C O N T E N T S
Preface xvii
Introduction xxi
Chapter 1
The Challenge of Financial/Economic Decision-making 1
Lessons for the Millennium 2
The New Economy 2
Some Key Questions 3
The Basics Never Change 6
The Economic Manager 7
Understanding Business Economics 8
Appropriate Economic Tools 9
The Practice of Financial/Economic Analysis 10
Day to Day Decisions and Operational Planning 10
Supporting Strategy Development 11
Performance Assessment and Incentives 12
Valuation and Investor Communications 14
The Value Creating Company 15
Relevant Decision Information 15
Economic Incentives 17
Total Systems Management 18
Chapter 2
A Systems Context for Financial Management 21
A Dynamic Perspective of Business 22
Decision Context 22
The Business System 26
Investment Decisions 29
Operating Decisions 31
Financing Decisions 33
Interrelationship of Strategy and Value Creation 36
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x Contents
The Nature of Financial Statements 37
The Balance Sheet 38
The Income Statement 40
The Cash Flow Statement 42
The Statement of Changes in Shareholders’ (Owners’) Equity 46
The Context of Financial Analysis 50
Key Issues 55
Analytical Support 57
Chapter 3
Managing Operating Funds 59
Funds Flow Cycles 61
The Funds Cycle for Manufacturing 64
The Funds Cycle for Sales 67
The Funds Cycle for Services 69
Variability of Funds Flows 70
Growth/Decline Variations 70
Seasonal Variations 74
Cyclical Variations 75
Generalized Funds Flow Relationships 77
Interpreting Funds Flow Data 78
Funds Management and Shareholder Value 89
Cash Management 89
Working Capital Management 90
Investment Management 91
Key Issues 91
Analytical Support 93
Chapter 4
Assessment of Business Performance 95
Ratio Analysis and Performance 95
Management’s Point of View 97
Operational Analysis 98
Resource Management 107
Profitability 112
Owners’ Point of View 115
Investment Return 116
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Contents xi
Disposition of Earnings 121
Market Indicators 123
Lenders’ Point of View 126
Liquidity 126
Financial Leverage 128
Debt Service 130
Ratios as a System 132
Elements of Return on Assets 133
Elements of Return on Equity 134
Integration of Financial Performance Analysis 137
Some Special Issues 139
Inventory Costing 140
Depreciation Methods 141
The Impact of Inflation 144
Key Issues 145
Analytical Support 147
Chapter 5
Projection of Financial Requirements 161
Pro Forma Financial Statements 163
Pro Forma Income Statement 164
Pro Forma Balance Sheet 167
Pro Forma Cash Flow Statement 171
Cash Budgets 174
Operating Budgets 178
Sales Budget 179
Production Budget 181
Interrelationship of Financial Projections 181
Financial Modeling 184
Sensitivity Analysis 186
Key Issues 187
Analytical Support 189
Chapter 6
Dynamics and Growth of the Business System 191
Leverage 192
Operating Leverage 193
xii Contents
Target Profit Analysis 202
Financial Leverage 203
Financial Growth Plans 209
Basic Financial Growth Model 210
Sustainable Growth and the Sustainable Growth Equation 214
Integrated Financial Plan 217
Key Issues 220
Analytical Support 222
Chapter 7
Cash Flows and the Time Value of Money 223
The Time Value of Money 224
Discounting, Compounding, and Equivalence 224
Components of Analysis 231
Net Investment 232
Net Operating Cash Inflows 232
Economic Life 233
Terminal (Residual) Value 233
Methods of Analysis 234
Simple Measures 234
Economic Investment Measures 237
Net Present Value 237
Present Value Payback 242
Profitability Index (BCR) 244
Internal Rate of Return (IRR, Yield) 245
Annualized Net Present Value 247
Applying Time-Adjusted Measures 250
Key Issues 250
Analytical Support 252
Chapter 8
Analysis of Investment Decisions 255
Strategic Perspective 256
Decisional Framework 259
Problem Definition 260
Nature of the Investment 261
Future Costs and Benefits 262
Contents xiii
Incremental Cash Flows 263
Relevant Accounting Data 264
Sunk Costs 265
Refinements of Investment Analysis 266
A Machine Replacement 266
Net Investment Refined 267
Operating Cash Inflows Refined 268
Unequal Economic Lives 271
Capital Additions and Recoveries 272
Analytical Framework 272
A Business Expansion 275
Mutually Exclusive Alternatives 277
Maintain versus Replace 277
Full-Fledged versus Economy Solution 279
Comparing Different Scenarios 280
Dealing with Risk and Changing Circumstances 282
Specifying Risk 283
Ranges of Estimates 284
Business Investments as Options 285
Probabilistic Simulation 287
Risk-Adjusted Return Standards 288
When to Use Investment Measures 289
Some Further Considerations 291
Leasing—A Financing Choice 291
Accelerated Depreciation 292
Inflation and Investment Analysis 292
Accuracy 293
Key Issues 293
Analytical Support 295
Chapter 9
Cost of Capital and Business Decisions 297
Decisional Context 298
Investment Decisions 298
Operating Decisions 299
Financing Decisions 300
Cost of Operating Funds 300
Cost of Long-term Debt 304
xiv Contents
Cost of Shareholders’ Equity 305
Preferred Stock 305
Common Equity 306
Weighted Cost of Capital 312
Cost Choices 312
Weighting the Proportions 313
Calculating the Weighted Cost of Capital 315
Cost of Capital and Return Standards 317
Cost of Capital as a Cutoff Rate 318
Risk Categories 319
Cost of Capital in Multibusiness Companies 321
Multiple Rate Analysis 322
Key Issues 322
Analytical Support 324
Chapter 10
Analysis of Financing Choices 325
Framework for Analysis 326
Cost of Incremental Funds 326
Risk Exposure 327
Flexibility 328
Timing 328
Control 329
The Choice 330
Techniques of Calculation 330
Current Performance 331
Long-Term Debt in the Capital Structure 332
Preferred Stock in the Capital Structure 335
Common Stock in the Capital Structure 336
Range of Earnings Chart 339
The Optimal Capital Structure 345
Some Special Forms of Financing 347
Leasing 347
Convertible Securities 350
Stock Rights 351
Warrants 352
Key Issues 352
Analytical Support 354
Contents xv
Chapter 11
Valuation and Business Performance 357
Definitions of Value 358
Economic Value 358
Market Value 359
Book Value 360
Liquidation Value 360
Breakup Value 361
Reproduction Value 361
Collateral Value 361
Assessed Value 362
Appraised Value 362
Going Concern Value 362
Shareholder Value 363
Value to the Investor 363
Bond Values 363
Preferred Stock Values 368
Common Stock Values 372
Specialized Valuation Issues 378
Rights and Warrants 378
Options 379
Business Valuation 380
Valuing the Equity 381
Valuing the Total Company 382
Using Shortcuts in Valuing an Ongoing Business 387
Key Issues 388
Analytical Support 389
Chapter 12
Managing for Shareholder Value 391
Shareholder Value Creation in Perspective 392
Evolution of Value-Based Methodologies 396
A Review of Key Measures 398
Economic Profit and CFROI 402
Creating Value in Restructuring and Combinations 411
Restructuring and Value 411
xvi Contents
Combinations and Synergy 414
Combinations and Share Values 415
Integration of Value Analysis 417
Perspectives 418
Expectations 419
Time Period 419
Cash Flow Pattern 419
Ongoing Values 420
Comparables 420
Negotiations 421
Key Issues 421
Analytical Support 423
APPENDIX I
Financial Analysis Using Financial Genome 425
APPENDIX II
Glossary of Key Terms and Concepts 433
APPENDIX III
Financial Information and On-Line Sources 449
APPENDIX IV
Basic Inflation Concepts 463
APPENDIX V
Some Issues in Multinational Financial Analysis 469
INDEX 477