Foundations of Financial Management 17th Edition pdf.

Foundations of Financial Management 17th Edition pdf. Review of Accounting LEARNING OBJECTIVES The income statement measures profitability. The price-earnings ratio indicates the relative valuation of earnings. The balance sheet shows assets and the financing of those assets with debt and equity. The statement of cash flows indicates changes in the cash position of the firm. Depreciation provides a tax reduction benefit that increases cash flow. cDonald’s does not show up on the “best restaurant” lists in many cities, but if you are looking for an inexpensive meal in a hurry, there is a good chance that you might pick Combo #1 at one of McDonald’s 35,000 locations. No restaurant chain has been more successful. The company serves almost 70 million meals around the world each day. McDonald’s is sometimes portrayed as a villain by social activists. However, if you are an investor, you probably see the company in a kind light. McDonald’s has raised its 84 Table 2-1 1. Sales 2. Cost of goods sold 3. Gross profit 4. Selling and administrative expense 5. Depreciation expense 6. Operating profit (EBIT)* 7. Interest expense 8. Earnings before taxes (EBT) page 27 dividend from $0.40 per share in 2003 to $4.04 in 2018. This long-term growth has been powered by a dependable earnings stream of approximately $5 billion per year. Its recent return on assets is almost 16 percent. Many businesses would like to copy the McDonald’s formula for success. Chipotle Mexican Grill is one firm that thought it had copied the formula pretty well. That should not be a surprise, since Chipotle was a McDonald’s subsidiary until 2006. Chipotle reported net income of over $475 million in 2015, a return on assets of over 18 percent. But food safety scares in 2016 drove Chipotle’s stock down by more than 50 percent. Net income declined so much that Chipotle’s return on assets fell to less than 1 percent. Net income is just one piece of accounting data that financial managers, investors, and bankers track. Without accounting data, these financial professionals would be flying blind. The same can be said for the data of IBM, Procter & Gamble, Microsoft, or any other major U.S. corporation. The language of finance flows logically from accounting. To ensure that you are adequately prepared to study significant financial concepts, we must lock in the preparatory material from the accounting area. Much of the early frustration suffered by students who have difficulty with finance can be overcome if such concepts as retained earnings, shareholders’ equity, depreciation, and historical/replacement cost accounting are brought into focus. In this chapter, we examine the three basic types of financial statements—the income statement, the balance sheet, and the statement of cash flows—with particular attention paid to the interrelationships among these three measurement devices. As special preparation for finance students, we briefly examine income tax considerations affecting financial decisions. Income Statement The income statement is the major device for measuring the profitability of a firm over a period of time. An example of the income statement for the Kramer Corporation is presented in Table 2-1. Kramer Corporation income statement KRAMER CORPORATION Income Statement For the Year Ended December 31, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 170,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 150,500 85 9. Taxes 10. Earnings after taxes (EAT) 11. Preferred stock dividends 12. Earnings available to common stockholders 13. Common shares outstanding 14. Earnings per share page 28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 110,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.00 *Earnings before interest and taxes. First, note that the income statement covers a defined period of time, whether it is one month, three months, or a year. The statement is presented in a stair-step, or progressive, fashion so we can examine the profit or loss after each type of expense item is deducted. We start with sales and deduct cost of goods sold to arrive at gross profit. The $500,000 thus represents the difference between the cost of purchased or manufactured goods and the sales price. We then subtract selling and administrative expense and depreciation from gross profit to determine our profit (or loss) purely from operations of $170,500. It is possible for a company to enjoy a high gross profit margin (25–50 percent) but a relatively low operating profit because of heavy expenses incurred in marketing the product and managing the company.1 Having obtained operating profit (essentially a measure of how efficient management is in generating revenues and controlling expenses), we now adjust for revenues and expenses not related to operational matters. In this case, we pay $20,000 in interest and arrive at earnings before taxes of $150,500. The tax payments are $40,000, leaving aftertax income of $110,500. Return to Capital Before proceeding further, we should note that there are three primary sources of capital—the bondholders, who received $20,000 in interest (item 7); the preferred stockholders, who receive $10,500 in dividends (item 11); and the common stockholders. After the $10,500 dividend has been paid to the preferred stockholders, there will be $100,000 in earnings available to the common stockholders (item 12). In computing earnings per share, we must interpret this in terms of the number of shares outstanding. As indicated in item 13, there are 100,000 shares of common stock outstanding, so the $100,000 of earnings available to the common stockholders may be translated into earnings per share of $1. Common stockholders are sensitive to the number of shares outstanding—the more shares, the lower the earnings per share. Before any new shares are issued, 86 Table 2-2 Retained earnings, balance, January 1, 2018 Add: Earnings available to common stockholders, 2018 Deduct: Cash dividends declared in 2018 Retained earnings, balance, December 31, 2018 page 29 the financial manager must be sure the cash received from the sale will eventually generate sufficient earnings to avoid reducing earnings per share. The $100,000 of profit ($1 earnings per share) may be paid out to the common stockholders in the form of dividends or retained in the company for subsequent reinvestment. The reinvested funds theoretically belong to the common stockholders, who hope they will provide future earnings and dividends. In the case of the Kramer Corporation, we assume $50,000 in dividends will be paid out to the common stockholders, with the balance retained in the corporation for their benefit. A short supplement to the income statement, a statement of retained earnings (Table 2-2), usually indicates the disposition of earnings. 2 Kramer Corporation statement of retained earnings STATEMENT OF RETAINED EARNINGS For the Year Ended December 31, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 250,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300,000 We see that a net value of $50,000 has been added to previously accumulated earnings of $250,000 to arrive at $300,000. Price-Earnings Ratio Applied to Earnings per Share A concept utilized throughout the text is the price-earnings ratio. This refers to the multiplier applied to earnings per share to determine current value of the common stock. In the case of the Kramer Corporation, earnings per share were $1. If the firm had a price-earnings ratio of 20, the market value of each share would be $20 ($1 × 20). The price-earnings ratio (or P/E ratio, as it is commonly called) is influenced by the earnings and the sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend payment policy, the quality of management, and a number of other factors. Since companies have various levels of earnings per share, price-earnings ratios allow us to compare the relative market value of many companies based on $1 of earnings per share. The P/E ratio indicates expectations about the future of a company. Firms expected to provide returns greater than those for the market in general with equal or less risk often have P/E ratios higher than the market P/E ratio. Expectations of returns and P/E ratios do change over time, as Table 2-3 illustrates. Looking at the bottom line for the Standard & Poor’s 500 Index, it is clear that the P/E of the 87 Table 2-3 overall market has varied considerably over the last 25 years. Notice, however, that individual companies’ P/E ratios are even more volatile. Price-earnings ratios can be confusing. When a firm’s earnings are dropping rapidly or perhaps even approaching zero, its stock price, though also declining, may not match the magnitude of the falloff in earnings. This process can give the appearance of an increasing P/E ratio under adversity. This happens from time to time in cyclical industries. For example, in 2001 Cisco Systems (as shown in Table 2-3) was trading at a P/E ratio of 58 because of cyclically low earnings. You can find other examples of this phenomenon with Southwest Air in 2010 and Bank of America in 2015. Price-earnings ratios for selected U.S. companies *dd means the company is operating at a deficit and has no P/E ratio at the time because there are no positive earnings per share. Note: January price-earnings ratios are based on the previous 12 months’ earnings per share and could change in later editions after annual earnings are announced. Limitations of the Income Statement The economist defines income as the change in real worth that occurs between the beginning and the end of a specified time period. To the economist, an increase in the value of a firm’s land as a result of a new shopping mall being built on adjacent property is an increase in the real worth of the firm and therefore represents income. Similarly, the elimination of a competitor might also increase the firm’s real worth and therefore result in income in an economic sense. The accountant does not ordinarily employ such broad definitions. Accounting values are established primarily by actual transactions, and income that is gained or lost during a given period is a function of verifiable transactions. While the potential sales price of a firm’s property may go from $100,000 to $200,000 as a result of new developments in the area, stockholders may perceive only a much smaller gain or loss from actual day-to-day operations. 88 Also, as will be pointed out in Chapter 3, “Financial Analysis,” page 30 there is some flexibility in the reporting of transactions, so similar events may result in differing measurements of income at the end of a time period. The intent of this section is not to criticize the accounting profession, for it is among the best organized, trained, and paid professions, but to alert you to imperfections already recognized within the profession. Balance Sheet The balance sheet indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest. While the income statement purports to show the profitability of the firm, the balance sheet delineates the firm’s holdings and obligations. Together, these statements are intended to answer two questions: How much did the firm make or lose, and what is a measure of its worth? A balance sheet for the Kramer Corporation is presented in Table 2-4. Note that the balance sheet is a picture of the firm at a point in time—in this case, December 31, 2018. It does not purport to represent the result of transactions for a specific month, quarter, or year, but rather is a cumulative chronicle of all transactions that have affected the corporation since its inception. In contrast, the income statement measures results only over a short, quantifiable period. Generally, balance sheet items are stated on an original cost basis rather than at current market value.