Finance for Executives Managing for Value Creation

by Hawawini, Gabriel; Viallet, Claude

• ISBN13: 9780324274318
• ISBN10: 0324274319
• Edition: 3rd
• Format: Hardcover
• Copyright: 2006-04-12
• Publisher: South-Western College Pub

Summary

FINANCE FOR EXECUTIVES: MANAGING FOR VALUE CREATION, 3e is ideal for the future manager or experienced executive who recognizes the importance of using financial information to maximize firm value. Respected authors Gabriel Hawawini and Claude Viallet have translated their wealth of experience into a concise, analytically sound introduction to financial management that is neither too simplistic nor too theoretical. Based on modern finance principles, the book presents the most recent financial data and latest references with a level of practicality and rigorous analysis appropriate for today's experienced executive - without complicated formulas that have no direct application to decision making. Each chapter is self-contained - providing ultimate flexibility for teaching and making the book an excellent source for reference or self-learning beyond the traditional classroom. This book is perfect for executive education, executive MBA courses, or any course where you want to translate theory into practice or use a case approach. A strong problem-scenario approach presents concepts within the context of financial management problems that executives commonly face. In addition, consistent case studies analyze the same set of companies throughout the text to provide a common thread that reinforces learning.

Table of Contents

PART I: INTRODUCTION
Financial Management and Value Creation: An Overview	1	(32)
The Key Question: Will Your Decision Create Value?	2	(3)
The Importance of Managing for Value Creation	3	(1)
The Saturn Story	4	(1)
The Fundamental Finance Principle	5	(3)
Measuring Value Creation with Net Present Value	5	(1)
Only Cash Matters	6	(1)
Discount Rates	7	(1)
A Proposal's Cost of Capital	7	(1)
Applying the Fundamental Finance Principle	8	(5)
The Capital Budgeting Decision	9	(1)
The Capital Structure Decision	10	(2)
The Business Acquisition Decision	12	(1)
The Foreign Investment Decision	13	(1)
The Role of Financial Markets	13	(5)
The Equity Market	14	(1)
What Is Bad for General Motors Is Good for Volkswagen . . . and Vice Versa	15	(1)
The Vioxx Recall	16	(1)
External Versus Internal Financing	17	(1)
The Business Cycle	18	(2)
HLC's Financial Statements	20	(5)
The Balance Sheet	20	(2)
A Variant of the Standard Balance Sheet: The Managerial Balance Sheet	22	(1)
The Income Statement	23	(2)
How Profitable is a Firm?	25	(1)
The Profitability of Equity Capital	25	(1)
The Profitability of Invested Capital	25	(1)
How Much Cash Does a Firm Generate?	26	(1)
Sources and Uses of Cash	26	(1)
The Statement of Cash Flows	26	(1)
How Risky is a Firm?	27	(2)
Is Value Created?	29	(2)
Summary	31	(1)
Further Reading	32	(1)
Understanding Balance Sheets and Income Statements	33	(34)
Financial Accounting Statements	33	(3)
The Balance Sheet	36	(9)
Current, or Short-Term, Assets	37	(3)
Noncurrent, or Fixed, Assets	40	(3)
Current, or Short-Term, Liabilities	43	(1)
Noncurrent Liabilities	44	(1)
Owners' Equity	45	(1)
The Income Statement	45	(4)
Net Sales	46	(1)
Gross Profit	47	(1)
Operating Profit	48	(1)
Earnings Before Interest and Tax (EBIT)	48	(1)
Earnings Before Tax (EBT)	49	(1)
Earnings After Tax (EAT)	49	(1)
Reconciling Balance Sheets and Income Statements	49	(1)
The Structure of the Owners' Equity Account	50
Summary	5	(55)
Appendix 2.1 Financial Reporting Reforms	55	(1)
Appendix 2.2 Specimen Financial Statements	56	(1)
Polo Ralph Lauren's Balance Sheets and Income Statements	56	(1)
Polo Ralph Lauren Balance Sheets	56	(3)
Polo Ralph Lauren Income Statements	59	(1)
Further Reading	60	(1)
Self-Test Problems	60	(2)
Review Problems	62	(5)
PART II: FINANCIAL DIAGNOSIS AND MANAGEMENT
Assessing Liquidity and Operational Efficiency	67	(46)
The Managerial Balance Sheet	68	(7)
The Three Components of a Firm's Invested Capital	71	(4)
The Components of Capital Employed	75	(2)
The Structure of the Managerial Balance Sheet	76	(1)
The Matching Strategy	77	(2)
A Measure of Liquidity Based on the Funding Structure of Working Capital Requirement	79	(3)
Improving Liquidity Through Better Management of the Operating Cycle	82	(7)
The Effect of the Firm's Economic Sector on Its Working Capital Requirement	83	(1)
The Effect of Managerial Efficiency on Working Capital Requirement	84	(3)
The Effect of Sales Growth on Working Capital Requirement	87	(2)
Traditional Measures of Liquidity	89	(2)
Net Working Capital	89	(1)
The Current Ratio	90	(1)
The Acid Test or Quick Ratio	91	(1)
Summary	91	(11)
Appendix 3.1 Financing Strategies	93	(3)
Appendix 3.2 Polo Ralph Lauren's Liquidity and Operational Efficiency	96	(1)
RL Managerial Balance Sheets	96	(2)
RL's Liquidity Position	98	(2)
RL's Management of the Operating Cycle	100	(2)
Further Reading	102	(1)
Self-Test Problems	102	(2)
Review Problems	104	(9)
Measuring Cash Flows	113	(40)
Cash Flows and Their Sources	114	(3)
Preparing a Detailed Cash-Flow Statement	117	(11)
Net Cash Flow from Operating Activities	118	(5)
Net Cash Flow from Investing Activities	123	(1)
Net Cash Flow from Financing Activities	124	(1)
The Cash-Flow Statement	124	(1)
The Statement of Cash Flow According to FASB 95	125	(3)
Net Operating Cash Flow Versus Free Cash Flow Versus Bankers' Cash Flow	128	(3)
Free Cash Flow	128	(1)
Bankers' Cash Flow	129	(2)
Managerial Implications	131	(1)
Summary	132	(7)
Appendix 4.1 Obtaining the Net Operating Cash Flow From Balance Sheet and Income Statement Accounts	134	(1)
Measuring Cash Inflow from Operations	134	(1)
Measuring Cash Outflow from Operations	135	(2)
Net Operating Cash Flow	137	(2)
Appendix 4.2 Polo Ralph Lauren's Cash Flows	139	(1)
Restructuring RL's Cash Flow Statements	139	(5)
RL's Cash Flows from Operating Activities	140	(1)
RL's Cash Flows from Investing Activities	141	(1)
RL's Cash Flows from Financing Activities	142	(2)
Further Reading	144	(1)
Self-Test Problems	144	(1)
Review Problems	145	(8)
Diagnosing Profitability, Risk, and Growth	153	(48)
Measures of Profitability	154	(1)
Return on Equity	155	(14)
Measuring Return on Equity	155	(1)
The Effect of Operating Decisions on Return on Equity	155	(6)
The Effect of Financing Decisions on Return on Equity	161	(4)
The Incidence of Taxation on Return on Equity	165	(1)
Putting It All Together: The Structure of a Firm's Profitability	166	(2)
The Structure of Return on Equity Across Industries	168	(1)
Other Measures of Profitability	169	(1)
Earnings Per Share (EPS)	169	(1)
The Price-To-Earnings Ratio (P/E)	170	(1)
The Market-To-Book Ratio	170	(1)
Financial Leverage and Risk	170	(4)
How Does Financial Leverage Work?	172	(1)
Two Related Caveats: Risk and the Ability to Create Value	173	(1)
Self-Sustainable Growth	174	(4)
Summary	178	(13)
Appendix 5.1 Factors Affecting a Firm's Operating Profitability	181	(1)
Market Share	182	(1)
Perceived Product Quality	182	(1)
Asset and Cost Structures	183	(2)
Appendix 5.2 The Relationship Between a Firm's ROE and Its After--Tax ROIC	185	(1)
Appendix 5.3 Polo Ralph Lauren's Profitability	186	(1)
RL's Profitability Structure	186	(1)
The Effect of RL's Operating Profitability on Its Return on Equity	187	(3)
The Effect of RL's Financial Policy on Its Return on Equity	190	(1)
The Effect of Taxation on RL's Return on Equity	191	(1)
Further Reading	191	(1)
Self-Test Problems	192	(3)
Review Problems	195	(6)
PART III: INVESTMENT DECISIONS
Using the Net Present Value Rule to Make Value-Creating Investment Decisions	201	(40)
The Capital Investment Process	202	(2)
Would You Buy This Parcel of Land?	204	(2)
The Alternative Investment	204	(1)
The Opportunity Cost of Capital	205	(1)
The Net Present Value Rule	206	(8)
A One-Period Investment	206	(2)
A Two-Period Investment without an Intermediate Cash Flow	208	(1)
A Two-Period Investment with an Intermediate Cash Flow	209	(1)
Multiple-Period Investments	210	(2)
Applying the Net Present Value Rule to a Capital Investment Decision	212	(2)
Why the NPV Rule is a Good Investment Rule	214	(1)
A Measure of Value Creation	214	(9)
Adjustment for the Timing of the Project's Cash Flows	215	(3)
Adjustment for the Risk of the Project's Cash Flows	218	(2)
Additive Property	220	(3)
Special Cases of Capital Budgeting	223	(5)
Comparing Projects of Unequal Size	223	(2)
Comparing Projects with Unequal Life Spans	225	(3)
Limitations of the Net Present Value Criterion	228	(3)
Managerial or Real Options Embedded in Investment Projects	228	(2)
Dealing with Managerial Options	230	(1)
Summary	231	(5)
Appendix 6.1 Calculation of the Present Value of an Annuity and the Constant Annual-Equivalent Cash Flow of a Project's Cash-Flow Stream	233	(1)
Present Value of an N-Period Annuity	233	(2)
Present Value of an Infinite Annuity or Perpetuity	235	(1)
Constant Annual-Equivalent Cash Flow	235	(1)
Further Reading	236	(1)
Self-Test Problems	236	(2)
Review Problems	238	(3)
Alternatives to the Net Present Value Rule	241	(28)
The Payback Period	242	(5)
The Payback Period Rule	244	(2)
Why Do Managers Use the Payback Period Rule?	246	(1)
The Discounted Payback Period	247	(3)
The Discounted Payback Rule	248	(2)
The Discounted Payback Period Rule Versus the Ordinary Payback Period Rule	250	(1)
The Internal Rate of Return (IRR)	250	(7)
The IRR Rule	251	(3)
The IRR Rule May Be Unreliable	254	(2)
Why Do Managers Usually Prefer the IRR Rule to the NPV Rule?	256	(1)
The Profitability Index (PI)	257	(3)
The Profitability Index Rule	258	(2)
Use of the Profitability Index Rule	260	(1)
The Average Accounting Return	260	(2)
The Average Accounting Return Rule	261	(1)
Summary	262	(2)
Further Reading	264	(1)
Self-Test Problems	264	(1)
Review Problems	265	(4)
Identifying and Estimating a Project's Cash Flows	269	(152)
The Actual Cash-Flow Principle	269	(1)
The With/Without Principle	270	(2)
The Designer Desk Lamp Project	272	(3)
Identifying a Project's Relevant Cash Flows	275	(5)
Sunk Costs	275	(1)
Opportunity Costs	275	(1)
Costs Implied by Potential Sales Erosion	276	(1)
Allocated Costs	276	(1)
Depreciation Expenses	277	(1)
Tax Expenses	277	(1)
Financing Costs	278	(1)
Inflation	279	(1)
Estimating a Project's Relevant Cash Flows	280	(7)
Measuring the Cash Flows Generated by a Project	281	(1)
Estimating the Project's Initial Cash Outflow	282	(3)
Estimating the Project's Intermediate Cash Flows	285	(1)
Estimating the Project's Terminal Cash Flow	286	(1)
Should SMC Launch the New Product?	287	(127)
Sensitivity of the Project's NPV to Changes in the Lamp Price	288	(1)
Sensitivity of NPV to Sales Erosion	289	(125)
Summary	414	(1)
Further Reading	415	(1)
Self-Test Problems	416	(1)
Review Problems	417	(4)
PART V: BUSINESS DECISIONS
Valuing and Acquiring a Business	421	(50)
Alternative Valuation Methods	422	(2)
Valuing a Firm's Equity Using Comparables	424	(6)
Estimating the Comparable Value of OS Distributors' Equity	424	(5)
Factors that Determine Earnings and Cash-Flow Multiples	429	(1)
Valuing a Firm's Assets and Equity Using the Discounted Cash-Flow Approach	430	(5)
Estimating the DCF Value of a Firm's Assets	431	(3)
Estimating the DCF Value of a Firm's Equity	434	(1)
Estimating the DCF Value of OS Distributors' Assets and Equity	435	(7)
Step 1: Estimation of OS Distributors' Cash Flow From Assets	435	(4)
Step 2: Estimation of OS Distributors' Weighted Average Cost of Capital	439	(1)
Step 3: Estimation of the DCF Value of OS Distributors' Assets	440	(1)
Step 4: Estimation of the DCF Value of OS Distributors' Equity	441	(1)
Comparison of DCF Valuation and Valuation by Comparables	441	(1)
Estimating the Acquisition Value of OS Distributors	442	(9)
Identifying the Potential Sources of Value Creation in an Acquisition	442	(3)
Why Conglomerate Mergers are Unlikely to Create Lasting Value Through Acquisitions	445	(3)
The Acquisition Value of OS Distributors' Equity	448	(3)
Estimating the Leveraged Buyout Value of OS Distributors	451	(9)
Estimating the Leveraged Buyout Value of OS Distributors' Equity	453	(7)
Summary	460	(4)
Appendix 12.1 The Dividend Discount Model Approach to the Valuation of a Firm's Equity	463	(1)
Further Reading	464	(1)
Self-Test Problems	464	(2)
Review Problems	466	(5)
Making Value--Creating Decisions in an International Environment	471	(50)
The Firm's Risk Exposure from Foreign Operations	472	(3)
Accounting, or Translation, Exposure	472	(1)
Economic Exposure	473	(1)
Country, or Political, Risk	474	(1)
The Foreign Exchange Market	475	(2)
The Organization of the Foreign Exchange Market	475	(1)
Spot Transactions Versus Forward Contracts	476	(1)
Hedging Contractual Exposure to Currency Risk	477	(10)
Hedging with Forward Contracts	477	(3)
Hedging with Futures Contracts	480	(2)
Hedging with Option Contracts	482	(4)
Which Hedging Technique to Choose?	486	(1)
Hedging Long-Term Contractual Exposure to Currency Risk with SWAPs	487	(2)
The Relationships among Exchange Rates, Inflation Rates, and Interest Rates	489	(6)
Exchange Rates and Inflation Rates: The Purchasing Power Parity Relation	489	(2)
Inflation Rates and Interest Rates	491	(1)
Exchange Rates and Interest Rates: The Interest Rate Parity Relation	492	(1)
Forward Rates and Future Spot Rates	493	(1)
Putting It All Together	493	(2)
Analyzing an International Investment Project	495	(8)
The Net Present Value Rule: A Brief Review	495	(1)
Surf'n Zap Cross-Border Alternative Investment Projects	496	(7)
Managing Country Risk	503	(1)
Invest in Projects with Unique Features	503	(1)
Use Local Sourcing	503	(1)
Choose a Low-Risk Financial Strategy	503	(1)
Design a Remittance Strategy	504	(1)
Consider Buying Insurance against Political Risk	504	(1)
Summary	504	(3)
Appendix 13.1 Translating Financial Statements with the Monetary/Nonmonetary Method and the Current Method	507	(1)
The Monetary/Nonmonetary Method	507	(1)
The Current Method	508	(1)
Which Method is Better?	508	(7)
Appendix 13.2 The Parity Relations	511	(1)
The Law of One Price	511	(1)
The Purchasing Power Parity (PPP) Relation	511	(1)
The International Fisher Effect	512	(1)
The Interest Rate Parity Relation (IRP)	513	(2)
Further Reading	515	(1)
Self-Test Problems	516	(1)
Review Problems	517	(4)
Managing for Value Creation	521	(42)
Measuring Value Creation	522	(6)
Estimating Market Value Added	523	(2)
Interpreting Market Value Added	525	(2)
A Look at the Evidence	527	(1)
Identifying the Drivers of Value Creation	528	(6)
Linking Value Creation to Operating Profitability, the Cost of Capital, and Growth Opportunities	530	(2)
Linking Value Creation to Its Fundamental Determinants	532	(2)
Linking Operating Performance and Remuneration to Value Creation	534	(7)
Mr. Thomas Hires a General Manager	534	(2)
Has the General Manager Achieved His Objectives?	536	(2)
Economic Profits versus Accounting Profits	538	(2)
Designing Compensation Plans that Induce Managers to Behave Like Owners	540	(1)
Linking the Capital Budgeting Process to Value Creation	541	(3)
The Present Value of an Investment's Future EVAs Is Equal to Its MVA	541	(1)
Maximizing MVA Is the Same as Maximizing NPV	542	(2)
Putting It All Together: The Financial Strategy Matrix	544	(3)
The Business Is a Value Creator but Is Short of Cash	546	(1)
The Business Is a Value Creator with a Cash Surplus	546	(1)
The Business Is a Value Destroyer with a Cash Surplus	547	(1)
The Business Is a Value Destroyer that Is Short of Cash	547	(1)
Summary	547	(6)
Appendix 14.1 Adjusting Book Values to Estimate the Amount of Invested Equity Capital and Operating Profit	549	(1)
Adjusting the Book Value of Equity Capital	549	(2)
Adjusting Earnings before Interest and Tax (EBIT)	551	(1)
Appendix 14.2 Estimating Market Value Added (MVA) when Future Cash Flows Are Expected to Grow at a Constant Rate in Perpetuity	552	(1)
Further Reading	553	(1)
Self-Test Problems	554	(2)
Review Problems	556	(7)
Answers to Review Problems	563	(38)
Glossary	601	(22)
Index	623