Financial Analysis, Planning & Forecasting. Theory and Application. Alice C Lee. State Street Corp., USA. John C Lee. Center for PBBEF Research, USA

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1 Financial Analysis, Planning & Forecasting Theory and Application Alice C Lee State Street Corp., USA John C Lee Center for PBBEF Research, USA Cheng F Lee Rutgers University, USA World Scientific NEW JERSEY LONDON SINGAPORE BEIJING S H A N G H A I HONG KONG TAIPEI CHENNAI

2 Contents 1. Introduction Financial Management: Analysis and Planning Basic Definitions Objectives of Financial Management Planning Horizon Classification Objectives and Philosophy of the Book Structure of the Book 4 Problem Set 8 References for Chapter 1 8 Part 1 Information and Methodology for Financial Analysis Accounting Information, Regression Analysis, and Financial Management Introduction Financial Statements: A Brief Review Balance Sheet Statement of Earnings (Income Statement) Statement of Equity Statement of Cash Flows Annual vs Quarterly Financial Data Critique of Accounting Information Criticism Method for Improvement Use of Alternative Information Statistical Adjustments 30

3 cii Financial Analysis, Planning, and Forecasting Application of Finance and Economic Theories Static-Ratio Analysis and Its Extension Static Determination of Financial Ratios Liquidity Ratios Leverage Ratios Activity Ratios Profitability Ratios Estimation of the Target of a Ratio Dynamic Analysis of Financial Ratios Single-Equation Dynamic Adjustment Process Simultaneous Determination of Financial Ratios Statistical Distribution of Financial Ratios Cost-Volume-Profit Analysis and Its Applications Deterministic Analysis Stochastic Analysis Accounting Income vs Economic Income Summary 49 Problem Set 50 Appendix 2.A. Simple Regression and Multiple Regression A.I. Introduction 56 2.A.2. Simple Regression 57 2.A.3. Variance of b 60 2.A.4. Multiple Regression 61 Appendix 2.B. Instrumental Variables and Two-Stage Least Squares 66 2.B.I. Errors-in-Variable Problem 66 2.B.2. Instrumental Variables 68 2.B.3. Two-Stage, Least-Square 70 References for Appendix 2 71 References for Chapter Discriminant Analysis and Factor Analysis: Theory and Method Introduction Important Concepts of Linear Algebra 74

4 Contents xiii 3.3. Two-Group Discriminant Analysis fc-group Discriminant Analysis Factor Analysis and Principal-Component Analysis Summary 92 Notes 92 Problem Set 92 Appendix 3.A. Relationship between Discriminant Analysis and Dummy Regression Analysis 93 3.A.I. Derivation of the Discriminant Function 93 Appendix 3.B. Principal-Component Analysis 98 3.B.I. Introduction 98 References for Chapter Application of Discriminant Analysis and Factor Analysis in Financial Management Introduction Credit Analysis Bankruptcy and Financial Distress Analysis Applications of Factor Analysis to Select Useful Financial Ratios Bond Rating Forecasting Bond Quality Ratings and the Change of Quality Ratings for the Electric Utility Industry Ohlson's and Shumway's Methods for Estimating Default Probability Summary 127 Problem Set 127 Appendix 4.A. Jackknife Method and its Application in MDA Analysis 128 References for Appendix References for Chapter Determination and Applications of Nominal and Real Rates-of-Return in Financial Analysis Introduction Theoretical Justification of Paying Interest Rate-of-Return Measurements and Types of Averages. 137

5 xiv Financial Analysis, Planning, and Forecasting Discrete Rates-of-Return and Continuous Rates-of-Return Types of Averages Power Means Theories of the Term Structure and Their Application Interest Rate, Price-Level Changes, and Components of Risk Premium Imperfect-Foresight Case Perfect-Foresight Case Three Hypotheses about Inflation and the Value of the Firm: A Review The Debtor-Creditor Hypothesis The Tax-Effects Hypothesis Operating-Income Hypothesis The Relationship among the Three Hypotheses Summary and Concluding Remarks 160 Problem Set 161 Appendix 5.A. Compounding and Discounting Processes and Their Applications A.I. Single-Value Case A.I.I. Compound Future Sum (Terminal Value) A.I.2. Present Value A.2. Annuity Case A.2.1. Compound Future Sum of An Annuity A.2.2. Present Value of An Annuity 170 Appendix 5.B. Taylor Series Expansion and Its Applications to Rates-of-Return Determination 171 References for Chapter Project I Analyses of Accounting, Market and Economic Data 179 Part 2 Alternative Financial Theories and Cost of Capital Valuation and Capital Structure: A Review and Integration 181

6 Contents xv 6.1. Introduction Components of Capital Structure Opportunity Cost, Required Rate-of-Return, and the Cost of Capital Bond Valuation Perpetuity Term Bonds Preferred Stock Common-Stock Valuation Valuation Inflation and Common Stock Valuation Growth Opportunity and Common-Stock Valuation Financial Leverage and Its Effect on EPS Measurement Effect Degree of Financial Leverage and Combined Effect Optimal Capital Structure Overall Discussion Arbitrage Process and the Proof of M&M Proposition I Possible Reasons for Optimal Capital Structure The Traditional Approach of Optimal Capital Structure Bankruptcy Costs Agency Costs Imperfect Markets Summary and Remarks 218 Questions and Problems 219 Appendix 6.A. Convertible-Security Valuation Theory Appendix 6.B. Derivation of DOL, DFL, and CML B.I. DOL B.2. DFL B.3. DCL 237 Appendix 6.C. Derivation of Dividend Discount Model C.I. Summation of Infinite Geometric Series C.2. Dividend Discount Model 238 References for Appendix References for Chapter 6 239

7 cvi Financial Analysis, Planning, and Forecasting 7. Risk Estimation and Diversification Introduction Risk Classification Business Risk Financial Risk Total Risk Portfolio Analysis and Application Expected Rate of Return on a Portfolio Variance and Standard Deviation of a Portfolio The Two-asset Case The AT-asset Case The Efficient Portfolios Corporate Application of Diversification The Market Rate of Return and Market Risk Premium The Risk Premium Determination of Commercial Lending Rates The Dominance Principle and Performance Evaluation Summary 264 Questions and Problems 264 Appendix 7.A. Estimation of Market Risks Premium 271 Appendix 7.B. The Normal Distribution 272 Appendix 7.C. Derivation of Minimum-Variance Portfolio Appendix 7.D. Sharpe Performance Approach to Derive Optimal Weight 277 References for Appendix References for Chapter Risk and Return Trade-Off Analysis Introduction Capital Market Line, Efficient-Market Hypothesis and Capital Asset Pricing Model Lending, Borrowing, and the Market Portfolio The Capital Market Line The Efficient-Market Hypothesis Weak-Form Efficient-Market Hypothesis Semistrong-Form Efficient-Market Hypothesis Strong-Form Efficient-Market Hypothesis The Capital Asset Pricing Model 288

8 Contents xvii 8.3. The Market Model and Beta Estimation Empirical Evidence for the Risk-Return Relationship Why Beta is Important in Financial Management Systematic Risk Determination Business Risk and Financial Risk Other Financial Variables Capital Labor Ratio Fixed Costs and Variable Costs Market-Based versus Accounting-Based Beta Forecasting Some Applications and Implications of the Capital Asset Pricing Model Applications Liquidity and Capital Asset Pricing Model Arbitrage Pricing Theory Intertemporal CAPM Summary 308 Questions and Problems 308 Appendix 8.A. Mathematical Derivation of the Capital Asset Pricing Model 314 Appendix 8.B. Arbitrage Pricing Model 315 References for Chapter Note 320 Options and Option Strategies Introduction The Option Market and Related Definitions What is an Option? Types of Options and Their Characteristics Relationships Between the Option Price and the Underlying Asset Price 324 Sample Problem Additional Definitions and Distinguishing Features Types of Underlying Asset Institutional Characteristics Put-Call Parity European Options 331

9 xviii Financial Analysis, Planning, and Forecasting Sample Problem American Options 334 Sample Problem Future Options Market Application Risk-Return Characteristics of Options Long Call Short Call Long Put Short Put Long Straddle 345 Sample Problem Short Straddle 348 Sample Problem Long Vertical (Bull) Spread 350 Sample Problem Short Vertical (Bear) Spread Calendar (Time) Spreads Examples of Alternative Option Strategies Protective Put Covered Call Collar Summary 359 Questions and Problems 360 References for Chapter Option Pricing Theory and Firm Valuation Introduction Basic Concepts of Options Option Price Information Factors Affecting Option Value Determining the Value of a Call Option before the Expiration Date Determining the Value of Options Expected Value Estimation The Black-Scholes Option Pricing Model Taxation of Options American Options 390

10 Contents xix Option Pricing Theory and Capital Structure Proportion of Debt in Capital Structure ' Riskiness of Business Operations Option Pricing Approach to Determine the Optimal Capital Structure Warrants Summary 400 Questions and Problems 400 Appendix 10.A. Applications of the Binomial Distribution to Evaluate Call Options A.1. What is an Option? A.2. The Simple Binomial Option Pricing Model A.3. The Generalized Binomial Option Pricing Model 408 References for Chapter Project II Application of Useful Finance Theories 415 Part 3 Capital Budgeting and Leasing Decisions Alternative Cost of Capital Analysis and Estimation Introduction Overview of Cost of Capital Average Earnings Yield Versus Current Earnings Yield Method Discounting Cash-Flow Method Weighted-Average Cost of Capital Theoretical,! ustification of the WACC The CAPM Method M&M's Cross-Sectional Method The Cost of Capital Regression Formulation and Empirical Results Chase Cost of Capital Summary and Concluding Remarks 446 Problem Set 446

11 xx Financial Analysis, Planning, and Forecasting Appendix 11. A. Derivative of the Basic Equilibrium Market Price of Stock and Its Implications References for Appendix References for Chapter Capital Budgeting Under Certainty Introduction Cash-Flow Evaluation of Alternative Investment Projects Alternative Capital-Budgeting Methods Accounting Rate-of-Return Internal Rate-of-Return Payback Method Net Present Value Method Profitability Index Comparison of the NPV and IRR Method Theoretical Criteria Multiple Rates-of-Return Reinvestment Rate Problem Separability of Projects Practical Perspective Equivalent Annual NPV and Equivalent Annual Cost Mutually Exclusive Investment Projects with Different Lives Capital-Rationing Decision Basic Concepts of Linear Programming Capital Rationing Summary 480 Problem Set 480 Appendix 12.A. NPV and Break-Even Analysis 485 Appendix 12.B. Managers' View on Alternative Capital-Budgeting Methods 490 Appendix 12.C. Derivation of Crossover Rate 495 References for Appendix References for Chapter Capital Budgeting Under Uncertainty Introduction 501

12 Contents xxi Risk-Adjusted Discount-Rate Method Certainty Equivalent Method The Relationship of the Risk-Adjusted Discount-Rate Method to the Certainty-Equivalent Method Three Other Related Stochastic Approaches to Capital Budgeting The Statistical Distribution Method The Decision-Tree Method Simulation Analysis Comparison of the Three Alternative Stochastic Methods Inflationary Effects in the Capital-Budgeting Procedure Multiperiod Capital Budgeting Overall Discussion The CAPM and Multi-Period Capital-Budgeting Decision-Making Summary and Concluding Remarks 543 Problem Set 544 Appendix 13.A. Time-State Preference and the Real option Approaches for Capital Budgeting Under Uncertainty 550 References for Appendix References for Chapter Leasing: Practices and Theoretical Developments Introduction Types of Leasing Arrangements and Accounting Treatments Three Leasing Forms Direct Leasing Sale and Leaseback Leveraged Leasing Accounting for Leases Capital Lease Treatment Accounting for Operating Leases Accounting for Leases from the Lessor's Standpoint 571

13 xxii Financial Analysis, Planning, and Forecasting Cash-Flow Estimation and Valuation Methods The Modigliani and Miller Propositions and the Theoretical Considerations of Leasing Leases-Versus-Buy Decisions Under Uncertainty: The CAPM Approach Summary and Conclusions 586 Problem Set 588 Appendix 14.A. APV Method and Application to Leasing Decision A.I Myers Adjusted-Present-Value Method A.2 Myers Adjusted-Present-Value Method to Leasing 591 References for Appendix References for Chapter Project III Capital Budgeting and Leasing Decisions 597 Part 4 Corporate Policies and Their Interrelationships Mergers: Theory and Evidence Introduction Overview of Mergers Classification of Business Combinations Classification by Corporate Structure Classification by Economic Relationship Methods of Business Combination Merger Accounting and Tax Effects Tax Implications Accounting Treatment of Business Combinations Economic Theories and Evidence Economic Theories Market Power Financial Theories and Evidence Diversification and Debt Capacity Integration and Summary 628 Problem Set 631 Appendix 15.A. Effects of Divestiture on Firm Valuation References for Chapter

14 Contents xxiii 16. Dividend Policy and Empirical Evidence Introduction The Value of Dividend Policy to the Firm Methods of Determining the Relevance of Dividends The Discounted Cash-Flow Approach The Investment Opportunities Approach Stream-of-Dividends Approach Stream-of-Earnings Approach Issues Marring the Dividend Problem The Classical CAPM Brennan's CAPM with Taxes The Litzenberger and Ramaswamy CAPM with Taxes Empirical Evidence Gordon's Empirical Work and Its Extensions M&M Empirical Work CAPM Approach Behavioral Considerations of Dividend Policy Partial Adjustment and Information Content Models An Integration Model Summary and Conclusions 672 Problem Set' 673 References for Chapter Interaction of Financing, Investment and Dividend Policies Introduction Investment and Dividend Interactions: The Internal-Versus-External Financing Decision Internal Financing External Financing Interactions Between Dividend and Financing Policies Cost of Equity Capital and Dividend Policy Default Risk and Dividend Policy 687

15 Financial Analysis, Planning, and Forecasting Interactions Between Financing and Investment Decisions Risk-Free Debt Case Risky Debt Case Implications of Financing and Investment Interactions for Capital Budgeting Equity-Residual Method t After-Tax, Weighted-Average Cost of Capital Method Arditti and Levy Method Myers Adjusted-Present-Value Method Debt Capacity and Optimal Capital Structure Implications of Different Policies on the Beta Coefficient Determination Impact of Financing Policy on Beta Coefficient Determination Impact of Production Policy on Beta Coefficient Determination Impact of Dividend Policy on Beta Coefficient Determination Summary and Conclusion 718 Problem Set 720 Appendix 17.A. Stochastic Dominance and Its Applications to Capital-Structure Analysis with Default Risk A.1. Introduction A.2. Concepts and Theorems of Stochastic Dominance A.3. Stochastic-Dominance Approach to Investigating the Capital-Structure Problem with Default Risk A.4. Summary 728 References for Appendix References for Chapter

16 Contents xxv Project IV Analyses of Investment, Financing and Dividend Policies 733 Part 5 Financial Planning and Forecasting Short-Term Financial Analysis and Planning Introduction The Components of Working Capital The Concept of Cash Flow Cash Flow versus Funds Flow Organizing for Short-Term Financial Planning Short-Term Financial Planning Principles The Cash Flow Cycle and Its Calculation Cash Flow Forecasting, Budgeting, and Planning The Cash Budget Demand-Driven, Capital-Driven, and Cost-Driven Cash Budgets Users of Cash Forecasts and Business Plans Planning Horizons and Time Intervals of Cash Budgets From Forecasting to Budgeting to Planning Summary 759 Questions and Problems 761 Appendix 18.A. Time-Series Components of Sales A.I The Contribution of Each Component A.2 Interpretation 771 References for Chapter Credit Management Introduction Trade Credit The Cost of Trade Credit The Seller's Perspective The Buyer's Perspective 780

17 xxvi Financial Analysis, Planning, and Forecasting Financial Ratios and Credit Analysis Financial Ratio Analysis Numerical Credit Scoring Benefits of Credit-Scoring Models Outside Sources of Credit Information Credit Decision and Collection Policies Collection Policy Factoring and Credit Insurance Summary 792 Questions and Problems 793 References for Chapter Cash, Marketable Securities, and Inventory Management Introduction The Baumol and Miller-Orr Model Baumol's EOQ Model Miller-Orr Model Cash Management Systems Float Cash Collection and Transference Systems Cash Transference Mechanism and Scheduling Credit Lines and Bank Relations Bank Relations Marketable Securities Management Investment Criteria for Surplus Cash Balances.., Types of Marketable Securities Hedging Considerations Inventory Management Inventory Loans Economic Order Quantity Summary 821 Questions and Problems 822 Appendix 20.A. Derivation of Eq. (20.1) 825 References for Chapter Elementary Applications of Programming Techniques in-working-capital Management 827

18 Contents xxvii Introduction Linear Programming Working-Capital Model and Short-Term Financial Planning Questions to be Answered Model Specification and Its Solution Which Constraints are Causing Bottlenecks? How Much More Profit is Being Lost Because of Constraints? How do the Constraints Affect the Solution? Duality and Shadow Prices Short-Term Financial Planning Goal Programming Introduction Application of GP to Working-Capital Management Summary and Remarks on Goal Programming Programming Approach to Cash Transfer and Concentration Transfer Mechanisms Cash-Transfer Scheduling: Contemporary Practice Managing About a Target Anticipation Weekend Timing and Dual Balances Limitations of the Popular Techniques Mathematical-Programming Formulation The Objective Function Constraints on Transfers Include: Average Balance, Flow Balance, Minimum Balance, and Maximum Transfer Formulation Summary Deposit Variation Relation of Model Formulation to Current Practice Implementation Tests Field Concentration Tests Lockbox Concentration 861

19 xxviii Financial Analysis, Planning, and Forecasting Summary and Concluding Remarks 861 Problem Set 862 Appendix 21.A. The Simplex Algorithm for Solving Eq. (21.8) 862 Appendix 21.B. Mathematical Formulation of Goal Programming 865 References for Chapter Long-Range Financial Planning A Linear-Programming Modeling Approach Introduction Carleton's Model Brief Discussion of Data Inputs Objective-Function Development The Constraints Definitional Constraints Sources and Uses Definition Policy Constraints Analysis of Overall Results Summary and Conclusion 907 Problem Set 907 Appendix 22.A. Carleton's Linear-Programming Model: General Mills as a Case Study., A.I Problem Specification A.2 Solution 909 Appendix 22.B. General Mills' Actual Key Financial Data References for Chapter Simultaneous-Equation Models for Financial Planning Introduction Warren and Shelton Model Anheuser-Busch Companies, Inc. As A Case Study Data Sources and Parameter Estimations Procedure for Calculating WS Model Francis and Rowell (FR) Model The FR Model Specification Sector One: Industry Sales Sector Two: Company Sales and Production 942

20 Contents xxix Sector Three: Fixed Capital-Stock Requirements Sector Four: Pricing Sector Five: Production Costs Sector Six: Income Sector Seven: New Financing Required Sector Eight: Risk Sector Nine: Cost of Financing Sector Ten: Common Stock Valuation A Brief Discussion of FR's Empirical Results Summary 948 Problem Set 948 Appendix 23.A. Procedure of Using Microsoft Excel to Run FINPLAN Program 949 Appendix 23.B. Program of FINPLAN with an Example References for Chapter Time-Series: Analysis, Model, and Forecasting Introduction The Classical Time-Series Component Model The Trend Component The Seasonal Component The Cyclical Component and Business Cycles The Irregular Component Moving Average and Seasonally Adjusted Time Series Moving Average Seasonal Index and Seasonally Adjusted Time Series Linear and Log-Linear Time Trend Regressions Exponential Smoothing and Forecasting Simple Exponential Smoothing and Forecasting The Holt-Winters Forecasting Model for Non-Seasonal Series Autoregressive Forecasting Model Summary 993

21 xxx Financial Analysis, Planning, and Forecasting Problem Set 994 Appendix 24.A. The X-ll Model for Decomposing Time-Series Components 1008 Appendix 24.B. The Holt-Winters Forecasting Model for Seasonal Series 1014 References for Chapter Econometric Approach to Financial Analysis, Planning, and Forecasting Introduction Simultaneous Nature of Financial Analysis, Planning, and Forecasting Basic Concepts of Simultaneous Econometric Models Interrelationship of Accounting Information Interrelationship of Financial Policies The Simultaneity and Dynamics of Corporate-Budgeting Decisions Definitions of Endogenous and Exogenous Variables Model Specification and Applications Applications of SUR Estimation Method in Financial Analysis and Planning The Role of Firm-Related Variables in Capital-Asset Pricing The Role of Capital Structure in Corporate-Financing Decisions Applications of Structural Econometric Models in Financial Analysis and Planning A Brief Review AT&T's Econometric Planning Model Programming vs Simultaneous vs Econometric Financial Models Financial Analysis and Business Policy Decisions Summary 1051 Problem Set 1051 Appendix 25.A. Johnson & Johnson as a Case Study A.I Introduction 1052

22 Contents xxxi 25.A.2 Study of the Company's Operations A.2.1 Consumer A.2.2 Pharmaceuticals A.2.3 Medical Devices and Diagnostics A.3 Analysis of the Company's Financial Performance A.4 Variables and Time Horizon A.5 Model and Empirical Results References for Appendix References for Chapter Project V Analyses of Financial Planning and Forecasting 1073 Author Index 1075 Subject Index 1083

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