 12 percent. + Real rate of return 3% + Inflation premium 6 = Risk-free rate 9% + Risk premium 3 = Required rate of return 12% With the required rate of return, or yield to maturity, now at 12 percent, the price of the bond will change.5 A bond that pays only 10 percent interest when the required rate of return (yield to maturity) is 12 percent will fall below its current value of approximately $1,000. The new price of the bond is $850.61. We can calculate the bond price by using the calculator keystrokes shown in the margin or by using the time-value equations as follows: FINANCIAL CALCULATOR Bond Price Value Function 20 N 12 I/V 1000 FV 100 PMT Function Solution CPT PV –850.61 Present Value of Interest Payments We take the present value of a $100 annuity for 20 years. The discount rate is 12 percent. Page 302 Present Value of Principal Payment at Maturity We take the present value of $1,000 after 20 years. The discount rate is 12 percent. Total Present Value Present value of interest payments $746.94 Present value of principal payment at maturity 103.67 Total present value, or price, of the bond $850.61 In this example, we assumed increasing inflation caused the required rate of return (yield to maturity) to go up and the bond price to fall by approximately $150. The same effect would occur if the business risk increased or the demanded level for the real rate of return became higher. Decrease in Inflation Premium The opposite effect would happen if the required rate of return went down because of lower inflation, less risk, or other factors. Let’s assume the inflation premium declines and the required rate of return (yield to maturity) goes down to 8 percent. The 20-year bond with the 10 percent interest rate (coupon rate) would now sell for $1,196.36 as shown in the calculator keystrokes in the margin or using the following calculations: FINANCIAL CALCULATOR Bond Price Value Function 20 N 8 I/V 1000 FV 100 PMT Function Solution CPT PV –1196.36 Present Value of Interest Payments Present Value of Principal Payment at Maturity Total Present Value Present value of interest payments $ 981.81 Present value of principal payment at maturity 214.55 Total present value, or price, of the bond $1,196.36 Page 303 The bond is now trading at $196.36 over par value. This is certainly the expected result because the bond is paying 10 percent interest when the yield required in the market is only 8 percent. The 2 percentage point differential on a $1,000 par value bond represents $20 per year. The investor will receive this differential for the next 20 years. The present value of $20 for the next 20 years at the current market rate of interest of 8 percent is approximately $196.36. This explains why the bond is trading at $196.36 over its stated, or par, value. The further the yield to maturity on a bond changes from the stated interest rate on the bond, the greater the price change effect will be. This is illustrated in Table 10-1 for the 10 percent coupon rate, 20-year bonds discussed in this chapter. Table 10-1 Bond price table We clearly see the impact that different yields to maturity have on the price of a bond. Time to Maturity The impact of a change in yield to maturity on valuation is also affected by the remaining time to maturity. The effect of a bond paying 2 percentage points more or less than the going rate of interest is quite different for a 20-year bond than it is for a 1-year bond. In the latter case, the investor will only be gaining or giving up $20 for one year. That is certainly not the same as having this $20 differential for an extended period. Let’s once again return to the 10 percent interest rate bond and show the impact of a 2 percentage point decrease or increase in yield to maturity for varying times to maturity. The values are shown in Table 10-2 and graphed in Figure 10-2. The upper part of Figure 10-2 shows how the amount (premium) above par value is reduced as the number of years to maturity becomes smaller and smaller. Figure 10-2 should be read from left to right. The lower part of the figure shows how the amount (discount) below par value is reduced with progressively fewer years to maturity. Clearly, the longer the maturity, the greater the impact of changes in yield. Determining Yield to Maturity from the Bond Price Until now we have used yield to maturity as well as other factors, such as the interest rate on the bond and number of years to maturity, to compute the price of the bond. We shall now assume we know the price of the bond, the interest rate on the bond, and the years to maturity, and we wish to determine the yield to maturity. Once we have computed this value, we have determined the rate of return that investors are demanding in the marketplace to provide for inflation, risk, and other factors. Page 304 Table 10-2 Impact of time to maturity on bond prices (10% Interest Payment, Various Times to Maturity) Time Period in Years to Maturity Bond Price with 8% Yield to Maturity Bond Price with 12% Yield to Maturity 0 $1,000.00 $1,000.00 1 1,018.52 982.14 5 1,079.85 927.90 10 1,134.20 887.00 15 1,171.19 863.78 20 1,196.36 850.61 25 1,213.50 843.14 30 1,225.16 838.90 Figure 10-2 Relationship between time to maturity and bond price* Let’s once again present Formula 10-1: Page 305 We now determine the value of Y, the yield to maturity, that will equate the interest payments (It) and the principal payment (Pn) to the price of the bond (Pb). Consider the following timeline for payments on a 15-year bond that pays $110 per year (11 percent of the face amount) in interest and $1,000 in principal repayment after 15 years. The current price of the bond is $931.89. We wish to compute the yield to maturity, or discount rate, that equates future flows with the current price. It turns out that there is no algebraic formula that allows us to solve for the yield to maturity directly. Once upon a time, this presented a difficult puzzle that required tedious trial-and-error estimations to be checked before a solution could be found. Fortunately, our tools have improved. Both Excel and financial calculators are able to do these calculations so rapidly that the user is frequently left unaware that they are using the same trial-and-error process that was once done by hand. Let us start by reorganizing the timeline in an Excel spreadsheet as shown in Table 10-3. The Excel function RATE(n, pmt, pv, fv) shown at the bottom of the spreadsheet can also be used to find the yield to maturity, but the full spreadsheet has the advantage of making all the steps transparent to the reader. The spreadsheet also introduces Excel’s very flexible “Goal Seek” feature, which has many uses in addition to finding yields to maturity. In the spreadsheet, the time (n) of each payment is shown in column B, and each payment amount is shown in column C. The last two payments are at time n = 15 when both the last coupon payment and the principal are paid. In column D, we see a “PV factor” that is used to find the present value of each payment. The general equation for each factor is shown in the first comment box that points to cell D2. The comment box pointing to cell D4 shows the actual Excel equation and syntax for that cell. Each of the PV factor cells references the discount rate in cell D$1, which is also the yield to maturity. The dollar sign in the cell ensures that each row in the D column is referencing cell D1. Column E shows the present value of each payment, and the sum of the present value of all these payments is shown in cell E20. This is the bond price. Once you have created the spreadsheet and entered the data and appropriate equations, you are ready to use “Goal Seek.” The yield to maturity of Y = 12.00% is shown in red in cell D1. This cell was calculated using the “Goal Seek” function in Excel. Goal Seek is used when you know the result that you want for a formula, but you are not sure what input value the formula needs to get the result. In the case of the yield to maturity, we know the bond price should be $931.89, but we do not know the discount rate that produces that price. The Goal Seek function can be found in the most recent version of Excel on the Data tab, in the Data Tools group, under What-If Analysis. See Figure 10-3 for a picture of the Excel Ribbon location. Earlier versions of Excel also include Goal Seek, but the feature may be in a menu or toolbar instead of on the Excel Ribbon. The financial calculator keystrokes function much like Excel’s RATE(nper, pmt, pv,(fv)) function. These keystrokes are shown in the margin near Table 10-3. Page 306 FINANCIAL CALCULATOR Bond Yield Value Function 15 N −931.89 PV 110 PMT 1000 FV Function Solution CPT I/V 12.00 Table 10-3 Excel functions for YTM Figure 10-3 Finding the Goal Seek function in Excel These are the steps used to find the yield to maturity: Page 307 1. Make sure that you have calculated an arbitrary bond price by putting an interest rate in cell D1. Any rate should work, but using 11% is a good place to start because you already know that, at 11%, the price of the bond should be $1,000 since the coupon payment of $110 is 11% of the principal. 2. Open the Goal Seek feature. 3. In the “Set cell” box, enter the reference for the cell containing the formula for the bond price. 4. In the “To value” box, type the value 931.89, which is the price of the bond. 5. In the “By changing cell” box, enter the reference for the cell that contains the discount rate that you wish to find. This is cell D1 for this example. 6. Click “OK.” Goal Seek runs and produces the result in cell D1: Y = 12%. The RATE (nper, pmt, pv,(fv)) function in cell A22 also produces a value of 12%. Semiannual Interest and Bond Prices We have been assuming that interest was paid annually in our bond analysis. In actuality, most bonds pay interest semiannually. Thus a 10 percent interest rate bond may actually pay $50 twice a year instead of $100 annually. To make the conversion from an annual to semiannual analysis, we follow three steps: 1. Divide the annual interest rate by 2. 2. Multiply the number of years by 2. 3. Divide the annual yield to maturity by 2. FINANCIAL CALCULATOR Bond Price Value Function 40 N 6 I/Y 50 PMT 1000 FV Function Solution CPT PV –849.54 Assume a 10 percent, $1,000 par value bond has a maturity of 20 years. The annual yield to maturity is 12 percent. In following the three steps above, we would show this: 1. 10%/2 = 5% semiannual interest rate; therefore, 5% × $1,000 = $50 semiannual interest. 2. 20 × 2 = 40 periods to maturity. 3. 12%/2 = 6% yield to maturity, expressed on a semiannual basis. The calculator solution for this problem is shown in the margin. The answer of $849.54 is slightly below what we found previously for the same bond, assuming an annual interest rate ($850.61). This value was initially shown on page 301. In terms of accuracy, the semiannual analysis is a more acceptable method and is the method used in bond tables. As is true in many finance texts, we present the annual interest rate approach first for ease of presentation, and then the semiannual basis is given. In the problems at the back of the chapter, you will be asked to do problems on both an annual and semiannual interest payment basis. Valuation and Preferred Stock Page 308 Preferred stock usually represents a perpetuity or, in other words, has no maturity date. It is valued in the market without any principal payment since it has no ending life. If preferred stock had a maturity date, the analysis would be similar to that of the preceding bond example. Preferred stock has a fixed dividend payment carrying a higher order of precedence than common stock dividends, but not the binding contractual obligation of interest on debt. Preferred stock, being a hybrid security, has neither the ownership privilege of common stock nor the legally enforceable provisions of debt. To value a perpetuity such as preferred stock, we first consider this formula: where Pp = the price of preferred stock Dp = the annual dividend for preferred stock (a constant value) Kp = the required rate of return, or discount rate, applied to preferred stock dividends Notice that, unlike a bond, the preferred stock never matures. Because the dividend payments are promised to continue forever, a preferred stock is valued as a perpetuity. A perpetuity is described by a timeline that stretches to infinity as shown here: The preferred stock is easily valued as Actually, Formula 10-3 can be used to value any perpetuity, as long as the first payment occurs one year from the valuation date. All we have to do to find the price of preferred stock (Pp) is to divide the constant annual dividend payment (Dp) by the required rate of return that preferred stockholders are demanding (Kp). For example, if the annual dividend were $10 and the stockholder required a 10 percent rate of return, the price of preferred stock would be $100. Page 309 As was true in our bond valuation analysis, if the rate of return required by security holders changes, the value of the financial asset (in this case, preferred stock) will change. You may also recall that the longer the life of an investment, the greater the impact of a change in required rate of return. It is one thing to be locked into a low-paying security for one year when the rate goes up; it is quite another to be locked in for 10 or 20 years. With preferred stock, you have a perpetual security, so the impact is at a maximum. Assume in the prior example that because of higher inflation or increased business risk, Kp (the required rate of return) increases to 12 percent. The new value for the preferred stock shares is: If the required rate of return were reduced to 8 percent, the opposite effect would occur. The preferred stock price would be computed as: It is not surprising that the preferred stock is now trading well above its original price of $100. It is still offering a $10 dividend (10 percent of the original offering price of $100), and the market is demanding only an 8 percent yield. To match the $10 dividend with the 8 percent rate of return, the market price will advance to $125. Determining the Required Rate of Return (Yield) from the Market Price In our analysis of preferred stock, we have used the value of the annual dividend (Dp) and the required rate of return (Kp) to solve for the price of preferred stock (Pp). We could change our analysis to solve for the required rate of return (Kp) as the unknown, given that we know the annual dividend (Dp) and the preferred stock price (Pp). We take Formula 10-3 and rewrite it as Formula 10-4, where the unknown is the required rate of return (Kp). Using Formula 10-4, if the annual preferred dividend (Dp) is $10 and the price of preferred stock (Pp) is $100, the required rate of return (yield) would be 10 percent as follows: If the price goes up to $130, the yield will be only 7.69 percent: We see the higher market price provides quite a decline in the yield. Page 310 Valuation of Common Stock The value of a share of common stock may be interpreted by the shareholder as the present value of an expected stream of future dividends. Although in the short run stockholders may be influenced by a change in earnings or other variables, the ultimate value of any holding rests with the distribution of earnings in the form of dividend payments. Though the stockholder may benefit from the retention and reinvestment of earnings by the corporation, at some point the earnings must be translated into cash flow for the stockholder. A stock valuation model based on future expected dividends, which is termed a dividend valuation model, can be stated as: where P0 = Price of stock today D = Dividend for each year Ke = the required rate of return for common stock (discount rate) This formula, with modification, is generally applied to three different circumstances: 1. No growth in dividends. 2. Constant growth in dividends. 3. Variable growth in dividends. No Growth in Dividends Under the no-growth circumstance, common stock is very similar to preferred stock. The common stock pays a constant dividend each year. For that reason, we merely translate the terms in Formula 10-3, which applies to preferred stock, to apply to common stock. This is shown as new Formula 10-6: P0 = Price of common stock today D1 = Current annual common stock dividend (a constant value) Ke = Required rate of return for common stock Assume D1 = $1.87 and Ke = 12 percent; the price of the stock would be $15.58: A no-growth policy for common stock dividends does not hold much appeal for investors and so is seen infrequently in the real world.6 Constant Growth in Dividends A firm that increases dividends at a constant rate is a more likely circumstance. Perhaps a firm decides to increase its dividends by 7 percent per year. The general valuation approach is shown in Formula 10-7: Page 311 where P0 = Price of common stock today D0(1 + g)1 = Dividend in year 1, D1 D0(1 + g)2 = Dividend in year 2, D2, and so on g = Constant growth rate in dividends Ke = Required rate of return for common stock (discount rate) As shown in Formula 10-7, the current price of the stock is the present value of the future stream of dividends growing at a constant rate. If we can anticipate the growth pattern of future dividends and determine the discount rate, we can ascertain the price of the stock. For example, assume the following information: D0 = Last 12-month’s dividend (assume $1.87) D1 = First year, $2.00 (growth rate, 7%) D2 = Second year, $2.14 (growth rate, 7%) D3 = Third year, $2.29 (growth rate, 7%) etc. Ke = Required rate of return (discount rate), 12% Then To find the price of the stock, we take the present value of each year’s dividend. This is no small task when the formula calls for us to take the present value of an infinite stream of growing dividends. Fortunately, Formula 10-7 can be compressed into a much more usable form if two circumstances are satisfied: 1. The firm must have a constant dividend growth rate (g). 2. The discount rate (Ke) must be higher than the growth rate (g). For most introductory courses in finance, these assumptions are usually made to reduce the complications in the analytical process. This allows us to reduce or rewrite Formula 10-7 as Formula 10-8. Formula 10-8 is the basic equation for finding the value of common stock and is referred to as the constant growth dividend valuation model: This is an extremely easy formula to use in which: P0 = Price of the stock today D1 = Dividend at the end of the first year Ke = Required rate of return (discount rate) g = Constant growth rate in dividends Page 312 In this formula, P0 is sometimes referred to as the value of a “growing perpetuity” because it is a perpetuity that grows at a constant rate. In order for Formula 10-8 to work, it is critical that the first dividend come at the end of the first year. Based on the current example: D1 = $2.00 Ke = 0.12 g = 0.07 and P0 is computed as: Thus, given that the stock has a $2 dividend at the end of the first year, a discount rate of 12 percent, and a constant growth rate of 7 percent, the current price of the stock is $40. Let’s take a closer look at Formula 10-8 shown earlier and the factors that influence valuation. For example, what is the anticipated effect on valuation if Ke (the required rate of return, or discount rate) increases as a result of inflation or increased risk? Intuitively, we would expect the stock price to decline if investors demand a higher return and the dividend and growth rate remain the same. This is precisely what happens. If D1 remains at $2.00 and the growth rate (g) is 7 percent, but Ke increases from 12 percent to 14 percent, using Formula 10-8, the price of the common stock will now be $28.57 as shown below. This is considerably lower than its earlier value of $40: Similarly, if the growth rate (g) increases while D1 and Ke remain constant, the stock price can be expected to increase. Assume D1 = $2.00, Ke is set at its earlier level of 12 percent, and g increases from 7 percent to 9 percent. Using Formula 10-8 once again, the new price of the stock would be $66.67: We should not be surprised to see that an increasing growth rate has enhanced the value of the stock. Page 313 Stock Valuation Based on Future Stock Value The discussion of stock valuation to this point has related to the concept of the present value of future dividends. This is a valid concept, but suppose we wish to approach the issue from a slightly different viewpoint. Assume we are going to buy a stock and hold it for three years and then sell it. We wish to know the present value of our investment. This is somewhat like the bond valuation analysis. We will receive a dividend for three years (D1, D2, D3) and then a price (payment) for the stock at the end of three years (P3). What is the present value of the benefits? To solve this, we add the present value of three years of dividends and the present value of the stock price after three years. Assuming a constant growth dividend analysis, the stock price after three years is simply the present value of all future dividends after the third year (from the fourth year on). Thus the current price of the stock in this case is nothing other than the present value of the first three dividends, plus the present value of all future dividends (which is equivalent to the stock price after the third year). Saying the price of the stock is the present value of all future dividends is also the equivalent of saying it is the present value of a dividend stream for a number of years, plus the present value of the price of the stock after that time period. The appropriate formula would be Formula 10-7, where the fourth term would be replaced by P3 = D4/(Ke − g). Determining the Required Rate of Return from the Market Price In our analysis of common stock, we have used the first year’s dividend (D1), the required rate of return (Ke), and the growth rate (g) to solve for the stock price (P0) based on Formula 10-8. We could change the analysis to solve for the required rate of return (Ke) as the unknown, given that we know the first year’s dividend (D1), the stock price (P0), and the growth rate (g). We take the preceding formula and algebraically change it to provide Formula 10-9. Formula 10-9 allows us to compute the required return (Ke) for the investment. Returning to the basic data from the common stock example: Ke = Required rate of return (to be solved) D1 = Dividend at the end of the first year, $2.00 P0 = Price of the stock today, $40 g = Constant growth rate 0.07, or 7% In this instance, we would say the stockholder demands a 12 percent return on the common stock investment. Of particular interest are the individual parts of the formula for Ke that we have been discussing. Let’s write out Formula 10-9 again. Page 314 The first term represents the dividend yield the stockholder will receive, and the second term represents the anticipated growth in dividends, earnings, and stock price. While we have been describing the growth rate primarily in terms of dividends, it is assumed the earnings and stock price will also grow at that same rate over the long term if all else holds constant. You should also observe that the preceding formula represents a total-return concept. The stockholder is receiving a current dividend plus anticipated growth in the future. If the dividend yield is low, the growth rate must be high to provide the necessary return. Conversely, if the growth rate is low, a high dividend yield will be expected. The concepts of dividend yield and growth are clearly interrelated. The Price-Earnings Ratio Concept and Valuation In Chapter 2, we introduced the concept of the price-earnings ratio. The price-earnings ratio represents a multiplier applied to current earnings to determine the value of a share of stock in the market. It is considered a pragmatic, everyday approach to valuation. If a stock has earnings per share of $3 and a price-earnings (P/E) ratio of 15 times, it will carry a market value of $45. Another company with the same earnings but a P/E ratio of 20 times will enjoy a market price of $60. The price-earnings ratio is influenced by the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors. Firms that have bright expectations for the future tend to trade at high P/E ratios while the opposite is true for low P/E firms. For example, the average P/E for the S&P 500 Index firms was 19 in early 2015, but Facebook traded at a P/E of 72 because its earnings were expected to grow dramatically, and ExxonMobil traded at a P/E of 11 because oil prices had fallen and profits were expected to follow oil prices down over the next year. P/E ratios can be looked up in Barron’s, at finance.yahoo.com, and a number of other publications and Internet sites. Quotations from Barron’s are presented in Table 10-4. The first column after the company’s name shows the ticker symbol and is followed by volume. The third column indicates the yield (dividends per share divided by stock price). The fourth column is the item of primary interest and it indicates the current price-earnings (P/E) ratio. The remaining columns cover the stock price (last), the weekly price change, and earnings and dividend data. For IBM, which is highlighted in white in Table 10-4, the P/E ratio is 13, indicating that the company’s stock price of $158.72 represents approximately 13 times earnings of $11.90 for the past 12 months.7 Firms that are operating at a loss (deficit) have the symbol dd in the P/E ratio column. The dividend valuation approach (based on the present value of dividends) that we have been using throughout the chapter is more theoretically sound than P/E ratios and more likely to be used by sophisticated financial analysts. To some extent, the two concepts of P/E ratios and dividend valuation models can be brought together. A stock that has a high required rate of return (Ke) because it’s risky will generally have a low P/E ratio. Similarly, a stock with a low required rate of return (Ke) because of the predictability of positive future performance will normally have a high P/E ratio. These are generalized relationships. There are, of course, exceptions to every rule. Page 315 Table 10-4 Quotations from Barron’s Source: Barron’s, February 9, 2015, p. M18. Variable Growth in Dividends In the discussion of common stock valuation, we have considered procedures for firms that had no growth in dividends and for firms that had a constant growth. Most of the discussion and literature in finance assumes a constant growth dividend model. However, there is also a third case, and that is one of variable growth in dividends. The most common variable growth model is one in which the firm experiences supernormal (very rapid) growth for a number of years and then levels off to more normal, constant growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers. Page 316 Finance in ACTION Managerial An Important Question—What’s a Small Business Really Worth? The value of a small, privately held business takes on importance when the business is put up for sale, is part of a divorce settlement, or is being valued for estate purposes at the time of the owner’s death. The same basic principles that establish valuation for Fortune 500 companies apply to small businesses as well. However, there are important added considerations. One factor is that private businesses often lack liquidity. Unlike a firm trading in the public securities market, there is no ready market for a local clothing goods store, a bowling alley, or even a doctor’s clinic. Therefore, after the standard value has been determined, it is usually reduced for lack of liquidity. Although circumstances vary, the normal reduction is in the 30 percent range. Thus a business that is valued at $100,000 on the basis of earnings or cash flow may be assigned a value of $70,000 for estate valuation purposes. There are other factors that are important to small business valuation as well. For example, how important was a key person to the operation of a business? If the founder of the business was critical to its functioning, the firm may have little or no value in his or her absence. For example, a bridal consulting shop or a barber shop may have minimal value upon the death of the owner. On the other hand, a furniture company with established brand names or a small TV station with programming under contract may retain most of its value. Another consideration that is important in valuing a small business is the nature of the company’s earnings. They are often lower than they would be in a publicly traded company. Why? First of all, the owners of many small businesses intermingle personal expenses with business expenses. Thus family cars, health insurance, travel, and so on may be charged as business expenses when, in fact, they have a personal element to them. While the IRS tries to restrict such practices, there are fine lines in distinguishing between personal and business uses. As a general rule, small, private businesses try to report earnings as low as possible to minimize taxes. Contrast this with public companies that report earnings quarterly with the intent of showing ever-growing profitability. For this reason, in valuing a small, privately held company, analysts often rework stated earnings in an attempt to demonstrate earning power that is based on income less necessary expenditures. The restated earnings are usually higher. After these and many other factors are taken into consideration, the average small, private company normally sells at 5 to 10 times average adjusted earnings for the previous three years. It is also important to identify recent sale prices of comparable companies, and business brokers may be able to supply such information. When establishing final value, many people often look to their CPA or a business consultant to determine the true worth of a firm. In evaluating a firm with an initial pattern of supernormal growth, we first take the present value of dividends during the exceptional growth period. We then determine the price of the stock at the end of the supernormal growth period by taking the present value of the normal, constant dividends that follow the supernormal growth period. We discount this price to the present and add it to the present value of the supernormal dividends. This gives us the current price of the stock. A numerical example of a supernormal growth rate evaluation model is presented in Appendix 10A at the end of this chapter. Page 317 Finally, in the discussion of common stock valuation models, readers may ask about the valuation of companies that currently pay no dividends. Since virtually all our discussion has been based on values associated with dividends, how can this “no dividend” circumstance be handled? One approach is to assume that even for the firm that pays no current dividends, at some point in the future, stockholders will be rewarded with cash dividends. We then take the present value of their deferred dividends. A second approach to valuing a firm that pays no cash dividends is to take the present value of earnings per share for a number of periods and add that to the present value of a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends. SUMMARY AND REVIEW OF FORMULAS The primary emphasis in this chapter is on valuation of financial assets: bonds, preferred stock, and common stock. Regardless of the security being analyzed, valuation is normally based on the concept of determining the present value of future cash flows. Thus we draw on many of the time-value-of-money techniques developed in Chapter 9. Inherent in the valuation process is a determination of the rate of return that investors demand. When we have computed this value, we have also identified what it will cost the corporation to raise new capital. Let’s specifically review the valuation techniques associated with bonds, preferred stock, and common stock. Bonds The price, or current value, of a bond is equal to the present value of interest payments (It) over the life of the bond plus the present value of the principal payment (Pn) at maturity. The discount rate used in the analytical process is the yield to maturity (Y). The yield to maturity (required rate of return) is determined in the marketplace by such factors as the real rate of return, an inflation premium, and a risk premium. The equation for bond valuation was presented as Formula 10-1. The actual terms in the equation are solved by the use of present value tables. We say the present value of interest payments is: The present value of the principal payment at maturity is: We add these two values together to determine the price of the bond. We use annual or semiannual analysis. FINANCIAL CALCULATOR Bond Price Value Function n N Y I/Y Pn FV It PMT Function Solution CPT PV Pb Page 318 The value of the bond will be strongly influenced by the relationship of the yield to maturity in the market to the interest rate on the bond and also the length of time to maturity. If you know the price of the bond, the size of the interest payments, and the maturity of the bond, you can solve for the yield to maturity through a trial and error approach, by an approximation approach, or by using financially oriented calculators (in Appendix 10B at the end of the chapter) or appropriate computer software. Preferred Stock In determining the value of preferred stock, we are taking the present value of an infinite stream of level dividend payments. This would be a tedious process if the mathematical calculations could not be compressed into a simple formula. The appropriate equation is Formula 10-3. According to Formula 10-3, to find the preferred stock price (Pp) we take the constant annual dividend payment (Dp) and divide this value by the rate of return that preferred stockholders are demanding (Kp). If, on the other hand, we know the price of the preferred stock and the constant annual dividend payment, we can solve for the required rate of return on preferred stock as: Common Stock The value of common stock is also based on the concept of the present value of an expected stream of future dividends. Unlike preferred stock, the dividends are not necessarily level. The firm and shareholders may experience: 1. No growth in dividends. 2. Constant growth in dividends. 3. Variable or supernormal growth in dividends. It is the second circumstance that receives most of the attention in the financial literature. If a firm has constant growth (g) in dividends (D) and the required rate of return (Ke) exceeds the growth rate, Formula 10-8 can be utilized. In using Formula 10-8, all we need to know is the value of the dividend at the end of the first year, the required rate of return, and the discount rate. Most of our valuation calculations with common stock utilize Formula 10-8. Page 319 If we need to know the required rate of return (Ke) for common stock, Formula 10-9 can be employed. The first term represents the dividend yield on the stock and the second term the growth rate. Together they provide the total return demanded by the investor. LIST OF TERMS required rate of return 296 yield to maturity 299 real rate of return 299 inflation premium 299 risk-free rate of return 300 risk premium 300 business risk 300 financial risk 300 perpetuity 307 dividend valuation model 310 dividend yield 314 price-earnings ratio 314 supernormal growth 315 DISCUSSION QUESTIONS 1. How is valuation of any financial asset related to future cash flows? (LO10-2) 2. Why might investors demand a lower rate of return for an investment in Microsoft as compared to United Airlines? (LO10-2) 3. What are the three factors that influence the required rate of return by investors? (LO10-2) 4. If inflationary expectations increase, what is likely to happen to the yield to maturity on bonds in the marketplace? What is also likely to happen to the price of bonds? (LO10-2) 5. Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices? (LO10-4) 6. What are the three adjustments that have to be made in going from annual to semiannual bond analysis? (LO10-4) 7. Why is a change in required yield for preferred stock likely to have a greater impact on price than a change in required yield for bonds? (LO10-4) 8. What type of dividend pattern for common stock is similar to the dividend payment for preferred stock? (LO10-1) 9. What two conditions must be met to go from Formula 10-7 to Formula 10-8 in using the dividend valuation model? (LO10-5) 10. What two components make up the required rate of return on common stock? (LO10-5) 11. What factors might influence a firm’s price-earnings ratio? (LO10-3) Page 320 12. How is the supernormal growth pattern likely to vary from the normal, constant growth pattern? (LO10-5) 13. What approaches can be taken in valuing a firm’s stock when there is no cash dividend payment? (LO10-5) PRACTICE PROBLEMS AND SOLUTIONS Bond value (LO10-3) 1. The Titan Corp. issued a $1,000 par value bond paying 8 percent interest with 15 years to maturity. Assume the current yield to maturity on such bonds is 10 percent. What is the price of the bond? Do annual analysis. Common stock value (LO10-5) 2. Host Corp. will pay a $2.40 dividend (D1) in the next 12 months. The required rate of return (Ke) is 13 percent and the constant growth rate (g) is 5 percent. a. Compute the stock price (P0). b. If Ke goes up to 15 percent, and all else remains the same, what will be the stock price (P0)? c. Now assume in the next year, D1 = $2.70, Ke = 12 percent, and g is equal to 6 percent. What is the price of the stock? Solutions 1. Present Value of Interest Payments Present Value of the Principal Payment at Maturity Total Present Value (Bond Price) Present value of interest payments $608.49 Present value of principal payment at maturity 237.39 Bond price $847.88 FINANCIAL CALCULATOR Bond Price Value Function 15 N 10% I/V 1000 FV 80 PMT Function Solution CPT PV –847.88 2. a. b. c. PROBLEMS Page 321 Selected problems are available with Connect. Please see the preface for more information. Basic Problems For the first 20 bond problems, assume interest payments are on an annual basis. Bond value (LO10-3) 1. The Lone Star Company has $1,000 par value bonds outstanding at 10 percent interest. The bonds will mature in 20 years. Compute the current price of the bonds if the present yield to maturity is a. 6 percent. b. 9 percent. c. 13 percent. Bond value (LO10-3) 2. Midland Oil has $1,000 par value bonds outstanding at 8 percent interest. The bonds will mature in 25 years. Compute the current price of the bonds if the present yield to maturity is a. 7 percent. b. 10 percent. c. 13 percent. Bond value (LO10-3) 3. Exodus Limousine Company has $1,000 par value bonds outstanding at 10 percent interest. The bonds will mature in 50 years. Compute the current price of the bonds if the percent yield to maturity is a. 5 percent. b. 15 percent. Bond value (LO10-3) 4. Barry’s Steroids Company has $1,000 par value bonds outstanding at 16 percent interest. The bonds will mature in 40 years. If the percent yield to maturity is 13 percent, what percent of the total bond value does the repayment of principal represent? Bond value (LO10-3) 5. Essex Biochemical Co. has a $1,000 par value bond outstanding that pays 15 percent annual interest. The current yield to maturity on such bonds in the market is 17 percent. Compute the price of the bonds for these maturity dates: a. 30 years. b. 20 years. c. 4 years. Bond value (LO10-3) 6. Kilgore Natural Gas has a $1,000 par value bond outstanding that pays 9 percent annual interest. The current yield to maturity on such bonds in the market is 12 percent. Compute the price of the bonds for these maturity dates: a. 30 years. b. 15 years. c. 1 year. Bond maturity effect (LO10-3) Page 322 7. Toxaway Telephone Company has a $1,000 par value bond outstanding that pays 6 percent annual interest. If the yield to maturity is 8 percent, and remains so over the remaining life of the bond, the bond will have the following values over time: Remaining Maturity Bond Price 15 $795.67 10 $830.49 5 $891.86 1 $973.21 Graph the relationship in a manner similar to the bottom half of Figure 10-2. Also explain why the pattern of price change takes place. Interest rate effect (LO10-3) 8. Go to Table 10-1, which is based on bonds paying 10 percent interest for 20 years. Assume interest rates in the market (yield to maturity) decline from 11 percent to 8 percent: a. What is the bond price at 11 percent? b. What is the bond price at 8 percent? c. What would be your percentage return on investment if you bought when rates were 11 percent and sold when rates were 8 percent? Interest rate effect (LO10-3) 9. Look at Table 10-1 again, and now assume interest rates in the market (yield to maturity) increase from 9 to 12 percent. a. What is the bond price at 9 percent? b. What is the bond price at 12 percent? c. What would be your percentage return on the investment if you bought when rates were 9 percent and sold when rates were 12 percent? Interest rate effect (LO10-3) 10. Using Table 10-1, assume interest rates in the market (yield to maturity) are 14 percent for 20 years on a bond paying 10 percent. a. What is the price of the bond? b. Assume five years have passed and interest rates in the market have gone down to 12 percent. Now, using Table 10-2 for 15 years, what is the price of the bond? c. What would your percentage return be if you bought the bonds when interest rates in the market were 14 percent for 20 years and sold them 5 years later when interest rates were 12 percent? Effect of maturity on bond price (LO10-3) 11. Using Table 10-2: a. Assume the interest rate in the market (yield to maturity) goes down to 8 percent for the 10 percent bonds. Using column 2, indicate what the bond price will be with a 10-year, a 15-year, and a 20-year time period. b. Assume the interest rate in the market (yield to maturity) goes up to 12 percent for the 10 percent bonds. Using column 3, indicate what the bond price will be with a 10-year, a 15-year, and a 20-year period. c. Based on the information in part a, if you think interest rates in the market are going down, which bond would you choose to own? d. Based on information in part b, if you think interest rates in the market are going up, which bond would you choose to own? Page 323 Intermediate Problems Bond value (LO10-3) 12. Jim Busby calls his broker to inquire about purchasing a bond of Disk Storage Systems. His broker quotes a price of $1,180. Jim is concerned that the bond might be overpriced based on the facts involved. The $1,000 par value bond pays 14 percent interest, and it has 25 years remaining until maturity. The current yield to maturity on similar bonds is 12 percent. Compute the new price of the bond and comment on whether you think it is overpriced in the marketplace. Effect of yield to maturity on bond price (LO10-3) 13. Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point as described next: Real rate of return 4% Inflation premium 6 Risk premium 5 Total return 15% Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond. Analyzing bond price changes (LO10-3) 14. Katie Pairy Fruits Inc. has a $1,000 20-year bond outstanding with a nominal yield of 15 percent (coupon equals 15% × $1,000 = $150 per year). Assume that the current market required interest rate on similar bonds is now only 12 percent. a. Compute the current price of the bond. b. Find the present value of 3 percent × $1,000 (or $30) for 20 years at 12 percent. The $30 is assumed to be an annual payment. Add this value to $1,000. c. Explain why the answers in parts a and b are basically the same. (There is a slight difference due to rounding in the tables.) Effect of yield to maturity on bond price (LO10-2 & 10-3) 15. Media Bias Inc. issued bonds 10 years ago at $1,000 per bond. These bonds had a 40-year life when issued and the annual interest payment was then 12 percent. This return was in line with the required returns by bondholders at that point in time as described next: Real rate of return 2% Inflation premium 5 Risk premium 5 Total return 12% Assume that 10 years later, due to good publicity, the risk premium is now 2 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 30 years remaining until maturity. Compute the new price of the bond. Page 324 Effect of yield to maturity on bond price (LO10-2 & 10-3) 16. Wilson Oil Company issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point in time as described next: Real rate of return 8% Inflation premium 3 Risk premium 4 Total return 15% Assume that 10 years later, due to bad publicity, the risk premium is now 7 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 15 years remaining until maturity. Compute the new price of the bond. Deep discount bonds (LO10-3) 17. Lance Whittingham IV specializes in buying deep discount bonds. These represent bonds that are trading at well below par value. He has his eye on a bond issued by the Leisure Time Corporation. The $1,000 par value bond pays 4 percent annual interest and has 18 years remaining to maturity. The current yield to maturity on similar bonds is 14 percent. a. What is the current price of the bonds? b. By what percent will the price of the bonds increase between now and maturity? c. What is the annual compound rate of growth in the value of the bonds? (An approximate answer is acceptable.) Yield to maturity—calculator or Excel required (LO10-3) 18. Bonds issued by the Coleman Manufacturing Company have a par value of $1,000, which of course is also the amount of principal to be paid at maturity. The bonds are currently selling for $690. They have 10 years remaining to maturity. The annual interest payment is 13 percent ($130). Compute the yield to maturity. Yield to maturity—calculator or Excel required (LO10-3) 19. Stilley Resources bonds have four years left to maturity. Interest is paid annually, and the bonds have a $1,000 par value and a coupon rate of 5 percent. If the price of the bond is $841.51, what is the yield to maturity? Yield to maturity—calculator or Excel required (LO10-3) 20. Evans Emergency Response bonds have six years to maturity. Interest is paid semiannually. The bonds have a $1,000 par value and a coupon rate of 8 percent. If the price of the bond is $1,073.55, what is the annual yield to maturity? For the next two problems, assume interest payments are on a semiannual basis. Bond value––semiannual analysis (LO10-3) 21. Heather Smith is considering a bond investment in Locklear Airlines. The $1,000 par value bonds have a quoted annual interest rate of 11 percent and the interest is paid semiannually. The yield to maturity on the bonds is 14 percent annual interest. There are seven years to maturity. Compute the price of the bonds based on semiannual analysis. Bond value––semiannual analysis (LO10-3) Page 325 22. You are called in as a financial analyst to appraise the bonds of Olsen’s Clothing Stores. The $1,000 par value bonds have a quoted annual interest rate of 10 percent, which is paid semiannually. The yield to maturity on the bonds is 10 percent annual interest. There are 15 years to maturity. a. Compute the price of the bonds based on semiannual analysis. b. With 10 years to maturity, if yield to maturity goes down substantially to 8 percent, what will be the new price of the bonds? Preferred stock value (LO10-4) 23. The preferred stock of Denver Savings and Loan pays an annual dividend of $5.70. It has a required rate of return of 6 percent. Compute the price of the preferred stock. Preferred stock value (LO10-4) 24. North Pole Cruise Lines issued preferred stock many years ago. It carries a fixed dividend of $6 per share. With the passage of time, yields have soared from the original 6 percent to 14 percent (yield is the same as required rate of return). a. What was the original issue price? b. What is the current value of this preferred stock? c. If the yield on the Standard & Poor’s Preferred Stock Index declines, how will the price of the preferred stock be affected? Preferred stock value (LO10-4) 25. X-Tech Company issued preferred stock many years ago. It carries a fixed dividend of $12.00 per share. With the passage of time, yields have soared from the original 10 percent to 17 percent (yield is the same as required rate of return). a. What was the original issue price? b. What is the current value of this preferred stock? c. If the yield on the Standard & Poor’s Preferred Stock Index declines, how will the price of the preferred stock be affected? Preferred stock rate of return (LO10-4) 26. Analogue Technology has preferred stock outstanding that pays a $9 annual dividend. It has a price of $76. What is the required rate of return (yield) on the preferred stock? All of the following problems pertain to the common stock section of the chapter. Common stock value (LO10-5) 27. Stagnant Iron and Steel currently pays a $12.25 annual cash dividend (D0). The company plans to maintain the dividend at this level for the foreseeable future as no future growth is anticipated. If the required rate of return by common stockholders (Ke) is 18 percent, what is the price of the common stock? Common stock value (LO10-5) 28. BioScience Inc. will pay a common stock dividend of $3.20 at the end of the year (D1). The required return on common stock (Ke) is 14 percent. The firm has a constant growth rate (g) of 9 percent. Compute the current price of the stock (P0). Advanced Problems Common stock value under different market conditions (LO10-5) 29. Ecology Labs Inc. will pay a dividend of $6.40 per share in the next 12 months (D1). The required rate of return (Ke) is 14 percent and the constant growth rate is 5 percent. a. Compute P0. (For parts b, c, and d in this problem, all variables remain the same except the one specifically changed. Each question is independent of the others.) b. Assume Ke, the required rate of return, goes up to 18 percent. What will be the new value of P0? Page 326 c. Assume the growth rate (g) goes up to 9 percent. What will be the new value of P0? Ke goes back to its original value of 14 percent. d. Assume D1 is $7.00. What will be the new value of P0? Assume Ke is at its original value of 14 percent and g goes back to its original value of 5 percent. Common stock value under different market conditions (LO10-5) 30. Maxwell Communications paid a dividend of $3 last year. Over the next 12 months, the dividend is expected to grow at 8 percent, which is the constant growth rate for the firm (g). The new dividend after 12 months will represent D1. The required rate of return (Ke) is 14 percent. Compute the price of the stock (P0). Common stock value based on determining growth rate (LO10-5) 31. Justin Cement Company has had the following pattern of earnings per share over the last five years: Year Earnings per Share 20X1 $5.00 20X2 5.30 20X3 5.62 20X4 5.96 20X5 6.32 The earnings per share have grown at a constant rate (on a rounded basis) and will continue to do so in the future. Dividends represent 40 percent of earnings. Project earnings and dividends for the next year (20X6). If the required rate of return (Ke) is 13 percent, what is the anticipated stock price (P0) at the beginning of 20X6? Common stock required rate of return (LO10-5) 32. A firm pays a $4.80 dividend at the end of year one (D1), has a stock price of $80, and a constant growth rate (g) of 5 percent. Compute the required rate of return (Ke). Common stock required rate of return (LO10-5) 33. A firm pays a $1.50 dividend at the end of year one (D1), has a stock price of $155 (P0), and a constant growth rate (g) of 10 percent. a. Compute the required rate of return (Ke). Indicate whether each of the following changes would make the required rate of return (Ke) go up or down. (Each question is separate from the others. That is, assume only one variable changes at a time.) No actual numbers are necessary. b. The dividend payment increases. c. The expected growth rate increases. d. The stock price increases. Common stock value based on PV calculations (LO10-5) 34. Trump Office Supplies paid a $3 dividend last year. The dividend is expected to grow at a constant rate of 7 percent over the next four years. The required rate of return is 14 percent (this will also serve as the discount rate in this problem). Round all values to three places to the right of the decimal point where appropriate. a. Compute the anticipated value of the dividends for the next four years. That is, compute D1, D2, D3, and D4—for example, D1 is $3.21 ($3.00 × 1.07). Page 327 b. Discount each of these dividends back to present at a discount rate of 14 percent and then sum them. c. Compute the price of the stock at the end of the fourth year (P4). (D5 is equal to D4 times 1.07) d. After you have computed P4, discount it back to the present at a discount rate of 14 percent for four years. e. Add together the answers in part b and part d to get P0, the current value of the stock. This answer represents the present value of the four periods of dividends, plus the present value of the price of the stock after four periods (which, in turn, represents the value of all future dividends). f. Use Formula 10-8 to show that it will provide approximately the same answer as part e. For Formula 10-8, use D1 = $3.21, Ke = 14 percent, and g = 7 percent. (The slight difference between the answers to part e and part f is due to rounding.) g. If current EPS were equal to $5.32 and the P/E ratio is 1.1 times higher than the industry average of 8, what would the stock price be? h. By what dollar amount is the stock price in part g different from the stock price in part f? i. In regard to the stock price in part f, indicate which direction it would move if (1) D1 increases, (2) Ke increases, and (3) g increases. Common stock value based on PV calculations (LO10-5) 35. Beasley Ball Bearings paid a $4 dividend last year. The dividend is expected to grow at a constant rate of 2 percent over the next four years. The required rate of return is 15 percent (this will also serve as the discount rate in this problem). Round all values to three places to the right of the decimal point where appropriate. a. Compute the anticipated value of the dividends for the next four years. That is, compute D1, D2, D3, and D4; for example, D1 is $4.08 ($4 × 1.02). b. Discount each of these dividends back to present at a discount rate of 15 percent and then sum them. c. Compute the price of the stock at the end of the fourth year (P4). (D5 is equal to D4 times 1.02) d. After you have computed P4, discount it back to the present at a discount rate of 15 percent for four years. Page 328 e. Add together the answers in part b and part d to get P0, the current value of the stock. This answer represents the present value of the four periods of dividends, plus the present value of the price of the stock after four periods (which in turn represents the value of all future dividends). f. Use Formula 10-8 to show that it will provide approximately the same answer as part e. For Formula 10-8, use D1 = $4.08, Ke = 15 percent, and g = 2 percent. (The slight difference between the answers to part e and part f is due to rounding.) g. If current EPS were equal to $4.98 and the P/E ratio is 1.2 times higher than the industry average of 6, what would the stock price be? h. By what dollar amount is the stock price in part g different from the stock price in part f? i. In regard to the stock price in part f, indicate which direction it would move if (1) D1 increases, (2) Ke increases, and (3) g increases. COMPREHENSIVE PROBLEM Preston Products (Dividend valuation model, P/E ratio) (LO10-5) Mel Thomas, the chief financial officer of Preston Resources, has been asked to do an evaluation of Dunning Chemical Company by the president and chair of the board, Sarah Reynolds. Preston Resources was planning a joint venture with Dunning (which was privately traded), and Sarah and Mel needed a better feel for what Dunning’s stock was worth because they might be interested in buying the firm in the future. Dunning Chemical paid a dividend at the end of year one of $1.30, the anticipated growth rate was 10 percent, and the required rate of return was 14 percent. a. What is the value of the stock based on the dividend valuation model (Formula 10-8)? b. Indicate that the value you computed in part a is correct by showing the value of D1, D2, and D3 and by discounting each back to the present at 14 percent. D1 is $1.30, and it increases by 10 percent (g) each year. Also discount the anticipated stock price at the end of year three back to the present and add it to the present value of the three dividend payments. The value of the stock at the end of year three is: If you have done all these steps correctly, you should get an answer approximately equal to the answer in part a. c. As an alternative measure, you also examine the value of the firm based on the price-earnings (P/E) ratio times earnings per share.Page 329 Since the company is privately traded (not in the public stock market), you will get your anticipated P/E ratio by taking the average value of five publicly traded chemical companies. The P/E ratios were as follows during the time period under analysis: P/E Ratio Dow Chemical 15 DuPont 18 Georgia Gulf 7 3M 19 Olin Corp 21 Assume Dunning Chemical has earnings per share of $2.10. What is the stock value based on the P/E ratio approach? Multiply the average P/E ratio you computed times earnings per share. How does this value compare to the dividend valuation model values that you computed in parts a and b? d. If in computing the industry average P/E, you decide to weight Olin Corp. by 40 percent and the other four firms by 15 percent, what would be the new weighted average industry P/E? (Note: You decided to weight Olin Corp. more heavily because it is similar to Dunning Chemical.) What will the new stock price be? Earnings per share will stay at $2.10. e. By what percent will the stock price change as a result of using the weighted average industry P/E ratio in part d as opposed to that in part c? WEB EXERCISE 1. ExxonMobil was referred to at the beginning of the chapter as a firm that had a low valuation in the marketplace. Go to finance.yahoo.com and type XOM into the “Get Quotes” box. Click on “Profile” in the left margin of the home page and write a one--paragraph description of the company’s activities. Return to the summary page and write down the company’s P/E ratio. Is it still relatively low (under 15)? Click on “Competitors” and compare ExxonMobil to others in the industry based on the P/E ratio and the PEG ratio (the P/E ratio divided by annual growth). 2. Go back to the summary page. Is the stock up or down from the prior day? (See the number in parentheses next to the share price.) 3. What is its 52-week range? 4. Scroll down and click on “Analyst Opinion.” What are the Mean Target, the High Target, and the Low Target? How many brokers follow the firm? Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for. Page 330 APPENDIX | 10A Valuation of a Supernormal Growth Firm The equation for the valuation of a supernormal growth firm is: The formula is not difficult to use. The first term calls for determining the present value of the dividends during the supernormal growth period. The second term calls for computing the present value of the future stock price as determined at the end of the supernormal growth period. If we add the two, we arrive at the current stock price. We are adding together the present value of the two benefits the stockholder will receive: a future stream of dividends during the supernormal growth period and the future stock price. Let’s assume the firm paid a dividend over the last 12 months of $1.67; this represents the current dividend rate. Dividends are expected to grow by 20 percent per year over the supernormal growth period (n) of three years. They will then grow at a normal constant growth rate (g) of 5 percent. The required rate of return (discount rate) as represented by Ke is 9 percent. We first find the present value of the dividends during the supernormal growth period. 1. Present Value of Supernormal Dividends D0 = $1.67. We allow this value to grow at 20 percent per year over the three years of supernormal growth. D1 = D0 (1 + 0.20) = $1.67(1.20) = $2.00 D2 = D1 (1 + 0.20) = $2.00(1.20) = $2.40 D3 = D2 (1 + 0.20) = $2.40(1.20) = $2.88 We then discount these values back at 9 percent to find the present value of dividends during the supernormal growth period. The present value of the supernormal dividends is $6.07. We now turn to the future stock price. 2. Present Value of Future Stock Price Page 331 We first find the future stock price at the end of the supernormal growth period. This is found by taking the present value of the dividends that will be growing at a normal, constant rate after the supernormal period. This will begin after the third (and last) period of supernormal growth. Since after the supernormal growth period the firm is growing at a normal, constant rate (g = 5 percent) and Ke (the discount rate) of 9 percent exceeds the new, constant growth rate of 5 percent, we have fulfilled the two conditions for using the constant dividend growth model after three years. That is, we can apply Formula 10-8 (without subscripts for now). In this case, however, D is really the dividend at the end of the fourth period because this phase of the analysis starts at the beginning of the fourth period and D is supposed to fall at the end of the first period of analysis in the formula. Also the price we are solving for now is the price at the beginning of the fourth period, which is the same concept as the price at the end of the third period (P3). We thus say: D4 is equal to the previously determined value for D3 of $2.88 compounded for one period at the constant growth rate of 5 percent. D4 = $2.88(1.05) = $3.02 Also: Ke = 0.09 discount rate (required rate of return) g = 0.05 constant growth rate This is the value of the stock at the end of the third period. We discount this value back to the present. Stock Price after Three Years Discount Rate* Ke = 9% Present Value of Future Price $75.50 0.772 $58.29 * Note: n is equal to 3. The present value of the future stock price (P3) of $75.50 is $58.29. By adding together the answers in parts (1) and (2) of this appendix, we arrive at the total present value, or price, of the supernormal growth stock. (1) Present value of dividends during the normal growth period $ 6.07 (2) Present value of the future stock price 58.29 Total present value, or price $64.36 The process is also illustrated in Figure 10A-1. Page 332 Figure 10A-1 Stock valuation under supernormal growth analysis Problem Valuation of supernormal growth firm (LO10-5) 10A-1. Surgical Supplies Corporation paid a dividend of $1.12 per share over the last 12 months. The dividend is expected to grow at a rate of 25 percent over the next three years (supernormal growth). It will then grow at a normal, constant rate of 7 percent for the foreseeable future. The required rate of return is 12 percent (this will also serve as the discount rate). a. Compute the anticipated value of the dividends for the next three years (D1, D2, and D3). b. Discount each of these dividends back to the present at a discount rate of 12 percent and then sum them. c. Compute the price of the stock at the end of the third year (P3). d. After you have computed P3, discount it back to the present at a discount rate of 12 percent for three years. e. Add together the answers in part b and part d to get the current value of the stock. (This answer represents the present value of the first three periods of dividends plus the present value of the price of the stock after three periods.) APPENDIX | 10B Using Calculators for Financial Analysis This appendix is designed to help you use either an algebraic calculator (Texas Instruments BAII Plus Business Analyst) or the Hewlett-Packard 12C Financial Calculator. We realize that most calculators come with comprehensive instructions, and this appendix is meant only to provide basic instructions for commonly used financial calculations. There are always two things to do before starting your calculations as indicated in the first table: Clear the calculator and set the decimal point. If you do not want to lose data stored in memory, do not perform steps 2 and 3 in the first box on the next page. Each step is listed vertically as a number followed by a decimal point. After each step you will find either a number or a calculator function denoted by a box . Entering the number on your calculator is one step and entering the function is another. Notice that the HP 12C is color coded. When two boxes are found one after another, you may have an f or a g in the first box. An f is orange coded and refers to the orange functions above the keys. After typing the f function, you will automatically look for an orange-coded key to punch. For example, after f in the first Hewlett-Packard box (right-hand panel), you will punch in the orange-color-coded REG. If the f function is not followed by another box, you merely type in f and the value indicated. Page 333 The g is coded blue and refers to the functions on the bottom of the function keys. After the g function key, you will automatically look for blue-coded keys. The TI BAII Plus is also color coded. The gold 2nd key, located near the top left corner of the calculator, refers to the gold functions above the keys. Upon pressing the 2nd key, the word “2nd” appears in the top left corner, indicating the gold function keys are active. Familiarize yourself with the keyboard before you start. In the more complicated calculations, keystrokes will be combined into one step. In the first four calculations, we solve for the future value (FV), present value (PV), future value of an ordinary annuity (FVA), and present value of an ordinary annuity (PVA), each for $100. On the following pages, you can determine bond valuation, yield to maturity, net present value of an annuity, net present value of an uneven cash flow, internal rate of return for an annuity, and internal rate of return for an uneven cash flow. Page 334 Page 335 Bond Valuation Using Both the TI BAII Plus and the HP 12C Solve for V = Price of the bond Given: Ct = $80 annual coupon payments or 8% coupon ($40 semiannually) Pn = $1,000 principal (par value) n = 10 years to maturity (20 periods semiannually) i = 9.0% rate in the market (4.5% semiannually) You may choose to refer to Chapter 10 for a complete discussion of bond valuation. Page 336 Yield to Maturity on Both the TI BAII Plus and HP 12C Solve for Y = Yield to maturity Given: V = $895.50 price of bond Ct = $80 annual coupon payments or 8% coupon ($40 semiannually) Pn = $1,000 principal (par value) n = 10 years to maturity (20 periods semiannually) You may choose to refer to Chapter 10 for a complete discussion of yield to maturity. Page 337 Net Present Value of an Annuity on Both the TI BAII Plus and the HP 12C Solve for A = Present value of annuity Given: n = 10 years (number of years cash flow will continue) PMT = $5,000 per year (amount of the annuity) i = 12% (cost of capital Ka) Cost = $20,000 You may choose to refer to Chapter 12 for a complete discussion of net present value. Page 338 Net Present Value of an Uneven Cash Flow on Both the TI BAII Plus and the HP 12C Solve for NPV = Net present value Given: n = 5 years (number of years cash flow will continue) PMT = $5,000 (yr. 1); $6,000 (yr. 2); $7,000 (yr. 3); $8,000 (yr. 4); $9,000 (yr. 5) i = 12% (cost of capital Ka) Cost = $25,000 You may choose to refer to Chapter 12 for a complete discussion of net present value concepts. Page 339 Internal Rate of Return for an Annuity on Both the TI BAII Plus and the HP 12C Solve for IRR = Internal rate of return Given: n = 10 years (number of years cash flow will continue) PMT = $10,000 per year (amount of the annuity) Cost = $50,000 (this is the present value of the annuity) You may choose to refer to Chapter 12 for a complete discussion of internal rate of return. Page 340 Internal Rate of Return with an Uneven Cash Flow on Both the TI BAII Plus and the HP 12C Solve for IRR = Internal rate of return (return that causes present value of outflows to equal present value of the inflows) Given: n = 5 years (number of years cash flow will continue) PMT = $5,000 (yr. 1); $6,000 (yr. 2); $7,000 (yr. 3); $8,000 (yr. 4); $9,000 (yr. 5) Cost = $25,000 You may choose to refer to Chapter 12 for a complete discussion of internal rate of return. 1The assumption is that the bond has a $1,000 par value. If the par value is higher or lower, then this value would be discounted to the present from the maturity date. 2For now, we are using annual interest payments for simplicity. Later in the discussion, we will shift to semiannual payments, and more appropriately determine the value of a bond. 3Actually a slightly more accurate representation would be this: Risk-free rate = (1 + Real rate of return)(1 + Inflation premium) − 1. We would show: (1.03)(1.04) − 1 = 1.0712 − 1 = .0712 = 7.12 percent. 4On the other hand, common stock carries the potential for very high returns when the corporation is quite profitable. 5Of course the required rate of return on all other financial assets will also go up proportionally. 6Since this is a no-growth stock, D1 equals D0. Formula 10-6 uses D1 to emphasize that the first dividend payment comes at the end of year 1. 7This EPS value for the past 12 months is different from the value in the table for the latest year, which represents a calendar year.

Budget: $25.00

Due on: April 28, 2020 00:00

Posted: 6 months ago.

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