Analysis for

Financial Management

Tenth Edition

ROBERT C.HIGGINS
(irmiente Keimers
ot Finance
The University of Washington,

McGraw-Hill
Irwin
Contents

Preface XI Ratio Analysis 60

Using Ratios Effectively 60
Ratio Analysis ofSensient Technologies
PART ONE Corporation 62
ASSESSING THE FINANCIAL Appendix
HEALTH OF THE FIRM 1 International Differences in Financial
Structure 71
Chapter 1 Comparisons among Foreign Companies Trading
Interpreting Financial Statements 3 on U.S. Markets 71
Public Companies 73
The Cash Flow Cycle 3 The Move Toward International Accounting
The Balance Sheet 6 Standards 77
Current Assets and Liabilities 9 Summary 79
Shareholders' Equity 11 Additional Resources 80
The Income Statement 11 Problems 82
Measuring Earnings 12
Sources and Uses Statements 16
The Two-Finger Approach 18 PART TWO
The Cash Flow Statement 18 PLANNING FUTURE FINANCIAL
Financial Statements and the Value Problem 23 PERFORMANCE 87
Market Value vs. Book Value 23
Economic Income vs. Accounting Income 2 7 Chapter 3
Imputed Costs 28
Financial Forecasting 89
Summary 30
Additional Resources 31 : Pro Forma Statements 89
Problems 32 Percent-of-Sales Forecasting 90
Interest Expense 96
Chapter 2 Seasonality 97
Pro Forma Statements and Financial Planning 97
Evaluating Financial Performance 37 Computer-Based Forecasting 98
The Levers of Financial Performance 37 Coping with Uncertainty 102
Return on Equity 38 Sensitivity Analysis 102
The Three Determinants ofROE 38 Scenario Analysis 103
The Profit Margin 40 Simulation 104
Asset Turnover 42 Cash Flow Forecasts 106
Financial Leverage 47 Cash Budgets 107
Is ROE a Reliable Financial Yardstick? 53 The Techniques Compared 110
The Timing Problem 53 Planning in Large Companies 111
The Risk Problem 54 Summary 113
The Value Problem 56 Additional Resources 114
ROE or Market Price? 57 Problems 116
viii Contents

Chapter 4 Financial Markets 168

Managing Growth 123 Private Equity Financing 168
Initial Public Offerings 170
Sustainable Growth 124 Seasoned Issues 172
The Sustainable Growth Equation 124 Issue Costs 177
Too Much Growth 127 Efficient Markets 178
Balanced Growth 127 What Is an Efficient Market? 179
Medifast's Sustainable Growth Rate 129 Implications of Efficiency 181
"What If Questions 130 Appendix
What to Do When Actual Growth Exceeds Using Financial Instruments to Manage
Sustainable Growth 131 Risks 183
Sell New Equity 131 Forward Markets 184
Increase Leverage 133 Hedging in Money and Capital Markets 189
Reduce the Payout Ratio 133 Hedging with Options 189
Profitable Pruning 134 Limitations of Financial Market Hedging 192
Outsourcing 135 Valuing Options 194
Pricing 135 Summary 197
Is Merger the Answer? 136 Additional Resources 198
Too Little Growth 136 Problems 200
What to Do When Sustainable Growth
Exceeds Actual Growth 137
Ignore the Problem 138 Chapter 6
Return the Money to Shareholders 139 The Financing Decision 203
Buy Growth 139
Sustainable Growth and Inflation 140
Financial Leverage 205
Sustainable Growth and Pro Forma Measuring the Effects of Leverage
Forecasts 141 on a Business 209
Leverage and Risk 211
New Equity Financing 142
Leverage and Earnings 213
Why Don't U.S. Corporations Issue More
Equity? 144
How Much to Borrow 216
Irrelevance 217
Summary 146
Tax Benefits 219
Problems 147
Distress Costs 219
Flexibility 223
Market Signaling 226
PART THREE Management Incentives 229
FINANCING OPERATIONS 151 The Financing Decision and Growth 229
Selecting a Maturity Structure 232
Chapter 5 Inflation and Financing Strategy 233
Appendix
Financial Instruments and The Irrelevance Proposition 233
Markets 153 No Taxes , 234
Financial Instruments 154 Taxes 236
Bonds 155 Summary 238
Common Stock 162 Additional Resources 239
Preferred Stock 166 Problems 240
 Contents ix

PART FOUR Estimating Investment Risk 301

EVALUATING INVESTMENT Three Techniques for Estimating Investment
Risk 302
OPPORTUNITIES 245 Including Risk in Investment Evaluation 303
Risk-Adjusted Discount Rates 303
Chapter 7 The Cost of Capital 304
Discounted Cash Flow Techniques 247 The Cost of Capital Defined 305
Figures of Merit 248 Cost of Capital for Sensient Technologies
The Payback Period and the Accounting Rate Corporation 307
ofReturn 249 The Cost of Capital in Investment
The Time Value ofMoney 250 Appraisal 314
Equivalence 254 Multiple Hurdle Rates 315
The Net Present Value 255 Four Pitfalls in the Use of Discounted Cash
The Benefit-Cost Ratio 257 Flow Techniques 317
The Internal Rate of Return 257 The Enterprise Perspective versus the Equity
A Few Applications and Extensions 261 Perspective 318
Mutually Exclusive Alternatives and Capital Inflation 320
Rationing 264 Real Options 321
The IRR in Perspective 265 Excessive Risk Adjustment 329
Determining the Relevant Cash Flows 266 Economic Value Added 330
Depreciation 268 EVA and Investment Analysis 331
Working Capital and Spontaneous Sources 270 EVA's Appeal 333
Sunk Costs 271 A Cautionary Note 334
Allocated Costs 272 Appendix
Cannibalization 273 Asset Beta and Adjusted Present
Excess Capacity 274 Value 334
Financing Costs 276 Beta and Financial Leverage 335
Appendix Using Asset Beta to Estimate Equity
Mutually Exclusive Alternatives and Beta 336
Capital Rationing 278 Asset Beta and Adjusted Present Value 337
What Happened to the Other $578,000? 279 Summary 340
Unequal Lives 280 Additional Resources 341
Capital Rationing 282 Problems 343
The Problem ofFuture Opportunities 284
A Decision Tree 284 Chapter 9
Summary 285 Business Valuation and Corporate
Additional Resources 287
Restructuring 349
Problems 287
Valuing a Business 351
Chapter 8 Assets or Equity? 352
Dead or Alive? 352
Risk Analysis in Investment
Minority Interest or Control? 354
Decisions 295 Discounted Cash Flow Valuation 355
Risk Defined 297 Free Cash Flow 356
Risk and Diversification 299,, The Terminal Value 357
x Contents

A Numerical Example 360 Why Do Venture Capitalists Demand

Problems with Present Value Approaches Such High Returns? 387
to Valuation 363 Summary 389
Valuation Based on Comparable Trades 363 Additional Resources 390
Lack ofMarketability 367 Problems 391
The Market for Control 368
The Premium for Control 368
Financial Reasons for Restructuring 3 70
Appendix A Present
The Empirical Evidence 378 Value of $1 397
The Cadbury Buyout 379 Appendix B Present Value of
Appendix an Annuity of $ 1 3 99
The Venture Capital Method of
Valuation 382 Glossary 401
The Venture Capital Method—One Suggested Answers to
Financing Round 382 Odd-Numbered Problems 413
The Venture Capital Method—Multiple
Financing Rounds 385 Index 443