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  • An Introduction to Accounting and Managerial Finance - A Merger of Equals

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    内容提示: AN INTRODUCTION TOACCOUNTING andMANAGERIAL FINANCEA Merger of Equals This page intentionally left blankThis page intentionally left blank N EW J ER S EY • LO N D O N • S I N G APO R E • BEI J I N G • S H AN G H AI • H O N G KO N G • TAI PEI • CH EN N AI World ScientifcHarold Bierman, Jr.Cornell University, USAAN INTRODUCTION TOACCOUNTING andMANAGERIAL FINANCEA Merger of Equals Library of Congress Cataloging-in-Publication DataBierman, Harold.An introduction to accounting and man...

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    AN INTRODUCTION TOACCOUNTING andMANAGERIAL FINANCEA Merger of Equals This page intentionally left blankThis page intentionally left blank N EW J ER S EY • LO N D O N • S I N G APO R E • BEI J I N G • S H AN G H AI • H O N G KO N G • TAI PEI • CH EN N AI World ScientifcHarold Bierman, Jr.Cornell University, USAAN INTRODUCTION TOACCOUNTING andMANAGERIAL FINANCEA Merger of Equals Library of Congress Cataloging-in-Publication DataBierman, Harold.An introduction to accounting and managerial finance : a merger of equals /by Harold Bierman.p. cm.Includes index.ISBN-13: 978-981-4273-82-4 (hardcover)ISBN-10: 981-4273-82-1 (hardcover)1. Corporations--Accounting. 2. Corporations--Finance. I. Title.HF5636.B54 2009657--dc222009034159British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British Library.For photocopying of material in this volume, please pay a copying fee through the CopyrightClearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission tophotocopy is not required from the publisher.Typeset by Stallion PressEmail: enquiries@stallionpress.comAll rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,electronic or mechanical, including photocopying, recording or any information storage and retrievalsystem now known or to be invented, without written permission from the Publisher.Copyright © 2010 by World Scientific Publishing Co. Pte. Ltd.Published byWorld Scientific Publishing Co. Pte. Ltd.5 Toh Tuck Link, Singapore 596224USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601UK office: 57 Shelton Street, Covent Garden, London WC2H 9HEPrinted in Singapore.Wanda - An Intro to Accounting.pmd3/8/201 0, 6:1 9 PM1 November 6, 200913:43spi-b8119in x 6inb811-fmPrefaceIntroductory accounting and finance have traditionally been taught as two separatecourses, even though the importance of a basic knowledge of finance in learningaccounting and a knowledge of accounting in learning finance have been widelyacknowledged. One important historical reason for having two separate courseswas that, in the past, few professors could teach both courses well. This lack ofcompetent instructors has disappeared, and there are now many professors whocan well integrate the basic elements of accounting and finance.Accounting is an ever-evolving art. Understanding accounting is necessary tounderstand financial reporting by business organizations and the uses of financialreports by decision makers, both internal managers and financial analysts.The structure ofaccounting is an important educational tool. The basic logic ofthe debit-credit process is elegant and logically consistent. The use of debits andcredits emphasizes the relationships between accounts and simplifies the explana-tion of a wide range of financial transactions.This book is also an introduction to corporate financial management, build-ing on the basic capital budgeting framework and the time value of money. Theobjective is to stress the theoretical formulations that are most useful in makingmanagerial financial decisions. A working knowledge of the time value of moneyis essential to having a complete liberal education.The terms net present value, internal rate ofreturn, and capital asset pricingmodelaretodaywidelyusedbymanagers.Afewyearsago, thepersonsinimportantmanagerial positions might have said that they made the firm’s big decisions on thebasis of their experience, judgment, and intuition. Now, top managers insist moreand more on having financial information properly analyzed before they exercisetheir judgments.Many ofthe financial models are simplifications ofthe real world. Ifthey wereto be applied without thought, it is likely that some of the models would lead toundesirable decisions. However, if used correctly, such models will give insightsinto the weaknesses ofother, more simplifiedanderroneous decision-making tech-niques. This book emphasizes that the correct application of financial techniquesv November 6, 200913:43spi-b8119in x 6inb811-fmviAn Introduction to Accounting and Managerial Financein business situations improves the likelihood ofmaking good decisions. However,exact answers and correct decisions are not always guaranteed in a complex anduncertain world.This bookis based on a numberoffundamental principles. First, the time valueofmoney is usedas the basic foundationforalarge amountofthe analysis. Second,decisions are approached on an after-tax basis. Third, we have avoided relativelycomplex models that are more appropriate for a more advanced finance course.Fourth, we emphasize decision making. We emphasize the models and methods ofanalysis thatare mostusefulandpracticalratherthandiscussing theory fortheory’ssake. Finally, once the readerunderstands the basic concepts andmethods, we thinkit is important to introduce various real-world constraints and complexities.I acknowledge the invaluable contributions of my co-authors on other writingprojects, Sy Smidt, Jerry Hass, and Bob Swieringa. While these friends and col-leagues cannot be held responsible for any mistakes (misstatements), they did helpcontribute significantly to my understanding of the topics covered in this book.Harold Bierman, Jr.Cornell University November 6, 200913:43spi-b8119in x 6inb811-fmContentsPrefacevChapter 1. Finance, Accounting and Corporate Objectives1Chapter 2. The Time Value of Money13Chapter 3. An Introduction to Financial Reporting29Chapter 4. Capital Budgeting57Chapter 5. The Income Statement85Chapter 6. Comparing the Use of Cash Flows and Incomes101Chapter 7. Depreciation Expense111Chapter 8. Long-Term Liabilities137Chapter 9. Stockholders’ Equity151Chapter 10. Distributions to Shareholders167Chapter 11. Capital Structure: Weighted Average Cost of Capital(WACC)193Chapter 12. Buy versus Lease223Chapter 13. Preferred Stock247vii November 6, 200913:43spi-b8119in x 6inb811-fmviiiAn Introduction to Accounting and Managerial FinanceChapter 14. Managerial Performance259Chapter 15. Mergers and Acquisitions: Consolidations289Chapter 16. Convertible Bonds323Chapter 17. Inventories343Chapter 18. The Cash Flow Statement363Appendices377About the Author385Index387 November 6, 200913:43spi-b8119in x 6inb811-ch01Chapter 1Finance, Accounting andCorporate ObjectivesCorporate ObjectivesThe motivation for buying the common stock ofa corporation is the expectation ofmaking a larger risk-adjusted return than can be earned elsewhere. The managersofa corporation have the responsibility ofadministering the affairs ofthe firm in amanner consistent with the expectation of returning the investors’ original capitalplus the required return on their capital. The common stockholders are the residualowners, and they earn a return only after the investors in the more senior securities(debt and preferred stock) have received their contractual claims. We will assumethat the objective of the firm is to maximize its common stockholders’ wealthposition.Stockholdersinvestinacorporationwiththeexpectationofmakinganetgainontheir investment consistent with the investment’s risk. The managers and the boardofdirectors ofa corporation have the responsibility ofadministering the affairs ofthe firm in a manner consistent with the interests ofthe stockholders. Thus, one ofmanagement’s primary goals should be the maximization ofstockholders’ wealth.Although corporations might have other objectives (such as fulfilling their socialresponsibilities or treating their workers fairly), we will focus our attention on themore narrow corporate goal of stockholder wealth maximization.But even this narrow definition is apt to give rise to misunderstanding andconflict. It is very likely that situations will arise where one group ofstockholderswill prefer one financial decision while another group of stockholders will preferanother decision. For example, imagine a situation where a business undertakes aninvestment that is deemedto be desirable by management, but the immediate effectof the investment will be to depress earnings and the common stock price today.In the future, the market may realize that the investment is desirable, and at that1 November 6, 200913:43spi-b8119in x 6inb811-ch012An Introduction to Accounting and Managerial Financetime the stockprice will reflect the enhanced value. But the stockholders expectingto sell their stock in the near future would prefer that the investment be rejected,while stockholders holding for the long run would prefer that the investment beundertaken.A statement such as “profit maximization” does not adequately describe theappropriate objective of the firm, since profits are conventionally computed anddo not effectively reflect the cost of the stockholders’ capital that is tied up in theinvestment. Total sales or share of product market are also inadequate normativedescriptions ofcorporategoals, althoughthesegoals mayalsoleadtomaximizationof the shareholders’ wealth position by their positive effect on profits.Since the managers of a corporation are acting on behalf of the stockholders,there is a fiduciary relationship between the managers (and the board of direc-tors) and the stockholders. The stockholders, the suppliers ofthe risk capital, haveentrustedapartoftheirwealthpositiontothe firm’s management. Thus, the successof the firm and the appropriateness of management’s decisions must be evaluatedin terms of how well this fiduciary responsibility has been met. The accountingreports measure (at their best) how well management is meeting this goal.Managerial FinanceThe study ofmanagerial finance is concerned with the financial decisions ofa firm(as distinct from the study of the structure of markets for obtaining capital). Webreak the firm’s decisions down into three basic types:1. Investmentdecisions or, more generally, the allocationoffunds among differenttypes of assets or activities.2. The obtaining of capital in the appropriate mixture of debt and common stockor other securities.3. The dividend or distribution decision (giving of funds back to common stockinvestors in return for the use of the capital).We shall find that there are analytical methods of analyzing all of these deci-sions. In some cases, we can reach fairly definite judgments as to correct andincorrect decisions; in others, we can only identify the relevant quantitative andqualitative considerations.Business organizations are continually faced with the problem of decidingwhether the commitments of resources — time or money — are worthwhile interms of the expected benefits. If the benefits are likely to accrue reasonablysoon after the expenditure is made, and if both the expenditure and the bene-fits can be measured in dollars, the solution to such a problem is relatively simple. November 6, 200913:43spi-b8119in x 6inb811-ch01Finance, Accounting and Corporate Objectives3If the expected benefits are likely to accrue over several years, the solution is morecomplex.We shall use the term investment to refer to commitments of resources madein the hope of realizing benefits that are expected to occur over a reasonably longperiodoftime inthe future. Capitalbudgeting is amany-sidedactivity thatincludessearching for new and more profitable investment proposals, investigating engi-neering and marketing considerations to predict the consequences ofaccepting theinvestment, andmaking economic analyses todetermine the profitpotentialofeachinvestment proposal.The Finance ManagersFinance managers (financial vice-presidents, controllers, treasurers, etc.) areresponsible for a wide range of decisions made in a corporation. The accountsthat appear on a balance sheet can be used to describe the tasks of a finance man-ager. Onthe assetside, there is the administrationofcurrentassets (managing cash,investing in short-term securities, and determining and administering a credit pol-icy) and long-term assets (i.e., making capital budgeting decisions that commit thecompany to investments in long-lived assets). Shifting to the equity (liabilities andstockholders’ equity) side ofthe balance sheet, the finance manager is responsiblefor offering advice as to the best financial structure (determining the relative useof debt, preferred stock, or common stock) and the characteristics of the firm’ssecurities and then implementing the decisions that are made.Decisions described in this book can be related to decisions that involve oneor more of the accounts on a balance sheet. This book will offer suggestions onhow to improve the likelihood ofmaking the correct decision, although frequentlyit will be seen that absolutely correct choices cannot be made.To study problems of a manageable size, we shall generally assume that aspecific decision does not affect other decisions. This naïve assumption may notbe valid because of the interrelationships of decisions, but it does enable us togain understanding. After this understanding is achieved, the complexities can beintroduced. We shall learn to walk before we try to run.Time, Risk, and the Risk-Return Trade-offTwo primary factors that make finance an interesting and complex subject are theelements oftime and risk. Because decisions today often affect cash flow for manyfuture time periods and we are not certain as to the outcomes of our actions, wehave to formulate decision rules that take risk and time value into consideration in November 6, 200913:43spi-b8119in x 6inb811-ch014An Introduction to Accounting and Managerial Financea systematic fashion. These two problems are as intellectually challenging as anyproblem that one is likely to encounter in the world of economic activity.Frequently, the existence of uncertainty means that the decision maker facesalternatives that involve trade-offs of less return and less risk or more return andmore risk. A large part of the study of finance has to do with learning how toapproach this type of risk-return trade-off choice.Three Basic GeneralizationsWe offer three generalizations that are useful in the types of financial decisionsthat are to be discussed. The first generalization is that investors prefer more return(cash) to less, all other things being equal. Investors who think that the returns areexcessively high could distribute the excess in such amannerthat the results wouldmeet their criterion of fairness.The secondgeneralization is that investors preferless risk(apossibility ofloss)to more riskandhave to be paidto undertake riskyendeavors. This generalizationiscontrary to commonobservations suchas the existence ofrace tracks andgamblingcasinos (where the customers of such establishments are willing to pay for theprivilege ofundertaking risky investments), but the generalization is useful even ifthere are some exceptions.The third generalization is that everyone prefers cash to be received todayrather than for the same amount to be received in the future. This only requires thereasonable assumption that the funds received today can be invested to earn somepositive return. Since this is the situation in the real world, the generalization isreasonable.These three generalizations are used implicitly and explicitly throughoutthe book.Relevance of Cash FlowsGiven the objective of stockholder wealth maximization, how should individualfinancial decisions be evaluated? For the publicly traded firm, it is convenient toassume that the market value of the stock is a reasonable measure of wealth. Themarket’s assessment of the firm’s future is manifest in today’s stock price, butunfortunately this assessment is not always accurate. For the privately held firm,where there is no market value, the wealth position is even more difficult to assess.Theoretically, alternative actions should be evaluated based on the extent towhich they will improve the market value of the stock, and the action leading toa maximization of value should be chosen. Unfortunately, while this evaluation November 6, 200913:43spi-b8119in x 6inb811-ch01Finance, Accounting and Corporate Objectives5scheme is correct, it is sometimes not operational, for the chain of relationshipsbetween a decision and its ultimate impact on the value of equity is long andcomplicated. As stated above, the decision time horizon may affect the choice ofdecision.There is, however, an approach that can be used to evaluate all decisions.The decision maker should focus on the cash flows resulting from the decision.Any decision that is expected to alter the anticipated cash flows of the firm islikely to alter the value of the firm’s common stock. Cash is the common elementin all financial decisions: investments require it, creditors are paid with it, andstockholders expect to receive it in the form of dividends or capital gains. Thus,most financial decisions can be characterized by the incremental cash flows thattheir acceptance is expected to cause.Cash Flows versus EarningsA decision may be characterized by its effect on accounting earnings as well as byits incremental cash flows. The earnings and cash flows would lead to consistentdecisions if it were not for the fact that earnings are affected by many account-ing conventions, such as expense versus capitalization decisions and the choiceof a depreciation method. Thus, following Generally Accepted Accounting Prin-ciples, an investment might generate substantial cash flows in its late years butadversely affect profits during the early years if the initial investment depreciatesrapidly. Assuming the firm has sufficient cash inflows with which to meet its cashobligations, the investment may be desirable regardless of the lack of short-runprofitability. Of course, long-run profitability is a necessary condition. If all theexpenses cannot be covered over all the years of the life of the decision, then theeffect of the decision on the stockholders’ wealth position will be negative. Prof-itability is a sufficient condition fora successful decision ifthe profits are correctlymeasured. But the correct measure of profits is a difficult task, and not alwaysperfectly executed by the accounting profession.Since cash flows are easily measured, when properly discounted for time andadjusted for risk they are a good proxy for profits. We consider cash flows to be arelevant measure of the impact of a decision on the firm, and will use cash flowsas the primary input in the financial decisions to be analyzed.A Merger of EqualsInthe parlance offinance, amergerofequals occurs whenamergeris executedwiththe stockholders of both the firm being acquired and the firm doing the acquiring November 6, 200913:43spi-b8119in x 6inb811-ch016An Introduction to Accounting and Managerial Financereceiving the same value after the merger as they did before the merger. In the titleof this book, the reference to a merger of equals implies that both accounting andknowledge of finance contribute to making good financial decisions.There follows an example of a merger-of-equals value calculation.Example: Parent firm wants to acquire Target firm.CompanyStock PriceShares OutstandingMarketCapitalizationParentTarget$ 5010050040Total$25,0004,000$29,000Assume Parent shareholders retain their 500 shares worth $50 each. Targetmust receive N shares with a value pershare ofP. Target’s shares must have a totalvalue of $4,000.NP = 4,000orP =4,000N.In addition, the total value of merged firms must equal $29,000.29,000 = P(N + 500)or29,000 =4,000N(N + 500)29,000N = 4,000N + 4,000(500)25,000N = 4,000(500)25N = 4(500)N = 4(20) = 80andP = $50.Give Target 80 shares (two for each outstanding share) with a total value of$4,000. With a new stock value of $50, we have for the merged firm value:50(500 + 80) = $29,000.The Capital MarketCorporationsatsomestageintheirlifearelikelytogotothecapitalmarkettoobtainfunds. Themarketthatsuppliesfinancialresourcesis calledthecapitalmarketandit November 6, 200913:43spi-b8119in x 6inb811-ch01Finance, Accounting and Corporate Objectives7consistsofallsavers (banks, insurancecompanies, pensionfunds, people, etc.). Thecapital market gathers resources from the savers of society (people who consumeless than they earn) and rations these savings out to the organizations that have aneed for new capital and that can pay the price that the capital market defines forcapital.The availability offunds (the supply) and the demand for funds determine thecost offunds to the organizations obtaining new capital and the return to be earnedby the suppliers of capital. The measure of the cost of new capital becomes veryimportant to a business firm in the process of making decisions involving the useofcapital. We shall have occasion to use the market cost offunds (the interest rate)frequently in our analyses, and you should be aware of the relevance of capitalmarket considerations to the decisions ofthe firm.Actually, there is not one market cost of funds; rather, there is a series ofdifferent but related costs depending on the specific terms on which the capital isobtained and the amount ofrisk associated with the security. One ofthe importantobjectives ofthis book is to develop an awareness ofthe cost ofthe different formsof capital (common stock, preferred stock, debt, retained earnings, etc.) and ofthe factors that determine these costs. This is a complex matter, since the cost ofa specific form of capital for one firm will depend on the returns investors canobtain from other firms, on the characteristics of the assets of the firm that isattempting to raise additional capital, and on the capital structure of the firm. Wecan expect that the largerthe risk, the higherthe return that will be neededto attractinvestors.Tactical and Strategic DecisionsInvestment decisions may be tactical or strategic. A tactical investment decisiongenerally involves a relatively small amount of funds and does not constitute amajor departure from what the firm has been doing in the past. The considerationof a new machine tool by a motor manufacturing company is a tactical decision,as is a buy-or-lease decision made by an oil company.Strategic investmentdecisions involve large sums ofmoneyandmayalso resultin a major departure from what the company has been doing in the past. Strategicdecisions directly affect the basic course of the company. Acceptance of a strate-gic investment will involve a significant change in the company’s expected profitsand in the risks to which these profits will be subject. These changes are likely tolead stockholders and creditors to revise their evaluation of the company. If a pri-vate corporation undertook the development ofa supersonic commercial transport November 6, 200913:43spi-b8119in x 6inb811-ch018An Introduction to Accounting and Managerial Finance(costing over $20 billion), this would be a strategic decision. Ifthe company failedin its attempt to develop the commercial plane, the very existence ofthe companywould be jeopardized. Frequently, strategic decisions are based on intuition ratherthan on detailed quantitative analysis.The investment strategy ofa firm is a statement ofthe formal criteria it appliesin searching forandevaluating investment opportunities. Strategic planning guidesthesearchforprojects byidentifyingpromisingproductlines orgeographic areas inwhich to search for good investment projects. One firm may seek opportunities forrapid growth in emerging high-technology businesses; another may seek oppor-tunities to become the low-cost producer of commodities with well-establishedtechnologies and no unusual market problems; a third firm may look for opportu-nities toexploitits specialknowledgeofaparticularfamilyofchemicals.Astrategyshould reflect both the special skill and abilities ofthe firm (its comparative advan-tage) and the opportunities that are available as a result ofdynamic changes in theworld economy.Strategicplanningleadstoachoiceofthe“forest”—tacticalanalysisstudies—and makes a choice between individual “trees.” The two activities should comple-ment and reinforce each other. Project analysis may provide a feedback loop toverify the accuracy ofthe strategic plan. Ifthere are good opportunities where thestrategic plan says they should be found, and few promising opportunities in linesof business that the strategy identifies as unattractive, confidence in the strategicplan increases. Alternatively, ifattractive projects are not found where the plan hadexpected them, or ifdesirable projects appear in lines ofbusiness that the strategicplan had identified as unattractive, a reassessment of both the project studies andthe strategic plan may be in order.Scope of Financial ManagementMany financial decisions have a time dimension: not all relevant events occurimmediately. Adjusting for the timing ofcash flows and choosing between certainalternative cash flow patterns are discussed in Chapter 2.ConclusionsThe study of accounting and finance should be an exciting and stimulating expe-rience, since it is an opportunity to eliminate a large number of common misun-derstandings and to add to your own understanding of financial instruments anddecisions. You will be better able to manage your own personal financial affairs aswell as the affairs of a business entity. November 6, 200913:43spi-b8119in x 6inb811-ch01Finance, Accounting and Corporate Objectives9The basic building blocks of this book are three generalizations that areintroduced in this chapter:1. Investors prefer more expected return to less.2. Investors prefer less risk to more risk.3. Investors prefer an amount ofcash to be received earlier than the same amountto be received later.All modern finance is built on these generalizations. Some investors accept orseek risk, but they normally do so with the hope of some monetary gain. Theyexpect to be compensated for the risk they undertake.Corporations, or more exactly, the managers running the corporations, havemany different goals. We have simplified the complex set of objectives thatexist to one basic objective, the maximization of the value of the stockhold-ers’ ownership rights in the firm. Though a simplification, it enables us tomake specific recommendations as to how corporate financial decisions shouldbe made.We shall find that while some financial decisions may be solved exactly, morefrequently we shall only be able to define and analyze the problem. We may notalways be able to identify the optimum decision with certainty, but we shall gener-ally be able to describe some errors in analysis to avoid. In most cases in corporatefinance, useful insights for improved decision making can be obtained by applyingmodern finance theory and using good accounting information.Questions and Problems1. Can a firm have income without having a positive cash flow? Explain.2. If a firm currently earning $1 million can increase its accounting income to$1.1 million (an action consistent with profit maximization), is this always adesirable move? Explain.3. A sales force is proud of having doubled sales in the past four years. Whatquestions should be asked before praising them?4. A president ofan automobile manufacturing firm has the opportunity to doublethe firm’s profits in the next year. To accomplish this profit increase, the qualityofthe product (currently the prestige car ofthe world market) must be reduced.No additional investment is required. What do you recommend?5. Namean“economiccost”thatisomittedfromtheaccountingincomestatementsthat should be of interest to management.6. TheABC Company can undertake aninvestment thatis economically desirable.It will adversely affect current earnings, but in management’s judgment will November 6, 200913:43spi-b8119in x 6inb811-ch0110An Introduction to Accounting and Managerial Financebenefit future earnings. Management fears that the stock market will interpretthe decrease in earnings as a sign ofweakness and the common stock price willimmediately go down as the lower earnings are reported. Management plansto describe the characteristics of the investment in the annual report and inmeetings with security analysts. The company’s primary goal is to maximizethe well-being of its stockholders.a. What would a decrease in stock price as a result of the investment implyabout the stock market?b. What does the decrease in income as a result of the investment imply aboutthe accounting measures?c. Should the company undertake the investment?7. The ABC Company has to make a choice between two strategies:Strategy 1: Is expected to result in a market price now of $100 per share ofcommon stock and a price of $120 five years from now.Strategy 2: Is expected to result in a market price now of $80 and a price of$140 five years from now.What do you recommend? Assume that all other things are unaffected by thedecision being considered.8. It has been said that few stockholders would think favorably of a project thatpromised its first cash flow in 100 years, no matter how large this return.Comment on this position.9. Each of the following is sometimes listed as a reasonable objective for a firm:(a) maximize profit (accounting income), (b) maximize sales (or share of themarket), (c) maximize the value of a share of common stock t time periodsfrom now, (d) ensure continuity of existence, (e) maximize the rate of growth,(f) maximize future dividends. Discuss each item and the extent ofits relevanceto the making of investment decisions.ReferencesA number of excellent introductory and intermediate financial management texts areavailable to be used in conjunction with this book to provide a parallel description ofmanyof the decisions we discuss and to fill the reader in on institutional material. Among themare the following:Brealey, R. andS. Myers (2000). Principles ofCorporate Finance. NewYork: McGraw-HillBook Company. November 6, 200913:43spi-b8119in x 6inb811-ch01Finance, Accounting and Corporate Objectives11Copeland,T. E. andJ. F. Weston(2004). FinancialTheoryandCorporate Policy, 4thEdition.Reading, MA: Addison-Wesley Publishing Company.VanHorne, J. C. (2001). FinancialManagementandPolicy, 12thEdition. EnglewoodCliffs,NJ: Prentice-Hall, Inc. This page intentionally left blankThis page intentionally left blank November 6, 200913:43spi-b8119in x 6inb811-ch02Chapter 2The Time Value of MoneyTime DiscountingOne ofthe basic concepts ofbusiness economics and managerial decision makingis that the value of an amount of money to be received in the future depends onthe time of receipt or disbursement of the cash. A dollar received today is morevaluable than a dollar to be received in the future. The only requirement for thisconcept to be valid is that there be a positive rate ofinterest at which funds can beinvested.The time value of money affects a wide range of business decisions, and aknowledge of how to incorporate time value considerations systematically intoa decision is essential to an understanding of finance. This chapter is devotedto describing the mathematical models of compound interest. The objective is todevelop skills in finding the present equivalent of a future amount and the futureequivalent ofa present amount.The Interest RateA dollar available today is more valuable than a dollar available one period fromnow ifdesirable investmentopportunities exist. There are two primary reasons whyreal investments can generate an interest return:1. Some types of capital increase in value through time because of changes inphysical characteristics, for example, cattle, wine, and trees.2. There are many work processes where roundabout methods of production aredesirable, leading to increased productivity. Ifyou are going to cut down alargetree, it may be worth investing some time to sharpen your axe. A sharp axe mayresult in less time being spent cutting down trees (including sharpening time)than working with a dull axe. Ifyou are going to dig a hole, you might want to13 November 6, 200913:43spi-b8119in x 6inb811-ch0214An Introduction to Accounting and Managerial Financebuild or buy a shovel, or even spend the time to manufacture a backhoe if it isa big hole. The investment increases productivity sufficiently compared to thealternative methods ofproduction without capital so that the new asset can earna return for the investor.These characteristics of capital lead to a situation in which business entitiescan pay interest for the use of money. If you invest $1 in an industrial firm, thefirm may be able to pay you $1 plus interest ifyour investment enabled the firm touse some roundabout method ofproduction or to delay the sale ofan item while itincreased in value.Future ValueAssume that you have $1.00 now and can invest it to earn r interest. After oneperiod, you will have the $1.00 plus the interest earned on the $1...

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