How efficient are capital markets?

STEPHEN A. ROSS Massachuset ts Ins t i tu te o f Technolog y

RANDOLPH W. WESTERFIELD Univer s i t y o f Southern Ca l i fo rn ia

BRADFORD D. JORDAN Univer s i t y o f Kentucky

GORDON S. ROBERTS Schul ich School o f Bus iness , Yor k Univer s i t y

Fundamenta l s o f

Corporate Finance

Eighth Canadian Edition

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Fundamentals of Corporate Finance Eighth Canadian Edition

Copyright © 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited, a Subsidiary of The McGraw-Hill Companies. Copyright © 1996, 1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic copying, a license from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777.

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ISBN-13: 978-0-07-105160-6 ISBN-10: 0-07-105160-0

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Library and Archives Canada Cataloguing in Publication

Fundamentals of corporate finance / Stephen A. Ross … [et al.].—8th Canadian ed. Includes bibliographical references and indexes.

ISBN 978-0-07-105160-6

1. Corporations—Finance—Textbooks.  I. Ross, Stephen A

HG4026.F86 2013               658.15               C2012-906997-3

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ABOUT THE AUTHORS

Stephen A. Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology

Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

Randolph W. Westerf ield Marshall School of Business, University of Southern California

Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors, including Health Management Associates, Inc., William Lyons Homes, and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour.

Bradford D. Jordan Gatton College of Business and Economics, Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long- standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published nu- merous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author (with Thomas W. Miller, Jr.) of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, published by McGraw-Hill/Irwin.

Gordon S. Roberts Schulich School of Business, York University, Canadian Imperial Bank of Commerce Professor of Financial Services

Gordon S. Roberts is Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His exten- sive teaching experience includes finance classes for un- dergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts con- ducts research on the pricing of bank loans and the reg- ulation of financial institutions. He has served on the editorial boards of several Canadian and international academic journals. Professor Roberts has been a consul- tant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.

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BRIEF CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 25

P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

3 Working with Financial Statements 53 4 Long-Term Financial Planning and

Corporate Growth 84

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

5 Introduction to Valuation: The Time Value of Money 111

6 Discounted Cash Flow Valuation 129 7 Interest Rates and Bond Valuation 165 8 Stock Valuation 196

P A R T 4

CAPITIAL BUDGETING 220

9 Net Present Value and Other Investment Criteria 220

10 Making Capital Investment Decisions 250 11 Project Analysis and Evaluation 288

P A R T 5

RISK AND RETURN 317

12 Lessons from Capital Market History 317 13 Return, Risk, and the Security Market Line 346

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

14 Cost of Capital 387 15 Raising Capital 423 16 Financial Leverage and Capital

Structure Policy 454 17 Dividends and Dividend Policy 490

P A R T 7

SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519

18 Short-Term Finance and Planning 519 19 Cash and Liquidity Management 552 20 Credit and Inventory Management 572

P A R T 8

TOPICS IN CORPORATE FINANCE 606

21 International Corporate Finance 606 22 Leasing 634 23 Mergers and Acquisitions 655

P A R T 9

DERIVATIVE SECURITIES AND CORPORATE FINANCE 685

24 Enterprise Risk Management 685 25 Options and Corporate Securities 711 26 Behavioural Finance: Implications for

Financial Management 750

Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802

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CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

C H A P T E R 1

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 1 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2

1.2 Forms of Business Organization 4 Sole Proprietorship 4 Partnership 5 Corporation 5 Income Trust 6 Co-operative (Co-op) 7

1.3 The Goal of Financial Management 8 Possible Goals 8 The Goal of Financial Management 8 A More General Goal 9

1.4 The Agency Problem and Control of the Corporation 10 Agency Relationships 10 Management Goals 10 Do Managers Act in the Shareholders’ Interests? 10 Corporate Social Responsibility and Ethical Investing 12

1.5 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 15 Money versus Capital Markets 15 Primary versus Secondary Markets 16

1.6 Financial Institutions 18

1.7 Trends in Financial Markets and Financial Management 20

1.8 Outline of the Text 21

1.9 Summary and Conclusions 22

C H A P T E R 2

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES 25

2.1 Statement of Financial Position 25 Assets 26 Liabilities and Owners’ Equity 26 Net Working Capital 27 Liquidity 28 Debt versus Equity 28 Value versus Cost 28

2.2 Statement of Comprehensive Income 30 International Financial Reporting Standards (IFRS) 30 Non-Cash Items 31 Time and Costs 31

2.3 Cash Flow 32 Cash Flow from Assets 32 Cash Flow to Creditors and Shareholders 34 Net Capital Spending 36 Change in NWC and Cash Flow from Assets 36

2.4 Taxes 37 Individual Tax Rates 37 Average versus Marginal Tax Rates 37 Taxes on Investment Income 39 Corporate Taxes 39 Taxable Income 39 Global Tax Rates 40 Capital Gains and Carry-forward and Carry-back 40 Income Trust Income and Taxation 41

2.5 Capital Cost Allowance 42 Asset Purchases and Sales 43

2.6 Summary and Conclusions 45

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P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

C H A P T E R 3

WORKING WITH FINANCIAL STATEMENTS 53

3.1 Cash Flow and Financial Statements: A Closer Look 54 Sources and Uses of Cash 54 The Statement of Cash Flows 56

3.2 Standardized Financial Statements 57 Common-Size Statements 57 Common-Base-Year Financial Statements: Trend Analysis 59

3.3 Ratio Analysis 60 Short-Term Solvency or Liquidity Measures 61 Other Liquidity Ratios 63 Long-Term Solvency Measures 64 Asset Management, or Turnover, Measures 65 Profitability Measures 67 Market Value Measures 68

3.4 The Du Pont Identity 71

3.5 Using Financial Statement Information 73 Why Evaluate Financial Statements? 73 Choosing a Benchmark 74 Problems with Financial Statement Analysis 75

3.6 Summary and Conclusions 75

C H A P T E R 4

LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH 84

4.1 What Is Financial Planning? 85 Growth as a Financial Management Goal 85 Dimensions of Financial Planning 86 What Can Planning Accomplish? 86

4.2 Financial Planning Models: A First Look 88 A Financial Planning Model: The Ingredients 88 A Simple Financial Planning Model 89

4.3 The Percentage of Sales Approach 90 An Illustration of the Percentage of Sales Approach 90

4.4 External Financing and Growth 95 External Financing Needed and Growth 95 Internal Growth Rate 97 Financial Policy and Growth 98 Determinants of Growth 100 A Note on Sustainable Growth Rate Calculations 101

4.5 Some Caveats on Financial Planning Models 103

4.6 Summary and Conclusions 103

Appendix 4 (available on Connect)

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

C H A P T E R 5

INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 111

5.1 Future Value and Compounding 112 Investing for a Single Period 112 Investing for More than One Period 112 A Note on Compound Growth 118

5.2 Present Value and Discounting 118 The Single-Period Case 119 Present Values for Multiple Periods 119

5.3 More on Present and Future Values 121 Present versus Future Value 121 Determining the Discount Rate 122 Finding the Number of Periods 124

5.4 Summary and Conclusions 126

C H A P T E R 6

DISCOUNTED CASH FLOW VALUATION 129

6.1 Future and Present Values of Multiple Cash Flows 129 Future Value with Multiple Cash Flows 129 Present Value with Multiple Cash Flows 131 A Note on Cash Flow Timing 134

6.2 Valuing Level Cash Flows: Annuities and Perpetuities 135 Present Value for Annuity Cash Flows 135

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Future Value for Annuities 140 A Note on Annuities Due 141 Perpetuities 142 Growing Perpetuities 143 Formula for Present Value of Growing Perpetuity 144 Growing Annuity 145 Formula for Present Value of Growing Annuity 145

6.3 Comparing Rates: The Effect of Compounding 145 Effective Annual Rates and Compounding 146 Calculating and Comparing Effective Annual Rates 146 Mortgages 147 EARs and APRs 148 Taking It to the Limit: A Note on Continuous Compounding 149

6.4 Loan Types and Loan Amortization 150 Pure Discount Loans 150 Interest-Only Loans 150 Amortized Loans 151

6.5 Summary and Conclusions 155

Appendix 6A: Proof of Annuity Present Value Formula 164

C H A P T E R 7

INTEREST RATES AND BOND VALUATION 165

7.1 Bonds and Bond Valuation 165 Bond Features and Prices 165 Bond Values and Yields 166 Interest Rate Risk 169 Finding the Yield to Maturity 170

7.2 More on Bond Features 173 Is It Debt or Equity? 173 Long-Term Debt: The Basics 174 The Indenture 174

7.3 Bond Ratings 177

7.4 Some Different Types of Bonds 178 Financial Engineering 178 Stripped Bonds 179 Floating-Rate Bonds 180 Other Types of Bonds 180

7.5 Bond Markets 181 How Bonds Are Bought and Sold 181 Bond Price Reporting 182 A Note on Bond Price Quotes 182 Bond Funds 184

7.6 Inflation and Interest Rates 184 Real versus Nominal Rates 184 The Fisher Effect 185 Inflation and Present Values 186

7.7 Determinants of Bond Yields 186 The Term Structure of Interest Rates 187 Bond Yields and the Yield Curve: Putting It All Together 188 Conclusion 189

7.8 Summary and Conclusions 190

Appendix 7A: On Duration 194

Appendix 7B (available on Connect)

C H A P T E R 8

STOCK VALUATION 196

8.1 Common Stock Valuation 196 Common Stock Cash Flows 196 Common Stock Valuation: Some Special Cases 198 Changing the Growth Rate 202 Components of the Required Return 203

8.2 Common Stock Features 205 Shareholders’ Rights 205 Dividends 206 Classes of Stock 206

8.3 Preferred Stock Features 207 Stated Value 207 Cumulative and Non-Cumulative Dividends 207 Is Preferred Stock Really Debt? 208 Preferred Stock and Taxes 209 Beyond Taxes 209

8.4 Stock Market Reporting 210 Growth Opportunities 211 Application: The Price-Earnings Ratio 211

8.5 Summary and Conclusions 213

Appendix 8A: Corporate Voting 218

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P A R T 4

CAPITAL BUDGETING 220

C H A P T E R 9

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 220

9.1 Net Present Value 221 The Basic Idea 221 Estimating Net Present Value 222

9.2 The Payback Rule 225 Defining the Rule 225 Analyzing the Payback Period Rule 225 Redeeming Qualities 226 Summary of the Rule 226 The Discounted Payback Rule 227

9.3 The Average Accounting Return 228 Analyzing the Average Accounting Return Method 229

9.4 The Internal Rate of Return 230 Problems with the IRR 233 Redeeming Qualities of the IRR 237

9.5 The Profitability Index 238

9.6 The Practice of Capital Budgeting 239

9.7 Summary and Conclusions 241

Appendix 9A: The Modified Internal Rate of Return 248

C H A P T E R 1 0

MAKING CAPITAL INVESTMENT DECISIONS 250

10.1 Project Cash Flows: A First Look 251 Relevant Cash Flows 251 The Stand-Alone Principle 251

10.2 Incremental Cash Flows 251 Sunk Costs 251 Opportunity Costs 252 Side Effects 252 Net Working Capital 253 Financing Costs 253 Inflation 253

Capital Budgeting and Business Taxes in Canada 254 Other Issues 254

10.3 Pro Forma Financial Statements and Project Cash Flows 254 Getting Started: Pro Forma Financial Statements 254 Project Cash Flows 255 Project Total Cash Flow and Value 256

10.4 More on Project Cash Flow 257 A Closer Look at Net Working Capital 257 Depreciation and Capital Cost Allowance 258 An Example: The Majestic Mulch and Compost Company (MMCC) 259

10.5 Alternative Definitions of Operating Cash Flow 263 The Bottom-Up Approach 263 The Top-Down Approach 264 The Tax Shield Approach 264 Conclusion 265

10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 265 Present Value of the Tax Shield on CCA 266 Salvage Value versus UCC 268

10.7 Some Special Cases of Discounted Cash Flow Analysis 269 Evaluating Cost-Cutting Proposals 269 Replacing an Asset 270 Evaluating Equipment with Different Lives 272 Setting the Bid Price 273

10.8 Summary and Conclusions 276

Appendix 10A: More on Inflation and Capital Budgeting 285

Appendix 10B: Capital Budgeting with Spreadsheets 286

C H A P T E R 1 1

PROJECT ANALYSIS AND EVALUATION 288

11.1 Evaluating NPV Estimates 288 The Basic Problem 289 Projected versus Actual Cash Flows 289 Forecasting Risk 289 Sources of Value 289

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11.2 Scenario and Other What-If Analyses 290 Getting Started 290 Scenario Analysis 291 Sensitivity Analysis 293 Simulation Analysis 295

11.3 Break-Even Analysis 296 Fixed and Variable Costs 296 Accounting Break-Even 297 Accounting Break-Even: A Closer Look 299 Uses for the Accounting Break-Even 299

11.4 Operating Cash Flow, Sales Volume, and Break-Even 300 Accounting Break-Even and Cash Flow 300 Cash Flow and Financial Break-Even Points 302

11.5 Operating Leverage 304 The Basic Idea 304 Implications of Operating Leverage 305 Measuring Operating Leverage 305 Operating Leverage and Break-Even 306

11.6 Managerial Options 307

11.7 Capital Rationing 310

11.8 Summary and Conclusions 311

P A R T 5

RISK AND RETURN 317

C H A P T E R 1 2

LESSONS FROM CAPITAL MARKET HISTORY 317

12.1 Returns 318 Dollar Returns 318 Percentage Returns 319

12.2 The Historical Record 321 A First Look 323 A Closer Look 324

12.3 Average Returns: The First Lesson 324 Calculating Average Returns 324 Average Returns: The Historical Record 324 Risk Premiums 325 The First Lesson 325

12.4 The Variability of Returns: The Second Lesson 326 Frequency Distributions and Variability 326 The Historical Variance and Standard Deviation 326 The Historical Record 328 Normal Distribution 329 Value at Risk 331 The Second Lesson 331 2008 The Bear Growled and Investors Howled 331 Using Capital Market History 332

12.5 More on Average Returns 333 Arithmetic versus Geometric Averages 333 Calculating Geometric Average Returns 333 Arithmetic Average Return or Geometric Average Return? 335

12.6 Capital Market Efficiency 335 Price Behaviour in an Efficient Market 336 The Efficient Markets Hypothesis 337 Market Efficiency—Forms and Evidence 339

12.7 Summary and Conclusions 341

C H A P T E R 1 3

RETURN, RISK, AND THE SECURITY MARKET LINE 346

13.1 Expected Returns and Variances 347 Expected Return 347 Calculating the Variance 349

13.2 Portfolios 351 Portfolio Weights 351 Portfolio Expected Returns 351 Portfolio Variance 352 Portfolio Standard Deviation and Diversification 353 The Efficient Set 355 Correlations in the Financial Crisis of 2007–2009 357

13.3 Announcements, Surprises, and Expected Returns 359 Expected and Unexpected Returns 359 Announcements and News 359

13.4 Risk: Systematic and Unsystematic 360 Systematic and Unsystematic Risk 360 Systematic and Unsystematic Components of Return 361

Contents ix

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13.5 Diversification and Portfolio Risk 361 The Effect of Diversification: Another Lesson from Market History 362 The Principle of Diversification 363 Diversification and Unsystematic Risk 364 Diversification and Systematic Risk 364 Risk and the Sensible Investor 364

13.6 Systematic Risk and Beta 365 The Systematic Risk Principle 366 Measuring Systematic Risk 366 Portfolio Betas 367

13.7 The Security Market Line 368 Beta and the Risk Premium 368 Calculating Beta 372 The Security Market Line 374

13.8 Arbitrage Pricing Theory And Empirical Models 377

13.9 Summary and Conclusions 379

Appendix 13A: Derivation of the Capital Asset Pricing Model 384

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

C H A P T E R 1 4

COST OF CAPITAL 387

14.1 The Cost of Capital: Some Preliminaries 388 Required Return versus Cost of Capital 388 Financial Policy and Cost of Capital 388

14.2 The Cost of Equity 389 The Dividend Growth Model Approach 389 The SML Approach 391 The Cost of Equity in Rate Hearings 392

14.3 The Costs of Debt and Preferred Stock 393 The Cost of Debt 393 The Cost of Preferred Stock 394

14.4 The Weighted Average Cost of Capital 394 The Capital Structure Weights 395 Taxes and the Weighted Average Cost of Capital 396 Solving the Warehouse Problem and Similar Capital Budgeting Problems 396 Performance Evaluation: Another Use of the WACC 398

14.5 Divisional and Project Costs of Capital 399 The SML and the WACC 399 Divisional Cost of Capital 401 The Pure Play Approach 401 The Subjective Approach 402

14.6 Flotation Costs and the Weighted Average Cost of Capital 403 The Basic Approach 403 Flotation Costs and NPV 404

14.7 Calculating WACC for Loblaw 406 Estimating Financing Proportions 406 Market Value Weights for Loblaw 406 Cost of Debt 407 Cost of Preferred Shares 408 Cost of Common Stock 408 CAPM 408 Dividend Valuation Model Growth Rate 409 Loblaw’s WACC 409

14.8 Summary and Conclusions 409

Appendix 14A: Adjusted Present Value 414

Appendix 14B: Economic Value Added and the Measurement of Financial Performance 419

C H A P T E R 1 5

RAISING CAPITAL 423

15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 423 Venture Capital 424 Some Venture Capital Realities 424 Choosing a Venture Capitalist 424 Conclusion 425

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15.2 The Public Issue 425

15.3 The Basic Procedure for a New Issue 426 Securities Registration 427 Alternative Issue Methods 427

15.4 The Cash Offer 427 Types of Underwriting 428 Bought Deal 428 Dutch Auction Underwriting 429 The Selling Period 429 The Overallotment Option 430 Lockup Agreements 430 The Quiet Period 430 The Investment Dealers 430

15.5 IPOs and Underpricing 431 IPO Underpricing: The 1999–2000 Experience 431 Evidence on Underpricing 432 Why Does Underpricing Exist? 435

15.6 New Equity Sales and the Value of the Firm 436

15.7 The Cost of Issuing Securities 437 IPOs in Practice: The Case of Athabasca Oil Sands 439

15.8 Rights 439 The Mechanics of a Rights Offering 439 Number of Rights Needed to Purchase a Share 440 The Value of a Right 441 Theoretical Value of a Right 442 Ex Rights 443 Value of Rights after Ex-Rights Date 444 The Underwriting Arrangements 444 Effects on Shareholders 444 Cost of Rights Offerings 445

15.9 Dilution 446 Dilution of Proportionate Ownership 446 Dilution of Value: Book versus Market Values 446

15.10 Issuing Long-term Debt 448

15.11 Summary and Conclusions 449

C H A P T E R 1 6

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 454

16.1 The Capital Structure Question 455 Firm Value and Stock Value: An Example 455 Capital Structure and the Cost of Capital 456

16.2 The Effect of Financial Leverage 456 The Basics of Financial Leverage 456 Corporate Borrowing and Homemade Leverage 460

16.3 Capital Structure and the Cost of Equity Capital 462 M&M Proposition I: The Pie Model 462 The Cost of Equity and Financial Leverage: M&M Proposition II 462 Business and Financial Risk 463

16.4 M&M Propositions I and II with Corporate Taxes 466 The Interest Tax Shield 466 Taxes and M&M Proposition I 466 Taxes, the WACC, and Proposition II 468

16.5 Bankruptcy Costs 470 Direct Bankruptcy Costs 470 Indirect Bankruptcy Costs 470 Agency Costs of Equity 471

16.6 Optimal Capital Structure 472 The Static Theory of Capital Structure 472 Optimal Capital Structure and the Cost of Capital 473 Optimal Capital Structure: A Recap 473 Capital Structure: Some Managerial Recommendations 475

16.7 The Pie Again 475 The Extended Pie Model 475 Marketed Claims versus Non-Marketed Claims 476

16.8 The Pecking-Order Theory 477 Internal Financing and the Pecking Order 477 Implications of the Pecking Order 477

16.9 Observed Capital Structures 478

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16.10 Long-Term Financing Under Financial Distress and Bankruptcy 479 Liquidation and Reorganization 480 Agreements to Avoid Bankruptcy 481

16.11 Summary and Conclusions 482

Appendix 16A: Capital Structure and Personal Taxes 487

Appendix 16B: Derivation of Proposition II (Equation 16.4) 489

C H A P T E R 1 7

DIVIDENDS AND DIVIDEND POLICY 490

17.1 Cash Dividends and Dividend Payment 491 Cash Dividends 491 Standard Method of Cash Dividend Payment 492 Dividend Payment: A Chronology 492 More on the Ex-Dividend Date 492

17.2 Does Dividend Policy Matter? 494 An Illustration of the Irrelevance of Dividend Policy 494

17.3 Real-World Factors Favouring a Low Payout 496 Taxes 496 Some Evidence on Dividends and Taxes in Canada 497 Flotation Costs 498 Dividend Restrictions 498

17.4 Real-World Factors Favouring a High Payout 499 Desire for Current Income 499 Uncertainty Resolution 499 Tax and Legal Benefits from High Dividends 500 Conclusion 500

17.5 A Resolution of Real-World Factors? 500 Information Content of Dividends 501 Dividend Signalling in Practice 501 The Clientele Effect 502

17.6 Establishing a Dividend Policy 503 Residual Dividend Approach 503

Dividend Stability 505 A Compromise Dividend Policy 507 Some Survey Evidence on Dividends 507

17.7 Stock Repurchase: An Alternative to Cash Dividends 508 Cash Dividends versus Repurchase 508 Real-World Considerations in a Repurchase 510 Share Repurchase and EPS 510

17.8 Stock Dividends and Stock Splits 510 Some Details on Stock Splits and Stock Dividends 511 Value of Stock Splits and Stock Dividends 512 Reverse Splits 512

17.9 Summary and Conclusions 513

P A R T 7

SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519

C H A P T E R 1 8

SHORT-TERM FINANCE AND PLANNING 519

18.1 Tracing Cash and Net Working Capital 520

18.2 The Operating Cycle and the Cash Cycle 521 Defining the Operating and Cash Cycles 522 Calculating the Operating and Cash Cycles 524 Interpreting the Cash Cycle 525

18.3 Some Aspects of Short-Term Financial Policy 526 The Size of the Firm’s Investment in Current Assets 526 Alternative Financing Policies for Current Assets 528 Which Financing Policy is Best? 531 Current Assets and Liabilities in Practice 531

18.4 The Cash Budget 533 Sales and Cash Collections 533 Cash Outflows 534 The Cash Balance 534

18.5 A Short-Term Financial Plan 536 Short-Term Planning and Risk 537

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18.6 Short-Term Borrowing 537 Operating Loans 537 Letters of Credit 539 Secured Loans 539 Factoring 540 Securitized Receivables—A Financial Innovation 541 Inventory Loans 541 Trade Credit 542 Money Market Financing 543

18.7 Summary and Conclusions 545

C H A P T E R 1 9

CASH AND LIQUIDITY MANAGEMENT 552

19.1 Reasons for Holding Cash 552 Speculative and Precautionary Motives 553 The Transaction Motive 553 Costs of Holding Cash 553 Cash Management versus Liquidity Management 553

19.2 Determining the Target Cash Balance 554 The Basic Idea 554 Other Factors Influencing the Target Cash Balance 555

19.3 Understanding Float 556 Disbursement Float 556 Collection Float and Net Float 557 Float Management 557 Accelerating Collections 560 Over-the-Counter Collections 561 Controlling Disbursements 563

19.4 Investing Idle Cash 564 Temporary Cash Surpluses 564 Characteristics of Short-Term Securities 565 Some Different Types of Money Market Securities 567

19.5 Summary and Conclusions 568

Appendix 19A (available on Connect)

C H A P T E R 2 0

CREDIT AND INVENTORY MANAGEMENT 572

20.1 Credit and Receivables 572 Components of Credit Policy 573 The Cash Flows from Granting Credit 573 The Investment in Receivables 573

20.2 Terms of the Sale 574 Why Trade Credit Exists 574 The Basic Form 575 The Credit Period 575 Cash Discounts 576 Credit Instruments 578

20.3 Analyzing Credit Policy 578 Credit Policy Effects 578 Evaluating a Proposed Credit Policy 579

20.4 Optimal Credit Policy 581 The Total Credit Cost Curve 581 Organizing the Credit Function 581

20.5 Credit Analysis 583 When Should Credit Be Granted? 583 Credit Information 584 Credit Evaluation and Scoring 585

20.6 Collection Policy 588 Monitoring Receivables 588 Collection Effort 589 Credit Management in Practice 589

20.7 Inventory Management 590 The Financial Manager and Inventory Policy 590 Inventory Types 590 Inventory Costs 591

20.8 Inventory Management Techniques 591 The ABC Approach 592 The Economic Order Quantity (EOQ) Model 592 Extensions to the EOQ Model 595 Managing Derived-Demand Inventories 596 Materials Requirements Planning (MRP) 597 Just-In-Time Inventory 598

20.9 Summary and Conclusions 600

Appendix 20A (available on Connect)

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P A R T 8

TOPICS IN CORPORATE FINANCE 606

C H A P T E R 2 1

INTERNATIONAL CORPORATE FINANCE 606

21.1 Terminology 607

21.2 Foreign Exchange Markets and Exchange Rates 608 Exchange Rates 609 Types of Transactions 611

21.3 Purchasing Power Parity 613 Absolute Purchasing Power Parity 613 Relative Purchasing Power Parity 614 Currency Appreciation and Depreciation 615

21.4 Interest Rate Parity, Unbiased Forward Rates, and the Generalized Fisher Effect 616 Covered Interest Arbitrage 616 Interest Rate Parity (IRP) 617 Forward Rates and Future Spot Rates 617 Putting It All Together 618

21.5 International Capital Budgeting 620 Method 1: The Home Currency Approach 620 Method 2: The Foreign Currency Approach 621 Unremitted Cash Flows 621

21.6 Financing International Projects 622 The Cost of Capital for International Firms 622 International Diversification and Investors 622 Sources of Short- and Intermediate-Term Financing 623

21.7 Exchange Rate Risk 624 Transaction Exposure 624 Economic Exposure 625 Translation Exposure 626 Managing Exchange Rate Risk 627

21.8 Political and Governance Risks 627 Corporate Governance Risk 628

21.9 Summary and Conclusions 629

C H A P T E R 2 2

LEASING 634

22.1 Leases and Lease Types 634 Leasing versus Buying 635 Operating Leases 635 Financial Leases 636

22.2 Accounting and Leasing 637

22.3 Taxes, Canada Revenue Agency (CRA), and Leases 639

22.4 The Cash Flows from Leasing 639 The Incremental Cash Flows 640

22.5 Lease or Buy? 641 A Preliminary Analysis 641 NPV Analysis 642 A Misconception 643 Asset Pool and Salvage Value 643

22.6 A Leasing Paradox 644 Resolving the Paradox 645 Leasing and Capital Budgeting 647

22.7 Reasons for Leasing 649 Good Reasons for Leasing 649 Bad Reasons for Leasing 649 Other Reasons for Leasing 650 Leasing Decisions in Practice 650

22.8 Summary and Conclusions 651

C H A P T E R 2 3

MERGERS AND ACQUISITIONS 655

23.1 The Legal Forms of Acquisitions 656 Merger or Consolidation 656 Acquisition of Stock 657 Acquisition of Assets 657 Acquisition Classifications 657 A Note on Takeovers 658 Alternatives to Merger 659

23.2 Taxes and Acquisitions 659 Determinants of Tax Status 659 Taxable versus Tax-Free Acquisitions 660

xiv Contents

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23.3 Accounting for Acquisitions 660

23.4 Gains from Acquisition 661 Synergy 661 Revenue Enhancement 662 Cost Reductions 663 Tax Gains 664 Changing Capital Requirements 665 Avoiding Mistakes 665 A Note on Inefficient Management and Opportunistic Takeover Offers 666 The Negative Side of Takeovers 666

23.5 Some Financial Side Effects of Acquisitions 667 EPS Growth 667 Diversification 668

23.6 The Cost of an Acquisition 668 Case I: Cash Acquisition 669 Case II: Stock Acquisition 669 Cash versus Common Stock 670

23.7 Defensive Tactics 670 The Control Block and the Corporate Charter 671 Repurchase ∕ Standstill Agreements 671 Exclusionary Offers and Dual Class Stock 672 Share Rights Plans 672 Going Private and Leveraged Buyouts 673 LBOs to Date: The Record 674 Other Defensive Devices 674

23.8 Some Evidence on Acquisitions 676

23.9 Divestitures and Restructurings 678

23.10 Summary and Conclusions 679

P A R T 9

DERIVATIVE SECURITIES AND CORPORATE FINANCE 685

C H A P T E R 2 4

ENTERPRISE RISK MANAGEMENT 685

24.1 Insurance 686

24.2 Managing Financial Risk 687 The Impact of Financial Risk: The Credit Crisis of 2007–2009 687

The Risk Profile 688 Reducing Risk Exposure 688 Hedging Short-Run Exposure 689 Cash Flow Hedging: A Cautionary Note 690 Hedging Long-Term Exposure 690 Conclusion 690

24.3 Hedging with Forward Contracts 691 Forward Contracts: The Basics 691 The Payoff Profile 691 Hedging with Forwards 692

24.4 Hedging with Futures Contracts 694 Trading in Futures 694 Futures Exchanges 694 Hedging with Futures 698

24.5 Hedging with Swap Contracts 698 Currency Swaps 699 Interest Rate Swaps 699 Commodity Swaps 699 The Swap Dealer 699 Interest Rate Swaps: An Example 700 Credit Default Swaps (CDS) 701

24.6 Hedging with Option Contracts 701 Option Terminology 701 Options versus Forwards 702 Option Payoff Profiles 702 Option Hedging 703 Hedging Commodity Price Risk with Options 703 Hedging Exchange Rate Risk with Options 704 Hedging Interest Rate Risk with Options 704 Actual Use of Derivatives 706

24.7 Summary and Conclusions 707

C H A P T E R 2 5

OPTIONS AND CORPORATE SECURITIES 711

25.1 Options: The Basics 711 Puts and Calls 712 Stock Option Quotations 712 Option Payoffs 713 Put Payoffs 716 Long-Term Options 716

Contents xv

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25.2 Fundamentals of Option Valuation 716 Value of a Call Option at Expiration 717 The Upper and Lower Bounds on a Call Option’s Value 718 A Simple Model: Part I 719 Four Factors Determining Option Values 720

25.3 Valuing a Call Option 721 A Simple Model: Part II 721 The Fifth Factor 722 A Closer Look 723

25.4 Employee Stock Options 724 ESO Features 725 ESO Repricing 725

25.5 Equity as a Call Option on the Firm’s Assets 726 Case I: The Debt Is Risk-Free 726 Case II: The Debt Is Risky 727

25.6 Warrants 729 The Difference between Warrants and Call Options 729 Warrants and the Value of the Firm 730

25.7 Convertible Bonds 732 Features of a Convertible Bond 732 Value of a Convertible Bond 732

25.8 Reasons for Issuing Warrants and Convertibles 734 The Free Lunch Story 735 The Expensive Lunch Story 735 A Reconciliation 735

25.9 Other Options 736 The Call Provision on a Bond 736 Put Bonds 736 The Overallotment Option 736 Insurance and Loan Guarantees 737 Managerial Options 737

25.10 Summary and Conclusions 740

Appendix 25A: The Black–Scholes Option Pricing Model 745

C H A P T E R 2 6

BEHAVIOURAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT 750

26.1 Introduction to Behavioural Finance 751

26.2 Biases 751 Overconfidence 751 Overoptimism 751 Confirmation Bias 752

26.3 Framing Effects 752 Loss Aversion 753 House Money 754

26.4 Heuristics 755 The Affect Heuristic 755 The Representativeness Heuristic 756 Representativeness and Randomness 756 The Gambler’s Fallacy 757

26.5 Behavioural Finance and Market Efficiency 758 Limits to Arbitrage 758 Bubbles and Crashes 761

26.6 Market Efficiency and the Performance of Professional Money Managers 766

26.7 Summary and Conclusions 770

Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802

xvi Contents

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PREFACE

Fundamentals of Corporate Finance continues on its tradition of excellence that has earned it its status as market leader. The rapid and extensive changes in financial markets and instruments has placed new burdens on the teaching of Corporate Finance in Canada. As a result, every chapter has been updated to provide the most current examples that reflect Corporate Finance in today’s world. This best-selling text is written with one strongly held principle—that Corporate Finance should be developed and taught in terms of a few integrated powerful ideas: Emphasis on Intuition, Unified Valuation Approach, and Managerial Focus.

An Emphasis on Intuition We are always careful to separate and explain the principles at work on an intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation.

A Unified Valuation Approach We treat net present value (NPV) as the basic concept un- derlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic notion—that NPV represents the excess of market value over cost— tends to get lost in an overly mechanical approach to NPV that emphasizes computation at the expense of understanding. Every subject covered in Fundamentals of Corporate Finance is firmly rooted in valuation, and care is taken throughout the text to explain how particular decisions have valuation effects.

A Managerial Focus Students will not lose sight of the fact that financial management con- cerns management. Throughout the text, the role of the financial manager as decision maker is emphasized, and the need for managerial input and judgement is stressed. “Black box” approaches to finance are consciously avoided.

These three themes work together to provide a sound foundation, and a practical and work- able understanding of how to evaluate and make financial decisions.

New to This Edition In addition to retaining the coverage that has characterized Fundamen- tals of Corporate Finance from the beginning, the Eighth Canadian Edition features enhanced Canadian content on current issues such as:

• Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the Euro- pean government debt credit crisis (Chapters 1, 12, and 24, among others).

• Updated and expanded coverage of corporate governance, social responsibility, ethical in- vesting, and shareholder activism (Chapters 1, 8, and 23).

• Addition of a new chapter on Behavioural Finance (Chapter 26). • Refocusing of the derivatives coverage on Enterprise Risk Management (Chapter 24).

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COVERAGE

This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need.

Just to give an idea of the breadth of coverage in the Eighth Canadian Edition, the following grid presents, for each chapter, some of the most significant features, as well as a few selected chapter highlights. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter materials have been thoroughly updated as well.

Chapters Selected Topics of Interest Benefits to You

PART ONE OVERVIEW OF CORPORATE FINANCE Chapter 1 Introduction to Corporate Finance

• New material: Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the European government debt credit crisis

• Links to headlines on financial crisis.

• Goal of the firm and agency problems • Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise.

• Ethics, financial management, and executive compensation

• Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay.

Chapter 2 Financial Statements, Cash Flow, and Taxes

• New material: Financial statements conforming to IFRS • Links to current practice.

• Cash flow vs. earnings • Defines cash flow and the differences between cash flow and earnings.

• Market values vs. book values • Emphasizes the relevance of market values over book values.

PART TWO FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING Chapter 3 Working with Financial Statements

• Using financial statement information • Discusses the advantages and disadvantages of using financial statements.

Chapter 4 Long-Term Financial Planning and Corporate Growth

• Explanation of alternative formulas for sustainable and internal growth rates

• Explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct.

• Thorough coverage of sustainable growth as a planning tool

• Provides a vehicle for examining the interrelationships among operations, financing, and growth.

PART THREE VALUATION OF FUTURE CASH FLOWS Chapter 5 Introduction to Valuation: The Time Value of Money

• First of two chapters on time value of money • Relatively short chapter introduces the basic ideas on time value of money to get students started on this traditionally difficult topic.

Chapter 6 Discounted Cash Flow Valuation

• Second of two chapters on time value of money • Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples.

Chapter 7 Interest Rates and Bond Valuation

• New material: Discussion of bond fund strategies at time of European government debt crisis

• Links chapter material to current events.

• “Clean” vs. “dirty” bond prices and accrued interest

• Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions.

• Bond ratings • Up-to-date discussion of bond rating agencies and ratings given to debt. Includes the latest descriptions of ratings used by DBRS.

Chapter 8 Stock Valuation

• New material: Stock valuation using multiples • Broadens coverage of valuation techniques.

• New material: Examples of shareholder activism at Canadian Pacific and Magna International

• Expands governance coverage and links chapter material to current events.

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Chapters Selected Topics of Interest Benefits to You PART FOUR CAPITAL BUDGETING

Chapter 9 Net Present Value and Other Investment Criteria

• New material: Enhanced discussion of multiple IRRs and modified IRR

• Clarifies properties of IRR.

• New material: Practice of capital budgeting in Canada • Current Canadian material demonstrates relevance of techniques presented.

• First of three chapters on capital budgeting • Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic.

• NPV, IRR, payback, discounted payback, and accounting rate of return

• Consistent, balanced examination of advantages and disadvantages of various criteria.

Chapter 10 Making Capital Investment Decisions

• Project cash flow • Thorough coverage of project cash flows and the relevant numbers for a project analysis.

• Alternative cash flow definitions • Emphasizes the equivalence of various formulas, thereby removing common misunderstandings.

• Special cases of DCF analysis • Considers important applications of chapter tools.

Chapter 11 Project Analysis and Evaluation

• New material: Detailed examples added of scenario analysis in gold mining and managerial options in zoo management

• Brings technique to life in real-world example.

• Sources of value • Stresses the need to understand the economic basis for value creation in a project.

• Scenario and sensitivity “what-if” analyses • Illustrates how to apply and interpret these tools in a project analysis.

• Break-even analysis • Covers cash, accounting, and financial break-even levels.

PART FIVE RISK AND RETURN Chapter 12 Lessons from Capital Market History

• New material: Capital market history updated through 2011, new section on market volatility in 2008, In Their Own Words box on the crash of 2008 and the efficient markets hypothesis

• Extensively covers historical returns, volatilities, and risk premiums.

• Geometric vs. arithmetic returns • Discusses calculation and interpretation of geometric returns. Clarifies common misconceptions regarding appropriate use of arithmetic vs. geometric average returns.

• Market efficiency • Discusses efficient markets hypothesis along with common misconceptions.

Chapter 13 Return, Risk, and the Security Market Line

• New material: Correlations in the financial crisis • Explains instability in correlations with a current example.

• Diversification, systematic and unsystematic risk • Illustrates basics of risk and return in straightforward fashion.

• Beta and the security market line • Develops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics.

PART SIX COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY Chapter 14 Cost of Capital

• Cost of capital estimation • Contains a complete step-by-step illustration of cost of capital for publicly traded Loblaw Companies.

Chapter 15 Raising Capital

• Dutch auction IPOs • Explains uniform price auctions using Google IPO as an example.

• IPO “quiet periods” • Explains the OSC’s and SEC’s quiet period rules.

• Lockup agreements • Briefly discusses the importance of lockup agreements.

• IPOs in practice • Takes in-depth look at IPOs of Facebook and Athabasca Oil Sands.

Chapter 16 Financial Leverage and Capital Structure Policy

• New material: Pecking order theory • Expands coverage of capital structure.

• Basics of financial leverage • Illustrates the effect of leverage on risk and return.

• Optimal capital structure • Describes the basic trade-offs leading to an optimal capital structure.

• Financial distress and bankruptcy • Briefly surveys the bankruptcy process.

Chapter 17 Dividends and Dividend Policy

• New material: Recent Canadian survey evidence on dividend policy

• Survey results show the most important (and least important) factors that financial managers consider when setting dividend policy.

• Dividends and dividend policy • Describes dividend payments and the factors favouring higher and lower payout policies.

Coverage xix

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Chapters Selected Topics of Interest Benefits to You PART SEVEN SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT

Chapter 18 Short-Term Finance and Planning

• Operating and cash cycles • Stresses the importance of cash flow timing.

• Short-term financial planning • Illustrates creation of cash budgets and potential need for financing.

Chapter 19 Cash and Liquidity Management

• Float management • Covers float management thoroughly.

• Cash collection and disbursement • Examines systems that firms use to handle cash inflows and outflows.

Chapter 20 Credit and Inventory Management

• Credit management • Analysis of credit policy and implementation.

• Inventory management • Briefly surveys important inventory concepts.

PART EIGHT TOPICS IN CORPORATE FINANCE Chapter 21 International Corporate Finance

• Exchange rate, political, and governance risks • Discusses hedging and issues surrounding sovereign and governance risks.

• Foreign exchange • Covers essentials of exchange rates and their determination.

• International capital budgeting • Shows how to adapt basic DCF approach to handle exchange rates.

Chapter 22 Leasing

• Synthetic leases • Discusses controversial practice of financing off the statement of financial position (also referred to as off-balance sheet financing).

• Leases and lease valuation • Discusses essentials of leasing.

Chapter 23 Mergers and Acquisitions

• New material: Expanded discussion of dual class stock, investor activism, and ownership and control

• Presents topical issues with Canadian examples.

• Alternatives to mergers and acquisitions • Covers strategic alliances and joint ventures and explains why they are important alternatives.

• Divestitures and restructurings • Examines important actions such as equity carve-outs, spins-offs, and split-ups.

• Mergers and acquisitions • Develops essentials of M&A analysis, including financial, tax, and accounting issues.

PART NINE DERIVATIVE SECURITIES AND CORPORATE FINANCE Chapter 24 Enterprise Risk Management

• New material: Enterprise risk management framework and insurance

• Illustrates need to manage risk and some of the most important types of risk.

• New material: Recent survey results on derivatives use • Relates material to practice by financial executives.

• Hedging with forwards, futures, swaps, and options • Shows how many risks can be managed with financial derivatives.

Chapter 25 Options and Corporate Securities

• Put-call parity and Black–Scholes • Develops modern option valuation and factors influencing option values.

• Options and corporate finance • Applies option valuation to a variety of corporate issues, including mergers and capital budgeting.

Chapter 26 (New Chapter) Behavioural Finance: Implications for Financial Management

• Introduction to Behavioural Finance • Introduces biases, framing effects, and heuristics.

• Behavioural Finance and market efficiency • Explains limits to arbitrage and discusses bubbles and crashes, including the Crash of 2008.

• Market efficiency and the performance of professional money managers

• Expands on efficient markets discussion in Chapter 12 and relates it to Behavioural Finance.

xx Coverage

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LEARNING SOLUTIONS

In addition to illustrating pertinent concepts and presenting up-to-date coverage, the authors strive to present the material in a way that makes it logical and easy to understand. To meet the varied needs of the intended audience, our text is rich in valuable learning tools and support.

Each feature can be categorized by the benefit to the student: • Real Financial Decisions • Application Tools • Study Aids

Real F inancial Decis ions We have included key features that help students connect chapter concepts to how decision makers use this material in the real world.

In Their Own Words Boxes A unique series of brief essays are written by distinguished scholars and by Canadian practitioners on key topics in the text. To name just a few, these include essays by Jeremy Siegel on efficient market theory and the financial crisis, Eric Lie on option backdating, and Heather Pelant on investment risk.

Jeremy Siegel on Efficient Market Theory and the Crisis

Financial journalist and best-selling author Roger Lowenstein didn’t mince words in a piece for the Washington WW Post this summer: “The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.” In a similar vein, thethethe highighiggghlyhlyhlyyy resresrespecpecpecpp tedtedted monmonmonmoneyeyey ey y manmanmanmanageageageageg rrr r andandand fifififinannannanciaciacialll l anaanaanalyslyslysyy ttt JJerJerJerJ emyemyemyy GGraGraGra thnthnthnthamamam wrowrowrottetete iininin hihishishis quaquaquaq trterterte lrlyrlyrlyy l tletletlettterterter llaslaslastttt JJanJanJanJ uaruaruary:y:y:yrrr “Th“ThThTheee iincincinc dredredredibliblibliblyyy y iinainainaccuccuccu tratratrateee ffieffieffieffi icieciecie tntntnt marmarmark tketketket ththethetheorororyyy yrrrr [[ca[ca[ca[ useuseused]d]d]d] ] aaa letletletlethalhalhalhallylylyly dandandandangergergergero sousousous comcomcomcombinbinbinbinatiatiatiationononon ofofofof assassassassetetetet b bbubbubbubbleblebleblesss,s, laxlaxlaxlax conconconcontrotrotrotrolslsls,ls,

thought that underlying collateral—the home—could always cover the principal in the event the homeowner defaulted. These models led credit agencies to rate these subprime mortgages as “investment grade.”

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IN THEIR OWN WORDSIN THEIR OWN WORDS…

Enhanced Real-World Examples There are many current examples integrated throughout the text, tying chapter concepts to real life through illustration and reinforcing the relevance of the material. For added reinforcement, some examples tie into the chapter-opening vignettes.

Web Links We have added and updated website references, a key research tool directing stu- dents to websites that tie into the chapter material.

Integrative Mini Cases These longer problems seek to integrate a number of topics from within the chapter. The Mini Cases allow students to test and challenge their abilities to solve real-life situations for each of the key sections of the text material.

Internet Application Questions Questions relevant to the topic discussed in each chapter, are presented for the students to explore using the Internet. Students will find direct links to the websites included in these questions on the Ross Connect site and linked out directly from the eBook.

Appl icat ion Tools Realizing that there is more than one way to solve problems in Corporate Finance, we include sections that will not only encourage students to learn different problem-solving methods, but will also help them learn or brush up on their financial calculator and Excel® spreadsheet skills.

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Calculator Hints This feature introduces students to problem solving with the assistance of a financial calculator. Sample keystrokes are provided for illustrative purposes, although individual calculators will vary.

Annuity Payments

Finding annuity payments is easy with a financial calculator. In our example just above, the PV is $100,000, the interest rate is 18 percent, and there are five years. We find the pay- ment as follows:

Enter 5 18 100,000

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CALCULATOR HINTS

Spreadsheet Strategies This feature either introduces students to Excel® or helps them brush up on their Excel® spreadsheet skills, particularly as they relate to Corporate Finance. This feature appears in self-contained sections and shows students how to set up spreadsheets to ana- lyze common financial problems—a vital part of every business student’s education.

How to Calculate Bond Prices and Yields Using a Spreadsheet

Most spreadsheets have fairly elaborate routines available for calculating bond values and yields; many of these routines involve details that we have not discussed. However, setting up a simple spreadsheet to calculate prices or yields is straightforward, as our next two spreadsheets show:

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SPREADSHEET STRATEGIES

Excel® Spreadsheet Templates Selected questions within the end-of-chapter material, identified by the following icon: , can be solved using the Excel® Spreadsheet Templates available on this text’s Connect. These Excel® templates are a valuable extension of the Spreadsheet Strategies feature.

Study Aids We want students to get the most from this resource and their course, and we realize that students have different learning styles and study needs. We therefore present a number of study features to appeal to a wide range of students.

Chapter Learning Objectives This feature maps out the topics and learning goals in each chapter. Each end-of-chapter problem is linked to a learning objective to help students organize their study time appropriately.

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Concept Building Chapter sections are intentionally kept short to promote a step-by-step, building block approach to learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read.

Numbered Examples Separate numbered and titled examples are extensively integrated into the chapters. These examples provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation.

Key Terms Within each chapter, key terms are highlighted in boldface type the first time they appear. Key terms are defined in the text, and also in a running glossary in the margins of the text for quick reminders. For reference, there is a list of key terms at the end of each chapter and a full glossary with page references for each term at the back of the textbook.

Summary Tables These tables succinctly restate key principles, results, and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts.

Key Equations These are called out in the text and identified by equation number. An Equa- tion Index is available at the end of the book and a Formula Sheet can be found on the text’s Connect site.

Chapter Summary and Conclusion These paragraphs review the chapter’s key points and provide closure to the chapter.

Chapter Review Problems and Self-Test Appearing after the Summary and Conclusions and Key Terms, each chapter includes Chapter Review Problems and a Self-Test section. These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement.

Concepts Review and Critical Thinking Questions This section facilitates students’ knowledge of key principles, and their intuitive understanding of chapter concepts. A number of the questions relate to the chapter-opening vignette—reinforcing students’ critical-thinking skills and the learning of chapter material.

Concepts Review and Critical Thinking Questions 1. (LO3) What effect would the following actions have on a

firm’s current ratio? Assume that net working capital is positive. a. Inventory is purchased. b. A supplier is paid. c. A short-term bank loan is repaid. d. A long-term debt is paid off early. e. A customer pays off a credit account. f. Inventory is sold at cost. gg.g InveInventorntory isy isy solsold fod for ar a profprofp itit.

222.2. 2. ( O(LO3(LO3(LO3(LO3(LO3( ))))))) IInIn In recerecerece tntntnt yearyearyeary ss, s, hCh tChetChetChetiicamicamicampppp CCoCo. Co. hhhashashas greagreagreag ltltlytlytly y iincrincrincreaseeaseeaseddddd ititsitsits currcurrcurrententent tiratiratiratiooo. AAtAtAt hthethethe samesamesame titimetimetime,, , hthethethe iquicquicquicq kkkk tiratiratiratiooo hhashashas f llfallfallfallenenen. WWWhhathathat hhhhasasas hhapphapphapppp denedenedened???? HasHasHas hthethethe lliquliquliquq diditiditidityyy yy fofofof hthethethe compcompcomppanananyyy yy i d?

closely watched for semiconductor manufacturers. A ratio of 0.93 indicates that for every $100 worth of chips shipped over some period, only $93 worth of new orders is received. In Feb- ruary 2006, the semiconductor equipment industry’s book-to- bill reached 1.01, compared to 0.98 during the month of January 2006. The book-to-bill ratio reached a low of 0.78 during October 2006. The three-month average of worldwide bookings in January 2006 was $1.30 billion, an increase of 6 percent over January 2005, while the three-month average of billbillingsingsg inin FebrFebruaryuaryy 20062006 waswas $1 2$1.2$ 99 billbillionion,, aa 22 percpercp entent in-in- creacreacreasese se fffromfromfrom bF bFebrFebrFebruaryuaryuaryy 2005200520052005. . hWh tWhatWhatWhat iisis is hthithisthisthis tiratiratiratioo o i tinteinteinte d dd dndedndednded ttototo measmeasmeas ?ure?ure?ure? WhWhyWhyWhyy ddododo youyouyou y hithinthinthink ik itk itk it iisisis so cso cso clloseloseloselly wly wly wy hatchatchatch d?ed?ed?ed?

9999.9. ((LO5(LO5(LO5(LO5(LO5( ))))))) SSo cSo-cSo-c llalleallealledddd ““samsamsame ste-ste-storeoreore lsalesalesale ”s”ss areareare aaa veryveryveryyy impoimpoimpop rtanrtanrtanttt meamea-mea- f i di C di Ti d Ti H

Questions and Problems We have found that many students learn better when they have plenty of opportunity to practise; therefore, we provide extensive end-of-chapter questions and problems. These are labelled by topic and separated into three learning levels: Basic, Intermediate, and Challenge. Throughout the text, we have worked to supply interesting problems that illustrate real-world applications of chapter material. Answers to selected end-of-chapter material appear in Appendix B (now available on Connect).

As described earlier in this Preface, students’ learning and understanding of the chapter con- tent is further supported by the following end-of-chapter materials:

• Internet Application Questions • Mini Cases • Suggested Readings (now available on Connect)

Learning Solutions xxiii

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McGraw-Hill Connect™ is a web-based assignment and assessment platform that gives students the means to better connect with their coursework, with their instructors, and with the important concepts that they will need to know for success now and in the future.

With Connect, instructors can deliver assignments, quizzes, and tests online. Nearly all the questions from the text are presented in an auto-gradeable format and tied to the text’s learning objectives. Instructors can edit existing questions and write entirely new problems. Instructors can track individual student performance—by question, assignment, or in relation to the class overall—with detailed grade reports. Integrate grade reports easily with Learning Management Systems (LMS) such as WebCT and Blackboard.

By choosing Connect, instructors are providing their students with a powerful tool for improving academic performance and truly mastering course material. Connect allows students to practise important skills at their own pace and on their own schedule. Importantly, students’ assessment results and instructors’ feedback are all saved online—so students can continually review their progress and plot their course to success.

Connect also provides 24/7 online access to an eBook—an online edition of the text—to aid them in successfully completing their work, wherever and whenever they choose.

Key Features Simple Assignment Management With Connect, creating assignments is easier than ever, so you can spend more time teaching and less time managing.

• Create and deliver assignments easily with selectable end-of-chapter questions and testbank material to assign online.

• Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever.

• Go paperless with the eBook and online submission and grading of student assignments.

Smart Grading When it comes to studying, time is precious. Connect helps students learn more efficiently by providing feedback and practice material when they need it, where they need it.

• Automatically score assignments, giving students immediate feedback on their work and side- by-side comparisons with correct answers.

• Access and review each response; manually change grades or leave comments for students to review.

• Reinforce classroom concepts with practice tests and instant quizzes.

Instructor Library The Connect Instructor Library is your course creation hub. It provides all the critical resources you’ll need to build your course, just how you want to teach it.

• Assign eBook readings and draw from a rich collection of textbook-specific assignments. • Access to all instructor resources:

Connect content Prepared by Merlyn Foo, Athabasca University. Instructor’s Manual Prepared by Lewis Stevenson, Brock University. The Instructor’s Manual contains two main sections. The first section contains a chapter outline with lecture tips, real-world tips, and ethics notes. The second section includes detailed solutions for all end-of-chapter problems.

TECHNOLOGY SOLUTIONS

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TECHNOLOGY SOLUTIONS

Computerized Test Bank Prepared by Sepand Jazzi, Kwantlen Polytechnic University. The computerized test bank is available through EZ Test Online—a flexible and easy-to-use electronic testing program—that allows instructors to create tests from book-specific items. EZ Test accommodates a wide range of question types and allows instructors to add their own questions. Test items are also available in Word format (Rich text format). For secure online testing, exams created in EZ Test can be exported to WebCT and Blackboard. EZ Test Online is supported at mhhe.com/eztest where users can download a Quick Start Guide, access FAQs, or log a ticket for help with specific issues. PowerPoint® Presentation Prepared by Anne Inglis. The Microsoft® PowerPoint® Pre- sentation slides have been enhanced to better illustrate chapter concepts. Image Bank All figures and tables are available in digital format on the McGraw-Hill Con- nect™ site associated with this text, which can be found at mcgrawhillconnect.ca. Excel® Templates (with Solutions) Prepared by Brent Matheson, University of Water- loo. Excel® templates are included with solutions for end-of-chapter problems indicated by an Excel® icon in the margin of the text. • View assignments and resources created for past sections. • Post your own resources for students to use.

eBook Connect reinvents the textbook learning experience for the modern student. Every Connect subject area is seamlessly integrated with Connect eBooks, which are designed to keep students focused on the concepts key to their success.

• Provide students with a Connect eBook, allowing for anytime, anywhere access to the text- book.

• Merge media, animation and assessments with the text’s narrative to engage students and im- prove learning and retention.

• Pinpoint and connect key concepts in a snap using the powerful eBook search engine. • Manage notes, highlights, and bookmarks in one place for simple, comprehensive review.

No two students are alike. McGraw-Hill LearnSmart™ is an intelligent learning system that uses a series of adaptive questions to pinpoint each student’s knowledge gaps. LearnSmart then provides an optimal learning path for each student, so that they spend less time in areas they already know and more time in areas they don’t. The result is LearnSmart’s adaptive learning path helps students retain more knowledge, learn faster, and study more efficiently.

Lyryx for Corporate F inance Lyryx Assessment for Finance is a leading-edge online assessment system, designed to support both students and instructors. The assessment takes the form of a homework assignment called a Lab. The assessments are algorithmically generated and automatically graded so that students get instant grades and feedback. New Labs are randomly generated each time, providing the student with unlimited opportunities to try a type of question. After they submit a Lab for marking, students receive extensive feedback on their work, thus promoting their learning experience.

Please contact your iLearning Sales Specialist for additional information on the Lyryx As- sessment Finance system. Visit lyryx.com.

a d v a n c i n g l e a r n i n g

Technology Solutions xxv

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Superior Learning Solut ions and Support The McGraw-Hill Ryerson team is ready to help you assess and integrate any of our products, technology, and services into your course for optimal teaching and learning performance. Whether it’s helping your students improve their grades, or putting your entire course online, the McGraw-Hill Ryerson team is here to help you do it. Contact your iLearning Sales Specialist today to learn how to maximize all of McGraw-Hill Ryerson’s resources!

For more information on the latest technology and Learning Solutions offered by McGraw-Hill Ryerson and its partners, please visit us online: mcgrawhill.ca/he/solutions.

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Course Management CourseSmart brings together thousands of textbooks across hundreds of courses in an e-

textbook format, providing unique benefits to students and faculty. By purchasing an e-textbook, students can save up to 50 percent off the cost of a print textbook, reduce their impact on the environment, and gain access to powerful Web tools for learning, including full-text search, notes and highlighting, and e-mail tools for sharing notes between classmates. For faculty, CourseSmart provides instant access to review and compare textbooks and course materials in their discipline area without the time, cost, and environmental impact of mailing print examination copies. For  further details contact your McGraw-Hill Ryerson iLearning Sales Specialist or go to coursesmart.com.

McGraw-Hill Ryerson offers a range of flexible integration solutions for Blackboard, WebCT, Desire2Learn, Moodle, and other leading learning management platforms. Please contact your local McGraw-Hill Ryerson iLearning Sales Specialist for details.

McGraw-Hill’s Create Online gives you access to the most abundant resource at your finger- tips—literally. With a few mouse clicks, you can create customized learning tools simply and af- fordably. McGraw-Hill Ryerson has included many of our market-leading textbooks within Create Online for ebook and print customization as well as many licensed readings and cases. For more information, go to mcgrawhillcreate.ca.

xxvi Technology Solutions

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We never would have completed this book without the incredible amount of help and support we received from colleagues, editors, family members, and friends. We would like to thank, without implicating, all of you.

For starters, a great many of our colleagues read the drafts of our first and current editions. Our reviewers continued to keep us working on improving the content, organization, exposition, and Canadian content of our text. To the following reviewers, we are grateful for their many con- tributions to the Eighth Canadian Edition:

Mohamed Ayadi, Brock University Larry Bauer, Memorial University Jaime Morales Burgos, Trent University Bill Dawson, University of Western Ontario Chris Duff, Royal Roads University Shantanu Dutta, University of Ontario Institute of Technology Larbi Hammami, McGill University Andras Marosi, University of Alberta Brent Matheson, University of Waterloo Judy Palm, Vancouver Island University William Rentz, University of Ottawa David Roberts, Southern Alberta Institute of Technology Jun Yang, Acadia University Yuriy Zabolotnyuk, Carleton University

A special thank you must be given to Hamdi Driss, Schulich School of Business, and VijayShree Vethantham for their vigilant effort of technical proofreading and, in particular, care- ful checking of the solutions in the Instructor’s Manual. Their keen eyes and attention to detail have contributed greatly to the quality of the final product.

Several of our most respected colleagues and journalists contributed essays, entitled “In Their Own Words,” that appear in selected chapters. To these individuals we extend a special thanks:

Edward Altman, New York University James Darroch, York University Christine Dobby, Financial Post Robert C. Higgins, University of Washington Ken Hitzig, Accord Financial Corp. Erik Lie, University of Iowa Robert C. Merton, Harvard University Merton H. Miller, University of Chicago Heather Pelant, Barclays Global Investors Canada Jay R. Ritter, University of Florida Robert J. Schiller, Yale University Hersh Shefrin, Santa Clara University Jeremy Siegel, University of Pennsylvania Bennett Stewart, Stern Stewart & Co. Jamie Sturgeon, Financial Post Samuel Weaver, The Hershey Company David Weitzner, York University

Ganesh Kannan, recent Schulich MBA graduate, deserves special mention for his role in producing the Eighth Canadian Edition. He capably researched updates, drafted revisions, and responded to editorial queries; and his excellent input was essential to this edition.

ACKNOWLEDGEMENTS

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Much credit goes to a “AAA-rated” group of people at McGraw-Hill Ryerson who worked on the Eighth Canadian Edition. Leading the team was Kimberley Veevers, Senior Product Manager, who continued her role as champion of this project by arranging unparalleled support for the development of the text and support package for this edition. Maria Chu, Senior Product Developer, efficiently and cheerfully supervised the reviews and revision as she has done for many prior editions. Production and copy-editing were handled ably by Joanne Limebeer, Supervising Editor, and Robert Templeton and Bradley T. Smith, First Folio Resource Group Inc., Copy Editors.

Through the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best Canadian textbook available in Corporate Finance.

Please forward your comments to: Professor Gordon S. Roberts Schulich School of Business, York University 4700 Keele Street, Toronto, Ontario M3J IP3

Or, email your comments to groberts@schulich.yorku.ca.

Stephen A. Ross Randolph W. Westerfield

Bradford D. Jordan Gordon S. Roberts

xxviii Acknowledgements

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Chapters Selected Topics of Interest Benefits to You

PART ONE OVERVIEW OF CORPORATE FINANCE

Chapter 1 Introduction to Corporate Finance

• New material: Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the European government debt credit crisis

• Links to headlines on financial crisis.

• Goal of the firm and agency problems • Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise.

• Ethics, financial management, and executive compensation

• Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay.

Chapter 2 Financial Statements, Cash Flow, and Taxes

• New material: Financial statements conforming to IFRS

• Links to current practice.

• Cash flow vs. earnings • Defines cash flow and the differences between cash flow and earnings.

• Market values vs. book values • Emphasizes the relevance of market values over book values.

PART TWO FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING

Chapter 3 Working with Financial Statements

• Using financial statement information • Discusses the advantages and disadvantages of using financial statements.

Chapter 4 Long-Term Financial Planning and Corporate Growth

• Explanation of alternative formulas for sustainable and internal growth rates

• Explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct.

• Thorough coverage of sustainable growth as a planning tool

• Provides a vehicle for examining the interrelationships among operations, financing, and growth.

PART THREE VALUATION OF FUTURE CASH FLOWS

Chapter 5 Introduction to Valuation: The Time Value of Money

• First of two chapters on time value of money • Relatively short chapter introduces the basic ideas on time value of money to get students started on this traditionally difficult topic.

Chapter 6 Discounted Cash Flow Valuation

• Second of two chapters on time value of money • Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples.

Chapter 7 Interest Rates and Bond Valuation

• New material: Discussion of bond fund strategies at time of European government debt crisis

• Links chapter material to current events.

• “Clean” vs. “dirty” bond prices and accrued interest

• Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions.

• Bond ratings • Up-to-date discussion of bond rating agencies and ratings given to debt. Includes the latest descriptions of ratings used by DBRS.

Chapter 8 Stock Valuation

• New material: Stock valuation using multiples • Broadens coverage of valuation techniques.

• New material: Examples of shareholder activism at Canadian Pacific and Magna International

• Expands governance coverage and links chapter material to current events.

PART FOUR CAPITAL BUDGETING

Chapter 9 Net Present Value and Other Investment Criteria

• New material: Enhanced discussion of multiple IRRs and modified IRR

• Clarifies properties of IRR.

• New material: Practice of capital budgeting in Canada

• Current Canadian material demonstrates relevance of techniques presented.

• First of three chapters on capital budgeting • Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic.

• NPV, IRR, payback, discounted payback, and accounting rate of return

• Consistent, balanced examination of advantages and disadvantages of various criteria.

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Chapters Selected Topics of Interest Benefits to You

Chapter 10 Making Capital Investment Decisions

• Project cash flow • Thorough coverage of project cash flows and the relevant numbers for a project analysis.

• Alternative cash flow definitions • Emphasizes the equivalence of various formulas, thereby removing common misunderstandings.

• Special cases of DCF analysis • Considers important applications of chapter tools.

Chapter 11 Project Analysis and Evaluation

• New material: Detailed examples added of scenario analysis in gold mining and managerial options in zoo management

• Brings technique to life in real-world example.

• Sources of value • Stresses the need to understand the economic basis for value creation in a project.

• Scenario and sensitivity “what-if” analyses • Illustrates how to apply and interpret these tools in a project analysis.

• Break-even analysis • Covers cash, accounting, and financial break-even levels.

PART FIVE RISK AND RETURN

Chapter 12 Lessons from Capital Market History

• New material: Capital market history updated through 2011, new section on market volatility in 2008, In Their Own Words box on the crash of 2008 and the efficient markets hypothesis

• Extensively covers historical returns, volatilities, and risk premiums.

• Geometric vs. arithmetic returns • Discusses calculation and interpretation of geometric returns. Clarifies common misconceptions regarding appropriate use of arithmetic vs. geometric average returns.

• Market efficiency • Discusses efficient markets hypothesis along with common misconceptions.

Chapter 13 Return, Risk, and the Security Market Line

• New material: Correlations in the financial crisis • Explains instability in correlations with a current example.

• Diversification, systematic and unsystematic risk • Illustrates basics of risk and return in straightforward fashion.

• Beta and the security market line • Develops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics.

PART SIX COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY

Chapter 14 Cost of Capital

• Cost of capital estimation • Contains a complete step-by-step illustration of cost of capital for publicly traded Loblaw Companies.

Chapter 15 Raising Capital

• Dutch auction IPOs • Explains uniform price auctions using Google IPO as an example.

• IPO “quiet periods” • Explains the OSC’s and SEC’s quiet period rules.

• Lockup agreements • Briefly discusses the importance of lockup agreements.

• IPOs in practice • Takes in-depth look at IPOs of Facebook and Athabasca Oil Sands.

Chapter 16 Financial Leverage and Capital Structure Policy

• New material: Pecking order theory • Expands coverage of capital structure.

• Basics of financial leverage • Illustrates the effect of leverage on risk and return.

• Optimal capital structure • Describes the basic trade-offs leading to an optimal capital structure.

• Financial distress and bankruptcy • Briefly surveys the bankruptcy process.

Chapter 17 Dividends and Dividend Policy

• New material: Recent Canadian survey evidence on dividend policy

• Survey results show the most important (and least important) factors that financial managers consider when setting dividend policy.

• Dividends and dividend policy • Describes dividend payments and the factors favouring higher and lower payout policies.

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Chapters Selected Topics of Interest Benefits to You

PART SEVEN SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT

Chapter 18 Short-Term Finance and Planning

• Operating and cash cycles • Stresses the importance of cash flow timing.

• Short-term financial planning • Illustrates creation of cash budgets and potential need for financing.

Chapter 19 Cash and Liquidity Management

• Float management • Covers float management thoroughly.

• Cash collection and disbursement • Examines systems that firms use to handle cash inflows and outflows.

Chapter 20 Credit and Inventory Management

• Credit management • Analysis of credit policy and implementation.

• Inventory management • Briefly surveys important inventory concepts.

PART EIGHT TOPICS IN CORPORATE FINANCE

Chapter 21 International Corporate Finance

• Exchange rate, political, and governance risks • Discusses hedging and issues surrounding sovereign and governance risks.

• Foreign exchange • Covers essentials of exchange rates and their determination.

• International capital budgeting • Shows how to adapt basic DCF approach to handle exchange rates.

Chapter 22 Leasing

• Synthetic leases • Discusses controversial practice of financing off the statement of financial position (also referred to as off-balance sheet financing).

• Leases and lease valuation • Discusses essentials of leasing.

Chapter 23 Mergers and Acquisitions

• New material: Expanded discussion of dual class stock, investor activism, and ownership and control

• Presents topical issues with Canadian examples.

• Alternatives to mergers and acquisitions • Covers strategic alliances and joint ventures and explains why they are important alternatives.

• Divestitures and restructurings • Examines important actions such as equity carve-outs, spins-offs, and split-ups.

• Mergers and acquisitions • Develops essentials of M&A analysis, including financial, tax, and accounting issues.

PART NINE DERIVATIVE SECURITIES AND CORPORATE FINANCE

Chapter 24 Enterprise Risk Management

• New material: Enterprise risk management framework and insurance

• Illustrates need to manage risk and some of the most important types of risk.

• New material: Recent survey results on derivatives use

• Relates material to practice by financial executives.

• Hedging with forwards, futures, swaps, and options

• Shows how many risks can be managed with financial derivatives.

Chapter 25 Options and Corporate Securities

• Put-call parity and Black–Scholes • Develops modern option valuation and factors influencing option values.

• Options and corporate finance • Applies option valuation to a variety of corporate issues, including mergers and capital budgeting.

Chapter 26 (New Chapter) Behavioural Finance: Implications for Financial Management

• Introduction to Behavioural Finance • Introduces biases, framing effects, and heuristics.

• Behavioural Finance and market efficiency • Explains limits to arbitrage and discusses bubbles and crashes, including the Crash of 2008.

• Market efficiency and the performance of professional money managers

• Expands on efficient markets discussion in Chapter 12 and relates it to Behavioural Finance.

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To begin our study of modern corporate fi nance and fi nancial management, we need to address two central issues: First, what is corporate fi nance, and what is the role of the fi nancial manager in the corporation? Second, what is the goal of fi nancial management? To describe the fi nancial management environment, we look at the corporate form of organization and discuss some con- fl icts that can arise within the corporation. We also take a brief look at fi nancial institutions and fi nancial markets in Canada.

1.1 Corporate Finance and the Financial Manager

In this section, we discuss where the fi nancial manager fi ts in the corporation. We start by looking at what corporate fi nance is and what the fi nancial manager does.

INTRODUCTION TO CORPORATE FINANCE

C H A P T E R 1

T im Hortons Inc. has come a long way since its 1964 inception in Hamilton, Ontario under the title “Tim Horton Donuts.” Today, the com-

pany is the largest quick-service restaurant chain in

Canada, and is among the well-recognized brands

in the country. Founded as a sole proprietorship by

Tim Horton, and later run as a partnership with Ron

Joyce, the company began with a specialized focus

on coffee and donuts. Following Horton’s death in

1974, Joyce continued to run the business under an

aggressive expansion strategy. By February 1987,

Tim Hortons had opened 300 stores across Canada.

In 1995, Tim Hortons was acquired by Wendy’s

International Inc., which gave new impetus to the

expansion of the brand in the United States. Eleven

years later in March of 2006, Tim Hortons held its

initial public offering (IPO) and was fully spun off

by Wendy’s International in September of the same

year. With more than 4,000 locations in Canada, the

United States, and the Gulf Cooperation Council,

the majority of which are franchisee owned, the Tim

Hortons story touches on different business forms,

corporate goals, and corporate control, all topics

that are discussed in this chapter. Tim Hortons is a

registered trademark of The TDL Marks Corporation.

Used with permission.

Learning Object ives

After studying this chapter, you should understand:

LO1 The basic types of financial management decisions and the role of the financial manager.

LO2 The financial implications of the different forms of business organization.

LO3 The goal of financial management.

LO4 The conflicts of interest that can arise between managers and owners.

LO5 The roles of financial institutions and markets.

P A R T 1

Ti m

H or

to ns

is a

re

gi st

er ed

t ra

de m

ar k

of T

he T

D L

M ar

ks

C or

p or

at io

n.

U se

d w

ith p

er m

is si

on .

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What Is Corporate Finance? Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, equipment, and research and development facili- ties will you need?

2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?

3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers?

Th ese are not the only questions by any means, but they are among the most important. Cor- porate fi nance, broadly speaking, is the study of ways to answer these three questions.

Accordingly, we’ll be looking at each of them in the chapters ahead. Th ough our discussion focuses on the role of the fi nancial manager, these three questions are important to managers in all areas of the corporation. For example, selecting the fi rm’s lines of business (Question 1) shapes the jobs of managers in production, marketing, and management information systems. As a result, most large corporations centralize their fi nance function and use it to measure perform- ance in other areas. Most CEOs have signifi cant fi nancial management experience.

The Financial Manager A striking feature of large corporations is that the owners (the shareholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the fi nancial manager is in charge of answering the three questions we raised earlier.

It is a challenging task because changes in the fi rm’s operations and shift s in Canadian and global fi nancial markets mean that the best answers for each fi rm are changing, sometimes quite rapidly. Globalization of markets and advanced communications and computer technology, as well as increased volatility of interest rates and foreign exchange rates, have raised the stakes in fi nancial management decisions. We discuss these major trends and how they are changing the fi nancial manager’s job aft er we introduce you to some of the basics of corporate fi nancial decisions.

Th e fi nancial management function is usually associated with a top offi cer of the fi rm, such as a vice president of fi nance or some other chief fi nancial offi cer (CFO). Figure 1.1 is a simpli- fi ed organization chart that highlights the fi nance activity in a large fi rm. Th e CFO reports to the president, who is the chief operating offi cer (COO) in charge of day-to-day operations. Th e COO reports to the chairman, who is usually chief executive offi cer (CEO). However, as businesses become more complex, there is a growing pattern among large companies to separate the roles of Chairman and CEO. Th e CEO has overall responsibility to the board. As shown, the vice presi- dent of fi nance coordinates the activities of the treasurer and the controller. Th e controller’s offi ce handles cost and fi nancial accounting, tax payments, and management information systems. Th e treasurer’s offi ce is responsible for managing the fi rm’s cash, its fi nancial planning, and its capital expenditures. Th ese treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s offi ce.

Financial Management Decisions As our discussion suggests, the fi nancial manager must be concerned with three basic types of questions. We consider these in greater detail next.

CAPITAL BUDGETING The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budget- ing. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. Loosely speaking, this means that the value

For current issues facing CFOs, see cfo.com

capital budgeting The process of planning and managing a firm’s investment in long-term assets.

2 Part 1: Overview of Corporate Finance

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of the cash flow generated by an asset exceeds the cost of that asset. The types of investment op- portunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a restaurant chain like Tim Hortons, deciding whether or not to open stores would be a major capital budgeting decision. Some decisions, such as what type of computer sys- tem to purchase, might not depend so much on a particular line of business.

Financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash fl ows is the essence of capital budgeting. We discuss how to do this in detail in the chapters ahead.

FIGURE 1.1

A simplified organization chart. The exact titles and organization differ from company to company.

Board of Directors

Chairman of the Board and Chief Executive Officer (CEO)

President and Chief Operating Officer (COO)

Vice President Production

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting Manager

Capital Expenditures

Financial Planning

Financial Accounting Manager

Data Processing Manager

Vice President Finance (CFO)

Vice President Marketing

Shareholders

CAPITAL STRUCTURE The second major question for the financial manager concerns how the firm should obtain and manage the long-term financing it needs to support its long-term investments. A firm’s capital structure (or financial structure) refers to the specific mixture of short-term debt, long-term debt, and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow; that is, what mixture is best? The mixture chosen affects both the risk and value of the firm. Second, what are the least expensive sources of funds for the firm?

If we picture the fi rm as a pie, then the fi rm’s capital structure determines how that pie is sliced. In other words, what percentage of the fi rm’s cash fl ow goes to creditors and what percentage goes to shareholders? Management has a great deal of fl exibility in choosing a fi rm’s fi nancial structure. Whether one structure is better than any other for a particular fi rm is the heart of the capital structure issue.

In addition to deciding on the fi nancing mix, the fi nancial manager has to decide exactly how and where to raise the money. Th e expenses associated with raising long-term fi nancing can be

capital structure The mix of debt and equity maintained by a firm.

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considerable, so diff erent possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders, tapping into both Canadian and international debt markets, in a number of diff erent—and sometimes exotic—ways. Choosing among lenders and among loan types is another of the jobs handled by the fi nancial manager.

WORKING CAPITAL MANAGEMENT The third major question concerns working capital management. The phrase working capital refers to the difference between a firm’s short- term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities, all related to the firm’s receipt and disbursement of cash.

Some of the questions about working capital that must be answered are: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms should we off er, and to whom should we extend them? (3) How do we obtain any needed short-term fi nanc- ing? Will we purchase on credit or borrow short-term and pay cash? If we borrow short-term, how and when should we do it? Th is is just a small sample of the issues that arise in managing a fi rm’s working capital.

Th e three areas of corporate fi nancial management we have described—capital budgeting, cap- ital structure, and working capital management—are very broad categories. Each includes a rich variety of topics; we have indicated only a few of the questions that arise in the diff erent areas. Th e following chapters contain greater detail.

1. What is the capital budgeting decision?

2. Into what category of financial management does cash management fall?

3. What do you call the specific mixture of short-term debt, long-term debt, and equity that a firm chooses to use?

1.2 Forms of Business Organization

Large fi rms in Canada, such as CIBC and BCE, are almost all organized as corporations. We examine the fi ve diff erent legal forms of business organization—sole proprietorship, partnership, corporation, income trust, and co-operative—to see why this is so. Each of the three forms has distinct advantages and disadvantages in the life of the business, the ability of the business to raise cash, and taxes. A key observation is that, as a fi rm grows, the advantages of the corporate form may come to outweigh the disadvantages.

Sole Proprietorship A sole proprietorship is a business owned by one person. Th is is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you can start up a proprietorship by doing little more than getting a business licence and opening your doors. For this reason, many businesses that later become large corporations start out as sole proprietor- ships. Th ere are more proprietorships than any other type of business.

As the owner of a sole proprietorship, you keep all the profi ts. Th at’s the good news. Th e bad news is that the owner has unlimited liability for business debts. Th is means that creditors can look beyond assets to the proprietor’s personal assets for payment. Similarly, there is no distinc- tion between personal and business income, so all business income is taxed as personal income.

Th e life of a sole proprietorship is limited to the owner’s life span, and, importantly, the amount of equity that can be raised is limited to the proprietor’s personal wealth. Th is limitation oft en means that the business cannot exploit new opportunities because of insuffi cient capital. Owner- ship of a sole proprietorship may be diffi cult to transfer, since this requires the sale of the entire business to a new owner.

working capital management Planning and managing the firm’s current assets and liabilities.

Concept Questions

sole proprietorship A business owned by a single individual.

For more information on forms of business organization, see the “Starting a Business” section at canadianlawsite.ca; also see canadabusiness.ca

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Partnership A partnership is similar to a proprietorship, except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. Th e way partnership gains (and losses) are divided is described in the partnership agreement. Th is agreement can be an informal oral agree- ment, or a lengthy, formal written document.

In a limited partnership, one or more general partners has unlimited liability and runs the busi- ness for one or more limited partners who do not actively participate in the business. A limited partner’s liability for business debts is limited to the amount contributed to the partnership. Th is form of organization is common in real estate ventures, for example.

Th e advantages and disadvantages of a partnership are basically the same as those for a pro- prietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership termi- nates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth. Ownership by a general partner is not easily transferred because a new partnership must be formed. A limited partner’s interest can be sold without dissolving the partnership. But fi nding a buyer may be diffi cult, because there is no organized market in limited partnerships.

Based on our discussion, the primary disadvantages of sole proprietorship and partnership as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) diffi culty of transferring ownership. Th ese three disadvantages add up to a single, central problem: the ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

Corporation In terms of size, the corporation is the most important form of business organization in Canada. A corporation is a legal entity separate and distinct from its owners; it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.

Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization, but not greatly so for a small business. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. Th e articles of incor- poration must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. Th is information must be supplied to regulators in the jurisdiction where the fi rm is incorporated. Canadian fi rms can be incorporated under either the federal Canada Business Corporation Act or provincial law.1

Th e bylaws are rules describing how the corporation regulates its own existence. For example, the bylaws describe how directors are elected. Th ese bylaws may be a very simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. Th e bylaws may be amended or extended from time to time by the shareholders.

In a large corporation, the shareholders and the management are usually separate groups. Th e shareholders elect the board of directors, which then selects the managers. Management is charged with running the corporation’s aff airs in the shareholders’ interest. In principle, share- holders control the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. Th e corporation borrows money in its own name. As a result, the shareholders in a corporation have limited liability for corporate debts. Th e most they can lose is what they have invested.2

1 In some provinces, the legal documents of incorporation are called letters patent or a memorandum of association. 2 An important exception is negligence by a corporate director. If this can be proven, for example in a case of environ- mental damage, the director may be liable for more than the original investment.

partnership A business formed by two or more co-owners.

corporation A business created as a distinct legal entity owned by one or more individuals or entities.

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While limited liability makes the corporate form attractive to equity investors, lenders some- times view the limited liability feature as a disadvantage. If the borrower experiences fi nancial dis- tress and is unable to repay its debt, limited liability blocks lenders’ access to the owners’ personal assets. For this reason, chartered banks oft en circumvent limited liability by requiring that owners of small businesses provide personal guarantees for company debt.

Th e relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are the reasons why the corporate form is superior when it comes to raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. Th e number of owners can be huge; larger corporations have many thou- sands or even millions of shareholders.

Th e corporate form has a signifi cant disadvantage. Because a corporation is a legal entity, it must pay taxes. Moreover, money paid out to shareholders in dividends is taxed again as income to those shareholders. Th is is double taxation, meaning that corporate profi ts are taxed twice—at the corporate level when they are earned, and again at the personal level when they are paid out.3

As the discussion in this section illustrates, the need of large businesses for outside investors and creditors is such that the corporate form generally is best for such fi rms. We focus on corpora- tions in the chapters ahead because of the importance of the corporate form in the Canadian and world economies. Also, a few important fi nancial management issues, such as dividend policy, are unique to corporations. However, businesses of all types and sizes need fi nancial management, so the majority of the subjects we discuss bear on all forms of business.

A CORPORATION BY ANOTHER NAME The corporate form of organization has many variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. These firms are often designated as joint stock companies, public limited companies, or limited liability com- panies, depending on the specific nature of the firm and the country of origin.

In addition to international variations, there are specialized forms of corporations in Canada and the U.S. One increasingly common example is the professional corporation set up by archi- tects, accountants, lawyers, dentists and others who are licensed by a professional governing body. A professional corporation has limited liability but each professional is still open to being sued for malpractice.

Income Trust Starting in 2001, the income trust, a non-corporate form of business organization, grew in impor- tance in Canada.4 In response to the growing importance of this sector, provincial legislation extended limited liability protection, previously limited to corporate shareholders, to trust unit holders. Along the same lines, at the end of 2005, the TSX began to include income trusts in its benchmark S&P / TSX composite index.

Business income trusts (also called income funds) hold the debt and equity of an underlying business and distribute the income generated to unit holders. Because income trusts are not cor- porations, they are not subject to corporate income tax and their income is typically taxed only in the hands of unit holders. As a result, investors viewed trusts as tax-effi cient and were generally willing to pay more for a company aft er it converted from a corporation to a trust. However, this tax advantage largely disappeared on Halloween 2006 when the government announced plans to tax income trusts at the same rate as corporations starting in 2011. As a result, most income trusts converted to corporations. Th e number of income trusts reduced from 179 (with a market capital- ization of $112.1 billion) in 2009 to 65 (with a market capitalization of $51.5 billion) in mid-2011.

3 The dividend tax credit for individual shareholders and a corporate dividend exclusion reduce the bite of double taxa- tion for Canadian corporations. These tax provisions are discussed in Chapter 2. Trusts and limited partnerships are designed to avoid double taxation. 4 For more on income trusts see J. Fenwick and B. Kalymon, “A Note on Income Trusts,” Ivey Publishing, 2004 and De- partment of Finance, “Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Lim- ited Partnerships),” September 8, 2005. Data for TSX: Jan S. Koyanagi, “Income Trusts on Toronto Stock Exchange,” TSX, January 2007. Chapter 2 covers income trust income and taxation in more detail.

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Co-operative (Co-op) A co-operative is an enterprise that is equally owned by its members who share the benefi ts of co-operation, based on how much they use the co-operative’s services.5 Th e co-ops are generally classifi ed into four types:

• Consumer Co-op: This provides products or services to its members (such as a retail co-op, housing, health-care or child-care co-op)

• Producer Co-op: This processes and markets the goods or services produced by its members, and supplies products or services necessary to the members’ professional activities (such as independent entrepreneurs, artisans, or farmers)

• Worker Co-op: This provides employment for its members. In this co-op, the employees are members and owners of the enterprise.

• Multi-Stakeholder Co-op: This serves the needs of different stakeholder groups—such as employees, clients, and other interested individuals and organizations (examples include health, home care and other social enterprises)

Th ere are more than 18 million members in Canada, which means every four out of ten Cana- dians are members of a co-op. Th ere are various key benefi ts of co-op such as to help producers compete eff ectively in the marketplace, to server rural and remote communities, to develop com- munity leadership, to build social capital and to promote local ownership and control.

Table 1.1 reviews the key features of Sole Proprietorship, Partnership and Corporation in Canada.

TABLE 1.1 Forms of business organization

Sole Proprietorship Partnership Corporation

Definition A business owned by a single individual.

A business formed by two or more co-owners.

A business created as a distinct legal entity owned by one or more individuals or entities.

Pros • Simplest form of business to start and is the least regulated.

• Owner keeps all profits.

• Simplest form of business to start with little regulation.

• Owners keep all profits. • Access to more human and

financial capital. • Limited partner(s) have limited

liability.

• Ownership can be easily transferred.

• Life of corporation not limited to lives of owners or managers.

• Corporation has limited liability. • Ability to raise and access large

sums of capital in both debt and equity markets.

Cons • Owner has unlimited liability for business debts.

• Business income taxed as personal income.

• Life of sole-proprietorship limited to life of owner.

• Limited ability to raise financing. • Difficulty in transferring ownership

of a sole proprietorship.

• General partner(s) have unlimited liability for business debts.

• Business income taxed as personal income.

• Life of partnership limited to lives of owners.

• Difficulty in transferring ownership. • Possible disagreements over

partnership.

• Double taxation. • Lenders sometimes view the limited

liability as a disadvantage and require the owners of small corporations to make personal guarantees.

• More complex and expensive form of organization to establish.

1. What are the three forms of business organization?

2. What are the primary advantages and disadvantages of a sole proprietorship or partnership?

3. What is the difference between a general and a limited partnership?

4. Why is the corporate form superior when it comes to raising cash?

5 For more on Co-operatives in Canada visit the website of the Co-operatives Secretariat at coop.gc.ca/

Concept Questions

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1.3 The Goal of Financial Management

Assuming that we restrict ourselves to for-profi t businesses, the goal of fi nancial management is to make money or add value for the owners. Th is goal is a little vague, of course, so we examine some diff erent ways of formulating it to come up with a more precise defi nition. Such a defi nition is important because it leads to an objective basis for making and evaluating fi nancial decisions.

Possible Goals If we were to consider possible fi nancial goals, we might come up with some ideas like the following: • Survive in business. • Avoid fi nancial distress and bankruptcy. • Beat the competition. • Maximize sales or market share. • Minimize costs. • Maximize profi ts. • Maintain steady earnings growth. Th ese are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for a fi nancial manager.

For example, it’s easy to increase market share or unit sales; all we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or taking any risks, and so on. It’s not clear that any of these actions would be in the shareholders’ best interests.

Profi t maximization would probably be the most commonly cited goal, but even this is not a very precise objective. Do we mean profi ts this year? If so, then actions such as deferring main- tenance, letting inventories run down, and other short-run cost-cutting measures tend to increase profi ts now, but these activities aren’t necessarily desirable.

Th e goal of maximizing profi ts may refer to some sort of long-run or average profi ts, but it’s still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the fi rm. Second, what do we mean by the long run? What is the appropriate trade-off between current and future profi ts?

Although the goals we’ve just listed are all diff erent, they fall into two classes. Th e fi rst of these relates to profi tability. Th e goals involving sales, market share, and cost control all relate, at least potentially, to diff erent ways of earning or increasing profi ts. Th e second group, involving bank- ruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. Th e pursuit of profi t normally involves some ele- ment of risk, so it isn’t really possible to maximize both safety and profi t. What we need, therefore, is a goal that encompasses both these factors.

The Goal of Financial Management Th e fi nancial manager in a corporation makes decisions for the shareholders of the fi rm. Given this, instead of listing possible goals for the fi nancial manager, we really need to answer a more fundamental question: From the shareholders’ point of view, what is a good fi nancial manage- ment decision?

If we assume that shareholders buy stock because they seek to gain fi nancially, the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease it.

Given our observation, it follows that the fi nancial manager acts in the shareholders’ best inter- ests by making decisions that increase the value of the stock. Th e appropriate goal for the fi nancial manager can thus be stated quite easily:

Th e goal of fi nancial management is to maximize the current value per share of existing stock.

Th e goal of maximizing the value of the stock avoids the problems associated with the diff er- ent goals we listed earlier. Th ere is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. If this goal

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seems a little strong or one-dimensional to you, keep in mind that the shareholders in a fi rm are residual owners. By this we mean that they are only entitled to what is left aft er employees, sup- pliers, and creditors (and anyone else with a legitimate claim) are paid their due. If any of these groups go unpaid, the shareholders get nothing. So, if the shareholders are winning in the sense that the left over, residual, portion is growing, it must be true that everyone else is winning also. For example, following its stock split in 2005 to mid 2012, technology giant Apple Inc. has increased value to its shareholders with a 1400 percent rise in its share price.6 Apple attributes this fi nancial success to major improvements in its bottom line and market share through the development and introduction of innovative products such as the iPod, iPhone, iPad, and MacBooks series.

Because the goal of fi nancial management is to maximize the value of the stock, we need to learn how to identify those investments and fi nancing arrangements that favourably impact the value of the stock. Th is is precisely what we are studying. In fact, we could have defi ned corporate fi nance as the study of the relationship between business decisions and the value of the stock in the business.

To make the market value of the stock a valid measure of fi nancial decisions requires an effi – cient capital market. In an effi cient capital market, security prices fully refl ect available informa- tion. Th e market sets the stock price to give the fi rm an accurate report card on its decisions. We return to capital market effi ciency in Part Five.

A More General Goal Given our goal of maximizing the value of the stock, an obvious question comes up: What is the appropriate goal when the fi rm is privately owned and has no traded stock? Corporations are certainly not the only type of business, and the stock in many corporations rarely changes hands, so it’s diffi cult to say what the value per share is at any given time.

To complicate things further, some large Canadian companies such as Irving are privately owned. Many large fi rms in Canada are subsidiaries of foreign multinationals, while others are controlled by a single domestic shareholder.

Recognizing these complications, as long as we are dealing with for-profi t businesses, only a slight modifi cation is needed. Th e total value of the stock in a corporation is simply equal to the value of the owners’ equity. Th erefore, a more general way of stating our goal is to maximize the market value of the owners’ equity. Th is market value can be measured by a business appraiser or by investment bankers if the fi rm eventually goes public.

With this in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good fi nancial decisions increase the market value of the owners’ equity and poor fi nancial decisions decrease it. In fact, although we choose to focus on corpora- tions in the chapters ahead, the principles we develop apply to all forms of business. Many of them even apply to the not-for-profi t sector.

Finally, our goal does not imply that the fi nancial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the fi rm. What we mean is that the fi nancial manager best serves the owners of the business by identifying opportunities that add to the fi rm because they are desired and valued in the free marketplace.

In fact, truthful fi nancial reporting is incredibly important to the long run viability of capital markets. Th e collapse of companies like Enron and Worldcom has illustrated what a dramatic impact unethical behaviour can have on public trust and confi dence in our fi nancial institutions. Th e ability of companies to raise capital and of our economies to function effi ciently is based on this trust and confi dence. If investors cannot assume that the information they receive is honest and truthful, many of the models and theories we learn through this textbook no longer apply.7

1. What is the goal of financial management?

2. What are some shortcomings of the goal of profit maximization?

3. How would you define corporate finance?

6 A current stock price quote for Apple Inc. can be found at google.com/finance. 7 For more on ethics and financial reporting visit the website of the Canadian Centre for Ethics and Corporate Policy at ethicscentre.ca

Concept Questions

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1.4 The Agency Problem and Control of the Corporation

We’ve seen that the fi nancial manager acts in the best interest of the shareholders by taking actions that increase the value of the stock. However, we’ve also seen that in large corporations ownership can be spread over a huge number of shareholders. Or a large shareholder may control a block of shares. In these cases, will management necessarily act in the best interests of the shareholders? Put another way, might not management pursue its own goals (or those of a small group of share- holders) at the shareholders’ expense? We briefl y consider some of the arguments next.

Agency Relationships Th e relationship between shareholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. For example, you might hire someone (an agent) to sell a car that you own. In all such relationships, there is a possibility of confl ict of interest between the principal and the agent. Such confl ict is called an agency problem.

In hiring someone to sell your car, you agree to pay a fl at fee when the car sells. Th e agent’s incentive is to make the sale, not necessarily to get you the best price. If you paid a commission of, say, 10 percent of the sale price instead of a fl at fee, this problem might not exist. Th is example illustrates that the way an agent is compensated is one factor that aff ects agency problems.

Management Goals To see how management and shareholders’ interests might diff er, imagine that the fi rm has a new investment under consideration. Th e new investment favourably impacts the share value, but it is a relatively risky venture. Th e owners of the fi rm may wish to take the investment because the stock value will rise, but management may not because of the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, the share- holders may have lost a valuable opportunity. Th is is one example of an agency cost.

More generally, agency costs refer to the costs of the confl ict of interests between shareholders and management. Th ese costs can be indirect or direct. An indirect agency cost is a lost opportu- nity such as the one we have just described.

Direct agency costs come in two forms: Th e fi rst is a corporate expenditure that benefi ts man- agement but costs the shareholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. Th e second direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of fi nancial statement information is one example.

Some argue that if left to themselves, managers would maximize the amount of resources they have control over or, more generally, corporate power or wealth. Th is goal could lead to an overemphasis on corporate size or growth. For example, cases where management is accused of overpaying to buy up another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefi t the shareholders.

Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-suffi ciency may be important goals.

Do Managers Act in the Shareholders’ Interests? Whether managers do, in fact, act in the best interest of shareholders depends on two factors. First, how closely are management goals aligned with shareholder goals? Th is question relates to the way managers are compensated. Second, can managers be replaced if they do not pursue shareholder goals? Th is issue relates to control of the fi rm. As we discuss, there are a number of reasons to think that, even in the largest fi rms, management has a signifi cant incentive to act in the interest of shareholders.8

8 The legal system is another important factor in restraining managers and controlling shareholders. The common law sys- tem in place in Canada, the U.S., and U.K. offers the greatest protection of shareholder rights according to R. La Porta, F. Lopez-de-Silanes, A. Schliefer, and R. W. Vishny, “Law and Finance,” Journal of Political Economy, December 1998.

agency problem The possibility of conflicts of interest between the shareholders and management of a firm.

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MANAGERIAL COMPENSATION Management frequently has a significant economic incentive to increase share value for two reasons: First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to the share value in particu- lar. For example, managers are frequently given the option to buy stock at current prices. The more the stock is worth, the more valuable this option becomes.9 The second incentive managers have relates to job prospects. Better performers within the firm get promoted. More generally, those managers who are successful in pursuing shareholder goals are in greater demand in the labour market and thus command higher salaries.

Of course, in management compensation, as with other areas of business, matters sometimes get off track. Many observers believe that top executives are overpaid. For example, shareholders of Novartis criticized the company for excessively compensating its chairman, Daniel Vasella, when he was paid over $21 million in 2011.10 One control on compensation is the ‘say on pay’ initiative whereby a fi rm’s shareholders have the right to vote on the remuneration of executives. Going further, creative forms of excessive corporate compensation at U.S. companies like World- com, Tyco, and Adelphia led to the passage of the Sarbanes-Oxley Act in 2002. Th e act is intended to protect investors from corporate abuses. For example, one section prohibits personal loans from a company to its offi cers, such as the ones that were received by former Worldcom CEO Bernie Ebbers.

Excessive management pay and unauthorized management consumption are examples of agency costs.11

CONTROL OF THE FIRM Control of the firm ultimately rests with shareholders. They elect the board of directors, who, in turn, hire and fire management. In 2007, frustrated with his management tactics and overly generous compensation package, shareholders of Home Depot pressured the board of directors into ousting CEO Robert Nardelli.12 From replacing CEOs to entire boards to demanding changes in a firm’s articles of incorporation, shareholder activism is becoming increasingly prominent worldwide. For example, shareholders of HudBay Minerals Inc. halted a proposed acquisition of Lundin Mining Corp. in 2008 over objections to issuing the 153 million shares that would be needed to fund the purchase.13 Poorly managed firms are more attractive as acquisitions than well-managed firms because a greater turnaround potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the shareholders’ interest.

Th e available theory and evidence substantiate that shareholders control the fi rm and that shareholder wealth maximization is the relevant goal of the corporation. Even so, at times man- agement goals are undoubtedly pursued at the expense of the shareholders, at least temporarily. For example, management may try to avoid the discipline of a potential takeover by instituting “poison pill” provisions to make the stock unattractive. Or the fi rm may issue non-voting stock to thwart a takeover attempt. Canadian shareholders, particularly pension funds and other insti- tutional investors, are becoming increasingly active in campaigning against such management actions.14

Large funds like the Ontario Teachers’ Pension Plan Board have set up detailed corporate gov- ernance and proxy voting guidelines for the companies in which they invest. Smaller funds may employ the services of fi rms like Institutional Shareholder Services (ISS) to advise them on how to vote on proposed governance changes.

STAKEHOLDERS Our discussion thus far implies that management and shareholders are the only parties with an interest in the firm’s decisions. This is an oversimplification, of course.

9 Employee stock options allow the manager to purchase a certain number of shares at a fixed price over a specified per- iod of time. By providing the manager an ownership stake in the company, the options are meant to align the manager’s goals and actions with the shareholders’ interests. For more on employee stock options, see Chapter 25. 10 2011 Dow Jones & Company, Inc. 11 Because it requires management to pay out almost all of the cash flow to unit holders, the income trust form of orga- nization can help to control these agency costs. 12 The New York Times, January 4, 2007. 13 financialpost.com/news/Shareholders+step+forefront/5433163/story.html 14 We discuss takeovers and pension managers’ activism in monitoring management activities in Chapter 23.

corporate governance Rules for corporate organization and conduct.

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Employees, customers, suppliers, and various levels of government all have financial interests in the firm.

Taken together, these various groups are called stakeholders in the fi rm. In general, a stake- holder is a shareholder, creditor, or other individual (or group) that potentially has a claim on the cash fl ows of the fi rm. Such groups also attempt to exert control over the fi rm by introducing alter- nate, socially oriented goals such as preserving the environment or creating employment equity. Even though stakeholder pressures may create additional costs for owners, almost all major cor- porations pay close attention to stakeholders because stakeholder satisfaction is consistent with shareholder wealth maximization. Table 1.2 summarizes concerns of various stakeholders.

TABLE 1.2 Inventory of typical stakeholders and issues

Company Employees Shareholders Customers Suppliers Public

Stakeholders Competitors Company history

Industry background

Organization structure

Economic performance

Competitive environment

Mission or purpose

Corporate codes

Stakeholder and social issues

Management

General policy Compensation and rewards

Career planning

Health promotion

Leaves of absence

Dismissal and appeal

Retirement and termination counselling

Women in management and on the board

Employee communication

Part-time temporary, or contract employees

Benefits

Training and development

Employee assistance program

Absenteeism and turnover

Relationships with unions

Termination, layoff, and redundancy

Employment equity and discrimination

Day care and family accommodation

Occupational health and safety

Other employee or human resource issues

General policy

Shareholder communications and complaints

Shareholder advocacy

Shareholder rights

Other shareholder issues

General policy

Customer communications

Product safety

Customer complaints

Special customer services

Other customer issues

General policy

Relative power

Other supplier issues

Public health, safety, and protection

Environmental issues

Public policy involvement

Community relations

Social investment and donations

General policy

Source: M. B. E. Clarkson, “Analyzing Corporate Performance: A New Approach,” Canadian Investment Review, Fall 1991, p. 70. (Reprinted with permission from Canadian Investment Review, Rogers Media Publishing.)

Corporate Social Responsibility and Ethical Investing Well-managed large corporations seek to maintain a reputation as good corporate citizens with detailed policies on important social issues. Investors are becoming increasingly concerned with corporate social responsibility (CSR) and may turn to fi rms like Sustainalytics, founded by Michael Jantzi in Canada, for information. Sustainalytics provides a social responsibility rating for corporations based on over 200 indicators of responsible behaviour with respect to stake- holder issues that dovetail with those in Figure 1.2: community and society, customers, corporate governance, employees, environment, and human rights. Jantzi ratings also assess controversial business activities; these include, alcohol, gaming, genetic engineering, nuclear power, pornogra- phy, tobacco, and weapons. An example Jantzi rating for Nexen Inc. is shown in Figure 1.2.

More than sixty companies that avoid controversial business activities and score well on Jant- zi’s other criteria are included in its Jantzi Social Index. Ethical investment mutual funds such as Ethical Growth and Investors Summa off er an opportunity to buy a portfolio of Canadian com- panies that meet criteria similar to Jantzi’s. Similar funds exist in the U.S. and Europe.

You might wonder about the performance of such funds: Can investors “do well by doing good”? Th e results to date are mixed. A Canadian study suggests that socially responsible invest- ing during the 1990s produced returns similar to those of the overall market aft er adjusting for

stakeholder Anyone who potentially has a claim on a firm.

sustainalytics.com

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risk and concludes that “investing for the soul may not hurt the bottom line.” However, because ethical funds tend to invest more heavily in “clean” tech companies, it remains an open ques- tion whether this fi nding applies in other periods. A more recent U.S. study argues that socially responsible investing imposes a heavy penalty on return.15 Given the mixed evidence, major Can- adian institutional investors like the Ontario Teachers’ Pension Plan and the Ontario Municipal Employees Retirement System pay careful attention to corporate social responsibility in selecting investments but do not eliminate companies from their portfolios based solely on environmental and other social issues.16 To address controversy over their corporate social responsibility Canad- ian mining companies like Barrick Gold and Sherritt International provide detailed information on their CSR activities in Latin America where they are the third largest source of foreign invest- ment aft er the United States and Spain.17

FIGURE 1.2

Sustainalytics Global Platform–Nexen Inc.

PERFORMANCE PER TOPIC

PERFORMANCE PER THEMETOP 5 RANKED COMPETITORS

Rank Company Score

1 Nexen Inc. 79

2 Talisman Energy Inc. 76

3 Hess Corporation 73

4 Suncor Energy Inc. 72

5 ARC Resources Ltd. 69

OVERALL PERFORMANCE RANKING

1 out of 87 79 TOTAL SCORE

Source: Sustainalytics. Used with permission.

15 P. Amundson and S.R. Foerster, “Socially Responsible Investing: Better for Your Soul or Your Bottom Line?” Canad- ian Investment Review, Winter 2001, pp. 26–34 and C. Geczy, R. F. Stambaugh and D. Levin, “Investing in Socially Re- sponsible Mutual Funds,” October 2005, available at SSRN: ssrn.com/sol3/papers.cfm?abstract_id=416380. 16 For a detailed summary of arguments in favour of socially responsible investing by pension funds, see “A legal frame- work for the integration of environmental, social and governance issues into institutional investment,” by Freshfields Bruckhaus Deringer and the UNEP Finance Initiative, October 2005, available at www.unepfi.org/publications/ investment/?&0= 17 J. Sagebien et al., “The Corporate Social Responsibility of Canadian Mining Companies in Latin America: A Systems Perspective,” Canadian Foreign Policy, 14, 3 (2008), 103–128

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David Weitzner and James Darroch on Why Moral Failures Precede Financial Crises

Innovation and crises are endemic to the fi nancial system and while every failure leads to signifi cant regulatory improvement, it has never been enough to prevent the next fi nancial crisis. Yet, each crisis has unique elements and the current crisis cannot be understood without seeing how fi nancial innovation fundamentally changed the fi nancial system of the USA and consequently for those fi nancial systems connected to the USA—essentially the globe. To this end, it is important to note that the drivers of the problems—structured fi nance products—were essentially creatures of the unregulated or lightly regulated side of the US fi nancial system, where greed was unchecked. While there was clearly a failure of regulation, it should be fi rst seen as a failure in scope of regulation. But it is equally important to understand how hubris united with greed was instrumental in players working to create an unregulated market. What is stunning about the current crisis is that it is the result of governance failures of both the boards of fi nancial institutions and markets despite signifi cant regulatory reforms in the banking world—Basel II—and corporate governance in the USA—Sarbanes-Oxley (SOX). The lesson to be learned is that regulatory reform without ethical reform will never be enough. The faith that public policymakers had resolved the major economic issues associated with business cycles and volatility combined with the private sector’s faith in hyper-rational modern fi nance and unregulated markets created an environment conducive to the growth of greed. The arrogant faith in the new fi nancial order led to a lack of attention to governance and ethics despite famous ethical failures and heightened regulatory concerns. While it is often said that success breeds success, long

bull markets and excess liquidity breed over-confi dence and an over-commitment to revenue-generating activities as opposed to control activities. In this environment of weak governance, unethical behavior fl ourishes. Management scholars have already faced tough questions about the ethical implications of their theoretical suppositions (Ghoshal, 2005), but the current fi nancial woes have led to renewed calls for a more central place for ethical considerations in mainstream management theories along with new questions about the signifi cant role greed and hubris tend to play in the practice of management. We believe that the time has come for researchers concerned with the fi nancial system and the question of ethics to address explicitly the problem of greed.

The immediate challenge is to restore trust not only among fi nancial institutions to restore the inter-bank markets, but also trust from the public. This is a tall order. Greed led to the governance failures at both the market and individual institutional level. Financial players who should have been committed to the good of the system in order to ensure that they could create wealth for themselves while improving the lot of others failed to recognize this obligation. Rather, greed and hubris led to the enrichment of the few to the cost of the many. It would be naive to believe that a moral renaissance is at hand and will solve all ills, so until that time we must enforce rules to promote the virtue of transparency to prevent shadow worlds in the fi nancial system.

Source: From the authors Used with permission.

David Weitzner is an Instructor (Strategy/Policy) and James Darroch is an Associate Professor (Policy) at Schulich School of Business, York University.

IN THEIR OWN WORDS…

1. What is an agency relationship?

2. What are agency problems and how do they come about? What are agency costs?

3. What incentives do managers in large corporations have to maximize share value?

4. What role do stakeholders play in determining corporate goals?

1.5 Financial Markets and the Corporation

We’ve seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are signifi cantly enhanced by the existence of fi nancial institutions and markets. Financial markets play an extremely important role in corporate fi nance.

Concept Questions

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FIGURE 1.3

Cash flows between the firm and the financial markets

A. Firm issues securities B. Firm invests in assets

Current assets Fixed assets

Financial markets

Short-term debt Long-term debt Equity shares

F. Dividends and debt payments

E. Reinvested cash flows

C. Cash flow from firm’s assets

D. Government Other stakeholders

Total Value of Firm’s Assets

Total Value of the Firm to Investors in

the Financial Markets

A. Firm issues securities to raise cash. B. Firm invests in assets. C. Firm’s operations generate cash flow.

D. Cash is paid to government as taxes. Other stakeholders may receive cash. E. Reinvested cash flows are plowed back into firm. F. Cash is paid out to investors in the form of interest and dividends.

Cash Flows to and from the Firm Th e interplay between the corporation and the fi nancial markets is illustrated in Figure 1.3. Th e arrows in Figure 1.3 trace the passage of cash from the fi nancial markets to the fi rm and from the fi rm back to the fi nancial markets.

Suppose we start with the fi rm selling shares of stock and borrowing money to raise cash. Cash fl ows to the fi rm from the fi nancial market (A). Th e fi rm invests the cash in current and fi xed assets (B). Th ese assets generate some cash (C), some of which goes to pay corporate taxes (D). Aft er taxes are paid, some of this cash fl ow is reinvested in the fi rm (E). Th e rest goes back to the fi nancial markets as cash paid to creditors and shareholders (F).

Companies like Tim Hortons routinely make decisions that create such cash fl ows to and from the fi rm. For example, in 2010 the company used increased cash fl ow from operations to fund its growth requirements.

A fi nancial market, like any market, is just a way of bringing buyers and sellers together. In fi nancial markets, it is debt and equity securities that are bought and sold. Financial markets diff er in detail, however. Th e most important diff erences concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of these diff erences are discussed next.

Money versus Capital Markets Financial markets can be classifi ed as either money markets or capital markets. Short-term debt securities of many varieties are bought and sold in money markets. Th ese short-term debt secur- ities are oft en called money market instruments and are essentially IOUs. For example, a bankers acceptance represents short-term borrowing by large corporations and is a money-market instru- ment. Treasury bills are an IOU of the government of Canada. Capital markets are the markets for long-term debt and shares of stock, so the Toronto Stock Exchange, for example, is a capital market.

Th e money market is a dealer market. Generally, dealers buy and sell something for them- selves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers

money markets Financial markets where short-term debt securities are bought and sold.

capital markets Financial markets where long-term debt and equity securities are bought and sold.

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and agents match buyers and sellers, but they do not actually own the commodity. A real estate agent or broker, for example, does not normally buy and sell houses.

Th e largest money-market dealers are chartered banks and investment dealers. Th eir trading facilities, like those of other market participants, are connected electronically via telephone and computer, so the money market has no actual physical location.

Primary versus Secondary Markets Financial markets function as both primary and secondary markets for debt and equity securities. Th e term primary markets refers to the original sale of securities by governments and corpora- tions. Th e secondary markets are where these securities are bought and sold aft er the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both govern- ments and corporations. In the following discussion, we focus only on corporate securities.

PRIMARY MARKETS In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name sug- gests, involves selling securities to the general public. For example, in 1999 and early 2000, investors were snapping up new issues providing equity funding to untested dot-com IPOs (initial public of- ferings). A private placement, on the other hand, is a negotiated sale involving a specific buyer. These topics are covered in some detail in Part 6, so we only introduce the bare essentials here.

Most publicly off ered debt and equity securities are underwritten. In Canada, underwriting is conducted by investment dealers specialized in marketing securities. Examples are RBC Capital Markets, Scotia Capital, BMO Capital Markets, and CIBC World Markets.

When a public off ering is underwritten, an investment dealer or a group of investment dealers (called a syndicate) typically purchase the securities from the fi rm and market them to the public. Th e underwriters hope to profi t by reselling the securities to investors at a higher price than they pay the fi rm.

By law, public off erings of debt and equity must be registered with provincial authorities, of which the most important is the Ontario Securities Commission (OSC). Registration requires the fi rm to disclose a great deal of information before selling any securities. Th e accounting, legal, and underwriting costs of public off erings can be considerable.

Partly to avoid the various regulatory requirements and the expense of public off erings, debt and equity are oft en sold privately to large fi nancial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the OSC and do not require the involvement of underwriters.

SECONDARY MARKETS A secondary market transaction involves one owner or credi- tor selling to another. Therefore, the secondary markets provide the means for transferring own- ership of corporate securities. There are two kinds of secondary markets: auction markets and dealer markets.

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Trading in debt securities takes place over the counter, with much of the trading now conducted electronically. Th e expression over-the-counter refers to days of old when securities were literally bought and sold at counters in offi ces around the country. Today, like the money market, a sig- nifi cant fraction of the market for stocks and all of the market for long-term debt have no central location; the many dealers are connected electronically.

THIRD AND FOURTH MARKETS A third market involves trading exchange-listed se- curities in OTC markets. This allows investors to trade large volume of securities directly without an exchange. Fourth Market trading involves institution-to-institution trading without using the services of brokers or dealers.

TRADING IN CORPORATE SECURITIES The equity shares of most of the large firms in Canada trade in organized auction and dealer markets. The largest stock market in Can- ada is the Toronto Stock Exchange (TSX). It is owned and operated as a subsidiary of the TMX Group for the trading of senior securities. Table 1.3 shows the top ten stock markets in the world in 2011, Toronto ranked number eight based on market value. The TMX Group also runs the

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TSX Venture Exchange for listing smaller, emerging companies. The four main industries repre- sented on the Venture Exchange are biotechnology, information technology, mining, and oil and gas.

Auction markets diff er from dealer markets in two ways: First, an auction market or exchange, unlike a dealer market, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. Th e primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the U.S. National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (NASD Automated Quotation system, pronounced “naz-dak” and now spelled “Nasdaq”). In January 2006, Nasdaq took the next step forward when its application to be registered as a national stock exchange was accepted by the U.S. Securities and Exchange Commission. Th ere are roughly three times as many companies on Nasdaq as there are on NYSE, but they tend to be much smaller in size and trade less actively. Th ere are exceptions, of course. For example, tech giants Microsoft and Intel trade on Nasdaq. Nonetheless, the total value of Nasdaq stocks is considerably less than the total value of the NYSE stocks.

TABLE 1.3

Largest stock markets in the world by market capitalization in 2011

Rank in 2011 Stock Exchanges Market Capitalization

(in U.S. $ billions)

1 NYSE Euronext (US) $11,796 2 NASDAQ OMX (US) 3,845 3 Tokyo Stock Exchange Group 3,325 4 London Stock Exchange Group 3,266 5 NYSE Euronext (Europe) 2,447 6 Shanghai Stock Exchange 2,357 7 Hong Kong Exchanges 2,258 8 TMX Group 1,912 9 BM&FBOVESPA 1,229

10 Australian Securities Exchange 1,198 Source: World Federation of Stock Exchanges at world-exchanges.org

LISTING Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for various exchanges.

Th e requirements for listing on the TSX Venture are not as strict as those for listing on the TSX, although the listing process is quite similar. Th e TSX Venture, however, has two diff erent tiers that companies can register under. Companies can list shares on the second tier with as little as $500,000 in net tangible assets and $50,000 in pre-tax earnings. Both tiers require that there exist 300 public shareholders, holding one board lot or more; Tier 1 also requires that there be 1 million free trading shares with a market value of $1 million or more, and Tier 2 requires at least 500,000 free trading shares with a market value of $500,000 or more. Th ese requirements make it possible for smaller companies that would not normally be able to obtain listing on the TSX to acquire equity fi nancing.

Th e TSX has the most stringent requirements of the exchanges in Canada. For example, to be listed on the TSX, a company is expected to have at least 1,000,000 freely tradable shares with a market value of at least $4 million and a total of at least 300 shareholders with at least 100 shares each.18 Th ere are additional minimums on earnings, assets, and number of shares outstanding. Research suggests that listing on exchanges adds valuable liquidity to a company’s shares.19 In

18 tmx.com/en/pdf/InternationalGuidetoListing.pdf 19 Relevant studies include S. R. Foerster and G. A. Karolyi, “The Effects of Market Segmentation and Investor Recogni- tion on Asset Prices: Evidence from Foreign Stocks Listings in the U.S.,” Journal of Finance, 54: 3, 1999, 981–1013 and U.R. Mittoo, “The Winners and Losers of Listings in the U.S.,” Canadian Investment Review, Fall 1998, 13–17.

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November 2002, the TSX itself went public and listed its shares for the fi rst time. With an off ering of just under 19 million shares at an initial off ering price of $18, the TSX easily exceeded its own listing requirements.

1.6 Financial Institutions

Financial institutions act as intermediaries between investors (funds suppliers) and fi rms raising funds. (Federal and provincial governments and individuals also raise funds in fi nancial markets, but our examples focus on fi rms.) Financial institutions justify their existence by providing a vari- ety of services that promote the effi cient allocation of funds. Th ese institutions also serve as inter- mediaries for households and individuals—providing a medium where individuals can save and borrow money. Individuals and households may choose to save not only in the traditional savings and chequing accounts, but also in savings plans such as a Registered Retirement Savings Plan (RRSP), Registered Education Savings Plan (RESP), or Tax-Free Savings Account (TFSA). Can- adian fi nancial institutions include chartered banks and other depository institutions—trust com- panies, credit unions, investment dealers, insurance companies, pension funds, and mutual funds.

Table 1.4 ranks the top eleven publicly traded fi nancial institutions in Canada by market capi- talization in 2011. Th ey include the Big Six chartered banks, three life insurance companies, one fi nancial holding company, and a diversifi ed fi nancial services company. Because they are allowed to diversify by operating in all provinces, Canada’s chartered banks are of a reasonable size on an international scale.

Chartered banks operate under federal regulation, accepting deposits from suppliers of funds and making commercial loans to mid-sized businesses, corporate loans to large companies, and per- sonal loans and mortgages to individuals.20 Banks make the majority of their income from the spread between the interest paid on deposits and the higher rate earned on loans. Th is is indirect fi nance.

Chartered banks also provide other services that generate fees instead of spread income. For example, a large corporate customer seeking short-term debt funding can borrow directly from another large corporation with funds supplied through a bankers acceptance. Th is is an interest- bearing IOU stamped by a bank guaranteeing the borrower’s credit. Instead of spread income, the bank receives a stamping fee. Bankers acceptances are an example of direct fi nance. Notice that the key diff erence between direct fi nance and indirect fi nance is that in direct fi nance funds do not pass through the bank’s balance sheet in the form of a deposit and loan. Oft en called securitization because a security (the bankers acceptance) is created, direct fi nance is growing rapidly.

TABLE 1.4

Largest financial institutions in Canada, by market capitalization, December 2011

Rank Company Market Capitalization

($ billion)

1 Royal Bank of Canada $79.9 2 Toronto Dominion 72.5 3 Bank of Nova Scotia 59.7 4 Bank of Montreal 38.7 5 Canadian Imperial Bank of Commerce 32.5 6 Manulife Financial Corp. 21.6 7 Great-West Lifeco 21.2 8 Power Financial 20.1 9 Sun Life Financial Inc. 13.3

10 National Bank of Canada 12.3 11 IGM Financial 11.5

Source: tmx.com/en/pdf/mig/ TSX_TSXV_Issuers.xls

Trust companies also accept deposits and make loans. In addition, trust companies engage in fi duciary activities—managing assets for estates, registered retirement savings plans, and so on.

20 Loan and mortgage calculations are discussed in Chapter 6.

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Like trust companies, credit unions also accept deposits and make loans. Caisses Desjardins du Quebec is a major Quebec credit union, but does not appear in Table 1.4 because it is member- owned and not publicly traded.

Investment dealers are non-depository institutions that assist fi rms in issuing new securities in exchange for fee income. Investment dealers also aid investors in buying and selling securities. Chartered banks own majority stakes in fi ve of Canada’s top 15 investment dealers.

Insurance companies include property and casualty insurance and health and life insurance companies. Life insurance companies engage in indirect fi nance by accepting funds in a form similar to deposits and making loans. Manulife Financial and Sun Life Financial are major life insurance companies that have expanded aggressively to become rivals of the chartered banks.

Fuelled by the aging of the Canadian population and the longest bull market in history, assets in pension and mutual funds grew rapidly in the 1990s. Pension funds invest contributions from employers and employees in securities off ered by fi nancial markets. Mutual funds pool individ- ual investments to purchase diversifi ed portfolios of securities. Th ere are many diff erent types of mutual funds. Table 1.5 shows the totals of mutual fund assets by fund type. In June 2011, the two largest categories were Canadian and foreign equity. However, the Canadian mutual fund market is small on a global scale. Table 1.6 shows the percentage of global mutual fund market by geography.

TABLE 1.5

Total net assets by fund type in June 2011

Net Assets ($ billions)

Canadian Equity $137.4 Global and International Equity 61.4 U.S. Equity 21.3 Sector Equity 18.2 Domestic Balanced 163.6 Global Balanced 129.5 Canadian Fixed Income 71.1 Global and High Yield Fixed Income 16.1 Specialty Funds Money Market Funds

5.2 32.5

Total $656.3

Source: Data drawn from Investment Funds Institute of Canada, Monthly statistics, June 2011. ific.ca.

TABLE 1.6

Global mutual fund industry by geography (Percentage of total net assets, year-end 2011)

Total worldwide mutual fund assets $23.8 trillion

Percentage of total net assets

United States 49 Europe 30 Africa and Asia/Pacific 13 Other Americas (includes Canada) 8

Source: Investment Company Institute, European Fund and Asset Management Association, and other national mutual fund associations

Hedge funds are another growing group of fi nancial institutions. According to the 2011 Hedge Fund Asset Flows & Trends report published by HedgeFund.net, the industry had approximately US$2.561 trillion under management worldwide in the second quarter of 2011. Hedge funds are largely unregulated and privately managed investment funds catering to sophisticated invest- ors, which look to earn high returns using aggressive fi nancial strategies prohibited by mutual

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funds. Th ese strategies may include arbitrage,21 high levels of leverage,22 and active involvement in the derivatives market. However, hedge funds are not restricted to investing in fi nancial instru- ments—some hedge fund strategies involve acquiring stakes in public or private companies and pressuring the board to sell the business. In January 2011, the Canadian hedge fund industry was worth between $35 billion and $40 billion.23 Th ere is a high risk associated with hedge funds as these are highly unregulated and subject to fraud. In 2011, Raj Rajaratnam, hedge-fund tycoon and founder of Galleon Group was sentenced to 11 years in prison for insider trading. He amassed over $72 million by using illegal tips to trade in stocks of companies including Goldman Sachs Group Inc., Intel Corp., Google Inc., ATI Technologies Inc., and Clearwire Corp.24

We base this survey of the principal activities of fi nancial institutions on their main activities today. Recent deregulation now allows chartered banks, trust companies, insurance companies, and investment dealers to engage in most of the activities of the others with one exception: Char- tered banks are not allowed to sell life insurance through their branch networks. Although not every institution plans to become a one-stop fi nancial supermarket, the diff erent types of institu- tions are likely to continue to become more alike.

1. What are the principal financial institutions in Canada? What is the principal role of each?

2. What are direct and indirect finance? How do they differ?

3. How are money and capital markets different?

4. What is a dealer market? How do dealer and auction markets differ?

5. What is the largest auction market in Canada?

1.7 Trends in Financial Markets and Financial Management

Like all markets, fi nancial markets are experiencing rapid globalization. Globalization also makes it harder for investors to shelter their portfolios from fi nancial shocks in other countries. In the summer of 1998, the Asian fi nancial crisis shook fi nancial markets around the world. With increasing globalization, interest rates, foreign exchange rates, and other macroeconomic vari- ables have become more volatile. Th e toolkit of available fi nancial management techniques has expanded rapidly in response to a need to control increased risk from volatility and to track complexities arising from dealings in many countries. Computer technology improvements are making new fi nancial engineering applications practical.

When fi nancial managers or investment dealers design new securities or fi nancial processes, their eff orts are referred to as fi nancial engineering. Successful fi nancial engineering reduces and controls risk and minimizes taxes. Financial engineering creates a variety of debt and equity securities and reinforces the trend toward securitization of credit introduced earlier. A controver- sial example is the invention and rapid growth of trading in options, futures, and other derivative securities. Derivative securities are very useful in controlling risk, but they have also produced large losses when mishandled. For example, in 2008 during the fi nancial crisis, American Inter- national Group (AIG) owed heft y Credit Default Swaps Settlement payments to various banks. When AIG was about to go bankrupt, the U.S. government intervened and bailed out the com- pany by providing $182 billion.25

Financial engineering also seeks to reduce fi nancing costs of issuing securities as well as the

21 The practice of taking advantage of a price differential between two or more markets. 22 The use of debt to increase the potential return of an investment. 23 Source: cbc.ca/news/business/taxseason/story/2011/01/17/f-hedge-funds-industry-canada.html. To learn more about hedge fund developments, visit hedgefund.net. 24 articles.economictimes.indiatimes.com/2012-09-08/news/33696695_1_raj-rajaratnam-roomy-khan-oral-arguments 25 theglobeandmail.com/globe-investor/aig-profit-lifted-by-aia-stake-tax-benefit/article2119948/

Concept Questions

financial engineering Creation of new securities or financial processes.

derivative securities Options, futures, and other securities whose value derives from the price of another, underlying, asset.

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costs of complying with rules laid down by regulatory authorities. An example is the Short Form Prospectus Distribution (SFPD) allowing fi rms that frequently issue new equity to bypass most of the OSC registration requirements.

In addition to fi nancial engineering, advances in technology have created e-business, bring- ing new challenges for the fi nancial manager. For example, consumers ordering products on a company’s website expect rapid delivery and failure to meet these expectations can damage a company’s image. Th is means that companies doing e-business with consumers must invest in supply chain management as well as in additional inventory.

Technological advances have also created opportunities to combine diff erent types of fi nancial institutions to take advantage of economies of scale and scope. For example, Royal Bank, Canada’s largest chartered bank, owns Royal Trust and RBC Dominion Securities. Such large institutions operate in all provinces and internationally and enjoy more lax regulations in some jurisdictions than in others. Financial institutions pressure authorities to deregulate in a push-pull process called the regulatory dialectic.

For example, in 1998 and again in 2002, banks planned mergers in an eff ort to pressure the federal government to grant approval. Although the federal government turned down the merg- ers, we believe this issue is dormant, not dead, and will reemerge in the not too distant future.

Not all trends are driven by technology. In the aft ermath of the technology bubble of the late 1990s, stakeholders and regulators have become very interested in corporate governance reform, a topic we introduced earlier in the chapter. For example, proponents of such reform argue that a stronger, independent board of directors can prevent management excesses.

Another trend underlying the global fi nancial crisis starting in 2007 was excessive fi nancial leverage. Following the technology bubble and September 11, the United States Federal Reserve looked to aggressively lower interest rates in order to restore confi dence in the economy. In the U.S., individuals with bad credit ratings, sub-prime borrowers, looked to banks to provide loans at historically low interest rates for home purchases. Investors also reacted to these low rates by seeking higher returns. Th e fi nancial industry responded by manufacturing sub-prime mortgages and asset-backed securities. However, once housing prices began to cool and interest rates rose, sub-prime borrowers started defaulting on their loans and the collapse of the sub-prime market ensued. With mortgages serving as the underlying asset supporting most of the fi nancial instru- ments that investment banks, institutions, and retail buyers had acquired, these assets lost much of their value and hundreds of billions of dollars of write-downs followed.

Canada faced much the same external environments in the leadup to the crisis as the US did. But despite its fi nancial and economic integration with the US, Canada did not experience a single bank failure or bailout., Th e diff erence was that a highly stable branch banking system dominated by six large institutions forms the heart of Canada’s fi nancial system. Banks dominate lending and credit creation nationally and account for over 60% of total fi nancial assets in Canada.26

Th ese trends have made fi nancial management a much more complex and technical activ- ity. For this reason, many students of business fi nd introductory fi nance one of their most chal- lenging subjects. Th e trends we reviewed have also increased the stakes. In the face of increased global competition, the payoff for good fi nancial management is great. Th e fi nance function is also becoming important in corporate strategic planning. Th e good news is that career opportuni- ties (and compensation) in fi nancial positions are quite attractive.

1.8 Outline of the Text

Now that we’ve completed a quick tour of the concerns of corporate fi nance, we can take a closer look at the organization of this book. Th e text is organized into the following nine parts:

Part 1: Overview of Corporate Finance Part 2: Financial Statements and Long-Term Financial Planning Part 3: Valuation of Future Cash Flows Part 4: Capital Budgeting

26 Donald J.S. Brean, Lawrence Kryzanowski & Gordon S. Roberts (2011): Canada and the United States: Different roots, different routes to financial sector regulation, Business History, 53:2, 249–269

rbcroyalbank.com

regulatory dialectic The pressures financial institutions and regulatory bodies exert on each other.

CHAPTER 1: Introduction to Corporate Finance 21

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Part 5: Risk and Return Part 6: Cost of Capital and Long-Term Financial Policy Part 7: Short-Term Financial Planning and Management Part 8: Topics in Corporate Finance Part 9: Derivative Securities and Corporate Finance

Part 1 of the text contains some introductory material and goes on to explain the relationship between accounting and cash fl ow. Part 2 explores fi nancial statements and how they are used in fi nance in greater depth.

Parts 3 and 4 contain our core discussion on valuation. In Part 3, we develop the basic proce- dures for valuing future cash fl ows with particular emphasis on stocks and bonds. Part 4 draws on this material and deals with capital budgeting and the eff ect of long-term investment decisions on the fi rm.

In Part 5, we develop some tools for evaluating risk. We then discuss how to evaluate the risks associated with long-term investments by the fi rm. Th e emphasis in this section is on coming up with a benchmark for making investment decisions.

Part 6 deals with the related issues of long-term fi nancing, dividend policy, and capital struc- ture. We discuss corporate securities in some detail and describe the procedures used to raise capital and sell securities to the public. We also introduce and describe the important concept of the cost of capital. We go on to examine dividends and dividend policy and important consider- ations in determining a capital structure.

Th e working capital question is addressed in Part 7. Th e subjects of short-term fi nancial plan- ning, cash management, and credit management are covered.

Part 8 contains the important special topic of international corporate fi nance. Part 9 covers risk management and derivative securities.

1.9 SUMMARY AND CONCLUSIONS

Th is chapter has introduced you to some of the basic ideas in corporate fi nance. In it, we saw that:

1. Corporate finance has three main areas of concern: a. What long-term investments should the firm take? This is the capital budgeting decision. b. Where will the firm get the long-term financing to pay for its investment? In other

words, what mixture of debt and equity should we use to fund our operations? This is the capital structure decision.

c. How should the firm manage its everyday financial activities? This is the working capital decision.

2. The goal of financial management in a for-profit business is to make decisions that increase the value of the stock or, more generally, increase the market value of the equity.

3. The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interest, but it has the disadvantage of double taxation.

4. There is the possibility of conflicts between shareholders and management in a large corpo- ration. We called these conflicts agency problems and discussed how they might be con- trolled and reduced.

5. The advantages of the corporate form are enhanced by the existence of financial markets. Financial institutions function to promote the efficiency of financial markets. Financial mar- kets function as both primary and secondary markets for corporate securities and can be or- ganized as either dealer or auction markets. Globalization, deregulation, and financial engineering are important forces shaping financial markets and the practice of financial management.

Of the topics we’ve discussed thus far, the most important is the goal of fi nancial management: Maximizing the value of the stock. Th roughout the text, as we analyze fi nancial decisions, we always ask the same question: How does the decision under consideration aff ect the value of the shares?

22 Part 1: Overview of Corporate Finance

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Key Terms agency problem (page 10) capital budgeting (page 2) capital markets (page 15) capital structure (page 3) corporate governance (page 11) corporation (page 5) derivative securities (page 20)

financial engineering (page 20) money markets (page 15) partnership (page 5) regulatory dialectic (page 21) sole proprietorship (page 4) stakeholder (page 12) working capital management (page 4)

Chapter Review Problems and Self-Test 1. The Financial Management Decision Process (LO1) What

are the three types of financial management decisions? For each type of decision, give an example of a business transac- tion that would be relevant.

2. Sole Proprietorships and Partnerships (LO2) What are the three primary disadvantages to the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organization as opposed to the corporate form?

3. Corporate Organization (LO2) What is the primary disad- vantage of the corporate form of organization? Name at least two advantages of corporate organization.

4. Corporate Finance Organizational Structure (LO4) In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of cor- porate finance?

5. The Goal of Financial Management (LO3) What goal should always motivate the actions of the firm’s financial manager?

6. Corporate Agency Issues (LO4) Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency rela- tionship exists in the corporate form of organization? In this context, what kind of problems can arise?

7. Financial Markets (LO5) An initial public offering (IPO) of a company’s securities is a term you’ve probably noticed in the financial press. Is an IPO a primary market transaction or a secondary market transaction?

8. Financial Markets (LO5) What does it mean when we say the Toronto Stock Exchange is both an auction market and a dealer market? How are auction markets different from dealer markets? What kind of market is Nasdaq?

9. Not-for-Profit Firm Goals (LO3) Suppose you were the fi- nancial manager of a not-for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate?

10. Firm Goals and Stock Value (LO3) Evaluate the following statement: “Managers should not focus on the current stock

value because doing so will lead to an overemphasis on short- term profits at the expense of long-term profits.”

11. Firm Goals and Ethics (LO3) Can our goal of maximizing the value of the stock conflict with other goals, such as avoid- ing unethical or illegal behaviour? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Try to think of some specific scenar- ios to illustrate your answer.

12. Firm Goals and Multinational Firms (LO3) Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?

13. Agency Issues and Corporate Control (LO4) Suppose you own shares in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding shares. Your company’s management immedi- ately begins fighting off this hostile bid. Is management acting in the shareholders’ best interests? Why or why not?

14. Agency Issues and International Finance (LO4) Corporate ownership varies around the world. Historically, individuals have owned the majority of shares in public corporations in the United States. In Canada this is also the case, but owner- ship is more often concentrated in the hands of a majority shareholder. In Germany and Japan, banks, other financial institutions, and large companies own most of the shares in public corporations. How do you think these ownership dif- ferences affect the severity of agency costs in different countries?

15. Major Institutions and Markets (LO5) What are the major types of financial institutions and financial markets in Canada?

16. Direct versus Indirect Finance (LO5) What is the difference between direct and indirect finance? Give an example of each.

17. Current Major Trends (LO5) What are some of the major trends in Canadian financial markets? Explain how these trends affect the practice of financial management in Canada.

Internet Application Questions 1. Equity markets are an important source of capital for private firms in Canada. Take a tour of the Toronto Stock Exchange at

tmx.com. What is the TSX Composite Index? Check out Index Lists/Information under Investor Information. What does a change in the TSX Composite Index tell you?

2. Canadian banks are actively involved in financing home mortgages. Describe the role played by the Canada Mortgage and Housing Corporation in home mortgages (cmhc.ca). What is the National Housing Act? Can an investor participate in the mortgage “pool” represented by housing loans insured by the CMHC? Click on the Investment Opportunities menu on the CMHC homepage and describe Mortgage Backed Securities offered by the CMHC.

CHAPTER 1: Introduction to Corporate Finance 23

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3. The choice of business organization form depends on many factors. The following website from British Columbia outlines the pros and cons of a sole proprietorship, partnership, and corporation: www.smallbusinessbc.ca/starting-a-business/ legal-requirements.

Can you suggest a few reasons why some firms that were organized as partnerships decided to incorporate (e.g., Goldman Sachs (goldmansachs.com) with shares traded on the NYSE (nyse.com)?

4. Ethical investing following socially responsible principles is gaining popularity. The Social Investment Organization website provides information about these principles and on Canadian ethical mutual funds at socialinvestment.ca. Sustainalytics offers research services to support socially responsible investing at sustainalytics.com/. How does investing in ethical funds differ from investing in general? What has been the performance record of Canadian ethical funds?

5. Ontario Securities Commission (OSC) administers and enforces securities law in the province of Ontario. The OSC website (osc.gov.on.ca) outlines various security laws and instruments. Visit the ‘Securities Law and Instruments’ section and check out the latest instruments, rules and policies. What are Securities Act (Ontario) and Commodity Futures Act?

24 Part 1: Overview of Corporate Finance

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In this chapter, we examine fi nancial statements, cash fl ow, and taxes. Our emphasis is not on preparing fi nancial statements. Instead, we recognize that fi nancial statements are frequently a key source of information for fi nancial decisions, so our goal is to briefl y examine such statements and point out some of their more relevant features along with a few limitations. We pay special attention to some of the practical details of cash fl ow. By cash fl ow, we simply mean the diff erence between the number of dollars that come in and the number that go out. A crucial input to sound fi nancial management, cash fl ow analysis is used throughout the book. For example, bankers lending to businesses are looking increasingly at borrowers’ cash fl ows as the most reliable mea- sures of each company’s ability to repay its loans. In another example, most large companies base their capital budgets for investments in plant and equipment on analysis of cash fl ow. As a result, there is an excellent payoff in later chapters for knowledge of cash fl ow.

One very important topic is taxes because cash fl ows are measured aft er taxes. Our discussion looks at how corporate and individual taxes are computed and at how investors are taxed on dif- ferent types of income. A basic understanding of the Canadian tax system is essential for success in applying the tools of fi nancial management.

2.1 Statement of Financial Position

Th e statement of fi nancial position, also referred to as the balance sheet, is a snapshot of the fi rm. It is a convenient means of organizing and summarizing what a fi rm owns (its assets), what a fi rm owes (its liabilities), and the diff erence between the two (the fi rm’s equity) at a given time. Figure 2.1 illustrates how the traditional statement of fi nancial position is constructed. As shown, the left -hand side lists the assets of the fi rm, and the right-hand side lists the liabilities and equity. However, most publicly accountable enterprises in Canada choose a vertical format for the state- ment of fi nancial position.

In 2011, publicly traded fi rms in Canada switched to International Financial Reporting Standards (IFRS).1 Under IFRS, a company enjoys fl exibility over how to present its statement

1 cica.ca/ifrs//index.aspx

statement of financial position Financial statement showing a firm’s accounting value on a particular date. Also known as a balance sheet.

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

C H A P T E R 2

I n 2011, the Ontario Securities Commission (OSC) began investigating Sino-Forest Corp., one of the leading commercial plant operators in People’s

Republic of China. The OSC found the company

to have misrepresented some of its revenue and/or

exaggerated some of its timber holdings. In August

2011, Allen Chan, the CEO of Sino-Forest Corp., had

resigned amid allegations of fraud and misconduct.

The story of Sino-Forest Corp. highlights the issue

of reliability of financial statements and the importance

of understanding the financial reporting of companies.

Financial statements are discussed in this chapter.

Learning Object ives

After studying this chapter, you should understand:

LO1 The difference between accounting value (or “book” value) and market value.

LO2 The difference between accounting income and cash flow.

LO3 How to determine a firm’s cash flow from its financial statements.

LO4 The difference between average and marginal tax rates.

LO5 The basics of Capital Cost Allowance (CCA) and Undepreciated Capital Cost (UCC).

Pe te

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G lo

be a

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ai l

02Ross_Chapter02_FIN.indd 2502Ross_Chapter02_FIN.indd 25 12-12-19 11:3512-12-19 11:35

 

 

of fi nancial position. For example, in applications of IFRS in Europe, many companies list fi xed assets at the top of the left -hand side of their balance sheets. In Canada, the practice is to retain the order used under GAAP.

FIGURE 2.1

The statement of financial position model of the firm. Left side lists total value of assets. Right side, or total value of the firm to investors, determines how the value is distributed.

Current assets

Fixed assets

1. Tangible fixed assets

2. Intangible fixed assets

Total Value of Assets

Current liabilities

Shareholders’ equity

Long-term debt

Total Value of the Firm to Investors

Net working capital

Assets Assets are classifi ed as either current or fi xed. A fi xed asset is one that has a relatively long life. Fixed assets can either be tangible, such as a truck or a computer, or intangible, such as a trade- mark or patent. Accountants refer to these assets as capital assets. A current asset has a life of less than one year. Th is means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classifi ed as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the fi rm by its customers) is also a current asset.

Liabil it ies and Owners’ Equity Th e fi rm’s liabilities are the fi rst thing listed on the right-hand side of the statement of fi nancial position. Th ese are classifi ed as either current or long-term. Current liabilities, like current assets, have a life of less than one year (meaning they must be paid within the year) and are listed before long-term liabilities. Accounts payable (money the fi rm owes to its suppliers) is one example of a current liability.

A debt that is not due in the coming year is a long-term liability. A loan that the fi rm will pay off in fi ve years is one such long-term debt. Firms borrow long-term from a variety of sources. We use the terms bond and bondholders generically to refer to long-term debt and long-term credi- tors, respectively.

Finally, by defi nition, the diff erence between the total value of the assets (current and fi xed) and the total value of the liabilities (current and long-term) is the shareholders’ equity, also called common equity or owners’ equity. Th is feature of the statement of fi nancial position is intended to refl ect the fact that, if the fi rm were to sell all of its assets and use the money to pay off its debts, whatever residual value remained would belong to the shareholders. So, the statement of fi nancial position balances because the value of the left -hand side always equals the value of the right-hand side. Th at is, the value of the fi rm’s assets is equal to the sum of liabilities and shareholders’ equity:2

Assets = Liabilities + Shareholders’ equity [2.1]

Th is is the statement of fi nancial position identity or equation, and it always holds because share- holders’ equity is defi ned as the diff erence between assets and liabilities.

2 The terms owners’ equity and shareholders’ equity are used interchangeably to refer to the equity in a corporation. The term net worth is also used. Variations exist in addition to these.

26 Part 1: Overview of Corporate Finance

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Net Working Capital As shown in Figure 2.1, the diff erence between a fi rm’s current assets and its current liabilities is called net working capital. Net working capital is positive when current assets exceed current liabilities. Based on the defi nitions of current assets and current liabilities, this means that the cash available over the next 12 months exceeds the cash that must be paid over that same period. For this reason, net working capital is usually positive in a healthy fi rm.3

EXAMPLE 2.1: Building the Statement of Financial Position

A firm has current assets of $100, fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the statement of financial position look like? What is shareholders’ equity? What is net working capital?

In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders’ equity is the difference: $600 – 270 = $330. The state- ment of financial position would thus look like:

Assets Liabilities

Current assets $100 Current liabilities $ 70 Fixed assets 500 Long-term debt 200

Shareholders’ equity 330 Total assets $600 Total liabilities and shareholders’ equity $600

Net working capital is the diff erence between current assets and current liabilities, or $100 – 70 = $30.

Table 2.1 shows a simplifi ed statement of fi nancial position for Canadian Enterprises Limited. Th e assets in the statement of fi nancial position are listed in order of the length of time it takes for them to convert to cash in the normal course of business. Similarly, the liabilities are listed in the order in which they would normally be paid.

TABLE 2.1

Canadian Enterprises Limited Statement of Financial Position as of December 31, 2011 and 2012

($ millions)

2011 2012 2011 2012

Assets Liabilities and Owners’ Equity Current assets Current liabilities Cash $ 114 $ 160 Accounts payable $ 232 $ 266 Accounts receivable 445 688 Notes payable 196 123 Inventory 553 555 Total $ 428 $ 389 Total $ 1,112 $ 1,403

Long-term debt $ 408 $ 454 Fixed assets Owners’ equity Net, plant and equipment $ 1,644 $ 1,709 Common shares 600 640

Retained earnings 1,320 1,629 Total $ 1,920 $ 2,269

Total assets $ 2,756 $ 3,112 Total liabilities and owners’ equity $ 2,756 $ 3,112

Th e structure of the assets for a particular fi rm refl ects the line of business that the fi rm is in and also managerial decisions about how much cash and inventory to maintain and about credit policy, fi xed asset acquisition, and so on.

3 Chapter 18 discusses net working capital in detail.

CHAPTER 2: Financial Statements, Cash Flow, and Taxes 27

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Th e liabilities side of the statement of fi nancial position primarily refl ects managerial decisions about capital structure and the use of short-term debt. For example, in 2012, total long-term debt for Canadian Enterprises Limited was $454 and total equity was $640 + 1,629 = $2,269, so total long-term fi nancing was $454 + 2,269 = $2,723. Of this amount, $454/2,723 = 16.67% was long- term debt. Th is percentage refl ects capital structure decisions made in the past by the manage- ment of Canadian Enterprises.

Th ree particularly important things to keep in mind when examining a statement of fi nancial position are liquidity, debt versus equity, and market value versus book value.4

Liquidity Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Liquidity really has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without signifi cant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.

Assets are normally listed on the statement of fi nancial position in order of decreasing liquid- ity, meaning that the most liquid assets are listed fi rst. Current assets are relatively liquid and include cash and those assets that we expect to convert to cash over the next 12 months. Accounts receivable, for example, represents amounts not yet collected from customers on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least liquid of the current assets, at least for many businesses.

Fixed assets are, for the most part, relatively illiquid. Th ese consist of tangible things such as buildings and equipment. Intangible assets, such as a trademark, have no physical existence but can be very valuable. Like tangible fi xed assets, they won’t ordinarily convert to cash and are gen- erally considered illiquid.

Liquidity is valuable. Th e more liquid a business is, the less likely it is to experience fi nancial distress (that is, diffi culty in paying debts or buying needed assets). Unfortunately, liquid assets are generally less profi table to hold. For example, cash holdings are the most liquid of all invest- ments, but they sometimes earn no return at all—they just sit there. Th erefore, the trade-off is between the advantages of liquidity and forgone potential profi ts. We discuss this trade-off further in the rest of the book.

Debt versus Equity To the extent that a fi rm borrows money, it usually gives creditors fi rst claim to the fi rm’s cash fl ow. Equity holders are only entitled to the residual value, the portion left aft er creditors are paid. Th e value of this residual portion is the shareholders’ equity in the fi rm and is simply the asset value less the value of the fi rm’s liabilities:

Shareholders’ equity = Assets – Liabilities

Th is is true in an accounting sense because shareholders’ equity is defi ned as this residual portion. More importantly, it is true in an economic sense: If the fi rm sells its assets and pays its debts, whatever cash is left belongs to the shareholders.

Th e use of debt in a fi rm’s capital structure is called fi nancial leverage. Th e more debt a fi rm has (as a percentage of assets), the greater is its degree of fi nancial leverage. As we discuss in later chapters, debt acts like a lever in the sense that using it can greatly magnify both gains and losses. So fi nancial leverage increases the potential reward to shareholders, but it also increases the potential for fi nancial distress and business failure.

Value versus Cost Th e accounting value of a fi rm’s assets is frequently referred to as the carrying value or the book value of the assets. IFRS allows companies to use the historical cost method; it also allows use of

4 Chapters 3 and 4 expand on financial statement analysis.

28 Part 1: Overview of Corporate Finance

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the revaluation (fair value) method. When a company adopts the revaluation method, all items in a class of assets should be revalued simultaneously, and the revaluation should be performed with enough regularity to ensure that, at the statement of fi nancial position date, the carrying amount is not materially diff erent from the fair value amount. Th us a class of property, plant, and equip- ment with signifi cant unpredictable changes in fair value will require more frequent revaluations (every one or two years) than will another class of asset that has insignifi cant changes in fair value (e. g., a building may only require revaluation every three to fi ve years).

Market value is the price at which willing buyers and sellers trade the assets. Manage ment’s job is to create a value for the fi rm that is higher than its cost. When market values are consider- ably below book values, it is customary accounting practice to write down assets. For example, in 2011, Suncor Energy Inc., took a massive $514 million write-down of Libyan assets as a result of instability in the war torn country.5 Sometimes, huge write-off s are also indicative of overstated profi ts in previous years, as assets were not expensed properly.

Th ere are many users of a fi rm’s statement of fi nancial position and each may seek diff erent informa tion from it. A banker may look at a balance sheet for evidence of liquidity and working capital. A supplier may also note the size of accounts payable, which refl ects the gen eral prompt- ness of payments. Many users of fi nancial statements, including managers and investors, want to know the value of the fi rm, not its cost. Th is is not found on the statement of fi nancial position. In fact, many of a fi rm’s true resources (good management, proprietary assets, and so on) do not appear on the statement of fi nancial position. Henceforth, whenever we speak of the value of an asset or the value of the fi rm, we will normally mean its market value. So, for example, when we say the goal of the fi nancial manager is to increase the value of the stock, we mean the market value of the stock.

EXAMPLE 2.2: Market versus Book Value

The Quebec Corporation has fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the books, but approxi- mately $600 would be realized if all the current accounts were liquidated. Quebec Corporation has $500 in long-

term debt, both book value and market value. What is the book value of the equity? What is the market value?

We can construct two simplified statements of financial position, one in accounting (book value) terms and one in economic (market value) terms:

QUEBEC CORPORATION Statement of Financial Position Market Value versus Book Value

Book Market Book Market

Assets Liabilities Net working capital $ 400 $ 600 Long-term debt $ 500 $ 500 Net fixed assets 700 1,000 Shareholders’ equity 600 1,100

$ 1,100 $ 1,600 $ 1,100 $ 1,600

1. What does the statement of financial position identity?

2. What is liquidity? Why is it important?

3. What do we mean by financial leverage?

4. Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

5 Scott Haggett and Jeffrey Jones, “Canadian oil profits marred by production woes” financialpost.com, July 28, 2011. business.financialpost.com/2011/07/28/canadian-oil-profits-marred-by-production-woes/.

Concept Questions

CHAPTER 2: Financial Statements, Cash Flow, and Taxes 29

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2.2 Statement of Comprehensive Income

Th e statement of comprehensive income measures performance over some period of time, usu- ally a year. Th e statement of comprehensive income equation is:

Revenues – Expenses = Income [2.2]

If you think of the statement of fi nancial position as a snapshot, then you can think of statement of comprehensive income as a video recording covering the period between, before, and aft er pic- tures. Table 2.2 gives a simplifi ed statement of comprehensive income for Canadian Enterprises.

Th e initial thing reported on the statement of comprehensive income would usually be revenue and expenses from the fi rm’s principal operations. Subsequent parts include, among other things, fi nancing expenses such as interest paid. Taxes paid are reported separately. Th e last item is net income (the so-called bottom line). Net income is oft en expressed on a per-share basis and called earnings per share (EPS).

TABLE 2.2

CANADIAN ENTERPRISES 2012 Statement of Comprehensive Income

($ millions)

Net sales $ 1,509 Cost of goods sold 750 Depreciation 65 Earnings before interest and taxes $ 694 Interest paid 70 Income before taxes $ 624 Taxes 250 Net income $ 374 Addition to retained earnings $309 Dividends 65

As indicated, Canadian Enterprises paid cash dividends of $65. Th e diff erence between net income and cash dividends, $309, is the addition to retained earnings for the year. Th is amount is added to the cumulative retained earnings account on the statement of fi nancial position. If you’ll look back at the two statements of fi nancial position for Canadian Enterprises in Table 2.1, you’ll see that retained earnings did go up by this amount, $1,320 + 309 = $1,629.

EXAMPLE 2.3: Calculating Earnings and Dividends per Share

Suppose that Canadian had 200 million shares outstanding at the end of 2012. Based on the preceding statement of comprehensive income, what was Canadian’s EPS? What were the dividends per share?

From the statement of comprehensive income in Table 2.2 Canadian had a net income of $374 million for the

year. Since 200 million shares were outstanding, EPS was $374/200 = $1.87 per share. Similarly, dividends per share were $65/200 = $.325 per share.

When looking at the statement of comprehensive in- come, the financial manager needs to keep three things in mind: IFRS, cash versus non-cash items, and time and costs.

International Financial Reporting Standards (IFRS) As pointed out earlier, the focus in fi nancial decisions is on market value, which depends

on cash fl ow. However, like the statement of fi nancial position, the statement of comprehensive income has many diff erent users and the accounting profession has developed IFRS to provide infor mation for a broad audience not necessarily concerned with cash fl ow. For this reason, it is

statement of comprehensive income Financial statement summarizing a firm’s performance over a period of time. Formerly called the income statement.

30 Part 1: Overview of Corporate Finance

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necessary to make adjustments to information on statements of comprehensive income to obtain cash fl ow.

For example, revenue is recognized on the statement of comprehensive income when the earn- ings process is virtually completed and an exchange of goods or services has occurred. Th erefore, the unrealized appreciation in owning property will not be recognized as income. Th is provides a device for smoothing income by selling appreciated property at convenient times. For example, if the fi rm owns a tree farm that has doubled in value, then in a year when its earnings from other businesses are down, it can raise overall earnings by selling some trees. Th e matching principle of IFRS dictates that revenues be matched with expenses. Th us, income is reported when it is earned or accrued, even though no cash fl ow has necessarily occurred. (For example, when goods are sold for credit, sales and profi ts are reported.)

Non-Cash Items A primary reason that accounting income diff ers from cash fl ow is that a statement of compre- hensive income contains non-cash items. Th e most important of these is depreciation. Suppose a fi rm purchases an asset for $5,000 and pays in cash. Obviously, the fi rm has a $5,000 cash outfl ow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a fi ve-year period.

If the depreciation is straight-line and the asset is written down to zero over that period, $5,000/5 = $1,000 would be deducted each year as an expense.6 Th e important thing to recog- nize is that this $1,000 deduction isn’t cash—it’s an accounting number. Th e actual cash outfl ow occurred when the asset was purchased.

Th e depreciation deduction is an application of the representational faithfulness principle in accounting. Th e revenues associated with an asset would generally occur over some length of time. So the accountant seeks to expense the purchase of the asset with the benefi ts produced from owning it as a way of representing the use of the asset over time.

As we shall see, for the fi nancial manager, the actual timing of cash infl ows and outfl ows is critical in coming up with a reasonable estimate of market value, so we need to learn how to sepa- rate the cash fl ows from the non-cash accounting entries.

Time and Costs It is oft en useful to think of the future as having two distinct parts: the short run and the long run. Th ese are not precise time periods. Th e distinction has to do with whether costs are fi xed or variable. In the long run, all business costs are variable. Given suffi cient time, assets can be sold, debts can be paid, and so on.

If our time horizon is relatively short, however, some costs are eff ectively fi xed—they must be paid no matter what (property taxes, for example). Other costs, such as wages to workers and pay- ments to suppliers, are still variable. As a result, even in the short run, the fi rm can vary its output level by varying expenditures in these areas.

Th e distinction between fi xed and variable costs is important, at times, to the fi nancial man- ager, but the way costs are reported on the statement of comprehensive income is not a good guide as to which costs are which. Th e reason is that, in practice, accountants tend to classify costs as either product costs or period costs.

Product costs include such things as raw materials, direct labour expense, and manufacturing overhead. Th ese are reported on the statement of comprehensive income as costs of goods sold, but they include both fi xed and variable costs. Similarly, period costs are incurred during a par- ticular time period and are reported as selling, general, and administrative expenses. Once again, some of these period costs may be fi xed and others may be variable. Th e company president’s sal- ary, for example, is a period cost and is probably fi xed, at least in the short run.

6 By straight-line, we mean that the depreciation deduction is the same every year. By written down to zero, we mean that the asset is assumed to have no value at the end of five years. Tax depreciation is discussed in more detail later in the chapter.

non-cash items Expenses charged against revenues that do not directly affect cash flow, such as depreciation.

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1. What is the statement of comprehensive income equation?

2. What are three things to keep in mind when looking at an statement of comprehensive income?

3. Why is accounting income not the same as cash flow? Give two reasons.

2.3 Cash Flow

At this point, we are ready to discuss one of the most important pieces of fi nancial information that can be gleaned from fi nancial statements: cash fl ow. Th ere is no standard fi nancial statement for presenting this information in the way that we wish. Th erefore, we discuss how to calculate cash fl ow for Canadian Enterprises and point out how the result diff ers from standard fi nancial statement calculations. Th ere is a standard accounting statement called the statement of cash fl ows, but it is concerned with a somewhat diff erent issue and should not be confused with what is discussed in this section. Th e accounting statement of cash fl ows is discussed in Chapter 3.

From the statement of fi nancial position identity, we know that the value of a fi rm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash fl ow from assets must equal the sum of the cash fl ow to bondholders (or creditors) plus the cash fl ow to sharehold- ers (or owners):

Cash flow from assets = Cash flow to bondholders + Cash flow to shareholders [2.3]

Th is is the cash fl ow identity. It says that the cash fl ow from the fi rm’s assets is equal to the cash fl ow paid to suppliers of capital to the fi rm. A fi rm generates cash through its various activities; that cash is either used to pay creditors or paid out to the owners of the fi rm.

Cash Flow from Assets Cash fl ow from assets involves three components: operating cash fl ow, capital spending, and additions to net working capital. Operating cash fl ow refers to the cash fl ow that results from the fi rm’s day-to-day activities of producing and selling. Expenses associated with the fi rm’s fi nancing of its assets are not included because they are not operating expenses.

As we discussed in Chapter 1, some portion of the fi rm’s cash fl ow is reinvested in the fi rm. Capital spending refers to the net spending on fi xed assets (purchases of fi xed assets less sales of fi xed assets). Finally, additions to net working capital is the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase in current assets over current liabilities. Th e three components of cash fl ow are examined in more detail next.

OPERATING CASH FLOW To calculate operating cash flow, we want to calculate rev- enues minus costs, but we don’t want to include depreciation since it’s not a cash outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes, be- cause taxes are, unfortunately, paid in cash.

If we look at the statement of comprehensive income in Table 2.2, Canadian Enterprises had earnings before interest and taxes (EBIT) of $694. Th is is almost what we want since it doesn’t include interest paid. We need to make two adjustments: First, recall that depreciation is a non- cash expense. To get cash fl ow, we fi rst add back the $65 in depreciation since it wasn’t a cash deduction. Th e second adjustment is to subtract the $250 in taxes since these were paid in cash. Th e result is operating cash fl ow:

Canadian Enterprises thus had a 2012 operating cash fl ow of $509 as shown in Table 2.3. Th ere is an unpleasant possibility for confusion when we speak of operating cash fl ow. In

accounting practice, operating cash fl ow is oft en defi ned as net income plus depreciation. For Canadian Enterprises in Table 2.2, this would amount to $374 + 65 = $439.

Th e accounting defi nition of operating cash fl ow diff ers from ours in one important way: Inter- est is deducted when net income is computed. Notice that the diff erence between the $509 operat- ing cash fl ow we calculated and this $439 is $70, the amount of interest paid for the year.

Concept Questions

cash flow from assets The total of cash flow to bondholders and cash flow to shareholders, consisting of: operating cash flow, capital spending, and additions to net working capital.

operating cash flow Cash generated from a firm’s normal business activities.

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TABLE 2.3

CANADIAN ENTERPRISES 2012 Operating Cash Flow

Earnings before interest and taxes $694

+ Depreciation 65

– Taxes 250

Operating cash flow $509

Th is defi nition of cash fl ow thus considers interest paid to be an operating expense. Our defi ni- tion treats it properly as a fi nancing expense. If there were no interest expense, the two defi nitions would be the same.

To fi nish our calculations of cash fl ow from assets for Canadian Enterprises, we need to con- sider how much of the $509 operating cash fl ow was reinvested in the fi rm. We consider spending on fi xed assets fi rst.

CAPITAL SPENDING Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets. At the end of 2011, net fixed assets were $1,644. During the year, we wrote off (depreciated) $65 worth of fixed assets on the statement of comprehensive in- come. So, if we did not purchase any new fixed assets, we would have had $1,644 – 65 = $1,579 at year’s end. The 2012 statement of financial position shows $1,709 in net fixed assets, so we must have spent a total of $1,709 – 1,579 = $130 on fixed assets during the year:

Ending fixed assets $ 1,709

– Beginning fixed assets 1,644

+ Depreciation 65

Net investment in fixed assets $ 130

Th is $130 is our net capital spending for 2012. Could net capital spending be negative? Th e answer is yes. Th is would happen if the fi rm sold

more assets than it purchased. Th e net here refers to purchases of fi xed assets net of any sales.

CHANGE IN NET WORKING CAPITAL In addition to investing in fixed assets, a firm also invests in current assets. For example, going back to the statement of financial position in Table 2.1, we see that, at the end of 2012, Canadian Enterprises had current assets of $1,403. At the end of 2011, current assets were $1,112, so, during the year, Canadian Enterprises invested $1,403 – 1,112 = $291 in current assets.

As the fi rm changes its investment in current assets, its current liabilities usually change as well. To determine the changes to net working capital, the easiest approach is just to take the diff erence between the beginning and ending net working capital (NWC) fi gures. Net working capital at the end of 2012 was $1,403 – 389 = $1,014. Similarly, at the end of 2011, net working capital was $1,112 – 428 = $684. So, given these fi gures, we have:

Ending NWC $ 1,014

– Beginning NWC 684

Change in NWC $ 330

Net working capital thus increased by $330. Put another way, Canadian Enterprises had a net investment of $330 in NWC for the year.

CONCLUSION Given the figures we’ve come up with, we’re ready to calculate cash flow from assets. The total cash flow from assets is given by operating cash flow less the amounts in- vested in fixed assets and net working capital. So, for Canadian Enterprises we have:

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CANADIAN ENTERPRISES 2012 Cash Flow from Assets

Operating cash flow $ 509

– Net capital spending 130

– Changes in NWC 330

Cash flow from assets $ 49

A NOTE ON “FREE” CASH FLOW Cash flow from assets sometimes goes by a differ- ent name, free cash flow. Of course, there is no such thing as “free” cash. Instead, the name refers to cash that the firm is free to distribute to creditors and shareholders because it is not needed for working capital or fixed asset investment. Free cash flow is the cash flow minus any reinvestment required to maintain the firm’s competitive advantage. We will stick with “cash flow from assets” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed; different users calculate it in different ways. Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets or something quite similar.

Cash Flow to Creditors and Shareholders Th e cash fl ows to creditors and shareholders represent the net payments to creditors and owners during the year. Th ey are calculated in a similar way. Cash fl ow to creditors is interest paid less net new borrowing; cash fl ow to shareholders is dividends less net new equity raised.

CASH FLOW TO CREDITORS Looking at the statement of comprehensive income in Table 2.2, Canadian paid $70 in interest to creditors. From the statement of financial position in Table 2.1, long-term debt rose by $454 – 408 = $46. So, Canadian Enterprises paid out $70 in interest, but it borrowed an additional $46. Net cash flow to creditors is thus:

CANADIAN ENTERPRISES 2012 Cash Flow to Creditors

Interest paid $70

– Net new borrowing 46

Cash flow to creditors $24

Cash fl ow to creditors is sometimes called cash fl ow to bondholders; we use these interchangeably.

CASH FLOW TO SHAREHOLDERS From the statement of comprehensive income, we see that dividends paid to shareholders amount to $65. To calculate net new equity raised, we need to look at the common share account. This account tells us how many shares the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have:

CANADIAN ENTERPRISES 2012 Cash Flow to Shareholders

Dividends paid $65

– Net new equity 40

Cash flow to shareholders $25

Th e cash fl ow to shareholders for 2012 was thus $25. Th e last thing that we need to do is to check that the cash fl ow identity holds to be sure that we

didn’t make any mistakes. Cash fl ow from assets adds up the sources of cash fl ow while cash fl ow to creditors and shareholders measures how the fi rm uses its cash fl ow. Since all cash fl ow has to be accounted for, total sources (cash fl ow from assets) must equal total uses (cash fl ow to creditors and shareholders). Earlier we found the cash fl ow from assets is $49. Cash fl ow to creditors and shareholders is $24 + 25 = $49, so everything checks out. Table 2.4 contains a summary of the various cash fl ow calculations for future reference.

Two important observations can be drawn from our discussion of cash fl ow: First, several types of cash fl ow are relevant to understanding the fi nancial situation of the fi rm. Operating cash fl ow, defi ned as earnings before interest and depreciation minus taxes, measures the cash generated from operations not counting capital spending or working capital requirements. It should usually be posi- tive; a fi rm is in trouble if operating cash fl ow is negative for a long time because the fi rm is not

free cash flow Another name for cash flow from assets.

cash flow to creditors A firm’s interest payments to creditors less net new borrowings.

cash flow to shareholders Dividends paid out by a firm less net new equity raised.

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generating enough cash to pay operating costs. Total cash fl ow of the fi rm includes capital spending and additions to net working capital. It will frequently be negative. When a fi rm is growing at a rapid rate, the spending on inventory and fi xed assets can be higher than cash fl ow from sales.

Second, net income is not cash fl ow. Th e net income of Canadian Enterprises in 2012 was $374 million, whereas total cash fl ow from assets was $49 million. Th e two numbers are not usually the same. In determining the economic and fi nancial condition of a fi rm, cash fl ow is more revealing.

EXAMPLE 2.4: Cash Flows for Dole Cola

During the year, Dole Cola Ltd. had sales and costs of $600 and $300, respectively. Depreciation was $150 and interest paid was $30. Taxes were calculated at a straight 40 per- cent. Dividends were $30. All figures are in millions of dol- lars. What was the operating cash flow for Dole? Why is this different from net income?

The easiest thing to do here is to create an statement of comprehensive income. We can then fill in the numbers we need. Dole Cola’s statement of comprehensive income follows:

DOLE COLA 2012 Statement of Comprehensive Income ($ millions)

Net sales $ 600 Cost of goods sold 300 Depreciation 150 Earnings before interest and taxes $ 150 Interest paid 30 Taxable income $ 120 Taxes 48 Net income $ 72 Retained earnings $42 Dividends 30

Net income for Dole is thus $72. We now have all the num- bers we need; so referring back to the Canadian Enterprises example, we have:

DOLE COLA 2012 Operating Cash Flow ($ millions)

Earnings before interest and taxes $ 150

+ Depreciation 150

– Taxes 48

Operating cash flow $ 252

As this example illustrates, operating cash flow is not the same as net income, because depreciation and interest are subtracted out when net income is calculated. If you recall our earlier discussion, we don’t subtract these out in com- puting operating cash flow because depreciation is not a cash expense and interest paid is a financing expense, not an operating expense.

TABLE 2.4 Cash flow summary

The cash flow identity

Cash flow from assets = Cash flow to creditors (or bondholders) + Cash flow to shareholders (or owners)

Cash flow from assets

Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital (NWC) where:

a. Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes

b. Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation

c. Changes in NWC = Ending NWC – Beginning NWC

Cash flow to creditors (bondholders)

Cash flow to creditors = Interest paid – Net new borrowing

Cash flow to shareholders (owners)

Cash flow to shareholders = Dividends paid – Net new equity raised

CHAPTER 2: Financial Statements, Cash Flow, and Taxes 35

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Net Capital Spending Suppose that beginning net fi xed assets were $500 and ending net fi xed assets were $750. What was the net capital spending for the year?

From the statement of comprehensive income for Dole, depreciation for the year was $150. Net fi xed assets rose by $250. We thus spent $150 to cover the depreciation and an additional $250 as well, for a total of $400.

Change in NWC and Cash Flow from Assets Suppose that Dole Cola started the year with $2,130 in current assets and $1,620 in current lia- bilities. Th e corresponding ending fi gures were $2,260 and $1,710. What was the change in NWC during the year? What was cash fl ow from assets? How does this compare to net income?

Net working capital started out as $2,130 – 1,620 = $510 and ended up at $2,260 – 1,710 = $550. Th e change in NWC was thus $550 – 510 = $40. Putting together all the information for Dole we have:

DOLE COLA 2012 Cash Flow from Assets

Operating cash flow $252

– Net capital spending 400

– Changes in NWC 40

Cash flow from assets -$188

Dole had a cash fl ow from assets of negative $188. Net income was positive at $72. Is the fact that cash fl ow from assets is negative a cause for alarm? Not necessarily. Th e cash fl ow here is negative primarily because of a large investment in fi xed assets. If these are good investments, the resulting negative cash fl ow is not a worry.

CASH FLOW TO CREDITORS AND SHAREHOLDERS We saw that Dole Cola had cash flow from assets of -$188. The fact that this is negative means that Dole raised more money in the form of new debt and equity than it paid out for the year. For example, suppose we know that Dole didn’t sell any new equity for the year. What was cash flow to shareholders? To bondholders?

Because it didn’t raise any new equity, Dole’s cash fl ow to shareholders is just equal to the cash dividend paid:

DOLE COLA 2012 Cash Flow to Shareholders

Dividends paid $ 30

– Net new equity 0

Cash flow to shareholders $ 30

Now, from the cash fl ow identity the total cash paid to bondholders and shareholders was -$188. Cash fl ow to shareholders is $30, so cash fl ow to bondholders must be equal to -$188 – $30 = -$218:

Cash flow to bondholders + Cash flow to shareholders = -$188 Cash flow to bondholders + $30 = -$188 Cash flow to bondholders = -$218

From the statement of comprehensive income, interest paid is $30. We can determine net new borrowing as follows:

DOLE COLA 2012 Cash Flow to Bondholders

Interest paid $ 30

– Net new borrowing -248 Cash flow to bondholders -$218

As indicated, since cash fl ow to bondholders is -$218 and interest paid is $30, Dole must have borrowed $248 during the year to help fi nance the fi xed asset expansion.

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1. What is the cash flow identity? Explain what it says.

2. What are the components of operating cash flow?

3. Why is interest paid not a component of operating cash flow?

2.4 Taxes

Taxes are very important because, as we just saw, cash fl ows are measured aft er taxes. In this section, we examine corporate and personal tax rates and how taxes are calculated. We apply this knowledge to see how diff erent types of income are taxed in the hands of individuals and corporations.

Th e size of the tax bill is determined through tax laws and regulations in the annual budgets of the federal government (administered by Canada Revenue Agency (CRA)) and provincial gov- ernments. If the various rules of taxation seem a little bizarre or convoluted to you, keep in mind that tax law is the result of political, as well as economic, forces. According to economic theory, an ideal tax system has three features. First, it should distribute the tax burden equitably, with each taxpayer shouldering a “fair share.” Second, the tax system should not change the effi cient alloca- tion of resources by markets. If this happened, such distortions would reduce economic welfare. Th ird, the system should be easy to administer.

Th e tax law is continually evolving so our discussion cannot make you a tax expert. Rather it gives you an understanding of the tax principles important for fi nancial management along with the ability to ask the right questions when consulting a tax expert. Th e Canada Revenue Agency allows students in Canada to claim an education tax credit. Th e credit reduces income tax based on the number of months that a student is enrolled in a qualifying educational program at a des- ignated educational institution.

Individual Tax Rates Individual tax rates in eff ect for federal taxes for 2012 are shown in Table 2.5. Th ese rates apply to income from employment (wages and salary) and from unincorporated businesses. Invest- ment income is also taxable. Interest income is taxed at the same rates as employment income, but special provisions reduce the taxes payable on dividends and capital gains. We discuss these in detail later in the chapter. Table 2.5 also provides information on provincial taxes for selected provinces. Other provinces and territories follow similar approaches, although they use diff erent rates and brackets.

To illustrate, suppose you live in British Columbia and have a taxable income over $75,042. Your tax on the next dollar is:7

32.50% = federal tax rate + provincial tax rate = 22% + 10.50%

Average versus Marginal Tax Rates In making fi nancial decisions, it is frequently important to distinguish between average and mar- ginal tax rates. Your average tax rate is your tax bill divided by your taxable income; in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the extra tax you would pay if you earned one more dollar. Th e percentage tax rates shown in Table 2.5 are all marginal rates. To put it another way, the tax rates in Table 2.5 apply to the part of income in the indicated range only, not all income.

Following the equity principle, individual taxes are designed to be progressive with higher incomes taxed at a higher rate. In contrast, with a fl at rate tax, there is only one tax rate, and this rate is the same for all income levels. With such a tax, the marginal tax rate is always the same as the average tax rate. As it stands now, individual taxation in Canada is progressive but approaches a fl at rate for the highest incomes. Alberta has introduced a fl at tax.

7 Actual rates are somewhat higher, as we ignore surtaxes that apply in higher brackets.

Concept Questions

average tax rate Total taxes paid divided by total taxable income.

marginal tax rate Amount of tax payable on the next dollar earned.

CHAPTER 2: Financial Statements, Cash Flow, and Taxes 37

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TABLE 2.5

Individual income tax rates—2012 (current as of December 31, 2011)

Tax Rates Tax Brackets Surtax

Rates Thresholds Federal 15.00% Up to $42,707

22.00 42,708–85,414 26.00 85,415–132,406 29.00 132,407 and over

British Columbia 5.06% Up to $37,013 7.70 37,014–74,028

10.50 74,029–84,993 12.29 84,994–103,205 14.70 103,206 and over

Alberta 10.00% All income Saskatchewan 11.00% Up to $42,065

13.00 42,066–120,185 15.00 120,186 and over

Manitoba 10.80% Up to $31,000 12.75 31,001–67,000 17.40 67,001 and over

Ontario 5.05% Up to $39,020 9.15 39,021–78,043 20% $4,213

11.16 78,044 and over 36 5,392 Quebec 16.00% Up to $40,100

20.00 40,101–80,200 24.00 80,201 and over

New Brunswick 9.10% Up to $38,190 12.10 38,191–76,380 12.40 76,381–124,178 14.30 124,179 and over

Nova Scotia 8.79% Up to $29,590 14.95 29,591-59,180 16.67 59,181-93,000 17.50 93,001–150,000 21.00 150,001 and over

Prince Edward Island

9.80% Up to $31,984 13.80 31,985–63,969 16.70 63,970 and over 10% $12,500

Newfoundland 7.70% Up to $32,893 12.50 32,894–65,785 13.30 65,786 and over

Source: © 2011 KPMG LLP, a Canadian limited liability partnership and a member fi rm of the KPMG network of independent member fi rms affi liated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Th e information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice aft er a thorough examination of the particular situation.

TABLE 2.6

Combined marginal tax rates for individuals in top federal tax bracket (over $132,407)—2012 (current as of December 31, 2011)

Provinces/ Territories

Interest and Regular

Income (%)

Capital Gains (%)

Eligible Dividends

(%)

Non-eligible Dividends

(%)

British Columbia 43.70 21.85 26.11 33.71 Alberta 39.00 19.50 19.29 27.71 Saskatchewan 44.00 22.00 24.81 33.33 Manitoba 46.40 23.20 28.13 39.15 Ontario 46.41 23.21 29.54 32.57 Quebec 48.22 24.11 32.81 36.35 New Brunswick 43.30 21.65 24.33 30.83 Nova Scotia 50.00 25.00 36.06 36.21 Prince Edward Island 47.37 23.69 30.50 41.17 Newfoundland 42.30 21.15 22.47 29.96

Source: © 2011 KPMG LLP, a Canadian limited liability partnership and a member fi rm of the KPMG network of independent member fi rms affi liated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Th e information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice aft er a thorough examination of the particular situation.

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Normally, the marginal tax rate is relevant for decision making. Any new cash fl ows are taxed at that marginal rate. Since fi nancial decisions usually involve new cash fl ows or changes in exist- ing ones, this rate tells us the marginal eff ect on our tax bill.

Taxes on Investment Income When introducing the topic of taxes, we warned that tax laws are not always logical. Th e treat- ment of dividends in Canada is at least a partial exception because there are two clear goals: First, corporations pay dividends from aft er-tax income so tax laws shelter dividends from full tax in the hands of shareholders. Th is diminishes double taxation, which would violate the principle of equitable taxation. Second, the dividend tax credit applies only to dividends paid by Canad- ian corporations. Th e result is to encourage Canadian investors to invest in Canadian fi rms as opposed to foreign companies.8

With these goals in mind, to see how dividends are taxed, we start with common shares held by individual investors. Table 2.6 shows the combined marginal tax rates for individuals in top federal tax bracket. For example, an individual in top federal tax bracket in Manitoba will pay $232 as taxes on a capital gain of $1,000.

Th e dividends are taxed far more lightly than regular income. Dividend taxation became lighter under recent changes with the stated goal of making dividend-paying stocks more attrac- tive in comparison to income trusts. Th e federal government announced an increase in the gross- up of the federal dividend tax credit to the levels shown in Table 2.6.

Individual Canadian investors also benefi t from a tax reduction for capital gains. Capital gains arise when an investment increases in value above its purchase price. For capital gains, taxes apply at 50 percent of the applicable marginal rate. For example, individuals in Newfoundland in the highest bracket in Table 2.6 would pay taxes on capital gains at a nominal rate of 21.15 percent = 42.30% × 0.50.

Table 2.6 shows that, for an individual in the top bracket, salary and interest are taxed far more heavily than capital gains and dividend income.

In practice, capital gains are lightly taxed because individuals pay taxes on realized capital gains only when stock is sold. Because many individuals hold shares for a long time (have unreal- ized capital gains), the time value of money dramatically reduces the eff ective tax rate on capital gains.9 Also, investors can manage capital gain realization to off set with losses in many cases.

Corporate Taxes Canadian corporations, like individuals, are subject to taxes levied by the federal and provin- cial governments. Corporate taxes are passed on to consumers through higher prices, to workers through lower wages, or to investors through lower returns.

Table 2.7 shows corporate tax rates using Alberta as an example. You can see from the table that small corporations (income less than $400,000) and, to a lesser degree, manufacturing and processing companies, receive a tax break in the form of lower rates.

Comparing the rates in Table 2.7 with the personal tax rates in Table 2.5 appears to reveal a tax advantage for small businesses and professionals that form corporations. Th e tax rate on corporate income of, say, $150,000 is less than the personal tax rate assessed on the income of unincorporated businesses. But this is oversimplifi ed because dividends paid to the owners are also taxed, as we saw earlier.

Taxable Income In Section 2.2 we discussed the statement of comprehensive income for Canadian Enterprises (Table 2.2); it includes both dividends and interest paid. An important diff erence is that interest paid is deducted from EBIT in calculating income but dividends paid are not. Because interest is

8 Evidence that the dividend tax credit causes investors to favour Canadian stocks is provided in L. Booth, “The Divi- dend Tax Credit and Canadian Ownership Objectives,” Canadian Journal of Economics 20 (May 1987). 9 L. Booth and D. J. Johnston, “The Ex-Dividend Day Behavior of Canadian Stock Prices: Tax Changes and Clientele Ef- fects,” Journal of Finance 39 (June 1984). Booth and Johnston find a “very low effective tax rate on capital gains” in the 1970s. They compare their results with a U.S. study that found an effective tax rate on capital gains under 7 percent.

dividend tax credit Tax formula that reduces the effective tax rate on dividends.

capital gains The increase in value of an investment over its purchase price.

realized capital gains The increase in value of an investment, when converted to cash.

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a tax-deductible expense, debt fi nancing has a tax advantage over fi nancing with common shares. To illustrate, Table 2.2 shows that Canadian Enterprises paid $250 million in taxes on taxable income of $624 million. Th e fi rm’s tax rate is $250/624 = 40%. Th is means that to pay another $1 in dividends, Canadian Enterprises must increase EBIT by $1.67. Of the marginal $1.67 EBIT, 40 percent, or 67 cents, goes in taxes, leaving $1 to increase dividends. In general, a taxable fi rm must earn 1/ (1 – Tax rate) in additional EBIT for each extra dollar of dividends. Because interest is tax deductible, Canadian Enterprises needs to earn only $1 more in EBIT to be able to pay $1 in added interest.

Th e tables are turned when we contrast interest and dividends earned by the fi rm. Interest earned is fully taxable just like any other form of ordinary income. Dividends on common shares received from other Canadian corporations qualify for a 100 percent exemption and are received tax free.10

TABLE 2.7 Corporate tax rates in percentages in 2012 (current as of December 31, 2011)

Federal (%)

Alberta (%)

Combined (%)

Basic corporations 15 10 25 All small corporations with a taxable income less than $400,000 11 3 14

Source: © 2011 KPMG LLP, a Canadian limited liability partnership and a member fi rm of the KPMG network of independent member fi rms affi liated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Th e information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice aft er a thorough examination of the particular situation.

Global Tax Rates Corporate and individual tax rates vary around the world. Corporate rates range from 10 percent in Bulgaria to 40 percent in India. Wealthy individuals in countries such as Canada, France, U.K., Sweden, and other high-taxing nations look for opportunities and tax laws that allow them to move their wealth to countries such as Monaco and Hong Kong where they can enjoy individual tax rates as low as 0 percent.11

How taxable income gains are calculated also varies. For instance, the U.S. tax regime distin- guishes between short-term capital gains (one year or less) taxed at ordinary income rates and long-term capital gains (more than one year), which receive preferential tax rates ranging between 0 and 15 percent depending on one’s marginal tax rate. Canada does not have a tiered capital gains tax system. Unlike the U.S. where long-term capital gains are taxed at lower rates than dividends, individuals in Canada have an incentive to hold dividend-paying stocks as dividends are taxed only marginally more than capital gains.

Capital Gains and Carry-forward and Carry-back When a fi rm disposes of an asset for more than it paid originally, the diff erence is a capital gain. As with individuals, fi rms receive favourable tax treatment on capital gains. At the time of writing, capital gains received by corporations are taxed at 50 percent of the marginal tax rate.

When calculating capital gains for tax purposes, a fi rm nets out all capital losses in the same year. If capital losses exceed capital gains, the net capital loss may be carried back to reduce tax- able capital gains in the three prior years. Under the carry-back feature, a fi rm fi les a revised tax return and receives a refund of prior years’ taxes. For example, suppose Canadian Enterprises

10 The situation is more complicated for preferred stock dividends, as we discuss in Chapter 7. 11 William Perez, “Capital Gains Tax Rates,” Tax Planning: U.S.

loss carry-forward, carry-back Using a year’s capital losses to offset capital gains in past or future years.

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experienced a net capital loss of $1 million in 2012 and net capital gains of $300,000 in 2011, $200,000 in 2010, and $150,000 in 2009. Canadian could carry back a total of $650,000 to get a refund on its taxes. Th e remaining $350,000 can be carried forward indefi nitely to reduce future taxes on capital gains.

A similar carry-forward provision applies to operating losses. Th e carry-back period is three years and carry-forward is allowed up to seven years.

Income Trust Income and Taxation As stated in Chapter 1, a revised tax regime was introduced for Income Trusts in 2011. Under this regime their tax treatment is like that of corporations, and their investors are treated like shareholders.

Income trust structure has worked well for trusts in stable businesses with strong cash-fl ow- generating abilities; examples are AltaGas Income Fund or Boston Pizza Royalty Fund. As cash fl ows fl uctuate in riskier industries, trusts have had to reduce or suspend distributions. When this happened to Halterm—a trust based on the container port business in Halifax—in 2003, the unit price dropped by 59 percent.

As we explained in Chapter 1, at the end of October 2006, the federal government announced plans to tax income trusts as corporations. Applicable to trusts in existence in October 2006 starting in 2011 and immediately to new trusts, these plans put an end to new trust conver- sions.12 In the meantime, the tax changes to income trusts include increased dividend tax credits (illustrated in Table 2.8) to remove the advantage of income trust distribution. Under the new system, the tax exempt investor (income trusts in this case) will be taxed at the same rate of large corporations.

TABLE 2.8 Taxation of Income Trust Distributions vs. Dividends

Investor

Previous System New System

Income Trust (Income)

Large Corporation (Dividend)

Income Trust (Non-Portfolio

Earnings) Large Corporation

(Dividend)

Taxable Canadian (*) 46% 46% 45.5% 45.5% Canadian tax-exempt 0% 32% 31.5% 31.5% Taxable U.S. investor (**) 15% 42% 41.5% 41.5%

(*) All rates in the table are as of 2011, include both entity- and investor-level tax (as applicable) and refl ect already-announced rate reductions and the additional 0.5% corporate rate reduction described below. Rates for “Taxable Canadian” assume that top personal income tax rates apply and that provincial governments increase their dividend tax credit for dividends of large corporations. (**) Canadian taxes only. U.S. tax will in most cases also apply.

Source: fin.gc.ca/n06/06-061-eng.asp

Market reaction to news of the modifi ed income trust taxation rule illustrates the effi cient market hypothesis (EMH). As will be discussed in Chapter 11, the EMH holds that prices refl ect all available information. On November 1, 2006, the day following the announcement of the new taxes, share prices of Yellow Pages Income Trust, AltaGas Income Fund, and Boston Pizza Royal- ties Income Fund all fell by more than 10 percent. In addition, income trust prices fell by lesser amounts in the days prior to the announcement, suggesting that rumours surrounding the new taxes were leaked at that time.13

12 ScotiaMcLeod, “Federal Government to Implement New Tax Fairness Plan,” November 1, 2006. 13 L. Kryzanowski and Y. Lu, “In Government We Trust: Rise and Fall of Canadian Business Income Trust Conversion,” Managerial Finance 35, pp. 789–802.

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2.5 Capital Cost Allowance

Capital cost allowance (CCA) is depreciation for tax purposes in Canada. Capital cost allowance is deducted in determining income. Because the tax law refl ects various political compromises, CCA is not the same as depreciation under IFRS so there is no reason calculation of a fi rm’s income under tax rules has to be the same as under IFRS. For example, taxable corporate income may oft en be lower than accounting income because the company is allowed to use accelerated capital cost allowance rules in computing depreciation for tax purposes while using straight-line depreciation for IFRS reporting.14

CCA calculation begins by assigning every capital asset to a particular class. An asset’s class establishes its maximum CCA rate for tax purposes. Intangible assets like leasehold improve- ments in Table 2.9 follow straight-line depreciation for CCA. For all other assets, CCA follows the declining balance method. Th e CCA for each year is computed by multiplying the asset’s book value for tax purposes, called undepreciated capital cost (UCC), by the appropriate rate.

Th e CCA system is unique to Canada and diff ers in many respects from the ACRS depreciation method used in the United States. One key diff erence is that in the Canadian system, the expected salvage value (what we think the asset will be worth when we dispose of it) and the actual expected economic life (how long we expect the asset to be in service) are not explicitly considered in the calculation of capital cost allowance. Some typical CCA classes and their respective CCA rates are described in Table 2.9.

To illustrate how capital cost allowance is calculated, suppose your fi rm is considering buying a van costing $30,000, including any setup costs that must (by law) be capitalized. (No rational, profi table business would capitalize, for tax purposes, anything that could legally be expensed.) Table 2.9 shows that vans fall in Class 10 with a 30 percent CCA rate. To calculate the CCA, we follow CRA’s half-year rule that allows us to fi gure CCA on only half of the asset’s installed cost in the fi rst year it is put in use. Table 2.10 shows the CCA for our van for the fi rst fi ve years.

TABLE 2.9

Common capital cost allowance classes

Class Rate Assets

1 4% Buildings acquired after 1987 8 20 Furniture, photocopiers 10 30 Vans, trucks, tractors, and equipment 13 Straight-line Leasehold improvements 16 40 Taxicabs and rental cars 43 30 Manufacturing equipment

TABLE 2.10

Capital cost allowance for a van

Year Beginning UCC CCA Ending UCC

1 $15,000* $4,500 $10,500 2 25,500† 7,650 17,850 3 17,850 5,355 12,495 4 12,495 3,748 8,747 5 8,747 2,624 6,123

*One-half of $30,000. †Year 1 ending balance 1 + Remaining half of $30,000.

14 Where taxable income is less than accounting income, the difference goes into a long-term liability account on the statement of financial position labelled deferred taxes.

capital cost allowance (CCA) Depreciation for tax purposes, not necessarily the same as depreciation under IFRS.

half-year rule CRA’s requirement to figure CCA on only one-half of an asset’s installed cost for its first year of use.

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As we pointed out, in calculating CCA under current tax law, the economic life and future market value of the asset are not an issue. As a result, the UCC of an asset can diff er substantially from its actual market value. With our $30,000 van, UCC aft er the fi rst year is $15,000 less the fi rst year’s CCA of $4,500, or $10,500. Th e remaining UCC values are summarized in Table 2.10. Aft er fi ve years, the undepreciated capital cost of the van is $6,123.

Asset Purchases and Sales When an asset is sold, the UCC in its asset class (or pool) is reduced by what is realized on the asset or by its original cost, whichever is less. Th is amount is called the adjusted cost of disposal. Suppose we wanted to sell the van in our earlier example aft er fi ve years. Based on historical averages of resale prices, it will be worth, say, 25 percent of the purchase price or .25 × $30,000 = $7,500. Since the price of $7,500 is less than the original cost, the adjusted cost of disposal is $7,500 and the UCC in Class 10 is reduced by this amount.

Table 2.10 shows that the van has a UCC aft er fi ve years of $6,123. Th e $7,500 removed from the pool is $1,377 more than the undepreciated capital cost of the van we are selling, and future CCA deductions will be reduced as the pool continues. On the other hand, if we had sold the van for, say, $4,000, the UCC in Class 10 would be reduced by $4,000 and the $2,123 excess of UCC over the sale price would remain in the pool. Th en, future CCA increases as the declining balance calculations depreciate the $2,123 excess UCC to infi nity.

EXAMPLE 2.5: Capital Cost Allowance Incentives in Practice

Since capital cost allowance is deducted in computing in- come, larger CCA rates reduce taxes and increase cash flows. As we pointed out earlier, finance ministers some- times tinker with the CCA rates to create incentives. For example, in a federal budget a few years ago, the minister announced an increase in CCA rates from 20 to 30 percent for manufacturing and processing assets. The combined federal/provincial corporate tax rate for this sector is 36.1 percent in Ontario.

Mississauga Manufacturing was planning to acquire new processing equipment to enhance efficiency and its ability to compete with U.S. firms. The equipment had an installed cost of $1 million. How much additional tax will the new

measure save Mississauga in the first year the equipment is put into use?

Under the half-year rule, UCC for the first year is 1/2 × $1 million = $500,000. The CCA deductions under the old and new rates are:

Old rate: CCA = .20 × $500,000 = $100,000 New rate: CCA = .30 × $500,000 = $150,000

Because the firm deducts CCA in figuring taxable in- come, taxable income will be reduced by the incremental CCA of $50,000. With $50,000 less in taxable income, Mis- sissauga Manufacturing’s combined tax bill would drop by $50,000 × .361 = $18,050.

So far we focused on CCA calculations for one asset. In practice, fi rms oft en buy and sell assets from a given class in the course of a year. In this case, we apply the net acquisitions rule. From the total installed cost of all acquisitions, we subtract the adjusted cost of disposal of all assets in the pool. Th e result is net acquisitions for the asset class. If net acquisitions are positive, we apply the half-year rule and calculate CCA as we did earlier. If net acquisitions is negative, there is no adjustment for the half-year rule.

WHEN AN ASSET POOL IS TERMINATED Suppose your firm decides to contract out all transport and to sell all company vehicles. If the company owns no other Class 10 assets, the asset pool in this class is terminated. As before, the adjusted cost of disposal is the net sales proceeds or the total installed cost of all the pool assets, whichever is less. This adjusted cost of disposal is subtracted from the total UCC in the pool. So far, the steps are exactly the same as in our van example where the pool continued. What happens next is different. Unless the adjusted cost of disposal just happens to equal the UCC exactly, a positive or negative UCC balance re- mains and this has tax implications.

A positive UCC balance remains when the adjusted cost of disposal is less than UCC before the sale. In this case, the fi rm has a terminal loss equal to the remaining UCC. Th is loss is deductible from income for the year. For example, if we sell the van aft er two years for $10,000, the UCC of

net acquisitions Total installed cost of capital acquisitions minus adjusted cost of any disposals within an asset pool.

terminal loss The difference between UCC and adjusted cost of disposal when the UCC is greater.

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$17,850 in Table 2.10 exceeds the market value by $7,850 as Table 2.12 shows. Th e terminal loss of $7,850 gives rise to a tax saving of .40 × $7,850 = $3,140. (We assume the tax rate is 40 percent.)

A negative UCC balance occurs when the adjusted cost of disposal exceeds UCC, in the pool. To illustrate, return to our van example and suppose that this van is the only Class 10 asset our company owns when it sells the pool for $7,500 aft er fi ve years. Th ere is a $1,377 excess of adjusted cost of disposal (7,500 – 6,123) over UCC, so the fi nal UCC credit balance is $1,377.

Th e company must pay tax at its ordinary tax rate on this balance. Th e reason that taxes must be paid is that the diff erence in adjusted cost of disposal and UCC is excess CCA recaptured when the asset is sold. We over depreciated the asset by $7,500 – $6,123 = $1,377. Because we deducted $1,377 too much in CCA, we paid $551 too little in taxes (at 40 percent), and we simply have to make up the diff erence.

EXAMPLE 2.6: CCA Calculations

Staple Supply Ltd. has just purchased a new computerized information system with an installed cost of $160,000. The computer qualifies for a CCA rate of 45 percent. What are the yearly capital cost allowances? Based on historical experience, we think that the system will be worth only $10,000 when we get rid of it in four years. What will be the tax conse- quences of the sale if the company has several other comput- ers still in use in four years? Now suppose that Staple Supply will sell all its assets and wind up the company in four years.

In Table 2.11, at the end of Year 4, the remaining bal- ance for the specific computer system mentioned would be $20,630.15 The pool is reduced by $10,000, but it will con- tinue to be depreciated. There are no tax consequences in Year 4. This is only the case when the pool is active. If this were the only computer system, we would have been clos- ing the pool and would have been able to claim a terminal loss of $20,630 – $10,000 = $10,630.

15

TABLE 2.11

CCA for computer system

Year Beginning UCC CCA Ending UCC

1 $ 80,000* $36,000 $44,000 2 124,000† 55,800 68,200 3 68,200 30,690 37,510 4 37,510 16,880 20,630

*One-half of $160,000. †Year 1 ending balance 1 + Remaining half of $160,000.

Notice that this is not a tax on a capital gain. As a general rule, a capital gain only occurs if the market price exceeds the original cost. To illustrate a capital gain, suppose that instead of buying the van, our fi rm purchased a classic car for $50,000. Aft er fi ve years, the classic car will be sold for $75,000. Th e sale price would exceed the purchase price, so the adjusted cost of disposal is $50,000 and UCC pool is reduced by this amount. Th e total negative balance left in the UCC pool is $50,000 – $6,123 = $43,877 and this is recaptured CCA. In addition, the fi rm has a capital gain of $75,000 – $50,000 = $25,000, the diff erence between the sale price and the original cost.16

TABLE 2.12

UCC and terminal loss

UCC Market value Terminal loss Tax Savings

17,850 10,000 7850 3140

6123 7500 -1377 -551

15 In actuality, the capital cost allowance for the entire pool will be calculated at once, without specific identification of each computer system. 16 This example shows that it is possible to have a recapture of CCA without closing out a pool if the UCC balance goes negative.

recaptured depreciation The taxable difference between adjusted cost of disposal and UCC when UCC is smaller.

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EXAMPLE 2.7: Capital Loss, CCA Recapture, and Terminal Loss

T-Grill is a manufacturer and distributor of high-end com- mercial barbeques. In 2010, the company purchased $900,000 worth of manufacturing equipment, subject to Class 43 for CCA purposes. Class 43 assets depreciate at an annual rate of 30 percent. In 2012, T-Grill’s CEO decided to sell the existing manufacturing equipment for $500,000 and outsource production to India. As a result, it no longer holds class 43 assets. Does this transaction result in a capital gain, CCA recapture, or terminal loss?

A capital gain occurs when the selling price exceeds the original cost of the asset. In T-Grill’s case, the selling price of $500,000 is below the original cost of $900,000 so there is no capital gain.

CCA recapture occurs when the selling price is greater than the ending UCC. According to Table 2.13, at the end of 2012, T-Grill had an ending UCC of $374,850.

CCA recapture = Lower of selling price and the original cost – Ending UCC = $500,000 – $374,850 = $125,150

T-Grill must pay tax on the $125,150. However, what if due to economic turmoil, T-Grill could

only sell its manufacturing equipment for $300,000. Would it continue to have a CCA recapture, or will it now experi- ence a terminal loss?

CCA terminal loss = $300,000 – $374, 850 = -$74,850.

T-Grill now has a terminal loss of $74,850 and this amount is considered as a tax-deductible expense.

TABLE 2.13

CCA for manufacturing equipment

Year Beginning UCC CCA Ending UCC

2010 $450,000 $135,000 $315,000 2011 765,000 229,500 535,500 2012 535,500 160,650 374,850

1. What is the difference between capital cost allowance and IFRS depreciation?

2. Why do governments sometimes increase CCA rates?

3. Reconsider the CCA increase discussed in Example 2.5. How effective do you think it was in stimulating investment? Why?

2.6 SUMMARY AND CONCLUSIONS

Th is chapter has introduced you to some of the basics of fi nancial statements, cash fl ow, and taxes. Th e Sino-Forest example that was introduced at the start of the chapter shows just how important these issues can be for shareholders. In this chapter, we saw that:

1. The book values on an accounting statement of financial position can be very different from market values. The goal of financial management is to maximize the market value of the stock, not its book value.

2. Net income as it is computed on the statement of comprehensive income is not cash flow. A pri- mary reason is that depreciation, a non-cash expense, is deducted when net income is computed.

3. Marginal and average tax rates can be different; the marginal tax rate is relevant for most fi- nancial decisions.

4. There is a cash flow identity much like the statement of financial position identity. It says that cash flow from assets equals cash flow to bondholders and shareholders. The calculation

Concept Questions

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of cash flow from financial statements isn’t difficult. Care must be taken in handling non- cash expenses, such as depreciation, and in not confusing operating costs with financial costs. Most of all, it is important not to confuse book values with market values and ac- counting income with cash flow.

5. Different types of Canadian investment income, dividends, interest, and capital gains are taxed differently.

6. Corporate income taxes create a tax advantage for debt financing (paying tax-deductible in- terest) over equity financing (paying dividends). Chapter 15 discusses this in depth.

7. Capital cost allowance (CCA) is depreciation for tax purposes in Canada. CCA calculations are important for determining cash flows.

Key Terms average tax rate (page 37) capital cost allowance (CCA) (page 42) capital gains (page 39) cash flow from assets (page 32) cash flow to creditors (page 34) cash flow to shareholders (page 34) dividend tax credit (page 39) free cash flow (page 34) half-year rule (page 42) loss carry-forward, carry-back (page 40)

marginal tax rate (page 37) net acquisitions (page 43) non-cash items (page 31) operating cash flow (page 32) realized capital gains (page 39) recaptured depreciation (page 44) statement of comprehensive income (page 30) statement of financial position (page 25) terminal loss (page 43)

Chapter Review Problems and Self-Test 2.1 Cash Flow for B.C. Resources Ltd. This problem will give

you some practice working with financial statements and cal- culating cash flow. Based on the following information for B.C. Resources Ltd., prepare an statement of comprehensive income for 2012 and statement of financial positions for 2011and 2012. Next, following our Canadian Enterprises ex- amples in the chapter, calculate cash flow for B.C. Resources, cash flow to bondholders, and cash flow to shareholders for 2012. Use a 40-percent tax rate throughout. You can check your answers in the next section.

2011 2012

Sales $4,203 $4,507 Cost of goods sold 2,422 2,633 Depreciation 785 952 Interest 180 196 Dividends 225 250 Current assets 2,205 2,429 Net fixed assets 7,344 7,650 Current liabilities 1,003 1,255 Long-term debt 3,106 2,085

Answers to Self-Test Problems 2.1 In preparing the statement of financial positions, remember that shareholders’ equity is the residual and can be found using the

equation: Total assets = Total liabilities + Total equity With this in mind, B.C. Resources’ statement of financial positions are as follows:

B.C. RESOURCES LTD. Statement of Financial Position as of December 31, 2011 and 2012

2011 2012 2011 2012

Current assets $ 2,205 $ 2,429 Current liabilities $1,003 $ 1,255 Net fixed assets 7,344 7,650 Long-term debt 3,106 2,085

Equity 5,440 6,739 Total assets $ 9,549 $10,079 Total liabilities and shareholders’ equity $9,549 $ 10,079

The statement of comprehensive income is straightforward:

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B.C. RESOURCES LTD. 2012 Statement of Comprehensive Income

Sales $ 4,507 Costs of goods sold 2,633 Depreciation 952 Earnings before interest and taxes $ 922 Interest paid 196 Taxable income $ 726 Taxes (40%) 290 Net income $ 436 Dividends $250 Addition to retained earnings 186

Notice that we’ve used a flat 40 percent tax rate. Also notice that retained earnings are just net income less cash dividends. We can now pick up the figures we need to get operating cash flow:

B.C. RESOURCES LTD. 2012 Operating Cash Flow

Earnings before interest and taxes $ 922

+ Depreciation 952

– Taxes 290

Operating cash flow $ 1,584

Next, we get the capital spending for the year by looking at the change in fixed assets, remembering to account for the depreciation:

Ending net fixed assets $ 7,650

– Beginning net fixed assets 7,344

+ Depreciation 952

Net capital spending $ 1,258

After calculating beginning and ending NWC, we take the difference to get the change in NWC:

Ending NWC $ 1,174

– Beginning NWC 1,202

Change in NWC -$ 28

We now combine operating cash flow, net capital spending, and the change in net working capital to get the total cash flow from assets:

B.C. RESOURCES LTD. 2012 Cash Flow from Assets

Operating cash flow $ 1,584

– Net capital spending 1,258

– Change in NWC 28

Cash flow from assets $ 354

To get cash flow to creditors, notice that long-term borrowing decreased by $1,021 during the year and that interest paid was $196: B.C. RESOURCES LTD.

2012 Cash Flow to Creditors

Interest paid $ 196

– Net new borrowing 1,021

Cash flow to creditors $1,217

Finally, dividends paid were $250. To get net new equity, we have to do some extra calculating. Total equity was found by balancing the statement of financial position. During 2012, equity increased by $6,739 – 5,440 = $1,299. Of this increase, $186 was from additions to retained earnings, so $1,113 in new equity was raised during the year. Cash flow to shareholders was thus:

B.C. RESOURCES LTD. 2012 Cash Flow to Shareholders

Dividends paid $ 250

– Net new equity 1,113

Cash flow to shareholders -$ 863

As a check, notice that cash flow from assets, $354, does equal cash flow to creditors plus cash flow to shareholders ($1,217 – 863 = $354).

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Concepts Review and Critical Thinking Questions 1. Liquidity (LO1) What does liquidity measure? Explain the

trade-off a firm faces between high liquidity and low liquidity levels.

2. Accounting and Cash Flows (LO2) Why might the revenue and cost of figures shown on a standard statement of compre- hensive income not be representative of the actual inflows and outflows that occurred during a period?

3. Book Values versus Market Values (LO1) In preparing a statement of financial position, why do you think standard ac- counting practice focuses on historical cost rather than mar- ket value?

4. Operating Cash Flow (LO3) In comparing accounting net in- come and operating cash flow, name two items you typically find in the net income that are not in operating cash flow. Ex- plain what each is and why it is excluded on operating cash flow.

5. Book Values versus Market Values (LO1) Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is nega- tive. Can this happen with market values? Why or why not?

6. Cash Flow for Assets (LO3) Suppose a company’s cash flow from assets is negative for a particular period. Is this necessar- ily a good sign or a bad sign?

7. Operating Cash Flow (LO3) Suppose a company’s operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?

8. Net Working Capital and Capital Spending (LO3) Could a company’s change in NWC be negative in a given year? Ex- plain how this might come about. What about net capital spending?

9. Cash Flow to Shareholders and Creditors (LO3) Could a company’s cash flow to shareholders be negative in a given year? Explain how this might come about. What about cash flow to creditors?

10. Enterprise Value (LO1) A firm’s enterprise value is equal to the market value of its debt and equity, less the firm’s holdings of cash and cash equivalents. This figure is particularly rele- vant to potential purchasers of the firm. Why?

Questions and Problems 1. Building a Statement of Financial Position (LO1) Oakville Pucks Inc. has current assets of $5,100, net fixed assets of $23,800,

current liabilities of $4,300, and long-term debt of 7,400. What is the value of the shareholders’ equity account for this firm? How much is net working capital?

2. Building an Statement of Comprehensive Income (LO1) Burlington Exterminators Inc. has sales of $586,000, cost of $247,000, depreciation expense of $43,000, interest expense of $32,000, and a tax rate of 35 percent. What is the net income for this firm?

3. Dividends and Retained Earnings (LO1) Suppose the firm in Problem 2 paid out $73,000 in cash dividends. What is the addition to retained earnings?

4. Per-Share Earnings and Dividends (LO1) Suppose the firm in Problem 3 had 85,000 shares of common stock outstanding. What is the earnings per share, or EPS, figure? What is the dividends per share figure?

5. Market Values and Book Values (LO1) Kimbo Widgets Inc. purchased new cloaking machinery three years ago for $7 million. The machinery can be sold to the Rimalons today for $4.9 million. Kimbo’s current statement of financial position shows net fixed assets of $3.7 million, current liabilities of $1.1 million, and net working capital of $380,000. If all the current assets were liquidated today, the company would receive $1.6 million cash. What is the book value of Kimbo’s assets today? What is the market value?

6. Calculating Taxes (LO4) The Grimsby Co. in Alberta had $236,000 in 2012 taxable income. Using the rates from Table 2.7 in the chapter, calculate the company’s 2012 income taxes.

7. Tax rates (LO4) In Problem 6 what is the average tax rate? What is the marginal tax rate? 8. Calculating OCF (LO3) Fergus Inc. has sales of $27,500, costs of $13,280, depreciation expense of $2,300, and interest expense

of $1,105. If the tax rate is 35 percent, what is the operating cash flow, or OCF? 9. Calculating Net Capital Spending (LO3) Yale Driving School’s 2011 statement of financial position showed net fixed assets of

$3.4 million, and the 2012 statement of financial position showed net fixed assets of $4.2 million. The company’s 2012 statement of comprehensive income showed a depreciation expense of $385,000. What was net capital spending in 2012?

10. Calculating Changes in NWC (LO3) The 2011 statement of financial position of Owosso Inc. showed current assets of $2,100 and current liabilities of $1,380. The 2012 statement of financial position showed current assets of $2,250 and current liabilities of $1,710. What was the company’s 2012 change in net working capital or NWC?

11. Cash Flow to Creditors (LO3) The 2011 statement of financial position of Roger’s Tennis Shop Inc. showed long-term debt of $2.6 million, and the 2012 statement of financial position showed long term debt of $2.9 million. The 2012 Statement of Comprehensive Income showed an interest expense of $170,000. What was the firm’s cash flow to creditors during 2012?

12. Cash Flow to Shareholders (LO3) The 2011 statement of financial position of Roger’s Tennis Shop Inc. showed $740,000 in the common stock account and $5.2 million in the additional retained earnings account. The 2012 statement of financial position showed $815,000 and $5.5 million in the same two accounts, respectively. If the company paid out $490,000 in cash dividends during 2012, what was the cash flow to shareholders for the year?

13. Calculating Total Cash Flows (LO3) Given the information for Roger’s Tennis Shop Inc. in Problem 11 and 12, suppose you also know the firm’s net capital spending for 2011 was $940,000, and that the firm reduced its net working capital investment by $85,000. What was the firm’s 2012 operating cash flow, or OCF?

Basic (Questions

1–12)

2

3

4

6

8

Intermediate (Questions

13–24)

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14. Calculating Total Cash Flows (LO3) Teeswater Corp. shows the following information on its 2012 statement of comprehensive income: sales = $196,000; costs = $104,000; other expenses = $6,800; depreciation expense = $9,100; interest expense = $14,800; taxes = $21,455; dividends = $10,400. In addition, you’re told that the firm issued $5,700 in new equity during 2012 and redeemed $7,300 in outstanding long-term debt.

a. What is the 2012 operating cash flow? b. What is the 2012 cash flow to creditors? c. What is the 2012 cash flow to shareholders? d. If net fixed assets increased by $27,000 during the year, what was the addition to NWC?

15. Using Statement of Comprehensive Income (LO1) Given the following information for Lucan Pizza Co., calculate the depreciation expense: sales = $41,000; costs = $19,500; addition to retained earnings = $5,100; dividends paid = $1,500; interest expense = $4,500; tax rate = 35 percent.

16. Preparing a Statement of Financial Position (LO1) Prepare a 2012 statement of financial position for Listowel Corp. based on the following information: cash = $195,000; patents and copyrights = $780,000; accounts payable = $405,000; accounts receivable = $137,000; tangible net fixed assets = $2,800,000; inventory = $264,000; notes payable = $160,000; accumulated retained earnings = $1,934,000; long-term debt = $1,195,000.

17. Residual Claims (LO1) Pelham Inc. is obligated to pay its creditors $7,300 during the year. a. What is the market value of the shareholder’s equity if assets have a market value of $8,400? b. What if assets equal $6,700?

18. Marginal versus Average Tax Rates (LO4) (Refer to Table 2.7) Corporation Growth has $88,000 in taxable income, and Corporation Income has $8,800,000 in taxable income.

a. What is the tax bill for each? b. Suppose both firms have identified a new project that will increase taxable income by $10,000. How much additional taxes

will each firm pay? Is this amount the same? if not, why? 19. Net Income and OCF (LO2) During 2012, Thorold Umbrella Corp. had sales of $730,000. Cost of goods sold, administrative

and selling expenses, and depreciation expenses were $580,000, $105,000, and $135,000, respectively. In addition, the company had an interest expense of $75,000 and a tax rate of 35 percent. (Ignore any tax loss carry-back or carry-forward provisions.)

a. What is Thorold’s net income for 2012? b. What is its operating cash flow? c. Explain your results in (a) and (b).

20. Accounting Values versus Cash Flows (LO3) In Problem 19, suppose Thorold Umbrella Corp. paid out $25,000 in cash dividends. Is this possible? If spending on net fixed assets and net working capital was zero, and if no new stock was issued during the year, what do you know about the firm’s long-term debt account?

21. Calculating Cash Flows (LO2) Nanticoke Industries had the following operating results for 2012: sales $22,800; cost of goods sold = $16,050; depreciation expense = $4,050; interest expense = $1,830; dividends paid = $1,300. At the beginning of the year, net assets were $13,650, current assets were $4,800, and current liabilities were $2,700. At the end of the year, net fixed assets were $16,800, current assets were $5,930, and current liabilities were $3,150. The tax rate for 2012 was 34 percent.

a. What is net income for 2012? b. What is the operating cash flow for 2012? c. What is the cash flow from assets for 2012? Is this possible? Explain. d. If no new debt was issued during the year, what is the cash flow to creditors? What is the cash flow to shareholders? Ex-

plain and interpret the positive and negative signs of your answers in (a) through (d). 22. Calculating Cash Flows (LO3) Consider the following abbreviated financial statements for Barrie Enterprises:

BARRIE Enterprises 2011 and 2012 Partial Statement of Financial Position

Assets Liabilities and Owner’s Equity

2011 2012 2011 2012 Current Assets $ 653 $ 707 Current liabilities $ 261 $ 293 Net fixed Assets 2,691 3,240 Long-term debt 1,422 1,512

BARRIE Enterprises 2012 Statement of Comprehensive Income

Sales $8,280 Costs 3,861 Depreciation 738 Interest Paid 211

a. What is owner’s equity for 2011 and 2012? b. What is the change in net working capital for 2012?

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c. In 2012, Barrie Enterprises purchased $1,350 in new fixed assets. How much in fixed assets did Barrie Enterprises sell? What is the cash flow from assets for the year? (The tax rate is 35 percent.)

d. During 2012, Barrie Enterprises raised $270 in new long-term debt. How much long-term debt must Barrie Enterprises have paid off during the year? What is the cash flow to creditors?

23. Income Trust Distributions vs. Corporate Dividends (LO4) The Bancroft Company is currently structured as an income trust. It is considering restructuring the company to become a corporation, but is unsure if this would benefit shareholders. Company executives have asked for your advice. They tell you that the corporate tax rate is 35 percent, last year’s net income before tax was $500,000 and there are 10,000 outstanding shares. If the company decides to restructure into a corporation, one income trust unit will become one share. From your experience doing your own tax returns, you know that dividends are taxed at 23 percent and income and interest income are taxed at 48 percent. Is it worth it for the Bancroft Company to restructure into a corporation? If so, how much more would an investor gain if that investor owned 2000 shares?

24. Net Fixed Assets and Depreciation (LO3) On the statement of financial position, the net fixed assets (NFA) account is equal to the gross fixed assets (FA) account (which records the acquisition cost of fixed assets) minus the accumulated depreciation (AD) account (which records the total depreciation taken by the firm against its fixed assets). Using the fact that NFA = FA – AD, show that the expression given in the chapter for net capital spending, NFAend – NFAbeg + D (where D is the depreciation expense during the year), is equivalent to FAend – FAbeg.

Use the following information for Clarington Inc. for Problems 25 and 26 (assume the tax rate is 34 percent): 2011 2012

Sales $7,233 $8,085 Depreciation 1,038 1,085 Cost of goods sold 2,487 2,942 Other expenses 591 515 Interest 485 579 Cash 3,972 4,041 Accounts receivable 5,021 5,892 Short-term notes payable 732 717 Long-term debt 12,700 15,435 Net fixed assets 31,805 33,291 Accounts payable 3,984 4,025 Inventory 8,927 9,555 Dividends 882 1,011

25. Financial Statements (LO1) Draw up an statement of comprehensive income and statement of financial position for this company for 2011 and 2012.

26. Calculating Cash Flow (LO3) For 2012, calculate the cash flow from assets, cash flow to creditors, and cash flow to shareholders.

27. Taxes on Investment Income (LO4) Linda Milner, an Alberta investor, receives $40,000 in dividends from Okotoks Forest Products shares, $20,000 in interest from a deposit in a chartered bank, and a $20,000 capital gain from Cremona Mines shares. Use the information in Tables 2.5 and 2.6 to calculate the after-tax cash flow from each investment. Ms. Milner’s federal tax rate is 29 percent.

28. Investment Income (LO4) Assuming that Ms. Milner’s cash flows in Problem 27 came from equal investments of $75,000 each, find her after-tax rate of return on each investment.

29. CCA (LO5) Scugog Manufacturing Ltd. just invested in some new processing machinery to take advantage of more favourable CCA rates in a new federal budget. The machinery qualifies for 25 percent CCA rate and has an installed cost of $500,000. Calculate the CCA and UCC for the first five years.

30. UCC (LO5) A piece of newly purchased industrial equipment costs $1,000,000. It is Class 8 property with a CCA rate of 20 percent. Calculate the annual depreciation allowances and end-of-year book values (UCC) for the first five years.

31. CCA and UCC (LO5) Our new computer system cost us $100,000. We will outgrow it in five years. When we sell it, we will probably get only 20 percent of the purchase price. CCA on the computer will be calculated at a 30 percent rate (Class 10). Calculate the CCA and UCC values for five years. What will be the after-tax proceeds from the sale assuming the asset class is continued? Assume a 40 percent tax rate.

32. CCA (LO5) Havelock Industries bought new manufacturing equipment (Class 8) with a CCA rate of 20 percent for $4,125,000 in 2011 and then paid $75,000 for installation it capitalized in Class 8. The firm also invested $4 million in a new brick building (Class 3) with a CCA rate of 5 percent. During 2011 Havelock finished the project and put it in use. Find the total CCA for Havelock for 2011 and 2012.

33. UCC (LO5) Kanata Construction specializes in large projects in Edmonton and Saskatoon. In 2011, Kanata invested $1.5 million in new excavating equipment, which qualifies for a CCA rate of 50 percent. At the same time the firm sold some older equipment on the secondhand market for $145,000. When it was purchased in 2008, the older equipment cost $340,000. Calculate the UCC for the asset pool in each year from 2008 through 2012.

Challenge (Questions

24–36)

2

2

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34. Income Tax (LO4) A resident of Alberta has taxable income from employment of $170,000. This individual is considering three investments of equal risk and wishes to determine the after-tax income for each:

a. $57,000 worth of bonds with a coupon rate of 5 percent. b. 250 shares of stock that will pay a dividend at the end of the year of $25 per share. c. 500 shares of another stock that is expected to increase in value by $15 per share during the year.

35. Tax Loss Carry-back and Carry-forward (LO4) The Stayner Company experienced an operating loss of $4,100,000 in 2009. Taxable income figures for recent years are given below. Show how the firm can maximize its tax refunds.

2006 2007 2008 2009 2010 2011 2012

Taxable income ($000) $116 $140 $168 ($600) $40 $40 $40

36. UCC (LO5) A proposed cost-saving device has an installed cost of $99,200. It is in Class 43 (30 percent rate) for CCA purposes. It will actually function for five years, at which time it will have no value.

a. Calculate UCC at the end of five years. b. What are the tax implications when the asset is sold?

Nepean Boards is a small company that manufactures and sells snowboards in Ottawa. Scott Redknapp, the founder of the company, is in charge of the design and sale of the snow- boards, but he is not from a business background. As a result, the company’s financial records are not well maintained. The initial investment in Nepean Boards was provided by Scott and his friends and family. Because the initial investment was relatively small, and the company has made snowboards only for its own store, the investors haven’t required detailed financial statements from Scott. But thanks to word of mouth among professional boarders, sales have picked up recently, and Scott is considering a major expansion. His plans include opening another snowboard store in Calgary, as well as sup- plying his “sticks” (boarder lingo for boards) to other sellers. Scott’s expansion plans require a significant investment, which he plans to finance with a combination of additional funds from outsiders plus some money borrowed from the banks. Naturally, the new investors and creditors require more organized and detailed financial statements than Scott previ- ously prepared. At the urging of his investors, Scott has hired financial analyst Jennifer Bradshaw to evaluate the perform- ance of the company over the past year. After rooting through old bank statements, sales receipts, tax returns, and other records, Jennifer has assembled the fol- lowing information:

2011 2012

Cost of goods sold $126,038 $159,143 Cash 18,187 27,478 Depreciation 35,581 40,217 Interest expense 7,735 8,866 Selling and administrative expenses 24,787 32,352 Accounts payable 32,143 36,404 Fixed assets 156,975 191,250 Sales 247,259 301,392 Accounts receivable 12,887 16,717 Notes payable 14,651 15,997 Long-term debt 79,235 91,195 Inventory 27,119 37,216 New equity 0 15,600

Nepean Boards currently pays out 50 percent of net income as dividends to Scott and the other original investors, and has a 20 percent tax rate. You are Jennifer’s assistant, and she has asked you to prepare the following: 1. A statement of comprehensive income for 2011 and 2012. 2. A statement of financial position for 2011 and 2012. 3. Operating cash flow for the year. 4. Cash flow from assets for 2012. 5. Cash flow to creditors for 2012. 6. Cash flow to shareholders for 2012.

Questions

1. How would you describe Nepean Boards’ cash flows for 2012? Write a brief discussion.

2. In light of your discussions in the previous question, what do you think about Scott’s expansion plans?

MINI CASE

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Internet Application Questions 1. The distinction between capital investment and current expenditure is somewhat arbitrary. Nevertheless, from the tax view-

point, a distinction must be made to calculate depreciation and its associated tax shield. The following link at Canada Revenue Agency provides a set of pointers to distinguish whether an expenditure is considered capital in nature, or whether it is a cur- rent expense.

cra-arc.gc.ca/E/pub/tp/it128r/it128r-e.html Use the guidelines in the link above to classify the following expenses as capital or current: a. Your company buys a fleet of trucks for material delivery b. The local barbershop buys a new chair c. The local barbershop buys a new pair of scissors What assumptions did you need to make to answer the above questions? 2. Capital cost allowance is not the only tax shelter available to Canadian firms. In some cases, notably cultural industries, there

are both federal and provincial tax credits to offset a portion of the production costs involved in content development. The fol- lowing website at Canada Revenue Agency describes the Film or Video Production Tax Credit (FTC), which is available to qualified producers.

cra-arc.gc.ca/tx/nnrsdnts/flm/ftc-cip/menu-eng.html For a company with $1 million in production costs, what is the size of the federal FTC? 3. The Canadian Institute of Chartered Accountants (cica.ca/index.aspx) provides standards and guidance for new issues, and

solicits comments for new policies. Click on What’s New and pick one item from Guidance and one item from Comments. Summarize the new guidelines and critique the comments article. Note that items on this site change from time to time.

4. The home page for Air Canada can be found at aircanada.ca. Locate the most recent annual report, which contains a statement of financial position for the company. What is the book value of equity for Air Canada? The market value of a company is the number of shares of stock outstanding times the price per share. This information can be found at ca.finance.yahoo.com using the ticker symbol for Air Canada (AC). What is the market value of equity? Which number is more relevant for shareholders?

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In Chapter 2, we discussed some of the essential concepts of fi nancial statements and cash fl ows. Part 2, this chapter and the next, continues where our earlier discussion left off . Our goal here is to expand your understanding of the uses (and abuses) of fi nancial statement information.

Financial statement information crops up in various places in the remainder of our book. Part 2 is not essential for understanding this material, but it helps give you an overall perspective on the role of fi nancial statement information in corporate fi nance.

A good working knowledge of fi nancial statements is desirable simply because such state- ments, and numbers derived from those statements, are the primary means of communicating fi nancial information both within the fi rm and outside the fi rm. In short, much of the language of corporate fi nance is rooted in the ideas we discuss in this chapter.

Furthermore, as we shall see, there are many diff erent ways of using fi nancial statement infor- mation and many diff erent types of users. Th is diversity refl ects the fact that fi nancial statement information plays an important part in many types of decisions.

In the best of all worlds, the fi nancial manager has full market value information about all the fi rm’s assets. Th is rarely (if ever) happens. So the reason we rely on accounting fi gures for much of our fi nancial information is that we almost always cannot obtain all (or even part) of the market

WORKING WITH FINANCIAL STATEMENTS

C H A P T E R 3

O n November 17, 2011, common shares of Canadian energy company, Suncor Energy Inc., traded at $33.15 on the Toronto Stock

Exchange (TSX). At that price, Bloomberg reported

that the company had a price–earnings (P/E) ratio of

11.30. In other words, investors were willing to pay

$11.30 for every dollar of income earned by Suncor

Energy. At the same time, investors were willing to

pay $18.01 for every dollar earned by TransCanada

Corporation. At the other extreme was RIM, which,

at that time, had a P/E ratio of 3.32. However, the

company was still trading at $19.25. At that time,

the typical stock on the S&P/TSX Composite Index

was trading at a P/E of 15.23, or roughly 15 times

earnings, as they say on Bay Street.

Price–earnings comparisons are examples of

financial ratios. As we will see in this chapter, there

is a wide variety of financial ratios, all designed to

summarize specific aspects of a firm’s financial posi-

tion. In addition to discussing how to analyze finan-

cial statements and compute financial ratios, we will

have quite a bit to say about who uses this informa-

tion and why.

Learning Object ives

After studying this chapter, you should understand:

LO1 The sources and uses of a firm’s cash flows.

LO2 How to standardize financial statements for comparison purposes.

LO3 How to compute and, more importantly, interpret some common ratios.

LO4 The determinants of a firm’s profitability.

LO5 Some of the problems and pitfalls in financial statement analysis.

P A R T 2

C ou

rt es

y of

Su

nc or

E ne

rg y

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information that we want. Th e only meaningful benchmark for evaluating business decisions is whether or not they create economic value (see Chapter 1). However, in many important situ- ations, it is not possible to make this judgement directly because we can’t see the market value eff ects of decisions.

We recognize that accounting numbers are oft en just pale refl ections of economic reality, but they frequently are the best available information. For privately held corporations, not-for-profi t businesses, and smaller fi rms, for example, very little direct market value information exists. Th e accountant’s reporting function is crucial in these circumstances.

Clearly, one important goal of the accountant is to report fi nancial information to the user in a form useful for decision making. Ironically, the information frequently does not come to the user in such a form. In other words, fi nancial statements don’t come with a user’s guide. Th is chapter and the next are fi rst steps in fi lling this gap.

3.1 Cash Flow and Financial Statements: A Closer Look

At the most fundamental level, fi rms do two diff erent things: Th ey generate cash and they spend it. Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (i.e., shares of stock) in the fi rm. Cash is spent by paying for materials and labour to produce a product and by purchasing assets. Payments to creditors and owners also require spending cash.

In Chapter 2, we saw that the cash activities of a fi rm could be summarized by a simple identity:

Cash flow from assets = Cash flow to creditors + Cash flow to owners

Th is cash fl ow identity summarizes the total cash result of all the transactions the fi rm engaged in during the year. In this section, we return to the subject of cash fl ows by taking a closer look at the cash events during the year that lead to these total fi gures.

Sources and Uses of Cash Th ose activities that bring in cash are called sources of cash. Th ose activities that involve spend- ing cash are called uses of cash (or applications of cash). What we need to do is to trace the changes in the fi rm’s statement of fi nancial position to see how the fi rm obtained its cash and how the fi rm spent its cash during some time period.

To get started, consider the statement of fi nancial position for the Prufrock Corporation in Table 3.1. Notice that we have calculated the changes in each of the items on the statement of fi nancial position over the year from the end of 2011 to the end of 2012.

Looking over the statement of fi nancial position for Prufrock, we see that quite a few things changed during the year. For example, Prufrock increased its net fi xed assets by $149,000 and its inventory by $29,000. Where did the money come from? To answer this and related questions, we must identify those changes that used up cash (uses) and those that brought cash in (sources). A little common sense is useful here. A fi rm uses cash by either buying assets or making payments. So, loosely speaking, an increase in an asset account means the fi rm bought some net assets, a use of cash. If an asset account went down, then, on a net basis, the fi rm sold some assets. Th is would be a net source. Similarly, if a liability account goes down, then the fi rm has made a net payment, a use of cash.

Given this reasoning, there is a simple, albeit mechanical, defi nition that you may fi nd use- ful. An increase in a left -hand side (asset) account or a decrease in a right-hand side (liability or equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash.

Looking back at Prufrock, we see that inventory rose by $29. Th is is a net use since Prufrock eff ectively paid out $29 to increase inventories. Accounts payable rose by $32. Th is is a source of cash since Prufrock eff ectively has borrowed an additional $32 by the end of the year. Notes payable, on the other hand, went down by $35, so Prufrock eff ectively paid off $35 worth of short- term debt—a use of cash.

sources of cash A firm’s activities that generate cash.

uses of cash A firm’s activities in which cash is spent.

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TABLE 3.1

PRUFROCK CORPORATION Statement of Financial Position as of December 31, 2011 and 2012

($ thousands)

2011 2012 Change

Assets Current assets

Cash $ 84 $ 98 +$ 14 Accounts receivable 165 188 + 23 Inventory 393 422 + 29 Total $ 642 $ 708 +$ 66 Fixed assets Net plant and equipment 2,731 2,880 + 149 Total assets $ 3,373 $ 3,588 +$ 215

Liabilities and Owners’ Equity Current liabilities Accounts payable $ 312 $ 344 +$ 32 Notes payable 231 196 – 35 Total $ 543 $ 540 -$ 3 Long-term debt $ 531 $ 457 -$ 74 Owners’ equity Common stock 500 550 + 50 Retained earnings 1,799 2,041 + 242 Total $ 2,299 $ 2,591 +$ 292 Total liabilities and owners’ equity $ 3,373 $ 3,588 +$ 215

Based on our discussion, we can summarize the sources and uses from the statement of fi nancial position as follows:

Sources of cash: Increase in accounts payable $ 32 Increase in common stock 50 Increase in retained earnings 242 Total sources $ 324 Uses of cash: Increase in accounts receivable $ 23 Increase in inventory 29 Decrease in notes payable 35 Decrease in long-term debt 74 Net fixed asset acquisitions 149 Total uses $ 310 Net addition to cash $ 14

Th e net addition to cash is just the diff erence between sources and uses, and our $14 result here agrees with the $14 change shown on the statement of fi nancial position.

Th is simple statement tells us much of what happened during the year, but it doesn’t tell the whole story. For example, the increase in retained earnings is net income (a source of funds) less dividends (a use of funds). It would be more enlightening to have these reported separately so we could see the breakdown. Also, we have only considered net fi xed asset acquisitions. Total or gross spending would be more interesting to know.

To further trace the fl ow of cash through the fi rm during the year, we need an income state- ment. For Prufrock, the results are shown in Table 3.2. Because we are looking at cash fl ow during calendar year 2012, we focus on the 2012 statement of comprehensive income.

CHAPTER 3: Working with Financial Statements 55

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TABLE 3.2

PRUFROCK CORPORATION Statement of Comprehensive Income

($ thousands)

2012

Sales $ 2,311 Cost of goods sold 1,344 Depreciation 276 Earnings before interest and taxes $ 691 Interest paid 141 Taxable income $ 550 Taxes 187 Net income $ 363 Addition to retained earnings $ 242 Dividends 121

Notice here that the $242 addition to retained earnings we calculated from the statement of fi nancial position is just the diff erence between the 2012 net income of $363 and that year’s dividend of $121.

The Statement of Cash Flows Th ere is some fl exibility in summarizing the sources and uses of cash in the form of a fi nancial statement. However, when it is presented, the result is called the statement of cash fl ows.

We present a particular format in Table 3.3 for this statement. Th e basic idea is to group all the changes into one of three categories: operating activities, fi nancing activities, and investment activities. Th e exact form diff ers in detail from one preparer to the next.

TABLE 3.3

PRUFROCK CORPORATION 2012 Statement of Cash Flows

Operating activities Net income $ 363 Plus: Depreciation 276 Increase in accounts payable 32 Less: Increase in accounts receivable -23 Increase in inventory -29 Net cash from operating activity $ 619 Investment activities: Fixed asset acquisitions -$ 425 Net cash from investment activity -$ 425 Financing activities: Decrease in notes payable -$ 35 Decrease in long-term debt -74 Dividends paid -121 Increase in common stock 50 Net cash from financing activity -$ 180 Net increase in cash $ 14

statement of cash flows A firm’s financial statement that summarizes its sources and uses of cash over a specified period.

56 Part 2: Financial Statements and Long-Term Financial Planning

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Don’t be surprised if you come across diff erent arrangements. Th e types of information pre- sented may be very similar, but the exact order can diff er. Th e key thing to remember is that we started out with $84 in cash and ended up with $98, for a net increase of $14. We’re just trying to see what events led to this change.

Going back to Chapter 2, there is a slight conceptual problem here. Interest paid should really go under fi nancing activities, but, unfortunately, that’s not the way the accounting is handled. Th e reason, you may recall, is that interest is deducted as an expense when net income is computed. Also, notice that our net purchase of fi xed assets was $149. Since we wrote off $276 worth (the depreciation), we must have actually spent a total of $149 + 276 = $425 on fi xed assets.

Once we have this statement, it might seem appropriate to express the change in cash on a per-share basis, much as we did for net income. Although standard accounting practice does not report this information, it is oft en calculated by fi nancial analysts. Th e reason is that accoun- tants believe that cash fl ow (or some component of cash fl ow) is not an alternative to accounting income, so only earnings per share are to be reported.

Now that we have the various cash pieces in place, we can get a good idea of what happened during the year. Prufrock’s major cash outlays were fi xed asset acquisitions and cash dividends. Th e fi rm paid for these activities primarily with cash generated from operations.

Prufrock also retired some long-term debt and increased current assets. Finally, current liabil- ities were virtually unchanged, and a relatively small amount of new equity was sold. Altogether, this short sketch captures Prufrock’s major sources and uses of cash for the year.

1. What is a source of cash? Give three examples.

2. What is a use or application of cash? Give three examples.

3.2 Standardized Financial Statements

Th e next thing we might want to do with Prufrock’s fi nancial statements is to compare them to those of other, similar companies. We would immediately have a problem, however. It’s almost impossible to directly compare the fi nancial statements for two companies because of diff erences in size. In Canada, this problem is compounded because some companies are one of a kind. BCE is an example. Further, large Canadian companies usually span two, three, or more industries, making comparisons extremely diffi cult.

To start making comparisons, one obvious thing we might try to do is to somehow standardize the fi nancial statements. One very common and useful way of doing this is to work with per- centages instead of total dollars. In this section, we describe two diff erent ways of standardizing fi nancial statements along these lines.

Common-Size Statements To get started, a useful way of standardizing fi nancial statements is to express the statement of fi nancial position as a percentage of total assets and to express the statement of comprehensive income as a percentage of sales. Such a fi nancial statement is called a common-size statement. We consider these statements next.

COMMON-SIZE STATEMENT OF FINANCIAL POSITION One way, but not the only way, to construct a common-size statement of financial position is to express each item as a percentage of total assets. Prufrock’s 2011 and 2012 common-size statement of financial posi- tion are shown in Table 3.4.

Notice that some of the totals don’t check exactly because of rounding errors. Also, notice that the total change has to be zero, since the beginning and ending numbers must add up to 100 percent.

Concept Questions

common-size statement A standardized financial statement presenting all items in percentage terms. Statement of financial position is shown as a percentage of assets and income statements as a percentage of sales.

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TABLE 3.4

PRUFROCK CORPORATION Common-Size Statement of Financial Position

December 31, 2011 and 2012

2011 2012 Change

Assets Current Assets Cash 2.5% 2.7% +0.2% Accounts receivable 4.9 5.2 +0.3 Inventory 11.7 11.8 +0.1 Total 19.0 19.7 +0.7 Fixed assets Net plant and equipment 81.0 80.3 -0.7 Total assets 100.0% 100.0% 0.0%

Liabilities and Owners’ Equity Current liabilities Accounts payable 9.2% 9.6% +0.4% Notes payable 6.8 5.5 -1.3 Total 16.1 15.1 -1.0 Long-term debt 15.7 12.7 -3.0 Owners’ equity Common stock 14.8 15.3 +0.5 Retained earnings 53.3 56.9 +3.6 Total 68.2 72.2 +4.0 Total liabilities and owners’ equity 100.0% 100.0% 0.0%

In this form, fi nancial statements are relatively easy to read and compare. For example, just looking at the two statement of fi nancial position for Prufrock, we see that current assets were 19.7 percent of total assets in 2012, up from 19 percent in 2011. Current liabilities declined from 16.1 percent to 15.1 percent of total liabilities and owners’ equity over that same time. Similarly, total equities rose from 68.2 percent of total liabilities and owners’ equity to 72.2 percent.

Overall, Prufrock’s liquidity, as measured by current assets compared to current liabilities, increased over the year. Simultaneously, Prufrock’s indebtedness diminished as a percentage of total assets. We might be tempted to conclude that the statement of fi nancial position has grown stronger. We say more about this later.

COMMON-SIZE INCOME STATEMENTS A useful way of standardizing statements of comprehensive income is to express each item as a percentage of total sales, as illustrated for Prufrock in Table 3.5.

Common-size statements of comprehensive income tell us what happens to each dollar in sales. For Prufrock in 2012 for example, interest expense eats up $.061 out of every sales dollar and taxes take another $.081. When all is said and done, $.157 of each dollar fl ows through to the bottom line (net income), and that amount is split into $.105 retained in the business and $.052 paid out in dividends.

Th ese percentages are very useful in comparisons. For example, a very relevant fi gure is the cost of goods sold percentage. For Prufrock, $.582 of each $1 in sales goes to pay for goods sold in 2012 as compared to $.624 in 2011. Th e reduction likely signals improved cost controls in 2012. To pursue this point, it would be interesting to compute the same percentage for Prufrock’s main competitors to see how Prufrock’s improved cost control in 2012 stacks up.

COMMON-SIZE STATEMENTS OF CASH FLOW Although we have not pre- sented it here, it is also possible and useful to prepare a common-size statement of cash flows. Unfortunately, with the current statement of cash flows, there is no obvious denominator such as total assets or total sales. However, when the information is arranged similarly to Table 3.5, each

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item can be expressed as a percentage of total sources or total uses. The results can then be inter- preted as the percentage of total sources of cash supplied or as the percentage of total uses of cash for a particular item.

TABLE 3.5

PRUFROCK CORPORATION Common-Size Statement of Comprehensive Income

2011 2012

Sales 100.0% 100.0% Cost of goods sold 62.4 58.2 Depreciation 12.0 11.9 Earnings before interest and taxes 25.6 29.9 Interest paid 6.2 6.1 Taxable income 19.4 23.8 Taxes 7.8 8.1 Net income 11.6% 15.7% Addition to retained earnings 5.8% 10.5% Dividends 5.8% 5.2%

Common-Base-Year Financial Statements: Trend Analysis Imagine that we were given statement of fi nancial position for the last 10 years for some company and we were trying to investigate trends in the fi rm’s pattern of operations. Does the fi rm use more or less debt? Has the fi rm grown more or less liquid? A useful way of standardizing fi nancial statements is to choose a base year and then express each item relative to the base amount. We call such a statement a common-base-year statement.

For example, Prufrock’s inventory rose from $393 to $422. If we pick 2011 as our base year, then we would set inventory equal to 1 for that year. For the next year, we would calculate inventory rela- tive to the base year as $422/$393 = 1.07. We could say that inventory grew by about 7 percent dur- ing the year. If we had multiple years, we would just divide each one by $393. Th e resulting series is very easy to plot, and it is then very easy to compare two or more diff erent companies. Table 3.6 summarizes these calculations for the asset side of the statement of fi nancial position.

COMBINED COMMON-SIZE AND BASE-YEAR ANALYSIS The trend analysis we have been discussing can be combined with the common-size analysis discussed earlier. The reason for doing this is that as total assets grow, most of the other accounts must grow as well. By first forming the common-size statements, we eliminate the effect of this overall growth.

For example, Prufrock’s accounts receivable were $165, or 4.9 percent of total assets in 2011. In 2012, they had risen to $188, which is 5.2 percent of total assets. If we do our trend analysis in terms of dollars, the 2012 fi gure would be $188/$165 = 1.14, a 14 percent increase in receivables. How- ever, if we work with the common-size statements, the 2012 fi gure would be 5.2%/4.9% = 1.06. Th is tells us that accounts receivable, as a percentage of total assets, grew by 6 percent. Roughly speaking, what we see is that of the 14 percent total increase, about 8 percent (14% – 6%) is attrib- utable simply to growth in total assets. Table 3.6 summarizes this discussion for Prufrock’s assets.

1. Why is it often necessary to standardize financial statements?

2. Name two types of standardized statements and describe how each is formed.

common-base-year statement A standardized financial statement presenting all items relative to a certain base year amount.

Concept Questions

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TABLE 3.6

PRUFROCK CORPORATION Summary of Standardized Statement of Financial Position (Asset side only)

($ thousands)

Assets Common-Size Common Base-Year

Combined Common- Size and Base-Year

2011 2012 2011 2012 2011 2012

Current Assets Cash $ 84 $ 98 2.5% 2.7% 1.17 1.08 Accounts receivable 165 188 4.9 5.2 1.14 1.06 Inventory 393 422 11.7 11.8 1.07 1.01 Total current assets $ 642 $ 708 19.0 19.7 1.10 1.04 Fixed assets Net plant and equipment 2,731 2,880 81.0 80.3 1.05 0.99 Total assets $ 3,373 $ 3,588 100.0% 100.0% 1.06 1.00

Th e common-size numbers are calculated by dividing each item by total assets for that year. For example, the 2011 common-size cash amount is $84/$3,373 = 2.5%. Th e common–base-year numbers are calculated by dividing each 2012 item by the base-year dollar (2011) amount. Th e common- base cash is thus $98/$84 = 1.17, representing a 17 percent increase. Th e combined common-size and base-year fi gures are calculated by dividing each common-size amount by the base-year (2011) common-size amount. Th e cash fi gure is therefore 2.7%/2.5% = 1.08, representing an 8 percent increase in cash holdings as a percentage of total assets.

3.3 Ratio Analysis

Another way of avoiding the problem of comparing companies of diff erent sizes is to calculate and compare fi nancial ratios. Such ratios are ways of comparing and investigating the relation- ships between diff erent pieces of fi nancial information. Using ratios eliminates the size problem since the size eff ectively divides out. We’re then left with percentages, multiples, or time periods.

Th ere is a problem in discussing fi nancial ratios. Since a ratio is simply one number divided by another, and since there is a substantial quantity of accounting numbers out there, there are a huge number of possible ratios we could examine. Everybody has a favourite, so we’ve restricted ourselves to a representative sampling. We chose the sample to be consistent with the practice of experienced fi nancial analysts. Another way to see which ratios are used most oft en in practice is to look at the output of commercially available soft ware that generates ratios.

Once you have gained experience in ratio analysis, you will fi nd that 20 ratios do not tell you twice as much as 10. You are looking for problem areas, not an exhaustive list of ratios, so you don’t have to worry about including every possible ratio.

What you do need to worry about is the fact that diff erent people and diff erent sources fre- quently don’t compute these ratios in exactly the same way, and this leads to much confusion. Th e specifi c defi nitions we use here may or may not be the same as ones you have seen or will see elsewhere.1 When you are using ratios as a tool for analysis, you should be careful to document how you calculate each one.

We defer much of our discussion of how ratios are used and some problems that come up with using them to the next section. For now, for each of the ratios we discuss, several questions come to mind:

1. How is it computed? 2. What is it intended to measure, and why might we be interested? 3. What might a high or low value be telling us? How might such values be misleading? 4. How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

1 For example, we compute ratios using year-end statement of financial position values in the denominators, while many other sources use average ending values from last year and the current year.

financial ratios Relationships determined from a firm’s financial information and used for comparison purposes.

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1. Short-term solvency or liquidity ratios. 2. Long-term solvency or financial leverage ratios. 3. Asset management or turnover ratios. 4. Profitability ratios. 5. Market value ratios.

We consider each of these in turn. To illustrate ratio calculations for Prufrock, we use the ending statement of fi nancial position (2012) fi gures unless we explicitly say otherwise. Aft er calculating the 2012 ratios, we illustrate the inferences you can make from them by making two comparisons for each ratio. Th e comparisons draw on numbers in Table 3.7 that summarize each ratio’s 2012 value and also present corresponding values for Prufrock in 2011 and for the industry average.2