14 Part 1: Fundamental Concepts of Corporate Finance

federal, state, and local governments are also net borrowers in the aggregate
(although many foreign governments, such as those of China and oil-producing
countries, are actually net lenders). Banks and other financial corporations raise
money with one hand and invest it with the other. For example, a bank might raise
money from individuals in the form of a savings account and then lend most of that
money to business customers. In the aggregate, financial corporations borrow slightly
more than they lend.
Transfers of capital between savers and those who need capital take place in
three different ways. Direct transfers of money and securities, as shown in Panel 1
of Figure 1-1, occur when a business (or government) sells its securities directly to
savers. The business delivers its securities to savers, who in turn provide the firm
with the money it needs. For example, a privately held company might sell shares of
stock directly to a new shareholder, or the U.S. government might sell a Treasury
bond directly to an individual investor.
As shown in Panel 2, indirect transfers may go through an investment banking
house such as Goldman Sachs, which underwrites the issue. An underwriter serves
as a middleman and facilitates the issuance of securities. The company sells its stocks
or bonds to the investment bank, which in turn sells these same securities to savers.
Because new securities are involved and the corporation receives the proceeds of the
sale, this is a “primary” market transaction.
Transfers can also be made through a financial intermediary such as a bank or
mutual fund, as shown in Panel 3. Here the intermediary obtains funds from savers
in exchange for its own securities. The intermediary then uses this money to pur-
chase and then hold businesses’ securities. For example, a saver might give dollars
to a bank and receive a certificate of deposit, and then the bank might lend the
money to a small business, receiving in exchange a signed loan. Thus, intermediaries
literally create new types of securities.

FIGURE 1-1 Diagram of the Capital Allocation Process

1. Direct Transfers

Business’s Securities
Business Savers
Dollars

2. Indirect Transfers through Investment Bankers

Business’s Business’s
Securities Securities
Investment Banking
Business Dollars Dollars Savers
Houses

3. Indirect Transfers through a Financial Intermediary

Business’s Intermediary’s
Securities Securities
Business Financial Savers
Dollars Intermediary Dollars
 Chapter 1: An Overview of Financial Management and the Financial Environment 43

FIGURE 1-6 The Determinants of Intrinsic Value: The Big Picture

Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix

Cost of debt
Cost of equity
Market risk aversion Firm’s business risk

lary and tools that you will use after graduation to improve your company’ s intrinsic
value. It is true that every manager needs to understand financial vocabulary and be
able to apply financial tools, but really successful managers also understand how their
decisions affect the big picture. So as you read this book, keep in mind where each
topic fits into the big picture.

e-RESOURCES
The textbook’
s Web site contains several types of files that will be helpful to you:
1. It contains Excel files, called Tool Kits, that provide well-documented models for
almost all of the text’ s calculations. Not only will these Tool Kits help you with
this finance course, they also will serve as tool kits for you in other courses and
in your career.
2. There are problems at the end of the chapters that require spreadsheets, and
the Web site contains the models you will need to begin work on these
resource problems.
When we think it might be helpful for you to look at one of the Web site’
s files,
we’ll show an icon in the margin like the one shown here.
Other resources are also on the Web site, including Cyberproblems and
problems that use the Thomson ONE—Business School Edition Web site. The
textbook’s Web site also contains an electronic library that contains Adobe PDF
60 Part 1: Fundamental Concepts of Corporate Finance

FIGURE 2-1 Calculating Free Cash Flow

Step 1 Step 2

Earning before interest and taxes Operating current assets

X (1 – Tax rate) – Operating current liabilities

Net operating profit after taxes Net operating working capital

Step 3
Net operating working capital
+ Operating long-term assets

Total net operating capital

Step 5
Step 4
Net operating profit after taxes
Total net operating capital this year
– Net investment in operating capital
– Total net operating capital last year

Free cash flow Net investment in operating capital

NOPAT ¼ EBITð1 − Tax rateÞ (2-3)

Using data from the income statements of Table 2-2, MicroDrive’s 2010 NOPAT is
NOPAT ¼ $283:8ð1 − 0:4Þ ¼ $283:8ð0:6Þ ¼ $170:3 million
This means MicroDrive generated an after-tax operating profit of $170.3 million,
a little better than its previous NOPAT of $263(0.6) = $157.8 million. However, the
income statements in Table 2-2 show that MicroDrive’s earnings per share actually
declined. This decrease in EPS was caused by an increase in interest expense, and not
by a decrease in operating profit.

Net Operating Working Capital

Most companies need some current assets to support their operating activities. For
example, all companies must carry some cash to “grease the wheels” of their opera-
tions. Companies continuously receive checks from customers and write checks to
suppliers, employees, and so on. Because inflows and outflows do not coincide per-
fectly, a company must keep some cash in its bank account. In other words, some
cash is required to conduct operations. The same is true for most other current as-
sets, such as inventory and accounts receivable, which are required for normal opera-
tions. The short-term assets normally used in a company’s operating activities are
called operating current assets.
Not all current assets are operating current assets. For example, holdings of
short-term securities generally result from investment decisions made by the
52 Part 1: Fundamental Concepts of Corporate Finance

2.3 THE INCOME STATEMENT

Table 2-2 shows the income statements for MicroDrive. Income statements can
resource cover any period of time, but they are usually prepared monthly, quarterly, and an-
See Ch02 Tool Kit.xls for nually. Unlike the balance sheet, which is a snapshot of a firm at a point in time, the
details. income statement reflects performance during the period.
Subtracting operating costs from net sales but excluding depreciation and amorti-
zation results in EBITDA, which stands for earnings before interest, taxes, deprecia-
tion, and amortization. Depreciation and amortization are annual charges that reflect
the estimated costs of the assets used up each year. Depreciation applies to tangible

M i c r oD r i v e I n c . : I n c o m e S t a t e m e n t s f or Ye a r s E n d i n g D e c e m b e r 3 1
TABLE 2- 2
( M i l l i o n s o f D o l l a rs , E x c ep t f o r P er Sh ar e D a t a )
2010 2009
Net sales $3,000.0 $2,850.0
Operating costs excluding depreciation and amortization 2,616.2 2,497.0
Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 383.8 $ 353.0

Depreciation 100.0 90.0

Amortization 0.0 0.0
Depreciation and amortization $ 100.0 $ 90.0
Earnings before interest and taxes (EBIT, or operating income) $ 283.8 $ 263.0
Less interest 88.0 60.0
Earnings before taxes (EBT) $ 195.8 $ 203.0
Taxes (40%) 78.3 81.2
Net income before preferred dividends $ 117.5 $ 121.8
Preferred dividends 4.0 4.0
Net income $ 113.5 $ 117.8
Additional Information
Common dividends $ 57.5 $ 53.0
Addition to retained earnings $ 56.0 $ 64.8
Per Share Data
Common stock price $ 23.00 $ 26.00
Earnings per share (EPS) $ 2.27 $ 2.36
Dividends per share (DPS) $ 1.15 $ 1.06
Book value per share (BVPS) $ 17.92 $ 16.80
Cash flow per share (CFPS) $ 4.27 $ 4.16

Notes: There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings after preferred divi-
dends—that is, on net income available to common stockholders. Calculations of the most recent EPS, DPS, BVPS, and
CFPS values are as follows:
Net income $113 ;500;000
Earnings per share ¼ EPS ¼ ¼ ¼ $ 2:27
Common shares outstanding 50;000;000

Dividends paid to common stockholders $57 ;500;000

Dividends per share ¼ DPS ¼ ¼ ¼ $ 1:15
Common shares outstanding 50;000;000

Total common equity $896 ;000;000

Book value per share ¼ BVPS ¼ ¼ ¼ $17 :92
Common shares outstanding 50;000;000

Net income þ Depreciation þ Amortization $213 ;500;000

Cash flow per share ¼ CFPS ¼ ¼ ¼ $ 4 :27
Common shares outstanding 50;000;000
58 Part 1: Fundamental Concepts of Corporate Finance

M i c r oD r i v e I n c . : S t a t e m e n t of Ca s h F l o w s f o r 2 0 10
T AB L E 2 - 4
(Millions of Dollars)
resource CASH PROVIDED
See Ch02 Tool Kit.xls for OR USED
details.
Operating Activities
Net income before preferred dividends $117.5
Adjustments:
Noncash adjustments:
Depreciationa 100.0
Due to changes in working capital:b
Increase in accounts receivable (60.0)
Increase in inventories (200.0)
Increase in accounts payable 30.0
Increase in accruals 10.0
Net cash provided (used) by operating activities ($ 2.5)
Investing Activities
Cash used to acquire fixed assetsc ($230.0)
Sale of short-term investments $ 65.0
Net cash provided (used) by investing activities ($165.0)
Financing Activities
Increase in notes payable $ 50.0
Increase in bonds outstanding 174.0
Payment of preferred and common dividends (61.5)
Net cash provided (used) by financing activities $162.5
Summary
Net change in cash ($ 5.0)
Cash at beginning of year 15.0
Cash at end of year $ 10.0
a
Depreciation is a noncash expense that was deducted when calculating net income. It must
be added back to show the correct cash flow from operations.
b
An increase in a current asset decreases cash. An increase in a current liability increases cash. For
example, inventories increased by $200 million and therefore reduced cash by a like amount.
c
The net increase in fixed assets is $130 million; however, this net amount is after a deduc-
tion for the year’s depreciation expense. Depreciation expense would have to be added
back to find the increase in gross fixed assets. From the company’s income statement, we
see that the 2010 depreciation expense is $100 million; thus, expenditures on fixed assets
were actually $230 million.

The second section shows investing activities. MicroDrive purchased fixed assets
totaling $230 million and sold $65 million of short-term investments, for a net cash
flow from investing activities of minus $165 million.
The third section, financing activities, includes borrowing from banks (notes payable),
selling new bonds, and paying dividends on common and preferred stock. MicroDrive
raised $224 million by borrowing, but it paid $61.5 million in preferred and common di-
vidends. Therefore, its net inflow of funds from financing activities was $162.5 million.
In the summary, when all of these sources and uses of cash are totaled, we see that
MicroDrive’s cash outflows exceeded its cash inflows by $5 million during 2010; that
is, its net change in cash was a negative $5 million.
MicroDrive’s statement of cash flows should be worrisome to its managers and to
outside analysts. The company had a $2.5 million cash shortfall from operations, it spent
 Chapter 3: Analysis of Financial Statements 103

TABLE 3-2 M i c r o D r i v e I n c . : S u m m a r y of F i n a n c i a l R a t i os (M i l l i on s o f D o l l a r s )
I N DU S T R Y
RATIO F O R MU L A CALCULATION RATIO A V ER AG E COMME NT

Liquidity
Current assets $1;000
¼ 3.2 4.2 Poor
Current Current liabilities $310

Current assets − Inventories $385

Quick ¼ 1.2 2.1 Poor
Current liabilities $310

Asset Management
Sales $3;000
Inventory turnover ¼ 4.9 9.0 Poor
Inventories $615

Receivables $375
Days sales outstanding ¼ 45.6 36.0 Poor
Annual sales=365 $8:219
(DSO)

Sales $3;000
Fixed assets turnover ¼ 3.0 3.0 OK
Net fixed assets $1;000

Sales $3;000
Total assets turnover ¼ 1.5 1.8 Poor
Total assets $2;000

Debt Management
Total liabilities $1;064
Debt ratio ¼ 53.2% 40.0% High (risky)
Total assets $2;000

Earnings before interest and taxes ðEBITÞ $283:8

Times-interest-earned ¼ 3.2 6.0 Low (risky)
Interest charges $88
(TIE)

EBITDA þ Lease pmts: $411:8

EBITDA coverage ¼ 3.0 4.3 Low (risky)
Interest þ Principal payments þ Lease pmts: $136

Profitability
Net income available to common stockholders $113:5
Profit margin on sales ¼ 3.8% 5.0% Poor
Sales $3;000

Earnings before interest and taxes ðEBITÞ $283:8

Basic earning power ¼ 14.2% 17.2% Poor
Total assets $2;000
(BEP)
Net income available to common stockholders $113:5
Return on total assets ¼ 5.7% 9.0% Poor
Total assets $2;000
(ROA)
Net income available to common stockholders $113:5
Return on common ¼ 12.7% 15.0% Poor
Common equity $896
equity (ROE)

Market Value
Price per share $23:00
Price/earnings (P/E) ¼ 10.1 12.5 Low
Earnings per share $2:27

Price per share $23:00

Price/cash flow ¼ 5.4 6.8 Low
Cash flow per share $4:27

Market price per share $23:00

Market/book (M/B) ¼ 1.3 1.7 Low
Book value per share $17:92