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Introduction to Corporate Financial Analysis

Introduction to Corporate Financial Analysis


by George W. Blazenko All Rights Reserved 2008

Chapter 1

Introduction and Overview


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What we now call finance is, I hold, an intellectual perversion of what began as war love!" Robert Graves 1

1
Fro a s!ee"h delivered on #e"e ber $% 1&$' to the (ondon )"hool o* +"ono i"s% !,blished as -.a on/ in Mammon and the Black Goddess% 1&$0. Robert Graves 118&021&803 4as a British !oet and novelist.

Introduction to Corporate Financial Analysis

5ha!ter 6ne 5ontents


11.13 7 1!1!1 # 1!1!$ % 1!1!& ' 1!1!# ( 11.23 11.'3 8 8

1!&!1 ) 1!&!$ ) 1!&!& 11 1!&!# 1$ 1!&!% 1& 1!&!' 1# 11.73 17 1!#!1 1% 1!#!$ 1% 1!#!& 1' 1!#!# 1' 1!#!% 1( 1!#!' 1* 11.03 11.$3 1& 22

1!'!1 $$ 1!'!$ $% 11.83 11.83 28 '0 2 1!(!1 &+

Introduction to Corporate Financial Analysis


11.&3 11.103 11.113 11.123 '2 '' '8 77

'

Introduction to Corporate Financial Analysis

11.13
Finan"e is an a"ade i" and a !ro*essional dis"i!line devoted to the st,dy and !ra"ti"e o* aking -invest ents./ An invest ent is anything o4ned or "ontrolled and that has the !otential to in"rease *,t,re "ons, !tion at the e9!ense o* ",rrent "ons, !tion. :his de*inition highlights the *a"t that invest ents are not so ething that ,nderlies the "ons, !tion. ;* yo, ade si !ly *or the !,r!ose o* onetary gain. :here also ,st be onetary gain 1or loss3. :his so ething is the level o* yo,r

ake 4ise invest ent de"isions% then yo,% yo,r "lients% or the *inan"ial asset ade today is re"eived

holders o* yo,r *ir % 4ill en<oy greater *,t,re "ons, !tion. :his de*inition also highlights the inter2te !oral di ension o* all invest ents. :he bene*it o* an invest ent e9a !le3 or very long *or others 1govern ent bonds3. at so e *,t,re date. :he delay "an be very short *or so e invest ents 1s!e",lative trades% *or

1.1.1
We st,dy t4o !rin"i!al ty!es o* invest ents= real assets and *inan"ial assets. :he 4ord -asset/ is synony o,s 4ith -invest ent./ We de*ine the ad<e"tives -real/ and -*inan"ial/ in greater detail later in this "ha!ter. For the o ent% yo, "an think o* real assets as ->ro!erty% >lant% and on sto"k or bonds3. +?,i! ent/ and *inan"ial assets as !a!er assets 1like shares o* "o

:here are t4o general "lasses o* investors in o,r e"ono y= corporations are the !ri ary o4ners 1and o!erators3 o* real assets% and individuals are the !ri ary o4ners o* financial assets. 6* "o,rse% there are e9"e!tions to these general r,les. For e9a !le% yo, ight be the o4ner o* an a!art ent b,ilding. ;n addition% govern ents o4n and o!erate real assets. @evertheless% o4nershi! o* real assets by individ,als and govern ents is s all "o !ared to "or!orations. Finan"ial assets are held dire"tly by individ,als or in tr,st by !ension and invest ent !lans. 5or!orations and govern ents are also o4ners o* *inan"ial assets% b,t individ,als are the !ri ary o4ners o* *inan"ial assets.

A !rin"i!al the e o* this book is that no *ir "an o!erate inde!endently o* the in*l,en"e o* *inan"ial arkets. For e9a !le% 4e !resent eviden"e in a later "ha!ter that% given so e te"hnologi"al "hara"teristi"s o* the ind,stry in 4hi"h a *ir o!erates% !rod,"t !ri"ing is in*l,en"ed 7

Introduction to Corporate Financial Analysis


by the rate o* ret,rn re?,ired by the *inan"ial asset holders o* a *ir . :his rate o* ret,rn is in*l,en"ed by the alternative *inan"ial asset invest ents that are available in *inan"ial arkets. :he t4o sides o* a "or!oration A the o!erating side and *inan"ial side A are ine9tri"ably intert4ined% tr,ly -t4o sides o* the "oin./

Fir s raise *,nds by selling *inan"ial assets. :hey then invest these *,nds in real o!erating assets. Be"a,se *inan"ial asset2holders re?,ire rates o* ret,rn that "o !ensate the *or the risk they bear% *ir s ,st earn "o ens,rate rates o* ret,rn *ro their o!erating invest ents. +arnings *ro ake !ay ents to *inan"ial asset2holders. ),"h !ay ents !rovide a real assets allo4 a *ir to

ret,rn on invested "a!ital. :his relation bet4een *ir sB o!erating a"tivity and *inan"ial a"tivity deter ines the *lo4 o* invest ent *,nds thro,gho,t the e"ono y. ;n 4ell2*,n"tioning *inan"ial arkets% invest ent dollars *lo4 to those b,sinesses 4hi"h earn the highest ret,rn on their b,siness invest ents and "an o**er investors the ost attra"tive rates o* ret,rn on their *inan"ial eas,re the invest ents 1relative to the risk they bear3. :he !,r!ose o* *inan"ial analysis is to o!erating !er*or an"e o* *ir s *ro this !ers!e"tive.

1.1.2
A *inan"ial analyst ,st "onsider *o,r !rin"i!al ?,estions *or any invest ent. :he *o",s o* ea"h ade in the !ast 1retros!e"tive investigation3 or ?,estion de!ends on 4hether the invest ent 4as s, arizes the *irst three o* these ?,estions=

4hether the invest ent is ,nder "onsideration 1a !ros!e"tive investigation3. :he *ollo4ing e9hibit

,etrospective Analysis

-rospective Analysis

.hree principal /uestions apply to any invest ent0 113 123 1'3 What e9!endit,re 4as adeC 113 What e9!endit,re is re?,iredC 123 What rate o* ret,rn is e!pectedC 1'3 What is the invest ent riskC

What ret,rn 4as reali edC What 4as the invest ent riskC

12hibit 1310 Funda ental 4uestions of Financial Analysis 0

Introduction to Corporate Financial Analysis


For any invest ents% the *irst ?,estion is ans4ered easily. For e9a !le% yo,r sto"kbroker "an on sto"k. :he val,e o* *inan"ial

tell yo, e9a"tly the !ri"e to !ay to b,y !,bli"ly traded "o

assets is o*ten easily deter ined be"a,se *inan"ial assets o*ten trade in organized !,bli" *inan"ial arkets% 4here !ri"es are readily observed. 6n the other hand% b,siness invest ent e9!endit,res are generally not so easy to deter ine. First% real assets do not ,s,ally trade in organized *a"ilities are o*ten s,b<e"t to variation and ,n"ertainty. :o hel! ,s ans4er this e9!endit,re ?,estion% 4e begin the !ro"ess by 4hi"h yo, "an val,e entire *ir s 4ith the notion o* invested capital in the *ollo4ing "ha!ter. arkets that allo4 their val,es to be observed. )e"ond% develo! ent and "onstr,"tion "osts *or b,siness

As to the se"ond ?,estion% the e9!e"ted ret,rn is obvio,s *or so e invest ents. For e9a !le% the e9!e"ted rate o* ret,rn on a bond "an be deter ined% at least to a *irst a!!ro9i ation% *ro the *inan"ial se"tion o* yo,r daily ne4s!a!er or *ro any "o only available internet 4ebsites. 6n on share or on a real asset invest ent% ake and are s,b<e"t to the other hand% to esti ate the e9!e"ted ret,rn on a "o

re?,ires !ro<e"tions o* *,t,re o!erating !er*or an"e and !redi"tions abo,t the e"ono i" environ ent. @eedless to say% s,"h esti ates "an be di**i",lt to "onsiderable ,n"ertainty.

We "an

ake one si !le general state ent *or the third ?,estion o* *inan"ial analysis= to eval,ate eas,re be"a,se

the risk o* any invest ent is a di**i",lt !ro!osition. ;nvest ent risk is di**i",lt to learn to "hara"terize% identi*y% and

4e o!erate in ,n"ertain b,siness environ ents. @onetheless% it is essential that b,siness analysts eas,re all sorts o* b,siness risks. :he notion o* invest ent risk is a "entral the e in any st,dy o* *inan"e.

1.1.'
:here are a n, ber o* general 4ays in 4hi"h yo, invest ent ight think abo,t risk. First% yo, ight think o* risk as being the variability o* !otential ret,rns on an invest ent. For an individ,al% this ight be a !ort*olio o* real and *inan"ial assets. An interesting ?,estion is 4hether an in"re ental invest ent in"reases or de"reases the risk o* the overall !ort*olio. A risky *inan"ial

Introduction to Corporate Financial Analysis


asset "an be de*ined as one that in"reases the overall risk o* yo,r !ort*olio. We 4ill st,dy this ?,estion% and portfolio 6n the other hand% yo, eas,res o* risk% in so e detail in another "ha!ter o* this book. ight think o* risk as being a statisti"al eas,re that identi*ies invest ents ight ,se the -standard deviation/ or

having greater or lesser ret,rn variability. For e9a !le% yo, the ran"e o* !otential ret,rns as a risk eas,re. Finally% yo, holders are ight *o",s on the "hara"teristi"s o* *ir s that

ake their *inan"ial assets

ore risky

or less risky. Fir s having "hara"teristi"s that lead to greater ret,rn variability *or *inan"ial asset2 ore -risky/ *ir s. ;n a later "ha!ter o* this ele"troni" book 4e e9a ine *ir "hara"teristi"s that lead to greater risk *or *inan"ial asset2holders.

1.1.7
-;s this a good invest ent%/ or% e?,ivalently% -4as this a good invest ent%/ is the *o,rth ?,estion o* *inan"ial analysis. Whether an invest ent is good or not re?,ires having a goal in ind. :hat goal is at the heart o* this *irst "ha!ter on "or!orate *inan"ial analysis. F,rther% it is at the heart o* yo,r develo!ing 4orld vie4 as a b,siness !erson. 6n"e 4e !res, e and <,sti*y a goal *or *inan"ial analysis in this "ha!ter% in the re ainder o* this book 4e add the details o* *inan"ial analysis.

11.23
Finan"ial analysis is the !ro"ess o* asking and ans4er the *o,r *,nda ental ?,estions re?,ired o* any invest ent= e9!endit,re% risk% ret,rn% and -is this a -good/ invest entC/ ;n this book% yo, 4ill be "ast into the role o* a b,dding *inan"ial analyst and yo,r role 4ill be to learn ho4 to ask and ans4er these *o,r ?,estions. Finan"ial analysis is the eval,ation o* the *inan"ial *eat,res o* a *ir . Finan"ial *eat,res are those "hara"teristi"s o* a *ir that have an in*l,en"e on its financial assets. :here are t4o ain ,ses o* *inan"ial analysis. :he *irst ,se is internal to the *ir and the se"ond is e9ternal. First% *ir s ,se *inan"ial analysis either to identi*y areas o* i !rove ent *or e9isting o!erations or to establish val,es *or !,r"hase or sale o* o!erating assets. :hese ,ses are related to b,siness a"tivity% and 8

Introduction to Corporate Financial Analysis


there*ore% *inan"ial analysis is an inval,able tool in o!erational and strategi" !lanning. )e"ond% investors ,se *inan"ial analysis to eval,ate the *inan"ial assets *or !ossible !ort*olio in"l,sion. ;n this regard% *or e9a !le% shareholders "onsider the dividend and "a!ital gains !otential o* a *ir 4hile "reditors seek to establish a *ir sD ability to re!ay indebtedness.

Both the internal and e9ternal ,ses o* *inan"ial analysis are related to invest ent !lanning. :he internal ,se g,ides *ir s in o!erations 4hile the e9ternal ,se aids investors in !ort*olio "hoi"e.

Be"a,se *inan"ial analysis is si ilar *or *ir s in o!erations !lanning and investors in !ort*olio de"isions% 4e intend this book *or both internal and e9ternal *inan"ial analysts andEor their advisors. :hese ,ses o* *inan"ial analysis are related to one another be"a,se the attrib,tes and !oli"ies o* a *ir that dis"o,rage investors are the sa e *a"tors% 4hi"h% i* i !roved ,!on% "reate 4ealth and val,e *or all o* the *inan"ial asset2holders.

:he *o",s o* this book is on 4idely held !,bli" *ir s rather than "losely held !rivate *ir s altho,gh ost o* the "on"e!ts a!!ly e?,ally 4ell. :here are t4o reasons *or this *o",s. First% *inan"ial analysis "annot be ,ndertaken by e9ternal analysts *or !rivate "or!orations be"a,se o* a la"k o* in*or ation% 1altho,gh% *inan"ial analysis is nonetheless ,se*,l *or internal analysts o* !rivate "or!orations3. )e"ond% a a<or distin"tion bet4een s aller !rivate *ir s and larger !,bli" *ir s is the i !ortan"e o* risk. .odern !,bli" "or!orations are e9tre ely e**i"ient vehi"les *or sharing risk a ong shareholders% and there*ore% it is o*ten the "ase that "or!orate !oli"y !res"ri!tions based on risk are less relevant *or large !,bli" "or!orations.

11.'3
Finan"ial analysis "an be ,sed by internal analysts *or o!erations and strategi" !lanning or by investors *or !ort*olio sele"tion. :he *irst ,se is related to real invest ent and the se"ond is related to *inan"ial invest ent. For "or!orations% real and *inan"ial assets are ine9tri"ably related% and there*ore% this book investigates both= invest ent by *ir s in real assets and invest ent by investors in *inan"ial assets. ;nternal analysts are !ri arily interested in o!erations and strategi" !lanning% 4hile e9ternal analysts are interested in *inan"ial assets. As a *o,ndation *or later 8

Introduction to Corporate Financial Analysis


analysis% the ter s asset% real asset% and financial asset are de*ined and dis",ssed in this s,b2 se"tion.

1.'.1
An asset is anything 4hi"h is o4ned or "ontrolled and has !otential to in"rease *,t,re "ons, !tion. :his in"rease "an arise *ro in"o e generated by the asset or *ro "a!ital gains that arise 4hen the asset is sold. )o e assets A like s!e",lative holding o* gold A generate only "a!ital gains% 4hile other assets Alike bonds A earn the largest !art o* their ret,rn in the *or o* !eriodi" in"o e.

:here are t4o general "ategories o* assets% real and *inan"ial assets.

1.'.2
:4o "hara"teristi"s de*ine a real asset. First% a real asset is not established by legal "ontra"t bet4een specific individ,als and% se"ond% it ,st be anaged to !rod,"e a ret,rn. An i !li"ation o* these "hara"teristi"s is that% *or a real asset% there are no "ontra"t,ally !ro ised !ay ents bet4een s!e"i*i" individ,als. A *a"tory is an e9a !le o* a real asset. :he *a"tory is o4ned by be"a,se o* the rights o* !rivate !ro!erty in o,r so"iety% it is not "reated by a legal "ontra"t bet4een s!e"i*i" individ,als. @o !ro*its are !ro ised to the o4ner% either by "ontra"t,al g,arantee or as a "ontingent o,t"o e. :he *irst de*ining "hara"teristi" o* a real asset is abo,t ho4 it "a e into being. :he *a"tory did not "o e into being as the res,lt o* a "ontra"t bet4een individ,als. ;t "a e into being be"a,se so eone invented the idea *or it% so eone engineered it% so eone designed it% and so eone "onstr,"ted it. @oti"e that there ight be legal "onta"ts that as ight asso"iated 4ith a real asset b,t that did not "a,se it to "o e into being. For e9a !le% there be a lease "ontra"t that allo4s an individ,al to ,se a *a"tory. Fo4ever% this "ontra"t did not "a,se the *a"tory to "o e into being in the *irst instan"e. Finally% be"a,se the *a"tory ,st be o!erated to !rod,"e a ret,rn% it satis*ies o,r de*inition o* a real asset.

&

Introduction to Corporate Financial Analysis


Real assets share so e other "o real assets are held *or the long ter on "hara"teristi"s. First% real assets are an i !ortant ost real assets are tangible% and last% any 1they !rod,"e a ret,rn over any years3. @ot all real assets

"o !onent o* the b,siness a"tivities o* *ir s. )e"ond%

are tangible. A !atented idea is an e9a !le o* an intan"ible real asset. A !atent is not "reated by a "ontra"t bet4een s!e"i*i" individ,als 1altho,gh a so"ial "ontra"t establishes the e9isten"e o* !atents and the rights o* !atent holders3. :he idea that ,nderlies the !atent is the real asset. ;t 4as not "reated as a legal "ontra"t bet4een individ,als. Rather% it 4as "reated by so eoneBs intelligen"e% "reativity% innovation% skill% dedi"ation and hard 4ork. F,rther% there is no ret,rn on the !atent i* it is le*t idle 1i.e.% it is not o!erated3. An idea is o* no val,e ,nless so eone ,ses it. @oti"e that that this o!eration need not be by yo,. For e9a !le% yo, idea% b,t yo, li"ense the right to ,se that idea to others *or a *ee. ight hold a !atent on an

5onsider a third e9a !le% s!e",lative holding o* gold. ;s gold a real asset or is gold a *inan"ial assetC @o "ontra"t bet4een individ,als establishes the e9isten"e o* gold. 64nershi! arises *ro the right o* !rivate !ro!erty and there are no !ro ised *,t,re "ontra"t,al !ay ents. For these reasons% an investor 4ith a s!e",lative holding o* gold o4ns a real asset. Fo4ever% it is ,ndeniable that this invest ent has *eat,res si ilar to a *inan"ial asset. 6ther than storage and sa*eg,arding% an invest ent in gold re?,ires no o!eration. :he s!e",lator b,ys the gold 4ith the belie* that its !ri"e 4ill rise in the near *,t,re. Gold "ost. :here*ore% *or ay be bo,ght or sold any day at ini al any investors% s!e",lative !,r"hase o* gold is e?,ivalent to a *inan"ial

invest ent. Gold has both *eat,res o* a real asset and *eat,res o* a *inan"ial asset. :h,s% s!e",lative holding o* gold is an e9a !le o* assets that are hard to "lassi*y. 6""asionally it is a atter o* inter!retation as to 4hether an asset is real or *inan"ial.

10

Introduction to Corporate Financial Analysis

1.'.'
A *inan"ial asset is a legal "ontra"t bet4een t4o s!e"i*i" individ,als 4hereby at least one !arty 2 and ost "o only only one !arty 2 !ro ises to ake *,t,re !ay ents to the other !arty. @at,rally% one !arty !ro ises to ake *,t,res !ay ents only in e9"hange *or e?,ivalent ake *,t,re !ay ents is "alled the seller% the

"onsideration% s,"h as a l, ! s, "ash !ay ent 4hen the "ontra"t is "reated. :he !erson 1!ossibly a "or!orate !erson3 4ho !ro ises to iss,er% or the 4riter o* the *inan"ial asset. :he individ,al 4ho is !ro ised the *,t,re !ay ents is "alled the b,yer% the holder% or the o4ner o* the *inan"ial asset. :he holder o* a *inan"ial asset is also "alled the investor. For ore s!e",lative *inan"ial assets% the iss,er o* the *inan"ial asset is anaging a b,siness and 4itho,t "reation or said to have a short !osition 4hile the holder o* the *inan"ial asset is said to have a long !osition. :he o4ner o* a *inan"ial asset earns a ret,rn 4itho,t trans*or ation o* !hysi"al goods.

5onsider a ho e

ortgage as an e9a !le o* a *inan"ial asset. :he borro4er !ro ises e?,al ortgage in e9"hange *or a l, !2s, !ay ent 4hen the ortgage

!ay ents d,ring the li*e o* the

is initiated. >ay ent every onth is "ontingent ,!on the borro4erDs "ontin,ed ability to !ay and ,!on% !erha!s% the level o* interest rates in the e"ono y. @o dire"t a"tivity is ty!i"ally re?,ired o* the lender to re"eive !ay ent. :he ortgage "ontra"t s!e"i*ies the obligations o* the borro4er and the re edies available to the lender sho,ld the borro4er de*a,lt. :he borro4er is the seller o* the *inan"ial asset and the lender is the b,yer. :he sale !ri"e is the a o,nt borro4ed.

)hares o* "o

on sto"k are another e9a !le o* a *inan"ial asset. :he seller o* this *inan"ial asset ight be reg,lar ?,arterly dividends% s!e"ial dividends% or they

is a "or!oration and the o4ner is a shareholder. :he !ro ised !ay ents *ro the "or!oration to shareholders are dividends. :hese ight even be li?,idating dividends. An i !li"ation o* the observation that the only thing o* val,e re"eived by shareholders *ro a "or!oration is dividends% is that the ,lti ate source o* val,e *or "o on shares is dividends 1or at least the !otential *or a *ir to !ay dividends3. :he "ontingen"y in the !ay ent o* dividends is de"laration by the board o* dire"tors. Based on their b,siness <,dg ent% the board o* dire"tors "an initiate% in"rease% de"rease% or eli inate% dividends. :he direct link bet4een shareholders and the *ir is de"lared o* dividends% b,t o* "o,rse the 11

Introduction to Corporate Financial Analysis


ability o* a *ir to !ay dividends de!ends ,!on its earnings ability. +arnings are% there*ore% the indirect "ontingen"y *or dividends.

A third e9a !le o* a *inan"ial asset is the a""o,nts re"eivable o* a *ir . ;n e9"hange *or goods or servi"es 1rather than "ash3% ",sto ers !ro ise to s"hed,le set by the *ir . )o e s,"h "ontra"ts are ake !ay ents in the *,t,re a""ording to a ore e9!li"it or so e are less e9!li"it% b,t

nonetheless% there e9ists a "ontra"t bet4een t4o s!e"i*i" legal !ersons 1the ",sto er and the *ir 3. :he !ro ised *,t,re !ay ent is the a o,nt o4ing *or goods or servi"es re"eived. >ay ent is "ontingent on a "hoi"e by the ",sto er not to de*a,lt. :he !,r"hase !ri"e o* the *inan"ial asset is the val,e o* the goods or servi"es sold to the ",sto er.

1.'.7
Another de*ining "hara"teristi" o* *inan"ial assets is that a*ter the original iss,er sells the % they are trans*erable by the holder to a third !arty% at least in !rin"i!le. ;* the original *inan"ial asset 4as designed by the iss,er to be trans*erable and i* it ",rrently trades a ong investors% it is "alled a !,bli" *inan"ial asset or a se",rity. :he ter tradability akes by the o4ner. security re*le"ts the *a"t that li?,idity arising *ro any !,bli" *inan"ial assets e9"ellent "ollateral *or other borro4ing ,ndertaken

:he sale o* se",rities by "or!orations 1or other iss,ers3 to general investors is s,b<e"t to govern ent reg,lation in the <,risdi"tion in 4hi"h the sale is ade. :he sale o* !rivate *inan"ial assets is a negotiated agree ent bet4een !rivate individ,als and is not s,b<e"t to e9tensive govern ent reg,lation.

5o

on shares and "or!orate bonds% 4hi"h trade in organized

arkets% are e9a !les o* !,bli"

*inan"ial assets. ;n the "ase o* "o

on shares% the in"or!oration !ro"ed,re o* the *ir as a ne4ly on shares as *inan"ial assets o* the *ir . :he on

"reated legal entity "an be inter!reted as the negotiated "ontra"t bet4een shareholders and the *ir . ;n"or!oration "reates both the *ir and "o in"or!oration do", ents and byla4s are the "ontra"t that establishes the e9isten"e o* a "o share. 6n the other hand% the "ontra"t that "reates a bond is "alled the indenture agree ent. 12

Introduction to Corporate Financial Analysis


Both the in"or!oration do", ents o* a *ir and the bond indent,re agree ent are 4ritten in ter s o* generi" investors= "o on shareholders or bondholders res!e"tively. :he identity o* the a"t,al o4ners o* these *inan"ial assets is not "ontra"t,ally stated. :his la"k o* identi*i"ation *a"ilitates trans*erability o* these *inan"ial assets a ongst investors.

A *inan"ial asset that is not designed to be trans*erable or is ",rrently not trading is re*erred to as a !rivate *inan"ial asset. >rivate *inan"ial assets arise in !rivately negotiated "ontra"ts bet4een iss,ers and holders. At the ti e o* in"or!oration% "o At so e ti e in the *,t,re% the original o4ners on shares o* a *ir are trans*erable b,t !rivate *inan"ial assets. ;n other 4ords% they have the !otential to be"o e !,bli" *inan"ial assets. ight sell the shares to general investors. At this ti e% the shares o* sto"k be"o e !,bli" *inan"ial assets. Fir s that have none o* their *inan"ial assets traded in !,bli" *inan"ial arkets 1a""essible by general investors3 are "alled !rivate "or!orations. ;n a !rivate "o !any% the right to trans*er shares is o*ten restri"ted in so e anner. For e9a !le% a sale o* shares to -o,tsiders/ dire"tors% or the e9isting shareholders restri"tions do not "o ight re?,ire the a!!roval o* the board o* ight have the right o* *irst re*,sal in the sale. ),"h

only e9ist *or a !,bli" "or!oration.

>rivate *inan"ial assets are "reated by a negotiated "ontra"t that identi*ies both the iss,er and o4ner. :his *eat,re !re"l,des trans*erability 1,nless this *eat,re is in"l,ded as a "ontra"t ter 3 or dire"t sale to a third !arty. 5o er"ial loans are an e9a !le o* this ty!e o* *inan"ial asset.

1.'.0
When a *inan"ial asset is "reated 1or in *a"t destroyed3% the e9"hange bet4een the iss,er and the b,yer is "alled a !ri ary arket trade. An e9a !le o* a !ri ary arket trade is the sale o* ne4 shares by Bo bardier (td. to any investor 4ho 4ants to b,y at a s!e"i*ied !ri"e. :he de*ining "hara"teristi"s o* a !ri ary arket trade are that the original iss,er o* the *inan"ial asset is a dire"t !arty to the transa"tion and that a ne4 set o* !ro ised !ay ents is "reated 1or destroyed3. 6n the other hand% 4hen an e9isting *inan"ial asset is traded bet4een investors% the transa"tion is "alled a se"ondary arket trade. @oti"e that the original iss,er 1Bo bardier% *or e9a !le3 is not

1'

Introduction to Corporate Financial Analysis


a dire"t !arty to this trade. )to"k and bond e9"hanges A like the @e4 Gork )to"k +9"hange% 4here both sto"ks and bonds are traded A is an e9a !le o* a se"ondary arket.

1.'.$
:he distin"tion bet4een !rivate and !,bli" *inan"ial assets is be"o ing di**i",lt to 5onsider the ortgage arket as an e9a !le. ;n a ho e aintain in ortgagor ",rrent *inan"ial arkets. :he reason *or this di**i",lty is a !ro"ess kno4n as se",ritization. ortgage% the borro4er 2 the 2 has sold a *inan"ial asset to the lender 2 the ortgagee. Beginning in the early 1&80s% lenders ortgage

have *or ed !ools o* si ilar ortgages and have sold rights to re"eive !ortions o* ;n e9"hange *or a *ee% the original lender si !ly !asses

!ay ents re"eived in these !ools to investors in deno inations a""essible even to s all investors. ortgage !ay ents to holders o* the ne4 se",rities. :hese se",rities% "alled ortgage2ba"ked se",rities% are designed to be tradable a ong investors. )e",ritization has the e**e"t o* trans*or ing !revio,sly !rivate *inan"ial assets into !,bli"ly tradable *inan"ial assets. :he original ortgagee has e**e"tively sold a set o* !rivate *inan"ial assets. )e",ritization has o"",rred in s,"h diverse arkets as "o er"ial bank loans% a,to obile loans% loans to less develo!ed "o,ntries% and "or!orate a""o,nts re"eivable. :he *,nda ental val,e o* the se",ritization !ro"ess is that it *a"ilitates the *lo4 o* *,nds to se"tors o* the e"ono y that are other4ise di**i",lt to *inan"e. For e9a !le% even tho,gh yo, kno4 it% yo,r ability to borro4 to b,y yo,r ne4 "ondo ight not ight de!end ,!on the e9isten"e o*

ortgage ba"ked se",rities and the se",ritization !ro"ess. Witho,t this !ro"ess% alternatively% banks ight not be 4illing to lend to yo,. ;n addition% s aller investors have a""ess to a variety o* ne4 *inan"ial arkets and *inan"ial assets that 4ere not !revio,sly a""essible. We all bene*it *ro innovation in *inan"ial arkets.

11.73
Finan"ial analysis di**ers de!ending ,!on 4hether it is ,ndertaken internally or e9ternally be"a,se o* a""ess to "or!orate in*or ation. Generally% internal analysts have better a""ess to *ir 2s!e"i*i" in*or ation. 5or!orate o**i"ers A like the "hie* *inan"ial o**i"er A ill,strates that the nat,re o* the "or!orate organizational *or 17 ake "or!orate in*or ation available to internal analysts% in*or ation that is generally not available to investors. :his *a"t "an i !ede *inan"ial analysis.

Introduction to Corporate Financial Analysis


Be"a,se o* this relation% this se"tion o,tlines the a<or attrib,tes o* the "or!orate organizational

*or and the e**e"ts these attrib,tes have on *inan"ial analysis.

1.7.1
:he "or!oration is the ost !ro inent organizational *or o* b,siness a"tivity in de o"rati" "o,ntries. By any eas,re o* a"tivity% *or e9a !le sales or asset size% "or!orations s,r!ass by a 4ide argin the !ri ary non2govern ent alternatives= sole !ro!rietorshi!s and !artnershi!s. :he !rin"i!al advantage o* the "or!oration 2 to 4hi"h all other advantages are related 2 is its legal identity.

5or!orations are legal !ersons in the eyes o* the la4H they have the sa e rights and the sa e d,ties as nat,ral !ersons. Fir s "an be s,ed *or 4rongdoing and da age se!arately *ro the *inan"ial asset2holders o* the *ir and other asso"iated gro,!s 1*or e9a !le= shareholders% bondholders% e !loyees% and anage ent3. #imited liability arises *ro the legal identity o* a "or!oration. ;* a "or!oration de*a,lts on "ontra"t,al obligations 2 4ith e9"e!tions 4hi"h are *e4 and o* ar"ane legal "hara"ter 2 da aged !arties i !lies that the "o ,st seek re edy 4ith the "or!oration itsel* and on shareholders. :his *a"t not 4ith *inan"ial asset2holders% in"l,ding and in !arti",lar% "o on share. :his *eat,re o* "o

a9i , loss a shareholder "an s,stain is hisEher original invest ent in a on share o4nershi! is attra"tive to investors and *a"ilitates on shares b,t also the sale o* additional shares by

not only tradability o* e9isting "o

"or!orations *or the !,r!ose o* *inan"ing b,siness a"tivity. @ote% ho4ever% that li ited liability is not an attra"tive *eat,re o* "or!orations to "reditors% and there*ore% li ited liability ight si !ly *avor one ty!e o* *inan"ing A e?,ity *inan"ing A over another A debt *inan"ing. :here is no inherent reason to believe that li ited liability in"reases overall *inan"ing in o,r e"ono y.

1.7.2
:he se!arate legal identity o* "or!orations !er its and *a"ilitates distin"t legislative treat ent o* "or!orations *ro nat,ral !ersons. An e9a !le o* this distin"tive treat ent arises in ta9ation. 5or!orate and !ersonal ta9able in"o es are "al",lated di**erently and di**erent rates are a!!lied in 10

Introduction to Corporate Financial Analysis


deter ining ta9es !ayable. :a9ation is an ines"a!able *a"t that di**erent "ha!ter in this ele"troni" book. ,st be re!resented in any

"o !lete *inan"ial analysis *or either individ,als or "or!orations. :a9ation is the s,b<e"t o* a

1.7.'
While li ited liability and ta9 advantages "ontrib,te to the !o!,larity o* the "or!orate *or % its !ri ary advantage is se!aration o* o4nershi! and "ontrol. .odern 4idely held "or!orations "o,ld not have evolved i* it 4ere ne"essary *or all "or!orate b,siness de"isions to be agreed ,!on by all shareholders or even a a<ority o* shareholders. :his re?,ire ent 4o,ld not only i !ede "or!orate de"ision2 aking% b,t 4o,ld also reveal to "o !etitors ele ents o* strategi" advantage.

:hro,gh the a,thority o* legislated "or!orations a"ts% shareholders o*

odern "or!orations have anaging the

delegated the dire"tion o* "or!orate a**airs to boards o* dire"tors 4ho are s all gro,!s o* individ,als ele"ted by shareholders and 4ho are "harged 4ith the res!onsibility *or ,nless arti"les o* in"or!oration s!e"i*i"ally re?,ire it. ;n ost "ases% ho4ever% b,siness and a**airs o* the "or!oration. A dire"tor is not re?,ired to o4n shares in a "or!oration e bers o* the board are shareholders% and o*ten !rin"i!al shareholders% o* the *ir . ;n larger *ir s% the board o* dire"tors delegates o!erational de"ision aking to !ro*essional anagers 1the "hie* e9e",tive o**i"er and other senior initiatives and anagers are "o only board e bers the selves3. )trategi" !oli"y a<or *,n"tions o* -the Board./ onitoring o* anagerial !er*or an"e re ain the

;t sho,ld be noted that 4hile shareholders ele"t boards o* dire"tors% legislated "or!orations a"ts de*ine and "o,rts have inter!reted the d,ties and obligations o* dire"tors to be the !ro otion o* the interests o* the *ir as a 4hole rather than the interests o* "o on shareholders s!e"i*i"ally. An analogo,s sit,ation e9ists in re!resentative de o"ra"ies. While lo"al area "onstit,ents vote a re!resentative to a national legislat,re% this re!resentative is o*ten regarded as a servant o* the nation rather than hisEher "onstit,ents s!e"i*i"ally.

1.7.7
:he "or!orate *or o* b,siness organization has advantages A !ri arily that *ir s "an "on"entrate on b,siness a"tivity rather than oderating and re"on"iling "o !eting and divergent vie4s o* 1$

Introduction to Corporate Financial Analysis


individ,al shareholders A b,t it also has disadvantages. :he !ri ary disadvantage to shareholders A es!e"ially shareholders o* 4idely held "or!orations A is that they are distan"ed *ro o!erational "ontrol and in*l,en"e over b,siness a"tivity. ;* shareholders are ,nsatis*ied 4ith *ir !er*or an"e% it is o*ten the "ase that their only re"o,rse is to sell their shares. :his distan"ing o* shareholders *ro o!erations also distan"es shareholders *ro to "or!orate in*or ation. Be"a,se shareholders are not !arty to "or!orate de"isions% generally they are not !arty to in*or ation ,sed ake s,"h de"isions. :his distan"ing res,lts *ro the legal identity o* "or!orations. Be"a,se *ir s are legal individ,als% they have the right o* !riva"y Aeven *ro shareholders 4ho are ostensibly the o4ners. :he !ri ary so,r"e o* in*or ation abo,t de"isions ade by !,bli" *ir s is its *inan"ial state ents% 4hi"h are available to any investor or other interested individ,al. Finan"ial state ent data are s, ary and aggregate eas,res o* "or!orate a"tivity% 4hi"h la"k the detail and "o !rehensiveness o* in*or ation available to internal analysts. For e9ternal analysts% a""o,nting *inan"ial data is o*ten the !ri ary so,r"e o* *ir 2s!e"i*i" in*or ation.

1.7.0
A se"ond disadvantage o* the "or!orate organization *or is that 4ith distan"ing o* shareholders *ro o!erations% the !ossibility arises that anagers be"o e entren"hed and !,rs,e "or!orate !oli"ies that serve their o4n interests rather than the interests o* shareholders. ;n 4idely held "or!orations% voting !o4er be"o es dis!ersed and o*ten no one shareholder has s,**i"ient in*l,en"e to dis"i!line anagers. ;n this environ ent% it "an be arg,ed that their o4n ai s 4ith i !,nity. anagers "an !,rs,e

Fo4ever% in "or!orations% real assets and their to tie the interests o* !lans are "o

anage ent are ine9tri"ably related to *inan"ial

assets. :he sa e e?,ity arket that dis!erses o4nershi! "an also be ,sed by boards o* dire"tors anage ent and shareholders to one another. .anagerial "o !ensation only designed so a large !ortion o* re ,neration is in the *or o* bon,ses% sto"k anagers !ros!er. +?,ity arkets ergers% and

o!tions% or e?,ity o4nershi!% 4hi"h are dire"tly related to !er*or an"e o* the *ir vis2I2vis shareholders. When the *ir !ros!ers both shareholders and a"?,isitions. 18 also !rovide a vehi"le *or re!la"e ent o* ine**e"tive anage ent thro,gh takeovers%

Introduction to Corporate Financial Analysis


:he arg, ent that both *inan"ial arkets and anagerial labor arkets align the interests o*

anagers and shareholders is develo!ed in the e bedded arti"le by Gary Be"ker% entitled -Why .anagers Fave the )hareholder at Feart%/ 4hi"h a!!eared in a 1&80 iss,e o* Business $eek. >,blisher= ."Gra42Fill ;n". A,thor= Gary Be"ker. :his aterial has been "o!ied ,nder li"ense *ro 5A@56>G. Resale or *,rther "o!ying o* this aterial is stri"tly !rohibited.

Gary Becker

1.7.$
:he interests o* anagers and shareholders ight be aligned% b,t 4hat abo,t the other stakeholders in a *ir = 4hat abo,t e !loyeesC )o"ial a"tivists o*ten arg,e that "or!orate interests are "ontrary to the interests o* 4orkers and e !loyees% and that shareholders and "or!orations enri"h the selves at the e9!ense o* their e !loyees. :he a,thor o* the e bedded arti"le belo4% 4hi"h a!!eared in the .ay 1&&7 iss,e o* 5anadian B,siness% arg,es that the interests o* "or!orations and e !loyees are% in *a"t% s,r!risingly "ongr,ent. 5li"k on the i"on to read -:he Botto (ine is Jobs and Ki"e Kersa%/ by George Kasi".

>,blisher= 5anadian B,siness .edia (i ited. A,thor= George Kasi". :his aterial has been "o!ied ,nder li"ense *ro 5A@56>G. Resale or *,rther "o!ying o* this aterial is stri"tly !rohibited.

George Vasic

18

Introduction to Corporate Financial Analysis

11.03
:he 5anadian B,siness 5or!orations A"t des"ribes the d,ties and obligations o* dire"tors as - anaging the b,siness and a**airs o* the "or!oration./ While this !res"ri!tion is rather vag,e% it is o*ten inter!reted to ob<e"tive o* ean the a9i ization o* shareholdersD 4ealth.2 Wealth is the a o,nt a9i ization o* the current sale !ri"e o* a a9i ization o* current share !ri"e *or re"eivable ,!on a"t,al or hy!otheti"al sale o* an asset. :here*ore% an inter!retation o* the anagers in o!erating a b,siness is the *ir ,!on hy!otheti"al sale 1*or a !rivate "or!oration3 or a !,bli" "or!oration. Why sho,ld this ob<e"tive *o",s on shareholdersC :here are any other gro,!s that have an

interest in the o!eration o* a b,siness= ",sto ers% s,!!liers% "reditors% e !loyees% govern ents% non2govern ental agen"ies% and so"iety at large. #es!ite the *a"t that the a,thor o* the above e bedded arti"le arg,es that the interests o* shareholders and these gro,!s are "ongr,ent% nonetheless% 4e !res, e that the !ri ary ob<e"tive o* the a little anagers in o!erating a b,siness is to a9i ize shareholdersB 4ealth. Why shareholdersC What is s!e"ial abo,t shareholders that gives ore !o4er "o !ared to the other interest gro,!s in a "or!orationC :he ans4er is ight so eti es be di**i",lt% i* shareholders donBt like ho4 a b,siness that shareholders have the right to vote *or the board o* dire"tors. @one o* these other gro,!s have this right. )o% 4hile it is being r,n% then they "an vote in a ne4 board o* dire"tors that 4ill "hange the !ro*essional anagers so that the *ir is r,n in the better interests o* shareholders. :his is the ans4er to o,r *o,rth ?,estion o* *inan"ial analysis. An invest ent is -good/ i* it in"reases shareholdersB 4ealth *or a !rivate "or!oration and i* it in"reases share !ri"e 1other things e?,al3 *or a !,bli" "or!oration.

2
>oitras 11&&73 and #obson 11&&&3 investigate the relations bet4een shareholder 4ealth a9i ization% b,siness ethi"s% and so"ial res!onsibility. #obson eval,ates shareholder 4ealth a9i ization as a oral <,sti*i"ation *or b,siness behavior. >oitras revie4s e !iri"al st,dies that test the ethi"al i !li"ations o* shareholder 4ealth a9i ization.

1&

Introduction to Corporate Financial Analysis


:he above goal *or *inan"ial analysis is still rather vag,e and 4e need to ake it ore "on"rete. ight be ade

:hat is% 4e need a 4ay to inter!ret and !redi"t 4hether a b,siness invest ent that "o

by anagers o* a *ir 4ill in"rease shareholdersB 4ealth or not. ;n b,siness !ra"ti"e% 4e only ,se net present value 1@>K3 or% e?,ivalently% discounted cash flow 1#5F3 analysis as a -theory o* val,e/ *or this !,r!ose.

;n #5F analysis% the val,e o* an invest ent is "al",lated as the net present value 1@>K3% 4hi"h is the !resent val,e o* !redi"ted *,t,re "ash2in*lo4s net o* the dis"o,nted val,e o* re?,ired e9!endit,res. :here are three *,nda ental ingredients to any @>K !roble = 1a3 !redi"ted a o,nts o* *,t,re "ash in*lo4s and o,t*lo4s% 1b3 an a"",rate re!resentation o* the ti ing o* these "ash *lo4s% 1"3 an o!!ort,nity "ost rate o* ret,rn *or the ,se o* "a!ital.

:he "on"e!t o* @>K "an be a!!lied to either b,siness invest ents or *inan"ial invest ents% b,t% *or the o ent% let ,s think o* its a!!li"ation to b,siness invest ents. ;n this "ase% 4e deter ine the *irst t4o ele ents o* a @>K !roble *ro an analysis o* a b,siness invest ent. We deter ine the third ele ent o* a @>K !roble *ro an analysis o* *inan"ial arkets. :hese t4o as!e"ts o* a @>K !roble % the b,siness invest ent side and the *inan"ial invest ent side% are 4hat 4e ight "all the yin and the yang o* a "or!oration=

20

Introduction to Corporate Financial Analysis


)o eti es 4e se!arate the t4o sides o* the -"oin/ 4hi"h is a "or!oration% the b,siness invest ent side *ro the *inan"ial side% to *o",s o,r *inan"ial analysis. 6ther ti es% like% *or e9a !le% in a @>K !roble % it is "riti"al that the t4o sides be bro,ght ba"k together to ans4er the ?,estion% -is this a good invest entC/

:he *inan"ial side o* a @>K !roble re?,ires an -o!!ort,nity "ost rate o* ret,rn/ as a ben"h ark *or b,siness invest ent analysis in a sense that 4e 4ill ake "lear as 4e !ro"eed thro,gh this "ha!ter. Fo4ever% be*ore 4e get there% 4e need to begin by ans4ering the ?,estion o* 4hose o!!ort,nity "ost rate o* ret,rn 4e sho,ld ,se. 5or!orations are legal -*i"tions/ and% there*ore% they do not have o!!ort,nity "osts the selves. 6n the other hand% 4e !res, e that the !ri ary ob<e"tive o* anagers in o!erating a b,siness is to a9i ize the 4ealth o* shareholders. )o% it on share2holders ,st be the o!!ort,nity "ost o* shareholders that 4e ,se in *inan"ial analysis. ;n *a"t% 4e "an do o,r *inan"ial analysis *ro the !ers!e"tive o* all *inan"ial asset2holders 1"o and "reditors% *or e9a !le3 or *ro the !ers!e"tive o* shareholders in !arti",lar. We al ost al4ays get the sa e res,lt. For the !,r!ose o* dis",ssion here% 4e 4ill *o",s on shareholders.

We have already said that the !ri ary investors in *inan"ial assets in o,r e"ono y are !ersons like yo, and ;. )hareholders are !ersons. )o% o,r !ers!e"tive *or b,siness invest ent analysis is that a "or!oration ight ,ndertake a b,siness invest ent or they ight ret,rn *,nds to shareholders so that they "an alternatively invest in !ort*olios o* *inan"ial assets in *inan"ial arkets. :h,s% the o!!ort,nity "ost rate o* ret,rn that 4e ,se in @>K analysis ,st be deter ined *ro *inan"ial arkets. :he details o* this deter ination 4e investigate as 4e !ro"eed thro,gh this book.

B,siness st,dents generally a""e!t the !res, !tion that the !ri ary ob<e"tive o* o!erating a b,siness is to

anagers in

a9i ize shareholdersB 4ealth. )o% in -ste!!ing into the shoes/ o*

shareholders and "onsidering their o!!ort,nity "osts deter ined in *inan"ial arkets% all b,siness st,dents have so e *a iliarity 4ith *inan"ial arkets and *inan"ial !rin"i!les. :h,s% even i* yo, do not !lan to st,dy *inan"e in detail in yo,r a"ade i" "areer% it is i !ortant that yo, as a st,dent o* b,siness% regardless o* yo,r s!e"ialization% take and aster at least one *inan"e "o,rse.

21

Introduction to Corporate Financial Analysis


:he opportunity cost of capital is the ret,rn shareholders "an earn on *inan"ial assets 4ith a!!ro9i ately the sa e risk as the b,siness invest ent ,nder investigation. :he o!!ort,nity "ost o* "a!ital goes by a n, ber o* di**erent na es% s,"h as the dis"o,nt rate% the arket "a!italization eas,red by a rate% and the h,rdle rate. For b,siness invest ents% the o!!ort,nity "ost is o*ten these "on"e!t,al notions into !ra"ti"e.

rate "alled the wei"hted avera"e cost of capital 4hi"h 4e investigate later in this book as 4e !,t

11.$3
Be*ore 4e begin to develo! the details o* *inan"ial analysis% it is instr,"tive to e9a ine a si !le e9a !le. :he e9a !le is not eant to dis!lay ho4 ,"h "o !le9ity is !ossible in *inan"ial ight ask analysis. Rather% this e9a !le highlights the *,nda ental "o !onents o* *inan"ial analysis and ho4 they relate to one another. We 4ill ,se this e9a !le to identi*y ho4 and 4here 4e and ans4er the *o,r *,nda ental ?,estions o* *inan"ial analysis. )ho,ld yo, *eel over4hel ed by details o* the analysis yo, see in later "ha!ters and be"o e disoriented% this e9a !le ay hel! yo, to regain !ers!e"tive.

1.$.1
),!!ose a *ir !redi"ts that it 4ill generate L700%000 in one year as the res,lt o* an invest ent o* L'00%000 today. :he L700%000 re!resents a*ter ta9 !ro*it% net o* e9!enses% dis!osal o* the asset% and all other bene*its. @oti"e that 4e have des"ribed t4o o* the three re?,ired in!,ts to a #5F !roble % the a o,nt and ti ing o* the !redi"ted *,t,re "ash *lo4s. :he L'00%000 is the ans4er to the *irst ?,estion o* *inan"ial analysis *or this b,siness invest ent= the e9!endit,re ?,estion. ;n addition% s,!!ose that 4e also have in hand an assess ent o* the vent,reBs risk that s,ggests an a!!ro!riate o!!ort,nity "ost is 8M !er ann, . Be"a,se 4e a""e!t the !rin"i!le that the !ri ary ob<e"tive o* anagers is to a9i ize shareholdersB 4ealth and be"a,se the alternative invest ent ake the b,siness invest ent% b,t o* shareholders is in *inan"ial assets in *inan"ial arkets% 4e deter ine this 8M rate o* ret,rn *ro an assess ent o* *inan"ial arkets. ;* the "or!oration does not 22

Introduction to Corporate Financial Analysis


instead% gives the *,nds 1that is% the L'00%0003 ba"k to shareholders and they invest in *inan"ial assets o* abo,t the sa e risk as the b,siness invest ent% 4e e9!e"t the o* 8M. )o% the 8M is shareholdersB o!!ort,nity "ost rate o* ret,rn. :here are t4o !rin"i!al deter inants o* any e9!e"ted rate o* ret,rn *ro *inan"ial arkets= interest rates in the e"ono y and risk o* the *inan"ial asset ,nder investigation. ;n "o !aring -a!!les to a!!les/ and -oranges to oranges/ 4ith res!e"t to risk% to deter ine the 8M o!!ort,nity "ost rate o* ret,rn% 4e at"h a *inan"ial asset 4ith the sa e risk as the b,siness invest ent that 4e are "onte !lating. )o% a !rin"i!al deter inant o* the 8M o!!ort,nity "ost rate o* ret,rn is risk. :his rate i beds 1"on"e!t,ally% 4itho,t giving the details3 the ans4er to the se"ond *,nda ental ?,estion o* *inan"ial analysis= the risk ?,estion. ;nvestors assess and are e9tre ely "ognizant o* risk in *inan"ial arkets. :here*ore% risk is assessed by *inan"ial asset investors and !rin"i!ally in this anner alone. ;n other 4ords% i* investors be"o e ore risk averse in o,r e"ono y% then the 8M o!!ort,nity "ost rate o* ret,rn 4o,ld be greater and vi"e versa. ;* the risk o* o,r b,siness invest ent 4ere greater% then 4e need to ben"h ark 4ith a *inan"ial asset that has greater risk and that% there*ore% has a greater e9!e"ted rate o* ret,rn. :his greater rate o* ret,rn eans that o,r o!!ort,nity "ost rate o* ret,rn is greater. Get the ideaC to earn a rate o* ret,rn

(et ,s no4 "o bine the yin and the yang o* o,r r,di entary *inan"ial analysis to ans4er the ?,estion -is this a good invest entC/ :he @>K o* the b,siness invest ent is= %&' = 700%000 '00%000 = L8'%8'1.88 1 + 0.08 akes a *e4 observations.

Be*ore 4e dis",ss 4hat this n, ber eans% let ,s

First% yo, never 1never% never% never3 take the L700%000 s,btra"t the L'00%000 and say that this is a good invest ent be"a,se its -!ro*it/ is L100%000. >ro*it is not L100%000 b,t alternatively !ro*it is e bedded in the L700%000. F,rther% the L700%000 is not dire"tly "o !arable to the L'00%000 *or t4o reasons. :4o "ash *lo4s to be !aid or re"eived at t4o di**erent !oints o* ti e are not "o !arable be"a,se o* the -ti e val,e o* oney%/ 4hi"h eans that 4e as investors never leave ore than N dollars re"eived in the *,t,re. ;n 2' oney idle b,t alternatively al4ays invest 1in di**erent 4ays3 to earn a rate o* interest. 5onse?,ently N dollars re"eived today is 4orth

Introduction to Corporate Financial Analysis


addition% the L700%000 is not "o !arable to the L'00%000 be"a,se the L700%000 is ,ndo,btedly ore risky than is the L'00%000. :he L700%000 is o,r best *ore"ast o* the -bene*it/ o* the b,siness invest ent% b,t there is likely to be ,"h variability in the a o,nt that 4e 4ill realize a*ter the *a"t 1e9 !ost3 "o !ared to 4hat 4e e9!e"t 4hen 4e initially ake the invest ent 1e9 ante3. We have done a risk assess ent *ro *inan"ial arkets and the 8M o!!ort,nity "ost rate o* ret,rn re!resents the "o !ensation that investors de and *or the higher risk o* the L700%000 relative to the L'00%000. )o% 4hen 4e -dis"o,nt/ the L700%000 by dividing by 1.08% 4e and the risk di ension. ;n !arti",lar% 4hen 4e dis"o,nt% 4e ake these t4o n, bers 1the L700%000 and the L'00%0003 "o !arable on t4o di ensions= the te !oral eas,re -!resent/ val,e 4hi"h eans that all dollars are as o* today and then% and only then% they are "o !arable. Go, ight 4onder 4hat the -1/ eans 4hen 4e -dis"o,nt/ by 1.08 in o,r @>K "al",lation

%&' =

700%000 '00%000 . :he ans4er is that this -1/ re!resents -ret,rn o* "a!ital./ Be"a,se 1 + 0.08

this is a -one2!eriod/ invest ent% the -1/ a!!ears in o,r dis"o,nt *a"tor 1.08 4hen 4e "al",late= %&' = 700%000 '00%000 . Fere% "a!ital is o,r initial invest ent o* L'00%000. For any L1 that 1 + 0.08 oney 1interest rates in the e"ono y3 and the risk o*

4e invest% 4e need to get ba"k at least L1 in order *or this to be a good invest ent. ;n addition% 4e need "o !ensation *or the ti e val,e o* this b,siness invest ent. :hese t4o *a"tors are e bedded 1in "o !osite3 in the o!!ort,nity "ost rate o* ret,rn= 8M. We ake the b,siness invest ent today and generate 1e9!e"ted3 L700%000 in one year. We get this L700%000 <,st on"e and not !er ann, inde*initely. ;* alternatively 4e 4ere to get a dollar ret,rn per annum inde*initely then the -1/ 4o,ld disa!!ear in o,r @>K "al",lation. ;n this instan"e% be"a,se 4e get a dollar ret,rn on o,r b,siness invest ent every year% "a!ital need never be ret,rned to ,s. ;n o,r e9a !le% @>K is L8'%8'1.88. What e9a"tly does this n, ber eanC ;t eans that i* 4e

,ndertake this invest ent% total shareholder 4ealth in"reases by L8'%8'1.88. :heir !otential *or "ons, !tion in"reases by this a o,nt. :h,s% the val,e o* this invest ent is L8'%8'1.88. :his b,siness invest ent "reates 4ealth *or shareholders. Be"a,se @>K is !ositive this is a -good/ invest ent and 4e as anagers 4ho are trying to 27 a9i ize shareholdersB 4ealth sho,ld ake this

Introduction to Corporate Financial Analysis


invest ent. @>K ans4ers the *o,rth ?,estion o* *inan"ial analysis= is this a good invest entC ;* @>K is !ositive% then the ans4er to this ?,estion is yes= this is a good invest ent. Wealth "reation by *ir s is ine9tri"ably <oined to the 4orkings o* *inan"ial arkets. :he val,e o* the *ir Bs assets de!ends on the o!!ort,nity "ost o* investors. :he o!!ort,nity "ost o* investors% in t,rn% re*le"ts the ret,rn e9!e"ted *ro alternative financial asset invest ents. :hese observations ean that no b,siness is inde!endent o* *inan"ial arkets and that every anager ,st have so e ,nderstanding o* *inan"ial arkets to ens,re that they in"rease shareholder 4ealth. )hareholders 4ho believe that they 4ill not earn the o!!ort,nity "ost o* "a!ital sell their shares. ;* any shareholders share a negative o!inion% share !ri"es *all ,ntil the anagers. ;n this 4ay% arket !ri"e re*le"ts a *air rate o* ret,rn. Falling share !ri"es red,"e the a o,nt o* "a!ital available to arkets 4ork to reallo"ate "a!ital% in"reasing the reso,r"es available to anagers 4ho s,""eed to earn at least the o!!ort,nity "ost o* "a!ital and de"reasing the reso,r"es available to ,ns,""ess*,l anagers.

1.$.2
6*ten *inan"ial analysis need not and does not go as *ar as the @>K "al",lation. Alternatively% any invest ent !roble s% in"l,ding the e9a !le sho4n above% "an be re"ast in ter s o* rates o* ret,rn. :he rate o* ret,rn on the invest ent "an be "al",lated as the internal rate of return 1;RR3. :he ;RR is -the/ rate o* ret,rn on an invest ent and is "al",lated as that hy!otheti"al dis"o,nt rate that akes @>K e?,al to zero. @oti"e that there is only one ",rrent arket2 deter ined dis"o,nt rate that re!resents both the risk o* the invest ent and its o!!ort,nity "ost. Fo4ever% in alternative arket environ ents interest rates ight di**er and the @>K 4o,ld be higher or lo4er. ;n o,r e9a !le% the ;RR satis*ies the *ollo4ing e?,ation= %&' = 700%000 '00%000 = 0 1 + IRR

With a little algebra% the ;RR is 1this is not a general *or ,la to be ,sed in all sit,ations b,t only in the "onte9t o* o,r e9a !le here3=

20

Introduction to Corporate Financial Analysis


IRR = 700%000 1 = ''.'M '00%000

:he ;RR is the ans4er to the ret,rn ?,estion *or a b,siness invest ent. :his is o,r third and *inal *,nda ental ?,estion o* *inan"ial analysis. What is the rate o* ret,rn on this b,siness invest entC :he general ans4er is the ;RR. Be"a,se the rate o* ret,rn on o,r b,siness invest ent is greater than the o!!ort,nity "ost rate o* ret,rn in *inan"ial arkets 1that is% 8M3% this is a -good/ invest ent. :his is another 1generally e?,ivalent3 4ay to ans4er the *o,rth ?,estion o* *inan"ial analysis% -is this a good invest ent./ ;t is a good invest ent i* it has a rate o* ret,rn that e9"eeds the o!!ort,nity "ost rate o* ret,rn. Go, sho,ld re"ognize that the e"ono i" deter inants o* the rate o* ret,rn on a b,siness invest ent 1the ;RR3 and the o!!ort,nity "ost rate o* ret,rn are very di**erent. We kno4 *ro o,r dis",ssion above that the !rin"i!al e"ono i" deter inants o* an o!!ort,nity "ost rate o* ret,rn are interest rates in the e"ono y and risk o* the b,siness invest ent ,nder "onsideration. ;nvestors are averse to risk. ;* risk is greater than% other things e?,als% *inan"ial asset !ri"es are lesser 4hi"h eans that e9!e"ted rates o* ret,rn are greater. :hese *inan"ial asset !ri"e "hanges allo4 the risk assess ent o* investors "o,!led 4ith their aversion to risk to be "onstantly and "ontin,o,sly re!resented in e9!e"ted rates o* ret,rn in *inan"ial arkets. :here are no s,"h !ri"e ad<,st ents that in*l,en"e the rate o* ret,rn on a b,siness invest ent. For e9a !le% in o,r n, eri"al e9a !le% the L'00%000 e9!endit,re re?,ired to "hange as investors in the e"ono y be"o e ake o,r b,siness invest ent does not ore or less risk averse. :he L'00%000 is based on

te"hni"al% e"hani"al% ar"hite"t,ral% engineering and s"ienti*i" as!e"ts o* the b,siness invest ent. @one o* these things de!end on investors in *inan"ial arkets. :h,s% risk is not an e"ono i" deter inant o* b,siness ret,rns. @ote% ho4ever% that there is risk inherent in any b,siness invest ent. We si !ly ean to say that this risk is assessed in *inan"ial arkets. :he L700%000 is ,n"ertain rather than "ertain. Fo4ever% no as!e"t o* o,r b,siness invest ent de!ends on the toleran"e or intoleran"e to risk by investors in *inan"ial arkets. Rather% the !rin"i!al e"ono i" deter inant o* b,siness ret,rns is !ro*itability. .ore e9a"tly% the !rin"i!al e"ono i" deter inant o* b,siness ret,rn is the relation bet4een e9!e"ted *,t,re !ro*itability and re?,ired e9!endit,re to ,ndertake a b,siness invest ent.

2$

Introduction to Corporate Financial Analysis


;n an a"t,al eval,ation o* o,r e9a !le b,siness invest ent% a b,siness !erson ight not go as *ar

as an a"",rate deter ination that the o!!ort,nity "ost is 8M. 6*ten% it is s,**i"ient to ,se only a r,di entary and Oball!arkO ,nderstanding o* 4hat "onstit,tes a good or a bad ret,rn on an invest ent relative to *inan"ial arkets. We deter ined that the ;RR on the invest ent is ''M. ;t is ,nlikely that 4e "o,ld earn a ret,rn so high "onsistently over ti e 1at least in the arket environ ent o* 20173. With only r,di entary ,nderstanding *ro *inan"ial arkets o* 4hat "onstit,tes a high or a lo4 ret,rn% 4e "an do a -ro,gh and ready/ assess ent o* the !ro!osed real asset invest ent. B,siness !ersons o*ten ake de"isions on the basis o* ro,gh and ready assess ents rather than detailed eval,ations. Fo4ever% yo,r skill in aking these ro,gh and ready assess ents arises o,t o* good% so,nd% *inan"ial b,siness <,dg ent. :he !,r!ose o* this book is to -ki"k2start/ yo,r b,siness <,dg ent. ;n addition% *or ore arginal invest ents or *or ore thoro,gh invest ents "riti"ally i !ortant to a *ir Ds strategi" !lanning e**ort% the val,e o* a

invest ent assess ent is indis!ensable to the !lanning !ro"ess. An i !ortant as!e"t o* *inan"ial analysis is that% in the process o* eval,ating invest ents% *ir s learn very ,"h abo,t the a"tivities ,!on 4hi"h they are abo,t to e bark. ;* invest ent eval,ation is not ,ndertaken% the bene*its o* the !lanning !ro"ess are issed.

11.83
;t is instr,"tive to "ontin,e the n, eri"al e9a !le 4e began in the !re"eding se"tion to ill,strate the di**eren"e in !ers!e"tive that e9ists bet4een *inan"ial analysis and *inan"ial state ent !resentation. :o do this% 4e asset invest ent. ,st add so e detail to o,r hy!otheti"al *ir and its !lanned real

),!!ose that this !ro<e"t is the only asset o* the *ir and that it is a !ro!rietary idea. ;n other 4ords% there are no tangible assets that ",rrently a""o !any the !ro<e"t b,t the idea "o,ld be sold i* the *ir "hose to do so 1i.e.% it ight be an idea !rote"ted by !atent legislation3. :he !ro<e"t is not yet *inan"ed b,t 4hen it is *inan"ed% e?,ity 4ill be ,sed 1i.e.% a sale o* ne4 shares to ne4 shareholders3. We kno4 *ro the @>K "al",lation that the *inan"ing re?,ire ent *or the !ro<e"t is L'00%000. :he !ro<e"t is a tangible real asset invest ent. :he !ro"ess o* *inan"ing and "a!ital 28

Introduction to Corporate Financial Analysis


s!ending trans*or s the idea A an intangible asset A into an idea and a tangible o!erating asset. :here have been no !rior transa"tions o* the *ir other than in"or!oration% 4hi"h 4e 4ill !res, e to take !la"e at zero "ost.

:ake a

o ent and *ill in the

issing ele ents o* the *ollo4ing t4o balan"e sheets. :he *irst arket val,e balan"e sheet% re"ord the 1i.e.% the sale !ri"e o* all o*

balan"e sheet is the a""o,nting balan"e sheet and the se"ond balan"e sheet is re*erred to as a - arket val,e balan"e sheet./ 6n the le*t2hand side o* the arket val,e o* the asset i* the *ir 4ere to sell it 1the *ir itsel* "ontin,es as a legal individ,al3. 6n the right2hand side re"ord the val,e o* all o* the shares in the *ir shares3. the shares i* sold in a blo"k to another investor or set o* investors A a se"ondary arket trade o*

5alance 6heets 5efore Financing and Capital 12penditure Accounting 5alance 6heet 7ar8et 9alue 5alance 6heet

+9hibit 12$0 Accounting :5oo8; 9alues versus Fair 7ar8et 9alues<Initial

Go, sho,ld have zeroes on both the asset and the e?,ity sides o* the a""o,nting balan"e sheet. :here have been no transa"tions% and there*ore% there is nothing as o* yet to a""o,nt *or. :he book value o* the *ir Bs assets and the book value o* the *ir Bs e?,ity are zero. 6n the other hand% the *a"t there have been no transa"tions does not i !ly that the *ir does not have val,e. ;n *a"t% by the @>K "al",lation 4e kno4 the 1esti ated3 val,e o* the real asset% L8'%8'1.88. ;n other 4ords% i* the *ir 4ishes to sell the asset 1the intangible idea3% they sho,ld be looking *or at least this a o,nt. (ike the a""o,nting balan"e sheet% the right and le*t sides o* the arket val,e balan"e sheet sho,ld be e?,al% and there*ore% the arket val,e o* e?,ity in the *ir is also 28

Introduction to Corporate Financial Analysis


L8'%8'1.88. :his a o,nt eans that i* all shareholders 4ere to sell their shares in a blo"k to

another gro,! o* shareholders% the total a o,nt they 4o,ld be looking *or is L8'%8'1.88. @oti"e that these transa"tions are so e4hat di**erent. ;n the *irst "ase% the *ir sells its assets 1the *ir ight go into so e other b,siness or develo! a ne4 !rod,"t or idea3% in the se"ond "ase% the *ir kee!s its assets b,t the shareholders in the *ir are ne4.

@o4% s,!!ose the *ir sells shares to ne4 shareholders. :he *ir needs L'00%000% and there*ore% this is the total val,e o* ne4 shares they sell. At the sa e ti e% the *ir akes "a!ital e9!endit,res in the a o,nt o* L'00%000. :he intangible idea o* the *ir is no4 trans*or ed into an o!erating b,siness 4ith tangible assets. As in the !revio,s "ase% the bene*its o* the invest ent are re"eivable in one !eriod. :ake a *e4 and o ents and on"e ore *ill in the *ollo4ing a""o,nting arket val,e balan"e sheets *or the *ir . 9alues I ediately After Financing and Capital 12penditure Accounting 5alance 6heet 7ar8et 9alue 5alance 6heet

12hibit 13&0 Accounting :5oo8; 9alues versus Fair 7ar8et 9alues<after Invest ent Be"a,se the *ir has raised L'00%000 in e?,ity and !,r"hased the sa e a o,nt o* *i9ed assets 1and !ossibly 4orking "a!ital assets3% yo, sho,ld have this val,e on both sides o* the a""o,nting balan"e sheet. 6n the other hand% the arket val,e o* the *ir Bs assets and e?,ity is no4 the present val,e 1rather than the net !resent val,e% be"a,se the e9!endit,re has been ade3. :his val,e is L700%000 1.08 P L'8'%8'1.88. :his a o,nt "an also be *o,nd as the @>K !l,s the e9!endit,re L8'%8'1.88 Q L'00%000 P L'8'%8'1.88. :his a o,nt is the s, o* the val,e o* the idea and the e9!endit,re on assets that !,t the idea into o!eration. :his is the a o,nt the *ir re?,ires i* they are to sell the idea and the assets and this is also the a o,nt shareholders re?,ire i* they are to sell all o* their shares.

2&

Introduction to Corporate Financial Analysis

1.8.1
A n, ber o* *inan"ial ratios and eas,res relate the *air arket val,e o* *inan"ial assets to eas,res are "o only ,sed in the the balan"e ,nderlying "or!orate "hara"teristi"s. :hese ratios and

*inan"ial ind,stry be"a,se they o**er a good deal o* insight into ho4 *inan"ial arkets val,e and !ri"e *inan"ial assets. :his !ro"ess is o* *,nda ental interest to investors. Fro sheets above 4e "an "al",late a "o assets or e?,ity. :he 1so eti es "alled the !ri"e to book ratio3. :he arket to book ratio is a only ,sed *inan"ial ratio= the market to book ratio arket to book ratio "an be "al",lated *or either eas,re o* val,e to e9!endit,re and is% there*ore% arket to book ratio is L8'%8'1.88

related to @>K o,r theory o* val,e. Be*ore *inan"ing% the the

divided by ero 1in*initely large3 *or both the *ir Bs assets and the *ir Bs e?,ity. A*ter *inan"ing% arket to book ratio is 1.27 1L'8'%8'1.88 L'00%0003 *or the *ir Bs assets and *or the *ir Bs arket to book ratios *or assets and e?,ity are the sa e in this e9a !le be"a,se the on "hara"teristi" o* !ro*itable and high arket to book ratio is greater than one. ;n the "ase at hand% 4e kno4 that arket val,e e9"eeds the book val,e and the arket to

e?,ity. :he

*ir ,ses no debt in its *inan"ial str,"t,re. ;t is a "o gro4th2*ir s that the

the *ir is -!ro*itable/ be"a,se the rate o* ret,rn on the invest ent is greater than the o!!ort,nity "ost. Be"a,se o* this !ro*itability% the *ir 4ere lesser than one% it 4o,ld the arket to book ratio book ratio e9"eeds one. :his is as it sho,ld beH i* the arket to book ratio *or a ne4ly develo!ing ay "hange and

ake no sense to "ontin,e 4ith the invest ent. ;t 4o,ld be a

negative @>K invest ent. A*ter e9!endit,res have been ade% "ir", stan"es

ay *all belo4 one. Fir s having *inan"ial !roble s 1that is% lo4

!ro*itability3 or shrinking !rod,"t andEor servi"e arkets tend to have arket to book ratios lesser than one.

11.83
Fir s invest in real assets 4ith *,nds raised *ro the sale o* *inan"ial assets to investors. ;nvest ent in real assets and invest ent by s,!!liers o* "a!ital in *inan"ial assets are t4o sides o* the sa e O"oinO 4hi"h is the *ir . Finan"ial analysis is the investigation o* the *inan"ial *eat,res o* a *ir . ;nternal analysts are !ri arily interested in i !roving the !er*or an"e o* o!erating assets and establishing val,es o* assets% 4hi"h *ir s ight !,r"hase or sell. :hese a"tivities are inti ately related to strategi" and o!erational !lanning. Fir s sell *inan"ial assets to raise *,nds '0

Introduction to Corporate Financial Analysis


*or their b,siness o!erations. ;nternal *inan"ial analysts are interested in both *inan"ial asset val,ation and strategi" *inan"ing !ossibilities. Both internal and e9ternal analysts ,se *inan"ial arkets to establish ob<e"tive ben"h arks against 4hi"h a *ir Bs !er*or an"e "an be assessed. ;* a *ir earns a rate o* ret,rn on invested assets that e9"eeds the o!!ort,nity "ost o* investors% then the !ri"es o* the *ir Ds *inan"ial assets in"rease. ;n !arti",lar% share val,e in"reases. :his in"rease is o* !ara o,nt i !ortan"e to the *ir i* its !ri ary ob<e"tive is a9i ization o* shareholdersD 4ealth.

+9ternal *inan"ial analysts are interested in establishing either the "redit 4orthiness o* a *ir Ds debt or dividends and "a!ital gains !otential o* its e?,ity. Fo4ever% a *ir Ds ability to ake "ontra"t,al debt !ay ents and dividends 14hi"h also ,nderlie "a!ital gains *or shareholders3 de!ends on the s,""ess o* real o!erations. 5onse?,ently% even *or e9ternal analysts% the !rin"i!al investigation o* a *ir *or !ort*olio invest ent de"ision is its real o!erations and *,nda ental b,siness a"tivity.

'1

Introduction to Corporate Financial Analysis

11.&3
J. #obson. -;s )hareholder Wealth .a9i ization ; !!. $&280. oralC/ Financial Analysts (ournal 0% 1&&&%

G. >oitras. -)hareholder Wealth .a9i ization% B,siness +thi"s% and )o"ial Res!onsibility./ (ournal of Business )thics 1' 11&&73% !!. 12021'7.

'2

Introduction to Corporate Financial Analysis

11.103
1! Objectives of the Firm! What arg, ents "an be ade *or the vie4 that odern "or!orations are o!erated !ri arily% altho,gh not e9"l,sively% *or the bene*it o* shareholdersC

2. Definition of a Financial Asset A si !le ter li*e ins,ran"e "ontra"t ay be !,r"hased *or a single !re i, 1no43 in e9"hange *or a l, !2s, !ay ent o* L100%000 to the bene*i"iary i* the ins,red individ,al dies 4ithin *ive years o* the !re i, !ay ent. +9!lain ho4 this "ontra"t satis*ies the de*inition o* a *inan"ial asset.

3. Real Versus Financial Assets ;s a !atent a real or a *inan"ial assetC +9!lain.

4. Real Versus Financial Assets :here is a *ir that trades on the .ontreal )to"k +9"hange that o4ns the OrightsO to the !o!,lar song ORo"k Aro,nd the 5lo"k.O +very ti e this song is !layed on radio% the *ir re"eives a!!ro9i ately 2 "ents in royalty !ay ents *ro the !layer o* the song. #oes the *ir o4n a real or a *inan"ial assetC +9!lain.

5. Primary Versus econ!ary "ar#et $ra!es ;s a sto"k s!lit a !ri ary or a se"ondary arket tradeC +9!lain.

'! Primary Versus econ!ary "ar#et $ra!es! (egislated "or!orations a"ts allo4 *ir s to re!,r"hase their o4n !,bli"ly traded *inan"ial assets. For e9a !le% *ir s b,y ba"k their o4n "o on in !,bli" e?,ity arkets at !ri"es that are agreeable to those investors selling shares. ;s a "or!orate share re!,r"hase a !ri ary or a se"ondary arket tradeC +9!lain and dis",ss. ''

Introduction to Corporate Financial Analysis

%. &nternal Versus '(ternal Financial Analysts +9!lain di**eren"es and si ilarities bet4een internal and e9ternal *inan"ial analysts.

). Primary Versus econ!ary "ar#et $ra!es A short2sale o* a !,bli"ly traded "o on share takes !la"e 4hen an individ,al borro4s the share% sells it to another investor% and !ro ises to re!,r"hase the share and ret,rn it at so e inde*inite ti e in the *,t,re. :he share is o*ten borro4ed *ro a se",rities dealer% like% *or e9a !le RB5 #o inion )e",rities. :he share is sold thro,gh the *a"ilities o* the organized sto"k e9"hange on 4hi"h the share is traded. :he intent o* the short2seller is to b,y ba"k the share at a !ri"e that is lo4er than it is sold 1o* "o,rse this does not al4ays ha!!en3. ;s the short sale a !ri ary or a se"ondary arket tradeC

*. Real Versus Financial Assets What are t4o "hara"teristi"s o* a real asset that disting,ish it *ro

a *inan"ial assetC

+,. Definition of a Financial Asset ;s a lottery ti"ket a real or a *inan"ial assetC +9!lain and dis",ss.

++. Real Versus Financial Assets )ervo ation% the "o !any that r,ns the -Ravens/ "a*eteria% o**ers a -"o**ee "ard./ +a"h ti e yo, b,y a "o**ee% the "ard is !,n"hed. A*ter yo, have nine !,n"hes% the tenth "o**ee is *ree. Go, no4 have *o,r !,n"hes on yo,r "o**ee "ard. #o yo, o4n a real or a *inan"ial assetC +9!lain and dis",ss.

+2. A!vanta-es an! Disa!vanta-es of the .or/orate Or-ani0ational Form What are the advantages and disadvantages o* the "or!orate organizational *or o* b,siness a"tivity "o !ared to its !rin"i!al alternatives= sole !ro!rietorshi!s and !artnershi!s.

'7

Introduction to Corporate Financial Analysis

+3. &nter/retation of 1PV Go, 4ork *or AB5 5o !any. Go,r boss never grad,ated *ro high s"hool. @onetheless% she has heard abo,t net !resent val,e 1@>K3 and 4ants yo, to e9!lain it to her. What does it eas,reC What are its *,nda ental "o !onentsC What *a"tors ake net !resent val,e di**i",lt to i !le ent in !ra"ti"eC

+4. Primary Versus econ!ary "ar#et $ra!es 5o ent brie*ly on the *ollo4ing assertion. -Be"a,se any ne4 shares that are sold by a *ir to raise *,nds *or b,siness !,r!oses event,ally trade on a sto"k arket 1like the :oronto )to"k +9"hange3 this sale is re*erred to as a se"ondary arket sale./ Rse no n, eri"al e9a !les in yo,r res!onse.
Suggested Solution

+5. Definition of a Financial Asset 5o ent brie*ly on the *ollo4ing assertion. -;n order to ake an e?,ity invest ent in a *ir % shareholders e9!e"t to re"eive "ash *ro the *ir in the *or o* dividends and "a!ital gains./ Rse no n, eri"al e9a !les in yo,r res!onse.
Suggested Solution

+2. 1et Present Value an! the "ar#et to 3oo# Ratio AB5 5o !any is !lanning a real asset invest ent. AB5 is a start2,! *ir % and there*ore% it has no !revio,s invest ents. Also% AB5 has no other invest ents !lanned or "onte !lated other than the one des"ribed in this !roble . For an invest ent o* L; today% the e9!e"ted bene*it to AB5 in one year is L170%000. :his bene*it is the !ro*it on the invest ent% !l,s salvage% net o* ta9es and "o issions% et". :he internal rate o* ret,rn on the !ro<e"t is 70M. 5,rrently% AB5 has no debt in its *inan"ial str,"t,re and its book e?,ity is zero. Book e?,ity is the s, o* share2 "a!ital and retained earnings. ;n order to ,ndertake its invest ent% AB5 needs to do so e *inan"ing. :hey !lan to sell AB5 sells ne4 shares to ne4 shareholders in the a o,nt o* L; to *inan"e their real asset invest ent. ; ediately a*ter the share iss,e and the re?,ired "a!ital e9!endit,re o* L;% AB5Bs arket to book ratio *or e?,ity is 1.20 1there re ains% nonetheless% one year be*ore the e9!e"ted "ash *lo4 bene*it o* L170%000 is re"eived3. Re?,ired= What is the *inan"ial arket o!!ort,nity "ost 1e9!ressed as a rate o* ret,rn3 *a"ing the shareholders o* AB5C 1;n other 4ords% 4hat is the dis"o,nt rateC3

'0

Introduction to Corporate Financial Analysis


+%. O//ortunity .ost 5o ent on the *ollo4ing assertion= -With res!e"t to "or!orate *inan"ial analysis% the opportunity cost rate o* ret,rn is the rate o* ret,rn that a *ir earns *ro its invest ent into b,siness a"tivity on behal* o* all its *inan"ial assetholders. :his ret,rn is "alled the o!!ort,nity "ost be"a,se the invest ent allo4s investors the -o!!ort,nity/ to !ro*itably invest ent in the dyna i" b,siness environ ent o* this !arti",lar *ir ./ Rse no n, eri"al e9a !les in yo,r res!onse.

+). Definition of a Real Asset 5o ent on the *ollo4ing assertion= -An a!art ent b,ilding is a *inan"ial asset rather than a real asset be"a,se its stable rental in"o e akes the rate o* ret,rn on this invest ent o* only odest risk./ Rse no n, eri"al e9a !les in yo,r res!onse.

1&. :he Funda ental 4uestions of Financial Analysis! For the !,r!ose o* ,ndertaking *inan"ial analysis% there are at least three *,nda ental ?,estions asso"iated 4ith any invest ent. What are these ?,estions. Go, are the *inan"ial analyst at AB5 "o !any 4ho is "harged 4ith eval,ating the re"ent !er*or an"e o* AB5 *or shareholders. With res!e"t to the invest ent ade by AB5Bs shareholders% dis",ss the ratios andEor eas,res 4hi"h yo, ight "al",late to ans4er or investigate ea"h o* these ?,estions *or the shareholders o* AB5.
Solution

20. =efinition of a ,eal Asset! Joe 5anoe is a ran"her. Fis herd o* "attle 1or any other herd o* "attle3 is not -allo4ed/ a "a!ital "ost allo4an"e by Reven,e 5anada. ;n Reven,e 5anadaBs eyes% this asset is not de!re"iable. 5o ent on the *ollo4ing assertion= -;* this asset is not de!re"iable% it "annot be a real asset% and there*ore% it ,st be a *inan"ial asset./
Solution

21. .arket to Book Ratio 5o ent on the *ollo4ing assertion= -Be"a,se *ir s "reate 4ealth *or their *inan"ial asset2 holders and their shareholders in !arti",lar% the .arket to Book ratio *or a *ir Bs "o on e?,ity ,st al4ays be greater than one./
Solution

22. 6!!ort,nity 5ost '$

Introduction to Corporate Financial Analysis


AB5 5o !any is !lanning a real asset invest ent. AB5 is a start2,! *ir % and there*ore% it has no !revio,s invest ents. Also% AB5 has no other invest ents !lanned or "onte !lated other than the one des"ribed in this !roble . For an invest ent o* L; today% the e9!e"ted "ash2*lo4 bene*it to AB5 in one year is L70%000. :herea*ter% this !er ann, bene*it is e9!e"ted to gro4 at 0M !er ann, inde*initely into the *,t,re. :hat is% *or e9a !le% the "ash2*lo4 bene*it t4o years *ro today is L70%000S1.00. ;gnore% ta9ation% salvage% de!re"iation and "o issions in this !roble . :he internal rate o* ret,rn on this invest ent is 70M. 5,rrently% AB5 has no debt in its *inan"ial str,"t,re and its book e?,ity is zero. Book e?,ity is the s, o* share2"a!ital and retained earnings. ;n order to ,ndertake its invest ent% AB5 needs to do so e *inan"ing. :hey !lan to sell shares to ne4 shareholders in the a o,nt o* L; to *inan"e their real asset invest ent. ; ediately a*ter the share iss,e and the re?,ired "a!ital e9!endit,re o* L;% AB5Bs arket to book ratio *or e?,ity is 7 1there re ains% nonetheless% one year be*ore the *irst e9!e"ted "ash *lo4 bene*it o* L70%000 is re"eived3. Re?,ired= What is the *inan"ial arket o!!ort,nity "ost 1e9!ressed as a !er ann, rate o* ret,rn3 *a"ing the shareholders o* AB5C 1;n other 4ords% 4hat is the dis"o,nt rateC3
Solution

11.113
+. Definition of a Financial Asset
First% yo, sho,ld re"ognize the "ontrary vie4 is that in 4idely held !,bli" "or!orations% it is o*ten the "ase that no single shareholder has s,**i"ient voting !o4er to dis"i!line anagers. 6rganizational "osts !re"l,de the !ossibility o* *or ing shareholder "oalitions to re ove anagers 4ho are in"o !etent or !,rs,e their o4n interests. ;n addition% be"a,se shares are 4idely held% organizational "osts *all ,!on a *e4 lead shareholders 4hereas the bene*its a""r,e to all. :he likelihood that ost shareholders -*ree ride/ on the organizational e**orts o* a *e4 shareholders red,"es the !ossibility that this organization 4ill take !la"e and that shareholders "an *or e**e"tive "oalitions to dire"t the o!erations o* their *ir . :he !ossibility there*ore arises that anagers ight o!erate their *ir s in their o4n best interests regardless o* shareholders and 4ith i !,nity. Fo4ever% the board o* dire"tors "an ,se the sa e sto"k arket that se!arates !ro*essional anagers and shareholders to align their !ersonal interests. :he Board "an ake anagerial "o !ensation de!end on *inan"ial variables o* dire"t relevan"e to shareholders% like R6+% +>)% or share !ri"e. :he board o* dire"tors "an sell 1or give3 shares in the *ir to anagers at dis"o,nted !ri"es. :hey "an o**er sto"k o!tions. All o* these "o !ensation ethods ake anagers -?,asi shareholders./ ;n a9i izing their o4n interests as ?,asi shareholders% anagers 4ill also tend to a9i ize the interests o* shareholders.

2. Definition of a Financial Asset


Re"all the de*inition o* a *inan"ial asset=

'8

Introduction to Corporate Financial Analysis


A *inan"ial asset is a legal "ontra"t bet4een t4o s!e"i*i" individ,als 4hereby at least one !arty 2 and ost "o only only one !arty and ty!i"ally in e9"hange *or i ediate "ash 2 !ro ises to ake *,t,re !ay ents 2 generally in "ash and o*ten "ontinently 2 to the other !arty. ;n the "ase o* a ter li*e ins,ran"e "ontra"t% the individ,al 4ho !,r"hases the ins,ran"e is the holder o* the *inan"ial asset. :he !ri"e o* the *inan"ial asset is the !re i, !aid *or the ins,ran"e !oli"y. :he iss,er o* the *inan"ial asset is the ins,ran"e "o !any. :he !ro ised !ay ent is the death bene*it. :he "ontingen"y is the ,n*ort,nate death o* the o4ner o* the *inan"ial asset. :er li*e ins,ran"e is a rather s!e"ial ty!e o* *inan"ial asset. First% the *inan"ial asset !ays o** ,!on the death o* the o4ner. )e"ond% the !ro ised !ay ent is not ade to the o4ner o* the *inan"ial asset b,t to a third !arty= the bene*i"iary o* the ins,ran"e !oli"y.

3. Real Versus Financial Assets


Re"all the de*inition o* a real asset= :here are t4o de*ining "hara"teristi"s o* a real asset. A real asset is an asset that is not established by legal "ontra"t bet4een s!e"i*i" individ,als and it ,st be o!erated to !rod,"e a ret,rn. An i !li"ation o* these "hara"teristi"s is that *or a real asset% there are no "ontra"t,ally !ro ised !ay ents bet4een s!e"i*i" individ,als. While a s!e"i*i" !atent ight e9ist be"a,se o* a so"ial "ontra"t bet4een individ,als in a nation state% it is not a "ontra"t bet4een s!e"i*i" individ,als. ;n !arti",lar% there are no !ro ised !ay ents on a !atent. ;n addition% so e ti e o* o!eration is re?,ired *or a !atent to !rod,"e a ret,rn. For these reasons ; 4o,ld "on"l,de that a !atent is a real asset rather than a *inan"ial asset.

4. Real Versus Financial Assets

Re"all the de*inition o* a real asset= :here are t4o de*ining "hara"teristi"s o* a real asset. A real asset is an asset that is not established by legal "ontra"t bet4een s!e"i*i" individ,als and it ,st be o!erated to !rod,"e a ret,rn. An i !li"ation o* these "hara"teristi"s is that *or a real asset% there are no "ontra"t,ally !ro ised !ay ents bet4een s!e"i*i" individ,als. :his asset has *eat,res o* both a real asset and a *inan"ial asset. ; 4o,ld arg,e that it has ore o* the "hara"teristi"s o* a real asset. While royalty legislation is a so"ial "ontra"t bet4een individ,als in a nation state% it is not a "ontra"t bet4een s!e"i*i" individ,als. A ,si"ian "reates the song as the res,lt o* a "reative !ro"ess. ;t is not "reated as a set o* !ro ised !ay ents bet4een individ,als. :here are !ro ised !ay ents *or ,se o* a song b,t these !ro ises are not bet4een s!e"i*i" individ,als% they are bet4een the o4ner o* the song and ,sers o* the song. All real assets re?,ire so e ty!e o* o!eration. For the asset at hand% o!eration is re?,ired o* the ,ser b,t not the o4ner o* the real asset.

5. Primary Versus econ!ary "ar#et $ra!es

6ne ight arg,e that a sto"k s!lit is not even a -trade./ A trade i !lies an e9"hange o* things o* val,e bet4een individ,als. ;n the "ase o* a sto"k s!lit% nothing o* val,e is really e9"hanged. :he *ir si !ly reiss,es all its "o on shares 4ith a ne4 set 4here the n, ber in the ne4 set is greater than the n, ber in the original set. Be"a,se o* the in"rease in the n, ber o* shares o,tstanding% !ri"e !er share "an be e9!e"ted to *all. Go, "an think o* a sto"k s!lit as a re!,r"hase o* all o* the shares o* a *ir at the arket !ri"e and a reiss,e o* ne4 shares by the *ir at the !ri"e !er share o* a -s!lit/ share. Both o* these -trades/ '8

Introduction to Corporate Financial Analysis


takes !la"e in a se"ondary arket% b,t be"a,se the iss,er is a !arty to these trades% yo, inter!ret a sto"k s!lit as a !ri ary arket trade. ight

2. Primary Versus econ!ary "ar#et $ra!es


A de*ining "hara"teristi" o* a !ri ary arket trade is that the iss,er is dire"tly a !arty to the transa"tion. :his "ondition is satis*ied *or a share re!,r"hase. :he trade takes !la"e thro,gh the *a"ilities o* a se"ondary arket b,t nonetheless% be"a,se the iss,er is the b,yer% it is a !ri ary arket trade. ;n *a"t% yo, ight sell shares in a "or!orate share re!,r"hase and never be a4are o* this *a"t be"a,se the !arties to trades in ost !,bli" *inan"ial arkets are anony o,s. )to"k and bond arkets are "alled se"ondary arkets be"a,se ost trades are se"ondary trades. Fo4ever% 4hen an iss,er re!,r"hases its o4n *inan"ial assets% a !ri ary arket trade has taken !la"e.

%. &nternal Versus '(ternal Financial Analysts


An internal *inan"ial analyst is e !loyed by the "or!oration. FisEher res!onsibilities are to onitor and i !rove ,!on the o!eration !er*or an"e o* the *ir . +9ternal *inan"ial analysts investigate the *inan"ial *eat,res o* a *ir *or the !,r!ose o* *inan"ial asset investing. Rnlike the internal *inan"ial analyst% ty!i"ally the !ri ary so,r"e o* *ir s!e"i*i" in*or ation is the *ir Bs !,bli" *inan"ial state ents. ;nternal *inan"ial analysts "o only "an a""ess ,"h ore detailed !rivate in*or ation o* the *ir s 4hi"h they 4ork *or.

). Primary Versus econ!ary "ar#et $ra!es

A ne4 *inan"ial asset is "reated in a short sale% and there*ore% it is a !ri ary arket trade altho,gh the trade "o only takes !la"e thro,gh the *a"ilities o* a se"ondary *inan"ial arket. ;n a short sale% yo, ,st -stand in the !la"e o* the iss,er/ 4ith res!e"t to distrib,tions o* val,e. ;n other 4ords% i* yo, short a "o on share and the *ir !ays a dividend% yo, ,st !ay this dividend to the individ,al 4ho !,r"hased the share in yo,r short sale. 1:he se",rities dealer 4here yo, have yo,r brokerage a""o,nt does the a""o,nting *or this !ay ent.3 ;n the short sale% yo, ake a !ro ised set o* !ay ents. Go, !ro ise to !ay dividends 4henever the *ir !ays dividends. :he sale !ri"e o* the *inan"ial asset is the !ri"e yo, re"eived in the short sale. ;n a short sale% yo, have e**e"tively "reated a ne4 "o on share. Rather than the *ir % yo, ake the dividend !ay ents on this ne4 "o on share.

*. Real Versus Financial Assets


:here are t4o de*ining "hara"teristi"s o* a real asset. ;t re?,ires o!eration to !rod,"e a ret,rn and it is not "reated as a set o* !ro ised "ash a o,nts bet4een s!e"i*i" individ,als.

+,. Definition of a Financial Asset

A lottery ti"ket is a *inan"ial asset. :he o4ner o* the *inan"ial asset is the !,r"haser o* the lottery ti"ket. :he seller o* the *inan"ial asset is the (ottery 5or!oration. :he (ottery 5or!oration !ro ises a o,nts in the *,t,re i* yo,r n, bers are "hosen. :he "ontingen"y is that yo,r n, bers are dra4n. :he rate o* ret,rn on a lottery ti"ket is negative. For every dollar that is "olle"ted% the (ottery 5or!oration !ays o,t abo,t L0.00% and there*ore% the rate o* ret,rn is 200M. #r,g dealers and gangsters o*ten ,se lottery ti"kets *or oney la,ndering. :hey are 4illing to a""e!t a negative rate o* ret,rn in order to trans*or a -dirty/ dollar into a "lean dollar. :he "lean dollar arises *ro lottery 4innings be"a,se the so,r"e o* this in"o e is easily established and veri*ied. F,rther% at least in 5anada% these 4innings are not even ta9ed. :he dr,g dealer !ays '&

Introduction to Corporate Financial Analysis


so eone to travel aro,nd lottery o,tlets and !,r"hase large b,t reasonable a o,nts o* lottery ti"kets. 6ver any o,tlets% a large n, ber o* ti"kets "an be a assed. ;n a large n, ber o* lottery ti"kets% yo, "an e9!e"t 00 "ents ba"k on the dollar. Fi*ty "ents on the dollar is !robably better than a dr,g dealer "an get on the -bla"k arket./ 6,r govern ent is e**e"tively r,nning a large oney la,ndering o!eration *or dr,g dealers in the sale o* lottery ti"kets.

++. Real Versus Financial Assets

:he "o**ee "ard has so e o* the "hara"teristi"s o* a real asset and so e o* the "hara"teristi"s o* a *inan"ial asset. :here are !ro ised !ay ents on the "o**ee "ard= one *ree "o**ee. :he !ri"e o* this asset is the other4ise higher "ost !er "o**ee o* the *irst nine "o**ees. 6n the other hand% there is so e s all ele ent o* o!eration re?,ired *or the "o**ee "ard. ;t ,st be !resented and !,n"hed *or ea"h o* the *irst nine !,r"hases. ;t is a atter o* yo,r inter!retation 4hether the "o**ee "ard is better "lassi*ied as a real or a *inan"ial asset. >ro*essor Rob Gra,er% o* )i on Fraser Rniversity% 4ho has a t4isted sense o* 4it% res!onded to this ?,estion by noting that the "o**ee "ard is a -li?,id/ asset.

1$! $he .or/orate Or-ani0ational Form !


:he "or!oration is the ost !ro inent organizational *or o* b,siness a"tivity in de o"rati" "o,ntries. By any eas,re o* a"tivity% *or e9a !le sales or asset size% "or!orations s,r!ass by a 4ide argin the !ri ary non2govern ent alternatives= sole !ro!rietorshi!s and !artnershi!s. :he !rin"i!al advantage o* the "or!orate *or 2 to 4hi"h all other advantages are related 2 is the legal identity o* a "or!oration. 5or!orations are legal !ersons in the eyes o* the la4H they have the sa e rights and d,ties% as do nat,ral !ersons. As the res,lt o* its legal identity% a "or!oration "an s,rvive its o4ners. :his "ontin,ity *a"ilitates intergenerational trans*ers o* 4ealth. ;n addition% this "ontin,ity akes it easier *or the *ir to sell *inan"ial assets be"a,se investors do not have to 4orry abo,t the de ise o* the "or!oration 4ith the de ise o* !rin"i!al andEor *o,nding shareholders. Be"a,se o* a legal identity% *ir s "an be s,ed *or 4rongdoing and da age se!arately *ro the *inan"ial asset2holders o* the *ir and other asso"iated gro,!s 1*or e9a !le= shareholders% bondholders% e !loyees% and anage ent3. (i ited liability arises *ro the legal identity o* a "or!oration. ;* a "or!oration de*a,lts on "ontra"t,al obligations 2 4ith e9"e!tions 4hi"h are *e4 and o* ar"ane legal "hara"ter 2 da aged !arties ,st seek re edy 4ith the "or!oration itsel* and not 4ith *inan"ial asset2holders 22 in"l,ding and in !arti",lar 22 "o on shareholders. :his *a"t i !lies that the a9i , invest ent loss a shareholder "an s,stain is hisEher original invest ent in a "o on share. :his *eat,re o* "o on share o4nershi! is attra"tive to investors and *a"ilitates not only tradability o* e9isting "o on shares b,t also the sale o* additional shares by "or!orations *or *inan"ing b,siness a"tivity. :he se!arate legal identity o* "or!orations !er its and *a"ilitates distin"t legislative treat ent o* "or!orations *ro nat,ral !ersons. An e9a !le o* this distin"tive treat ent arises in ta9ation. 5or!orate and !ersonal ta9able in"o es are "al",lated di**erently and di**erent rates are a!!lied in deter ining ta9es !ayable. ;n"reasingly% the in"o e ta9 legislation o* 4estern "o,ntries has treated "or!orations as inter ediaries bet4een !rod,"tion o* goods and servi"es and the distrib,tion o* bene*its o* that !rod,"tion to nat,ral !ersons. ;n light o* this re"ognition% in"o e has in"reasingly been ta9ed in the hands o* nat,ral !ersons and less onero,sly in the hands o* "or!orations. :his treat ent has en"o,raged the ,se o* "or!orations *or the de*erral or red,"tion 70

Introduction to Corporate Financial Analysis


o* ta9ation by nat,ral !ersons. For individ,als or "or!orations% ta9ation is an ines"a!able *a"t that ,st be re!resented in any "o !lete *inan"ial analysis. While li ited liability and ta9 advantages "ontrib,te to the !o!,larity o* the "or!orate *or % its !ri ary advantage is se!aration o* o4nershi! and "ontrol. .odern 4idely2held "or!orations "o,ld not have evolved i* it 4ere ne"essary *or all "or!orate b,siness de"isions to be agreed ,!on by either all o* or a a<ority o* shareholders. :his re?,ire ent 4o,ld not only i !ede "or!orate de"ision2 aking% b,t it 4o,ld also reveal to "o !etitors ele ents o* strategi" advantage. :hro,gh the a,thority o* legislated "or!orations a"ts% shareholders o* odern "or!orations have delegated the dire"tion o* "or!orate a**airs to boards o* dire"tors. #ire"tors are s all gro,!s o* individ,als ele"ted by shareholders. :hey are "harged 4ith the res!onsibility o* anaging the b,siness and a**airs o* the "or!oration. :he "or!orate *or o* b,siness organization has advantages 22 !ri arily that *ir s "an "on"entrate on b,siness a"tivity rather then oderate and re"on"ile the "o !eting and divergent vie4s o* individ,al shareholders 2 b,t it also has disadvantages. :he !ri ary disadvantage to shareholders 2 es!e"ially shareholders o* 4idely held "or!orations 2 is that they are distan"ed *ro o!erational "ontrol and in*l,en"e over b,siness a"tivity. ;* shareholders are ,nsatis*ied 4ith *ir !er*or an"e% it is o*ten the "ase that their only re"o,rse is to sell their shares. :his distan"ing o* shareholders *ro o!erations also distan"es shareholders *ro "or!orate in*or ation. Be"a,se shareholders are not generally !arty to "or!orate de"ision aking% they also do not have a""ess to "or!orate in*or ation ,sed in this !ro"ess. :his distan"ing res,lts *ro the legal identity o* "or!orations. Be"a,se the *ir is a legal individ,al% it has rights o* !riva"y 22 even *ro shareholders 4ho are ostensibly the o4ners o* the *ir . :he !ri ary so,r"e o* "or!orate in*or ation available to shareholders is also available to any investor or interested individ,al 22 a""o,nting *inan"ial state ents% 4hi"h are andated by legislated "or!orationsB a"ts.

+3. &nter/retation of 1PV


@et !resent val,e eas,res the in"rease in 4ealth arising *ro an invest ent. Fro a "or!orate !ers!e"tive% @>K is the in"re ent to *inan"ial asset2holdersB 4ealth arising *ro the *ir Bs real asset invest ent a"tivities. Wealth is the sellable val,e o* an asset and @>K is an atte !t to eas,re this sellable val,e. Be"a,se @>K is asso"iated 4ith at least the hy!otheti"al sale o* assets% it is inti ately related to% and really arises o,t o*% the trading o* *inan"ial assets in *inan"ial arkets. :he val,e o* an invest ent is deter ined% at least in !art% by the alternative invest ents that are available. A "riti"ally i !ortant "o !onent o* @>K is there*ore an o!!ort,nity "ost that re!resents the e9!e"ted rate o* ret,rn on these alternative invest ents 14hi"h are o* !res, ably e?,ivalent risk3. :he other "o !onents o* @>K are !redi"ted *,t,re "ash *lo4s and the ti ing o* these "ash *lo4s. :he "ash *lo4s di**er de!ending ,!on the asset ,nder "onsideration. @>K "an be di**i",lt to a!!ly in !ra"ti"e be"a,se the "ash *lo4s "an be di**i",lt to !redi"t. ;n addition% the notion o* -e?,ivalent risk/ is di**i",lt to a!!ly. Finally% deter ining the e9!e"ted rate o* ret,rn on invest ents o* e?,ivalent risk re?,ires "onsiderable ,nderstanding o* ho4 rates o* ret,rn are deter ined in *inan"ial arkets. Be"a,se this !ro"ess is not obvio,s% @>K is also di**i",lt to a!!ly.

+4. Primary Versus econ!ary "ar#et $ra!es


71

:he sale by a *ir o* ne4 shares to ne4 shareholders is a !ri ary arket trade o* a *inan"ial asset be"a,se a ne4 *inan"ial asset is "reated. ;t is tr,e that event,ally% this ne4 share ight trade in an

Introduction to Corporate Financial Analysis


organized sto"k arket 4here trades are !ri arily se"ondary A that is% bet4een investors rather than bet4een the *ir and investors A ho4ever% in the *irst instan"e% 4hen a *ir sells ne4 shares% a ne4 *inan"ial asset is "reated 4hi"h is a !ri ary arket trade.

+5. Definition of a Financial Asset

:he sale by a *ir o* ne4 shares to ne4 shareholders is a !ri ary arket trade o* a *inan"ial asset be"a,se a ne4 *inan"ial asset is "reated. ;t is tr,e that event,ally% this ne4 share ight trade in an organized sto"k arket 4here trades are !ri arily se"ondary A that is% bet4een investors rather than bet4een the *ir and investors A ho4ever% in the *irst instan"e% 4hen a *ir sells ne4 shares% a ne4 *inan"ial asset is "reated 4hi"h is a !ri ary arket trade.

+2. 1et Present Value an! the "ar#et to 3oo# Ratio

Be"a,se the ;RR is 70M% 170%000E1.72; P 0% so ; P 100%000. .arket val,e P 100%000S1.2 P 120%000. Also% arket val,e P 120%000 P 170%000E11Qr3% so r P 1$.$8M.

+%. O//ortunity .ost

:his ?,estion is isstated. :he o!!ort,nity "ost rate o* ret,rn is not the rate o* ret,rn that a *ir earns *ro its invest ent into b,siness a"tivity. :he rate o* ret,rn that a *ir earns *ro its b,siness invest ent is rate o* ret,rn is as the rate o* ret,rn on invested "a!ital 1a*ter ta9 and a*ter de!re"iation3. An o!!ort,nity "ost re!resents an -ne9t best/ ,se o* s"are reso,r"e. ;n this instan"e% *inan"ial asset holders "an invest in this !arti",lar *ir or alternatively% they "an invest in *inan"ial assets. :he o!!ort,nity "ost rate o* ret,rn is% there*ore% established in *inan"ial arkets and is ,sed as a ben"h ark *or "or!orate o!erating !er*or an"e. ;t is the rate o* ret,rn that *inan"ial asset2holders "an earn on their o4n 1at least on average3 on *inan"ial assets o* ore or less the sa e risk as the *ir Bs b,siness invest ent.

+). Definition of a Real Asset

:here are t4o de*ining "hara"teristi"s o* a real asset. First% it is not "reated by legal "ontra"t bet4een s!e"i*i" individ,als. :his "hara"teristi" is satis*ied by the a!art ent b,ilding. :he b,ilding 4as not "reated by legal "ontra"ted. ;t 4as "reated be"a,se so eone b,ilt it in order to earn a rate o* ret,rn on this invest ent. )e"ond% a real asset ,st be o!erated to !rod,"e a ret,rn. :here are no !ro ised !ay ents on a real asset% i* it is le*t idle it !rod,"es no ret,rn. :his "hara"teristi" is also satis*ied by an a!art ent b,ilding. An a!art ent b,ilding ,st be o!erated to !rod,"e a ret,rn. ;t ,st be "leaned and re!aired% the rent ,st be "olle"ted% s,!!liers and bills ,st be !aid% et". ;n the state ent o* the !roble % it is asserted that risk is a de*ining "hara"teristi" o* a real asset. :his assertion is in"orre"t. Real assets "an be ore or less risky than *inan"ial assets% b,t in any event% they are not de*ined by risk.

1&. :he Funda ental 4uestions of Financial Analysis!

:he three *,nda ental ?,estions o* *inan"ial analysis are= risk% ret,rn% and e9!endit,re. ;* a *inan"ial analyst 4ants to investigate these ?,estions *or a *ir % then a n, ber o* *inan"ial ratios and eas,res are !ossible. :heir ,se de!ends ,!on the !arti",lar sit,ation at hand. We "an eas,re b,siness e9!endit,re 4ith invested "a!ital. ;nvest ent by the *ir *or shareholders is book e?,ity% !ossibly eas,red as the s, o* share "a!ital !l,s retained earnings. 72

Introduction to Corporate Financial Analysis


We "an eas,re ret,rn 4ith the rate o* ret,rn on invested "a!ital 1R6;53 *or all o* the *ir Bs *inan"ial asset holders and 4ith rate o* ret,rn on e?,ity 1R6+3 *or a *ir Bs shareholders in !arti",lar. Ret,rn *or "reditors is the interest rate that a *ir !ays on its debt. :here are n, ero,s !ossible risk eas,res% 4hi"h in"l,de% the ",rrent ratio% the ?,i"k ratio% ti es interest earned% *i9ed !ay ent "overage ratio% the degree o* o!erating leverage 1#6(3% and the +B;:#A argin as an inverse eas,re o* b,siness risk. +a"h o* these risk eas,res is s,itable *or di**eren"e b,siness sit,ations.

$+! =efinition of a ,eal Asset!

:here are t4o de*ining "hara"teristi"s o* a real asset. First% it 4as not "reated by legal "ontra"t bet4een s!e"i*i" and identi*iable individ,als. )e"ond% it ,st be o!erated to !rod,"e a ret,rn. A herd o* "attle 4as not "reated by legal "ontra"t. F,rther% i* yo, do nothing 4ith the "attle *or the !,r!ose o* ilk or eat !rod,"tion they earn no ret,rn. )o% a herd o* "attle see s to satis*y o,r de*inition o* a real asset. #e!re"iability is not a de*ining "hara"teristi" o* a real asset. ;t is a "o on "hara"teristi"% b,t not a de*ining "hara"teristi".

$1! 7ar8et to 5oo8 ,atio


Fir s ake b,siness invest ents 4hen they e9!e"t to earn a rate o* ret,rn better than the o!!ort,nity "ost o* their *inan"ial asset holders and their shareholders in !arti",lar. :his e9!e"tation eans that% at least 4hen they *irst ake these b,siness invest ents% val,e is greater than e9!endit,re% be"a,se other4ise the invest ents 4o,ld not be ade. Be"a,se val,e e9"eeds e9!endit,re% the arket to book ratio *or -ne4 vent,re/ *ir s is al4ays greater than one. Fo4ever% as ti e !asses a*ter the b,siness invest ent% o!erating !er*or an"e ight eet e9!e"tations. #o4n4ardly revised e9!e"tations ean that val,e *alls relative to e9!endit,re. ;t "an *all to s,"h an e9tent that val,e is belo4 e9!endit,re% in 4hi"h "ase% the arket to book ratio is less than one.

$$! >pportunity Cost


@ote that the sol,tion to this !roble re?,ires the *or ,la *or the !resent val,e o* a gro4ing !er!et,ity. ;* yo, donBt kno4 this *or ,la% yo, "an *ind it in "ha!ter $. Be"a,se the ;RR is 70M% 70%000E10.7020.0032;P0% so% ;P100%000. @o4% the arketEbook ratio is 7% so 170000E1r20.0033E100%000P7% so rP10M.

7'

Introduction to Corporate Financial Analysis

11.123
a""o,nting balan"e sheet............................28 a""o,nts re"eivable.....................................12 arti"les o* in"or!oration..............................1$ asset..............................................................& board o* dire"tors.......................................11 boards o* dire"tors......................................1$ "o on sto"k............................................11 "or!orate organizational *or ....................17 dis"o,nted "ash *lo4..................................20 dividends.....................................................11 *inan"ial analysis...........................................0 Finan"ial analysis..........................................8 *inan"ial asset..........................................7% 11 *inan"ial state ents.....................................18 ;n"or!oration..............................................12 internal rate o* ret,rn..................................20 invest ent....................................................7 investor.......................................................11 (i ited liability...........................................10 long !osition...............................................11 arket to book ratio...................................'0 arket val,e balan"e sheet.........................28 a9i ization o* shareholdersD 4ealth.........1& ortgage....................................................11 net !resent val,e.........................................20 o!erating asset..............................................0 o!!ort,nity "ost.........................................20 o!!ort,nity "ost o* "a!ital..........................22 !artnershi!s................................................10 !ri ary arket trade..................................1' !rivate *inan"ial asset..................................1' !,bli" *inan"ial asset...................................12 real asset...................................................7% & risk................................................................$ se"ondary arket trade..............................1' se",ritization..............................................17 se",rity.......................................................12 short !osition..............................................11 sole !ro!rietorshi!s....................................10 Wealth........................................................1& 4eighted average "ost o* "a!ital................22

77