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MBA in FINANCE AND Accounting final notes

Written By Noush on Saturday, June 15, 2013 | 8:43 AM

 

PORTABLE

MBA

in

FINANCE AND

ACCOUNTING

The Portable MBA Series

The Portable MBA, Third Edition, Robert Bruner, Mark Eaker, R. Edward

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The Portable MBA in Entrepreneurship, Second Edition, William D. Bygrave

The Portable MBA in Entrepreneurship Case Studies, William D. Bygrave

The Portable MBA in Finance and Accounting, Third Edition, John Leslie

Livingstone and Theodore Grossman

The Portable MBA in Investment, Peter L. Bernstein

The Portable MBA in Management, First Edition, Allan Cohen

The Portable MBA in Market-Driven Management: Using the New

Marketing Concept to Create a Customer-Oriented Company,

Frederick E. Webster

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Charles Schewe

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for Strategic Success, Robert J. Thomas

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Proven at Today's Most Successful Companies, Stephen George and

Arnold Weimerskirch

Forthcoming:

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PORTABLE

MBA

in

FINANCE AND

ACCOUNTING

THIRD EDITION

Edited by

John Leslie Livingstone

and

Theodore Grossman

John Wiley & Sons, Inc.

Copyright c 2002 by John Wiley & Sons, Inc., New York. All rights reserved.

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v

Preface

Do you know how to accomplish these important business tasks?

• Understand financial statements.

• Measure liquidity of a business.

• Analyze business profitability.

• Differentiate between regular income and extraordinary items.

• Predict future bankruptcy for an enterprise.

• Prepare a budget.

• Do a break-even analysis.

• Measure productivity.

• Figure out return on investment.

• Compute the cost of capital.

• Put together a business plan.

• Legitimately minimize income taxes payable by you or your business.

• Decide whether your business should be a limited partnership, a C or S

corporation, or some other type of entity.

• Take your company public.

• Manage foreign currency exposure.

• Evaluate a merger or acquisition target.

• Serve as a director of a corporation.

• Build a successful e-business.

• Understand and use financial derivatives.

• Use information technology for competitive advantage.

• Value a business.

These are some of the key topics explained in this book. It is a book designed

to help you learn the basics in finance and accounting, without incurring

the considerable time and expense of a formal MBA program.

vi Preface

The first edition of this book was published in 1992, and the second edition

in 1997. Both editions, hardback and paperback, have been highly successful

and have sold many, many copies. In addition, the book has been translated

into Chinese (Cantonese and Mandarin), French, Indonesian, Portuguese, and

Spanish. We are delighted that so many readers in various countries have found

this book useful. Now, the entire book has been updated for the third edition.

The following new chapters have been added:

• Chapter 1: Using Financial Statements

• Chapter 3: Cost-Volume-Profit Analysis

• Chapter 5: Information Technology and You

• Chapter 6: Forecasts and Budgets

• Chapter 9: The Business Plan

• Chapter 10: Planning Capital Expenditure

• Chapter 17: Profitable Growth by Acquisition

• Chapter 18: Business Valuation

Also, there are eight new authors, substantial revisions of four chapters

and complete updates of all remaining chapters. The book consists of valuable,

practical how-to-do-it information, applicable to an entire range of businesses,

from the smallest startup to the largest corporations in the world.

Each chapter of the book has been written by an outstanding expert in the

subject matter of that particular chapter. Some of these experts are full-time

practitioners in the real world, and others are part-time consultants who also

serve as business school professors. Most of these professors are on the faculty

of Babson College, which is famous for its major contributions to the

field of entrepreneurship and which, year after year, is at the top of the annual

list of leading independent business schools compiled by U.S. News and

World Report.

This book can be read, and reread, with a great deal of profit. Also, it can

be kept handy on a nearby shelf in order to pull it down and look up answers to

questions as they occur. Further, this book will help you to work with finance

and accounting professionals on their own turf and in their own jargon. You

will know what questions to ask, and you will better understand the answers

you receive without being confused or intimidated.

Who can benefit from this book? Many different people, such as:

• Managers wishing to improve their business skills.

• Engineers, chemists, scientists and other technical specialists preparing

to take on increased management responsibilities.

• People already operating their own businesses, or thinking of doing so.

• Business people in nonfinancial positions who want to be better versed in

financial matters.

• BBA or MBA alumni who want a refresher in finance and accounting.

Preface vii

• People in many walks of life who need to understand more about financial

matters.

Whether you are in one, some, or even none of the above categories, you

will find much of value to you in this book, and the book is reader friendly.

Frankly, most finance and accounting books are technically complex, boringly

detailed, or just plain dull. This book emphasizes clarity to nonfinancial readers,

using many helpful examples and a bright, interesting style of writing.

Learn, and enjoy!

JOHN LESLIE LIVINGSTONE

THEODORE GROSSMAN

 

ix

Acknowledgments

A book like this results only from the contributions of many talented people.

We would like to thank the chapter authors that make up this book for their

clear and informative explanations of the powerful concepts and tools of finance

and accounting. In this world of technology and the Internet, while most

of the underlying concepts remain fixed, the applications are ever changing,

requiring the authors to constantly rededicate themselves to their professions.

Our deepest appreciation goes to our wives, Trudy Livingstone and Ruth

Grossman, and to our children Robert Livingstone, Aaron and Melissa Grossman,

and Michael Grossman. They provide the daily inspiration to perform our

work and to have undertaken this project.

J. L. L.

T. G.

 

xi

Contents

Preface v

Acknowledgments ix

PART ONE UNDERSTANDING THE NUMBERS 1

1. Using Financial Statements 3

John Leslie Livingstone

2. Analyzing Business Earnings 35

Eugene E. Comiskey and Charles W. Mulford

3. Cost-Volume-Profit Analysis 102

William C. Lawler

4. Activity-Based Costing 126

William C. Lawler

5. Information Technology and You 149

Edward G. Cale Jr.

6. Forecasts and Budgets 173

Robert Halsey

7. Measuring Productivity 199

Michael F. van Breda

xii Contents

PART TWO PLANNING AND FORECASTING 223

8. Choosing a Business Form 225

Richard P. Mandel

9. The Business Plan 260

Andrew Zacharakis

10. Planning Capital Expenditure 291

Steven P. Feinstein

11. Taxes and Business Decisions 314

Richard P. Mandel

12. Global Finance 353

Eugene E. Comiskey and Charles W. Mulford

13. Financial Management of Risks 423

Steven P. Feinstein

PART THREE MAKING KEY

STRATEGIC DECISIONS 457

14. Going Public 459

Stephen M. Honig

15. The Board of Directors 510

Charles A. Anderson and Robert N. Anthony

16. Information Technology and the Firm 536

Theodore Grossman

17. Profitable Growth by Acquisition 561

Richard T. Bliss

18. Business Valuation 593

Michael A. Crain

Glossary 626

About the Authors 643

Index 649

PART ONE

UNDERSTANDING

THE NUMBERS

 

3

1 USING FINANCIAL

STATEMENTS

John Leslie Livingstone

WHAT ARE FINANCIAL STATEMENTS? A CASE STUDY

Pat was applying for a bank loan to start her new business, Nutrivite, a retail

store selling nutritional supplements, vitamins, and herbal remedies. She described

her concept to Kim, a loan officer at the bank.

Kim: How much money will you need to get started?

Pat: I estimate $80,000 for the beginning inventory, plus $36,000 for store

signs, shelves, fixtures, counters, and cash registers, plus $24,000 working

capital to cover operating expenses for about two months. That's a total of

$140,000 for the startup.

Kim: How are you planning to finance the investment of the $140,000?

Pat: I can put in $100,000 from my savings, and I'd like to borrow the remaining

$40,000 from the bank.

Kim: Suppose the bank lends you $40,000 on a one-year note, at 15% interest,

secured by a lien on the inventory. Let's put together projected financial

statements from the figures you gave me. Your beginning balance sheet

would look like what you see on my computer screen:

4 Understanding the Numbers

Nutrivite

Projected Balance Sheet as of January 1, 200X

Assets Liabilities and Equity

Cash $ 24,000 Bank loan $ 40,000

Inventory 80,000

Current assets 104,000 Current liabilities 40,000

Fixed assets: Equity:

Equipment 36,000 Owner capital 100,000

Total assets $140,000 Liabilities and equity $140,000

The left side shows Nutrivite's investment in assets. It classifies the assets

into "current" (which means turning into cash in a year or less) and

"noncurrent" (not turning into cash within a year). The right side shows how

the assets are to be financed: partly by the bank loan and partly by your equity

as the owner.

Pat: Now I see why it's called a "balance sheet." The money invested in assets

must equal the financing available—its like the two sides of a coin. Also, I

see why the assets and liabilities are classified as "current" and "noncurrent"—

the bank wants to see if the assets turning into cash in a year or less

will provide enough cash to repay the one-year bank loan. Well, in a year

there should be cash of $104,000. That's enough cash to pay off more than

twice the $40,000 amount of the loan. I guess that guarantees approval of

my loan!

Kim: We're not quite there yet. We need some more information. First, tell

me, how much do you expect your operating expenses will be?

Pat: For year 1, I estimate as follows:

Store rent $36,000

Phone and utilities 14,400

Assistants' salaries 40,000

Interest on the loan 6,000 (15% on $40,000)

Total $96,400

Kim: We also have to consider depreciation on the store equipment. It probably

has a useful life of 10 years. So each year it depreciates by 10% of its cost

of $36,000. That's $3,600 a year for depreciation. So operating expenses

must be increased by $3,600 a year, from $96,400 to $100,000. Now, moving

on, how much do you think your sales will be this year?

Pat: I'm confident that sales will be $720,000 or even a little better. The

wholesale cost of the items sold will be $480,000, giving a markup of

$240,000—which is 3313% on the projected sales of $720,000.

Using Financial Statements 5

Kim: Excellent! Let's organize this information into a projected income statement.

We start with the sales, then deduct the cost of the items sold to arrive

at the gross profit. From the gross profit we deduct your operating

expenses, giving us the income before taxes. Finally we deduct the income

tax expense in order to get the famous "bottom line," which is the net income.

Here is the projected income statement shown on my computer

screen:

Nutrivite

Projected Income Statement for the

Year Ending December 31, 200X

Sales $720,000

Less cost of goods sold 480,000

Gross profit 240,000

Less expenses

Salaries $ 40,000

Rent 36,000

Phone and utilities 14,400

Depreciation 3,600

Interest 6,000 100,000

Income before taxes 140,000

Income tax expense (40%) 56,000

Net income $ 84,000

Pat, this looks very good for your first year in a new business. Many

business startups find it difficult to earn income in their first year. They do

well just to limit their losses and stay in business. Of course, I'll need to carefully

review all your sales and expense projections with you, in order to

make sure that they are realistic. But first, do you have any questions about

the projected income statement?

Pat: I understand the general idea. But what does "gross profit" mean?

Kim: It's the usual accounting term for sales less the amount that your suppliers

charged you for the goods that you sold to your customers. In other words,

it represents your markup from the wholesale cost you paid for goods and the

price for which you sold those goods to your customers. It is called "gross

profit" because your operating expenses have to be deducted from it. In

accounting, the word gross means "before deductions." For example "gross

sales" means sales before deducting goods returned by customers. Sales after

deducting goods returned by customers are referred to as "net sales." In accounting,

the word net means "after deductions." So "gross profit" means income

before deducting operating expenses. By the same token, "net income"

means income after deducting operating expenses and income taxes. Now,

moving along, we are ready to figure out your projected balance sheet at the

6 Understanding the Numbers

end of your first year in business. But first I need to ask you how much cash

you plan to draw out of the business as your compensation?

Pat: My present job pays $76,000 a year. I'd like to keep the same standard of

compensation in my new business this coming year.

Kim: Let's see how that works out after we've completed the projected balance

sheet at the end of year 1. Here it is on my computer screen:

Nutrivite

Projected Balance Sheet as of December 31, 200X

Assets Liabilities and Equity

Cash $ 35,600 Bank loan $ 40,000

Inventory 80,000

Current assets 115,600 Current liabilities 40,000

Fixed assets: Equity:

Equipment $36,000 Capital: Jan 1 100,000

Less depreciation 3,600 Add net income 84,000

Net equipment $32,400 32,400 Less drawings (76,000)

Capital: Dec 31 108,000

Total assets $148,000 Liabilities and equity $148,000

Let's go over this balance sheet together, Pat. It has changed compared

to the balance sheet as of January 1. On the Liabilities and Equity side of

the balance sheet, the Net Income of $84,000 has increased Capital to

$184,000 (because earning income adds to the owner's Capital), and deducting

Drawings of $76,000 has reduced Capital to $108,000 (because

Drawings take Capital out of the business). On the asset side, notice that the

Equipment now has a year of depreciation deducted, which writes it down

from the original $36,000 to a net (there's that word net again) $32,400 after

depreciation. The Equipment had an expected useful life of 10 years, now

reduced to a remaining life of 9 years. Last but not least, notice that the

Cash has increased by $11,600 from $24,000 at the beginning of the year to

$35,600 at year-end. This leads to a problem: The Bank Loan of $40,000 is

due for repayment on December 31. But there is only $35,600 in Cash available

on December 31. How can the Loan be paid off when there is not

enough Cash to do so?

Pat: I see the problem. But I think it's bigger than just paying off the loan.

The business will also need to keep about $25,000 cash on hand to cover two

months operating expenses and income taxes. So, with $40,000 to repay the

loan plus $25,000 for operating expenses, the cash requirements add up to

$65,000. But there is only $35,600 cash on hand. This leaves a cash shortage

of almost $30,000 ($65,000 less $35,600). Do you think that will force me to

Using Financial Statements 7

cut down my drawings by $30,000, from $76,000 to $45,000? Here I am

opening my own business, and it looks as if I have to go back to what I was

earning five years ago!

Kim: That's one way to do it. But here's another way that you might like better.

After your suppliers get to know you and do business with you for a few

months, you can ask them to open credit accounts for Nutrivite. If you get

the customary 30-day credit terms, then your suppliers will be financing one

month's inventory. That amounts to one-twelfth of your $480,000 annual

cost of goods sold, or $40,000. This $40,000 will more than cover the cash

shortage of $30,000.

Pat: That's a perfect solution! Now, can we see how the balance sheet would

look in this case?

Kim: Sure. When you pay off the Bank Loan, it vanishes from the balance

sheet. It is replaced by Accounts Payable of $40,000. Then the balance sheet

looks like this:

Nutrivite

Projected Balance Sheet as of December 31, 200X

Assets Liabilities and Equity

Cash $ 35,600 Accounts payable $ 40,000

Inventory 80,000

Current assets 115,600 Current liabilities 40,000

Fixed assets: Equity:

Equipment $36,000 Capital: Jan 1 100,000

Less depreciation 3,600 Add net income 84,000

Net equipment $32,400 32,400 Less drawings (76,000)

Capital: Dec 31 108,000

Total assets $148,000 Liabilities and equity $148,000

Now the cash position looks a lot better. But it hasn't been entirely

solved: There is still a gap between the Accounts Payable of $40,000 and the

Cash of $35,600. So you will need to cut your drawings by about $5,000 in

year 1. But that's still much better than the cut of $30,000 that had seemed

necessary before. In year 2 the Bank Loan will be gone, so the interest expense

of $6,000 will be saved. Then you can use $5,000 of this saving to restore

your drawings back up to $76,000 again.

Pat: That's good news. I'm beginning to see how useful projected financial

statements are for business planning. Can we look at the revised projected

balance sheet now?

Kim: Of course. Here it is:

8 Understanding the Numbers

Nutrivite

Projected Balance Sheet as of December 31, 200X

Assets Liabilities and Equity

Cash $ 40,600 Accounts payable $ 40,000

Inventory 80,000

Current assets 120,600 Current liabilities 40,000

Fixed assets: Equity:

Equipment $36,000 Capital: Jan 1 100,000

Less depreciation 3,600 Add net income 84,000

Net equipment $32,400 32,400 Less drawings (71,000)

Capital: Dec 31 113,000

Total assets $153,000 Liabilities and equity $153,000

As you can see, Cash is increased by $5,000 to $40,600—which is sufficient

to pay the Accounts Payable of $40,000. Drawings is decreased by

$5,000 to $71,000, which provided the $5,000 increase in Cash.

Pat: Thanks. That makes sense. I really appreciate everything you've taught

me about financial statements.

Kim: I'm happy to help. But there is one more financial statement to discuss.

Besides the balance sheet and income statement, a full set of financial statements

also includes a cash f low statement. Here is the projected cash flow

statement:

Nutrivite

Projected Cash Flow Statement for the

Year Ending December 31, 200X

Sources of Cash

From Operations:

Net income $ 84,000

Add depreciation 3,600

Add increase in current liabilities 40,000

Total cash from operations (a) $ 127,600

From Financing:

Drawings $ (71,000) Negative cash

Bank loan repaid (40,000) Negative cash

Net cash from financing (b) (111,000) Negative cash

Total sources of cash (a + b) $ 16,600

Using Financial Statements 9

Uses of Cash

Total uses of cash 0

Total sources less total uses of cash $ 16,600 Net cash increase

Add cash at beginning of year 24,000

Cash at end of year $ 40,600

Pat, do you have any questions about this Cash Flow Statement?

Pat: Actually, it makes sense to me. I realize that there are only two sources

that a business can tap in order to generate cash: internal (by earning income)

and external (by obtaining cash from outside sources, such as bank

loans). In our case the internal sources of cash are represented by the "Cash

from Operations" section of the Cash Flow Statement, and the external

sources are represented by the "Cash from Financing" section. It happens

that the "Cash from Financing" is negative because no additional outside financing

is received for the year 200X, but cash payments are incurred for

Drawings and for repayment of the Bank Loan. I also understand that there

are no "Uses of Cash" because no extra Equipment was acquired. In addition,

I can see that the Total Sources of Cash less the Total Uses of Cash

must equal the Increase in Cash, which in turn is the Cash at the end of the

year less the Cash at the beginning of the year. But I am puzzled by the

"Cash from Operations" section of the Cash Flow Statement. I can understand

that earning income produces Cash. However why do we add back Depreciation

to the Net Income in order to calculate Cash from Operations?

Kim: This can be confusing, so let me explain. Certainly Net Income increases

Cash, but first an adjustment has to be made in order to convert Net Income

to a cash basis. Depreciation was deducted as an expense in figuring Net Income.

So adding back depreciation to Net Income just reverses the charge

for depreciation expense. We back it out because depreciation is not a cash

outflow. Remember that depreciation represents just one year's use of the

Equipment. The cash outf low for purchasing the Equipment was incurred

back when the Equipment was first acquired and amounted to $36,000. The

Equipment cost of $36,000 is spread out over the 10-year life of the Equipment

at the rate of $3,600 per year, which we call Depreciation expense. So

it would be double counting to recognize the $36,000 cash outf low for the

Equipment when it was originally acquired and then to recognize it a second

time when it shows up as Depreciation expense. We do not write a check to

pay for Depreciation each year, because it is not a cash outflow.

Pat: Thanks. Now I understand that Depreciation is not a cash outflow. But I

don't see why we also added back the Increase in Current Liabilities to the

Net Income to calculate Cash from Operations. Can you explain that?

Kim: Of course. The increase in Current Liabilities is caused by an increase in

Accounts Payable. These Accounts Payable are amounts owed to our suppliers

10 Understanding the Numbers

for our purchases of goods for resale in our business. Purchasing goods for

resale from our suppliers on credit is not a cash outflow. The cash outflow

only occurs when the goods are actually paid for by writing out checks to our

suppliers. That is why we added back the Increase in Current Liabilities to

the Net Income in order to calculate Cash from Operations. In the future,

the Increase in Current Liabilities will, in fact, be paid in cash. But that will

take place in the future and is not a cash outf low in this year. Going back to

the Cash Flow Statement, notice that it ties in neatly with our balance sheet

amount for Cash. It shows how the Cash at the beginning of the year plus the

Net Cash Increase equals the Cash at the end of the year.

Pat: Now I get it. Am I right that you are going to review my projections and

then I'll hear from you about my loan application?

Kim: Yes, I'll be back to you in a few days. By the way, would you like a printout

of the projected financial statements to take with you?

Pat: Yes, please. I really appreciate your putting them together and explaining

them to me. I picked up some financial skills that will be very useful to me

as an aspiring entrepreneur.

POINTS TO REMEMBER ABOUT

FINANCIAL STATEMENTS

When Pat arrived home, she carefully reviewed the projected financial statements,

then made notes about what she had learned.

1. The basic form of the balance sheet is Assets = Liabilities + Owner Equity.

2. Assets are the expenditures made for items, such as Inventory and Equipment,

that are needed to operate the business. The Liabilities and Owner

Equity ref lect the funds that financed the expenditures for the Assets.

3. Balance sheets show the financial position of a business at a given moment

in time.

4. Balance sheets change as transactions are recorded.

5. Every transaction is an exchange, and both sides of each transaction are

recorded. For example, when a company obtains a bank loan, there is an

increase in the asset cash that is matched by an increase in a liability entitled

"Bank Loan." When the loan is repaid, there is a decrease in cash

which is matched by a decrease in the Bank Loan liability. After every

transaction, the balance sheet stays in balance.

6. Income increases Owner Equity, and Drawings decrease Owner Equity.

7. The income statement shows how income for the period was earned.

8. The basic form of the income statement is:

a. Sales Cost of Goods Sold = Gross Income.

b. Gross Income Expenses = Net Income.

Using Financial Statements 11

9. The income statement is simply a detailed explanation of the increase in

Owner Equity represented by Net Income. It shows how the Owner Equity

increased from the beginning of the year to the end of the year because

of the Net Income.

10. Net Income contributes to Cash from Operations after it has been adjusted

to a cash basis.

11. Not all expenses are cash outflows—for instance, Depreciation.

12. Changes in Current Assets (except Cash) and Current Liabilities are not

cash outf lows nor inf lows in the period under consideration. They represent

future, not present, cash f lows.

13. Cash can be generated internally by operations or externally from sources

such as lenders or equity investors.

14. The Cash Flow Statement is simply a detailed explanation of how cash at

the start developed into cash at the end by virtue of cash inf lows, generated

internally and externally, less cash outf lows.

15. As previously noted:

a. The Income Statement is an elaboration of the change in Owner Equity

in the Balance Sheet caused by earning income.

b. The Cash Flow Statement is an elaboration of the Balance-Sheet

change in beginning and ending Cash.

Therefore, all three financial statements are interrelated or, to use the

technical term, "articulated." They are mutually consistent, and that is

why they are referred to as a "set" of financial statements. The threepiece

set consists of a balance sheet, income statement, and cash flow

statement.

16. A set of financial statements can convey much valuable information about

the enterprise to anyone who knows how to analyze them. This information

goes to the core of the organization's business strategy and the effectiveness

of its management.

While Pat was making her notes, Kim was carefully analyzing the Nutrivite

projected financial statements in order to make her recommendation to the

bank's loan committee about Nutrivite's loan application. She paid special attention

to the Cash Flow Statement, keeping handy the bank's guidelines on

cash flow analysis, which included the following issues:

• Is cash from operations positive? Is it growing over time? Is it keeping

pace with growth in sales? If not, why not?

• Are cash withdrawals by owners only a small portion of cash from operations?

If owners' cash withdrawals are a large share of cash from operations,

then the business is conceivably being milked of cash and may not

be able to finance its future growth.

12 Understanding the Numbers

• Of the total sources of cash, how much is being internally generated by

operations versus obtained from outside sources? Normally wise businesses

rely more on internally generated cash for growth than on external

financing.

• Of the outside financing, how much is derived from equity investors and

how much is borrowed? Normally, a business should rely more on equity

than debt financing.

• What kind of assets is the company acquiring with the cash being expended?

Are these asset expenditures likely to be profitable? How long

will it take for these assets to repay their cost and then to earn a reasonable

return?

Kim ref lected carefully on these issues and then finalized her recommendation,

which was to approve the loan. The bank's loan committee accepted

Kim's recommendation and even went further. They authorized Kim to tell Pat

that—if she met all her responsibilities in regard to the loan throughout the

year—the bank would renew the loan at the end of the year and even increase

the amount. Kim called Pat with the good news. Their conversation included

the following dialogue:

Kim: To renew the loan, the bank will ask you for new projected financial

statements for the subsequent year. Also, the loan agreement will require

you to submit financial statements for the year just past—that is, not projected

but actual financial statements. The bank will require that these actual

financial statements be reviewed by an independent CPA before you

submit them.

Pat: Let me be sure I understand: Projected financial statements are forwardlooking,

whereas actual financial statements are backward looking, is that

correct?

Kim: Yes, that's right.

Pat: Next, what is an independent CPA?

Kim: As you probably know, a CPA is a certified public accountant, a professional

trained in finance and accounting and licensed by the state. Independent

means a CPA who is not an employee of yours or a relative. It means

someone in public practice in a CPA firm, someone who will likely make an

objective and unbiased evaluation of your financial statements.

Pat: And what does reviewed mean?

Kim: Good question. CPAs offer three levels of service relating to financial

statements:

• An audit is a thorough, in-depth examination of the financial statements

and test of the supporting records. The result is an audit report, which

states whether the financial statements are free of material misstatements

(whether caused by error or fraud). A "clean" audit report provides

assurance that the financial statements are free of material

misstatements. A "modified" report gives no such assurance and is cause

Using Financial Statements 13

for concern. Financial professionals always read the auditor's report

first, even before looking at any financial statement, to see if the report

is clean. The auditor is a watchdog, and this watchdog barks by issuing a

modified audit report. By law all companies that have publicly traded

securities must have their financial statements audited as a protection to

investors, creditors, and other financial statement users. Private companies

are not required by law to have audits, but sometimes particular

investors or creditors demand them. An audit provides the highest level

of assurance that a CPA can provide and is the most expensive level of

service. Less expensive and less thorough levels of service include the

following.

• A review is a less extensive and less expensive level of financial statement

inspection by a CPA. It provides a lower level of assurance that the financial

statements are free of material misstatements.

• Finally, the lowest level of service is called a compilation, where the outside

CPA puts together the financial statements from the client company's

books and records without examining them in much depth. A

compilation provides the least assurance and is the least expensive level

of service.

So the bank is asking you for the middle level of assurance when it requires

a review by an independent CPA. Banks usually require a review

from borrowers that are smaller private businesses.

Pat: Thanks. That makes it very clear.

We now leave Pat and Kim to their successful loan transaction and

move on.

FINANCIAL STATEMENTS:

WHO USES THEM AND WHY

Here is a brief list of who uses financial statements and why. This list gives

only a few examples and is by no means complete.

1. Existing equity investors and lenders, to monitor their investments and to

evaluate the performance of management.

2. Prospective equity investors and lenders, to decide whether or not to

invest.

3. Investment analysts, money managers, and stockbrokers, to make

buy/sell/hold recommendations to their clients.

4. Rating agencies (such as Moody's, Standard & Poor's, and Dun & Bradstreet),

to assign credit ratings.

5. Major customers and suppliers, to evaluate the financial strength and

staying power of the company as a dependable resource for their business.

14 Understanding the Numbers

6. Labor unions, to gauge how much of a pay increase a company is able to

afford in upcoming labor negotiations.

7. Boards of directors, to review the performance of management.

8. Management, to assess its own performance.

9. Corporate raiders, to seek hidden value in companies with underpriced

stock.

10. Competitors, to benchmark their own financial results.

11. Potential competitors, to assess how profitable it may be to enter an

industry.

12. Government agencies responsible for taxing, regulating, or investigating

the company.

13. Politicians, lobbyists, issue groups, consumer advocates, environmentalists,

think tanks, foundations, media reporters, and others who are supporting

or opposing any particular public issue the company's actions

affect.

14. Actual or potential joint venture partners, franchisors or franchisees, and

other business interests who need to know about the company and its financial

situation.

This brief list shows how many people and institutions use financial statements

for a large variety of business purposes and suggests how essential the ability to

understand and analyze financial statements is to success in the business world.

FINANCIAL STATEMENT FORMAT

Financial statements have a standard format whether an enterprise is as small

as Nutrivite or as large as a major corporation. For example, a recent set of financial

statements for Microsoft Corporation can be summarized in millions of

dollars as follows:

Income Statement

Years Ended June 30 XXX1 XXX2 XXX3

Revenue $15,262 $19,747 $22,956

Cost of revenue 2,460 2,814 3,002

Research and development 2,601 2,970 3,775

Other expenses 3,787 4,035 5,242

Total expenses $ 8,848 $ 9,819 $12,019

Operating income $ 6,414 $ 9,928 $10,937

Investment income 703 1,963 3,338

Income before income taxes 7,117 11,891 14,275

Income taxes 2,627 4,106 4,854

Net income $ 4,490 $ 7,785 $ 9,421

Using Financial Statements 15

Cash Flow Statement

Years Ended June 30 XXX1 XXX2 XXX3

Operations

Net income $ 4,490 $ 7,785 $ 9,421

Adjustments to convert net

income to cash basis 3,943 5,352 4,540

Cash from operations $ 8,433 $ 13,137 $ 13,961

Financing

Stock repurchased, net $(1,509) $ (1,600) $ (2,651)

Stock warrants sold 538 766 472

Preferred stock dividends (28) (28) (13)

Cash from financing $ (999) $ (862) $ (2,192)

Investing

Additions to property and equipment $ (656) $ (583) $ (879)

Net additions to investments (6,616) (10,608) (11,048)

Net cash invested $(7,272) $ (11,191) $(11,927)

Net change in cash 162 1,084 (158)

Balance Sheet

Years Ended June 30 XXX2 XXX3

Current Assets

Cash and equivalents $ 4,975 $ 4,846

Short-term investments 12,261 18,952

Accounts receivable 2,245 3,250

Other 2,221 3,260

Total current assets $21,702 $30,308

Property and equipment, net $ 1,611 $ 1,903

Investments 15,312 19,939

Total fixed assets $16,923 $21,842

Total assets $38,625 $52,150

Current Liabilities

Accounts payable $ 874 $ 1,083

Other 7,928 8,672

Total current liabilities 8,802 9,755

Noncurrent liabilities 1,385 1,027

Total liabilities $10,187 $10,782

Preferred stock $ 980

Common stock 13,844 $23,195

Retained earnings 13,614 18,173

Total equity $28,438 $41,368

Total liabilities and equity $38,625 $52,150

Note: There are only two years of balance sheets but three years of income statements and cash f low

statements. This is because the Microsoft financial statements above were obtained from filings with

the U.S. Securities and Exchange Commission (SEC), and the SEC requirements for corporate annual

report filings are two years of balance sheets, plus three years of income statements and cash f low

statements.

16 Understanding the Numbers

The Microsoft financial statements contain numbers very much greater

than those for Nutrivite. But there is no difference in the general format of

these two sets of financial statements.

HOW TO ANALYZE FINANCIAL STATEMENTS

Imagine that you are a nurse or a physician and you work in the emergency

room of a busy hospital. Patients arrive with all kinds of serious injuries or illnesses,

barely alive or perhaps even dead. Others arrive with less urgent injuries,

minor complaints, or vaguely suspected ailments. Your training and

experience have taught you to perform a quick triage, to prioritize the most

endangered patients by their vital signs—respiration, pulse, blood pressure,

temperature, and ref lexes. A more detailed diagnosis follows based on more

thorough medical tests.

We check the financial health of a company in much the same fashion by

analyzing the financial statements. The vital signs are tested mostly by various

financial ratios that are calculated from the financial statements. These vital

signs can be classified into three main categories:

1. Short-term liquidity.

2. Long-term solvency.

3. Profitability.

We explain each of these three categories in turn.

SHORT-TERM LIQUIDITY

In the emergency room the first question is: Can this patient survive? Similarly,

the first issue in analyzing financial statements is: Can this company survive?

Business survival means being able to pay the bills, meet the payroll, and

come up with the rent. In other words, is there enough liquidity to provide the

cash needed to pay current financial commitments? "Yes" means survival. "No"

means bankruptcy. The urgency of this question is why current assets (which

are expected to turn into cash within a year) and current liabilities (which are

expected to be paid in cash within a year) are shown separately on the balance

sheet. Net current assets (current assets less current liabilities) is known as

working capital. Because most businesses cannot operate without positive

working capital, the question of whether current assets exceed current liabilities

is crucial.

When current assets are greater than current liabilities, there is sufficient

liquidity to enable the enterprise to survive. However, when current liabilities

exceed current assets the enterprise may well be in immanent danger of bankruptcy.

The financial ratio used to measure this risk is current assets divided

Using Financial Statements 17

by current liabilities, and is known as the current ratio. It is expressed as "2.5

to 1" or "2.5_1" or just "2.5." Keeping the current ratio from dropping below

1 is the bare minimum to indicate survival, but it lacks any margin of safety. A

company must maintain a reasonable margin of safety, or cushion, because the

current ratio, like all financial ratios, is only a rough approximation. For this

reason, in most cases a current ratio of 2 or more just begins to provide credible

evidence of liquidity.

An example of a current ratio can be found in the current sections of the

balance sheets shown earlier in this chapter:

Nutrivite

Selected Sections of Projected Balance Sheet

as of December 31, 200X

Assets Liabilities and Equity

Cash $ 40,600 Accounts payable $40,000

Inventory 80,000

Current assets $120,600 Current liabilities $40,000

The current ratio is 120,600/40,000, or 3. This is only a rough approximation for

several reasons. First, a company can, quite legitimately, improve its current

ratio. In the earlier case of Nutrivite, assume the business wanted its balance

sheet to ref lect a higher current ratio. One way to do so would be to pay off

$20,000 on the bank loan on December 31. This would reduce current assets to

$100,600 and current liabilities to $20,000. Then the current ratio is changed

to $100,600/$20,000, or 5. By perfectly legitimate means, the current ratio has

been improved from 3 to 5. This technique is widely used by companies that

want to put their best foot forward in the balance sheet, and it always works

provided that the current ratio was greater than 1 to start with.

Current assets usually include:

• Cash and Cash Equivalents.

• Securities expected to become liquid by maturing or being sold within

a year.

• Accounts Receivable (which Nutrivite did not have, because it did not sell

to its customers on credit).

• Inventory.

Current liabilities usually include:

• Accounts Payable.

• Other current payables, such as taxes, wages, or insurance.

• The current portion of long-term debt.

Some items included in Current Assets need a further explanation.

These are:

18 Understanding the Numbers

• Cash Equivalents are near-cash securities such as U.S. Treasury bills maturing

in three months or less.

• Accounts Receivable are amounts owed by customers and should be reported

on the balance sheet at "realizable value," which means "the

amount reasonably expected to be collected in cash." Any accounts whose

collectibility is in doubt must be reduced to realizable value by deducting

an allowance for doubtful debts.

• Inventories in some cases may not be liquid in a crisis (except at fire-sale

prices). This condition is especially likely for goods of a perishable, seasonal,

high-fashion, or trendy nature or items subject to technological obsolescence,

such as computers. Since inventory can readily lose value, it

must be reported on the balance sheet at the "lower of cost or market

value," or what the inventory cost to acquire (including freight and insurance),

or the cost of replacement, or the expected selling price less costs

of sale—whichever is lowest.

Despite these requirements designed to report inventory at a realistic

amount, inventory is regarded as an asset subject to inherent liquidity

risk, especially in difficult economic times and especially for items that

are perishable, seasonal, high-fashion, trendy, or subject to obsolescence.

For these reasons the current ratio is often modified by excluding inventory

to get what is called the quick ratio or acid test ratio:

• In the case of Nutrivite, the quick ratio as of December 31 is $40,600/

$40,000, or 1. This indicates that Nutrivite has a barely adequate quick

ratio, with no margin of safety at all. It is a red f lag or warning signal.

The current ratio and the quick ratio deal with all or most of the current

assets and current liabilities. There are also short-term liquidity ratios that

focus more narrowly on individual components of current assets and current liabilities.

These are the turnover ratios, which consist of:

• Accounts Receivable Turnover.

• Inventory Turnover.

• Accounts Payable Turnover.

Turnover, which means "making liquid," is a key factor in liquidity. Faster

turnover allows a company to do more business without increasing assets. Increased

turnover means that less cash is tied up in assets, and that improves

liquidity. Moving to the other side of the balance sheet, slower turnover of liabilities

conserves cash and thereby increases liquidity. Or more simply, achieving

better turnover of working capital can significantly improve liquidity.

Turnover ratios thus provide valuable information. The working capital

turnover ratios are described next.

Quick Ratio

Current Assets Inventory

Current Liabilities

=

 −

 

 

Using Financial Statements 19

Accounts Receivable Turnover

The equation is:

So, if Credit Sales are $120,000 and Accounts Receivable are $30,000, then

On average, Accounts Receivable turn over 4 times a year, or every 91 days.

The 91-day turnover period is found by dividing a year, 365 days, by the

Accounts Receivable Turnover ratio of 4. This average of 91 days is how long it

takes to collect Accounts Receivable. That is fine if our credit terms call for

payment 90 days from invoice but not fine if credit terms are 60 days, and it is

alarming if credit terms are 30 days.

Accounts Receivable, unlike vintage wines or antiques, do not improve with

age. Accounts Receivable Turnover should be in line with credit terms; turnover

sliding out of line with credit terms signals increasing danger to liquidity.

Inventory Turnover

Inventory turnover is computed as follows:

If Cost of Goods Sold is $100,000 and Inventory is $20,000, then

or about 70 days. Note that the numerator for calculating Accounts Receivable

Turnover is Credit Sales but for Inventory Turnover is Cost of Goods Sold. The

reason is that both Accounts Receivable and Sales are measured in terms of the

selling price of the goods involved. That makes Accounts Receivable Turnover

a consistent ratio, where the numerator and denominator are both expressed at

selling prices in an "apples-to-apples" manner. Inventory Turnover is also an

"apples-to-apples" comparison in that both numerator, Cost of Goods Sold, and

denominator, Inventory, are expressed in terms of the cost, not the selling

price, of the goods.

In our example, the Inventory Turnover was 5, or about 70 days. Whether

this is good or bad depends on industry standards. Companies in the autoretailing

or the furniture-manufacturing industry would accept this ratio. In

the supermarket business or in gasoline retailing, however, 5 would fall far

Inventory Turnover = = times a year $ ,

$ ,

100 000

20 000

5

Inventory Turnover

Cost of Goods Sold

Inventory

=

Accounts Receivable Turnover= = $ ,

$ ,

120 000

30 000

4

Accounts Receivable Turnover

Credit Sales

Accounts Receivable

=

20 Understanding the Numbers

below their norm of about 25 times a year, or roughly every 2 weeks. As with

Accounts Receivable Turnover, an Inventory Turnover that is out of line is a

red f lag.

Accounts Payable Turnover

This measure's equation is:

If Cost of Goods Sold is $100,000 and Accounts Payable is $16,600, then

which is about 6, or around 60 days. Again, note the consistency of the numerator

and denominator, both stated at the cost of the goods purchased. Accounts

Payable Turnover is evaluated by comparison with industry norms. An Accounts

Payable Turnover that is appreciably faster than the industry norm is

fine, if liquidity is satisfactory, because prompt payments to suppliers usually

earn cash discounts, which in turn lower the Cost of Goods Sold and thus

lead to higher income. However, such faster-than-normal Accounts Payable

Turnover does diminish liquidity and is therefore unwise when liquidity is

tight. Accounts Payable Turnover that is slower than the industry norm enhances

liquidity and is therefore wise when liquidity is tight but inadvisable

when liquidity is fine, because it sacrifices cash discounts from suppliers and

thus reduces income.

This concludes our survey of the ratios relating to short-term liquidity—

the current ratio; quick, or acid test, ratio; Accounts Receivable Turnover; Inventory

Turnover; and Accounts Payable Turnover.

If these ratios are seriously deficient, our diagnosis may be complete. The

subject business may be almost defunct, and even desperate measures may be

insufficient to revive it. If these ratios are favorable, then short-term liquidity

does not appear to be a threat and the financial doctor should proceed to the

next set of tests, which measure long-term solvency.

It is worth noting, however, that there are some rare exceptions to these

guidelines. For example, large gas and electric utilities typically have current

ratios less than 1 and quick ratios less than 0.5. This is due to utilities' exceptional

characteristics:

• They usually require deposits before providing service to customers, and

they can shut off service to customers who do not pay on time. Customers

are reluctant to go without necessities such as gas and electricity and

therefore tend to pay their utility bills ahead of most other bills. These

factors sharply reduce the risk of uncollectible accounts receivable for

gas and electric utility companies.

Accounts Payable Turnover =$ ,

$ ,

100 000

16 600

Accounts Payable Turnover

Cost of Goods Sold

Accounts Payable

=

Using Financial Statements 21

• Inventories of gas and electric utility companies are not subject to much

risk from changing fashion trends, deterioration, or obsolescence.

• Under regulation, gas and electric utility companies are stable, low-risk

businesses, largely free from competition and consistently profitable.

This reduced risk and increased predictability of gas and electric utility

companies make short-term liquidity and safety margins less crucial. In turn,

the ratios indicating short-term liquidity become less important, because shortterm

survival is not a significant concern for these businesses.

LONG-TERM SOLVENCY

Long-term solvency focuses on a firm's ability to pay the interest and principal

on its long-term debt. There are two commonly used ratios relating to servicing

long-term debt. One measures ability to pay interest, the other the ability to

repay the principal. The ratio for interest compares the amount of income

available for paying interest with the amount of the interest expense. This ratio

is called Interest Coverage or Times Interest Earned.

The amount of income available for paying interest is simply earnings before

interest and before income taxes. (Business interest expense is deductible

for income tax purposes; therefore, income taxes are based on earnings after

interest, otherwise known as earnings before income taxes.) Earnings before

interest and taxes is known as EBIT. The ratio for Interest Coverage or Times

Interest Earned is EBIT/Interest Expense. For instance, assume that EBIT is

$120,000 and interest expense is $60,000. Then:

This shows that the business has EBIT sufficient to cover 2 times its interest

expense. The cushion, or margin of safety, is therefore quite substantial.

Whether a given interest coverage ratio is acceptable depends on the industry.

Different industries have different degrees of year-to-year f luctuations in

EBIT. Interest coverage of 2 times may be satisfactory for a steady and mature

firm in an industry with stable earnings, such as regulated gas and electricity

supply. However, when the same industry experiences the uncertain forces of

deregulation, earnings may become volatile, and interest coverage of 2 may

prove to be inadequate. In more-turbulent industries, such as movie studios and

Internet retailers, an interest coverage of 2 may be regarded as insufficient.

The long-term solvency ratio that ref lects a firm's ability to repay principal

on long-term debt is the "Debt to Equity" ratio. The long-term capital structure

of a firm is made up principally of two types of financing: (1) long-term debt and

(2) owner equity. Some hybrid forms of financing mix characteristics of debt

and equity but usually can be classified as mainly debt or equity in nature.

Therefore the distinction between debt and equity is normally clear.

Interest Coverage or Times Interest Earned= = $ ,

$ ,

120 000

60 000

2

22 Understanding the Numbers

If long-term debt is $150,000 and equity is $300,000, then the debtequity

relationship is usually measured as:

Long-term debt is frequently secured by liens on property and has priority

on payment of periodic interest and repayment of principal. There is no priority

for equity, however, for dividend payments or return of capital to owners.

Holders of long-term debt thus have a high degree of security in receiving full

and punctual payments of interest and principal. But, in good times or bad,

whether income is high or low, long-term creditors are entitled to receive no

more than these fixed amounts. They have reduced their risk of gain or loss in

exchange for more certainty. By contrast, owners of equity enjoy no such certainty.

They are entitled to nothing except dividends, if declared, and, in the

case of bankruptcy, whatever funds might be left over after all obligations have

been paid. Theirs is a totally at-risk investment. They prosper in good times

and suffer in bad times. They accept these risks in the hope that in the long run

gains will substantially exceed losses.

From the firm's point of view, long-term debt obligations are a burden

that must be carried whether income is low, absent, or even negative. But longterm

debt obligations are a blessing when income is lush since they receive no

more than their fixed payments, even if incomes soar. The greater the proportion

of long-term debt and smaller the proportion of equity in the capital structure,

the more the incomes of the equity holders will f luctuate according to

how good or bad times are. The proportion of long-term debt to equity is

known as leverage. The greater the proportion of long-term debt to equity, the

more leveraged the firm is considered to be. The more leveraged the firm is,

the more equity holders prosper in good times and the worse they fare in bad

times. Because increased leverage leads to increased volatility of incomes, increased

leverage is regarded as an indicator of increased risk, though a moderate

degree of leverage is thus considered desirable. The debt-to-equity ratio is

evaluated according to industry standards and each industry's customary

volatility of earnings. For example, a debt-to-equity ratio of 80% would be considered

conservative in banking (where leverage is customarily above 80% and

earnings are relatively stable) but would be regarded as extremely risky for

toy manufacturing or designer apparel (where earnings are more volatile). The

well-known junk bonds are an example of long-term debt securities where

leverage is considered too high in relation to earnings volatility. The increased

risk associated with junk bonds explains their higher interest yields. This illustrates

the general financial principle that the greater the risk, the higher the

expected return.

Debt to Equity Ratio

Long-Term Debt

Long-Term Debt Equity

=

+

=

+

=

$ ,

($ , $ , )

%

150 000

150 000 300 000

33 1

3

Using Financial Statements 23

In summary, the ratios used to assess long-term solvency are Interest Coverage

and Long-Term Debt to Equity.

Next, we consider the ratios for analyzing profitability.

PROFITABILITY

Profitability is the lifeblood of a business. Businesses that earn incomes can

survive, grow, and prosper. Businesses that incur losses cannot stay in operation,

and will last only until their cash runs out. Therefore, in order to assess

business viability, it is important to analyze profitability.

When analyzing profitability, it is usually done in two phases, which are:

1. Profitability in relation to sales.

2. Profitability in relation to investment.

Profitability in Relation to Sales

The analysis of profitability in relation to sales recognizes the fact that:

or, rearranging terms:

Therefore, Expenses and Income are measured in relation to their sum, which is

Sales. The expenses, in turn, may be broken down by line item. As an example,

we use the Nutrivite Income Statement for the first three years of operation.

Income Statements for the

Years Ending December 31

Year 1 Year 2 Year 3

Sales $720,000 $800,000 $900,000

Less cost of goods sold 480,000 530,000 600,000

Gross profit $240,000 $270,000 $300,000

Less expenses

Salaries $ 40,000 $ 49,600 $ 69,000

Rent 36,000 49,400 54,400

Phone and utilities 14,400 19,400 26,000

Depreciation 3,600 3,600 3,600

Interest 6,000 6,000 6,000

Total expenses $100,000 $128,000 $159,000

Income before taxes $140,000 $142,000 $141,000

Income tax expense (40%) 56,000 56,800 56,400

Net income $ 84,000 $ 85,200 $ 84,600

Sales = Expenses + Income

Income = Sales Expenses

24 Understanding the Numbers

These income statements show a steady increase in Sales and Gross Profits

each year. Despite this favorable result, the Net Income has remained virtually

unchanged at about $84,000 for each year. To learn why this is the case, we

need to convert expenses and income to percentages of sales. The income statements

converted to percentages of sales are known as "common size" income

statements and look like the following:

Common Size Income Statements for the

Years Ending December 31

Change

Year 1 Year 2 Year 3 Years 1–3

Sales 100.0% 100.0% 100.0% 0.0%

Less cost of goods sold 66.7 66.2 66.7 0.0

Gross profit 33.3% 33.8% 33.3% 0.0%

Less expenses

Salaries 5.6% 6.2% 7.7% 2.1%

Rent 5.0 6.2 6.0 1.0

Phone and utilities 2.0 2.4 2.9 0.9

Depreciation 0.5 0.4 0.4 0.1

Interest 0.8 0.8 0.7 0.1

Total expenses 13.9% 16.0% 17.7% 3.8%

Income before taxes 19.4% 17.8% 15.6% 3.8%

Income tax expense (40%) 7.8 7.2 6.2 1.6

Net income 11.6% 10.6% 9.4% 2.2%

From the percentage figures above it is easy to see why the Net Income

failed to increase, despite the substantial growth in Sales and Gross Profit.

Total Expenses rose by 3.8 percentage points, from 13.9% of Sales in Year 1 to

17.7% of Sales in Year 3. In particular, the increase in Total Expenses relative

to Sales was driven mainly by increases in Salaries (2.1 percentage points),

Rent (1 percentage point) and Phone and Utilities (0.9 percentage point). As a

result, Income before Taxes relative to Sales fell by 3.8 percentage points from

Year 1 to Year 3. The good news is that the drop in Income before Taxes caused

a reduction of Income Tax Expense relative to Sales of 1.6 percentage points

from Year 1 to Year 3. The net effect was a drop in Net Income, relative to

Sales, of 2.2 percentage points from Year 1 to Year 3.

This useful information shows that:

1. The profit stagnation is not related to Sales or Gross Profit.

2. It is entirely due to the disproportionate increase in Total Expenses.

3. Specific causes are the expenses for Salaries, Rent, and Phone and

Utilities.

4. Action to correct the profit slump requires analyzing these particular expense

categories.

Using Financial Statements 25

The use of percent-of-sales ratios is a simple but powerful technique for

analyzing profitability. Generally used ratios include:

• Gross Profit.

• Operating Expenses:

a. In total.

b. Individually.

• Selling, General, and Administrative Expenses (often called SG&A).

• Operating Income.

• Income before Taxes.

• Net Income.

The second category of profitability ratios is profitability in relation to

investment.

Profitability in Relation to Investment

To earn profits, usually a firm must invest capital in items such as plant, equipment,

inventory, and/or research and development. Up to this point we have

analyzed profitability without considering invested capital. That was a useful

simplification in the beginning, but, since profitability is highly dependent

on the investment of capital, it is now time to bring invested capital into the

analysis.

We start with the balance sheet. Recall that Working Capital is Current

Assets less Current Liabilities. So we can simplify the balance sheet by including

a single category for Working Capital in place of the separate categories for

Current Assets and Current Liabilities. An example of a simplified balance

sheet follows:

Example Company

Simplified Balance Sheet as of December 31, 200X

Assets Liabilities and Equity

Working capital $ 40,000 Long-term debt $ 30,000

Fixed assets, net 80,000 Equity 90,000

Total assets $120,000 Liabilities and equity $120,000

A simplified Income Statement for Example Company for the year 200X is

summarized below:

Income before interest and taxes (EBIT) $36,000

Less interest expense 3,000

Income before income taxes 33,000

Less income taxes (40%) 13,200

Net income $19,800

26 Understanding the Numbers

The first ratio we will consider is EBIT (also known as Operating Profit)

to Total Assets. This ratio is often referred to as Return on Total Assets

(ROTA), and it can be expressed as either before tax (more usual) or after tax.

From the Example Company, the calculations are as follows:

Return on Total Assets Before Tax After Tax

EBIT/total assets = $36,000/$120,000 30%

EBIT/total assets = $21,600/$120,000 18%

This ratio indicates the raw (or basic) earning power of the business. Raw earning

power is independent of whether assets are financed by equity or debt.

This independence exists because:

1. The numerator (EBIT) is free of interest expense.

2. The denominator, Total Assets, is equal to total capital regardless of how

much capital is equity and how much is debt.

Independence allows the ratio to be measured and compared:

• For any business, from one period to another.

• For any period, from one business to another.

These comparisons remain valid, even if the debt to equity ratio may vary from

one period to the next and from one business to another.

Now that we have measured basic earning power regardless of the debt to

equity ratio, our next step is to take the debt to equity ratio into consideration.

First, it is important to note that long-term debt is normally a less expensive

form of financing than equity because:

1. Whereas Dividends paid to stockholders are not a tax deduction for the

paying company, Interest Expense paid on Long-Term Debt is. Therefore

the net after-tax cost of Interest is reduced by the related tax deduction.

This is not the case for Dividends, which are not deductible.

2. Debt is senior to equity, which means that debt obligations for interest

and principal must be paid in full before making any payments on equity,

such as dividends. This makes debt less risky than equity to the investors,

and so debt holders are willing to accept a lower rate of return than holders

of the riskier equity securities.

This contrast can be seen from the simplified financial statements of Example

Company above. The interest of $3,000 on the Long-Term Debt of

$30,000 is 10% before tax. But after the 40% tax deduction the interest after

tax is only $1,800 ($3,000 40% tax on $3,000), and this $1,800 represents an

after-tax interest rate of 6% on the Long-Term Debt of $30,000. For comparison

let us turn to the rate of return on the Equity. The Net Income, $19,800,

represents a 22% rate of return on the Equity of $90,000. This 22% rate of return

is a financial ratio known as Return on Equity, sometimes abbreviated

ROE. Return on Equity is an important and widely used financial ratio.

Using Financial Statements 27

There is much more to be said about Return on Equity, but first it may be

helpful to recap brief ly the main points we have covered about profitability in

relation to investment.

The EBIT of $36,000 represented a 30% return on total assets, before income

tax, and this $36,000 was shared by three parties, as follows:

1. Long-Term Debt holders received Interest of $3,000, representing an interest

cost of 10% before income tax, and 6% after income tax.

2. City, state, and/or federal governments were paid Income Taxes of

$13,200.

3. Stockholder Equity increased by the Net Income of $19,800, which represented

a 22% Return on Equity.

If there had been no Long-Term Debt, there would have been no Interest

Expense. The EBIT of $36,000 less income tax at 40% would provide a Net Income

of $21,600, which is larger than the prior Net Income of $19,800 by

$1,800. This $1,800 equals the $3,000 amount of Interest before tax less the

40% tax, which is $1,200. In the absence of Long-Term Debt, the Total Assets

would have been funded entirely by equity, which would have required equity

to be $120,000. In turn, with Net Income of $21,600, the revised Return on

Equity would be

The increase in the Return on Equity, from this 18% to 22% was attributable

to the use of Long-Term Debt. The Long-Term Debt had a cost after taxes of

only 6% versus the Return on Assets after tax of 18%. When a business earns

18% after tax, it is profitable to borrow at 6% after tax. This in turn improves

the Return on Equity from 18% to 22%, which illustrates the advantage of

leverage: A business earning 18% on assets can, with a little leverage, earn

22% on equity.

But what if EBIT is only $3,000? The entire $3,000 would be used up to

pay the interest of $3,000 on the Long-Term Debt. The Net Income would be

$0, resulting in a 0% Return on Equity. This illustrates the disadvantage of

leverage. Without Long-Term Debt, the EBIT of $3,000 less 40% tax would result

in Net Income of $1,800. Return on Equity would be $1,800 divided by

equity of $120,000, which is 1.5%. A Return on Equity of 1.5% may not be impressive,

but it is certainly better than the 0% that resulted with Long-Term

Debt.

Leverage is a fair-weather friend: It boosts Return on Equity when earnings

are robust but depresses ROE when earnings are poor. Leverage makes

the good times better but the bad times worse. Therefore, it should be used in

moderation and in businesses with stable earnings. In businesses with volatile

earnings, leverage should be used sparingly and cautiously.

We have now described all of the main financial ratios, and they are summarized

in Exhibit 1.1.

Net Income

Equity

= = $ ,

$ ,

%

21 600

120 000

18

28 Understanding the Numbers

USING FINANCIAL RATIOS

Some important points to keep in mind when using financial ratios are:

• Whereas all balance sheet numbers are end-of-period numbers, all income

statement numbers relate to the entire period. For example, when

calculating the ratio for Accounts Receivable Turnover, we use a numerator

of Credit Sales, which is an entire-period number from the income

statement, and a denominator of Accounts Receivable, which is an end-ofperiod

number from the balance sheet. To make this an apples-to-apples

ratio, the Accounts Receivable can be represented by an average of the

beginning-of-year and end-of-year figures for Accounts Receivable. This

average is closer to a mid-year estimate of Accounts Receivable and therefore

is more comparable to the entire-period numerator, Credit Sales. Because

using averages of the beginning-of-year and end-of-year figures for

balance sheet numbers helps to make ratios more of an apples-to-apples

EXHIBIT 1.1 Summary of main financial ratios.

Ratio Numerator Denominator

Short-Term Liquidity

Current ratio Current assets Current liabilities

Quick ratio (acid test) Current assets Current liabilities

(excluding inventory)

Receivables turnover Credit sales Accounts receivable

Inventory turnover Cost of sales Inventory

Payables turnover Cost of sales Accounts payable

Long-Term Solvency

Interest coverage EBIT Interest on L/T debt

Debt to capital Long-term debt L/T debt + equity

Profitability on Sales

Gross profit ratio Gross profit Sales

Operating expense ratio Operating expenses Sales

SG&A expense ratio SG&A expenses Sales

EBIT ratio EBIT Sales

Pretax income ratio Pretax income Sales

Net income ratio Net income Sales

Profitability on Investment

Return on total assets:

Before tax EBIT Total assetsa

After tax EBIT times (1-tax rate) Total assetsa

Return on equity Net income: Commonb Common equity

a Total Assets = Fixed Assets + Working Capital (Current Assets less Current Liabilities)

b Net Income less Preferred Dividends

Using Financial Statements 29

comparison, averages should be used for all balance sheet numbers when

calculating financial ratios.

• Financial ratios can be no more reliable than the data with which the ratios

were calculated. The most reliable data is from audited financial

statements, if the audit reports are clean and unqualified.

• Financial ratios cannot be fully considered without yardsticks of comparison.

The simplest yardsticks are comparisons of an enterprise's current

financial ratios with those from previous periods. Companies often provide

this type of information in their financial reporting. For example,

Apple Computer Inc., recently disclosed the following financial quarterly

information, in millions of dollars:

Quarter 4 3 2 1

Net sales $1,870 $1,825 $1,945 $2,343

Gross margin $1,122 $1,016 $1,043 $1,377

Gross margin 25% 30% 28% 28%

Operating costs $ 383 $ 375 $ 379 $ 409

Operating income $ 64 $ 168 $ 170 $ 100

Operating income 4% 9% 9% 4%

This table compares four successive quarters of information, which

makes it possible to see the latest trends in such important items as Sales,

and Gross Margin and Operating Income percentages. Other types of

comparisons of financial ratios include:

1. Comparisons with competitors. For example, the financial ratios of

Apple Computer could be compared with those of Compaq, Dell, or

Gateway.

2. Comparisons with industry composites. Industry composite ratios can

be found from a number of sources, such as:

a. The Almanac of Business and Industrial Financial Ratios, authored

by Leo Troy and published annually by Prentice-Hall (Paramus,

NJ). This publication uses Internal Revenue Service data for

4.6 million U.S. corporations, classified into 179 industries and divided

into categories by firm size, and reporting 50 different financial

ratios.

b. Risk Management Associates: Annual Statement Studies. This is a

database compiled by bank loan officers from the financial statements

of more than 150,000 commercial borrowers, representing

more than 600 industries, classified by business size, and reporting

16 different financial ratios. It is available on the Internet at

www.rmahq.org.

c. Financial ratios can also be obtained from other firms who specialize

in financial information, such as Dun & Bradstreet, Moody's,

and Standard & Poor's.

30 Understanding the Numbers

COMBINING FINANCIAL RATIOS

Up to this point we have considered financial ratios one at a time. However,

there is a useful method for combining financial ratios known as Dupont1

analysis. To explain it, we first need to define some financial ratios, together

with their abbreviations, as follows:

Ratio Calculation Abbreviation

Profit margin2 Net income/sales NI/S

Asset turnover Sales/total assets S/TA

Return on assets3 Net income/total assets NI/TA

Leverage Total assets/common equity TA/CE

Return on equity Net income/common equity NI/CE

Now, these financial ratios can be combined in the following manner:

and

In summary:

This equation says that Profit Margin × Asset Turnover × Leverage = Return

on Equity.

Also, this equation provides a financial approach to business strategy. It

recognizes that the ultimate goal of business strategy is to maximize stockholder

value, that is, the market price of the common stock. This goal requires

maximizing the return on common equity. The Dupont equation above breaks

the return on common equity into its three component parts: Profit Margin

(Net Income/Sales), Asset Turnover (Sales/Total Assets), and Leverage (Total

Assets/Common Equity). If any one of these three ratios can be improved

(without harm to either or both of the remaining two ratios), then the return

on common equity will increase. A firm thus has specific strategic targets:

• Profit Margin improvement can be pursued in a number of ways. On the

one hand, revenues might be increased or costs decreased by:

N1

S

S

TA

TA

CE

N1

CE

× × =

Return on Assets Leverage Return on Equity

Net Income

Total Assets

Total Assets

Common Equity

Net Income

Common Equity

× =

× =

Profit Margin Asset Turnover Return on Assets

Net Income

Sales

Sales

Total Assets

Net Income

Total Assets

× =

× =

Using Financial Statements 31

1. Raising prices perhaps by improving product quality or offering extra

services. Makers of luxury cars have done this successfully by providing

free roadside assistance and loaner cars when customer cars are

being serviced.

2. Maintaining prices but reducing the quantity of product in the package.

Candy bar manufacturers and other makers of packaged foods

often use this method.

3. Initiating or increasing charges for ancillary goods or services. For example,

banks have substantially increased their charges to stop checks

and for checks written with insufficient funds. Distributors of computers

and software have instituted fees for providing technical assistance

on their help lines and for restocking returned items.

4. Improving the productivity and efficiency of operations.

5. Cutting costs in a variety of ways.

• Asset Turnover may be improved in ways such as:

1. Speeding up the collection of accounts receivable.

2. Increasing inventory turnover, perhaps by adopting "just in time" inventory

methods.

3. Slowing down payments to suppliers, thus increasing accounts payable.

4. Reducing idle capacity of plant and equipment.

• Leverage may be increased, within prudent limits, by means such as:

1. Using long-term debt rather than equity to fund additions to plant,

property, and equipment.

2. Repurchasing previously issued common stock in the open market.

The chief advantage of using the Dupont formula is to focus attention on

specific initiatives that will improve return on equity by means of enhancing

profit margins, increasing asset turnover, or employing greater financial leverage

within prudent limits.

In addition to the Dupont formula, there is another way to combine financial

ratios, one that serves another useful purpose—predicting solvency or

bankruptcy for a given enterprise. It uses what is known as the z score.

THE Z SCORE

Financial ratios are useful not only to assess the past or present condition of

an enterprise, but also to reliably predict its future solvency or bankruptcy.

This type of information is of critical importance to present and potential

creditors and investors. There are several different methods of analysis for

obtaining this predictive information. The best-known and most time-tested

is the z score, developed for publicly traded manufacturing firms by Professor

32 Understanding the Numbers

Edward Altman of New York University. Its reliability can be expressed in

terms of the two types of errors to which all predictive methods are vulnerable,

namely:

1. Type I error: predicting solvency when in fact a firm becomes bankrupt

(a false positive).

2. Type II error: predicting bankruptcy when in fact a firm remains solvent

(a false negative).

The predictive error rates for the Altman z score have been found to be as

follows:

Years Prior to % False % False

Bankruptcy Positives Negatives

1 6 3

2 18 6

Given the inherent difficulty of predicting future events, these error rates are

relatively low, and therefore the Altman z score is generally regarded as a reasonably

reliable bankruptcy predictor. The z score is calculated from financial

ratios in the following manner:

A z score above 2.99 predicts solvency; a z score below 1.81 predicts bankruptcy;

z scores between 1.81 and 2.99 are in a gray area, with scores above

2.675 suggesting solvency and scores below 2.675 suggesting bankruptcy.

Since the z score uses equity at market value, it is not applicable to private

firms, which do not issue marketable securities. A variation of the z score

for private firms, known as the zscore, has been developed that uses the book

value of equity rather than the market value. Because of this modification, the

multipliers in the formula have changed from those in the original z score, as

have the scores that indicate solvency, bankruptcy, or the gray area. For nonmanufacturing

service-sector firms, a further variation in the formula has

been developed. It omits the variable for asset turnover and is known as the z′′

score. Once again, the multipliers in the formula have changed from those in

the zscore, and so have the scores that indicate solvency, bankruptcy, or the

gray area.

Professor Altman later developed a bankruptcy predictor more refined

than the z score and named it ZETA. ZETA uses financial ratios for times interest

earned, return on assets (the average and the standard deviation), and

debt to equity. Other details of ZETA have not been made public. ZETA is

proprietary and is made available to users for a fee.

z= × + × + ×

+ × + ×

1 2 1 4 3 3

0 6 1 0

. . .

. .

Working Capital

Total Assets

Retained Earnings

Total Assets

EBIT

Total Assets

Equity at Market Value

Debt

Sales

Total Assets

Using Financial Statements 33

SUMMARY AND CONCLUSIONS

Financial statements contain critical business information and are used for

many different purposes by many different parties inside and outside the business.

Clearly all successful businesspeople should have a good basic understanding

of financial statements and of the main financial ratios. For further

information and explanations about financial statements, see the following

chapters in this book:

Chapter 2: Analyzing Business Earnings

Chapter 6: Forecasts and Budgets

Chapter 15: The Board of Directors

Chapter 18: Business Valuation

INTERNET LINKS

Some useful Internet links on financial statements and financial ratios are:

www.aicpa.org Web site for the American Institute of Certified

Public Accountants.

www.freedgar.com This site lets users download financial statements

and other key financial information filed with the

SEC and maintained in Edgar (the name of its

database) for all corporations with securities that

are publicly traded in the United States. This

service is free of charge. Another Web site,

Spredgar.com, displays financial ratios calculated

from freedgar.com.

www.10k.com Provides free downloads of annual reports (which

include financial statements) filed with the SEC

for all corporations with securities that are

publicly traded in the United States.

www.rmahq.org Web site of the Risk Management Association

(RMA) that contains financial ratios classified by

size of firm for more than 600 industries.

www.cpaclass.com Information and instruction on many finance and

accounting topics.

www.financeprofessor.com Information and instruction on many finance and

accounting topics.

www.smallbusiness.org Information and instruction from public television

on many finance and accounting topics.

34 Understanding the Numbers

www.wmw.com The World Market Watch (wmw) provides

business research information, including financial

ratios, for many companies and 74 different

industries.

FOR FURTHER READING

Anthony, Robert N., Essentials of Accounting, 6th ed. (Boston, MA: Addison-Wesley,

1996).

Brealey, Richard A., and Stewart C. Myers, Fundamentals of Corporate Finance, 3rd

ed. (New York: McGraw-Hill, 2001).

Fridson, Martin S., Financial Statement Analysis: A Practitioner's Guide, 2nd ed.

(New York: John Wiley, 1995).

Simini, Joseph P., Balance Sheet Basics for Nonfinancial Managers (New York: John

Wiley, 1990).

Tracy, John A., How to Read a Financial Report: Wringing Cash Flow and Other

Vital Signs Out of the Numbers, 4th ed. (New York: John Wiley, 1994).

Troy, Leo, Almanac of Business and Industrial Financial Ratios (Paramus, NJ:

Prentice-Hall, Annual).

Financial Studies of the Small Business (Winter Haven, FL: Financial Research Associates,

Annual).

Industry Norms and Key Business Ratios (New York: Dun & Bradstreet, Annual).

RMA Annual Statement Studies (Philadelphia, PA: Risk Management Association,

Annual).

Standard and Poor's Industry Surveys (New York: Standard & Poor's, Quarterly).

NOTES

1. The name comes from its original use at the Dupont Corporation.

2. After income taxes.

3. Ibid.

35

2

ANALYZING

BUSINESS

EARNINGS

Eugene E. Comiskey

Charles W. Mulford

A special committee of the American Institute of Certified Public Accountants

(AICPA) concluded the following about earnings and the needs of those

who use financial statements:

Users want information about the portion of a company's reported earnings

that is stable or recurring and that provides a basis for estimating sustainable

earnings.1

While users may want information about the stable or recurring portion of

a company's earnings, firms are under no obligation to provide this earnings series.

However, generally accepted accounting principles (GAAPs) require separate

disclosure of selected nonrecurring revenues, gains, expenses, and losses

on the face of the income statement or in notes to the financial statements.

Further, the Securities and Exchange Commission (SEC) requires the disclosure

of material nonrecurring items.

The prominence given the demand by users for information on nonrecurring

items in the above AICPA report is, no doubt, driven in part by the explosive

growth in nonrecurring items over the past decade. The acceleration of

change together with a passion for downsizing, rightsizing, and reengineering

have fueled this growth. The Financial Accounting Standards Board's (FASB)

issuance of a number of new accounting statements that require recognition of

previously unrecorded expenses and more timely recognition of declines in

asset values has also contributed to the increase in nonrecurring items.

A limited number of firms do provide, on a voluntary basis, schedules that

show their results with nonrecurring items removed. Mason Dixon Bancshares

36 Understanding the Numbers

provides one such example. Exhibit 2.1 shows a Mason Dixon schedule that adjusts

reported net income to a revised earnings measure from which nonrecurring

revenues, gains, expenses, and losses have been removed. This is the type

of information that the previously quoted statement of the AICPA's Special

Committee calls for.

Notice the substantial number of nonrecurring items that Mason Dixon

removed from reported net income in order to arrive at a closer measure of

core or sustainable earnings. In spite of the number of nonrecurring items removed

from reported net income, the revised earnings differ by only about 6%

from the original reported net income.

Firms that record either a large nonrecurring gain or loss frequently attempt

to offset its effect on net income by recording a number of offsetting

items. In the case of Mason Dixon, the large gain on the sale of branches if not

offset may raise earnings expectations to levels that are unattainable. Alternatively,

the recording of offsetting charges may be seen as a way to relieve future

earnings of their burden. We do not claim that this was done in the case of

Mason Dixon Bancshares, but its results are consistent with this practice.

Though exceptions like the Mason Dixon Bancshares example do occur,

the task of developing information on a firm's recurring or sustainable results

normally falls to the statement user. Companies do provide, to varying degrees,

the raw materials for this analysis; however, the formidable task of creating—an

analysis comparable to that provided by Mason Dixon—is typically left to the

user. The central goal of this chapter is to help users develop the background

and skills to perform this critical aspect of earnings analysis. The chapter will

discuss nonrecurring items and outline efficient approaches for locating them in

financial statements and associated notes. As key background we will also discuss

and illustrate income statement formats and other issues of classification.

Throughout the chapter, we illustrate concepts using information drawn from

EXHIBIT 2.1 Core business net income: Mason Dixon Bancshares Inc.,

year ended December 31 (in thousands).

1998

Reported net income $10,811

Adjustments, add (deduct), for nonrecurring items:

Gain on sale of branches (6,717)

Special loan provision for loans with Year 2000 risk 918

Special loan provision for change in charge-off policy 2,000

Reorganization costs 465

Year 2000 costs 700

Impairment loss on mortgage sub-servicing rights 841

Income tax expense on the nonrecurring items above 1,128

Core (sustainable) net income $10,146

SOURCE: Mason Dixon Bancshares Inc., annual report, December 1998. Information obtained from

Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC

(Bethesda, MD: Disclosure Inc., June 2000).

Analyzing Business Earnings 37

the financial statements of many companies. As a summary exercise, a comprehensive

case is provided that removes all nonrecurring items from reported results

to arrive at a sustainable earnings series.

THE NATURE OF NONRECURRING ITEMS

Defining nonrecurring items is difficult. Writers often begin with phrases like

"unusual" or "infrequent in occurrence." Donald Keiso and Jerry Weygandt in

their popular intermediate accounting text use the term irregular to describe

what most statement users would consider nonrecurring items.2 For our purposes,

irregular or nonrecurring revenues, gains, expenses, and losses are not

consistent contributors to results, in terms of either their presence or their

amount. This is the manner in which we use the term nonrecurring items

throughout this chapter.

From a security valuation perspective, nonrecurring items have a smaller

impact on share price than recurring elements of earnings. Some items, such as

restructuring charges, litigation settlements, f lood losses, product recall costs,

embezzlement losses, and insurance settlements, can easily be identified as

nonrecurring. Other items may appear consistently in the income statement

but vary widely in sign (revenue versus expense, gain versus loss) and amount.

For example, the following gains on the disposition of f light equipment were

reported over a number of years by Delta Air Lines:3

1992 $35 million

1993 65 million

1994 2 million

1995 0 million

1996 2 million

The gains averaged about $25 million over the 10 years ending in 1996

and ranged from a loss of $1 million (1988) to a gain of $65 million (1993). The

more recent five years typify the variability in the amounts for the entire 10-

year period. These gains did recur, but they are certainly irregular in amount.

There are at least three alternative ways to handle this line item in revising

results to identify sustainable or recurring earnings. First, one could simply

eliminate the line item based on its highly inconsistent contribution to

results.4 Second, one could include the line item at its average value ($25 million

for the period 1987 to 1996) for some period of time. Third, one could attempt

to acquire information on planned aircraft dispositions that would make

possible a better prediction of the contribution of gains on aircraft dispositions

to future results. While the last approach may appear to be the most

appealing, it may prove to be difficult to implement because of lack of information,

and it may also be less attractive when viewed from a cost-benefit perspective.

In general, we would normally recommend either removing the gains

38 Understanding the Numbers

or simply employing a fairly recent average value for the gains in making earnings

projections.

After 1996, Delta Air Lines disclosed little in the way of nonrecurring

gains on the sale of f light equipment. Its 2000 annual report, which covered

the years from 1998 to 2000, did not disclose any gains or losses on the disposition

of f light equipment.5 With hindsight, the first option, which would remove

all of the gains and losses on f light equipment, may have been the most

appropriate alternative.

The Goodyear Tire and Rubber Company provides a timeless example of

the impact of nonrecurring items on the evaluation of earnings performance.

Exhibit 2.2 shows pretax results for Goodyear, with and without losses on foreign

exchange.

As with Delta Air Lines, it may seem questionable to characterize as nonrecurring

exchange losses that appear repeatedly. However, in line with the key

characteristics of nonrecurring items given earlier, Goodyear's foreign exchange

losses are both irregular in amount and unlikely to be consistent contributors to

results in future years. Across the period 1993 to 1995 the reduction in foreign

exchange losses contributed to Goodyear's pretax results by $35.5 million in

1994 and $60.2 million in 1995. That is, the entire $60.1 million increase in earnings

for 1995 could be attributed to the $60.2 million decline in foreign exchange

losses. The only way that the foreign exchange line could contribute a further

$60.2 million to pretax earnings in 1996 would be for Goodyear to produce a foreign

exchange gain of $42.8 million ($60.2 $17.4).6

Other examples of irregular items of revenue, gain, expense, and loss

abound. For example, there were temporary revenue increases and decreases

associated with the Gulf War. ("Sales to the United States government increased

substantially during the Persian Gulf War. However, sales returned to

more normal levels in the second half of the year."7) Temporary revenue increases

have been associated with expanded television sales due to World Cup

EXHIBIT 2.2 The Goodyear Tire and Rubber Company, results with

and without foreign-exchange losses, years ended

December 31 (in millions).

1993 1994 1995

Income before income taxes, extraordinary

item and cumulative effect of

accounting change $784.9 $865.7 $925.8

Add back foreign exchange losses 113.1 77.6 17.4

Income exclusive of foreign-exchange losses $898.0 $943.3 $943.2

Percentage income increase:

Income as reported 10.3% 6.9%

Income exclusive on foreign-exchange losses 5.0% 0.0%

SOURCE: The Goodyear Tire and Rubber Company, annual report, December 1995, 24.

Analyzing Business Earnings 39

soccer. Temporary increases or decreases in earnings have resulted from adjustments

to loan loss provisions resulting from economic downturns and subsequent

recoveries in the financial services industry. Most recently, there have

been widely publicized problems with tires produced for sports utility vehicles

that will surely create substantial nonrecurring increases in legal and warranty

expenses.

Identifying nonrecurring or irregular items is not a mechanical process;

it calls for the exercise of judgment and involves both line items and as the

period-to-period behavior of individual income statement items.

THE PROCESS OF IDENTIFYING NONRECURRING ITEMS

Careful analysis of past financial performance aimed at removing the effects

of nonrecurring items is a more formidable task than one might suspect. This

task would be fairly simple if (1) there was general agreement on just what constitutes

a nonrecurring item and (2) if most nonrecurring items were prominently

displayed on the face of the income statement. However, neither is the

case. Some research suggests that fewer than one-fourth of nonrecurring items

are likely to be found separately disclosed in the income statement.8 Providing

guidance for locating the remaining three-fourths is a key goal of this chapter.

Identifying Nonrecurring Items:

An Efficient Search Procedure

The search sequence outlined in the following discussion locates a high cumulative

percentage of material nonrecurring items and does so in a cost-effective

manner. Search cost, mainly in time spent by the financial analyst, is an important

consideration. Time devoted to this task is not available for another and,

therefore, there is an opportunity cost to consider. The discussion and guidance

that follows are organized around this recommended search sequence

(see Exhibit 2.3). Following only the first five steps in this search sequence is

likely to locate almost 60% of all nonrecurring items.9 Continuing through

steps six and seven will typically increase this location percentage. However,

the 60% discovery rate is higher if the focus is only on material nonrecurring

items. The nonrecurring items disclosed in other locations through steps 6 and

7 are fewer in number and normally less material than those initially found

through the first five.

NONRECURRING ITEMS IN THE INCOME STATEMENT

An examination of the income statement, the first step in the search sequence,

requires an understanding of the design and content of contemporary income

statements. This knowledge will aid in the location and analysis of nonrecurring

40 Understanding the Numbers

components of earnings. Generally accepted accounting principles (GAAPs)

determine the structure and content of the income statement. Locating nonrecurring

items in the income statement is a highly efficient and cost-effective

process. Many nonrecurring items will be prominently displayed on separate

lines in the statement. Further, leads to other nonrecurring items, disclosed

elsewhere, may be discovered during this process. For example, a line item that

summarizes items of other income and expense may include an associated note

reference detailing its contents. These notes should always be reviewed—step

5 in the search sequence—because they will often reveal a wide range of nonrecurring

items.

Alternative Income Statement Formats

Examples of the two principal income statement formats under current GAAPs

are presented below. The income statement of Shaw Industries Inc., in Exhibit

2.4 is single step and that of Toys "R" Us Inc. in Exhibit 2.5 is multistep.

An annual survey of financial statements conducted by the American Institute

of Certified Public Accountants (AICPA) reveals that about one-third of the

600 companies in its survey use the single-step format and the other two-thirds

the multistep.10

EXHIBIT 2.3 Ef f icient search sequence for nonrecurring items.

Search

Step Search Location

1 Income statement.

2 Statement of cash flows—operating activities section only.

3 Inventory note, generally assuming that the firm employs the LIFO inventory

method. However, even with non-LIFO firms, inventory notes may reveal

inventory write-downs.

4 Income tax note, with attention focused on the tax-reconciliation schedule.

5 Other income (expense) note in cases where this balance is not detailed on the

face of the income statement.

6 MD&A of Financial Condition and Results of Operations—a Securities and

Exchange Commission requirement and therefore available only for public

companies.

7 Other notes which often include nonrecurring items:

Note Nonrecurring items revealed

a. Property and equipment Gains and losses on asset sales

b. Long-term debt Foreign currency and debt-retirement gains and losses.

c. Foreign currency Foreign currency gains and losses

d. Restructuring Current and prospective impact of of restructuring

activities

e. Contingencies Prospective revenues and expenses

f. Segment disclosures Various nonrecurring items

g. Quarterly financial data Various nonrecurring items

Analyzing Business Earnings 41

The distinguishing feature of the multistep statement is that it provides

intermediate earnings subtotals that are designed to measure pretax operating

performance. In principle, operating income should be composed almost entirely

of recurring items of revenue and expense, which result from the main

operating activities of the firm. In practice, numerous material nonrecurring

items are commonly included in operating income. For example, "restructuring"

charges, one of the most common nonrecurring items of the past decade,

is virtually always included in operating income.

Shaw Industries' single-step income statement does not partition results

into intermediate subtotals. For example, there are no line items identified as

either "gross profit" or "operating income." Rather, all revenues and expenses

are separately listed and "income before income taxes" is computed in a single

step as total expenses are deducted from total revenues. However, the Toys "R"

Us multistep income statement provides both gross profit and operating income/(

loss) subtotals.

Note that Shaw Industries has a number of different nonrecurring items in

its income statements. While they vary in size, the following would normally be

considered to be nonrecurring: charges related to residential retail operations,

EXHIBIT 2.4 Consolidated single-step statements of income: Shaw

Industries Inc. (in thousands).

Year Ended

Jan. 3 Jan. 2 Jan. 1

1998 1999 2000

Net sales $3,575,774 $3,542,202 $4,107,736

Cost of sales $2,680,472 $2,642,453 $3,028,248

Selling, general and administrative 722,590 620,878 627,075

Charge to record loss on sale of residential

retail operations, store closing costs and

write-down of certain assets — 132,303 4,061

Charge to record plant closing costs — — 1,834

Pre-opening expenses 3,953 — —

Charge to record store closing costs 36,787 — —

Write-down of U.K. assets 47,952 — —

Interest, net 60,769 62,553 62,812

Loss on sale of equity securities — 22,247 —

Other expense (income), net (7,032) 4,676 1,319

Income before income taxes 30,283 57,092 382,387

Provision for income taxes 5,586 38,407 157,361

Income before equity in income of joint ventures 24,697 18,685 225,026

Equity in income of joint ventures 4,262 1,947 2,925

Net income $ 28,959 $ 20,632 $ 227,951

Note: Per share amounts omitted.

SOURCE: Shaw Industries Inc., annual report, January 2000, 24.

42 Understanding the Numbers

plant closing costs, record-store closing costs, write-down of U.K. assets, the

loss on sale of equity investments, and the preopening expenses.

There will usually be other nonrecurring items lurking in other statements

or footnotes. Note the approximately $12-million change in the Other expense

(income) net balance for the year ending January 2, 1999, compared to the year

ending January 3, 1998. Also, there must be something unusual about income

taxes in the year ending January 3, 1998. The effective tax rate ($5,586,000 divided

by $30,283,000) is only about 18%, well below the 35% statutory federal

tax rate for large companies. By contrast, the effective tax rate ($38,407,000 divided

by $57,092,000) for the year ending January 2, 1999, is about 67%.

Nonrecurring Items Located in Income

from Continuing Operations

Whether a single- or multistep format is used, the composition of income from

continuing operations is the same. It includes all items of revenue, gain, expense,

and loss except those (1) identified with discontinued operations, (2)

meeting the definition of extraordinary items, and (3) resulting from the cumulative

effect of changes in accounting principles. Because income from continuing

operations excludes only these three items, it follows that all other

nonrecurring items of revenues or gains and expenses or losses are included in

this key profit subtotal.

EXHIBIT 2.5 Consolidated multi-step statements of earnings:

Toys "R" Us Inc. (in millions).

Year Ended

Jan. 31 Jan. 30 Jan. 29

1998 1999 2000

Net sales $11,038 $11,170 $11,862

Cost of sales 7,710 8,191 8,321

Gross Profit 3,328 2,979 3,541

Selling, general and administrative expenses 2,231 2,443 2,743

Depreciation, amortization and asset write-offs 253 255 278

Restructuring charge — 294 —

Total Operating Expenses 2,484 2,992 3,021

Operating Income/(Loss) 844 (13) 520

Interest expense 85 102 91

Interest and other income (13) (9) (11)

Interest Expense, Net 72 93 80

Earnings/(loss) before income taxes 772 (106) 440

Income taxes 282 26 161

Net earnings/(loss) $ 490 $ (132) $ 279

Note: Per share amounts omitted.

SOURCE: Toys "R" Us Inc., annual report, January 2000, 25.

Analyzing Business Earnings 43

The Nature of Operating Income

Operating income is designed to ref lect the revenues, gains, expenses, and losses

that are related to the fundamental operating activities of the firm. Notice, however,

that the Toys "R" Us operating loss for the year ending January 30, 1999,

included two nonrecurring charges. These were the asset write-offs and a restructuring

charge. While operating income or loss may include only operationsrelated

items, some of these items may be nonrecurring. Hence, operating

income is not the "sustainable" earnings measure called for in our opening quote

from the AICPA Special Committee on Financial Reporting. Even at this early

point in the operations section of the income statement, nonrecurring items have

been introduced that will require adjustment in order to arrive at an earnings

base "that provides a basis for estimating sustainable earnings."11 Also be aware

that "operating income" in a multistep format is an earlier subtotal than "income

from continuing operations." Moreover, operating income is a pretax measure,

whereas income from continuing operations is after tax. A more extensive sampling

of items included in operating income is provided next.

Nonrecurring Items Included in Operating Income

Reviewing current annual reports reveals that corporations very often include

nonrecurring revenues, gains, expenses, and losses in operating income. A

sample of nonrecurring items included in the operating income section of

multistep income statements is provided in Exhibit 2.6. As is typical, nonrecurring

expenses and losses are more numerous than nonrecurring revenues

and gains. This imbalance is due in part to GAAP, which require firms to recognize

unrealized losses but not unrealized gains. Moreover, fundamental accounting

conventions, such as the historical cost concept and conservatism,

may also provide part of the explanation.

Many of the nonrecurring expense or loss items involve declines in the

value of specific assets. Restructuring charges have been among the most common

items in recent years in this section of the income statement. These

charges involve asset write-downs and liability accruals that will be paid off in

future years. Seldom is revenue or gain recorded as a result of writing up assets.

Further, unlike the case of restructuring charges, the favorable future

consequences of a management action would seldom support current accrual of

revenue or gain.

There is substantial variety in the nonrecurring expenses and losses included

in operating income. Many of the listed items appear closely linked to

operations, and their classification seems appropriate. However, some appear

to be at the fringes of normal operating items. Examples related to expenses

and losses include the f lood costs of Argosy Gaming, merger-related charges

incurred by Brooktrout Technologies, the embezzlement loss of Osmonics, and

the loss on the sale of Veeco Instruments' leak detection business. Among the

gains, the Fairchild and H.J. Heinz gains on selling off businesses would seem

to be candidates for inclusion further down the income statement.

44 Understanding the Numbers

Comparing the items included in operating income to those excluded reveals

a reasonable degree of f lexibility and judgment in the classification of

many of these items. In any event, operating income may not be a very reliable

measure of ongoing operating performance given the wide range of nonrecurring

items that are included in its determination.

Nonrecurring Items Excluded from Operating Income

Unlike the multistep format, the single-step income statement omits a subtotal

representing operating income. The task of identifying core or operating income

is therefore more difficult. Nonrecurring items of revenue or gain and

EXHIBIT 2.6 Nonrecurring items of revenue, gain, expense, and loss

included in operating income.

Company Nonrecurring Item

Expenses and Losses

Air T Inc. (2000) Start-up/merger expense

Akorn Inc. (1999) Relocation costs

Amazon.Com Inc. (1999) Stock-based compensation

Argosy Gaming Company (1995) Flood costs

Avado Brands Inc. (1999) Asset revaluation charges

Brooktrout Technologies Inc. (1998) Merger related charges

Burlington Resources Inc. (1999) Impairment of oil and gas properties

Cisco Systems Inc. (1999) Charges for purchased R&D

Colonial Commercial Corporation (1999) Costs of an abandoned acquisition

Dean Foods Company (1999) Plant closure costs

Delta Air Lines Inc. (2000) Asset write-downs and other special charges

Detection Systems Inc. (2000) Shareholder class action litigation charge

Escalon Medical Corporation (2000) Write-down of patents and goodwill

Gerber Scientific Inc. (2000) Write-downs of inventory and receivables

Holly Corporation (2000) Voluntary early retirement costs

JLG Industries Inc. (2000) Restructuring charges

Osmonics Inc. (1993) Embezzlement loss

Saucony Inc. (1999) Write-down of impaired real estate

Silicon Valley Group Inc. (1999) Inventory write-downs

Veeco Instruments Inc. (1999) Loss on sale of leak detection business

Wegener Corporation (1999) Write-down of capitalized software

Revenues and Gains

Alberto-Culver Company (2000) Gain on sale of European trademark

The Fairchild Corporation (2000) Gains on the sale of subsidiaries

H.J. Heinz Company (1995) Gain on sale of confectionery business

Lufkin Industries Inc. (1999) LIFO-liquidation benefit

National Steel Corporation (1999) Benefit from property-tax settlement

Praxair Inc. (1999) Hedge gain in Brazil and income-hedge gain

Tyco International Ltd. (2000) Reversal of restructuring accrual

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example was drawn.

Analyzing Business Earnings 45

expense or loss are either presented as separate line items within the listing of

revenues or gain and expense or loss, or are included in an "other income (expense)"

line. A sampling of nonrecurring items found in the other-income-andexpense

category of the multistep income statements of a number of

companies is provided in Exhibit 2.7.

A comparison of the items in two exhibits reveals some potential for overlap

in these two categories. The first, nonrecurring items in operating income,

should be dominated by items closely linked to company operations. The nonrecurring

items in the second category, below operating income, should fall outside

the operations area of the firm. Notice that there is a litigation charge

included in operating income (Exhibit 2.6, Detection Systems) as well as several

excluded from operating income (Exhibit 2.7, Advanced Micro Devices,

Cryomedical Sciences, and Trimark Holdings). Gains on the sale of investments

are found far less frequently within operating income. Firms may avoid

EXHIBIT 2.7 Nonrecurring items of revenue or gain and expense or

loss excluded from operating income.

Company Nonrecurring Item

Expenses or Losses

Advanced Micro Devices Inc. (1999) Litigation settlement charge

Baltek Corporation (1997) Foreign currency loss

Champion Enterprises (1995) Environmental reserve

Cryomedical Sciences Inc. (1995) Settlement of shareholder class action suit

Galey & Lord Inc. (1998) Loss on foreign-currency hedges

Global Industries (1993) Fire loss on marine vessel

Hollywood Casino Corporation (1992) Write-off of deferred preacquisition costs

Imperial Holly Corporation (1994) Workforce reduction charge

Trimark Holdings Inc. (1995) Litigation settlement

Revenues or Gains

Artistic Greetings Inc. (1995) Unrealized gains on trading securities

Avado Brands Inc. (1999) Gain on asset disposals

Colonial Commercial Corporation (1999) Gain on land sale

Delta Air Lines Inc. (2000) Gains from the sale of investments

The Fairchild Corporation (2000) Gains on the sale of subsidiaries and affiliates

Freeport-McMoRan Inc. (1991) Insurance settlement (tanker grounding)

Gerber Scientific Inc. (2000) Litigation award

Imperial Sugar Company (1999) Realized securities gains

Meredith Corporation (1994) Sale of broadcast stations

National Steel Corporation (1999) Gain on disposal of noncore assets

New England Business Service Inc. (1996) Gain on sale of product line

Noble Drilling (1991) Insurance on rig abandoned in Somalia

Pollo Tropical Inc. (1995) Business-interruption insurance recovery

Raven Industries Inc. (2000) Gain on sale of investment in affiliate

Saucony Inc. (1999) Foreign currency gains

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example was drawn.

46 Understanding the Numbers

classifying these nonrecurring gains within operating income to prevent shareholders'

unrealistic expectations for earnings in subsequent periods. It is common

to see foreign-currency gains and losses classified below operating

income. This is somewhat difficult to rationalize because currency exposure

is an integral part of operations when a firm does business with foreign customers

and/or has foreign operations.

The operating income subtotal should measure the basic profitability of a

firm's operations. It is far from a net earnings number because its location in

the income statement is above a number of other nonoperating revenues, gains,

expenses, and losses, as well as interest charges and income taxes. Clearly, the

range and complexity of nonrecurring items create difficult judgment calls

in implementing this concept of operating income. Management may use this

f lexibility to manage the operating income number. That is, the classification

of items either inside or outside operating income could be inf luenced by the

goal of maintaining stable growth in this key performance measure.

Some of the items in Exhibit 2.7 would seem to have been equally at home

within the operating income section. An environmental reserve (Champion Enterprises)

appears to be closely tied to operations, as are the workforce reduction

charges, a common element of restructuring charges (Imperial Holly); the

insurance settlement from the tanker grounding (Freeport-McMoRan); and

business interruption insurance (Pollo Tropical).

Nonrecurring Items Located below Income from

Continuing Operations

The region in the income statement below income from continuing operations

has a standard organization and is the same for both the single- and multistep

income statement. This format is outlined in Exhibit 2.8. The income statement

of AK Steel Holding Corporation, shown in Exhibit 2.9, illustrates this format.

Each of the special line items—that is, discontinued operations, extraordinary

EXHIBIT 2.8 Income statement format with

special items.

Income from continuing operations $000

Discontinued operations 000

Extraordinary items 000

Cumulative effect of changes in accounting principles 000

Net income 000

Other comprehensive income 000

Comprehensive income $000

SOURCES: Key guidance is found in Accounting Principles Board Opinion

No. 30, Reporting the Results of Operations (New York: AICPA, June 1973)

and Statement of Financial Accounting Standards (SFAS), No. 130, Reporting

Comprehensive Income (Norwalk, CT: FASB, June 1997).

Analyzing Business Earnings 47

items, and changes in accounting principles—along with examples is discussed

in the following sections. All of these items are presented in the income statement

on an after-tax basis.

Discontinued Operations

The discontinued operations section is designed to enhance the interpretive

value of the income statement by separating the results of continuing operations

EXHIBIT 2.9 Consolidated statements of income: AK Steel Holding

Corp., years ended December 31 (in millions).

1997 1998 1999

Net sales $4,176.6 $4,029.7 $4,284.8

Cost of products sold 3,363.3 3,226.5 3,419.8

Selling, general and administrative expense 288.0 278.0 309.8

Depreciation 141.0 161.2 210.7

Special charge — — 99.7

Total operating costs 3,792.3 3,665.7 4,040.0

Operating profit 384.3 364.0 244.8

Interest expense 111.7 84.9 123.7

Other income 48.4 30.3 20.8

Income from continuing operations before income

taxes and minority interest 321.0 309.4 141.9

Income tax provision 127.5 105.5 63.9

Minority interest 8.1 8.1 6.7

Income from continuing operations 185.4 195.8 71.3

Discontinued operations 1.6 — 7.5

Income before extraordinary item and cumulative

effect of a change in accounting 187.0 195.8 78.8

Extraordinary loss on retirement of debt, net of tax 1.9 — 13.4

Cumulative effect of change in accounting,

net of tax — 133.9 —

Net income 185.1 329.7 65.4

Other comprehensive income, net of tax:

Foreign currency translation adjustment (1.4) 0.3 (1.4)

Unrealized gains (losses) on securities:

Unrealized holding gains (losses) arising

during the period 2.1 (0.5) (1.2)

Less: reclassification for gains included in net

income (0.2) (1.0) (1.9)

Minimum pension liability adjustment — (2.6) 1.2

Comprehensive income $ 185.6 $ 325.9 $ 62.1

Note: Note references as well as earnings-per-share data included in the AK Steel income statement

were omitted from the above.

SOURCE: AK Steel Holdings Corp., annual report, December 1999, 20.

48 Understanding the Numbers

from those that have been or are being discontinued. Only the discontinuance

of operations that constitute a separate and complete segment of the business

have normally been reported in this special section. The current segmentreporting

standard, SFAS 131, Disclosures about Segments of an Enterprise and

Related Information, identifies the following as characteristics of a segment:

1. It engages in business activities from which it may earn revenues and

incur expenses (including revenues and expenses relating to transactions

with other components of the same enterprise).

2. Its operating results are regularly reviewed by the enterprise's chief operating

decision maker to allocate resources to the segment and assess its

performance.

3. Discrete financial information is available.12

Some examples of operations that have been viewed as segments and

therefore classified as "discontinued operations" are provided in Exhibit

2.10. Most of the discontinued operations that are disclosed in Exhibit 2.10

appear to satisfy the traditional test of being separate and distinct segments

of the business. The retail furniture business of insurance company Atlantic

American is a good example. The case of Textron is a somewhat closer call.

Textron reports its operations in four segments: Aircraft, Automotive, Industrial,

and Finance. The disposition of Avco Financial Services could be seen

as a product line within the Finance segment. However, it may very well qualify

as a segment under the newer guidance of SFAS No. 131, Disclosures

about Segments of an Enterprise and Related Information, previously presented.

The treatment of vegetables as a separate segment of the food processor

Dean Foods also suggests that there are judgment calls in deciding

whether a disposition is a distinct segment or simply a product line and thus

only part of a segment.

Extraordinary Items

Income statement items are considered extraordinary if they are both (1) unusual

and (2) infrequent in occurrence.13 Unusual items are not related to the

typical activities or operations of the firm. Infrequency of occurrence simply

implies that the item is not expected to recur in the foreseeable future.

In practice the joint requirement of "unusual and nonrecurring" results

in very few items being reported as extraordinary. GAAPs identify two types of

extraordinary transactions the gains or losses from which do not have to be

both unusual and nonrecurring. These are (1) gains and losses from the extinguishment

of debt14 and (2) gains or losses resulting from "troubled debt restructurings."

15 Included in the latter type are either the settlement of

obligations or their continuation with a modification of terms.

A tabulation of extraordinary items, based on an annual survey of

600 companies conducted by the American Institute of CPAs, is provided in

Analyzing Business Earnings 49

Exhibit 2.11. This summary highlights the rarity of extraordinary items under

current reporting requirements. Debt extinguishments represent the largest

portion of the disclosed extraordinary items. This leaves only from two to five

discretionary extraordinary items per year among the 600 companies surveyed.

The small number of gains and losses classified as extraordinary is consistent

with their definition. However, this rarity adds to the challenge of locating

all nonrecurring items as part of a thorough earnings analysis. Few nonrecurring

items will qualify for the prominent disclosure that results from display in

one of the special sections, such as for extraordinary items, of the income

statement. A sample of discretionary extraordinary items—that is, items not

treated as extraordinary by a specific standard—is provided in Exhibit 2.12.

Natural disasters and civil unrest are some of the more typical causes of

extraordinary items. The extraordinary gain of American Building Maintenance

may appear to fail the criterion of unusual since small earthquakes are

EXHIBIT 2.10 Examples of discontinued operations.

Discontinued

Company Principal Business Operation

American Standard Companies Inc. Air conditioning, bathroom Medical systems

(1999) fixtures, and electronics

Atlantic American Corporation Insurance Retail furniture

(1999)

Bestfoods Inc. (1999) Food preparations Corn refining

Dean Foods Inc. (1999) Food processor Vegetables segment

Decorator Industries Inc. (1999) Interior furnishing products Manufacture and sale

for the retail market

The Fairchild Corporation (2000) Aerospace fasteners and Fairchild technologies

aerospace parts distribution business

Gleason Corporation (1995) Gear machinery and Metal stamping and

equipment fabricating

Maxco Inc. (1996) Manufacturing, distri- Automotive refinishing

bution, and real estate products

A.O. Smith Corporation (1999) Motors and generators Storage tank and

fiberglass pipe markets

Standard Register Company (1999) Document management Promotional direct

and print production mail operation

Textron Inc. (1999) Aircraft engines, automotive Avco Financial

parts, and finance Services

Watts Industries Inc. (1999) Valves for plumbing, heating Industrial oil and gas

and water quality industries businesses

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example was drawn.

50 Understanding the Numbers

EXHIBIT 2.11 Frequency and nature of extraordinary items.

1996 1997 1998 1999

Debt extinguishments 60 62 73 56

Other 5 3 2 6

Total extraordinary items 65 65 75 62

Companies presenting extraordinary items 63 64 74 61

Companies not presenting extraordinary items 537 536 526 539

Total companies 600 600 600 600

SOURCE: American Institute of Certified Public Accountants, Accounting Trends and Techniques (New

York: AICPA, 1999), 392.

EXHIBIT 2.12 Discretionary extraordinar y items.

Company Item or Event

American Building Maintenance Gain on an insurance settlement for damage to a

Inc. (1989) building from a San Francisco earthquake

Avoca Inc. (1995) Insurance proceeds from the destruction of a

building by a fire

BLC Financial Services Inc. (1998) Settlement of a lawsuit

KeyCorp Ohio (1999) Gain on the sale of residential mortgage loan-servicing

operations

Noble Drilling Corporation (1991) Insurance settlement due to deprivation of use of

logistics and drilling equipment abandoned in

Somalia due to civil unrest

NACCO Industries Inc. (1995) Gain on a downward revision of an obligation to the

United Mine Workers of America Combined Benefit

Fund

NS Group Inc. (1992) Loss from an accidental melting of radioactive

substance in the steel-making operation

Phillips Petroleum Company (1990) Gain from a settlement with the government of Iran

over the expropriation of Phillips' oil production

interests

SunTrust Banks Inc. (1999) Gain on the sale of the Company's consumer credit

portfolio

Weyerhaeuser Company (1980) Losses from Mount St. Helens eruption

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example was drawn.

Analyzing Business Earnings 51

frequent in the Bay Area. However, the magnitude of this quake, at about 7.0

on the Richter scale, was probably enough for it to qualify as both unusual and

nonrecurring. Earthquakes of such magnitude have not occurred since the San

Francisco quake of 1906. The Mount St. Helens eruption (Weyerhaeuser) was

certainly enormous on the scale of volcanic eruptions.

The discretionary character of the definition of extraordinary items

combined with the growing complexity of company operations results in considerable

diversity in the classification of items as extraordinary. For example,

Sun Company (not displayed in Exhibit 2.12) had a gain from an expropriation

settlement with Iran. Unlike Phillips Petroleum, however, Sun did not classify

the gain as extraordinary. Neither Exxon nor Union Carbide (also not in Exhibit

2.12) classified as extraordinary their substantial losses from what could

be seen as accidents related to their operating activities.16 The classifications

as extraordinary of gains on the sale of servicing operations by KeyCorp and

on a consumer credit portfolio by SunTrust are rather surprising. These two

items would seem to fail the unusual part of the test for extraordinary items.

The task of locating all nonrecurring items of revenue or gain and expense

or loss is aided only marginally by the presence of the extraordinary category

in the income statement, because the extraordinary classification is

employed so sparingly. Location of most nonrecurring items calls for careful

review of other parts of the income statement, other statements, and notes to

the financial statements.

Changes in Accounting Principles

The cumulative effects (catch-up adjustments) of changes in accounting principles

are also reported below income from continuing operations (see Exhibit

2.8). Most changes in accounting principles result from the adoption of

new standards issued by the Financial Accounting Standards Board (FASB).

The most common reporting treatment when a firm changes from one accepted

accounting principle to another is to show the cumulative effect of the

change on the results of prior years in the income statement for the year of the

change. Less common is the retroactive restatement of the prior-year statements

to the new accounting basis. Under this method, the effect of the

change on the years prior to those presented in the annual report for the year of

the change is treated as an adjustment to retained earnings of the earliest year

presented.

As noted previously, in recent years accounting changes have been dominated

by the requirement to adopt new generally accepted accounting principles

(GAAPs). Discretionary changes in accounting principle are a distinct

minority. Examples of discretionary changes would be a switch from accelerated

to straight-line depreciation or from the LIFO to FIFO inventory method.

Information on accounting changes in both accounting principles and in

estimates is provided in Exhibit 2.13. This information is drawn from an annual

survey of the annual reports of 600 companies conducted by the American

52 Understanding the Numbers

Institute of Certified Public Accountants (AICPA). The distribution of adoption

dates across several years, especially for SFAS 121, occurs because some

firms adopt the new statement prior to its mandatory adoption date. In addition,

the required adoption date for new standards is typically for years beginning

after December 15 of the year specified. This means that firms whose

fiscal year starts on January 1 are the first to be required to adopt the new

standard. Other firms adopt throughout the following year.

Most recent changes in accounting principles have been reported on a cumulative-

effect basis. The cumulative effect is reported net of tax in a separate

section (see Exhibit 2.8) of the income statement. The cumulative effect is the

impact of the change on the results of previous years. The impact of the change

on the current year, that is, year of the change, is typically disclosed in a note

describing the change and its impact. However, it is not disclosed separately on

the face of the income statement. An example of the disclosure of both the cumulative

effect of an accounting change and its effect on income from continuing

operations is provided below:

Cumulative effect

Effective January 1, 1998, Armco changed its method of amortizing unrecognized

net gains and losses related to its obligations for pensions and other

postretirement benefits. In 1998, Armco recognized income of $237.5 million,

or $2.20 per share of common stock, for the cumulative effect of this accounting

change.

Effect on income from continuing operations for the year of change

EXHIBIT 2.13 Accounting changes.

Number of Companies

Subject of the Change 1996 1997 1998 1999

Software development costs (SOP 98-1) — 1 37 66

Start-up costs (SOP 98-5) — 2 29 39

Inventories 5 4 5 5

Revenue recognition (SAB 101) — — — 5

Depreciable lives 3 3 4 4

Software revenue recognition — — 4 3

Derivatives and hedging activities — — — 3

Market-value valuation of pension assets — — — 3

Bankruptcy code reporting (SOP 90-7) — — — 3

Recoverability of goodwill — — — 2

Depreciation method 4 3 — 2

Business process reengineering (EITF 97-13) — 28 10 2

Impairment of long-lived assets (SFAS 121) 134 39 3 —

Reporting entity 1 1 2 —

Other 28 57 13 10

SOURCE: American Institute of Certified Public Accountants, Accounting Trends and Techniques (New

York: AICPA, 2000), 79.

Analyzing Business Earnings 53

Adoption of the new method increased 1998 income from continuing operations

by approximately $3.0 million or $0.03 per share of common stock.17

In analyzing earnings, the effect of an accounting change on the results of

previous years will be prominently displayed net of its tax effect on the face of

the income statement. However, the effect on the current year's income from

continuing operations appears only in the note describing the change. While

not the case for the Armco example, the current-year effect of the change is

often large and should be considered in interpreting the performance of the

current year in relation to previous years.

Most of the entries in Exhibit 2.13 represent the mandatory adoption of

new GAAP. Two statements of position (SOP), SOP 98-1 and 98-5, produced

most of the accounting changes in 1998. Statements of position are issued by

the AICPA and are considered part of the body of GAAP. The same is true for

EITF 97-13. An EITF represents a consensus reached on a focused technical

accounting and reporting issue by the Emerging Issues Task Force of FASB.

The item listed as SAB 101 is a document issued by the SEC and will continue

to cause changes in the timing of the recognition of income by many companies.

18 The single listed FASB statement, SFAS 121, illustrates the multiyear

adoption pattern that ref lects early adopters in 1995, followed by mandatory

adopters in subsequent years.

Some of the items listed in Exhibit 2.13 represent changes in accounting

estimates as opposed to accounting principles. Changes in depreciation method

are changes in accounting principle, whereas changes in depreciable lives are

changes in estimate. The accounting treatments of the two different types of

changes are quite different. Changes in accounting estimates are discussed next.

Changes in Estimates

Whereas changes in accounting principles are handled on either a cumulativeeffect

(catch-up) or retroactive restatement basis, changes in accounting estimates

are handled on a prospective basis only. The impact of a change is

included only in current or future periods; retroactive restatements are not

permitted. For example, effective January 1, 1999, Southwest Airlines changed

the useful lives of its 737-300 and 737-500 aircraft. This is considered a change

in estimate. Southwest's change in estimate was disclosed in the following note:

Change in Accounting Estimate

Effective January 1, 1999, the Company revised the estimated useful lives of its

737-300 and 737-500 aircraft from 20 years to 23 years. This change was the result

of the Company's assessment of the remaining useful lives of the aircraft

based on the manufacturer 's design lives, the Company's increased average

aircraft stage (trip) length, and the Company's previous experience. The effect

of this change was to reduce depreciation expense approximately $25.7 million

and increase net income $.03 per diluted share for the year ended December

31, 1999.19

54 Understanding the Numbers

The $25.7 million reduction in 1999 depreciation was not set out separately

in Southwest's 1999 income statement, as would be the case if the

depreciation reduction resulted from a change to straight-line from the accelerated

method. Unlike the case of AK Steel (Exhibit 2.9), there is no cumulativeeffect

adjustment in the Southwest income statement.

Southwest reported pretax earnings of $774 million in 1999. Pretax earnings

in 1998 were $705 million. On an as-reported basis, Southwest's pretax

earnings grew by 10% in 1999. Without the $25.7 million benefit from the increase

in aircraft useful lives, however, the pretax earnings increase in 1999

would have been only 6%. That is, on a consistent basis Southwest's improvement

in operating results is sharply lower than the as-reported results would

suggest. Locating the effect of this accounting change and determining its contribution

to Southwest's 1999 net income is essential in any effort to judge its

1999 financial performance.

Identifying nonrecurring items in the income statement as outlined above

is a key first step in earnings analysis; many such items will be located at other

places in the annual report. The discussion that follows considers other locations

where additional nonrecurring items may be located.

NONRECURRING ITEMS IN THE STATEMENT

OF CASH FLOWS

After the income statement, the operating activities section of the statement

of cash f lows is an excellent secondary source to use in locating nonrecurring

items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of

this section of the statement of cash f lows results from two factors. First,

gains and losses on the sale of investments and fixed assets must be removed

from net income in arriving at cash f low from operating activities. Second,

noncash items of revenue or gain and expense or loss must also be removed

from net income. All cash inf lows associated with the sale of investments and

fixed assets must be classified in the investing activities section of the statement

of cash f lows. This classification requires removal of the gains or losses

typically nonrecurring in nature from net income in arriving at cash flow

from operating activities. Similarly, because many nonrecurring expenses or

losses do not involve a current-period cash outflow, such items must be adjusted

out of net income in arriving at cash f low from operating activities.

Such adjustments, if not simply combined in a miscellaneous balance, often

highlight nonrecurring items.

The partial statement of cash flows of Escalon Medical Corporation in

Exhibit 2.14 illustrates the disclosure of nonrecurring items in the operatingactivities

section of the statement of cash flows. The nonrecurring items would

appear to be (1) the write-down of intangible assets, (2) the net gain on sale of

the Betadine product line, (3) the net gain on the sale of the Silicone Oil product

Analyzing Business Earnings 55

line, and (4) the write-down of patent costs and goodwill. The Escalon income

statement also disclosed, on separate lines, each of the nonrecurring items revealed

in the operating activities section, with the exception of the intangible

assets write-down.

The asset write-downs, items (1) and (4) above, are added back to net income

or loss because they are noncash. The gains on the product-line sales are

deducted from net income or loss because all cash from such transactions, including

the portion represented by the gain, must be classified in the investing

activities section of the cash f low statement. As the gains are part of net income

or loss, a failure to remove them would both overstate cash f lows from

operating activities and understate investing cash inf lows.

Examples of nonrecurring items disclosed in the operating activities section

of a number of different companies are presented in Exhibit 2.15. Frequently,

nonrecurring items appear in both the income statement and operating

activities section of the statement of cash flows. However, some nonrecurring

items are disclosed in the statement of cash f lows but not the income statement.

Exhibit 2.15 provides examples of both types of disclosure.

EXHIBIT 2.14 Nonrecurring items disclosed in the statement of cash

f lows: Escalon Medical Corporation, partial consolidated

statements of cash f lows, years ended June 30.

1998 1999 2000

Cash Flows from Operating Activities

Net income (loss) $ 171,472 $1,193,787 $ (862,652)

Adjustments to reconcile net income (loss)

to net cash provided from (used in)

operating activities:

Depreciation and amortization 331,987 363,687 666,770

Equity in net loss of joint venture — — 33,382

Income from license of intellectual

laser property (75,000) — —

Write-down of intangible assets — 24,805 —

Net gain on sale of Betadine product line — (879,159) —

Net gain on sale of Silicone Oil product line — — (1,863,915)

Write-down of patents and goodwill — — 417,849

Change in operating assets and liabilities:

Accounts receivable (353,113) (48,451) 586,424

Inventory 115,740 (410,476) 162,862

Other current and long-term assets (16,862) (116,491) (164,960)

Accounts payable and accrued expenses (360,396) 519,764 (416,506)

Net cash provided from (used in)

operating activities $(186,172) $647,466 $(1,440,746)

SOURCE: Escalon Medical Corporation, annual report, June 2000, F-6.

56 Understanding the Numbers

Interpreting Information in the Operating

Activities Section

The statement of cash f lows is an important additional source of information

on nonrecurring items. It enables one to detect items that are not disclosed separately

in the income statement but appear in the statement of cash flows

because of either their noncash or nonoperating character. To realize the diagnostic

value of the statement of cash f lows, one must determine which items in

the operating activities section of the statement of cash f lows are nonrecurring.

The appearance in the statement of cash f lows as merely an addition to

or deduction from net income or loss does not signify that the item is nonrecurring.

Some entries in this section simply ref lect the noncash character of

EXHIBIT 2.15 Disclosure of nonrecurring items in both the income

statement and operating activities section of the

statement of cash f lows.

Company Nonrecurring Item

Separately disclosed in both the income statement and statement of cash f lows

Advanced Micro Devices Inc. (1999) Gain on sale of Vantis

Air T Inc. (2000) Loss on the sale of assets

AmSouth Bancorporation (1999) Merger-related costs

Armstrong World Industries Inc. (1999) Charge for asbestos liability

Baycorp Holdings Ltd. (1999) Unrealized loss on energy trading contracts

Callon Petroleum Company (1999) Impairment of oil and gas properties

Corning Inc. (1999) Nonoperating gains

Delta Air Lines Inc. (2000) Asset write-downs and other special charges

The Fairchild Corporation (2000) Restructuring charges

Gerber Scientific Inc. (2000) Nonrecurring special charges

Hercules Inc. (1999) Charge for acquired in-process R&D

Raven Industries Inc. (2000) Gain on sale of investment in affiliate

Separately disclosed only in the statement of cash f low

Advanced Micro Devices Inc. (1999) Charge for settlement of litigation

Brush Wellman Inc. (1999) Impairment of fixed assets and related intangibles

Chiquita Brands International Inc. (1999) Write-down of banana production assets, net

Dal-Tile International Inc. (1999) Impairment of assets and foreign-currency gain

Evans & Sutherland Computer Inventory write-downs

Corporation (1998)

M.A. Hanna Company (1999) Provision for loss on sale of assets

H.J. Heinz Company (1999) Gain on sale of bakery products unit

JLG Industries Inc. (2000) Restructuring charges

Kulicke & Soffa Industries Inc. (1999) Provision for impairment of goodwill

Petroleum Helicopters Inc. (1999) Gain on asset dispositions

Schnitzer Steel Industries Inc. (1999) Environmental reserve reversal

Synthetech Inc. (2000) Realized gain on sale of securities

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which the example was drawn.

Analyzing Business Earnings 57

certain items of revenue, gain, expense, and loss. For example, depreciation

and amortization are added back to Escalon's net income or loss (Exhibit 2.14)

because they are not cash expenses.20 The two asset write-downs are likewise

added back to net income or loss because of their noncash character. However,

a separate judgment may also be made that, unlike depreciation, these two

items are both noncash and nonrecurring.

Also notice that two different gains on sales of product lines are deducted

in arriving at operating cash flow. It would be tempting to assume that these

are noncash gains. However, the investing activities section of the Escalon

statement of cash f lows, a portion of which is included in Exhibit 2.16, reveals

this not to be the case. Cash inf lows of $2,059,835 and $2,117,180 from the

sales of Betadine and Silicone Oil, respectively, are disclosed in cash flows

from investing activities. The gains are fully backed by cash inf lows, but they

are deducted from net income because they are not considered a source of operating

cash flow. Whatever the specific basis for deducting these gains from

net income to arrive at cash f low from operating activities, the process of deduction

simultaneously discloses these nonrecurring items.

Two other items in Escalon's operating activities section (Exhibit 2.14)

require comment. First, the addition to the 2000 net loss of $33,382 for "equity

in net loss of joint venture" is required because of the noncash nature of this

loss. GAAPs require that a firm (the investor) with an ownership position that

permits it to exercise significant inf luence over another company (the investee)

short of control must recognize its share of the investee's results. This principle

caused Escalon to recognize its share of its investee's loss in 2000. However,

there is no cash outflow on Escalon's part associated with simply

recognizing this loss in its income statement.21 Therefore, the addition of the

loss to net income simply ref lects its noncash character. Determining whether

the loss is nonrecurring would require an examination of the income statement

of the underlying investee company.

The second item is the $75,000 of "income from license of intellectual

laser property." This item is deducted from 1998 net income in arriving at

EXHIBIT 2.16 Investing cash f lows: Escalon Medical Corporation,

partial investing cash f lows section, years ended

June 30.

1998 1999 2000

Cash Flows from Investing Activities:

Purchase of investments $(470,180) $ (259,000) $(7,043,061)

Proceeds from maturities of investments 375,164 589,016 7,043,061

Net change in cash and cash

equivalents—restricted — (1,000,000) 1,000,000

Proceeds from the sale of Betadine product line — 2,059,835 —

Proceeds from sales of Silicone Oil product line — — 2,117,180

SOURCE: Escalon Medical Corporation, annual report, June 2000, F-6.

58 Understanding the Numbers

operating cash flow. This deduction may indicate either that no cash was collected

in connection with recording this income or that the income is not considered

to be an operating cash-f low item. The absence of a cash inf low is the

more likely explanation. But should the $75,000 be seen as nonrecurring? If

this were a one-time licensing fee, then it should be treated as nonrecurring

in evaluating the $171,472 of 1998 net income. Escalon has a substantial

net-operating-loss carryforward, and its 1998 pretax and after-tax results are

the same. As a result, this $75,000 of income amounted to 44% of Escalon's

1998 net income. The absence of this item in the cash f lows statement in either

1999 or 2000 gives the licensing fee the appearance of being nonrecurring.

NONRECURRING ITEMS IN THE INVENTORY

DISCLOSURES OF LIFO FIRMS

The carrying values of inventories maintained under the LIFO method are

sometimes significantly understated in relationship to their replacement cost.

For public companies, the difference between the LIFO carrying value and

replacement cost (frequently approximated by FIFO) is a required disclosure

under SEC regulations.22 An example of a substantial difference between

LIFO and current replacement value is found in a summary of the inventory

disclosures of Handy and Harman Inc. in Exhibit 2.17.

A reduction in the physical inventory quantities of a LIFO inventory is

called a LIFO liquidation. With a LIFO liquidation a portion of the firm's cost

of sales for the year will consist of the carrying values associated with the liquidated

units. These costs are typically lower than current replacement costs,

resulting in increased profits or reduced losses.

As with the differences between the LIFO cost and the replacement

value of the LIFO inventory, SEC regulations also call for disclosures of the effect

of LIFO liquidations.23 Handy and Harman had LIFO liquidations in both

1996 and 1997. In line with these SEC requirements, Handy and Harman provided

the following disclosure of the effects of these inventory reductions:

Included in continuing operations for 1996 and 1997 are profits before taxes of

$33,630,000 and $6,408,000, respectively, from reduction in the quantities of

EXHIBIT 2.17 LIFO inventory valuation differences: Handy and Harman

Inc. inventory footnote, years ended December 31

(in thousands).

1996 1997

Precious metals stated at LIFO cost $24,763 $ 20,960

LIFO inventory—excess of year-end market value over LIFO cost 97,996 106,201

SOURCE: Data obtained from Disclosure Inc., Compact D/SEC: Corporate Information on Public Companies

Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998).

Analyzing Business Earnings 59

precious metal inventories valued under the LIFO method. The after-tax effect

on continuing operations for 1996 and 1997 amounted to $19,260,000 ($1.40 per

basic share) and $3,717,000 ($.31 per basic share), respectively.24

The effect of the Handy and Harman LIFO liquidation is quite dramatic.

Including the effects of the LIFO liquidations, Handy and Harman reported

after-tax income from continuing operations of $33,773,000 in 1996 and

$20,910,000 in 1997. Of the after-tax earnings from continuing operations 57%

in 1996 and 18% in 1997 resulted from the LIFO liquidations. Handy and Harman

reported benefits from LIFO liquidations for most years between 1991

and 1997.

Although Handy and Harman reported LIFO liquidations with some regularity,

an analysis of sustainable earnings should consider the profit improvements

from the liquidations to be nonrecurring. The LIFO-liquidation benefits

result from reductions in the physical quantity of inventory. There are obvious

limits on the ability to sustain these liquidations in future years; as a practical

matter, the inventory cannot be reduced to zero.25 Moreover, the variability in

the size of the liquidation benefits argues for the nonrecurring classification.

The profit improvements resulting from the LIFO liquidations simply represent

the realization of an undervalued asset and are analogous to the gain associated

with the disposition of an undervalued investment, piece of equipment,

or plot of land.

A statement user cannot rely on the disclosure requirements of the SEC

when reviewing the statements of nonpublic companies, especially where an

outside accountant has performed only a review or compilation.26 However,

one can infer the possibility of a LIFO liquidation through the combination of

a decline in the dollar amount of inventory across the year and an otherwise

unexplainable improvement in gross margins. Details on the existence and impact

of a LIFO liquidation could then be discussed with management.27

NONRECURRING ITEMS IN THE INCOME TAX NOTE

Income tax notes are among the more challenging of the disclosures found in

annual reports. They can, however, be a rich source of information on nonrecurring

items. Fortunately, our emphasis on the persistence of earnings requires

a focus on a single key schedule found in the standard income tax note.

The goal is simply to identify nonrecurring tax increases and decreases in this

schedule.

The key source of information on nonrecurring increases and decreases in

income taxes is a schedule that reconciles the actual tax expense or tax benefit

with the amount that would have resulted if all pretax results had been taxed at

the statutory federal rate. This disclosure for Archer Daniels Midland Company

(ADM) is presented in Exhibit 2.18.

Notice that ADM's effective tax rate is reduced in 2000 by 17 percentage

points as a result of redetermining taxes in prior years. This percentage reduction

60 Understanding the Numbers

is expressed in terms of the relationship of the tax reduction to income from

continuing operations before taxes. ADM's 2000 pretax income from continuing

operations is $353,237,000 and its total tax provision was $52,334,000. The

2000 effective tax rate, disclosed in Exhibit 2.18, is derived by dividing the

total tax provision by income from continuing operations before taxes:

$52,334,000 divided by $353,237,000 equals 14.8%.

The dollar, as opposed to percentage tax savings, is found by multiplying

17% times the 2000 pretax earnings: $353,237,000 × 0.17 = $60 million. ADM

explained that "The decrease in income taxes for 2000 resulted primarily from

a $60 million tax credit related to a redetermination of foreign sales corporation

benefits and the resolution of various other tax issues."28 ADM had a dispute

with tax authorities over taxes for previous years, and it won. While there

may be some ongoing benefit from this outcome, the $60 million should be

viewed as nonrecurring in evaluating ADM's earnings performance. Ongoing

tax savings from its foreign sales corporations will continue to be realized and

will be ref lected in the reduced level of the ADM effective tax rate.

ADM's 1998 effective tax rate was also increased by 1.4 percentage points

as a result of fines and litigation settlements being deducted in arriving at pretax

earnings. For income tax purposes, however, these amounts are not deductible,

which means that unlike most other expenses these fines and settlements reduce

after-tax earnings by the full amount of the expenses. There are no associated income

tax savings, and the 1.4-percentage-point increase in the effective tax rate

for 1998 is due to the nondeductible character of the litigation settlements and

fines. The nonrecurring item in this case is simply the total of the fines and settlements.

The tax benefit not realized because of the nondeductibility of the

fines and settlements is not a separate nonrecurring item.

ADM's net income increased from about $266 million in 1999 to about

$301 million in 2000. Without the $60 million nonrecurring tax benefit, ADM's

2000 net income would have declined to $241 million: $301 million $60 million

= $241 million. Identifying and adjusting 2000 earnings for this nonrecurring

tax benefit results in a far different message: a decline in earnings in

contrast to the reported increase.

EXHIBIT 2.18 Reconciliation of statutory and actual federal tax rates:

Archer Daniels Midland Company, years ended June 30.

1998 1999 2000

Statutory rate 35.0% 35.0% 35.0%

Prior years tax redetermination — — (17.0)

Foreign sales corporation (4.7) (4.5) (6.3)

State income taxes, net of federal benefit 2.4 2.2 2.7

Indefinitely invested foreign earnings 0.7 (1.8) (0.3)

Litigation settlements and fines 1.4 — —

Other (1.0) 2.1 0.7

Effective rate 33.8% 33.0% 14.8%

SOURCE: Archer Daniels Midland Company, annual report, June 2000, 32.

Analyzing Business Earnings 61

The benefit from the tax redetermination is clearly a nonrecurring item.

The tax reductions due to the foreign sales corporation feature of the tax law may

or may not be sustainable. Any profit component that relies on a specific feature

of the current tax law should be viewed as somewhat vulnerable. That is, its continuance

requires that (1) this feature of the tax law be preserved and (2) that

ADM continues to take the actions necessary to earn these tax benefits.

The ADM disclosures provide one example of a nonrecurring tax benefit

plus at least one example of a benefit that may be somewhat more vulnerable

than other sources of operating profit. Exhibit 2.19 provides a sampling of

other nonrecurring tax benefits and tax charges that were found in recent company

tax notes.

The tax benefits of both Biogen and Dana result from utilizing loss carryforwards

whose benefits had not previously been recognized. The losses that

produced the tax savings originated in earlier periods. Because the likelihood

of their realization was not sufficiently high, the potential tax savings of the

losses were not recognized in the income statements in the years in which

these losses were incurred. The subsequent realization of these benefits occurs

when the operating and capital loss carryforwards are used to shield operating

earnings and capital gains, respectively, from taxation. These benefits should

be treated as nonrecurring in analyzing earnings performance for the year in

which the benefits are realized.

Gerber Scientific's effective tax rate was reduced as a result of its recognizing

benefits from research and development tax credits. This feature of the

tax law is designed to encourage R&D spending. As with all other tax credits,

continuation of this source of tax reduction requires that the feature continue

to be part of the tax law and that Gerber make the R&D expenditures necessary

to earn future benefits.

The nonrecurring items of First Aviation Services and Micron Technology

both result from adjustments of their tax valuation allowances. The allowance

balances represent the portion of tax benefits that have been judged

unlikely to be realized.29 Increasing this balance will create a nonrecurring tax

EXHIBIT 2.19 Examples of nonrecurring income tax charges

and benef its.

Company Nonrecurring Charge or Benefit

Biogen Inc. (1999) Benefits from net operating loss utilization

Dana Corporation (1999) Capital loss utilization tax benefit

Detection Systems Inc. (2000) Benefit from lower foreign tax rates

First Aviation Services Inc. (1999) Benefit from valuation allowance decrease

The Fairchild Corporation (2000) Benefit from revision of estimate for tax accruals

Gerber Scientific Inc. (2000) Research and development tax credit

M.A. Hanna Company (1999) Benefit from reversal of tax liability—tax settlement

Micron Technology Inc. (2000) Charge for valuation allowance increase

Pall Corporation (2000) Tax benefit of Puerto Rico operations

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which the example was drawn.

62 Understanding the Numbers

charge; decreasing it, a benefit. The prospects for realization of the tax benefit

must have declined for Micron Technology but improved for First Aviation

Services.

Both the Fairchild Corporation and M.A. Hanna Company tax benefits

were the result of reducing previously recorded tax obligations. Subsequent information

indicated that the liabilities where overstated. The liability reduction

was offset by a comparable reduction in the tax provision. This benefit

should also be viewed as nonrecurring.

Pall Corporation has a tax reduction that is associated with operations located

in Puerto Rico. In fact, most firms with operations in other countries

produce such tax benefits. Foreign states offer these benefits to encourage

companies, typically manufacturing companies, to locate within their borders.

In many cases these benefits are for a limited period of time, though renewals

are sometimes possible. As a result, while the benefits are real, there remains

a possibility that they will cease at some point. In fact, Pall Corporation disclosed

just such a change in its income tax note:

The Company has two Puerto Rico subsidiaries that are organized as "possessions

corporations" as defined in Section 936 of the Internal Revenue Code.

The Small Business Job Protection Act of 1996 repealed Section 936 of the Internal

Revenue Code, which provided a tax credit for U.S. companies with operations

in certain U.S. possessions, including Puerto Rico. For companies with

existing qualifying Puerto Rico operations, such as Pall, Section 936 will be

phased out over a period of several years, with a decreasing credit being available

through the last taxable year beginning before January 1, 2006.

This change in U.S. tax law means that previous tax benefits from the operations

in Puerto Rico are not sustainable. When a company reports tax benefits

because of operations in other countries, the possibility that the benefits might

end or be reduced should be considered.

NONRECURRING ITEMS IN THE OTHER INCOME

AND EXPENSE NOTE

An "other income (expense), net," or equivalent line item is commonly found in

both the single- and multistep income statement. In the case of the multistep

format, the composition of other income and expenses is sometimes detailed on

the face of the income statement. In both the multi- and single-step formats,

the most typical presentation is a single line item with a supporting note. Even

though a note detailing the contents of other income and expense may exist,

companies typically do not specify its location. Other income and expense

notes tend to be listed close to the end of the notes to the financial statements.

The other income and expense note of The Sherwin-Williams Company is

provided in Exhibit 2.20. The balance (income) of the Sherwin-Williams other

income and expense note shows a modest increase between 1997 to 1998 and

Analyzing Business Earnings 63

1998 to 1999. In the absence of sharp changes in the balance over time, an analyst

would be less inclined to look for a note detailing the makeup of the balance

on the face of the income statement. However, some large nonrecurring

items underlie this net balance.

Notice the very large increase in the provision for environmental matters.

This increase is in turn offset in part by the sharp decline in the provision for

disposition and termination of operations. Similarly, the foreign currency loss

declined by about $12 million over the three years covered by the note. Some

or all of the large 1999 increase in the provision for environmental matters

should be considered to be nonrecurring. This would mean that results for 1999

would appear somewhat stronger with the provision added back to earnings.

Some or all of the $12 million provision for disposition and termination of operations

should also be added back to results for 1998.

Foreign currency gains and losses usually are not treated as nonrecurring.

However, the case was made in Exhibit 2.2 (Goodyear Tire and Rubber Company)

for treating them as nonrecurring when they are very irregular, either in

terms of amount or sign (i.e., gain versus loss). The Sherwin-Williams foreigncurrency

loss declined by about $12 million between 1997 and 1999. Nonrecurring

elements are included in at least three of the line items in the

Sherwin-Williams other income and expense note. The net balance of the

other income and expense line item has changed only modestly in the face of

very substantial changes in the components of the net balance. The smooth and

modest growth in this net balance contributes in turn to preserving the growth

and stability of the bottom line, or net income. There is always the possibility

that some of the offsetting balances in the Sherwin-Williams note were

recorded for the purpose of producing smooth growth in this line item.

The location and careful analysis of the other income and expense note is

especially important in the case of income statements with very little detail. In

this regard, firm size and the level of detail in the income statement appear to

EXHIBIT 2.20 Composition of an other income and expense note:

The Sherwin-Williams Company, years ended

December 31 (in thousands).

1997 1998 1999

Dividend and royalty income $ (3,361) $ (3,069) $ (4,692)

Net expense of financing and investing activities 3,688 2,542 7,084

Provisions for environmental matters, net 107 695 15,402

Provisions for disposition and termination

of operations 4,152 12,290 3,830

Foreign currency transaction losses 15,580 11,773 3,333

Miscellaneous 3,199 1,815 4,583

$23,365 $26,046 $29,540

Note: Note references included in the Sherwin-Williams this schedule have been omitted.

SOURCE: The Sherwin-Williams Company, annual report, December 1999, 30.

64 Understanding the Numbers

be inversely related. For example, excluding subtotals and the bottom line of

the income statement, C.R. Bard had a total of only eight line items on its 1997

to 1999 income statements. However, its other income and expense note (Exhibit

2.21) includes numerous nonrecurring items.

A review only of C.R. Bard's 1997 to 1999 income statements would have

yielded a single nonrecurring item. Depending on what is judged to be nonrecurring,

Bard's other income and expense note yields an additional nine to

eleven nonrecurring items. As with the Sherwin-Williams note, there is a tendency

for nonrecurring items to offset each other. Notice that Bard booked a

$24.5 million gain in 1997, when it also had a restructuring charge of $44.1

million. Also, an asset write-down of $34.1 million partially offset a $48.6 million

gain from legal and patent settlements in 1998.30

Careful analysis of the composition of other income and expense line

items is very important in locating nonrecurring items. As the disclosures of

both Sherwin-Williams and C.R. Bard illustrate, this task is made far easier if

a note is provided detailing the line item's composition. However, you should

not expect to be guided to the note by a reference attached to this line item in

the income statement.

NONRECURRING ITEMS IN MANAGEMENT'S

DISCUSSION AND ANALYSIS (MD&A)

Management's Discussion and Analysis of Financial Condition and Results of

Operations (MD&A) is an annual and a quarterly Securities and Exchange

Commission reporting requirement. Provisions of this regulation have a direct

bearing on the goal of locating nonrecurring items. As part of the MD&A, the

SEC requires registrants to:

Describe any unusual or infrequent events or transactions or any significant

economic changes that materially affected the amount of reported income from

EXHIBIT 2.21 Composition of the other income and expense note:

C.R. Bard Inc., years ended December 31 (in thousands).

1997 1998 1999

Interest income $ (3,500) $(6,000) $(2,100)

Foreign exchange (gains) losses — (2,100) (900)

Legal and patent settlements, net 2,000 (48,600) —

Asset write-down 8,500 34,100 9,700

Restructuring 44,100 3,200 —

Gains from sale of product lines and other (24,500) — —

Acquired R&D — 6,400 —

Other, net — 10,100 (200)

Total $26,600 $(2,900) $ 6,500

SOURCE: C.R. Bard Inc., annual report, December 1999, 27.

Analyzing Business Earnings 65

continuing operations and, in each case, indicate the extent to which income

was so affected. In addition, describe any other significant components of revenues

and expenses that, in the registrant's judgment, should be described in

order to understand the registrant's results of operations.31

Complying with this regulation will require some firms to identify and discuss

items that may have already been listed in other financial statements and notes.

In reviewing the MD&A with a view to locating nonrecurring items, the analyst

should focus on the section dealing with results of operations. Here management

presents a comparison of results over the most recent three years;

comparing, for example, 2001 with 2002 and 2002 with 2003 is standard.

Locating nonrecurring items in MD&A is somewhat more difficult than

locating them in other places. Typically the nonrecurring items in MD&A are

discussed in text and are not set out in schedules or statements. However, a

small number of firms do summarize nonrecurring items in schedules within

MD&A. These tend to be more comprehensive and user-friendly than piecemeal

disclosures embedded in text.

The disclosure presented earlier in Exhibit 2.1 provided a restatement of

the as-reported net income of Mason Dixon Bancshares. This restatement removed

the effects of all items considered by Mason Dixon to be nonrecurring.

32 This disclosure was found in the MD&A of Mason Dixon. An additional

example of the disclosure of nonrecurring items from the MD&A of Phillips

Petroleum Company is presented in Exhibit 2.22. Unlike Mason Dixon, Phillips

Petroleum's schedule simply presents a listing of their nonrecurring items.

Phillips Petroleum uses the term "special items" to describe the items in

Exhibit 2.22. The reluctance to refer to these items as "nonrecurring" is understandable.

Four of the seven line items include amounts in each of the three

EXHIBIT 2.22 Nonrecurring items included in MD&A of

f inancial condition and results of operations:

Phillips Petroleum Company, years ended

December 31 (in millions).

1997 1998 1999

Kenai tax settlement $83 $115 —

Property impairments (46) (274) $(34)

Tyonek prospect dry hole costs — (71) —

Net gains on asset sales 16 21 73

Work force reduction charges (3) (60) (3)

Pending claims and settlements 15 108 35

Other items — 23 (10)

Total special items $65 $(138) $61

Note: The above numbers have been presented on an after-tax basis. Also, in a footnote to

this schedule, not provided here, Phillips disclosed that the 1997 and 1998 numbers had

been restated to exclude foreign-currency transaction gains and losses. That is, they were

previously considered to be special (nonrecurring) items but now are not.

SOURCE: Phillips Petroleum Company, annual report, December 1999, 33.

66 Understanding the Numbers

years. This might seem inconsistent with the term nonrecurring. Phillips Petroleum

provides the following explanation of the special items:

Net income is affected by transactions defined by management and termed special

items, which are not representative of the company's ongoing operations.

These transactions can obscure the underlying operating results for a period

and affect comparability of operating results between periods.33

While Phillips Petroleum uses special to describe what we have referred to as

nonrecurring, the above description of its special items is consistent with earlier

discussion in this chapter.

Phillips provided the following discussion of the effects of the information

in Exhibit 2.22 on net income:

Phillips's net income was $609 million in 1999, up 157 percent from net income

of $237 million in 1998. Special items benefited 1999 net income by $61 million,

while reducing net income in 1998 by $138 million. After excluding these

items, net operating income for 1999 was $548 million, a 46 percent increase

over $375 million in 1998.34

The above comments reveal a sharply lower growth in profit in 1999 after adjusting

for the effects of the nonrecurring (special) items. A 157% increase in

net income drops to 46% after adjustment for the nonrecurring items. Notice

that the above discussion refers to the adjusted net income numbers as the "net

operating income." This is consistent with the characterization of the special

items as "not representative of the company's ongoing operations." Nevertheless,

we will continue to use the term sustainable to refer to earnings that have

been adjusted for nonrecurring items.

Presenting information on nonrecurring items in MD&A schedules is still

a fairly limited practice but may be on the rise.35 Though helpful in locating

nonrecurring items, such schedules must be viewed as useful complements to

but not substitutes for a complete search and restatement process. Textual discussion

and disclosure of the effects on nonrecurring items on earnings is far

more common than user-friendly schedules. The disclosures of C.R. Bard Inc.

are illustrative:

In 1999, Bard reported net income of $118.1 million or diluted earnings per

share of $2.28. Excluding the impact of the after-tax gain on the sale of the cardiopulmonary

business of $0.12 and the impact of the fourth quarter writedown

of impaired assets of $0.11, diluted earnings per share was $2.27.36

Bard included information on revised results for each of the three years included

in its 1999 annual report. The adjusted earnings-per-share series provides

a better indicator of underlying trends in operating performance and is a

more reliable base on which to develop projections of future earnings. The asreported

and revised earnings-per-share information is summarized in Exhibit

2.23. As is common, the adjusted earnings, from which the effects of nonrecurring

items have been removed, are less volatile.

Analyzing Business Earnings 67

The discussion to this point has taken us through the first six steps in the

nonrecurring-items search process outlined in Exhibit 2.3. The seventh and

last step illustrates how additional nonrecurring items may sometimes be located

in other selected notes to the financial statements.

NONRECURRING ITEMS IN OTHER SELECTED NOTES

Typically, most material nonrecurring items will have been located by proceeding

through the first six steps of the search sequence in Exhibit 2.3. However,

some additional nonrecurring items may be located in other notes. Nonrecurring

items can surface in virtually any note to the financial statements. We will

now discuss three selected notes that frequently contain other nonrecurring

items: notes on foreign exchange, restructuring, and quarterly and segment financial

data. Recall that inventory, income tax, and other income and expense

notes have already been discussed in steps 3 to 5.

Foreign Exchange Notes

Foreign exchange gains and losses can result from both transaction and translation

exposure. Transaction gains and losses result from either unhedged or partially

hedged foreign-currency exposure.37 This exposure is created by items

such as accounts receivable and accounts payable resulting from sales and purchases

denominated in foreign currencies. As foreign-currency exchange rates

change, the value of the foreign-currency assets and liabilities will expand and

contract. This results, in turn, in foreign currency transaction gains and losses.

This is the essence of the concept of currency exposure.

Translation gains and losses result from either unhedged or partially

hedged exposure associated with foreign subsidiaries. Translation exposure depends

on the mix of assets and liabilities of the foreign subsidiary. In addition,

the character of the operations of the foreign subsidiary and features of the

foreign economy are also factors in determining both exposure and the translation

method applied. There are two possible statement translation methods,

and of the two only one results in translation gains or losses that appear as

EXHIBIT 2.23 Reported and revised earnings per

share: C.R. Bard Inc., years ended

December 31.

As-Reported Earnings Adjusted Earnings

Year per Share per Share

1997 $1.26 $1.67

1998 4.51 1.76

1999 2.28 2.27

SOURCE: C.R. Bard Inc., annual report, December 1999.

68 Understanding the Numbers

part of net income. With the other method, the translation adjustment will be

reported as part of other comprehensive income.38

Foreign-currency gains and losses can also result from the use of various

currency contracts, such as forwards, futures, options, and swaps, entered into

for both hedging and speculation. It is not uncommon to observe foreign exchange

gains and losses year after year in a company's income statement. The

amounts of these items, however, as well as whether they are gains or losses are

often very irregular, making them candidates for nonrecurring classification.

To illustrate, a portion of a note titled "foreign currency translation" from

the 1993 annual report of Dibrell Brothers Inc. follows:

Net gains and losses arising from transaction adjustments are accumulated on a

net basis by entity and are included in the Statement of Consolidated Income,

Other Income—Sundry for gains, Other Deductions—Sundry for losses. For

1993, the transaction adjustments netted to a gain of $4,180,000. The transaction

adjustments were losses of $565,000 and $206,000 for 1992 and 1991, respectively,

and were primarily related to the Company's Brazilian operations.39

The gains and losses disclosed above appeared as adjustments, ref lecting either

their noncash or nonoperating character, in the operating activities of Dibrell's

statement of cash f lows. The effect of the 1993 currency exchange gain is also

referenced in Dibrell's MD&A as part of the comparison of earnings in 1993

to those in 1992.40

While appearing in each of the past three years, Dibrell's foreigncurrency

gains and losses were far from stable—two years of small losses followed

by a year with a large gain. One way to gauge the significance of these

exchange items is to compute their contribution to the growth in income before

income taxes, extraordinary items, and cumulative effect of accounting

changes. This computation is outlined for 1993 in Exhibit 2.24.

EXHIBIT 2.24 Contribution of foreign-currency gains to pretax income

from continuing operations: Dibrell Brothers Inc.,

years ended December 31.

Pretax income from continuing operations

1993 $58,259,560

1992 43,246,860

Increase $15,012,700

Foreign-currency gains and losses

1993 gain $ 4,180,000

1992 loss 565,000

Improvement $ 4,745,000

Contribution of the improvement in foreign currency results to 1993

pretax income from continuing operations:

$4,745,000/$15,012,700 32%

Analyzing Business Earnings 69

Dibrell's currency gain made a major contribution to its profit growth in

1993. Hence, a separate note to the financial statements is devoted to its discussion

and disclosure. Following the recommended search sequence, these

items would be identified at step 2, the statement of cash f lows, or step 6,

MD&A. If search failures occur at these steps, then examination of the foreign

exchange note would be a backup to ensure that the important information

contained in this note is available in assessing Dibrell's 1993 performance.

Restructuring Notes

The past decade has been dominated by the corporate equivalent of a diet program.

Call it streamlining, downsizing, rightsizing, redeploying, or strategic

repositioning—the end result is that firms have been recording nonrecurring

charges of a size and frequency that are unprecedented in our modern economic

history. The size and scope of these activities ensure that they leave their

tracks throughout the statements and notes. Notes on restructuring charges are

among the most common transaction-specific notes. The Fairchild Corporation's

restructuring note is provided in Exhibit 2.25.

A number of different items make up the Fairchild restructuring charge.

Included are severance benefits, asset write-offs, and integration costs.

Fairchild declares that the charges recorded in fiscal 2000 "were the direct result

of formal plans to move equipment, close plants and to terminate employees."

This point is made to counter criticism that some restructuring charges

go well beyond restructuring activities to accrue unrelated costs plus costs that

should properly be charged against future operations.

A tendency to overaccrue restructuring charges has a number of possible

explanations. First, firms facing a poor year for profits may decide to take a "big

EXHIBIT 2.25 Sample restructuring note: The Fairchild Corporation,

year ended June 30, 2000 (in thousands).

In fiscal 1999, we recorded $6,374 of restructuring charges. Of this amount, $500 was

recorded at our corporate office for severance benefits and $348 was recorded at our aerospace

distribution segment for the write-off of building improvements from premises vacated.

The remaining $5,526 was recorded as a result of the Kaynar Technologies initial

integration into our aerospace fasteners segment, i.e., for severance benefits ($3,932), for

product integration costs incurred as of June 30, 1999 ($1,334) and for the write-down of

fixed assets ($260). In fiscal 2000, we recorded $8,578 of restructuring charges as a result of

the continued integration of Kaynar Technologies into our aerospace fasteners segment. All

of the charges recorded during the current year were a direct result of product and plant integration

costs incurred as of June 30, 2000. These costs were classified as restructuring and

were the direct result of formal plans to move equipment, close plants and to terminate employees.

Such costs are nonrecurring in nature. Other than a reduction in our existing cost

structure, none of the restructuring charges resulted in future increases in earnings or represented

an accrual of future costs. As of June 30, 2000, significantly all of our integration plans

have been executed and our integration process is substantially complete.

SOURCE: The Fairchild Corporation, annual report, June 2000, F-27.

70 Understanding the Numbers

bath" and recognize excessive amounts of restructuring costs. The assumption

is that simply increasing a current-period loss will not have additional negative

consequences for share values. Moreover, by writing off costs currently, future

profits are relieved of this burden and will therefore look stronger.

Restructuring charges have attracted the attention of the SEC. Arthur

Levitt, chairman of the SEC, has registered strong objections against the use of

overstated restructuring accruals to increase the earnings of subsequent periods.

41 The chairman refers to these excessive reserves as "cookie jar" reserves.42

There has also been some resistance to considering restructuring charges

to be nonrecurring. The very need for restructuring charges indicates that

earnings in previous periods were overstated. Moreover, restructuring charges

commonly recur with some frequency. Note that the Fairchild disclosure in

Exhibit 2.25 reveals a second charge following the initial charge for the restructuring

of Kaynar Technologies. In some circles restructuring charges are

referred to as "cockroach" charges—from the old saying that if you see one

cockroach there are many more where that one came from.

Restructuring charges will continue to be common in income statements

until the level of restructuring activity in the economy subsides. In the meantime,

restructuring charges and associated reversals of charges should typically

be treated as nonrecurring, even though they may appear with some repetition.

At some point firms will complete the bulk of their restructuring activities,

and the charges will either disappear or drop to immaterial levels.

The materiality of most restructuring charges is such that it would be difficult

to miss them. In the case of The Fairchild Corporation (Exhibit 2.25),

the restructuring charges were disclosed in at least five separate locations

as follows:

1. On a separate line item within the operating income section of the income

statement (step one in the nonrecurring items search sequence).

2. Within the operating activities section of the statement of cash f lows,

with the noncash portion of the charges added back to net earnings or loss

(step 2 in the search sequence).

3. Disclosed in the section of the MD&A dealing with earnings (step 6 in

the search sequence).

4. Disclosed in a separate note to the financial statements on restructuring

charges (step 7[d]).

5. Disclosed in a note dealing with segment reporting (step 7[f] in the

search sequence).

Quarterly and Segmental Financial Data

Quarterly and segmental financial disclosures frequently reveal nonrecurring

items. In the case of segment disclosures, the goal is to aid in the evaluation

of profitability trends by segments. The Fairchild Corporation discussion (Exhibit

2.25) disclosed its restructuring charges in the reports of segment results.

Analyzing Business Earnings 71

Quarterly financial data of Office Depot Inc. disclosed inventory writedowns

of $56.1 million for the third quarter of 1999, a store closure and relocation

charge of $46.4 million in the third quarter of 1999, and a $6.0 million

reversal of the charge in the fourth quarter of 1999. Office Depot also disclosed

merger and restructuring charges as part of the reporting for its segments.43

To complete this review of selected financial statement notes, we discuss

one last item before illustrating the summarization of information on nonrecurring

items and the development of the sustainable earnings series. This

topic is the most recent standard-setting activity with a focus on the fundamental

structure and content of the income statement.

EARNINGS ANALYSIS AND OTHER

COMPREHENSIVE INCOME

The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted

to the reporting of other comprehensive income. This is a relatively new

feature of the income statement and was introduced with the issuance by the

FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the

standard is to expand the concept of income to included selected items of nonrecurring

revenue, gain, expense and loss. Under the new standard, traditional

net income is combined with a new component, "other comprehensive income,"

to produce a new bottom line, "comprehensive income."

The principal elements of other comprehensive income are listed in the

other comprehensive income section of the AK Steel Holdings comprehensive

income statement (Exhibit 2.9). They include:

1. Foreign currency translation adjustments.45

2. Unrealized gains and losses on certain securities.

3. Minimum pension liability adjustments.

Each one of these items was already recognized prior to the issuance of SFAS

No. 130. However, they were reported not as part of net income but directly in

shareholders' equity. The items made their way into the income statement only

if they became realized gains or losses by, for example, selling securities. Notice

that the AK Steel disclosures in Exhibit 2.9 list the reclassification of gains

on securities that had previously been recognized in other comprehensive income.

When these gains were realized they were reported in net income. However,

since they had earlier been included in other comprehensive income,

avoiding double counting them requires an adjustment to other comprehensive

income in the year of sale.

SFAS No. 130 permitted other comprehensive income to be reported in

three different ways. The preferred alternative was the income statement format

of AK Steel, though reporting other comprehensive income in a separate

income statement was also permitted. The third option permitted other comprehensive

income to be reported directly in shareholders' equity. It should

72 Understanding the Numbers

come as no surprise that most firms have elected this third option. Firms have

an aversion to including items in the income statement that have the potential

to increase the volatility of earnings. Hence, given the option, firms can and

did choose to avoid the income statement.46

There is scant evidence at this time that statement users pay any attention

to other comprehensive income. Companies do not include other comprehensive

income in discussions of their earnings performance, nor does the financial press

comment on it when earnings are announced. Earnings per share statistics do

not incorporate other comprehensive income. Other comprehensive income is

not currently part of earnings analysis. Hence, we consider it no further. Attitudes

may change, however, about the usefulness of other comprehensive income

as analysts and others become more familiar with these relatively new

disclosures. It seems worthwhile to at least be made aware of these disclosures as

part of a thorough treatment of income statement structure and content.

With the structure of the income statement and relevant GAAP now reviewed,

the nature of nonrecurring items considered, and methods of locating

nonrecurring items outlined and illustrated, we can turn to the task of developing

the sustainable earnings series.

SUMMARIZING NONRECURRING ITEMS AND

DETERMINING SUSTAINABLE EARNINGS

The work to this point has laid out important background but is not complete.

Still required is a device to assist in summarizing information discovered on

nonrecurring items so that new measures of sustainable earnings can be developed.

We devote the balance of this chapter to introducing a worksheet

specially designed to summarize nonrecurring items and illustrating its development

and interpretation in a case study.47

THE SUSTAINABLE EARNINGS WORKSHEET

The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions

on completing the worksheet follow:

1. Net income or loss is recorded on the top line of the worksheet.

2. All identified items of nonrecurring expense or loss, which were included

in the income statement on a pretax basis, are recorded on the "add" lines

provided. Where a prelabeled line is not listed in the worksheet, a descriptive

phrase should be recorded on one of the "other" lines and the

amounts recorded there. In practice, the process of locating nonrecurring

items and recording them on the worksheet would take place at the same

time. However, effective use of the worksheet calls for the background

provided earlier in the chapter. This explains the separation of these steps

in this chapter.

Analyzing Business Earnings 73

EXHIBIT 2.26 Adjustment worksheet for sustainable earnings base.

Year Year Year

Reported net income or (loss)

Add

Pretax LIFO liquidation losses

Losses on sales of fixed assets

Losses on sales of investments

Losses on sales of other asset

Restructuring charges

Investment write-downs

Inventory write-downs

Other asset write-downs

Foreign currency losses

Litigation charges

Losses on patent infringement suits

Exceptional bad-debt provisions

Nonrecurring expense increases

Temporary revenue reductions

Other

Other

Other

Subtotal

Multiply by

(1-combined federal, state tax rates)

Tax-adjusted additions

Add

After-tax LIFO liquidation losses

Increases in deferred tax valuation allowances

Other nonrecurring tax charges

Losses on discontinued operations

Extraordinary losses

Losses/cumulative-effect accounting changes

Other

Other

Other

Subtotal

Total additions

Deduct

Pretax LIFO liquidation gains

Gains on fixed asset sales

Gains on sales of investments

Gains on sales of other assets

Reversals of restructuring accruals

Investment write-ups (trading account)

Foreign currency gains

Litigation revenues

(continued)

74 Understanding the Numbers

3. When all pretax nonrecurring expenses and losses have been recorded,

subtotals should be computed. These subtotals are then multiplied times 1

minus a representative combined federal, state, and foreign income-tax

rate. This puts these items on an after-tax basis so that they are stated on

the same basis as net income or net loss.

4. The results from step 3 should be recorded on the line titled "tax-adjusted

additions."

5. All after-tax nonrecurring expenses or losses are next added separately.

These items are either tax items or special income-statement items that

are disclosed on an after-tax basis under GAAP, such as discontinued operations,

extraordinary items, or the cumulative effect of accounting

changes. The effects of LIFO liquidations are sometimes presented pretax

and sometimes after-tax. Note that a line item is provided for the effect

of LIFO liquidations in both the pretax and after-tax additions

section of the worksheet.

EXHIBIT 2.26 (Continued)

Year Year Year

Gains on patent infringement suits

Temporary expense decreases

Temporary revenue increases

Reversals of bad-debt allowances

Other

Other

Other

Subtotal

Multiply by

Times (1-combined federal, state tax rate)

Tax-adjusted deductions

After-tax LIFO liquidation gains

Reductions in deferred tax valuation allowances

Loss carryforward benefits from prior years

Other nonrecurring tax benefits

Gains on discontinued operations

Extraordinary gains

Gains/cumulative-effect accounting changes

Other

Other

Other

Subtotal

Total deductions

Sustainable earnings base

Analyzing Business Earnings 75

6. Changes in deferred-tax-valuation allowances are recorded in the taxadjusted

additions (or deductions) section only if such changes affected

net income or net loss for the period. Evidence of an income-statement

impact will usually take the form of an entry in the income tax ratereconciliation

schedule.

7. The next step is to subtotal the entries for after-tax additions and then

combine this subtotal with the amount labeled "tax adjusted additions."

The result is then recorded on the "total additions" line at the bottom of

the first page of the worksheet.

8. Completion of page 2 of the worksheet, for nonrecurring revenues and

gains, follows exactly the same steps as those outlined for nonrecurring

expense and loss.

9. With the completion of page 2, the sustainable earnings base for each

year is computed by adding the "total additions" line item to net income

(loss) and then deducting the "total deductions" line item.

ROLE OF THE SUSTAINABLE EARNINGS BASE

The sustainable earnings base provides earnings information from which the

distorting effects of nonrecurring items have been removed. Some analysts

refer to such revised numbers as representing "core" or "underlying" earnings.

Sustainable is used here in the sense that earnings devoid of nonrecurring

items of revenue, gain, expense, and loss are much more likely to be maintained

in the future, other things equal. Base implies that sustainable earnings

provide the most reliable foundation or starting point for projections of future

results. The more reliable such forecasts become, the less the likelihood that

earnings surprises will result. Again, Phillips Petroleum captures the essence

of nonrecurring items in the following:

Net income is affected by transactions defined by management and termed

"special items," which are not representative of the company's ongoing operations.

These transactions can obscure the underlying operating results for a period

and affect comparability of operating results between periods.48

APPLICATION OF THE SUSTAINABLE EARNINGS BASE

WORKSHEET: BAKER HUGHES INC.

This case example of using the SEB worksheet is based on the 1997 annual report

of Baker Hughes Inc. and its results for 1995 to 1997. The income statement,

statement of cash flows, management's discussion and analysis of results

of operations (MD&A), and selected notes are in Exhibits 2.27 through 2.34.

Further, to reinforce the objective of efficiency in financial analysis, we adhere

to the search sequence outlined in Exhibit 2.3.

76 Understanding the Numbers

Most of the content of the Baker Hughes financial statements as well as

relevant footnote and other textual information is provided. This is designed to

make the exercise as realistic as possible.

THE BAKER HUGHES WORKSHEET ANALYSIS

The nonrecurring items located in the Baker Hughes annual report are enumerated

in the completed SEB worksheet in Exhibit 2.35. Each of the nonrecurring

items is recorded on the SEB worksheet. When an item is disclosed for the first,

second, third, or fourth time, it is designated by a corresponding superscript

EXHIBIT 2.27 Consolidated statements of operations: Baker Hughes

Inc., years ended September 30 (in millions).

1995 1996 1997

Revenues:

Sales $1,805.1 $2,046.8 $2,466.7

Services and rentals 832.4 980.9 1,218.7

Total $2,637.5 $3,027.7 $3,685.4

Costs and expenses:

Costs of sales $1,133.6 $1,278.1 $1,573.3

Costs of services and rentals 475.1 559.5 682.9

Selling, general, and administrative 743.0 814.2 966.9

Amortization of goodwill and other intangibles 29.9 29.6 32.3

Unusual charge 39.6 52.1

Acquired in-process research and development — — 118.0

Total $2,381.6 $2,721.0 $3,425.5

Operating income $ 255.9 $ 306.7 $ 259.9

Interest expense (55.6) (55.5) (48.6)

Interest income 4.8 3.4 1.8

Gain on sale of Varco stock — 44.3 —

Income before income taxes and cumulative effect

of accounting changes 205.1 298.9 213.1

Income taxes (85.1) (122.5) (104.0)

Income before cumulative effect of

accounting changes 120.0 176.4 109.1

Cumulative effect of accounting changes:

Impairment of long-lived assets to be disposed of

(net of $6.0 income tax benefit) (12.1)

Postemployment benefits (net of $7.9 income

tax benefit) (14.6) — —

Net income $ 105.4 $ 176.4 $ 97.0

SOURCE: Baker Hughes Inc., annual report, September 1997, 37.

Analyzing Business Earnings 77

in a summary of the search process provided in Exhibit 2.36. For purposes of

illustration, all nonrecurring items have been recorded on the SEB worksheet

without regard to their materiality. We have followed this procedure because a

materiality threshold would exclude a series of either immaterial gains or losses

that could, in combination, distort a firm's apparent profitability. An effort is

made to consider the possible effects of materiality in a report on the efficiency

of the search process presented in Exhibit 2.37.

Without adjustment, Baker Hughes's income statement reports net income

of $105.4 million in 1995, $176.4 million in 1996, and $97.0 million in

1997. The impression obtained is a company with a volatile earnings stream

and no apparent growth. However, the complete adjustment for nonrecurring

items conveys quite a different message. After restatement, sustainable earnings

amount to $97.4 million in 1995, $158.6 million in 1996, and $241.3 million

in 1997. This suggests that profits are in fact growing, though acquisitions

have contributed to this result.

It should be clear that the number and magnitude of nonrecurring items

identified in the Baker Hughes annual report caused its unanalyzed earnings

data to be unreliable indicators of profit performance. Without the comprehensive

identification of nonrecurring items and the development of the SEB

EXHIBIT 2.28 Consolidated statements of cash f lows (operating

activities only): Baker Hughes Inc., years ended

September 30 (in millions).

1995 1996 1997

Cash Flows from Operating Activities:

Net income $105.4 $176.4 $97.0

Adjustments to reconcile net income to net cash

f lows from operating activities:

Depreciation and amortization of:

Property $114.2 $115.9 $143.9

Other assets and debt discount 40.4 39.9 42.1

Deferred income taxes 44.8 30.2 (6.8)

Noncash portion of unusual charge 25.3 32.7

Acquired in-process research and development 118.0

Gain on sale of Varco stock (44.3)

Gain on disposal of assets (18.3) (31.7) (18.4)

Foreign currency translation (gain)/loss-net 1.9 8.9 (6.1)

Cumulative effect of accounting changes 14.6 12.1

Change in receivables (94.7) (84.1) (129.8)

Change in inventories (79.9) (73.8) (114.9)

Change in accounts payable 51.7 22.6 65.3

Changes in other assets and liabilities (52.9) 9.4 (35.6)

Net cash f lows from operating activities $127.2 $194.7 $199.5

SOURCE: Baker Hughes Inc., annual report, September 1997, 40.

78 Understanding the Numbers

EXHIBIT 2.29 Income tax note: Baker Hughes Inc., years ended

September 30 (in millions).

The geographical sources of income before income taxes and cumulative effect of accounting

changes are as follows:

1995 1996 1997

United States $128.3 $116.4 $ 20.6

Foreign 76.8 182.5 192.5

Total $205.1 $298.9 $213.1

The provision for income taxes is as follows:

1995 1996 1997

Current:

United States $ 3.7 $ 40.1 $ 46.5

Foreign 36.6 52.2 64.3

Total current 40.3 92.3 110.8

Deferred:

United States 42.1 20.7 (.2)

Foreign 2.7 9.5 (6.6)

Total deferred 44.8 30.2 (6.8)

Total provision for income taxes $ 85.1 $122.5 $104.0

The provision for income taxes differs from the amount computed by applying the U.S. statutory

income tax rate to income before income taxes and cumulative effect of accounting

changes for the reasons set forth below:

1995 1996 1997

Statutory income tax $ 71.8 $104.6 $ 74.6

Nondeductible acquired in-process research and

development charge 41.3

Incremental effect of foreign operations 24.8 12.5 (6.5)

1992 and 1993 IRS audit agreement (11.4)

Nondeductible goodwill amortization 4.2 5.4 4.5

State income taxes, net of U.S. tax benefit 1.0 2.1 2.9

Operating loss and credit carryforwards (13.1) (3.3) (4.2)

Other, net (3.6) 1.2 2.8

Total provision for income taxes $ 85.1 $122.5 $104.0

Deferred income taxes ref lect the net tax effects of temporary differences between the carrying

amounts of assets and liabilities for financial reporting purposes and the amounts used

for income tax purposes, and operating loss and tax credit carryforwards. The tax effects of

the Company's temporary differences and carryforwards are as follows:

Analyzing Business Earnings 79

EXHIBIT 2.29 (Continued)

1996 1997

Deferred tax liabilities:

Property $62.3 $ 90.6

Other assets 57.7 147.5

Excess costs arising from acquisitions 64.0 67.6

Undistributed earnings of foreign subsidiaries 41.3 41.3

Other 37.4 36.5

Total $262.7 $ 383.5

Deferred tax assets:

Receivables $4.1 $ 2.8

Inventory 72.4 72.4

Employee benefits 44.0 21.5

Other accrued expenses 20.2 40.6

Operating loss carryforwards 16.6 9.0

Tax credit carryforwards 30.8 15.9

Other 15.9 34.9

Subtotal $204.0 $ 197.1

Valuation allowance (13.1) (5.7)

Total 190.9 191.4

Net deferred tax liability $ 71.8 $ 192.1

A valuation allowance is recorded when it is more likely than not that some portion or all of

the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets

depends on the ability to generate sufficient taxable income of the appropriate character in

the future. The Company has reserved the operating loss carryforwards in certain non-U.S.

jurisdictions where its operations have decreased, currently ceased or the Company has withdrawn

entirely.

Provision has been made for U.S. and additional foreign taxes for the anticipated repatriation

of certain earnings of foreign subsidiaries of the Company. The Company considers

the undistributed earnings of its foreign subsidiaries above the amounts already provided for

to be permanently reinvested. These additional foreign earnings could become subject to additional

tax if remitted, or deemed remitted, as a dividend; however, the additional amount of

taxes payable is not practicable to estimate.

SOURCE: Baker Hughes Inc., annual report, September 1997, 48–49.

80 Understanding the Numbers

EXHIBIT 2.30 Management's discussion and analysis (excerpts from

results of operations section): Baker Hughes Inc., years

ended September 30 (in millions).

Revenues

1997 versus 1996

Consolidated revenues for 1997 were $3,685.4 million, an increase of 22% over 1996 revenues

of $3,027.7 million. Sales revenues were up $419.9 million, an increase of 21%, and services

and rental revenues were up $237.8 million, an increase of 24%. Approximately 64% of the

Company's 1997 consolidated revenues were derived from international activities. The three

1997 acquisitions contributed $192.1 million of the revenue improvement.

Oilfield Operations 1997 revenues were $2,862.6 million, an increase of 19.4% over 1996

revenues of $2,397.9 million. Excluding the Drilex acquisition, which accounted for $70.5

million of the revenue improvement, the revenue growth of 16.4% outpaced the 14.4% increase

in the worldwide rig count. In particular, revenues in Venezuela increased 37.6%, or

$58.6 million, as that country continues to work towards its stated goal of significantly increasing

oil production.

Chemical revenues were $417.2 million in 1997, an increase of 68.5% over 1996 revenues of

$247.6 million. The Petrolite acquisition was responsible for $91.6 million of the improvement.

Revenue growth excluding the acquisition was 31.5% driven by the strong oilfield market

and the impact of acquiring the remaining portion of a Venezuelan joint venture in 1997.

This investment was accounted for on the equity method in 1996.

Process Equipment revenues for 1997 were $386.1 million, an increase of 9.4% over 1996 revenues

of $352.8 million. Excluding revenues from 1997 acquisitions of $32.7 million, revenues

were f lat compared to the prior year due to weakness in the pulp and paper industry

combined with delays in customers' capital spending.

1996 versus 1995

Consolidated revenues for 1996 increased $390.2 million, or 14.8%, over 1995. Sales revenues

were up 13.4% and services and rentals revenues were up 17.8%. International revenues

accounted for approximately 65% of 1996 consolidated revenues.

Oilfield Operations revenues increased $325.7 million or 15.7% over 1995 revenues of

$2,072.2 million. Activity was particularly strong in several key oilfield regions of the world

including the North Sea, Gulf of Mexico and Nigeria where revenues were up $93.4 million,

$56.8 million and $30.1 million, respectively. Strong drilling activity drove a $35.5 million

increase in Venezuelan revenues.

Chemical revenues rose $23.9 million, or 10.7% over 1995 revenues as its oilfield business

benefited from increased production levels in the U.S.

Process Equipment revenues for 1996 increased 10.4% over 1995 revenues of $319.6 million.

Excluding revenues from 1996 acquisitions of $21.5 million, revenues increased 3.7%. The

growth in the minerals processing and pulp and paper industry slowed from the prior year.

Costs and Expenses Applicable to Revenues

Costs of sales and costs of services and rentals have increased in 1997 and 1996 from the

prior years in line with the related revenue increases. Gross margin percentages, excluding

the effect of a nonrecurring item in 1997, have increased from 39.0% in 1995 to 39.3% in

1996 and 39.4% in 1997. The nonrecurring item relates to finished goods inventory acquired

in the Petrolite acquisition that was increased by $21.9 million to its estimated selling price.

The Company sold the inventory in the fourth quarter of 1997 and, as such, the $21.9 million

is included in cost of sales in 1997.

Analyzing Business Earnings 81

EXHIBIT 2.30 (Continued)

Selling, General, and Administrative

Selling, general and administrative ("SG&A") expense increased $152.7 million in 1997 from

1996 and $71.2 million in 1996 from 1995. The three 1997 acquisitions were responsible for

$54.3 million of the 1997 increase. As a percent of consolidated revenues, SG&A was 26.2%,

26.9% and 28.2% in 1997, 1996 and 1995, respectively.

Excluding the impact of acquisitions, the Company added approximately 2,500 employees

during 1997 to keep pace with the increased activity levels. As a result, employee training

and development efforts increased in 1997 as compared to the previous two years. These increases

were partially offset by $4.1 million of foreign exchange gains in 1997 compared to foreign

exchange losses of $11.4 million in 1996 due to the devaluation of the Venezuelan Bolivar.

The three-year cumulative rate of inf lation in Mexico exceeded 100% for the year

ended December 31, 1996; therefore, Mexico is considered to be a highly inf lationary economy.

Effective December 31, 1996, the functional currency for the Company's investments in

Mexico was changed from the Mexican Peso to the U.S. Dollar.

Amortization Expense

Amortization expense in 1997 increased $2.7 million from 1996 due to the Petrolite acquisition.

Amortization expense in 1996 remained comparable to 1995 as no significant acquisitions

or dispositions were made during those two years.

Unusual Charge

1997: During the fourth quarter of 1997, the Company recorded an unusual charge of $52.1

million. In connection with the acquisitions of Petrolite, accounted for as a purchase, and

Drilex, accounted for as a pooling of interests, the Company recorded unusual charges of

$35.5 million and $7.1 million, respectively, to combine the acquired operations with those of

the Company. The charges include the cost of closing redundant facilities, eliminating or relocating

personnel and equipment and rationalizing inventories that require disposal at

amounts less than their cost. A $9.5 million charge was also recorded as a result of the decision

to discontinue a low margin, oilfield product line in Latin America and to sell the Tracor

Europa subsidiary, a computer peripherals operations, which resulted in a write-down of the

investment to its net realizable value. Cash provisions of the unusual charge totaled $19.4

million. The Company spent $5.5 million in 1997 and expects to spend substantially all of the

remaining $13.9 million in 1998. Such expenditures relate to specific plans and clearly defined

actions and will be funded from operations and available credit facilities.

1996: During the third quarter of 1996, the Company recorded an unusual charge of $39.6

million. The charge consisted primarily of the write-off of $8.5 million of Oilfield Operations

patents that no longer protected commercially significant technology, a $5.0 million impairment

of a Latin America joint venture due to changing market conditions in the region in

which it operates and restructuring charges totaling $24.1 million. The restructuring charges

include the downsizing of Baker Hughes INTEQ's Singapore and Paris operations, a reorganization

of EIMCO Process Equipment's Italian operations and the consolidation of certain

Baker Oil Tools manufacturing operations. Noncash provisions of the charge totaled $25.3

million and consist primarily of the write-down of assets to net realizable value. The remaining

$14.3 million of the charge represents future cash expenditures related to severance

under existing benefit arrangements, the relocation of people and equipment and abandoned

leases. The Company spent $4.2 million of the cash during 1996, $6.3 million in 1997 and expects

to spend the remaining $3.8 million in 1998.

(continued)

EXHIBIT 2.30 (Continued)

Acquired In-Process Research and Development

In the Petrolite acquisition, the Company allocated $118.0 million of the purchase price to

in-process research and development. In accordance with generally accepted accounting

principles, the Company recorded the acquired in-process research and development as a

charge to expense because its technological feasibility had not been established and it had no

alternative future use at the date of acquisition.

Interest Expense

Interest expense in 1997 decreased $6.9 million from 1996 due to lower average debt levels,

primarily as a result of the maturity of the 4.125% Swiss Franc Bonds in June 1996. Interest

expense in 1996 remained comparable to 1995 as slightly higher average debt balances were

offset by a slightly lower weighted average interest rate.

Gain on Sale of Varco Stock

In May 1996, the Company sold 6.3 million shares of Varco International, Inc. ("Varco") common

stock, representing its entire investment in Varco. The Company received net proceeds of

$95.5 million and recognized a pretax gain of $44.3 million. The Company's investment in

Varco was accounted for using the equity method. Equity income included in the Consolidated

Statements of Operations for 1996 and 1995 was $1.8 million and $3.2 million, respectively.

Income Taxes

During 1997, the Company reached an agreement with the Internal Revenue Service ("IRS")

regarding the audit of its 1992 and 1993 U.S. consolidated income tax returns. The principal

issue in the examination related to intercompany pricing on the transfer of goods and services

between U.S. and non-U.S. subsidiary companies. As a result of the agreement, the Company

recognized a tax benefit through the reversal of deferred income taxes previously provided of

$11.4 million ($.08 per share) in the quarter ended June 30, 1997.

The effective income tax rate for 1997 was 48.8% as compared to 41.0% in 1996 and

41.5% in 1995. The increase in the rate for 1997 is due in large part to the nondeductible

charge for the acquired in-process research and development related to the Petrolite acquisition

offset by the IRS agreement as explained above. The effective rates differ from the federal

statutory rate in all years due primarily to taxes on foreign operations and nondeductible

goodwill amortization. The Company expects the effective income tax rate in 1998 to be between

38% and 39%.

SOURCE: Baker Hughes Inc., annual report, September 1997, 30–32.

EXHIBIT 2.31 Summary of signif icant accounting policies note

(partial): Baker Hughes Inc., years ended September 30

(in millions).

Impairment of assets: The Company adopted Statement of Financial Accounting Standards

("SFAS") No. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived

Assets to be Disposed Of, effective October 1, 1996. The statement sets forth guidance as to

when to recognize an impairment of long-lived assets, including goodwill, and how to measure

such an impairment. The methodology set forth in SFAS No. 121 is not significantly different

from the Company's prior policy and, therefore, the adoption of SFAS No. 121 did not

have a significant impact on the consolidated financial statements as it relates to impairment

of long-lived assets used in operations. However, SFAS No. 121 also addresses the accounting

for long-lived assets to be disposed of and requires these assets to be carried at the lower of

cost or fair market value, rather than the lower of cost or net realizable value, the method

that was previously used by the Company. The Company recognized a charge to income of

$12.1 million ($.08 per share), net of a tax benefit of $6.0 million, as the cumulative effect

of a change in accounting in the first quarter of 1997.

SOURCE: Baker Hughes Inc., annual report, September 1997, 41.

Analyzing Business Earnings 83

EXHIBIT 2.32 Acquisitions and dispositions note: Baker Hughes Inc.,

years ended September 30 (in millions).

1997

Petrolite

In July 1997, the Company acquired Petrolite Corporation ("Petrolite") and Wm. S. Barnickel

& Company ("Barnickel"), the holder of 47.1% of Petrolite's common stock, for 19.3 million

shares of the Company's common stock having a value of $730.2 million in a three-way business

combination accounted for using the purchase method of accounting. Additionally, the Company

assumed Petrolite's outstanding vested and unvested employee stock options that were

converted into the right to acquire 1.0 million shares of the Company's common stock. Such assumption

of Petrolite options by the Company had a fair market value of $21.0 million resulting

in total consideration in the acquisitions of $751.2 million. Petrolite, previously a publicly held

company, is a manufacturer and marketer of specialty chemicals used in the petroleum and

process industries. Barnickel was a privately held company that owned marketable securities,

which were sold after the acquisition, in addition to its investment in Petrolite.

The purchase price has been allocated to the assets purchased and the liabilities assumed

based on their estimated fair market values at the date of acquisition as follows (millions of

dollars):

Working capital $ 64.5

Property 170.1

Prepaid pension cost 80.3

Intangible assets 126.0

Other assets 89.6

In-process research and development 118.0

Goodwill 263.7

Debt (31.7)

Deferred income taxes (106.7)

Other liabilities (22.6)

Total $751.2

In accordance with generally accepted accounting principles, the amount allocated to inprocess

research and development, which was determined by an independent valuation, has been

recorded as a charge to expense in the fourth quarter of 1997 because its technological feasibility

had not been established and it had no alternative future use at the date of acquisition.

The Company incurred certain liabilities as part of the plan to combine the operations of

Petrolite with those of the Company. These liabilities relate to the Petrolite operations and include

severance of $13.8 million for redundant marketing, manufacturing and administrative

personnel, relocation of $5.8 million for moving equipment and transferring marketing and

technology personnel, primarily from St. Louis to Houston, and environmental remediation of

$16.5 million for redundant properties and facilities that will be sold. Cash spent during the

fourth quarter of 1997 totaled $7.7 million. The Company anticipates completing these activities

in 1998, except for some environmental remediation that will occur in 1998 and 1999.

The operating results of Petrolite and Barnickel are included in the 1997 consolidated

statement of operations from the acquisition date, July 2, 1997. The following unaudited pro

forma information combines the results of operations of the Company, Petrolite and Barnickel

assuming the acquisitions had occurred at the beginning of the periods presented. The pro

forma summary does not necessarily ref lect the results that would have occurred had the acquisitions

been completed for the periods presented, nor do they purport to be indicative of

the results that will be obtained in the future, and excludes certain nonrecurring charges related

to the acquisition which have an after tax impact of $155.2 million.

(continued)

84

EXHIBIT 2.32 (Continued)

(Millions of dollars,

except per share amounts)

1996 1997

Revenues $3,388.4 $3,944.0

Income before accounting change 189.3 283.9

Income per share before accounting change 1.16 1.69

In connection with the acquisition of Petrolite, the Company recorded an unusual

charge of $35.5 million. See Note 5 of Notes to Consolidated Financial Statements.

Environmental Technology Division of Deutz AG

In July 1997, the Company acquired the Environmental Technology Division, a decanter centrifuge

and dryer business, of Deutz AG ("ETD") for $53.0 million, subject to certain postclosing

adjustments. This acquisition is now part of Bird Machine Company and has been

accounted for using the purchase method of accounting. Accordingly, the cost of the acquisition

has been allocated to assets acquired and liabilities assumed based on their estimated

fair market values at the date of acquisition, July 7, 1997. The operating results of ETD are

included in the 1997 consolidated statement of operations from the acquisition date. Pro

forma results of the acquisition have not been presented as the pro forma revenue, income

before accounting change and earnings per share would not be materially different from the

Company's actual results. For its most recent fiscal year ended December 31, 1996, ETD had

revenues of $103.0 million.

Drilex

In July 1997, the Company acquired Drilex International Inc. ("Drilex") a provider of products

and services used in the directional and horizontal drilling and workover of oil and gas

wells for 2.7 million shares of the Company's common stock. The acquisition was accounted

for using the pooling of interests method of accounting. Under this method of accounting, the

historical cost basis of the assets and liabilities of the Company and Drilex are combined at

recorded amounts and the results of operations of the combined companies for 1997 are included

in the 1997 consolidated statement of operations. The historical results of the separate

companies for years prior to 1997 are not combined because the retained earnings and results

of operations of Drilex are not material to the consolidated financial statements of the Company.

In connection with the acquisition of Drilex, the Company recorded an unusual charge

of $7.1 million for transaction and other one time costs associated with the acquisition. See

Note 5 of Notes to Consolidated Financial Statements. For its fiscal year ended December 31,

1996 and 1995, Drilex had revenues of $76.1 million and $57.5 million, respectively.

1996

In April 1996, the Company purchased the assets and stock of a business operating as Vortoil

Separation Systems, and certain related oil /water separation technology, for $18.8 million. In

June 1996, the Company purchased the stock of KTM Process Equipment, Inc., a centrifuge

company, for $14.1 million. These acquisitions are part of Baker Hughes Process Equipment

Company and have been accounted for using the purchase method of accounting. Accordingly,

the costs of the acquisitions have been allocated to assets acquired and liabilities assumed

based on their estimated fair market values at the dates of acquisition. The operating results

are included in the consolidated statements of operations from the respective acquisition dates.

In April 1996, the Company exchanged the 100,000 shares of Tuboscope Inc. ("Tuboscope")

Series A convertible preferred stock held by the Company since October 1991, for 1.5

million shares of Tuboscope common stock and a warrant to purchase 1.25 million shares of

Tuboscope common stock. The warrants are exercisable at $10 per share and expire on December

31, 2000.

SOURCE: Baker Hughes Inc., annual report, September 1997, 43–45.

85

EXHIBIT 2.33 Unusual charges note: Baker Hughes Inc., years ended

September 30 (in millions).

1997

During the fourth quarter of 1997, the Company recognized a $52.1 million unusual charge

consisting of the following (millions of dollars):

Baker Petrolite:

Severance for 140 employees $ 2.2

Relocation of people and equipment 3.4

Environmental 5.0

Abandoned leases 1.5

Integration costs 2.8

Inventory write-down 11.3

Write-down of other assets 9.3

Drilex:

Write-down of property and other assets 4.1

Banking and legal fees 3.0

Discontinued product lines:

Severance for 50 employees 1.5

Write-down of inventory, property and other assets 8.0

Total $52.1

In connection with the acquisitions of Petrolite and Drilex, the Company recorded unusual

charges of $35.5 million and $7.1 million, respectively, to combine the acquired operations

with those of the Company. The charges include the cost of closing redundant facilities,

eliminating or relocating personnel and equipment and rationalizing inventories that require

disposal at amounts less than their cost. A $9.5 million charge was recorded as a result of the

decision to discontinue a low margin, oilfield product line in Latin America and to sell the

Tracor Europa subsidiary, a computer peripherals operation, which resulted in a write-down

of the investment to net realizable value. Cash provisions of the unusual charge totaled $19.4

million. The Company spent $5.5 million in 1997 and expects to spend substantially all of the

remaining $13.9 million in 1998.

1996

During the third quarter of 1996, the Company recognized a $39.6 million unusual charge

consisting of the following (millions of dollars):

Patent write-off $ 8.5

Impairment of joint venture 5.0

Restructurings:

Severance for 360 employees 7.1

Relocation of people and equipment 2.3

Abandoned leases 2.8

Inventory write-down 1.5

Write-down of assets 10.4

Other 2.0

Total $39.6

The Company has certain oilfield operations patents that no longer protect commercially

significant technology resulting in the write-off of $8.5 million. A $5.0 million impairment

of a Latin America joint venture was recorded due to changing market conditions in the

region in which it operates. The Company recorded a $24.1 million restructuring charge including

the downsizing of Baker Hughes INTEQ's Singapore and Paris operations, a reorganization

of EIMCO Process Equipment's Italian operations and the consolidation of certain

Baker Oil Tools manufacturing operations. Cash provisions of the charge totaled $14.3 million.

The Company spent $4.2 million in 1996, $6.3 million in 1997 and expects to spend the

remaining $3.8 million in 1998.

SOURCE: Baker Hughes Inc., annual report, September 1997, 45.

86 Understanding the Numbers

EXHIBIT 2.34 Segment and related information note: Baker Hughes

Inc., years ended September 30 (in millions).

NOTE 10

Segment and Related Information

The Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related

Information, in 1997 which changes the way the Company reports information about its

operating segments. The information for 1996 and 1995 has been restated from the prior

year 's presentation in order to conform to the 1997 presentation.

The Company's nine business units have separate management teams and infrastructures

that offer different products and services. The business units have been aggregated into three

reportable segments (oilfield, chemicals and process equipment) since the long-term financial

performance of these reportable segments is affected by similar economic conditions.

Oilfield: This segment consists of five business units—Baker Hughes INTEQ, Baker Oil

Tools, Baker Hughes Solutions, Centrilift and Hughes Christensen—that manufacture and

sell equipment and provide services and solutions used in the drilling, completion, production

and maintenance of oil and gas wells. The principle markets for this segment include all

major oil and gas producing regions of the world including North America, Latin America,

Europe, Africa and the Far East. Customers include major multinational, independent and

national or state-owned oil companies.

Chemicals: Baker Petrolite is the sole business unit reported in this segment. They manufacture

specialty chemicals for inclusion in the sale of integrated chemical technology solutions

for petroleum production, transportation and refining. The principle geographic markets for

this segment include all major oil and gas producing regions of the world. This segment also

provides chemical technology solutions to other industrial markets throughout the world including

petrochemicals, steel, fuel additives, plastics, imaging and adhesives. Customers include

major multinational, independent and national or state-owned oil companies as well as

other industrial manufacturers.

Process Equipment: This segment consists of three business units—EIMCO Process Equipment,

Bird Machine Company and Baker Hughes Process Systems—that manufacture and sell

process equipment for separating solids from liquids and liquids from liquids through filtration,

sedimentation, centrifugation and f loatation processes. The principle markets for this segment

include all regions of the world where there are significant industrial and municipal wastewater

applications and base metals activity. Customers include municipalities, contractors, engineering

companies and pulp and paper, minerals, industrial and oil and gas producers.

The accounting policies of the reportable segments are the same as those described in

Note 1 of Notes to Consolidated Financial Statements. The Company evaluates the performance

of its operating segments based on income before income taxes, accounting changes,

nonrecurring items and interest income and expense. Intersegment sales and transfers are not

significant.

Summarized financial information concerning the Company's reportable segments is

shown in the following table. The "Other" column includes corporate related items, results of

insignificant operations and, as it relates to segment profit (loss), income and expense not allocated

to reportable segments (millions of dollars).

1997

Revenues $2,862.6 $417.2 $386.1 $19.5 $3,685.4

Segment profit (loss) 416.8 41.9 36.3 (281.9) 213.1

Total assets 3,014.3 1,009.5 363.7 368.8 4,756.3

Capital expenditures 289.7 24.8 6.4 21.8 342.7

Depreciation and amortization 143.2 20.5 8.4 4.1 176.2

Analyzing Business Earnings 87

EXHIBIT 2.34 (Continued)

1996

Revenues $2,397.9 $247.6 $352.8 $29.4 $3,027.7

Segment profit (loss) 329.1 23.3 31.2 (84.7) 298.9

Total assets 2,464.6 270.3 258.9 303.6 3,297.4

Capital expenditures 157.5 16.6 6.6 1.5 182.2

Depreciation and amortization 123.6 12.2 6.7 3.0 145.5

1995

Revenues $2,072.2 $223.7 $319.6 $22.0 $2,637.5

Segment profit (loss) 249.6 17.8 29.7 (92.0) 205.1

Total assets 2,423.7 259.8 187.3 295.8 3,166.6

Capital expenditures 119.1 11.0 5.0 3.8 138.9

Depreciation and amortization 123.9 12.4 5.4 2.4 144.1

The following table presents the details of "Other" segment profit (loss).

1995 1996 1997

Corporate expenses $(39.7) $(40.2) $(44.3)

Interest expense-net (50.8) (52.1) (46.8)

Unusual charge (39.6) (52.1)

Acquired in-process research and development (118.0)

Nonrecurring charge to cost of sales for

Petrolite inventories (21.9)

Gain on sale of Varco stock 44.3

Other (1.5) 2.9 1.2

Total $(92.0) $(84.7) $(281.9)

The following table presents revenues by country based on the location of the use of the

product or service.

1995 1996 1997

United States $972.9 $1,047.2 $1,319.7

United Kingdom 207.6 277.9 288.0

Venezuela 122.7 160.0 244.2

Canada 157.5 165.1 204.5

Norway 104.2 145.6 175.0

Indonesia 54.5 92.7 128.0

Nigeria 33.5 64.1 83.5

Oman 45.7 56.8 77.2

Other (approximately 60 countries) 938.9 1,018.3 1,165.3

Total $2,637.5 $3,027.7 $3,685.4

The following table presents property by country based on the location of the asset.

1995 1996 1997

United States $353.0 $359.9 $593.3

United Kingdom 67.6 77.7 145.3

Venezuela 19.0 25.1 33.3

Germany 18.4 19.3 21.4

Norway 11.3 10.9 20.0

Canada 8.0 9.1 16.9

Singapore 25.0 17.7 11.7

Other countries 72.8 79.3 141.0

Total $575.1 $599.0 $982.9

SOURCE: Baker Hughes Inc., annual report, September 1997, 49–51.

88 Understanding the Numbers

EXHIBIT 2.35 Adjustment worksheet for sustainable earnings base:

Baker Hughes Inc., years ended September 30

(in millions).

1995 1996 1997

Reported net income or (loss) $105.4 $176.4 $97.0

Add

Pretax LIFO liquidation losses

Losses on sales of fixed assets

Losses on sales of investments

Losses on sales of "other" assets

Restructuring charges (unusual charge) 39.6 52.1

Investment write-downs

Inventory write-downs (included in cost of sales) 21.9

Other asset write-downs

Foreign currency losses 1.9 11.4

Litigation charges

Losses on patent infringement suits

Exceptional bad debt provisions

Temporary expense increases

Temporary revenue reductions

Other

Other

Other

Subtotal $1.9 $51.0 $74.0

Multiply by

(1 – Combined federal and state tax rates) 58% 58% 58%

Tax-adjusted additions $1.1 $29.6 $42.9

Add

After-tax LIFO liquidation losses

Increases in deferred tax valuation allowances

Other nonrecurring tax charges

Losses on discontinued operations

Extraordinary losses

Losses/cumulative-effect accounting changes 14.6 12.1

Other (acquired in-process R&D) 118.0

Other

Other

Subtotal $14.6 $130.1

Total additions $15.7 $29.6 $173.0

Analyzing Business Earnings 89

EXHIBIT 2.35 (Continued)

1995 1996 1997

Deduct

Pretax LIFO liquidation gains

Gains on sales of fixed assets (disposal of assets) 18.3 31.7 18.4

Gains on sales of investments (Varco stock) 44.3

Gains on sales of other assets

Reversals of restructuring charges

Investment write-ups (trading account)

Foreign currency gains 4.1

Litigation revenues

Gains on patent infringement suits

Temporary expense decreases

Temporary revenue increases

Reversals of bad-debt allowances

Other

Other

Other

Subtotal $18.3 $76.0 $22.5

Multiply by

(1 – Combined federal and state tax rate) 58% 58% 58%

Tax-adjusted deductions $10.6 $44.1 $13.1

Deduct

After-tax LIFO liquidation gains

Reductions in deferred tax valuation allowances

Loss carryforward benefits—from prior periods 13.1 3.3 4.2

Other nonrecurring tax benefits

(IRS audit agreement) 11.4

Gains on discontinued operations

Extraordinary gains

Gains/cumulative-effect accounting changes

Other

Other

Other

Subtotal $13.1 $3.3 $15.6

Total deductions $23.7 $47.4 $28.7

Sustainable earnings base $97.4 $158.6 $241.3

90 Understanding the Numbers

EXHIBIT 2.36 Summary of nonrecurring items search process: Baker

Hughes Inc.

Step and Search Location Nonrecurring Item Revealed

1. Income statement Unusual charge (1996-1997)1

Acquired in-process research and development (1997)1

Gain on sale of Varco stock (1996)1

Cumulative effect of accounting changes (1995, 1997)1

2. Statement of cash f lows Acquired in-process research and development (1997)2

Gain on sale of Varco stock (1996)2

Gain on disposal of assets (1995–1997)1

Foreign currency translation (gain)/loss, net

(1995–1997)1

Cumulative effect of accounting changes (1995, 1997)2

3. Inventory note No nonrecurring items located

4. Income tax note 1992 and 1993 IRS audit agreement (1997)1

Operating loss and credit carryforwards (1995–1997)1

5. Other income (expense) note No note provided

6. MD&A Petrolite inventory writedown in cost of sales (1997)1

Unusual charge (1996-1997)2

Acquired in-process research and development (1997)3

Gain on sale of Varco stock (1996)3

1992 and 1993 IRS audit agreement (1997)2

Foreign currency translation (gain)/loss, net

(1996–1997)2

7. Other notes revealing nonrecurring

items:

a. Significant accounting policies Cumulative effect of accounting changes (1995, 1997)3

b. Acquisitions and dispositions Acquired in-process research and development (1997)4

Unusual charges (1996-1997)3

Gain on sale of Varco stock (1996)4

c. Unusual charge Unusual charges (1996-1997)4

d. Segment information Unusual charges (1996-1997)5

Acquired in-process research and development (1997)5

Petrolite inventory writedown in cost of sales (1997)2

Gain on sale of Varco stock (1996)5

Note: The superscripts 1, 2, 3, and so on indicate the number of times the nonrecurring item was found.

For instance, "Gain on sale of Varco stock" was found in the income statement (first location); in the

statement of cash f lows (second location); in MD&A (third location); in the "Acquisitions and dispositions"

note (fourth location); and in the "Segment and related information" note (fifth location).

Analyzing Business Earnings 91

worksheet, the company's three-year operating performance is virtually impossible

to discern.

The efficient search sequence for identifying nonrecurring items in Exhibit

2.3 was based on the experience of the authors supported by a large-scale

study of nonrecurring items by H. Choi. While the recommended search sequence

may not be equally effective in all cases, Exhibit 2.37 demonstrates

that most of Baker Hughes's nonrecurring items could be located by employing

only steps 1 to 5, a sequence that is very cost-effective. In fact, 92% of all

material nonrecurring items were located through the first four steps of the

search sequence. Further, locating these items requires reading very little text,

and the nonrecurring items are generally set out prominently in either statements

or schedules.

Exhibit 2.37 presents information on the efficiency of the search process.

The meaning of each column in the exhibit is as follows:

Column 1: The number of nonrecurring items located at each step in

the search process. This is based on all 17 nonrecurring

items without regard to their materiality.

Column 2: The cumulative percentage of all nonrecurring items

located through each step of the search process. Ninety

four percent of the total nonrecurring items were located

through the first five steps of the search process. All

nonrecurring items were located by step 6.

EXHIBIT 2.37 Ef f iciency of nonrecurring items search process: Baker

Hughes Inc.

Incremental Nonrecurring Items Discovered

(1) (2) (3) (4)

All Non- All

recurring Cumulative Materiala Cumulative

Step and Search Location Items % Located Items % Located

1. Income statement 6 35% 6 50%

2. Statement of cash f lows 6 71 3 75

3. Inventory note 0 71 0 75

4. Income tax note 4 94 2 92

5. Other income (expense) note 0 94 0 92

6. MD&A 1 100 1 100

7a. Significant accounting

policies note 0 100 0 100

7b. Acquisitions and dispositions

note 0 100 0 100

7c. Unusual charge note 0 100 0 100

7d. Segment and related

information note 0 100 0 100

Total nonrecurring items 17 100% 12 100%

a Five percent or more of the amount of the net income or net loss, on a tax-adjusted basis.

92 Understanding the Numbers

Column 3: Same as column 1 except only material nonrecurring items

(those items exceeding 5% of net income on an after-tax

basis).

Column 4: Same as column 2 except that only material nonrecurring

items were considered.

SOME FURTHER POINTS ON THE

BAKER HUGHES WORKSHEET

The construction of an SEB worksheet always requires a judgment call. One

could, of course, avoid all materiality judgments by simply recording all nonrecurring

items without regard to their materiality. However, the classification

of items as nonrecurring, as well as on occasion their measurement, calls for

varying degrees of judgment. Some examples of Baker Hughes items that required

the exercise of judgment, either in terms of classification or measurement,

are discussed next.

The Petrolite Inventory Adjustment

A pretax addition was made in Exhibit 2.35 for the effect on 1997 earnings of

inventory obtained with the Petrolite acquisition (see Exhibits 2.30 and 2.34).

Accounting requirements for purchases call for adjusting acquired assets to

their fair values. This adjustment required a $21.9 million increase in Petrolite

inventories to change them from cost to selling price. This meant that there

was no profit margin on the subsequent sale of this inventory in the fourth

quarter of 1997. That is, cost of sales was equal to the sales amount. Baker

Hughes labeled this $21.9 million acquisition adjustment "nonrecurring

charge to cost of sales for Petrolite inventories" (see segment disclosures in

Exhibit 2.34).

This Petrolite inventory charge raised the level of cost of sales in relationship

to sales. However, this temporary increase in the cost-of-sales percentage

(cost of sales divided by sales) was not expected to persist in the future. We

concurred with the Baker Hughes judgment and treated this $21.9 million

cost-of-sales component as a nonrecurring item in developing sustainable

earnings.

Foreign Exchange Gains and Losses

Information on foreign exchange gains and losses was disclosed in the statement

of cash flows (Exhibit 2.28) and in the MD&A (Exhibit 2.30). The statement

of cash flows disclosed foreign-currency losses of $1.9 million in 1995

and $8.9 million in 1996. A $6.1 million gain was disclosed in 1997. However,

the MD&A disclosed a foreign-currency loss of $11.4 million for 1996 and a

gain of $4.1 million for 1997. The foreign-currency items in the statement of

Analyzing Business Earnings 93

cash f lows represent recognized but unrealized gains and losses. As such, there

are no associated cash inflows and outflows. However, the disclosures in the

MD&A represent all of the net foreign-exchange gains and losses, both realized

and unrealized. These are the totals that would have been added or deducted

in arriving at net income and also represent the nonrecurring foreign

currency gains and losses.

For 1996 and 1997, the Baker Hughes worksheet includes the foreign currency

gain and loss disclosed in the MD&A, a loss of $11.4 million for 1996 and

a gain of $4.1 million for 1997. In the absence of a disclosure of any foreign

currency gain or loss in the MD&A for 1995, the worksheet simply included

the $1.9 million loss disclosed in the statement of cash f lows. Adjusting the

foreign-currency gains and losses out of net income is based on a judgment that

comparative performance is better represented in the absence of these

irregular items.

The Tax Rate Assumption and Acquired R&D

The tax rate used in the Baker Hughes worksheet was a combined (state, federal,

and foreign) 42%. This is the three-year average effective tax rate for the

company once nonrecurring tax items were removed from the tax provision.

Two nonrecurring tax items stand out in the income tax disclosures in Exhibit

2.29. First is the increase in the tax provision because of the lack of tax

deductibility of the $118 million of acquired in-process research and development

in 1997.49 The tax effect of this nonrecurring item, $41.3 million, pushed

the effective rate up to 49% for 1997. Because of this lack of deductibility for

tax purposes, the pretax and after-tax amounts of this charge are the same,

$118 million. Therefore, we recorded the $118 million charge with the other

tax and after-tax items in the bottom section of the SEB worksheet. Because

this item is added back to net income on its after-tax basis, no additional adjustment

was needed for the $41.3 million tax increase resulting from the lack

of deductibility.

The second adjustment was for the $11.4 million nonrecurring tax reduction

that resulted from an IRS audit agreement. The tax rate scales the numbers

in the worksheet to their after-tax amounts. The goal should be a rate that

is a reasonable representation of this combined rate. It is usually not cost beneficial

to devote an inordinate amount of time to making this estimate.

Equity Earnings and Disposal of

the Varco Investment

The MD&A included discussion of the gain on the sale of the Varco investment.

This is a clear nonrecurring item, and it was adjusted from results in the Baker

Hughes SEB worksheet. Baker Hughes accounted for its investment in Varco by

using the equity method. This indicates that its ownership was sufficient to provide

it with the capacity to exercise significant inf luence over Varco. Baker

94 Understanding the Numbers

Hughes disclosed that it recognized equity income from Varco of $3.2 million in

1995 and $1.8 million in 1996. However, the disposal of the Varco investment

did not qualify as a discontinued operation. If it had been so classified, then the

Baker Hughes share of earnings would have been removed from income from

continuing operations of 1995 and 1996 and reported with discontinued operations—

along with the gain on the disposition of the investment.

Clearly, a case could be made for treating the 1995 and 1996 equity earnings

as nonrecurring and removing them from earnings in developing the SEB

worksheet. This would not alter the message conveyed by the SEB worksheet in

this particular case. However, if the effect were more material, then a judgment

to treat as nonrecurring the equity earnings from the Varco investment

would be in order.

Using the Summary Disclosures of Unusual Charges

In completing the worksheet, the summary totals from the unusual-charge disclosures

(Exhibit 2.33) were used. Alternatively, the detail on the charges

could have been recorded in appropriate lines in the worksheet. We saw this as

offering no advantage here.

Having the detail on the makeup of the unusual charges is helpful in determining

whether other additional nonrecurring items have already been included

in these totals. Recall that the 1997 Petrolite inventory adjustment of

$21.9 million was not included in the unusual charges total (it was included in

cost of sales). Summaries for unusual charges, it should be noted, usually do

not include all items that could reasonably be considered nonrecurring. In addition,

care should be taken not to duplicate the recording of items already included

in summary totals for unusual charges.

SUMMARY

An estimation of the sustainable portion of earnings should be the centerpiece

of analyzing business earnings. This task has become a far greater challenge

over the past decade as the number of nonrecurring items has increased dramatically.

This explosion has been driven by corporate reorganizations and

associated activities. Some of the labels attached to these producers of nonrecurring

items are restructuring, rightsizing, downsizing, reengineering, redeployment,

repositioning, reorganizing, rationalizing, and realignment. The

following are some key points for the reader to consider:

• An earnings series from which nonrecurring items have been purged is

essential in order to both evaluate current trends in operating performance

and make projections of future results.

• The identification and measurement of nonrecurring items will typically

require the exercise of judgment.

Analyzing Business Earnings 95

• There are no agreed-upon definitions of nonrecurring items as part of

GAAP. Moreover, a variety of labels are used beyond the term nonrecurring

and they include special, unusual, nonoperating, and noncore.

• It is common to treat items as nonrecurring even though they may appear

with some regularity in the income statement. However, these items are

usually very irregular in terms of their amount as well as whether they are

revenues/gains or expenses/losses.

• The key question to pose in making the nonrecurring judgment is: Will

underlying trends in operating performance be obscured if the item remains

in earnings?

• Many material nonrecurring items will be separately disclosed on the face

of the income statement. However, a substantial number will be disclosed

in other statements and locations. It is typically necessary to extend the

search for nonrecurring items well beyond the income statement.

• In response to reductions in the time available for a whole range of important

activities, an efficient and abbreviated search sequence is presented

in the chapter and illustrated with a comprehensive case example.

While a comprehensive review of all financial reporting is the gold standard,

reliable information on sustainable earnings can typically be developed

while employing only a subset of reported financial information.

FOR FURTHER READING

Bernstein, L., and J. Wild, Financial Statement Analysis: Theory, Application, and

Interpretation, 6th ed. (Homewood, IL: Irwin McGraw-Hill, 1998).

Comiskey, E., and C. Mulford, Guide to Financial Reporting and Analysis (New

York: John Wiley, 2000).

Comiskey, E., C. Mulford, and H. Choi, "Analyzing the Persistence of Earnings: A

Lender 's Guide," Commercial Lending Review (winter 1994–1995).

White, G., A. Sondhi, and D. Fried, The Analysis and Use of Financial Statements

(New York: John Wiley, 1997).

Mulford, C., and E. Comiskey, Financial Warnings (New York: John Wiley, 1996).

Special Committee on Financial Reporting of the American Institute of Certified

Public Accountants, Improving Business Reporting—A Customer Focus (New

York: AICPA, 1994).

INTERNET LINKS

www.fasb.org This site provides updates on the agenda of the FASB.

It also includes useful summaries of FASB statements

and other information related to standard setting.

www.freeedgar.com This site provides a very convenient alternative source

of SEC filings.

96 Understanding the Numbers

www.sec.gov A source for accessing company Securities and

Exchange Commission filings. This site also includes

Accounting and Auditing Enforcement Releases of the

SEC. These releases provide very useful examples of

the actions sometimes taken by companies to

misrepresent their financial performance or position.

ANNUAL REPORTS REFERENCED IN THE CHAPTER

Advanced Micro Devices Inc. (1999)

Air T Inc. (2000)

Akorn Inc. (1999)

AK Steel Holdings Corporation (1999)

Alberto-Culver Company (2000)

Amazon.Com Inc. (1999)

American Building Maintenance Inc. (1989)

American Standard Companies Inc. (1999)

AmSouth Bancorporation (1999)

Archer Daniels Midland Company (2000)

Argosy Gaming Company (1995)

Armco Inc. (1998)

Armstrong World Industries Inc. (1999)

Artistic Greetings Inc. (1995)

Atlantic American Corporation (1999)

Avado Brands Inc. (1999)

Avoca Inc. (1995)

Baker Hughes Inc. (1997)

Baltek Corporation (1997)

C.R. Bard Inc. (1999)

Baycorp Holdings Ltd. (1999)

Bestfoods Inc. (1999)

Biogen Inc. (1999)

BLC Financial Services Inc. (1998)

Brooktrout Technologies Inc. (1998)

Brush Wellman Inc. (1999)

Burlington Resources Inc. (1999)

Callon Petroleum Company (1999)

Champion Enterprises Inc. (1995)

Chiquita Brands International Inc. (1999)

Analyzing Business Earnings 97

Cisco Systems Inc. (1999)

Colonial Commercial Corporation (1999)

Corning Inc. (1999)

Cryomedical Sciences Inc. (1995)

Dal-Tile International Inc. (1999)

Dana Corporation (1999)

Dean Foods Company (1999)

Decorator Industries Inc. (1999)

Delta Air Lines Inc. (1996, 2000)

Detection Systems Inc. (2000)

Dibrell Brothers Inc. (1993)

Escalon Medical Corporation (2000)

Evans and Sutherland Computer Corporation (1998)

The Fairchild Corporation (2000)

First Aviation Services Inc. (1999)

Freeport-McMoRan Inc. (1991)

Galey & Lord Inc. (1998)

Geo. A. Hormel & Company (1993)

Gerber Scientific Inc. (2000)

Gleason Corporation (1995)

Goodyear Tire and Rubber Company (1995, 1998)

Handy and Harman Inc. (1997)

M.A. Hanna Company (1999)

Hercules Inc. (1999)

H.J. Heinz Company (1995)

Holly Corporation (2000)

Hollywood Casino Corporation (1992)

Imperial Holly Corporation (1994)

Imperial Sugar Company (1999)

JLG Industries Inc. (2000)

KeyCorp Ohio Inc. (1999)

Kulicke & Soffa Industries Inc. (1999)

Lufkin Industries Inc. (1999)

Mason Dixon Bancshares Inc. (1999)

Maxco Inc. (1996)

Meredith Corporation (1994)

Micron Technology Inc. (2000)

NACCO Industries Inc. (1995)

National Steel Corporation (1999)

98 Understanding the Numbers

New England Business Services Inc. (1996)

Noble Drilling Inc. (1991)

NS Group Inc. (1992)

Office Depot Inc. (1999)

Osmonics Inc. (1993)

Pall Corporation (2000)

Petroleum Helicopters Inc. (1999)

Phillips Petroleum Company (1990)

Pollo Tropical Inc. (1995)

Praxair Inc. (1999)

Raven Industries Inc. (2000)

Saucony Inc. (1999)

Schnitzer Steel Industries Inc. (1999)

Shaw Industries Inc. (1999)

The Sherwin-Williams Company (1999)

Silicon Valley Group Inc. (1999)

Southwest Airlines Inc. (1999)

Standard Register Company (1999)

SunTrust Banks Inc. (1999)

Synthetech Inc. (2000)

Textron Inc. (1999)

Toys "R" Us Inc. (1999)

Trimark Holdings Inc. (1995)

Tyco International Ltd. (2000)

Watts Industries Inc. (1999)

Wegener Corporation (1999)

NOTES

1. The American Institute of CPA's Special Committee on Financial Reporting,

Improving Business Reporting—A Customer Focus (New York: AICPA, November

1993), 4.

2. Donald Kieso and Jerry Weygandt, Intermediate Accounting, 9th ed. (New

York: John Wiley, 1998), 154–161.

3. Delta Air Lines, annual reports, June 1996, 50–51, and June 2000.

4. Some might also remove these gains because they do not represent operating

items. However, the ongoing disposition of f light equipment is an inherent feature of

being in the airline business. It is not what they are in the business to do, but it does

come with the territory.

5. Delta Air Lines does disclose some proceeds from the sale of f light equipment

in its 1998–2000 statements of cash flow. The gains and losses were probably too small

Analyzing Business Earnings 99

to receive separate disclosure. Delta Air Lines, annual report, June 2000, 36. Delta

does disclose balances for deferred gains on sale and leaseback transactions. These

balances declined by $50 million in 2000, suggesting that gains equal to this amount

were included in earnings for 2000. They are treated as a reduction in lease expense

and do not appear on a line item as gains on the disposition of f light equipment.

6. In fact, 1996 saw a loss of $7.4 million, followed by gains of $34.1 in 1997 and

$2.6 million in 1998. Goodyear Tire and Rubber Company, annual report on Form

10-K to the Securities and Exchange Commission, December 1998, 32.

7. George A. Hormel & Company, annual report, 1993, 58.

8. H. Choi, Analysis and Valuation Implications of Persistence and Cash-

Content Dimensions of Earnings Components Based on Extent of Analyst Following,

unpublished PhD thesis, Georgia Institute of Technology, October 1994, 80.

9. Ibid. The authors of this chapter served as committee member and committee

chair for Dr. Choi's thesis guidance committee.

10. AICPA, Accounting Trends and Techniques (New York: AICPA, 2000), 311.

11. AICPA's Special Committee on Financial Reporting, Improving Business Reporting—

A Customer Focus (New York: AICPA, November 1993), 4

12. SFAS 131, Disclosures about Segments of an Enterprise and Related Information

(Norwalk, CT: Financial Accounting Standards Board, June 1997), para. 10.

13. APB Opinion No. 30, Reporting the Results of Operations (New York: AICPA,

July 1973), para. 20.

14. SFAS 4, Reporting Gains and Losses from the Extinguishment of Debt (Stamford,

CT: FASB, March 1975).

15. SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings

(Stamford, CT: FASB, June 1977).

16. Exxon's accident took the form of a massive oil spill in Alaska, and Union

Carbide's was a release of toxic fumes in India.

17. Armco Inc. annual report, December 1998. Information obtained from Disclosure

Inc., Compact D/SEC: Corporate Information on Public Companies Filing

with the SEC (Bethesda, MD: Disclosure Inc., June 2000).

18. Securities and Exchange Commission, Staff Accounting Bulletin No. 101

(Washington, DC: SEC, 1999).

19. Southwest Airlines Inc., annual report, December 1999.

20. This statement needs some expansion. With the exception of barter transactions,

almost all expenses involve a cash outf low at some point in time. In the case of

depreciation, the cash outf low normally takes place when the depreciable assets are

acquired. At that time, the cash outf low is classified as an investing cash outf low in

the statement of cash f lows. If the depreciation were not added back to net income in

computing operating cash flow, then cash would appear to be reduced twice—once

when the assets were purchased and a second time when depreciation is recorded,

and with it net income is reduced.

21. To keep the books in balance, the recognition of the loss in the income statement

is matched by a reduction in the carrying value of the investment in the balance sheet.

22. SEC Reg. S-X, Rule 5-02.6 (Washington, DC: SEC, 2001).

23. SEC, Staff Accounting Bulletin No. 40 (Washington, DC: SEC, February 8,

1981).

100 Understanding the Numbers

24. Handy and Harman Inc., annual report, December 1997. Information obtained

from Disclosure Inc., Compact D/SEC: Corporate Information on Public

Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998.

25. Even with great improvements in supply chain management, it is still difficult

to get along without any inventories.

26. Reviews and compilations represent a level of outside accountant service well

below that of an audit. Compilations typically provide only an income statement and

balance sheet. Neither notes nor a statement of cash f lows are part of the standard

compilation disclosures.

27. Absent disclosures, the effect of a LIFO liquidation can be estimated. This

requires the assumption that the observed increase in the gross margin is due largely

to the LIFO liquidation. The pretax effect of the LIFO liquidation can then be approximated

by multiplying sales for the period of the liquidation times the increase in

the gross margin percentage.

28. Archer Daniels Midland Company, annual report, June 2000, 20.

29. Guidance in this area is found in SFAS No. 109, Accounting for Income Taxes

(Norwalk, CT: FASB, February 1992).

30. The offsetting of gains and losses in the 1998 other income and expense note

is swamped by a $329 million nonrecurring gain on the disposition of C.R. Bard's cardiology

business.

31. Reg. S-K, Subpart 229.300, Item 303(a)(3)(i) (Washington, DC: SEC, 2001).

32. Mason Dixon Bancshares might take issue with this characterization. Financial

firms tend to characterize these disclosures as designed to measure core earnings.

However, our experience is that the end product is very similar to sustainable earnings,

where the focus is on purging nonrecurring items from reported net income.

33. Phillips Petroleum, annual report, December 1999, 33.

34. Ibid., 33.

35. Other companies that have provided similar presentations in recent years include

Amoco Corp., Carpenter Technology, Chevron Corp., Deere & Company Inc.,

Halliburton Co. Inc., Maxus Energy Corp., and Raychem Corp.

36. C. R. Bard Inc., annual report, December 1999, 17.

37. A hedge of foreign-currency exposure is achieved by creating an offsetting

position to the financial statement exposure. The most common offsetting position is

established by the use of a foreign-currency derivative. These issues are discussed

more fully in Chapter 12.

38. These alternative translation methods are discussed and illustrated in Chapter

12.

39. Dibrell Brothers Inc., annual report, December 1993, 35.

40. Ibid., 14.

41. Arthur Levitt, The Numbers Game, speech given at the NYU Center for Law

and Business, September 28, 1998 (available at: www.sec.gov/news/speeches

/spch220.txt).

42. The earnings of a subsequent period are increased by reducing the previously

accrued restructuring charge on the basis that the accrual was too large. The amount

by which the liability is reduced is also included in the income statement as either an

item of income or an expense reduction.

Analyzing Business Earnings 101

43. Office Depot Inc., annual report, December 1999, 57, 56.

44. SFAS No. 130, Reporting Comprehensive Income (Norwalk, CT: FASB,

June 1997).

45. Translation (remeasurement) gains and losses that result from the application

of the temporal (remeasurement) method continue to be included in the income

statement as part of conventional net income. Only translation adjustments that result

from application of the all-current translation method are included in other comprehensive

income. Recent changes in the accounting for financial derivatives also

result in the inclusion of certain hedge gains and losses in other comprehensive income:

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities

(Norwalk, CT: FASB, November 1998).

46. An annual survey conducted by the AICPA reveals the following pattern of

adoption of the alternative reporting methods of SFAS No. 130 for 497 firms: (1) a

combined statement of income and comprehensive income, 26 firms; (2) a separate

statement of comprehensive income, 65 firms; and (3) reporting comprehensive income

directly in shareholders' equity, 406 firms. AICPA, Accounting Trends and

Techniques (New York: AICPA, 2000), 429.

47. An earlier version of the Baker Hughes case study also appeared in

E. Comiskey and C. Mulford, Guide to Financial Reporting and Analysis (New York:

John Wiley, 2000), chapter 3.

48. Phillips Petroleum, annual report, December 1999, 33.

49. Research and development costs must be written off immediately—even if

the in-process R&D is purchased from another firm. Whether this expense is deductible

for tax purposes turns on the manner in which the acquisition is structured.

Generally, the expense is deductible in transactions structured as asset acquisitions

but not in the case of stock acquisitions.

102

3 COST-VOLUMEPROFIT

ANALYSIS

William C. Lawler

Abigail Peabody was a very well-known nature photographer. Over the years

she had had a number of best-sellers, and her books adorned the coffee tables

of many households worldwide. On this particular day she was contemplating

her golden years, which were fast approaching. In particular she was reviewing

her year-end investment report and wondering why she was not better prepared.

After all, she had been featured in the Sunday New York Times book

section, had discussed her works with Martha Stewart, and had been the

keynote speaker at the Audubon Society's annual fund-raiser. She knew it was

not her investment advisers' fault. Their performance over the past years had

been better than many of the market indixes. She wondered if she was just a

poor businessperson.

The last thought struck a pleasant chord. She had a grandson who was a

junior at a well-known business school just outside Boston. It was time, anyway,

to catch up to his latest business idea. She dialed the number from memory.

He was as lively as usual. "Hi, Abbey, I was just going to call you.

How's the new bird book coming?" [Of her many grandchildren, he had the most

irresistible charm.] How she loved his ability to make her feel young—and his

ability to remember never to call her anything that began with Grand-.

"Actually, Stephen, that's why I'm calling. I was just reviewing my retirement

portfolio, and I think it's time for me to renegotiate my royalty structure

with my publisher. I could use some help from a bright business mind."

"Love to help you. What's wrong with the current contract? Haven't you

been with them since the beginning?"

"Yes I have, but things have changed. In the old days, they provided me

with many services. They brainstormed projects with me, suggested different

Cost-Volume-Profit Analysis 103

ideas such as the Baskets of Nantucket best-seller, and edited my work wordby-

word and frame-by-frame. They worked hard for me and earned every

penny they made on me. I was not the easiest artist to put up with."

Stephen was interested. "Go on."

"Well, now I barely talk with them. I am at the point where loyal readers

suggest many of my projects. I design them myself, edit them myself, and even

help my publisher prepare the promotion materials. They don't work so hard

anymore. I think I have paid my dues. I want a bigger piece of the pie."

"That could be a problem, Abbey. I just finished a case study on that industry,

and it is very competitive. There are many parts to the industry value

system that ultimately ends with someone buying a book (see Exhibit 3.1). It

starts with people like you who have the intellectual capital. The next piece of

the system is the publisher, who manages the creativity process, supplies the

editing, prints the book, and markets it. Wholesalers like Ingram add value to

this system by buying books in large quantity from publishers, warehousing

them, and selling in smaller quantities to bookstores. Of course, the last piece

is the bookstore, where in-store promotion and the final sales process takes

place. On, say, a $50 book, the bookstore buys it from the wholesaler for about

$35, netting about $15 to cover its costs such as rent and salespeople. The

wholesaler buys the book from the publisher in large lot sizes for about $30 a

book, giving the wholesaler about $5 to cover its logistics costs. Of the $30 the

publisher sells it for, 15% of the retail price, or $7.50 ($50 × 15%) is your royalty,

and the rest covers printing, client development, returned books, administrative

expenses, and a profit. The publisher really can't give you too much

more since its margin is already very slim. Sorry to disappoint you but that's

how it is."

Abbey was disappointed. "Stephen, for all that money your parents are

paying, doesn't that business school teach creativity? You have to look at the

world and think of what it could be, not what it is today."

Unembarrassed by Abbey's chastisement, Stephen, reacted positively.

"How much risk do you want to take on this new project, Abbey?"

EXHIBIT 3.1 Publishing industry value system.

Author Customer

Competency: Intellectual

Printing

Logistics Promotion

Capital Editing Warehousing Sales

Development

Revenue: $7.50 $30.00 $35.00 $50.00

Purchase cost: 30.00 35.00

Gross margin: $ 5.00 $15.00

Publisher Wholesaler Bookstore

104 Understanding the Numbers

"That's more like it. For now, let's 'roll the bones'—I mean, assume risk is

not an issue. What do you have in mind?"

"Well, this semester I have a Web-marketing course and I need a project.

Are you familiar with the World Wide Web?"

"I spend a good part of the day corresponding with friends on it."

"Good. What you just said to me is that you don't see too many pieces of

the publishing system adding value commensurate with the value they extract.

How about setting up your own Web site and selling your latest project yourself?

We would have to contract with others to provide the necessary parts of

the chain, but selling the book through our Web site is possible. It could fail,

and you would have one very unhappy publisher."

Abbey thought she was now getting somewhere. "As long as you are getting

credit for it, why don't you develop this idea further. See if it's possible

and what my risks would be. I might even give you a piece of the action."

COST STRUCTURE ANALYSIS

A month later Abbey met Stephen for lunch in Boston. He was excited.

"Abbey, this is what I have found so far. Setting up a Web site is very easy,

but maintaining it and keeping it fresh and exciting so that people want to revisit

it is the challenge. Neither you nor I want to do that, trust me. I have

talked with a number of companies who offer this type of service. Many of

them were excited when I showed them copies of your past books. To set up

and maintain the site, the offers ran anywhere from a low of $25,000 a year to

four times that. The high-end ones also charge a 5% fee on all revenues generated.

I think we want a high-end site that is creative, custom designed, and exciting

so I lean toward the more expensive ones. They are good."

Abbey liked how he used the word we. And being an artist, she too

thought that her Web site should be exciting, creative, and different. "Go on."

"I also found a number of printers who specialize in small run sizes, typically

less than 50 books in any one printing. Their technology is called printon-

demand, and they also work with photographs. I brought some samples of

printed photos."

Abbey was impressed with the quality. It looked no different than her

previous books. "What would they charge?"

"They said they could print your books on demand and guarantee the

quality for about $35 each. Now, this is much more than what traditional printers

charge, but they always run large volumes, a minimum of 5,000 copies in

one printing, and want to be paid for every one of them even before we could

sell them. Bottom line, we would be at risk if this doesn't work."

Abbey was disappointed that she was again making someone else rich, but

moved on. "How would we do all the promotion and sales?"

"Two ways. Once your readers learn of your site, they will visit it. If the

Web-design company delivers what they promise, we should be able to sell

Cost-Volume-Profit Analysis 105

directly to them. Until that traffic happens, the Web designers will develop

links with all the major sites that might be interested."

"How does that work?"

"Well, your newest project is a Florida bird book for all the retired baby

boomers down there, right? So we develop what is called a link with the

Audubon's Web site and maybe AARP and the Florida Tourism Bureau. When

people see your book on those sites, they click on a link and get transferred to

our site. If they buy the book, we pay the site a 10% royalty."

"Does that mean I spend all my days, assuming we are successful, mailing

books all over the world? That doesn't interest me."

"No. I also talked with logistics companies like UPS and FedEx. They will

do all of that. When we sell a book, we just notify them electronically. They

work with the printer to obtain the book and with the credit card company to

get paid, and they ship it. They even collect the money, pay everyone involved

with the sale, and electronically deposit the remainder in your account. They

would charge about $10 per book for all of this, assuming we can guarantee a

certain minimal volume."

"Now that sounds like your parents are getting their money's worth. Have

you summarized all of this?"

"Sure have. You're still thinking about a price of $80 for this book?"

"My others have sold for that, and I think the demand for this might even

be greater. So $80 is a good assumption."

"Okay. First, all business models have only two types of costs, variable

and fixed. Each is defined by the behavior of the total cost function. Variable

costs are those that increase proportionately with volume—basically, the more

books we sell the higher these total costs will be. They can be expressed either

on a per-unit basis or as a percentage of the selling price. Notice we have both

types. Our printing and logistics costs total $45 for each book sold—$35 printing

plus $10 logistics. Our Web-site sales referral cost of 10% and Web-design

cost of 5% for every dollar of revenue are examples of the latter kind of variable

cost. For the targeted price of $80, these costs come to $12 for each book

sold ($80 × 15%). Note this type of variable cost is a little more complicated

than the simple $45 per book—here if we change selling price, the variable

cost will change. Given the $80 selling price, the total variable cost per book is

then $57 per unit ($45 + $12). Unlike these costs, the Web-site design cost is a

mixed cost1 and has to be broken into a variable and a fixed component. We

have already treated the 5% variable cost component. There is also a fixed

charge per year of about $100,000 if we go high-end. Note the difference in

behavior of this cost. Here the total cost is not dependent on a volume factor

such as "books sold." Fixed costs are often called period costs since they are

time dependent. So in summary, we have a time-dependent fixed charge of

$100,000 per year, which remains the same regardless of the number of books

sold, and a variable cost, which is better understood on a per-unit or, in this

case, per-book rate of $57. I made a graph of this—what businesspeople call

cost structure (see Exhibit 3.2)."2

106 Understanding the Numbers

Abbey thought she understood. "So this structure will always be the same?"

"With one proviso," Stephen affirmed. "Although my chart looks the

same from zero volume to an infinite amount sold, we really should only be

talking about a smaller relevant range. Both the printer and the logistics company

are assuming an annual volume of between 10,000 and 25,000 books—essentially

what your past books sold. Outside this range, especially on the high

side, the costs probably will change. I don't think the printer can do much

more than 25,000 a year for us. Likewise, at greater than this volume, we would

probably have to redesign the Web site. So the cost structure could change if

we were to move outside the range."

"Okay. So now I think I do understand what the cost structure would be

given our plans for the Web site. All that you said makes sense, and I'm sure my

new book will sell in that range. So tell me why I shouldn't do this."

COST-VOLUME-PROFIT ANALYSIS

"If we add a revenue line to my first exhibit," said Stephen, "we will start to get

a better picture of the answer to this question (see Exhibit 3.3). First, you must

understand the concept of contribution margin. For us, it is simple. For every

$80 book we sell, there is a variable cost to print, sell, and deliver that book of

$57. This means that the net contribution of each book sold is $23. Does this

make sense?"

"Sure does," Abbey answered, delighted. "This is wonderful. I was only

making $12 with my publisher, and now I can make almost double that."

"Not quite. You forgot one thing. Contribution margin must first go toward

covering the fixed costs before we can realize any profit. Each year we

have to cover the Web-site designer's charge of $100,000. At a contribution

margin of $23 per book, it will take about 4,350 books sold to do this (see

EXHIBIT 3.2 Web site cost structure.

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

0 5,000 10,000 15,000 20,000 25,000

Dollars (thousands)

Units

Relevant range

Cost-Volume-Profit Analysis 107

Exhibit 3.4). On my graph, this is the point where the revenue line intersects

the total cost line and is called the break-even point. After that, you are correct.

For any additional book we sell, the $23 contribution per book is all profit.

So, as I see it, there is little risk since you are sure that we will sell at a minimum

10,000 copies per year."

Abbey became a bit uncomfortable. "Actually, I think this book will sell

about 20,000 copies per year at a minimum. But isn't my alternative to stay

with my publisher? And if so, shouldn't we be talking about whether I would be

better off with the Web site?"

Stephen was suddenly not so cocky. Abbey thought that maybe some remedial

work on those tuition dollars was needed. "I have some work to do. Why

don't you get back to me on that, Stephen?"

Two nights later, after faxing her two charts, Stephen phoned Abbey. "I

sent you a different type of chart, called a profit chart, which shows the two

EXHIBIT 3.3 Web site CVP analysis.

Dollars (thousands)

Units

Total revenue line

Total cost line

Fixed cost

Profit area

Break-even point

0

500

1,000

1,500

2,000

2,500

0 5,000 10,000 15,000 20,000 25,000

EXHIBIT 3.4 Break-even calculations.

Solving for x,

General Rule: Break-even point

Fixed Costs

Contribution Margin

=

$ $ $ ,

$ $ ,

$ ,

,

80 57 100 000

23 100 000

100 000

23

4 348

x x

x

x

− =

=

= = books

Sales Revenue = Fixed Costs +Variable Costs

$80 x = $100, 000 + $57x

108 Understanding the Numbers

alternatives (see Exhibit 3.5). 'Stay with the publisher' shows that you make

$12 for every book sold. 'Sell through the Web site' is a bit more involved in

that it shows that you first must cover your fixed cost before making any profit.

Note that they intersect at about 9,100 books sold, which means that you would

be indifferent to which business model you chose at this volume of books sold.3

But at less than the 9,100 you should stay with your publisher; at greater than

that volume, build your own Web site. At the 20,000 books-per-year level you

said you are sure this project will hit, you make $240,000 per year (20,000 ×

$12 royalty per book) if you stay with your publisher, and $360,000 with the

Web site (20,000 × [$80 $57] $100,000 fixed costs). Another way to think

about this is that if we set up our own Web site there is an additional variable

cost for each book we sell—the $12 we could have made from the publisher

(see Exhibit 3.6). This is called an opportunity cost. It is a relative measure—

EXHIBIT 3.5 Profit chart.

5,000 10,000 15,000 20,000 25,000

Dollars (thousands)

Units

Stay with publisher

Sell through Web site

–200

–100

0

100

200

300

400

500

600

EXHIBIT 3.6 Revised Web site CVP analysis.

0 5,000 10,000 15,000 20,000 25,000

Dollars (thousands)

Units

Total revenue line

Revised total cost line

$69x + $100,000

Break-even now

indifference point

0

500

1,000

1,500

2,000

2,500

Cost-Volume-Profit Analysis 109

what is sacrificed when we choose one alternative, selling through the Web

site, over the next best alternative, staying with the publisher. If we think this

way, our contribution margin is now only $11 ($80 selling price less $57 variable

costs less $12 royalty per book sacrificed). We do arrive at the same indifference

point using this method—using the general rule:

I think this is the better way to think about the Web-site alternative. Note,

using this method, at 20,000 books per year we make a total contribution of

$220,000 (20,000 × $11), which covers our fixed costs and yields the $120,000

incremental profit—same as ($360,000 $240,000)."

Abbey was becoming very interested in this business opportunity. She

liked the 50% greater return ($120,000/$240,000). "How fast can we get this

Web site up and running?"

"Let's talk a bit more. I also presented today in class what we have done so

far. Many students liked the idea. The only criticism was that Web customers

expect lower prices since they know the middle person has been eliminated.

The class agreed that a 10% to 15% price decline would be very likely, resulting

in a price closer to $70. This is not so good for us. Even though our variable cost

will fall to $67.50 since part of it is price dependent ($35 printing + $10 logistics

+ $12 opportunity cost + [15% × $70]), our contribution margin would

now only be $2.50 per book. Just to match what you could make with your

publisher, we would have to sell about 40,000 books a year ($100,000/$2.50

per book). At the 20,000-book level, we would now be worse off by $50,000

([20,000 × $2.50] $100,000). Well, you asked about the risks and here they

are. The price could even be lower, so there is a high probability we could wind

up worse off."

"So, you're my business partner, what do you suggest?" was Abbey's reply.

"That's a hard one," was all Stephen could say.

CVP for Decision Making

The next day Abbey called Stephen for more advice. "Public Broadcasting System

of Florida called me after our talk yesterday. They just began planning

their end-of-year membership drive and heard about my book project. They

want to offer a free copy of my book to any member who donates $250

or more."

Stephen thought that was great.

"Unfortunately, since they are a public company they have constraints on

their spending. They can give a gift equivalent to only 20% of the donation.

CVP Point

Fixed Costs

Contribution Margin

units

=

=

=

$ ,

$

,

100 000

11

9 091

110 Understanding the Numbers

Fifty dollars a book for 5,000 books was their offer to me. Since we just went

over the numbers, I said I couldn't possibly do this since our variable costs

alone were greater than $50 a unit. This analysis we did does help with decision

making. Last year I might have agreed to the deal. I am starting to feel like a

businessperson."

Stephen asked whether the PBS group accepted her decision. When

Abbey said that they were very persistent and would call back next week,

Stephen suggested he and Abbey meet again for lunch. He needed to review

some of his class notes on relevant cost analysis, specifically on something he

remembered as "special orders."

At lunch Stephen explained some analysis he had done. "Abbey, this is

called a special order situation. These types of business decisions are shortrun

decisions that have no long-term ramifications.4 Assuming that we have

the Web site up by that time, we have to be careful in identifying only those

costs that are relevant to the decision. For instance, the $100,000 we will

spend on our site per year is not relevant, since regardless of whether we accept

this special order, those costs will still be there. The rule that we use is:

A cost is relevant if and only if it will change due to the decision being analyzed,

in this case our special order. Let's review the relevant costs. First,

there's the $35 charge to print the books on demand. Since this is a 5,000-unit

order the printer's costs to prepare the run, called set-up costs, will be spread

over a much larger number of books. I talked with him, and he would be willing

to do this run for $30 per book. Likewise, UPS or FedEx will ship these

books all at once and not individually, so the $10 charge per book will be

avoided. A one-time fixed charge of $250 for shipment of the 5,000-book

order is closer to the correct number. Since this order was not sold through a

EXHIBIT 3.7 Relevant cost analysis of special order.

Accept the

Order, No Accept the

Adjustments Order, Reject the

to Costs Adjusted Costs Order Difference

Number of books sold 5,000 5,000 0 5,000

Revenue $250,000 $250,000 $ 0 $250,000

Relevant costs:

Printing $175,000 $150,000 $ 0 $150,000

Logistics 50,000 250 0 250

10% site referral 25,000 0 0 0

5% Web site expense 12,500 12,500 0 12,500

Total relevant costs $262,500 $162,750 $ 0 $162,750

Nonrelevant costs

Web site design $100,000 $100,000 $100,000 $ 0

Profit from order $ 87,250

Cost-Volume-Profit Analysis 111

site reference, the 10% commission can also be avoided. I looked into the

Web-site contract, and I do think we will have to pay this charge of $2.50 per

book (5% × $50). Summing up, the variable cost per book for this special

order will be only $32.50 ($30 printing charge plus $2.50 Web-site fee)—less

than the $50 PBS is willing to pay. The end result is a $17.50 contribution margin

per book for this special order. There is an incremental fixed charge of

$250 but we still will make just over $87,000 (5,000 × [$50 $32.50] $250

= $87,250). So we should think about reconsidering the offer" (see Exhibit 3.7).

Though Abbey was beginning to appreciate the complexity of this type of

analysis, all the numbers did make sense. She had only one question: "What

happens if customers I would have sold to anyway get their books this way?

Don't I lose money?"

Stephen had done that analysis. "In the business world, we call that cannibalization.

On every book sold through this special offer, you could potentially

lose the $23 contribution margin per book sold through the regular Web

site if these people would have bought anyway. To solve for the potential number

of regular customers that would have to be cannibalized in order for us to

lose money on this special order, follow this procedure:

Solving for x, we get

This means that if about 3,800 of the 5,000 books sold by PBS go to customers

that would have bought anyway, we are indifferent to accepting this order. If

more than 3,800 would have bought anyway, we lose on this special order. Do

you think 76% (3,800/ 5,000) of these people would buy from our Web site? I

don't think it is anywhere near that. And, on the positive side, these 5,000 people

would now be advertising our Web site with your book on their coffee tables

all over Florida."

Abbey was searching for the PBS phone number before Stephen had finished

the last sentence. She made a mental note to understand this "relevant

cost" analysis a bit more.

Price Discrimination

In the above special order situation, there was a legitimate reason to offer PBS

the lower price. As Exhibit 3.7 illustrates, the relevant cost analysis justified

the lower price. When offering different prices to different customers, one

must be aware of the laws regarding price discrimination. Under the federal

Robinson-Patman Act and many state laws, it is illegal to price discriminate

unless there are mitigating circumstances. One must be very careful to do a

x =

=

$ ,

$

,

87 250

23

3 793 customers

$23x = $87,250

112 Understanding the Numbers

relevant cost analysis before granting any price concessions to customers on a

selective basis.

CVP in a Multiple Product Situation

The special order was a great opportunity, but both Abbey and Stephen knew

that the success of the Web site ultimately would depend on the regular, dayto-

day business activity. The two of them were still worried about the potential

Web discount resulting in a $70 price point. As an artist Abbey understood risk

and had learned long ago to accept risk and figure a way to minimize it. She decided

to talk with some of her artist friends.

In two weeks she and Stephen met again. Stephen was desperate to finish

his project since semester end was right around the corner. Abbey walked in

wearing a rather stylish straw hat.

"I think I have the solution, Stephen. I do not want to drop my price from

$80. My other books sold at this price, and to drop the price on this one might

send the wrong message to my loyal following. This book will not be in any

manner inferior to my past works. But I do have an idea. We are going to expand

our product offerings. I have a dear friend who makes these hats, and I

think this would be a perfect complement to my bird book. After all, if you are

going out bird-watching in Florida you need both to look good and to have sun

protection. We are going to package the book with a hat and a Peterson's

Florida Bird Guide at a very reasonable price for those that are more price

conscious."

Stephen was stunned. "Whoa, do you want all this complexity in your

business, Abbey?"

She smiled. "I, too, can do some field research. My friend will package

the three items as orders come in. I don't have to do any more work than before.

She was happy to build demand for her hats."

"So, how about the costs?"

"This is how I see it. We sell the hats for $50 by themselves; the books for

$80 by themselves; and then offer the package for $140. A Peterson's Guide

typically sells for $20, so this package price is a deal—you could say I'm selling

my book for $70 as part of this package, although I would never admit to it. I

coerced my friend to give us her hats for $24 each, and the book costs when included

in this package will change a bit. I put your relevant cost technique to

work here. My friend and I think we can assemble the package for a variable

cost of about $100 (see Exhibit 3.8). Peterson will give us the guide for $10 to

get the exposure, and since we are still shipping only one item, I'm hoping that

the logistics charge will not change too much. I had some problems figuring out

what we have to sell since there were now multiple items—hats, books, and

packages. But I have faith in you."

As his laptop was booting Stephen began. "CVP analysis for multiple

products is very common since few companies sell just one item. Instead of

Cost-Volume-Profit Analysis 113

focusing on a contribution margin per unit, when we have multiple products

we must base our calculations on the percentage contribution margin for each

dollar of revenue."

"Sounds complicated."

"Not really, Abbey. It's probably easier, though, for me to show you how it

works than to explain it. All I need is your estimate of the sales mix. For every

book you sell individually, how many hats will you sell and how many packages

will you sell? These estimates do not have to be exact—businesspeople typically

talk about ballpark estimates."

"My friend and I did discuss this. We were not sure, so we came up with a

range. We think that for every 100 books we sell individually, we will sell 50

packages. A surprisingly large number of people are active in this regard. They

actually do enjoy seeking these birds out in the wild. And, of course, everyone

knows you need a wide-brimmed hat in Florida. We guessed that we might also

sell 20 hats individually for every 100 books sold. If things go really well, we

might sell as many as 70 packages and 30 hats for every 100 books. On the pessimistic

side, we could sell as few as 30 packages and 10 hats for the same 100

books. Is this okay?"

"Actually, that's even better. If you're sure of these ranges, then we can

do a sensitivity analysis to see how our profits will change as the mix changes.

We need to know how much our profit will vary with changes in the mix. Are

you comfortable with these ranges?"

"Yes."

"To do this analysis we must first build a product mix analysis. Here, I'll

show you."

Abbey was very impressed as Stephan built the analysis on his laptop (see

Exhibit 3.9). "Just as we analyzed the unit costs before, we build a similar cost

analysis. The only difference is that this time we build it for a composite unit

defined by the mix. For your expected mix, 100 books plus 50 packages plus 20

hats, we see that for every $16,000 in sales you will have $11,180 in variable

costs. This means that on a percentage basis your variable costs are 69.9%

of sales as long as you sell in that mix. Note that we now have a percentage definition

of contribution margin, not a unit definition—contribution margin

EXHIBIT 3.8 Variable package cost

estimates.

Hat $ 24

Book printing 35

10% site referral fee 14

5% Web site commission 7

Peterson Guide 10

Package logistics 10

$100

114 Understanding the Numbers

percentage of 30.1%. Our fixed costs are still $100,000 per year, so we now adjust

the general rule for CVP point as follows:5

Solving for x,

To test this model, assume that we have $332,226 in sales revenue and we did

sell the planned mix. Our contribution margin will be 30.1%, which yields the

$100,000 necessary to cover the fixed costs. We do, in fact, break even. The

key, of course, is to be able to forecast the correct mix and then to attain it."

Abbey was quick to correct Stephen. "Don't forget, I still want to be at

least as well off as if I chose to stay with my publisher—say the 20,000 books at

my $12 royalty."

"Easy enough. We just revise the equation by adding a necessary profit requirement—

this is why they call it cost-volume-profit analysis:

Sales Variable Costs Fixed Costs = Profit

x (69.9%)x $100, 000 = $240, 000

( . %) $ ,

$ ,

. %

$ ,

30 1 100 000

100 000

30 1

332 226

x

x

=

=

= in sales revenue

Sales Variable Costs Fixed Costs =

− − =

0

x (69.9%)x $100, 000 0

EXHIBIT 3.9 Mix contribution estimates.

Books Packages Hats Mix

Per Unit Total Per Unit Total Per Unit Total Total

Low Mix 100 30 10

Revenue $80 $8,000 $140 $4,200 $50 $ 500 $12,700

Variable Cost $57 $5,700 $100 $3,000 $24 $ 240 $ 8,940

Contribution 71.3% 71.4% 48.0% 70.4%

Expected Mix 100 50 20

Revenue $80 $8,000 $140 $7,000 $50 $1,000 $16,000

Variable Cost $57 $5,700 $100 $5,000 $24 $ 480 $11,180

Contribution 71.3% 71.4% 48.0% 69.9%

High Mix 100 70 30

Revenue $80 $8,000 $140 $9,800 $50 $1,500 $19,300

Variable Cost $57 $5,700 $100 $7,000 $24 $ 720 $13,420

Contribution 71.3% 71.4% 48.0% 69.5%

Cost-Volume-Profit Analysis 115

Solving for x,

We find that you must do about $1.130 million in sales to be as well-off."

"Hmm. I'm not sure what this means. So how much of what do I have to

sell? That's what I want to know."

"What we do is take the total required sales of $1.130 million and split it

by your revenue mix percentages. Given your expected mix estimates, half of

your revenues will come from sales of books, or $564,315; seven-sixteenths

from packages, or $493,776; and the other one-sixteenth from sales of hats, or

$70,539. Dividing by the selling price of each item, we can also compute the

necessary unit sales levels—7,054 books, 3,527 packages, and 1,411 hats. With

our variable cost estimates, if you meet these targets we will indeed meet the

targeted profit level (see Exhibit 3.10). In summary, we were worried that our

9,100-book target was too optimistic because price cuts were possible. With

this mix we will have to sell 10,581 books—7,054 individually and 3,527 in

packages—but one-third of them will essentially sell for around $70. This

seems more realistic if the packages are marketed correctly."

"What does the sensitivity analysis tell us?"

"Since the contribution percentage for the package is about equal to an

individual book, this solution is not very sensitive to variation in mix. If you

do meet your 'optimistic' mix projection, your contribution percentage increases

by less than 1%—30.1% to 30.5% (see Exhibit 3.11). As a result your

( . %) $ ,

$ ,

. %

$ , ,

30 1 340 000

340 000

30 1

1 128 631

x

x

=

=

= (with no rounding)

EXHIBIT 3.10 Required unit revenues and sales volumes expected mix.

Books Packages Hats Mix

Per Unit Total Per Unit Total Per Unit Total Total

Expected mix 100 50 20

Revenue $80 $ 8,000 $140 $ 7,000 $50 $ 1,000 $ 16,000

Percentage of

total 50.00% 43.75% 6.25% 100.00%

CVP target $1,128,631

Mix % allocation $564,315 $493,776 $70,539 $1,128,631

Variable cost 71.3% 402,075 71.4% 352,697 48.0% 33,859

Contribution

margin $162,241 $141,079 $36,680 $ 340,000

Divide by unit

price to find

unit sales

needed Books 7,054 Packages 3,527 Hats 1,411

116 Understanding the Numbers

sales revenue target to meet your profitability goal will drop only a small

amount—from about $1.130 million ($340,000/30.1%) to $1.120 million

($340,000/30.5%). Basically, we would have to sell only 9,830 books with 41%

at discount. This would mean, though, that we would have to sell substantially

more packages. All in all, our answer is not that sensitive to the mix."

Abbey now asked Stephen if he wanted to partner with her.

METHODS OF COST BEHAVIOR ESTIMATION

CVP analysis is a rough, first-pass analytic technique. Businesspeople use it to

make some initial profitability estimates of potential opportunities and to cull

those that show the most promise. More in-depth analysis would then follow.6

The key to CVP analysis is correctly identifying the cost structure of the

business opportunity being analyzed. Without a proper knowledge of the cost

behaviors—identification of the fixed period costs and the variable costs per

unit or as a percentage of sales revenue—business planning cannot be done

properly. There are four methods used to analyze cost behavior. Three are analytic

approaches that require historical data, and the other is more judgmental.

Abbey's Web-site example discussed above is an example of the latter.

Since the business was not yet operating, there was no database to study.

Rather, the cost structure was estimated by analyzing the processes on which

Abbey's business would be based. The data came from discussions with process

partners such as the Web-site designer and the logistics company and from

Abbey's firsthand knowledge of the book business. This procedure depends on

correctly identifying all the necessary business processes and the experience

EXHIBIT 3.11 Mix sensitivity analysis optimistic mix.

Books Packages Hats Mix

Per Unit Total Per Unit Total Per Unit Total Total

Expected mix 100 70 30

Revenue $80 $ 8,000 $140 $ 9,800 $50 $ 1,500 $ 19,300

Percentage of

total 41.45% 50.78% 7.77% 100.00%

CVP target $1,115,986

Mix % allocation $462,585 $566,667 $86,735 $1,115,986

Variable cost 71.3% 329,592 71.4% 404,762 48.0% 41,633

Contribution

margin $132,993 $161,905 $45,102 $ 340,000

Divide by unit

price to find

unit sales

needed Books 5,782 Packages 4,048 Hats 1,735

Cost-Volume-Profit Analysis 117

and ability of those who provide accurate process cost estimates. Since

Abbey's business model was relatively simple and many of the processes were

outsourced to experienced third-party providers, the resulting cost structure

estimates are probably relatively accurate. Given a more complex business opportunity

that might require many internal process steps that are not yet well

understood, this methodology might not yield such accurate results.

The three analytic approaches are techniques used when historical data is

available. Unfortunately, many firms first develop this analysis after they have

begun operations—an inopportune time. For instance, now that the bloom is

off the Internet rose, there are many such firms scrambling to do this analysis

after the fact. Investors are withholding later-round financing until these firms

can develop the analysis we illustrated above.

Assume that Books "R" Us is one of those firms. Since it has not yet broken

even, its investors want to better understand the cost structure and when,

if ever, they can expect a return. The company has been in business for two

years and over the past 12 months has shifted from building infrastructure to

its primary focus, selling books.7 All agree that these past 12 months would be

a good basis on which to develop the analysis.8 The relevant data are given in

Exhibit 3.12.

There are many ways to analyze this data. They all assume the following

first-order cost equation:

The first of the three databased techniques is simply to plot the data in an x-y

coordinate system with costs on the y-axis and sales revenues on the x-axis. It

Total Cost Variable Cost Fixed Cost

(Variable Cost Percentage Sales Revenue) Fixed Cost

= +

= × +

EXHIBIT 3.12 Books "R" Us data.

Revenue Total Costs Profit

$(000) $(000) $(000)

January $ 12,250 $ 13,500 $ (1,250)

February 14,500 16,000 (1,500)

March 15,000 16,500 (1,500)

April 16,250 17,250 (1,000)

May 15,250 16,500 (1,250)

June 13,750 15,500 (1,750)

July 11,500 13,000 (1,500)

August 17,500 18,250 (750)

September 23,750 25,000 (1,250)

October 15,500 16,500 (1,000)

November 16,000 17,250 (1,250)

December 22,500 22,000 500

Total $193,750 $207,250 $(13,500)

118 Understanding the Numbers

is called visual fit because one simply draws a straight line through the data

that "best fits" the pattern (see Exhibit 3.13). The point where this line intersects

the y-axis yields an estimate of the fixed cost component—those costs

that exist even without any sales activity. The slope of the line drawn is defined

mathematically as: rise over run or change in y-axis values divided by the

change in x-axis values. Using business rather than mathematical terminology,

how much the total costs change (the y-axis or rise) as the sales volume changes

(the x-axis or run). As was discussed above, this is simply the variable cost expressed

as a percentage of sales. For the Books "R" Us example, given the line

I've drawn subjectively, the result would be:

With today's computer software, this method is easy and time efficient. Unfortunately,

it lacks verifiability. If 20 people were to analyze this same data set,

you could end up with twenty different cost structure estimates.

The second method is called high-low analysis. It also is time efficient

and has the added advantage of verifiability. Since it is rule based, all twenty

people in this case would arrive at the same estimate. It has four steps:

1. On the x-axis, identify the high and the low points of the data set.

2. Identify the historical costs for each of those points.

3. Assume a straight line through these two points and calculate the variable

cost component using the traditional slope equation:

4. For either the high or the low set of data points, plug the values into the

cost equation and solve for the fixed cost component.

Slope

Change in - xis Values

Change in - xis Values

= y A

x A

Fixed Cost Estimate: line crosses -axis at about million dollars

Variable Cost Percentage of Sales Estimate Slope: about 85.2%9

y $4

=

EXHIBIT 3.13 Books "R" Us scatter plot.

0 5,000 10,000 15,000 20,000 25,000

Revenue ($)

Total Cost ($)

0

5,000

10,000

15,000

20,000

25,000

30,000

Cost-Volume-Profit Analysis 119

For the example and data set in Exhibit 3.12, the steps would be as

follows:

1. High and low points = September sales or $23.75 million and July sales of

$11.5 million.

2. Historical costs for each point = $25,000 (September) and $13,000 (July).

3. Slope = Rise/Run = ($25,000 13,000)/($23,750 $11,500) = 98%.

4. Fixed component: Total Cost = Variable Cost + Fixed Cost.

For high data points:

For low data points:

This method has two weaknesses. First, the high and low data points chosen

are assumed to ref lect the pattern of all data points. Often, however, either or

both of these points may not be such, and the analysis is f lawed.10 The second

weakness is an extension of the first. We had 12 data points but chose to analyze

only two of them, ignoring the other 10. This method is data inefficient; if

you have 12 data points, all 12 should be considered for the analysis.

The third databased technique is called regression analysis. Here a function

is fit through all data points in a manner that minimizes the total squared

error between each data point and the fitted line. The mathematics underlying

this technique are beyond the scope of this chapter, but the method is widely

used and preferred when the data set has problems such as a stepped fixed cost

or variable costs based on multiple factors. All spreadsheet software packages

have a function that performs simple regression analysis.11 Exhibit 3.14 is an

example of what the output would look like for a least-squares regression analysis

using Excel. The estimate for the fixed cost is $2.73 million, and the variable

cost is 90% per sales dollar. The adjusted R2 of 98% means that 98% of

the variance of the Total Cost data is explained by this equation. The drawback

of this analysis is that it is not intuitive. One must trust the output from the statistical

package. If the user does not understand the statistical technique and

the assumptions of the software package, the output is often f lawed.12 This approach

needs a sound grounding in statistical analysis.

In summary, for the data set being analyzed, the three databased techniques

yield results that vary considerably (see Exhibit 3.15). The key to

correctly using databased techniques, however, is not choosing the right technique

but beginning with a data set that truly ref lects the cost structure being

$ , %($ , )

$ , %($ , )

$ .

13 000 98 11 500

13 000 98 11 500

1 725

= +

= −

=

Fixed Cost

Fixed Cost

million (rounded)

$ , %($ , )

$ , %($ , )

$ .

25 000 98 23 750

25 000 98 23 750

1 725

= +

= −

=

Fixed Cost

Fixed Cost

million (rounded)

120 Understanding the Numbers

analyzed. To emphasize this, the cost function, Total Cost = (76%)Revenue

+ $5 million, was used to generate the data set in Exhibit 3.12. A randomized

error term was then added to these data estimates, they were rounded to the

nearest quarter million, and then the high and low data points, July and September,

were purposely changed. For instance, assume September was a very

busy month for Books " " Us because of the many college-student book orders.

This rush caused overtime and other disruptive cost behavior. Without

the analyst first adjusting the data point for this aberrant behavior, the results

are skewed. For databased techniques such as these, the adage "Garbage in,

garbage out" holds true. Before employing any of these techniques first ensure

that your data does truly ref lect the cost structure being studied.

R

EXHIBIT 3.14 Least-squares regression output (Books "R" Us data).

SUMMARY OUTPUT

Regression Statistics

Multiple R 99.1%

R square 98.2%

Adjusted

R square 98.0%

Standard

error 471.36

Observations 12

ANOVA

df SS MS F Significance F

Regression 1 119,835,495 119835495 539.363 4.956E-10

Residual 10 2,221,797 222179.69

Total 11 122,057,292

Coefficients

Intercept $2,733

X variable 1 90%

EXHIBIT 3.15 Databased cost structure estimates.

Variable Cost Fixed Cost

Percentage (in millions)

Visual fit 85 $4.0

High-low 98 1.725

Least squares 90 2.733

Cost-Volume-Profit Analysis 121

THE ROLE OF PRICING IN CVP ANALYSIS

CVP analysis is often erroneously used to set prices. The P in CVP does not

stand for "price"; it stands for "profit." A rule to remember: There is no such

thing as "cost-based pricing." Prices are market driven. If a firm finds itself in

a competitive market where competition among rivals is based on delivering

comparable value to customers at the lowest cost, the market sets the price. As

Adam Smith wrote centuries ago, only the most efficient firms will survive. To

use CVP analysis in this situation, one starts with estimates of the marketdriven

price and then calculates the profitability given probable unit demand

and the current cost structure. If the forecasted profit is not sufficient to satisfy

investors, one must then focus on reducing costs, not raising prices.

Incumbent firm behavior in the U.S. health care industry after deregulation

in the 1980s is a perfect example of incorrect use of this technique. New

entrants into the lower, more profitable segments of this industry—for example,

the walk-in clinics that have sprung up in metropolitan areas—gave patients

(and insurance providers) a lower-cost option than traditional hospitals

for minor health-care procedures. Large hospitals responded to this loss of segment

revenue by spreading their costs (mostly fixed) over their remaining

health-care offerings and raising prices. With those higher prices, the clinics

were able to offer lower-priced alternatives for more complex procedures.

With the loss of these revenues, the hospitals responded in the same manner.

This is called the "doom loop," and it led to the closing of many such institutions.

The proper move for the hospitals should have been to pare expenses on

the noncompetitive offerings.

For firms that compete by differentiating themselves from rivals by offering

additional value to customers at comparable cost, pricing should be based

on value to the customer, not cost. Microsoft certainly does not price its products

on the costs to develop and deliver them. Bill Gates long ago understood

the value of an industry-standard PC operating system and has priced Microsoft's

offerings accordingly. The key here, of course, is that the additional value

must exceed the costs to create it. CVP analysis in this situation is basically no

different than previous examples. Only here, one starts with estimates of the

value-based price and then calculates the profitability given probable unit demand

and the current cost structure. If the forecasted profit is not sufficient to

satisfy investors, one must then focus not simply on raising prices but on reducing

costs or increasing the willingness of consumers to pay more.

Predatory Pricing

In recent years a legal battle raged between two of the nation's largest tobacco

companies.13 The Brooke Group Inc. (previously known as Liggett Group Inc.)

accused Brown & Williamson Tobacco Corporation of predatory pricing in the

wholesale cigarette market. At trial in federal court the jury decided that

Brown & Williamson had indeed engaged in predatory pricing against Brooke.

122 Understanding the Numbers

The jury awarded damages of $150 million to be paid to Brooke by Brown &

Williamson. However, the presiding judge threw out this verdict. Brooke then

filed an appeal, and the case continued.

Predatory pricing cases are not unusual, and damage awards as large as

$150 million are not unheard of. Predatory pricing, as the name implies, is a

tactic where the predator company slashes prices in order to force its competitors

to follow suit. The purpose is to wage a price war and inf lict upon the

competition losses of such severity that they will be driven out of business.

After destroying the competition, the predator company will be free to raise

prices so that it can recover the losses it sustained in the price war and also

rake in profits that will greatly exceed normal earnings at the competitive

level. This final result is harmful to competition, and predatory pricing has

therefore been made unlawful.

To determine whether a firm has engaged in predatory pricing, the courts

need a test that will supply the correct answer. One of the usual tests is

whether there is a sustained pattern of pricing below average variable cost. If

the answer is yes, this indicates predatory pricing. Let us examine the logic underlying

this widely used test.

First, recall that contribution is the margin between selling price and

variable cost. Contribution goes toward paying fixed costs and providing a

profit. If price is less than variable cost, contribution is negative. In that case,

the firm cannot fully cover its fixed costs, and certainly it will suffer losses.

Therefore, it makes no sense for the firm to charge a price that is below variable

cost unless the firm is engaging in predatory pricing in order to destroy

competing firms. That is why pricing below variable cost is considered to be

consistent with predatory pricing.

We should bear in mind that the variable cost used in the test is that of

the alleged predator, not of the alleged victim. The reason is that the alleged

predator may be an efficient low-cost producer, whereas the alleged victim

may be an inefficient high-cost producer. Therefore, a price below the alleged

victim's variable cost may be above that of the alleged predator, in which case

it could be a legitimate price and simply a ref lection of the superior efficiency

of the alleged predator. The antitrust laws are designed to protect competition,

but not competitors (especially those competitors who are inefficient).

Of course, this is only one indicator of predatory pricing, and all of the

relevant evidence must be considered. There should also be a pattern of sustained

pricing below variable cost. Prices that are slashed only sporadically or

occasionally are probably legitimate business tactics, such as loss-leader pricing

to attract customers or clearance sales to get rid of obsolete goods.

Predatory pricing is an important topic and has been the subject of major

lawsuits in a wide variety of industries. Because it is a common test for predatory

pricing, variable cost is also a very important topic that all successful businesspeople

will benefit from thoroughly understanding.

Predatory pricing is usually thought of in a regional sense, or perhaps on a

national scale. But it can also occur on an international basis. In that case, it is

known as dumping.

Cost-Volume-Profit Analysis 123

Dumping

If a foreign company is the predator, there is no inherent difference in the tactics

or the goal of predatory pricing. Pricing below variable cost would still remain

a valid test. However, U.S. law imposes a stricter test on foreign than on

domestic companies. The legal test for dumping does not involve variable cost.

Rather, it focuses on whether the foreign company is selling its product here at

a price less than the price in its home market.

Dumping is simply predatory pricing by a foreign company. So the logic

that supported using variable cost as a test for predatory pricing would also

support using the same test for dumping. But the test actually used is the

domestic selling price (usually higher than variable cost). This test makes it

easier to prove dumping than to prove predatory pricing. It favors the domestic

firms and is harder on the foreign company. This may be a matter of politics as

well as one of economics.

Perhaps the best-known cases of dumping have involved the textile and

steel industries. Another recent case of dumping concerned Japanese auto

companies accused by U.S. competitors of dumping minivans in this country.

Also, the Japanese makers of f lat screens for laptop computers (active matrix

liquid crystal displays) were alleged to have sold their products in the United

States at prices below those in the home market.

It is not always easy to ascertain the home market selling price. Even if

there are list prices or catalog prices in the home market, there may be discounts

or rebates that are difficult to detect. Therefore, instead of using the

home market selling price as the test, the production cost may be used instead.

This is reasonable, because the production cost is likely to be below the home

market selling price. Therefore a dumping price below production cost is virtually

certain to be also below the home market selling price. But production

cost includes both fixed and variable costs and is therefore above variable cost.

Also, it may be arguable as to what should be included in production cost. For

example, some may include interest expense on money borrowed to purchase

manufacturing material inventories. Others may believe that interest is not

part of production cost.

If it is determined that dumping has indeed taken place, then the U.S. International

Trade Commission (ITC) will impose an import duty on the foreign

product involved. This duty will be sufficiently high to boost the U.S. selling

price to the same level as the home market price.

Dumping has a large potential impact on businesses and industries in our

economy. By extension, production cost is also a subject that successful businesspeople

will find profitable to understand.

FOR FURTHER READING

Garrison, Ray, and Eric Noreen, Managerial Accounting, 8th ed. (New York: McGraw-

Hill, 1999).

Hilton, Ronald, Managerial Accounting, 4th ed. (New York: McGraw-Hill, 1998).

124 Understanding the Numbers

Horngren, Charles, Cost Accounting: A Managerial Emphasis, 9th ed. (Upper Saddle

River, NJ: Prentice-Hall, 1998).

Zimmerman, Jerold, Accounting for Decision Making and Control, 3rd ed. (New York:

McGraw-Hill, 1999).

NOTES

1. Mixed simply means that it has both a variable- and a fixed-cost component.

Mixed costs are very common—note your monthly phone bill or many car rental

contracts.

2. Economists argue that variable costs should not be represented by linear

functions, since economies and diseconomies of scale do exist. For instance, price

discounts are often given if one buys inputs such as paper for book printing in large

quantities. They are better represented by quadratic functions. Most agree, however,

that if we are analyzing a narrow enough range the assumption of linearity does not

lead to material error.

3. This can be expressed in an algebraic equation as follows. Since the indifference

point is where the two alternatives are equal:

Solving for x yields:

4. Defining the parameters of a "short-run" decision is often difficult. For this

special offer, if accepted, will PBS assume that this will be the price in the future?

Will other customers learn of this offer and expect the same terms? Short-run decisions

often have hidden long-run effects—they should always be scrutinized.

5. In this format, x represents required dollar sales volume, not required unit

sales volume.

6. ABC analysis, which is covered in the following chapter, is one such

technique.

7. When estimating cost structure from historical data the analyst must first

ascertain that the structure has not changed during the period being analyzed. If

Books " " Us made major additions to its infrastructure, it would make little sense to

aggregate the costs pre- and postaddition and consider them to be representative of a

single cost structure.

8. For this simple example we will assume that there are none of the seasonalities

in the fixed cost one would expect, say, for heating costs during the winter in New

England. Likewise, we will assume that the variable cost per dollar of revenue is the

same for all types of books.

R

$ $ ,

$ ,

$

,

11 100 000

100 000

11

9 091

x

x

=

=

= units

$12x = $23x $100,000

Cost-Volume-Profit Analysis 125

9. To compute the slope, find a point that the line intersects and then measure

the "rise-over-run" using the y-axis intercept and that point. For this calculation my

line intersected the June data at point ($13,500, $15,500) so my rise was $11,500

($4,000 to $15,500 in Total Cost) and my run was $13,500 ($0 to $13,500 in Revenue).

The slope, therefore, was $11,500/$13,500 or 85.2%.

10. To avoid this shortcoming, many analysts first plot the data and then select

high and low data points that "best fit" the data set. This technique is a melding of

the first two databased techniques discussed.

11. For instance, Excel has a function that will perform a simple least-squares

regression on a given data set. Other regression techniques that relax the linear fit assumption

are also available on many statistical software packages.

12. For instance, infrastructure may have been expanded over the period

the data set covers. The regression software will assume a constant fixed cost rather

than some type of step function unless otherwise told. This can be treated using

dummy variables, but the user needs to have a working knowledge of the statistical

technique.

13. The final two sections of this chapter were written by John Leslie Livingstone

for earlier editions of this book. They are reproduced here in their entirety.

126

4 ACTIVITY-BASED

COSTING

William C. Lawler

Dave Roger, CEO of Electronic Transaction Network (ETN/W), sat stunned

in his office. He had just come out of a preliminary third-round financing

meeting with potential investors. Six months ago his CFO had assured him that

third-round financing would not be a problem. Much had happened since that

date. The Internet stocks had crashed. Money for the technology sector was

now tight. In the two rounds before the crash, ETN/W had so many prospective

investors, the company had to turn some away. Since then their business

model had not changed; ETN/W had a solid revenue stream, and the forecast

was for continued revenue growth—unlike many of the recently failed Internet

companies, ETN/W had real customers who were happy with its services.

Yet the meeting had concluded without closure on the third round for one simple

reason. When Dave started talking about their "proven" business model the

potential investors immediately asked for specific details—"Explain your business

model in terms of how you will create wealth for us, your investors."

As he fumbled to explain how ETN/W would create shareholder wealth,

they stopped him and suggested an approach with which they were all

comfortable.

If you were a manufacturer we would expect you to tell us how you will use our

investment—some goes to infrastructure such as plant and equipment and some

to working capital such as inventory and receivables. You would then tell us how

much it would cost you to build your product, how much to market it, how much

to service it, and what customers would be willing to pay for it. Our first two

rounds of investment would have given you sufficient experience to gather this

type of data. With this information, you could explain your business model—

how you would create enough wealth to pay back our principal plus our required

Activity-Based Costing 127

return. Now, since you are a service provider rather than a manufacturer, explain

your business model in like terms. What infrastructure is necessary for

your business? What does it cost you to provide your service? How much does it

cost to market these services? What are customers willing to pay for it?

As he sat there now, Dave wondered if the analogy the investors had used

was appropriate. In a manufacturing environment these questions were more

easily answered than in a service company like ETN/W. Yet after two rounds of

investment and eighteen months in business he had fumbled the most important

question in the meeting. In his hand he had the business card of a consultant

suggested by his investors. They said this person had worked with a

number of their clients and could help him develop the appropriate analysis. As

much as he disliked being pushed by anyone to make decisions, he knew that 25

employees were counting on him. He lifted the phone to call Denise Pizzi.

PREPARING FOR DENISE

Denise was very professional on the phone. She was awaiting his call and suggested

that he prepare some documentation for their first meeting: a brief history

of the company, their customer value proposition (she called it CVP), a

blueprint of the value system for their industry, and their strategy—what was

it that ETN/W could offer clients that was distinct and value producing? Much

of this had already been prepared.

ETN/W History

Three MBA classmates with extensive experience in electronic commerce had

founded ETN/W in Dallas, Texas, 18 months ago. Two came from a Houston

computer giant—Carol Kelly from the hardware side and Eric Rock, a senior

software applications manager. The third, Dave Roger, came from a well-known

Dallas IT consultancy, a company focused on the Internet and e-commerce. The

idea had come from Dave. Many of his clients were in e-commerce, and all had

the same problem—transaction processing. Although most people think online

commerce is a relatively simple process—point and click—it is actually

quite complicated (see Exhibit 4.1). Assume customer A buys an item

at Books " " Us. When the order comes in, the company must first ascertain

A's creditworthiness. This means a credit check with a payment processor. If

credit is okay, then Books " " Us has to contact the book wholesaler it partners

with to see if the book is in stock (this is called fulfillment). If the answer is in

the affirmative, Books " " Us gives the wholesaler the appropriate shipping

information, gets the tracking information from the shipper, and contacts the

payment processor once more to charge customer A. Books " " Us then relays

this information to A. This all has to be done in real time. Customer A does not

want to wait and will quickly move to a competitor if not satisfied. In addition,

R

R

R

R

128 Understanding the Numbers

Books " " Us will update Customer A's buying profile (or open a new one) in

order to better serve that person in the future. Books " " Us's focus is on retail

sales and Web-site design; this is the key to its success. The transaction processing

is a necessary evil. In order to do this, Web merchants typically, purchase

three to four software systems—one each for credit and payment processing, inventory

management and fulfillment, tracking, and customer-information storage

and mining. All these systems must talk to one another, which means that

interfaces must be maintained. This interfacing is a nightmare because updates

for each of these software systems are constantly being brought to market, requiring

all interfaces to be rewritten. IT personnel in this area are highly valued,

and retention is a major issue, especially for the smaller Web merchants.

This nightmare blossomed into a business opportunity during a golf

match. Carol was complaining about a new assignment—setting up a server

farm.1 She was given the task of transforming her company from a provider of

"boxes" (servers) to a provider of the services embedded in the box. This

meant that her company had to get closer to customers, understand their computing

needs, and meet those needs with a bundle of services delivered by the

"server farm" she would be running. Basically this was a hardware outsourcing

service similar to an offering of one of Dave's sister divisions. Although he

understood the move, and although servers were becoming commodified and

margins were falling, he doubted that Carol could change the culture of her

company. Maintaining customer relationships was expensive, much like the required

maintenance on any hardware system; but unlike hardware maintenance

they also required a unique set of people skills.

On the next hole it was Dave's turn to complain about his customers and

how he had to hold their hands every time one of their transaction processing

systems needed updating—every day the same thing only a different customer

and a different software system. Eric laughed at this since he had much the

same problems within his software applications group. Yet all three realized

R

R

EXHIBIT 4.1 E-Commerce transaction detail.

Customer A #1

#2

#3

#4

#5

#6

Web-merchant

Fulfiller

Shipper

Credit company

Credit company

Summary from ETN/W

to Web-merchant

Update customer profile Batch

process

ETN/W

Real-time

Activity-Based Costing 129

that this was how software companies made their money. Once they captured a

customer with an installed software system, that client was treated as an annuity.

Every update required an additional payment to move each installed customer

to the new system. They all agreed that this would never change.

The golf round continued, as did the complaining about both work and

golf. It was not until later, over libations in the 19th Hole, that they realized

this could be a real opportunity. Dave was convinced that his customers would

be more than willing to outsource their transaction-processing headaches. If a

company could provide an integrated service that would perform all the tasks,

it would be a winner. A customer value proposition (CVP) that said, "All your

e-commerce transactions will be processed with the latest technology, and you

will never have to worry about a customer waiting, updating your interfaces, or

hiring and training another IT person," would be music to their ears. Eric insisted

that most application service providers (ASPs), much like Carol's hardware

company, were focused on selling their software packages, not on service.

They were not capable of providing such a service. Carol agreed with both

Eric and Dave—although she would try her hardest, her new assignment was

like pushing a boulder uphill. All systems inside her company were focused on

selling product; engineers designed the latest bells and whistles into their hardware

and avoided customer contact whenever possible. All commission systems

were based on dollar revenues; the top salespeople only sold what made them

money, high priced items. They were not interested in selling low-commission

service contracts.

Within a month the threesome was working almost full-time on developing

the business model. Carol was focused on designing the necessary hardware

infrastructure—N/T and UNIX servers, hubs and routers, firewalls, disk

arrays, frame relays, and the like—and identifying the staffing requirements.

Eric was researching the software offering for payment, fulfillment, tracking,

and storage and attempting to identify which systems would likely become industry

standards. Dave was running focus groups with a number of potential

customers, trying to refine the CVP—exactly what should they offer these Web

merchants?—and measure their willingness to pay.

The business plan came together rather quickly. As expected, Dave

found that customers would highly value the ability to focus all their attention

on their primary activity, Web-based marketing and selling, rather than

transaction processes and the hiring and training of people involved in these

processes. In addition, the avoidance of investment in this type of infrastructure

was important since capital was becoming scarce for many Web-based

merchants and obsolescence was always a problem. An additional value that

potential customers asked about involved the nature of the charge: Was it to

be a variable per-transaction charge or a fixed fee? For this type of business,

scalability was always a problem. No one knew what size system to build, but

to have a system crash due to excess demand was fatal. As a result, idle infrastructure

charges were always a problem. Many customers were ready to sign

on immediately if the charge was on a per-transaction basis.

130 Understanding the Numbers

Carol found that the infrastructure build-out would not be cheap. She estimated

that it would cost approximately $8 million in the startup mode and

require about a dozen people. She estimated that this would give them the capacity

to process about 120,000 transactions per day, which would be about 10

average-sized customers in a peak demand period such as Christmas or Valentines

Day.

Eric found that the software system would be cheaper. He also found

some additional interesting information. Many ASPs such as Yantra, Oracle,

and Cybersource offered to work with them in an alliance if they could advertise

their applications, say, like the "Intel inside" model in the PC industry. He

estimated that to build a totally integrated software platform would cost

around $600,000 to $800,000.

In this manner ETN/W (Electronic Transaction Network) was started.

Angel investors and alliance partners contributed $20 million, and the doors

were open for business 18 months ago. Within a year they had nine customers

and added another three in the following six months. Various pricing schemes

were tried, but ETN/W seemed to be gravitating toward a market-based,

purely per-transaction charge between $0.10 and $0.15. Although transaction

volume had not met the projected 120,000-per-day level, they were currently

in the process of identifying potential new customers.

ETN/W CVP

The group provided Denise the following from one of their marketing

brochures:

Web merchants should spend the majority of their time on their primary mission,

creating value through innovative marketing and sales to customers and

clients.2 You should avoid spending both scarce managerial talent and investor

capital on any activity that could best be performed by third-party partners

such as ETN/W. Do investors see the value in your using their investment dollars

and your creative energy to build transaction-processing systems that are

suboptimal in scale and soon obsolete? In you spending your scarce time to hire

and train high-cost personnel to manage and run these inefficient systems? The

answer is clearly no.

Join our network and get all these services seamlessly provided with stateof-

the-art applications run by highly trained IT professionals. We will convert a

difficult-to-manage fixed infrastructure cost into a totally scaleable variable

cost that you pay only on a per-transaction basis. With us as your partner, you

can spend your creative energies on tasks of value to your investors.

ETN/W Value System & Strategy

This part of preparing for their meeting with Denise was an interesting task for

the threesome, one that they had not previously performed. After referring to

some of their old MBA notes, they prepared the following:

Activity-Based Costing 131

Value System. ETN/ W is an intermediary providing services to the Web merchant

and its fulfillment, payment, and shipping partners. Although ETN/W

charges the merchant for the service, who ultimately pays for the service could

be left to negotiation amongst the parties (see Exhibit 4.2).

This exercise did open some interesting discussion regarding our narrowly

defined CVP. We recalled Metcalf 's Law: The value of a network is equal to the

square of the number of nodes. Clearly, as our network expands, fulfillers such

as Ingram, a $2 billion wholesaler of books, PCs, and home electronics, would

see value in joining because it could provide fulfillment services to a number of

the network's Web merchants. Likewise, UPS and FedEx would want to join

ETN/ W to offer their services if there was enough commerce going over the

network. We did not have time to fully develop this thought, but discussion of

an expanded scope for our CVP and potential pricing schemes is on the agenda

for an upcoming meeting. This process might really be worth your fee.

Strategy. ETN/W will be the global cost leader in transaction processing for ecommerce

providers. Exactly what is it that ETN/W offers that others cannot

copy? A sustainable strategy is based on doing things differently or doing different

things, not simply doing the same thing as other competitors only better.

As noted above, it would be difficult for any of the hardware companies and

ASPs to copy our model, since their culture and internal systems are so geared

to selling hardware or software rather than servicing customers. Hewlett

Packard coined the term solution provider almost thirty years ago but still

struggles in making the requisite transition. We all feel that ETN/W can successfully

compete with hardware providers and ASPs. The problem is the low

barriers to entry: If all it takes is building an infrastructure with hardware and

software technology that are readily available, what is to stop others from imitating

our model? The only advantage we see is to be the first mover; once

someone joins our network, why join another? We understand the urgency of

building the network as quickly as possible to be recognized as the industry

standard for transaction processing.

EXHIBIT 4.2 ETN/W value system.

Customer ETN/W

Visa, AmExp,

MasterCard

Fulfiller

FedEx,

UPS

Transaction flow

Physical flow

Webmerchant

132 Understanding the Numbers

THE FIRST MEETING

Denise was very happy with the work they had done. She had reviewed the materials

and asked a few questions. Within an hour all felt comfortable that she

understood ETN/W in sufficient detail to aid them in preparing an answer for

the investment group. They then turned to this phase of the meeting.

Denise began.

The value system analysis you did is a map at an aggregate level of the many

firm-level value chains that together form this industry. It identifies all the

processes that create value for an end customer or set of end customers and

maps all the players and who adds what to the system. Our focus is on ETN/W,

but we cannot lose sight of how it interacts with other members of the system.

The next step is to add another layer of detail—what are the process steps that

ETN/ W performs, and do their values exceed the costs to perform them?

Dave, Carol, and Eric did not understand what she meant and asked for

clarification.

"Simply stated," Denise replied, "what is it that you do? Map the valueproducing

processes you add to the system."

Carol was quick to answer: "We already told you—we process e-commerce

transactions."

"Okay. So that is all you do? If I were to talk to any number of your people

spread throughout this building, they would say, 'I process transactions'?"

Dave jumped in this time: "Well, not really. While most of us are involved

in this in some form, we also have marketing and sales people."

"What do they do?"

This dialog went on for another hour, with Denise at a blackboard capturing

their discussion. After many edits the group arrived at the following. The

process map for ETN/W had three sequential steps:

1. Customer Capture.

2. Customer Loading onto the network.

3. Transaction Processing.

Denise then stated:

The next phase of this analysis is critical. Although most accounting systems

capture costs by function—for example, manufacturing costs such as direct material,

labor, and overhead and operating costs such as sales, marketing, R&D,

and administrative—we can understand and forecast them only if we identify

their causes. This analysis is called activity-based costing, or ABC. Not everyone

believes the cost of ABC is worth the benefit, but higher cost is, I believe,

more often due to how it is implemented rather than to the approach itself. Too

many firms have limited it to manufacturing situations, yet it is appropriate also

for service companies such as yours. ABC is also often too narrowly applied—

some now argue that ABC begins too late and ends too soon in many companies.

We have to analyze costs across the value system since causal factors for one

Activity-Based Costing 133

company's costs often are found within another company in the value system.

Although this may sound confusing, I will of course show you examples as we

analyze your costs.

Let's start with what I think will be the easiest process—customer capture.

Exactly what activities do you perform that result in a capture, which we

defined as a signed contract?

Again, the discussion went on for at least an hour. Denise nearly drove the

group crazy asking the most basic questions, "Why?" and "How?" By the end,

all three agreed that the first activity was customer identification. This was

accomplished either through cards filled out at trade shows or responses from

their advertising campaign. The next activity was customer qualification,

which entailed basic research on these companies to identify those with

enough size and creditworthiness to pursue. And the final one was customer

sale, where an inside salesperson first made contact with each customer to see

if there still was interest. Few were ready to sign contracts at this point, and

often multiple site visits were necessary before contracts were signed to assure

the customer that ETN/W understood their business.

Denise then gave them a template to be filled in for the next meeting (see

Exhibit 4.3).

What you have to do is reformat the way your costs are compiled. For external

reporting your financial statements are sufficient, but for decision making and

communicating your business model they are worthless. As I have drawn in the

template, we need to build the total costs for each activity we identified above.

To do this, some of my past clients estimated as best they could from historical

data, and others, if they perform the activity frequently enough, develop the

EXHIBIT 4.3 Activity-based costing process.

General Ledger Cost Format ABC Cost Format

Customer identification

Customer qualification

Customer sale

Activity n

Corporate costs

Labor costs

Marketing costs

Outside consultants

Sales costs

Travel costs

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

$XXX

134 Understanding the Numbers

activity costs by studying their processes real time. I suggest you recreate from

past data as best you can what you spent to capture the clients you already have

on your system, since you're currently selling to only a few—a sample size too

small to study real time. A detailed discussion with all those involved with the

process typically is sufficient to develop a crude analysis. I can meet next

week—Okay?

THE SECOND MEETING

Dave, Carol, and Eric did a lot of work that week. After many false starts they

agreed to use the financial statement data from the past 12 months for the

analysis. Discussions with a number of their employees resulted in some interesting

analyses. Although unsure of a few of their assumptions, they walked in

with deeper insight into customer identification, qualification, and sale.

The activities we initially agreed upon needed some refinement. The first, customer

identification, was correct. There are actually three subactivities, trade

show attendance, trade show preparation, and advertising, which lead to an

identified customer. These activities are not mutually exclusive; often people

respond to the advertising after seeing us at a trade show, or, vise versa, they

come to our booth because they remember one of our advertising pieces. Using

your template, we arrived at some interesting results. First, you were correct,

customer identification does draw on many resources within the company. People

from across ENT/ W attend the trade shows: our sales and marketing people

as you would expect; our corporate officers, who typically talk with the top

management of potential customers; and our operations people, who demonstrate

the system and answer the technical questions. In addition, for each show

there is quite a bit of preparation: Collateral materials such as brochures have

to be produced, booths have to be designed and built, and site contracts negotiated.

Aside from the trade shows, we also spend a large amount on advertising

in trade journals. In the last 12 months, we spent approximately $875,000 on

these three subactivities, which resulted in 1,200 customer leads (potential customers).

We arrived at this number by talking with just about everybody in the

organization, checking travel itineraries, expense reports, ad agency vouchers,

and the like. It's not an exact number, so we decided to round all our numbers

to the nearest $5,000; but we think it's close. This comes out to about $730 per

lead ($875,000/1,200, rounded). We think this is a reasonable number given

some industry benchmarks. Is that OKAY?

Denise was excited; these could be good clients. "Yes, ABC analysis does

sacrifice some accuracy for relevance. So, when you divided by the 1,200, you

implicitly assumed that each of these leads were the same. Is this true?"

Dave answered since he had done most of this analysis. "Yes, each lead is

about the same. When people show interest, either at a show or from answering

an ad, we do about the same thing: talk with them, take down their information,

and pass it on to the next step."

Denise thought it was now time to do a little process review. "Good, you

have just concluded your first activity-based cost analysis. Let me review the

Activity-Based Costing 135

steps. First, we drilled down from a high-level value system view to a process

map and then ultimately into an activity and subactivity analysis. I have only

one question: After identifying subactivities, why did you pool the costs together;

why not analyze them separately?"

"We initially did it separately but then found that there was no additional

value to this added work. Ultimately, we were concerned with what it cost us to

generate a lead, and, since we found that the subactivities were not mutually

exclusive, we think the $730 number is sufficient," Dave replied.

Let that be you first lesson. ABC involves pooling costs from various functions

within the company into homogeneous activity pools, as you have just done. The

$875,000 ref lects your best estimate of the total customer identification cost

pool for the last 12 months. ABC analysis is often done at too fine a level of detail.

You could have tried to identify the cost of identifying each customer by

having your people keep a log and entering the exact time they spent with each

customer—in essence, 1,200 cost pools. Would this additional level of accuracy

be worth the effort? Certainly not. The first key to ABC is to find the correct

level of disaggregation of cost information: too little and the system does not

provide relevant information; too much and the system becomes too complex

and hard to communicate. I once saw a system installed by a consulting group

with over 6,000 cost pools. No one understood it but the consultants that designed

it, and when they left no one was able to explain the information from it

or update it. It died in less than six months. Okay, what was your next step?

Carol had done the customer qualification analysis. "This was an easy

one. We outsource this function to a credit agency that gives us a report on

each lead—credit history, sales history, and any other relevant information. We

paid them about $210,000 for the 1,200 reports—about $175 per report, which

is about the contract rate."

Denise thought, "Can I do one more lesson without overreaching? Why

not try?"

Note the difference between these two cost pools. This pool is very much a

variable cost—the more customer reports, the greater the total cost pool. And

the manner in which we apply the total costs to the object we wish to cost—a

customer cost report—is obvious—the number of cost reports, since each is the

same. ABC is a two-step process. First we identify the appropriate level of disaggregation—

that is, the cost pools—and then we identify the appropriate "driver"

for each pool. A driver is the method we use to take the total cost pool and

trace it to the object we wish to cost. It's the causal factor for the cost pool. For

customer qualification, the total pool of $210,000 was spread over its causal factor,

the 1,200 cost reports, to arrive at the $175 per cost report. This is what it

costs to qualify a customer, the cost object. ABC is nothing more than pools and

drivers. Are you totally comfortable with our first two analyses?"

Dave answered: "We did argue about this. Now I think we are beginning

to understand. The first activity we discussed, customer identification, is more

a fixed cost pool—it doesn't vary with the number of customer leads. Once we

agree on how many trade shows we will present at and what our budget is with

the ad agency, this cost is relatively fixed. Maybe one person more or less might

136 Understanding the Numbers

travel to the show, but the cost is budgeted. As a result, the cost per lead decreases

as we become more successful in generating leads. We have already

talked about ways of being more effective in this regard."

"Exactly," said Denise. "We will no doubt go more deeply into proper

identification of drivers for fixed and variable cost pools. What you should understand,

though, is that ABC is just a first stage in a long journey. Most people,

as you did, move quickly into ABM—activity-based management. Once you

make your cost system transparent, you then naturally seek to optimize it as

you are doing with customer identification. So, our end objective of this 'long

journey' is simply that, transparency of the cost system. And the final piece?"

Eric had this one.

This was my responsibility and it was a lot more difficult than Carol's piece.

The final activity, customer sale, also has subactivities. We review the consultant

reports and identify those we want to pursue. Of the 1,200, we identified

eighty as "high potential" and tried to sell to them. Although all the effort did

not fall neatly into the 12-month window, essentially we went through the full

process to a signed contract for the equivalent of 10 customers. The process included

phone conversations and site visits. In total, we spent $410,000 to bring

to contract these 10—many of the others went through part of the process before

either they or we lost interest. As with the other two activities, the costs

that loaded into this pool came from across the company. Often we had to f ly

out technicians to explain how the system works as well as salespeople. For

larger clients, they expected a visit from a corporate officer for the formal signing.

So in the end it cost us about $41,000 each to sign them to contracts."

Denise asked only one question: "Would you say this is a variable- or a

fixed-cost pool?"

After a lengthy discussion, the consensus was that it clearly was both a variable

and a fixed cost since more high-potential leads meant more resources dedicated

to pursuing them. But it was not a pure variable cost since once you hire

someone to do this work, they can handle a certain number of leads rather than

just one. At the end, they agreed on the following: Unlike setting a budget for a

year, this cost was a step function. Within certain steps, defined as the number

of high potentials a sales person could pursue—say, eight at a time—the cost was

fixed. In essence, the cost was step fixed in units of eight. They also agreed that

this thinking should also be applied to the customer-identification cost analysis,

but left that for later.

Denise then asked, "Is the $41,000 roughly the same for each potential

customer sale?"

Eric was quick to respond, "Absolutely not. Some require a lot more work

than others."

They were at the end of the agreed meeting time but Denise thought one

more lesson would not hurt.

When this happens, it is an indication that you have improperly identified the

driver for the pool. You must drill down to a more detailed driver definition. As

Activity-Based Costing 137

we discussed last meeting, on one hand, you could keep an individual log on each

customer to identify the cost to sell them, but this would be time-consuming and

few people take the time to accurately enter this information. On the other

hand, you could aggregate the cost and average it over the 10 customers sold. But

it seems that this is also not appropriate. A reasonable midpoint is to identify a

separate driver defined as your best-case and worst-case customer and see if this

gives you the required amount of detail. Why don't you do that for next time and

also develop a summary of the total cost to capture a customer.

THE THIRD MEETING

Denise watched as the group approached the room. They were arguing something

in a manner that indicated they were enjoying themselves. This was a

good sign.

Dave began:

It's amazing to us as an organization how much we didn't know we knew about

our business. When we relayed your first assignment for this meeting to those

that work with potential customers, they immediately began identifying characteristics

that made some more expensive to sell than others. Large ones expect

to meet our management team before signing a contract, whereas smaller ones

do not. Flying one of us to these customers is expensive given our larger salaries

and what it takes to backfill in our absence. Also, customers who do not really

understand e-commerce and the complexity of transaction processing require

on average twice as many trips as those who do. They want us to demonstrate

what is wrong with their systems and to see how ours works better. Since we are

not familiar with their systems, this takes a while. For the selling process, the

best-case customer is a midsized company familiar with e-commerce and the

headaches caused by transaction processing. We can sell them on the first trip.

Unfortunately, of the 10 we signed to a contract in our sample, only 3 were of

this type. The other 7 were worst-case customers—larger with less knowledge

of the intricacies of e-commerce. In summary, when we trace the $410,000

using these driver definitions we estimate that the best-case customers cost

about $18,300 each and the worst-case about $50,700 ($18,300 × 3 + $50,700 ×

7 $410,000). What amazed us is that, once we asked these questions, our people

had a number of good suggestions on how to reengineer this process. They

knew these worst-case people were a problem, but never saw how much more

they cost. Transparency does help.

The answer to your second assignment, to calculate the total cost to capture

a customer, is also amazing. This customer capture process is like a funnel.

Last time we said that the activity cost per lead of $730 was reasonable, as was

the $175 for each research report. But when you recognize that the process

ended with only 10 signed contracts, you get a different picture. The overall

process cost us a total of $1.495 million ($875 for identification, $210 for qualification,

and $410 for selling) or about $150,000 per signed contract ($1.495/10,

rounded)—quite a bit less for best case and a bit more for worst case. Some of

these costs are variable, some fixed, and some step fixed, but all of them can be

138 Understanding the Numbers

better managed. Although our accountant classified these costs as expenses,

they are really an investment, and, at this amount, we would have to do a lot of

transactions just to recoup our investment in each customer. The key for us is to

identify better-qualified customers in the first stage and then to convert a

greater number of these to signed contracts.

Denise had only one question: "Why did you charge the costs of the 70

customers you failed to convert to the 10 that you sold?"

Dave answered, "Actually, initially we broke out the cost of the 70, but we

felt that, as with any business process, you spoil some units in order to get good

ones (see Exhibit 4.4). It really cost us only about $8,000 to sell each best-case

customer and almost three times that for the worst-case one. But when you allocated

the cost of the 70 customers dropped during the process, these costs

increase dramatically. Don't you agree?"

The depth of the analysis impressed Denise. She thought she might even

invest in this company. It was time for another summary.

There is no right answer, since we could argue over the correct way to allocate

the dropped-customer costs. But that is not what is important here. You have to

be careful with any reallocation procedure since this is a strategic analysis. You

have already noted that your only advantage was being first to enter. By your actions,

I am not sure you know what that means. Since all of your technology

comes from third-party suppliers, the only way you will win in this industry is

to become the low-cost provider. Your first-mover advantage means simply that

you are first down the experience curve. Research has shown that as one repeats

an activity, one can become more efficient and thus lower the cost of the

activity. This, however, does not happen automatically; one must manage the

learning process. Until we began the ABC analysis it seems that you had not

leveraged your first-mover advantage. Do you agree? Remember saying, "As an

organization, we were amazed at how much we didn't know we knew"?

None of the three were willing to argue with her.

The key number in your exhibit is the $8,000 cost to sell a best-case customer. If

you were able to identify only those that understood your CVP and wanted to

EXHIBIT 4.4 Customer-sale activity analysis.

Best-Case Worst-Case Dropped Total

Number of customers 3 7 70 80

Estimated cost pool $24,000 $154,000 $ 232,000 $410,000

Cost /customer $ 8,000 $ 22,000 N/A N/A

Reallocation* $31,000 $201,000 $(232,000)

Adjusted cost pool $55,000 $355,000 — $410,000

Full cost /customer $18,300 $ 50,700

* Dropped Cost total was allocated based on relative total cost /customer ratios:

3

8 000

7

22 000

24 000

154 000

31 000

201 000

× × = ≅ $ ,

$ ,

$ ,

$ ,

$ ,

$ ,

Activity-Based Costing 139

buy, this would be the cost, not the average of $41,000 or the higher one for

worst-case. Are you getting better? Is your cost of this activity decreasing? The

research from the Chasm Group seems relevant here.3 They found that newtechnology

buyers over the product life cycle fall into four segments. Each responds

to a different CVP and requires a different selling approach. The first

product life-cycle segment, called early adopters, is the smallest but the most

important. They seek new technology, are risk takers, and are probably much

like your three best-case customers. This customer group is important because

you can use their results as validation of your new offering. The later life-cycle

segments are larger, less technologically savvy, and more risk averse. They are

skeptics and need to see validation before they buy. If you studied your seven

worst-case data points they probably fall into this segment. If you learn to use

the experiences of your first customers to sell to these more risk-averse segments,

your cost should approach the $8,000, and you would have a true firstmover

advantage.

Denise didn't like to further dampen their spirits but knew she had to.

"We haven't finished yet. Don't forget you also have to load the customers on

the network. What does this process cost?"

After a collective groan, the group got to work. The customer loading

process involves the activities necessary to enter a Web merchant and its fulfiller(

s) onto the ETN/W network. Although the activities are much different

than for customer capture, the analysis is similar. The activities in this process

are customer business operations review, system design, and implementation

and certification. Over the past 12 months seven customers had been loaded.

The analysis was a bit easier since there was no funnel effect; seven went

through each activity.4

Business operations review was outsourced to a number of subcontractors

that ETN/W used. Their report detailed the customer's IT systems and how

transactions were treated. While most handled them real time, some batched

the orders and dealt with these at the end of the business day, sending confirmation

to customers on the next business day. For the seven customers loaded,

ETN/W paid $25,000, or about $3,600 each. System design—writing the necessary

software interfaces and configuring hardware linkages for the payment

processing, fulfillment, and shipping systems—was done by ETN/W technical

staff, as was implementation and certification. System design cost $35,000, and

implementation and design, $160,000. Both the business operations review and

system design activities were relatively homogeneous—they did not vary from

customer to customer. The final activity, however, implementation and certification,

was much like the customer sale activity. Depending upon the customer,

the cost could vary greatly. From discussions with those involved with these activities,

the threesome recognized this variability and did the necessary analysis.

A best-case customer was one that understood the process, had compiled

the necessary documentation, had their IT group prepared, and had only one or

two fulfillers. As before, the worst-case was unprepared, unresponsive, and had

numerous fulfillment agreements. Of the seven studied, three fell in the former

140 Understanding the Numbers

group and four in the latter with the following result: best-case cost to load onto

network approximately $13,000, and worst-case a bit, under $30,000 ($13,000 ×

3 + $30,000 × 4 $160,000). Dave reported that this result necessitated

adding a penalty clause to their standard contract to emphasize the importance

of the customer prework for the implementation team.

Denise thought there was time for a quick summary. She went to the

board and drew the following chart (see Exhibit 4.5). "As I see it there is a lot

of room for improvement. Granted, you will never reach the ideal cost of

$30,500, which is the total of the activity costs to capture and load a customer.

But the transparency you now have given these activities means that, as an organization,

you should make steady progress down the experience curve. Next

time, let's tackle transaction processing."

TRANSACTION PROCESSING—MEETING 1

Since Carol was the hardware guru, she had taken the lead in this analysis.

Our transaction-processing system has three front-end N/T systems that do the

order entry, transaction-processing, and fulfillment inventory management.

They sit on a UNIX backbone system that also runs the database. It made little

sense to go back and compile the costs for these systems over the past 12

months, since we were expanding them continually. What we did was take the

costs of the system for the last month and annualize it. The costs fall into two

groupings—people and system depreciation.

I have one systems manager and three shifts of two people—don't forget,

we do provide service on a 365-by-24-by-7 basis. One person monitors the system

and troubleshoots any transaction-related problems, and the other handles

all hardware-related problems. Fully loaded, these seven people cost us approximately

$750,000 per year.

Ideally, we would have cost the N/ T systems independently of the UNIX

backbone. We didn't have that fine a separation of costs in this area, however,

and we ultimately grouped all of them together. Since the UNIX system

EXHIBIT 4.5 Customer-capture and customer-loading

cost summary.

Activity Average Cost Ideal Cost

Customer identification $ 87,500 [$875,000/10] $00,730

Customer qualification 21,000 [$210,000/10] 175

Customer sale 41,000 [$410,000/10] 8,000

Business process review 3,600 [$ 25,000/7] 3,600

System design 5,000 [$ 35,000/7] 5,000

Implementation & certification 23,000 [$160,000/7] 13,000

Total (rounded) $181,000 $30,500

Activity-Based Costing 141

represents the large majority of the cost, this probably doesn't cause us any

material error. In total we estimate that at the current level our systems cost us

about $1.35 million a year in depreciation of hardware and amortization of

software. We are writing off the technology over a three-year life, which is

reasonable. So we estimate that it will cost us in total about $2.1 million a year

($1.35 million in systems and 0.75 million in personnel) at our current level of

operations. This pool is a fixed pool since both the people and systems costs

are independent of volume—our people now are nowhere near capacity but

you can't hire a half-person.

The driver for this cost pool is clearly the number of transactions

processed, but arriving at the proper measure was difficult. For the order-entry

and payment-processing systems a transaction is measured at the order level.

But for the fulfillment and database systems, transactions are dependent on the

line items in the order. Once that was understood we found that we were currently

handling about 20,000 transactions per day on average, which annualizes

to about 7.3 million per year (20,000 × 365). Dividing this total into the cost to

run the system—people and systems—we estimate that it costs us just under

$0.30 for each transaction that is processed by our system ([$750 + 1,350]/7,300

$0.29). This cost is far above our target price of between $0.10 and $0.15 per

transaction.

"How do you plan to become more competitive?" Denise asked.

"We were hoping you could help us," was the answer.

Denise had a number of questions. "Okay, first, a lesson. Driver identification

is different for variable- and fixed-cost pools. For variable pools, drivers

are usage based—for ETN/W, the customer-qualification cost pool driver was

the number of reports outsourced; for materials cost pools in car manufacturing,

it is cars produced; and for fuel cost pools in freight hauling, it is miles driven.

But for fixed-cost pools, the causal factor is capacity, not usage—the $2.1

million gives you the capacity to handle a given number of transactions; the

number that you do deal with is not meaningful other than as an indication of

the capacity utilized. And when we talk about capacity, we have to be aware of

the distinction between used and useful. You said that you are processing about

20,000 transactions per day. Is every day the same?

"Absolutely not," Dave shot back. "Christmas and special holidays such as

Mother's Day are our busy time."

Denise then asked Carol, "How does this impact your area?"

Carol thought she understood. "When I planned the system, I had to use

our peak demand forecasts as the long-run target for the capacity. Unfortunately,

just as you can't build an apartment complex apartment by apartment to

meet demand, you cannot build a system such as ours in small increments.

Right now our system is larger than what is needed, and it is built to meet a

projected peak demand, not today's average demand."

Denise asked, "Do you have that data?"

"No, but I can get it within the week. Why don't you let us build this into

our model, and we will have a "version 2.0" transaction processing cost for you

next week?"

142 Understanding the Numbers

Denise said she could meet then and added one more piece of advice.

"When you do your cost estimates, do them from the customer's viewpoint.

Assume that your system is fully transparent to your customer and that they

must see the value of anything you charge to them."

TRANSACTION PROCESSING—MEETING 2

The group started by explaining their transaction-processing chart (see Exhibit

4.6).

"Right now," said Carol, "the data discussed last time, 20,000 transactions

per day on average, is correct, but our current peak demand is closer to 80,000.

Our system today can process close to 120,000 transactions per day, so we do

have excess capacity because of the cost of acquiring technology in certain

sizes. Likewise, the 80,000 peak demand represents about 50% of the capacity

of our personnel because of the decision we made in hiring and training the six

people in anticipation of future demand. As we said last week, using part-time

people may have been cheaper in the short run, but we decided to fully staff

for the future.

"So, we have developed the following analysis (see Exhibit 4.7). For the

personnel costs, we took 50% of them and charged it to an idle-capacity account.

Clearly, the other $375,000 is, to our customers, value added.

"Likewise, we have some idle capacity in our hardware and software systems.

From a customer point of view, we feel that the amount they should see

as value added is our peak capacity of 80,000. Although they only average

20,000 transactions per day, when they have their peaks they need us to be

ready, so this is value added and not excess. Only 40,000 currently is idle

(120,000 capacity less the 80,000 peak). This means that $450,000 of the systems

costs ($1.35 million × [40,000/120,000]) is not adding value to our current

customers. So we feel that currently about $825,000 ($375,000 personnel and

$450,000 systems) is idle and not chargeable to our customers. The other

EXHIBIT 4.6 Transaction-processing volume.

Time

Average per day

20,000 transactions

Peak demand per day

80,000 transactions

System capacity per day

120,000 transactions

Activity-Based Costing 143

$1.275 million ($375,000 in personnel and $900,000 in systems) is of value to

our customers, and they should be willing to pay for this. Unfortunately, if we

charge these costs to the current annual level of transactions, 7.2 million, we

arrive at a cost per transaction of about $0.175 ($1.275 million/7.2 million

transactions). Our research shows that the maximum we can charge is $0.15.

The peak demand problem is killing us."

Denise agreed. "Your work is well thought out and your results seem

correct. Your problem is a classic one for all systems operators. Electric utilities

have studied this peak load problem for decades and have developed

demand-management solutions such as off-peak discounts. Can you do anything

like this?"

Dave answered this one. "Some of our current customers do not need

their transactions dealt with on a real-time basis. They send us their orders at

end of day in batches, and we treat them by the next business day. I'm sure that

others would do this if given some type of incentive."

Denise asserted that this could be the key to their profitability. "If you

were able to decrease the peak demands, your costs per transactions would decrease.

In the extreme, assume that there was no peak loads and the 80,000 was

utilized every day. Your analysis shows that when your $1.275 million system

costs are spread over useful capacity of 29.2 transactions per year, this results

in an ideal systems cost under $0.05 per transaction."

Eric then summarized: "This would mean that if we could sell it for

$0.15, we could be very profitable. And given the growth rate forecasts for

e-commerce, we could get rich."

Denise then tied it all together. "Let's see. Assume that with some management

focus, you could get your costs to acquire and load a customer onto

your network down to about, say, $35,000. If you make a nickel profit on a

transaction, you would need 700,000 transactions to recoup your investment.

Given that your average customer now does about 3,000 transactions per day

(average demand of 20,000 per day/7 customers current on network), this

means that you cover your investment in about 240 days (700,000/3,000) or

eight months. After that, it's pure profit. For larger customers, this payback

happens sooner, meaning you become profitable more quickly."

EXHIBIT 4.7 Transaction-processing cost summary.

Value Add Idle Value Add

Portion Portion Total Portion

Personnel $0,375,000 $375,000 $0,750,000 $0.051 [$375/7,300]

H/ W & S/W 900,000 450,000 1,350,000 0.123 [$900/7,300]

$1,275,000 $825,000 $2,100,000 $0.174 [$1,275/7,300]

System usage 20,000 × 365 days 7,300,000 transactions/day

Useful capacity 80,000 × 365 days 29,200,000 transactions/day $0.044 [$1,275/29,200]

144 Understanding the Numbers

Denise concluded: "So, it looks like the keys to success for ETN/W are

threefold. First, study your customer capture and customer loading processes

and make them more efficient. Second, figure out a way to minimize your peak

periods such that you run your transaction processing systems at capacity most

of the time. And last, focus your business model on large-volume e-commerce

retailers such that you recoup your front-end investment sooner. If you can address

these three issues, your investors should grant your third-round request.

Of course, we could not have come to these action steps until we achieved

transparency of your cost systems through ABC analysis. Good luck.

A REVIEW OF THE ABC METHODOLOGY

There are a number of lessons to be taken from the ETN/W example.

ABC is a strategic model. The strategy literature states in various ways

that a company will achieve a strategic advantage over rivals if it can deliver

(1) additional value to customers at a cost comparable to rivals or (2)

comparable value at a cost lower than rivals. This advantage is sustainable

if and only if the company does this in a manner different than its rivals.

The myth that all companies have a strategic cost model that provides the

necessary information unfortunately, in today's world, does not hold true.

Most cost systems mainly provide aggregated cost information for estimating

inventory valuation and cost of goods sold—they focus on external

financial reporting. ABC, if done correctly, can provide the necessary

strategic information.

The earlier ABC is done in the strategic planning process, the

more value it creates. In the mid-1980s, when ABC analysis was being

touted as the key tool in making the United States more competitive on a

global basis, some researchers focused their studies on Japanese companies.

Their hypothesis was that, since the Japanese have dominated

many key industries over the last two decades, they must have some type

of ABC methodologies. These researchers found exactly the opposite;

costing systems for Japanese companies had even more arbitrary cost allocations

than their U.S. rivals. Further research, however, unveiled a key

competitive advantage.5 Japanese product development was very cost

based. They employed a technique, called target costing, in which prices

were first set for new products through extensive market research, then

profitability targets based upon investor capital requirements for the

new product were estimated, yielding cost targets which were set at the

design stage. Techniques such as value engineering and experiencecurve

analysis were employed to ensure that when the production began,

the product would meet its target cost. The Japanese understood that

this type of activity-cost analysis was best done very early in the product

development stage. An interesting additional insight was that these

Activity-Based Costing 145

strategic cost systems were more often under the responsibility of the engineering

rather than the finance department in Japanese companies.

When done after the strategy implementation stage, ABC becomes

ABM. Much research has demonstrated that about 85% of costs

for a new product are committed in the design stage. As a result, it can be

argued that performing an ABC analysis after this point is of little

value—once a system is in place, operational efficiency should be the

goal.6 The challenge is to maximize output given the constraints of the

system.7 Note that by optimizing output, the fixed costs are minimized on

a per-unit basis leading to the lowest-cost situation and the best possible

shareholder value position. Since pricing is not cost dependant, detailed

cost information is not really necessary.8 This is not quite correct since

no business situation is static. Note in the ETN/W example, we did do an

ABC analysis after the fact. But also note that the final result of the

analysis was not an ABC model. The key to the analysis was the managerial

decisions that were implemented to make ETN/W more competitive.

When done after the fact, the focus of ABC is not costing—it is to gain

transparency of the business model so that it can be reengineered to create

additional shareholder value. When done after the fact ABC necessarily

leads to ABM, activity-based management.

The value of ABC analysis is the "journey" rather than the final

result. As was stated in the ETN/W example, the purpose of ABC is ultimately

to gain business-wide transparency of your business model. It is

important that every function within the organization understand the

strategic logic of how your company is going to create shareholder value.

This includes how it is positioned in the industry-level value system, how

its processes link to those of upstream and downstream partners, as well

as a detailed activity-by-activity understanding of internal processes. The

steps are as follows.

1. Develop a cross-functional team to do the analysis and assign ownership

of the final ABC system to one function within your organization.

If an outside consulting group is used, its role should be facilitator

rather than designer of the system. It is important that ownership of

the ABC model be internal since it will have to be updated on a regular

basis. Because this is a strategic tool, ownership need not reside in

the finance function. Many companies have found that, since this

analysis requires business-wide vision, the strategy function is a more

appropriate owner.

2. Begin with a map of the industry-level value system that shows all

participants in the value creation process. Before moving to the next

step, ensure that each member of the team understands and agrees

with the strategic positioning logic for your company. This is necessary

because all members must agree upon the strategic underpinnings

of the analysis. In addition, cost drivers for one company often

146 Understanding the Numbers

reside within another in the chain. For instance, the driver for the

ETN/W customer sale cost pool was the technical sophistication of

the potential customer. Those that did not understand the costs of

transaction processing and what ETN/W could provide were much

more difficult to sell, and more costly. Once ETN/W understood this,

it developed a short video that explained the transaction processing

side of e-commerce and the cost and complexity of performing this

function internally. This video made the selling process much easier

for those customers—and less costly.

3. Once the industry-level value system is understood, prepare a process

map for your company. Identify what value pieces of the overall system

your company contributes. Although most people assume that everyone

"knows what we do," this is most often not the case. Like the

Hindu parable of the blind men trying to describe an elephant by feeling

only one piece—trunk, ear, leg—few managers within an organization

truly understand how all processes are integrated across the firm.

4. Prepare a detailed activity analysis for each internal process—exactly

what steps are taken, who does them, and with what resources. Since

this will be the basis for determining your cost pools, activities must

first be identified at a granular level—if you are too fine you always can

aggregate them later.9 Activity identification can be done from a historical

perspective or by studying the activity real time. In either case

this stage will require discussion with those people responsible for the

process to identify the activity steps. Since these steps often are performed

by many functions within an organization, it is sometimes

necessary to gather all participants such that a true cross-functional activity

map be drawn and agreed upon.

5. Estimate the cost pools for each activity and identify their behavior—

variable or fixed. If an activity has both fixed and variable costs, use

two pools for that activity. Often secondary support functions such as

payroll and human resources are first "allocated" to primary ledger accounts

such as manufacturing labor or sales salaries accounts before

being traced to activities.10 At the end of this step a reconciliation

should be performed. All of the costs from the general ledger should be

traced to activity pools using the activity map. Typically some costs

such as corporate administration and R&D do not get traced to activity

pools since they have little to do with current operations. This is acceptable,

and the key parameter one looks at is what percentage of overall

costs is ultimately charged to activity pools. Rather than being

discouraged by the 10% to 20% of costs not traced to any activity pool,

focus on the 80% to 90% of which you now have a better understanding.

To reiterate, this analysis is a strategic one; the acceptable percentage of

unknowns is dependent on how good your rivals' cost systems are.

6. Select drivers for each pool—that is, the method to be used to transfer

the costs from the pool to the object we wish to cost. Note the different

Activity-Based Costing 147

"objects" we developed costs for in the ETN/W example—capturing

and loading a customer onto the network and processing a transaction.

• For variable cost pools, drivers should be usage based since this is

the causal factor for a variable cost. Note how we used Outsourced

Credit Reports as a driver for the customer-qualification cost pool.

• For fixed-cost pools, the driver should be capacity based since this

is the causal factor for a fixed cost. Capacity drivers are often more

complex than usage drivers. Since fixed-cost pools are "chunkier"

than variable ones that increase in a proportionate fashion,11 idle

costs are often a problem. Only that portion of the fixed cost pool

that is "useful" to a cost object should be charged to it—note how

peak demand was used to define that portion of the transactionprocessing

system that was deemed idle in the ETN/W example.

7. Develop the final cost estimates for your system. Understand that

there are no right answers. Since this is a strategic analysis, the longrun

value of your results is dependent upon actions of rivals. For

ETN/W we found that the current cost for each transaction processed

was $0.175. Can it make any money at this cost level? Probably there

are a few customers who understand that their costs are higher than

this and would be willing to pay ETN/W a price today that is in excess

of the $0.175. But in the long run, rivals could enter and provide services

at a lower price. Given that ETN/W set its pricing target in the

$0.10 to $0.15 range, it understands that it currently has no sustainable

advantage. By figuring out how to better manage the peak problem, it

thinks it can attain that advantage. The main goal of an ABC analysis

is a set of activity-based target costs that everyone in the organization

may see. The message should be: "If we as an organization achieve

these, we will be successful." Progress towards these goals is the key

strategic performance indicator.

FOR FURTHER READING

Brimson, James, Activity Accounting: An Activity-Based Costing Approach (New

York: John Wiley, 1997).

Cokins, Gary, Activity-Based Cost Management: Making It Work: A Manager's Guide

to Implementing and Sustaining an Effective ABC System (Chicago: Irwin,

1996).

Forrest, Edward, Activity-Based Management: A Comprehensive Implementation

Guide (New York: McGraw-Hill, 1996).

Kaplan, Robert, and Robin Cooper, Cost and Effect: Using Integrated Cost Systems to

Drive Profitability and Performance (Cambridge, MA: Harvard Business

School Press, 1997).

Player, Steve, and David Keys, Activity-Based Management: Arthur Andersen's

Lessons From the ABM Battlefield, 2nd ed. (New York: John Wiley, 1999).

148 Understanding the Numbers

NOTES

1. A server farm is a new service-offering concept in the IT industry enabled by

advances in optic fiber connectivity. NT- and UNIX-based IT computer systems (i.e.,

servers) are housed in a service facility, and customers are given the option of buying

the service on a usage basis rather than buying the computer itself. Customers are

then supplied this service through a fiber-optic telecommunication network.

2. Clients are also called fulfillers. An apt analogy in the non-ebusiness world is

the role played by Wal-Mart for its suppliers ("fulfillers" in the e-commerce world),

such as a Procter & Gamble.

3. See Geoffrey Moore, Crossing the Chasm (New York: HarperCollins, 1990)

and Inside the Tornado (New York: HarperCollins, 1995).

4. As discussed previously, some of these had been started but not finished at

the beginning of the period, and at the end some were still in process; but on average

they estimated that the equivalent of seven customers were loaded onto the network

during this period.

5. See Womack et al., The Machine That Changed the World (New York:

Macmillan, 1990), chapter 5 particularly.

6. See Eli Goldratt, Theory of Constraints (Croton on Hudson: North River Press,

1990).

7. Where output is defined by any parameter—units produced for a manufacturing

system, units sold for a sales infrastructure, customers serviced for a service

infrastructure, and so on.

8. Economists argue that in a competitive market prices are set by the marketplace,

and in a market where there is product differentiation, prices are value based—

i.e., dependent on the perceived value to the customer, not on cost to produce.

9. Many companies today do not limit their analysis to within company walls.

This type of activity analysis is often done across the value system to understand

how much value is being developed as a whole and who is capturing the majority of it.

This understanding can be very valuable when negotiating with partners. See

Gadlesh & Gilbert, "How to Map Your Industry's Profit Pool," Harvard Business Review,

May–June 1998, pp. 149–162.

10. Quotation marks are used here to emphasize that this analysis needs to have

causal underpinnings. The key here is to allocate these costs using some type of a logical

procedure; avoid doing it in an arbitrary manner. The simple rule is: If there is no

logical manner in which to trace the cost, don't!

11. Note in the ETN/W example, the customer-qualification activity pool

increased with each additional outsourced report while the customer-sale pool increased

with each additional person hired. It increased in larger increments, thus the

descriptor chunky is often used.

149

5

INFORMATION

TECHNOLOGY

AND YOU

Edward G. Cale Jr.

Amazing though it may seem, the personal computer has only been around for

about 20 years. Before 1980 the world of computing belonged to highly trained

technical people who worked their wizardry wearing white coats in hermetically

sealed rooms. Today kindergarten students use personal computers to

learn the alphabet, grade school students use the Internet to research term

papers, and on-the-go executives are always in touch with their beepers, Webenabled

cell phones, cellular personal digital assistants (PDAs), and laptop

computers. However, many people are not yet comfortable with these technologies.

The range of people's acceptance and knowledge of information technology

is wide, with the technical novice at one end of the continuum and the

"techie" at the other end. Where you fall in this range will dictate what you

gain from this chapter. If you are fortunate to fall near the techie side, skim

this chapter for ideas which you might find interesting.

Technology has changed the way people conduct business. Computers

have replaced pencil and paper in contemporary business life. In the past,

when a new employee was hired, he or she was shown to a desk and given pen,

pencil, paper, and a telephone. Today, the new hire is given a computer, usually

attached to a network; a cellular phone; a beeper; and possibly a laptop computer

for portable use. People's lives have been turned upside down as they

learn to manage the latest technology. E-mail is replacing U.S. Mail. Secretaries

are being replaced by personal productivity technology such as voice

150 Understanding the Numbers

mail and Internet-based calendaring. People question how much more productive

they as workers can be. Technology will allow managers' and workers' productivity

to reach the next plateau and enable them to find better and

alternative modes for working and succeeding.

Information technology has changed not only the way people work but

also in some cases the venue from which they perform their work. No longer

are workers chained to their desks. The number of telecommuters—people

who work from home via computer and telephone communications—is increasing

dramatically. Business people who travel with their portable computers

have become so prevalent that hotels have installed special hardware on their

hotel room telephones that allows guests to plug their computers into the telephone

system and communicate with their home offices. Sometimes people

even connect their laptop computer modems to the airline telephones at their

seats!

How much do you need to understand about the technology to become

technologically enabled? The answer to this question will depend in part on the

job you hold and the organization for which you work. However, at this time,

when information technology is having a dramatic impact on the very definition

of many industries, the material covered in this chapter and in Chapter 16 has

to be considered essential.

HARDWARE

Computer hardware comes in several shapes and sizes. This chapter concentrates

on personal computers (PCs). Over the past 15 years, Microsoft and Intel

have become so dominant in the software and hardware ends of the PC business

that they have, de facto, set the worldwide standard for PCs, which is referred

to as the Wintel standard, short for Microsoft Windows and the Intel

CPU chip. More than 90% of all personal computers use the Wintel standard,

affecting both the hardware marketplace and the applications software that is

developed. Currently, Dell and Compaq are the largest producers of personal

computers, with Gateway, Hewlett-Packard, and IBM following closely.

Personal computers come in two basic shapes: desktop and laptop. Regardless

of their shape, all PCs have the same basic components. When you

buy a computer, you usually have a choice on the size, speed, or amount of any

given component that will be a part of your system. The basic components

with which users must concern themselves are the CPU, RAM, hard disk, CD

ROM/DVD ROM, modem, various adapters, and the monitor. Most of the rest

of this section deals with the basic options you will have to choose in selecting

these components.

However, beyond personal computers, we are also seeing the emergence

of a whole range of small digital products for supporting effective managers.

These products as a group are called personal digital assistants, or PDAs, and

will be discussed brief ly.

Information Technology and You 151

Desktop Computers

Underneath their covers, most desktop computers are very similar. Many of

the various manufacturers of desktop machines use parts from the same suppliers

because there are only a handful of companies that manufacture hard

disk drives and many other desktop components. Before buying a machine,

compare the attributes and capabilities of many different ones. Also, check the

warranty offered by the different manufacturers. Though one-year warranties

are fairly typical, some computers come with two- or three-year warranties.

Beware of hype advertising and read the fine print. Most advertised specials

do not include the monitor, which will cost upward of $200 depending on the

size and quality.

Laptop Computers

The laptop has become a mainstay for the traveling worker. It provides all the

functionality and most of the power of most desktop units, in a package that

weighs approximately six pounds. Laptops are powered by standard electricity

or, for about two hours, by their self-contained batteries. Unlike desktop units,

under the covers all laptops are not the same. While they all utilize either an

Intel or Intel clone chip, the majority of the electronics are frequently custom

designed. Consequently, servicing laptops is more complicated and more expensive,

and laptop parts are not necessarily interchangeable.

The display screen is one of the most important features of the laptop

computer. Display quality and size are rapidly approaching that of desktop

machines.

Although laptops provide the luxury of portability, that is their only advantage

over desktop machines. Desktops offer better displays, more memory,

and higher speed—higher performance for far less money. A laptop computer

will cost between twice and three times as much as a comparable desktop unit.

Personal Digital Assistants (PDAs)

PDAs are small digital devices that can be used to take notes, to manage tasks,

to keep track of appointments and addresses, and even to send and receive email.

Similar to PCs, PDAs have CPUs, RAM, displays, and keyboards of sorts,

and some even have modems. However, a PDA can typically fit easily into a

pocket or purse. Today, the most popular PDA is made by Palm Inc. and has

its own proprietary software. However, there are a number of competing

PDAs, some of which use a stripped-down version of Windows software called

Windows CE. As miniaturization continues to develop and as cellular and computer

technologies continue to be woven together, we can expect a further

blurring of the line between PDAs and PCs.

Probably the two most popular capabilities of PDAs are their ability to

keep track of appointments and to store and retrieve contact information such

152 Understanding the Numbers

as phone numbers and addresses. These same capabilities are also available on

PCs, most typically in software products such as Microsoft Outlook, which also

includes e-mail. Most PDAs come with the ability to transfer appointments and

contact information bidirectionally between the PDA and a PC.

Computer Components

Exhibit 5.1 shows a schematic rendition of the components in a computer system.

This section of Chapter 5 will explain the basic functioning of these components

and present some of the tradeoffs that you will face in making an

intelligent decision to buy a computer system.

CPU

All basic computers have a central processing unit (CPU). The CPU is the basic

logical unit that is the computer's "brain." As mentioned earlier, it is usually

provided by Intel Corporation or one of the clone-chip manufacturers such as

AMD. While Intel enjoys the lion's share of the market, the clones have

recently made significant inroads by offering lower prices for comparable

products. State-of-the-art CPUs manage to integrate onto one thumbnail sized

silicon chip tens of millions of electronic components. CPUs such as the Pentium

come in different speeds, expressed in megahertz or gigahertz (millions

or billions of cycles per second). Speed represents how fast the CPU is capable

of performing its various calculations and data manipulations. A typical CPU

today operates at between 800 MHz and 1.5 GHz.

EXHIBIT 5.1 Layout of a personal computer.

CPU

RAM

Hard

drive

CD ROM/

DVD drive

Monitor

Phone

jack

Keyboard Mouse

Disk controller

Display adapter

Modem

Sound card

Speaker Speaker

Network adapter Network

jack

Information Technology and You 153

RAM

Random access memory (RAM) is the space that the computer uses to execute

programs. The amount of RAM required is dictated by the number of applications

that the computer is asked to run simultaneously as well as by the systems

software in use (e.g., Windows 98, Windows XP). For most average users, 128

megabytes of RAM is an appropriate amount (a megabyte is 1,048,576 bytes of

data). You can never have too much RAM, though, so the more, the better.

While RAM prices f luctuate widely with supply and demand, you should plan

on spending about a dollar per megabyte.

Hard Disk

All programs and data are stored on the hard disk. Disk technology has advanced

greatly in the past five years. Recording density has enabled disk capacity

to approach numbers previously unheard of except in large mainframe

commercial systems. In 1992 the typical disk stored 80 megabytes. Today typical

disk capacity on desktop machines ranges from 10 to 20 gigabytes. Although

it seems unimaginable to fill up an entire 10-gigabyte disk, it happens

faster than one might think. Typical office applications require 100 megabytes

of storage for the application alone, not including any associated data. Multimedia

applications (sound and video) are very data intensive and quickly consume

disk space. For example, CD-quality music recordings consume roughly

10 megabytes per minute! Again, the more storage the better.

Reminder: Hard disk failures do occur. Always back up your data onto a

removable disk or tape!

CD ROM/DVD ROM

Today an increasing amount of data and number of applications are being supplied

on digital, compact disk (CD) technology. Using this technology, large

amounts of data can be stored inexpensively. CD ROMs, which have the storage

capacity for approximately 700 megabytes of data, are usually sold as "read

only." Recently, however, inexpensive recordable CD drives have become popular,

allowing people to store massive databases or record music on their own.

Other than the speed at which they access and transfer data, all CD ROMs are

very similar. Speed is expressed as a multiple of the speed of the original CD

ROMs, which were produced in the early 1990s. Today, typical CD ROMs

transfer data 32 or 48 times faster than the original CD ROMs and are referred

to as 32X or 48X CD ROMs. Again, the faster, the better.

There are numerous information databases available on CD that would

interest the accountant or finance executive. For example, most census data is

available on CD. Also, historical data on stock and bond prices, copies of most

trade articles, IRS regulations, state tax regulations, tax forms, recent court

154 Understanding the Numbers

decisions, tax services, accounting standards (GAAP and GAAS), continuing

education courses, and many other topics are available on CD.

Today, DVD ROMs, which have roughly ten times the capacity of CD

ROMs, are becoming popular and in many cases replacing CD ROMs. DVD

popularity is being driven at least in part by the fact that a single DVD can accommodate

the massive amount of data necessary to digitally store the sound

and pictures of a full-length feature movie. Recordable DVD drives are now

becoming reasonably priced. With their ability to read both CDs and DVDs

and their ability to record DVDs, one would expect that recordable DVD

drives will soon replace CD drives in new computer systems.

Modems

Modems are devices that allow computers to communicate with each other

using standard telephone lines. In the past few years, modem technology has

increased the speed of data communications over standard telephone lines to

speeds more than 10 times higher than in 1990. However, there is a practical

limit to how fast computers can transmit data over ordinary telephone lines—

currently about 56 KB (kilobit—a thousand bits) per second.

Because of the limitations of telephone lines, alternatives have been and

are being developed. Cable modems, which use cable television wires, and

DSL connections, which use regular telephone wires but with a new technology,

both have the capability of transmitting data at rates higher than 1 MB

(megabit) per second. While both technologies are spreading quickly, neither is

yet available in all geographic locations. In addition, satellite data service, similar

to satellite television service, is an available high-speed possibility for data

communications.

Network Adapter

Whereas modems connect computers using phone lines, network adapters

allow computers to directly communicate with each other over wires or cables

that physically connect the computers. In most office environments, the various

computers are interconnected through a local area network (LAN) so that

they can share printers, data, access to the Internet, and other capabilities.

Today, the dominant type of LAN is called an Ethernet network, and most network

adapters are Ethernet adapters. In addition, Ethernet adapters are the

most common form of hardware connection between PCs and cable modems

or DSL connections. An Ethernet network adapter typically costs between

$30 and $50.

Multimedia

By the latter half of the 1990s, most new personal computers came equipped

for multimedia, the ability to seamlessly display text, audio, and full-motion

Information Technology and You 155

video. To be capable of multimedia, a computer must be equipped with a

high-resolution monitor and a CD or DVD drive and have audio capabilities.

Because of the amount of storage that video requires, full-motion video is

somewhat difficult to accomplish on a personal computer. For it to look

smooth, video requires roughly 30 frames (pictures) per second, and each

frame requires about 500,000 characters of information. In other words, one

minute of smooth video could require as much as 900,000,000 characters of

storage. In order to manage the large amount of storage that video processing

requires, the video data is compressed. Data compression examines the data

and, using an algorithm or formula, reduces the amount of storage space

needed by eliminating redundancies in the data. Then, before the data is displayed,

it is inf lated back to its original form with little or no loss of picture

quality.

Printers

Printer technology has stabilized in recent years, with two standards having

emerged, laser printers and inkjet printers. Laser printers offer the best quality

and speed. They are, for the most part, black-and-white and offer high print

resolution. There are several speed and memory options, and models range in

price from $400 for the individual user to several thousand dollars for a fast

unit that offers printer sharing and color. Inkjet printers offer the lowest price.

Models cost as little as $100. In higher-priced inkjet printers, print quality is

excellent in black-and-white and color. Today many people are using high-end

inkjet printers to print pictures taken with digital cameras. With high-end

inkjet printers and digital cameras, the results can be virtually indistinguishable

from prints produced from film cameras.

Laser printers are the clear choice for network sharing, whereas inkjets

have become the mainstay of the individual user. In either case Hewlett-

Packard is the market leader in the development of printers.

Monitors

The most common type of computer monitor is a cathode ray tube, or CRT,

which physically resembles a television. In recent years, however, f lat-panel or

LCD (Liquid Crystal Display) have emerged. The major advantage of the f latpanel

display is that it takes up much less space on a desktop than does the

CRT. This advantage comes at a cost roughly three times as much as a comparably

sized CRT. Whether CRT or f lat panel, there are significant advantages

to having a display that is as large as space and budget allow. Some of the real

power of windowing software is the ability to view several windows of data at

the same time. Small displays make such windowing much more difficult. A

17-inch display (the screen measured diagonally) is about the minimum acceptable

size.

156 Understanding the Numbers

OPERATING SYSTEMS

The operating system is the basic software that makes the computer run. Applications

software is the software that runs a particular user function. Some

say that the operating system is the software closest to the machine, while the

applications software is the software closest to the user.

Microsoft Windows is the predominant operating-system software for

the personal computer. In the past 10 years, Microsoft has become the acknowledged

leader in the development of both operating-system and officeautomation

software. The Windows operating system provides a graphical

format for communicating between the computer and the user, while a pointing

device, such as a mouse, is used to point to the icon of the folder or application

that the user wishes to open.

APPLICATIONS SOFTWARE

Applications software is the personal computer's raison d'etre. Although there

are a multitude of applications available for the PC, this chapter focuses on the

following personal-productivity programs:

• Word processing.

• Spreadsheets.

• Presentation graphics.

• Databases.

• Personal finance.

• Project management.

Most of the popular packages are available as application suites that include

word processing, spreadsheets, graphics, and sometimes database management

systems. Microsoft Office is one of the most widely used suites; it

includes Word for Windows (word processing), Excel (spreadsheet), PowerPoint

(presentation graphics), Access (database), as well as several other applications.

The original spreadsheet application was developed at the very beginning

of the PC revolution and was called VisiCalc. It was later replaced by Lotus

1-2-3, which became the standard until the tremendous success of Microsoft

Office and Excel.

Word Processing

One of the two most popular applications, word processing and spreadsheets,

word processing has increased people's ability to communicate more effectively.

With word processing software, the user can create, edit, and produce a

high-quality document that appears as professional as that of any large organization.

Thus, word processing has become the great business equalizer, making

Information Technology and You 157

it difficult to decipher a small company or single practitioner from the large,

Fortune 500 company with a dedicated media department.

Today's word processing is as powerful as most desktop publishing software,

and it is so simple to use that any novice equipped with simple instructions

can master the software. Not only can documents include text, but they

can also contain spreadsheet tables, drawings, and pictures; be specially formatted;

and be black-and-white or color. Most word processing applications

come with clip art, which consists of drawings, cartoons, symbols, and/or caricatures

that can be incorporated into the document for emphasis.

Spreadsheet Software

For the accounting and finance executive, spreadsheet software has had the

greatest impact on productivity. Imagine a company controller who has been

asked to prepare the budget for the coming year. The company manufactures in

over a thousand products with special pricing depending on volume. The controller

not only has to make assumptions about material costs, which might

change over time, but also has a history of expense levels that must be factored

into the analysis. Using pencil and paper (usually a columnar pad), the controller

calculates and prepares all of the schedules necessary to produce the

final page of the report, which contains the income statement and cash flow.

Confident that all calculations are complete, the controller presents the findings

to management, only to be asked to modify some of the underlying assumptions

to ref lect an unexpected change in the business. As a result, the

controller must go back over all of the sheets, erasing and recalculating, then

erasing and recalculating some more.

Computer spreadsheets rendered this painful process unnecessary. Spreadsheets

allow the user to create the equivalent of those columnar sheets, but with

embedded formulas. Consequently, any financial executive can create a financial

simulation of a business. Thus, merely by changing any of a multitude of assumptions

(formulas), one can immediately see the ramifications of those changes.

Spreadsheets allow for quick and easy what-if analyses. What if the bank

changes the interest rate on my loan by 1%? What impact will that have on my

cash flow and income? In addition, most of the packages provide utilities for

graphing results, which can be used independently or integrated into a word

processing report or graphics presentation.

A spreadsheet is composed of a series of columns and rows. The intersection

of a row and column is referred to as a cell. Columns have alphabetic

letters, while rows have numbers. Cell reference "B23" indicates the cell in

column B and row 23.

Exhibit 5.2 provides an example of a simple spreadsheet application. A

company's pro forma income statement, the sample spreadsheet is a plan for

what the company expects its performance to ref lect. In this example, the

company expects to earn $275,475 (cell H18) after tax on $774,000 (cell H3) of

sales revenues. At the bottom of the exhibit, there is a series of assumptions

158 Understanding the Numbers

that govern the way the calculations are performed in this spreadsheet. For example,

cost of goods sold is always equal to 32.75% of sales, and advertising is

always equal to 12% of sales. Likewise, the income tax rate for this company

is set at 25%.

Looking behind the cells (Exhibit 5.3), you can see the spreadsheet's formula

infrastructure. For example, cell B4, which calculates the cost of goods

sold for the month of January, contains the formula that requires the spreadsheet

to multiply the cost-of-goods-sold percentage that is shown in cell B21

by the sales shown in cell B3; the formula in cell B5, which calculates the

gross profit, subtracts the cost of goods sold in cell B4 from the sales in cell

B3; and cell H5, which calculates the total gross profit for the six months of

January through June, contains the formula that adds the contents of cells B5

through G5.

The spreadsheet is set up so that, should the user wish to change any of

the assumptions, such as the cost-of-goods-sold-percentage, the contents of

cell B21 would be changed to a new desired value, and any other cell that was

affected by this change would immediately assume its new value. As mentioned

earlier, most spreadsheet packages provide excellent facilities for displaying

EXHIBIT 5.2 Pro forma income statement (in dollars).

Pro Forma Income Statement

Year

January February March April May June to Date

Sales 100,000 125,000 135,000 127,000 132,000 155,000 774,000

Cost of goods sold 32,750 40,938 44,213 41,593 43,230 50,763 253,485

Gross profit 67,250 84,063 90,788 85,408 88,770 104,238 520,515

Operating Expenses

Salaries 22,800 28,500 30,780 28,956 30,096 35,340 176,472

Benefits 11,200 14,000 15,120 14,224 14,784 17,360 86,688

Rent 3,200 3,200 3,200 3,200 3,200 3,200 19,200

Utilities 4,300 4,750 3,790 4,100 3,100 2,800 22,840

Advertising 12,000 15,000 16,200 15,240 15,840 18,600 92,880

Supplies 1,300 1,400 1,270 1,500 1,550 1,600 8,620

Total operating expenses 54,800 66,850 70,360 67,220 68,570 78,900 406,700

Net profit before taxes 45,200 58,150 64,640 59,780 63,430 76,100 367,300

Income taxes 11,300 14,538 16,160 14,945 15,858 19,025 91,825

Net profit after taxes 33,900 43,613 48,480 44,835 47,573 57,075 275,475

Assumptions

Costs of goods sold % 0.3275

Salaries (% sales) 0.228

Benefits (% sales) 0.112

Advertising (% sales) 0.12

Income taxes % 0.25

159

EXHIBIT 5.3 Spreadsheet formula infrastructure.

Pro Forma Income Statement

January February March April May June Year to Date

Sales 100,000 125,000 135,000 127,000 132,000 155,000 =SUM(B3:G3)

Cost of goods sold =$B21*B3 =$B21*C3 =$B21*D3 =$B21*E3 =$B21*F3 =$B21*G3 =SUM(B4:G4)

Gross profit =B3-B4 =C3-C4 =D3-D4 =E3-E4 =F3-F4 =G3-G4 =SUM(B5:G5)

Operating Expenses

Salaries =$B22*B3 =$B22*C3 =$B22*D3 =$B22*E3 =$B22*F3 =$B22*G3 =SUM(B8:G8)

Benefits =$B23*B3 =$B23*C3 =$B23*D3 =$B23*E3 =$B23*F3 =$B23*G3 =SUM(B9:G9)

Rent =3,200 =3,200 =3,200 =3,200 =3,200 =3,200 =SUM(B10:G10)

Utilities 4,300 4,750 3,790 4,100 3,100 2,800 =SUM(B11:G11)

Advertising =$B24*B3 =$B24*C3 =$B24*D3 =$B24*E3 =$B24*F3 =$B24*G3 =SUM(B12:G12)

Supplies 1,300 1,400 1,270 1,500 1,550 1,600 =SUM(B13:G13)

Total operating expenses =SUM(B8:B13) =SUM(C8:C13) =SUM(D8:D13) =SUM(E8:E13) =SUM(F8:F13) =SUM(G8:G13) =SUM(B14:G14)

Net profit before taxes =B3-B14 =C3-C14 =D3-D14 =E3-E14 =F3-F14 =G3-G14 =SUM(B16:G16)

Income taxes =$B25*B16 =$B25*C16 =$B25*D16 =$B25*E16 =$B25*F16 =$B25*G16 =SUM(B17:G17)

Net profit after taxes =B16-B17 =C16-C17 =D16-D17 =E16-E17 =F16-F17 =G16-G17 =SUM(B18:G18)

Assumptions

Costs of goods sold % 0.3275

Salaries (% sales) 0.228

Benefits (% sales) 0.112

Advertising (% sales) 0.12

Income taxes % 0.25

160 Understanding the Numbers

data in a graphical format. Exhibit 5.4 presents a graph of the information in

our demonstration spreadsheet. It contrasts sales and net profit over the six

months.

Presentation Graphics Software

Presentation graphics software is used to create slide presentations. These presentations

can include a variety of media through which information can be

presented to an audience, such as text, graphs, pictures, video, and sound. Special

effects are also available, meaning animation can be incorporated as the

system transitions from one slide to the next. Slides can be printed, in blackand-

white and color, for use on overhead projectors. Alternatively, the computer

can be directly connected to a system for projection onto a screen or a

television monitor, allowing the presenter to utilize the software's animation

and sound features. Most of the software comes equipped with various predeveloped

background formats and clip art to help simplify the process of creating

the presentation. Also, these software packages allow the user to import

both graphs and text from other software packages, such as word processing

and spreadsheets.

EXHIBIT 5.4 Pro forma sales and income.

January February March April May June

Sales

Net profit

after taxes

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

Months

Dollars

Information Technology and You 161

Database Software

A database is a collection of data stored in such a way that the user may create

and identify relationships among data. For example, a mailing list of one's customers

might contain information about each customer's purchases and everything

about the sales transactions, including the prices the customer paid, who

sold it to him, how she paid, and so forth. This information can be retrieved in

a variety of ways usually specified by the user at the time of execution. The

user might want a list of all customers that purchased a specific product between

January and May or perhaps an aggregate list of all products a customer

has ordered and purchased from a particular salesperson. The number of possible

combinations and permutations and ways one may view the data is limited

only by the collection of the data and the imagination of the user. Databases

are discussed in more detail in Chapter 16, Information Technology and

the Firm.

Personal Finance Software

There are several software packages that allow individuals or small businesses

to manage finances, such as paying bills either electronically or by check, and

monitor investments. The packages are fairly sophisticated in that they provide

for secure communications for electronic bill paying and other online banking

services such as account reconciliation, as well as the importing of current

stock-market quotes. The most widely used package is Quicken and, for small

businesses, Quickbooks. Microsoft Money is also a comparable and popular

package.

Exhibit 5.5 displays a sample screen that is used to enter bills to be paid.

As you can see, the user input metaphor is a check, the very same document the

user would use if he or she were paying the bill manually. The difference using

Quicken is that data is collected for a host of other purposes such as:

• Paying bills.

• Tracking paid bills by category for budgeting purposes.

• Tracking payments for tax purposes.

• Reconciling the checking account.

The system has the capability to keep track of more than one account and to

make interaccount transfers.

Project Management Software

Often a manager or entrepreneur is faced with the challenge of managing the

many details concerned with a project, be it constructing a building or pulling

together a financial plan. With fairly simple projects, paper and pencil or a

simple spreadsheet might be an adequate tool for coordinating the people and

steps involved in a project. But, as the project gets complex, involving, say,

162

EXHIBIT 5.5 Personal f inancial sof tware check-writing screen.

Screen shot printed with permission of Intuit.

163

EXHIBIT 5.6 Project management software screen.

164 Understanding the Numbers

more than a few people and more than a few dozen steps, one should consider

using project management software to help with the planning and control of

the activities.

Project management software allows a manager to plan for and then control

the steps in a project with an eye toward managing the people working and

resources being spent on the project. Good project-management software can

help a manager foresee bottlenecks or constraints in a plan and can help the

manager bring the project to completion in the shortest possible time.

One popular tool for managing projects is Microsoft Project. Exhibit 5.6

shows a typical screen from Microsoft Project, which shows the steps in a project

along with a graphical representation of those steps called a GAANT chart.

NETWORKING

Another electronic advent of the 1990s was extensive networking, or interconnecting,

of computers, which has facilitated the sharing and exchanging of information.

The interconnecting may be done through wires within a building;

via the telephone system using modems; or through radio frequency transmissions

between the computers using wireless modems. There are several different

approaches, or types of architecture, for computer networks. In a small

office environment with only a few computers, the computers might be connecting

in what is referred to as a peer-to-peer network. Here all the computers

function on the same level as peers or equals to each other. Peer-to-peer networking

software comes built into Windows 98 and Windows Millennium Edition

(ME), making it relatively easy to set up a peer-to-peer network between

two or more PCs. All one needs is a network adapter card in each computer,

the cables for connecting the computers, and a connecting piece of hardware

called a hub.

However, in a larger networking environment (dozens, hundreds, or even

thousands of computers hooked together), the situation is more complex. In

this case, the most common network architecture is called a client-server network.

To deal with the added complexity, in a client-server network there is a

hierarchy of computers with a host or file server acting as the traffic policeman,

storing common data and directing the network traffic. In this architecture,

the user computer is frequently referred to as the client in the network. A

picture of a typical client-server network appears in Exhibit 5.7.

As mentioned earlier, the file server is the centerpiece of the network,

and the software that makes the network operate is called the network operating

system. Novell's NetWare and Microsoft's Windows 2000 (formerly Windows

NT) are two popular network operating systems. Within a business the

typical network is called a local area network, or LAN. Clients are connected

to the server, using wires or fiber-optic cables. Transmission speeds are generally

either 10 or 100 megabytes per second. As with the peer-to-peer network,

there is a hub that acts as a concentrator for all of the cabling. Again, each PC

Information Technology and You 165

on the network must have a network interface card if it is connected to a LAN,

or a modem if it is connected through telephone lines. When a series of LANs

in different cities are interconnected, they form a wide area network, or

WAN. Large businesses with facilities around the country or world network

their users' personal computers together in a series of LANs that are further

interconnected into a large WAN. The largest WAN, the Internet, connects together

millions of computers of commercial companies, government agencies,

schools, colleges and universities, and nonprofit agencies around the world.

Preventing unauthorized people from accessing confidential information

is one of the biggest challenges posed by networks. To do so, people and organizations

use special security software. One technique, a fire wall, allows outside

users to obtain only that data which is outside the "fire wall" of the file

server; subsequently, only people inside the company may access information

inside the fire wall.

Electronic Mail (E-mail)

E-mail is the most popular network application because it has become the

method of choice for communicating over both short distances (interoffice)

and long distances. It allows you to send communications to any other person

EXHIBIT 5.7 Diagram of client-server network.

Ethernet/WinNT Network

User PC User PC User PC

File server Print server Internet/mail server

Laptop

Laptop

Printers

Internet

Files

Files

166 Understanding the Numbers

on your local network as well as to any other network within your WAN,

including the Internet. E-mail has become so popular that U.S. Mail and

overnight delivery services such as FedEx are being rendered obsolete for

some types of communication.

Most e-mail software packages include a basic word-processing application

with which you can generate your letters. In addition, these packages allow

you to keep mailing lists and send a document to numerous people simultaneously.

Once sent, a document can be received within seconds by people thousands

of miles away. One of the more advantageous features of e-mail is that it

allows you to attach another document—a spreadsheet, graphic presentation,

another word processing report, a picture, or even a database—to your letter,

much as you would do with a paper clip.

Imagine that you have used a spreadsheet package to prepare a budget for

your division in Boston. You print out your letter and spreadsheet and mail or

ship it overnight to the main office in Chicago. You may even include an electronic

copy of your spreadsheet on a f loppy disk, in case the individual in

Chicago needs to further modify the numbers. Sometime within the next day

or two, the recipient will receive the package. He or she will then read the

information and may even use the f loppy disk for additional reporting. Alternatively,

using e-mail, you could draft your letter, electronically attach the

spreadsheet file, and send it via e-mail to your recipient in Chicago. Within a

matter of seconds or minutes, she or he will receive the electronic package,

read your letter, and be able to extract your attachment and load it directly into

a spreadsheet software package for any necessary additional processing.

Since colleges and universities have sites on the Internet, many college

students use e-mail regularly to keep in contact with their friends both in the

United States and around the world. Likewise, parents of college students have

picked up the e-mail bug and use it to correspond with their children.

The Internet

The Internet is the worldwide WAN that has become the major growth area in

technology and the business community. While the Internet has been around

for decades, its popularity exploded with the development of the World Wide

Web and the necessary software programs that made the "Web" very userfriendly

to explore.

Accessing the Internet requires that the user establish a connection to it

called a node. Large organizations have a dedicated data link to the Internet

using very fast data telephone lines. Individual users connect to the Internet

using third-party companies called Internet Service Providers (ISPs), such as

America Online (AOL) and Microsoft Network (MSN). These ISPs allow users

to dial into their computers, which are connected directly to the Internet. Recently,

a number of ISPs have started providing high-speed or broadband

connectivity between users and the Internet with the use of cable modems or

DSL technology (as discussed previously). High-speed connectivity will

Information Technology and You 167

typically cost $20 to $30 more than the normal $20 per month for modem

speed (56K) access.

World Wide Web

Though the terms Internet, World Wide Web, the Web, and the Net have become

synonymous, the Web is actually a subsystem of the Internet. One of the

major attractions of the Web is that it is quite easy for the average person to access

any of the millions of sites on the Web. All you need is a Web browser and

a connection to the Internet. Web browsers are merely software programs that

allow users to navigate the Web. The two most common browsers are Microsoft

Explorer and Netscape Navigator. Internet Explorer comes free with Windows,

and Netscape Navigator can be downloaded for free from Netscape's

Web site.

Every site that appears on the Internet has an address composed of a

company or organization name, called a domain name, and a domain type. For

example, "www.GenRad.com" refers to the Web site of a commercial company

named GenRad. These addresses are referred to as universal resource locators,

or URLs. Some of the more common domain types are as follows:

.com commercial organization

.org not-for-profit organization

.gov government organization

.mil military group

.edu educational institution

Each Web site displays its information using a series of Web pages. A Web

page may contain text, drawings, pictures, even audio and video, as well as blue

text called hypertext. Position your mouse pointer over one of these words, and

the arrow changes to a drawing of a hand. Click the mouse, and the computer

will automatically move to a new Web page. This move is called a hypertext

link. Using these hypertext links, a user can move around the Internet, from

page to page, company to company, state to state, country to country.

Internet e-mail addresses often consist of a username followed by the

symbol "@," followed by the domain name, followed by the domain type. Thus,

Bill Smith's e-mail address at GenRad might well be bsmith@genrad.com.

Many companies have put much of their literature on the Web, thereby

using the Web as an electronic catalogue. Home pages are the first page of information

that you encounter when you reach an organization's Web site. Companies

use their Web sites for marketing and distributing information about

their products. Instead of waiting on a telephone line for customer service, the

user can go online to get expert help about frequently asked questions (FAQs),

at any time of day, unattended. For example, the AICPA (American Institute of

CPAs) has a Web site at www.aicpa.org. Available at that Web site are many of

the AICPA services, including information on their membership, conferences,

168 Understanding the Numbers

continuing education, publications, and IRS forms. The home page for the

Financial Management Association, located at www.fma.org, is another interesting

site for financial executives. This site provides information on all of the

association's services with links to other pages.

Computer hardware and software companies use the Web as a device for

distributing software to users. As software device drivers change, users can

download the new software over the Net. The Net also provides a venue for

people with common interests to "chat" electronically in "chat rooms."

Internet Search Engines

The Web has become so extensive with so much information available to the

user that often one literally does not know where to look. Consequently, search

engines were created to help users navigate the Web. Search engines like

Yahoo, Alta Vista, Lycos, Google, and Northernlight constantly explore the

Web, indexing each site. When presented with key words or a topic to be

searched, they provide the user with a list and description of each site that

contains the information requested in the search. The search results also display

the hypertext links to the sites found, enabling the user to click on and immediately

go to those sites that seem most promising.

Electronic Commerce

Electronic commerce, the ability to purchase goods and services over the Net,

has grown geometrically in recent years. Before e-commerce can achieve its

full potential, however, there are a number of hurdles that must be overcome

successfully. First, as will be discussed in more detail in the following section,

there are strong concerns over the security of credit card and other confidential

data concerning sales transactions. Until consumers can be assured that

their personal data are confidential and their financial transactions are secure,

e-commerce will be under a cloud of suspicion. Second, shopping in cyberspace

is different from shopping in physical space. When shopping in physical

space, consumers see, touch, try on, test-drive, and buy physical products. In

cyberspace, consumers shop on the Net by referring only to metaphors, twodimensional

representations of what they see when shopping in stores. Essentially,

cyberspace consumers are supplied only secondhand information about

products.

For electronic commerce to be successful, therefore, the mode and the

metaphor for the cyberspace shopping experience must be improved. New

mechanisms for Internet shopping will be developed, many of which will include

experiments in virtual reality and the appearance of three-dimensional

venues. Also, the shopping experience will be custom-tailored to you, the individual

consumer. Many Internet sites already keep a profile on you when you

visit their site. These profiles include information on what products you buy

and what products you tend to look at, allowing the Internet sites to create

shopping experiences specific to your needs. Along these lines, the mail-order

Information Technology and You 169

and online shopping company Lands End now provides their customers with

the opportunity to have a three-dimensional computer model built from laser

scans of the customer's body. Once this model is built, the customer can "try

on" clothing on their computer screen to see how the actual clothes will look

on their computer-based body.

As electronic shopping becomes more effective, virtual malls, or groupings

of stores that share the same electronic Internet address, will spring up on

the Internet, creating the feel of a physical mall. Both consumers and retailers

will be able to benefit from one-stop shopping in cyberspace.

Privacy on the Internet

When using the Internet for e-mail, e-commerce, or other applications, you

must remember that, like the radio spectrum, the Internet is a public network.

With the right skill, anyone on the Internet has the ability to "listen in" on your

electronic transaction. While the transaction will appear to be processed normally,

its confidentiality might well be compromised. Beware! Never send

across the Net any confidential information that you would not want any other

person or company to know.

However, Web browsers usually have the ability to encrypt data that is

transmitted between a user and a Web site. Most organizations conducting

business on the Web will, therefore, only send and receive confidential information

using encryption technology, which should provide you with adequate

protection. Generally, Web sites will notify you that they are using such a secure

connection. In addition, whenever you are connected to a secure site, your

Web browser will show a little icon of a closed padlock on the status bar at the

bottom of your screen.

Beyond protecting data as it is transmitted, there is a significant privacy

issue surrounding the use of data in your Internet activities. Whenever you sign

onto a Web site, those sites can collect information about your activities, such as

purchases, credit card number, address, and so on. At the moment, there is very

little legislation either at the federal or state level preventing Internet sites from

selling or sharing information about you with third parties. Various industry

groups are trying to encourage self-regulation in the e-commerce industry, and

many Web sites will post their privacy policy, usually as a link on the home

page. However, at the moment there is little consistency or enforcement of privacy

policy. We can expect that there will be significant legislation on privacy

issues in the future, but until such legislation is in place, beware!

In addition, some Internet sites place small files, called cookies, on your

hard drive when you are in contact with the site. In most cases, these cookies

are innocuous, allowing you to access the site without having to remember a

password or providing you with your favorite screen. However, cookies can also

be used to help track your Web actions and build a profile of you and your activities.

Inexpensive or free software is available to help you manage or prevent

cookies being placed on your computer, but blocking cookies may prevent you

from being able to use certain Web sites.

170 Understanding the Numbers

Internet Multimedia

The Internet provides an amazing plethora of information, and not just in text

or still-picture format. Video and audio streaming media is becoming increasingly

available on the Internet. There are several sites on the Net where one

can obtain audio clips, listen to music, or listen to radio shows. For example,

NFL football games and commentaries are available on the National Football

League's or National Public Radio's Web pages. In addition, many music companies

are allowing consumers to listen to music in the comfort of their homes

before buying the CDs. In addition, sites such as Napster have been created to

allow users to share or swap music and other files. Some of this sharing comes

dangerously close to violating copyright legislation. We have seen and can expect

to continue to see the courts play a significant role in defining the boundary

of propriety.

THE FUTURE—TODAY, TOMORROW, AND NEXT WEEK

Although the industrial revolution began in the United States toward the beginning

of the nineteenth century, we are still feeling its effects today. Consider

for a moment how our everyday lives have changed as a result of those

innovations. The computer revolution began about 1950, and the microprocessor—

the heart of the PC revolution—has been exploited only for the last 20

years. Now think about how our everyday lives have changed as a result of

these innovations. Remember, the microprocessor is part of so many of our appliances,

computers, automobiles, watches, and so forth. The impact of the

computer revolution is just as large if not larger than its precursor, the industrial

revolution, and has taken far less time. Moreover, the acceleration of

change in our lives that results from the use of computer technology has been

rapidly increasing. Technologists speak about the rapid changes in the development

of the Internet and its allied products. They even joke that things are

happening so fast that three months is equivalent to an "Internet year." Funny,

but true.

One of the biggest trends in the last several years has been the merging of

heretofore separate technologies. As we mix computer technology with communication

technology and throw in a good measure of miniaturization, it is

difficult to imagine the products we may soon see.

Mix together a PDA, a cell phone, and a global positioning satellite (GPS)

receiver, miniaturize the result, and you have a product that will remind you as

you drive past the supermarket where you were supposed to pick up a quart of

milk on the way home! Walk in the door to the market, and your pocket wonder

may tell you, based on your past love of Snickers candy bars, that they are on

sale for half-price on aisle 5. As you move towards the checkout line, the clerk,

who has never met you, may greet you by name because your pocket wonder

has announced your arrival to her cash register. While this scenario may

sound fanciful, all of the technologies exist today that could make this fancy

Information Technology and You 171

real. How these technologies will be used in the future, and the tremendous

entrepreneurial potential for new products and services, is wide open for the

resourceful.

This section is titled "The Future—Today, Tomorrow, and Next Week,"

because the horizon for change in the world of technology is very short. Each

year, major enhancements to both hardware and technology are released, rendering

previous technology obsolete. Some people are paralyzed from buying

computers because they are concerned that the technology will change very

soon. How right they are! The promise of technology is that it is constantly

changing. Today's worker must recognize that fact and learn to adapt to the

changing methods. Those who are technologically comfortable will be the first

to gain strategic advantage in the work environment and succeed. A word to

the wise: Hold on to your hat, and enjoy the ride. Adapt and go with it.

FOR FURTHER READING

There are many excellent books on the personal use of computer systems. Topics

run the spectrum from books about individual software packages to those

that explain how to program a computer. Many of these books come equipped

with a f loppy disk or CD and include step-by-step examples and exercises.

There are several popular series of these books. The following are but a few of

the books you might consider. You would probably find it worth your while to

browse through a number of books at your local store, searching for those that

meet your needs for detail and appear to be aimed at your current level of

understanding.

SYBEX has a series of books on Microsoft's Office software, including

Microsoft Office 2000: No Experience Required by Courter and Marquis.

QUE has published many books on various software applications, including

Microsoft Office 2000 User Manual.

Hungry Minds Inc. has a series of very noteworthy books, the for Dummies

series, one book for nearly every software package (e.g., Excel: Excel for

Dummies). See books on Office 2000, the Internet, and so on.

Microsoft Press also publishes numerous titles for users on both its operating-

system and application software.

USEFUL WEB SITES

Search Engines

www.yahoo.com A good search site which organizes the Web into

a hierarchy of categories

www.northernlight.com A very extensive search engine that organizes

search findings by subject matter

www.google.com A very extensive search site

172 Understanding the Numbers

Computer Information Sites

www.cnet.com A site that provides product reviews and prices

on a broad range of technology products

www.zdnet.com Web site of a large technology publisher, with

product reviews, software downloads, useful

articles, and price comparisons

Accounting Sites

www.aicpa.org Homepage of the American Institute of

Certified Public Accountants, with lots of useful

information and many links to other Web sites of

interest to accountants

www.rutgers.edu Homepage of the American Accounting

/Accounting/raw/aaa Association

Financial Management Site

www.fma.org Homepage of the Financial Management

Association International, with lots of useful

information and many links to other Web sites of

interest to financial managers

finance.yahoo.com Very useful homepage for personal financial

management, with many links to other personal

finance Web sites

173

6 FORECASTS

AND BUDGETS

Robert Halsey

THE CONCEPT OF BUDGETING

Budgets serve a critical role in managing any business, from the smallest sole

proprietor to the largest multinational corporation. Businesses cannot operate

effectively without estimating the financial implications of their strategic plans

and monitoring their progress throughout the year. During preparation, budgets

require managers to make resource allocation decisions and, as a result, to

reaffirm their core operating strategy by requiring each business unit to justify

its part of the overall business plan. During the subsequent year, variances of

actual results from expectations serve to direct management to the areas that

may deserve a greater allocation of capital and those that may need adjustments

to retain their viability.

A budget is a comprehensive formal plan, expressed in quantitative terms,

describing the expected operations of an organization over some future time

period. Thus, the characteristics of a budget are that it deals with a specific entity,

covers a specific future time period, and is expressed in quantitative terms.

This chapter describes the essential features of a budget and includes a

comprehensive example of the preparation of a monthly budget for a small

business. Although the focus of this chapter is on budgeting from a business

perspective, many of the principles are also applicable to individuals in the

planning of their personal finances.

174 Understanding the Numbers

FUNCTIONS OF BUDGETING

The two basic functions of budgeting are planning and control. Planning encompasses

the entire process of preparing the budget, from initial strategic direction

through preparation of expected financial results. Planning is the

process that most people think of when the term budgeting is mentioned. Most

of the time and effort devoted to budgeting is expended in the planning stage.

Careful planning provides the framework for the second function of budgeting,

control.

Control involves comparing actual results with budgeted data, evaluating

the differences, and taking corrective actions when necessary. The comparison

of budget and actual data can occur only after the period is over and actual accounting

data are available. For example, April manufacturing cost data are

necessary to compare with the April production budget to measure the difference

between planned and actual results for the month of April. The comparison

of actual results with budget expectations is called performance reporting.

The budget acts as a gauge against which managers compare actual financial

results.

REASONS FOR BUDGETING

Budgeting is a time-consuming and costly process. Managers and employees are

asked to contribute information and time in preparing the budget and in responding

to performance reports and other control-phase budgeting activities.

Is it all worth it? Do firms get their money's worth from their budgeting

systems?

The answer to those questions cannot be generalized for all firms. Some

firms receive far more value than other firms for the dollars they spend on

budgeting. Budgets do, however, provide a wealth of value for many firms who

effectively operate their budgeting systems. I now discuss some of the reasons

for investing in formal budgeting systems. In the next section of this chapter I

discuss issues that contribute to effective budgeting.

Budgets offer a variety of benefits to organizations. Some common benefits

of budgeting include the following:

1. Requires periodic planning.

2. Fosters coordination, cooperation, and communication.

3. Forces quantification of proposals.

4. Provides a framework for performance evaluation.

5. Creates an awareness of business costs.

6. Satisfies legal and contractual requirements.

7. Orients a firm's activities toward organizational goals.

Forecasts and Budgets 175

Periodic Planning

Virtually all organizations require some planning to ensure efficient and effective

use of scarce resources. Some managers are compulsive planners who continuously

update plans that have already been made and plan for new activities

and functions. At the other extreme are people who do not like to plan at all

and, therefore, find little or no time to get involved in the planning process.

The budgeting process closes the gap between these two extremes by creating

a formal planning framework that provides specific, uniform periodic deadlines

for each phase of the planning process. People who are not attuned to this

process must still meet budget deadlines. Of course, planning does not guarantee

success. People must still execute the plans, but budgeting is an important

prerequisite to the accomplishment of many activities.

Coordination, Cooperation, and Communication

Planning by individual managers does not ensure an optimum plan for the entire

organization. The budgeting process, however, provides a vehicle for the

exchange of ideas and objectives among people in an organization's various segments.

The budget review process and other budget communication networks

should minimize redundant and counterproductive programs by the time the

final budget is approved.

Quantification

Because we live in a world of limited resources, virtually all individuals and organizations

must ration their resources. The rationing process is easier for some

than for others. Each person and each organization must compare the costs and

benefits of each potential project or activity and choose those that result in the

most efficient resource allocation.

Measuring costs and benefits requires some degree of quantification.

Profit-oriented firms make dollar measurements for both costs and benefits.

This is not always an easy task. For example, the benefits of an advertising campaign

are increased sales and a better company image, but it is difficult to estimate

precisely the additional sales revenue caused by a particular advertising

campaign, and it is even more difficult to quantify the improvements in the company

image. In nonprofit organizations such as government agencies, quantification

of benefits can be even more difficult. For example, how does one quantify

the benefits of better police protection, more music programs at the city park,

or better fire protection, and how should the benefits be evaluated in allocating

resources to each activity? Despite the difficulties, resource-allocation decisions

necessitate some reasonable quantification of the costs and benefits of the various

projects under consideration.

176 Understanding the Numbers

Performance Evaluation

Budgets serve as estimates of acceptable performance. Managerial effectiveness

in each budgeting entity is appraised by comparing actual performance

with budgeted projections. Most managers want to know what is expected of

them so that they can monitor their own performance. Budgets help to provide

that information. Of course, managers can also be evaluated on other criteria,

but it is valuable to have some quantifiable measure of performance.

Cost Awareness

Accountants and financial managers are concerned daily about the cost implications

of decisions and activities, but many other managers are not. Production

supervisors focus on output, marketing managers on sales, and so forth. It

is easy for people to overlook costs and cost-benefit relationships. At budgeting

time, however, all managers with budget responsibility must convert their

plans for projects and activities to costs and benefits. This cost awareness provides

a common ground for communication among the various functional areas

of the organization.

Legal and Contractual Requirements

Some organizations are required to budget. Local police departments, for example,

cannot ignore budgeting even if it seems too much trouble, and the National

Park Service would soon be out of funds if its management decided not

to submit a budget this year. Some firms commit themselves to budgeting requirements

when signing loan agreements or other operating agreements. For

example, a bank may require a firm to submit an annual operating budget and

monthly cash budgets throughout the life of a bank loan.

Goal Orientation

Resources should be allocated to projects and activities according to organizational

goals and objectives. Logical as this may sound, relating general organizational

goals to specific projects or activities is sometimes difficult. Many

general goals are not operational, meaning that determining the impact of specific

projects on the organization's general goals is difficult. For example, organizational

goals may be stated as follows:

1. Earn a satisfactory profit.

2. Maintain sufficient funds for liquidity.

3. Provide high-quality products for customers.

These goals, which use terms such as satisfactory, sufficient, and highquality,

are not operational: the terms may be interpreted differently by each

manager. To be effective, goals must be more specific and provide clear direction

for managers. The previous goals can be made operational as follows:

Forecasts and Budgets 177

1. Provide a minimum return on gross assets invested of 18%.

2. Maintain a minimum current ratio of 2 to 1 and a minimum quick ratio of

1.2 to 1.

3. Products must receive at least an 80% approval rating on customer satisfaction

surveys.

EFFECTIVE BUDGETING

There are many reasons why some firms use budgeting more effectively than

others, including the following:

1. Budgets should be oriented to help a firm accomplish its goals and

objectives.

2. Budgets must be realistic plans of action rather than wishful thinking.

3. The control phase of budgeting must be used effectively to provide a

framework for evaluating performance and improving budget planning.

4. Participative budgeting should be utilized to instill a sense of cooperation

and team play.

5. Budgets should not be used as an excuse for denying appropriate employee

resource requests.

6. Management should use the budgeting process as a vehicle for modifying

the behavior of employees to achieve company goals.

Goal Orientation

Some firms have more resources than others, but it seems no firm has all the

resources it needs to accomplish all its goals. Consequently, budgets should

provide a means by which resources are allocated among projects, activities,

and business units in accordance with the goals and objectives of the organization.

As logical as this may sound, it is sometimes difficult to relate general,

organization-wide goals to specific projects or activities. Many general goals

are not operational, meaning the impact of specific projects on the achievement

of the general goals of the organization is not readily measurable.

A prerequisite to goal-oriented budgeting is the development of a formal

set of operational goals. Some organizations have no formally defined goals,

and even those that do often have only general goals for the entire organization.

Major operating units may function without written or clearly defined

goals or objectives. A logical first step toward effective budgeting is to formalize

the goals of the organization. Starting at the top, general organizational

goals should be as specific as possible, and written. Next, each major unit of

the organization should develop more specific operational goals. The process

should continue down the organizational structure to the lowest level of budget

responsibility. This goal development process requires management at all levels

178 Understanding the Numbers

to resolve difficult issues, but it results in a budgeting framework that is much

more likely to be effective since all business units proceed in a coordinated

manner toward the achievement of a common objective. Even individuals need

to understand their goals and objectives as they prepare budgets for their own

activities.

Realistic Plan

Budgeting is not wishful thinking; it is a process designed to optimize the use of

scarce resources in accordance with the goals of the company. Many firms have

budgets that call for sales growth, higher profits, and improved market share,

but to be effective such plans must be based on specific executable plans and

on available resources and management talent that the company can bring to

bear in meeting the budget. If the management of a firm wants to improve its

level of operations, there must be a clearly defined path between the present

and the future that the firm can travel.

The process begins with an analysis of the market and preparation of a

SWOT (strengths, weaknesses, opportunities, and threats) analysis. Utilizing

this background information, the company develops an overall strategy together

with the operational tactics required to achieve it (the development of a

business plan is discussed further in Chapter 9). The financial impact of this

strategy is then assessed in the preparation of the budget. If the financial results

are unfavorable, strategies and tactics must be revised until an acceptable

outcome is achieved. Once the budget is finalized, strategies are implemented

and the company's operations are subsequently monitored throughout the year

in the control phase, as discussed next. Exhibit 6.1 presents an iterative model

that embodies these concepts.

Participative Budgeting

Most behavioral experts believe that individuals work harder to achieve objectives

that they have had a part in creating. Applied to budgeting, this concept

states that employees will strive harder to achieve performance levels defined

by budgets if the employees have had a part in creating the budget. Budgets

imposed by top-level management, in contrast, may get little support from

employees. The concept of building budgets from the bottom up with input

from all employees and managers affected by the budget is called participative

budgeting.

The Control Phase of Budgeting

The first and most time-consuming phase of budgeting is the planning process.

The control phase of budgeting, however, may be the time when firms get the

most value from their budgeting activities. Exhibit 6.2 is a budget-performance

report for the first quarter of 2001. The difference between budgeted and

Forecasts and Budgets 179

actual amount is called a budget variance. Budget variances are reported for

both revenues and costs separately. In this case, revenues were $20,000 under

budget and are, therefore, considered as an unfavorable budget variance (U).

Expenses, though, were $30,000 less than expected, a favorable budget variance

(F). The net result is a favorable, profit budget variance of $10,000.

Each category is then separately analyzed to uncover the source of the

variance. Although total revenues are lower than expected, management is interested

in the actual product lines causing this variance. Further analysis

might reveal, for example, that all of the product lines are performing satisfactorily

except for one that is performing more poorly than expected. On the

expense side, a favorable budget variance may be due to positive effects of management

actions to operate the company more efficiently. Or, positive variances

may have occurred because costs necessary for long-term performance—such as

maintenance of machinery, research and development, or advertising—were

deferred to achieve short-term gains.

Management must thoroughly investigate the causes for budget discrepancies

so that corrective action can be taken. Are markets as a whole performing

EXHIBIT 6.1 Comprehensive budgeting process.

Strategic planning

Market/SWOT analysis

Strategic

development

Budgeting

Implementation

Control

EXHIBIT 6.2 Budget variance report.

Budgeted Actual Variance

Revenues $800,000 $780,000 $(20,000)U

Expenses (500,000) (470,00) 30,000 F

Profit 300,000 310,000 10,000 F

180 Understanding the Numbers

better or worse than expected? Is the company's marketing support adequate?

Has the competitive landscape changed? Are cost variances the result of management

actions in response to competitive pressures or due to inadequate

control? The answers to these questions may suggest changes in the company's

strategic and tactical plans to compensate for the variances.

When actual prices and quantities are compared with expected prices

and quantities, an additional level of analysis can be conducted. Exhibit 6.3 illustrates

a more in-depth analysis of price and quantity variance. During the

month, the firm realizes a positive variance of $6,000 relating to the cost of

aluminum, one of its production inputs.

This $6,000 variance can then be further decomposed into a price variance

and a quantity variance. The price variance is $21,000 favorable because

of the lower than expected purchase price for aluminum. It is computed by

multiplying the price variance per unit ($3 to $2.80) by the actual pounds utilized

(105,000). The quantity variance is $15,000 unfavorable as a result of

lower efficiency in the production process that led to more material usage than

had been expected. This is computed by multiplying the quantity variance

(105,000 to 100,000) by the expected price ($3). This analysis reveals that the

manufacturing process was less efficient than planned in that it utilized more

material to produce its products. This inefficiency was more than offset, however,

by lower prices for direct materials than had been forecasted. The price

variance, therefore, masks the production inefficiency, which would not be revealed

without the additional level of analysis.

Comparing actual results with the budget, adjusting plans when necessary,

and evaluating the performance of managers are essential elements of

budget control. Many people, however, find the control phase difficult. When

business results are less than expected it may be painful to evaluate the results.

For some it is much easier to look ahead to future periods when things hopefully

will be better. But frequently, realistic plans for future success can be

made only when management learns from its past mistakes. The control phase

of budgeting provides much of that learning process. Firms must be willing to

evaluate performance carefully, adjusting plans and performance to stay on

track toward achieving goals and objectives.

EXHIBIT 6.3 Price and quantity variance analysis.

Budgeted Actual Variance

Production level in units 20,000 20,000 0

Lbs aluminum/unit 5.00 5.25 0.25U

Aluminum cost /lb $ 3.00 $ 2.80 $ 0.20F

Total lbs aluminum 100,000 105,000 5,000U

Total material cost $300,000 $294,000 $ 6,000F

Price variance ($3.00 $2.80) × 105,000 = $21,000F

Quantity variance (105,000 100,000) × $3.00 = $15,000U

Total net variance $ 6,000F

Forecasts and Budgets 181

Many companies have intricate budget performance reporting systems in

place, but the firms achieve little control from their use. In order to provide

effective control, a business must use the budget as an integral part of the company's

reward system. That is, employees must understand that budget performance

reports are a component of their performance evaluation. Rewards such

as pay raises, bonuses, and promotions should be tied to budget performance.

Generally it is easy to determine if a company's budget performance reporting

system is working effectively. If, on one hand, discussions with managers

yield comments such as, "If we fail to achieve the budget, we just add

more to it next period," the budget-control process is likely ineffective. If, on

the other hand, employees say, "If we are over our budget by more than 2%, we

will be called on the carpet and forced to explain the problem," then one

knows the control process is having an effect.

Improper Use of Budgets

Sometimes managers use budgets as scapegoats for unpopular decisions. For

example, rather than telling a department head that his or her budget request

for three additional employees is not convincing when compared with all of the

other budget requests, the vice president says, "The budget just would not

allow any new employees this year." In another case, the director of the marketing

department requests travel funds to send all of his staff to an overseas

education program. The vice president believes the program is a waste of

money. Instead of giving the marketing director his opinion, the vice president

says, "We would really like to send your staff to the program, but the budget is

just too tight this year." Of course, the truth in this situation is that the trip is

not a good use of business resources, regardless of the condition of the budget.

The marketing director is left with the impression that the real problem is the

state of the budget, when in fact the benefits of his travel proposal did not outweigh

the cost. Management should be careful not to undermine the budgeting

process by assigning to it adverse characteristics.

Behavioral Issues in Budgeting

Many of the internal accounting reports firms prepare are intended to inf luence

managers and employees to behave in a particular way. For example, many

manufacturing cost reports are intended to enable and motivate employees to

reduce costs or keep them at an acceptable level. Similarly, reports that compare

the performance of one division with those of other divisions are used to

evaluate the performance of division managers and encourage better results

for each division.

Budgets and budget performance reports are among the more useful internal

accounting reports businesses use to inf luence employee performance in

a positive manner. Budget control is based on the principle that managers be

held responsible for activities they manage. Performance reports ref lect the

182 Understanding the Numbers

degree of achievement of plans embodied in the budget. To minimize adverse

behavioral problems, managers should take care to develop and administer budgets

appropriately. Budgets should not be used as a hammer to demand unattainable

performance from employees. The best safeguard against unrealistic

budgets is participative budgeting.

DEVELOPING A BUDGET

Budgets are useful, and in most cases essential, to the success of virtually all

organizations whether they are for-profit or not-for-profit organizations. The

larger and more complex the organization, the more time, energy, and resources

are needed to prepare and implement the budget.

The Structure of Budgets

Regardless of the size or type of organization, most budgets can be divided

into two categories: the operating budget and the financial budget. The operating

budget consists of plans for all those activities that make up the normal operations

of the firm. For a manufacturing business, the operating budget

includes plans for sales, production, marketing, distribution, administration,

and any other activities that the firm carries on in its normal course of business.

For a merchandising firm, the operating budget includes plans for sales,

merchandise purchases, marketing, distribution, advertising, personnel, administration,

and any other normal activities of the merchandising firm. The

financial budget includes all of the plans for financing the activities described

in the operating budget plus any plans for major new projects, such as a new

production plant or plant expansion. Both the operating and financial budgets

are described later in more detail.

The Master Budget

The master budget is the total budget package for an organization; it is the end

product of the budget preparation process. The master budget consists of all the

individual budgets for each part of the organization combined into one overall

budget for the entire organization. The exact composition of the master budget

depends on the type and size of the business. However, all master budgets represent

the organization's overall plan for a specific budget period. Exhibit 6.4

lists the common components of a master budget for a manufacturing business.

The components of the master budget form the firm's detailed operating

plan for the coming year. As noted earlier, the master budget is divided into the

operating budget and the financial budget. The operating budget includes revenues,

product costs, operating expenses, and other components of the income

statement. The financial budget includes the budgeted balance sheet, capital

expenditure budget, and other budgets used in financial management. A large

part of the financial budget is determined by the operating budget and the beginning

balance sheet.

Forecasts and Budgets 183

Exhibit 6.5 is a simplified budget for C&G's Gift Shop. It is prepared on a

monthly basis. The number preceding each heading refers to the applicable

line in the budget.

Sales Budget (1–3)

The sales budget, or revenue budget, is the first to be prepared. It is usually the

most important budget because so many other budgets are directly related to

sales and therefore largely derived from the sales budget. Inventory budgets,

production budgets, personnel budgets, marketing budgets, administrative

budgets, and other budget areas are all affected significantly by the overall

sales volume expected.

For C&G's Gift Shop, expected sales in units are reported on line 1. Note

that the business is highly seasonal, with most of the sales and profits realized

during the months of November and December. To keep the budget simple, we

assume an average sales price of $100 per unit. In practice, the business would

forecast unit sales by individual product lines.

Budgeted Cost of Goods Sold (4)

C&G assumes a cost of goods sold of 65% of sales revenues. This results in a

gross profit of 35%. For a retailing company, cost of goods sold represents the

purchase cost of inventories sold during the period. It is computed as

where all inventories and purchases are computed at the purchase price to the

company.

Cost of Goods Sold Beginning Inventory Purchases during the Period

Ending Inventory

= +

EXHIBIT 6.4 A manufacturing firm's

master budget.

Operating Budget

Sales budget

Budget of ending inventories

Production budget

Materials budget

Direct labor budget

Manufacturing overhead budget

Administrative expense budget

Budgeted non-operating items

Budgeted net income

Financial Budget

Capital expenditure budget

Budgeted statement of financial position (balance sheet)

Budgeted statement of cash f lows

184 Understanding the Numbers

EXHIBIT 6.5 C&G's Gift Shop: 2000 cash budget.

Line Assumptions Nov-99 Dec-99 Jan Feb Mar

1 Total sales—units 5000 6430 3680 3530 2760

2 Selling price 100 100 100 100 100

3 TOTAL GROSS SALES 500000 643000 368000 353000 276000

4 TOTAL COST OF SALES 65% 325000 417950 239200 229450 179400

5 GROSS MARGIN 35% 175000 225050 128800 123550 96600

6

7 Selling expense 15% 75000 96450 55200 52950 41400

8 Administration (fixed) 23000 23000 23000 23000 23000

9 Administration (variable) 10% 50000 64300 36800 35300 27600

10 Depreciation expense 15yr sl amort 3472 3472 3472 3472 3472

11 TOTAL OPERATING EXPENSE 151472 187222 118472 114722 95472

12

13 OPERATING PROFIT 23528 37828 10328 8828 1128

14 Interest income 0 0 0 0 354

15 Interest expense 1956 2872 1989 441 0

16 PROFIT BEFORE TAX 21572 34956 8339 8387 1482

17 Taxes at 35% 7550 12235 2918 2936 519

18 PROFIT AFTER TAX 14022 22721 5420 5452 963

19 Cumulative profit 5420 10872 11835

20 BALANCE SHEET

21 Cash 25000 25000 95836 160060

22 Accounts and interest receivable 65%,30/35%,60 637000 412050 300800 218904

23 Inventory Next month sales 239200 229450 179400 170950

24 TOTAL CURRENT ASSETS 901200 666500 576036 549914

25

26 Property, plant, & equipment (gross) 625000 625000 625000 625000

27 Accumulated depreciation 15yr sl amort 41667 45139 48611 52083

28 Property, plant, & equipment (net) 583333 579861 576389 572917

29

30 TOTAL ASSETS 1484533 1246361 1152425 1122831

31

32 Bank loan (line of credit) 198949 44056 0 0

33 Accounts payable 239200 229450 179400 170950

34 Accrued expenses 198857 119908 114626 92519

35 TOTAL CURRENT LIABILITIES 637006 393414 294026 263469

36

37 Common stock 800000 800000 800000 800000

38 Retained earnings 47527 52947 58399 59362

39 TOTAL SHAREHOLDERS' EQUITY 847527 852947 858399 859362

40

41 TOTAL LIAB. + S/H EQUITY 1484533 1246361 1152425 1122831

42 STATEMENT OF CASH FLOWS (INDIRECT METHOD)

43 Net income 5420 5452 963

44 Depreciation 3472 3472 3472

45 Change in current assets (other than cash) 234700 161300 90346

46 Change in current liabilities (other than notes payable) 88699 55332 30557

47 Net cash f low from operations 154893 114892 64224

48

49 Net cash f low from investing activities 0 0 0

50

51 Net cash f low from financing activities 154893 44056 0

52

53 Net change in cash 0 70836 64224

54 Beginning cash 25000 95836

55 Ending cash 95836 160060

Forecasts and Budgets 185

Apr May Jun Jul Aug Sep Oct Nov Dec Jan

2630 2580 2600 2650 2780 2990 4370 5220 7200 4220

100 100 100 100 100 100 100 100 100 100

263000 258000 260000 265000 278000 299000 437000 522000 720000 422000

170950 167700 169000 172250 180700 194350 284050 339300 468000 274300

92050 90300 91000 92750 97300 104650 152950 182700 252000

39450 38700 39000 39750 41700 44850 65550 78300 108000

23000 23000 23000 23000 23000 23000 23000 23000 23000

26300 25800 26000 26500 27800 29900 43700 52200 72000

3472 3472 3472 3472 3472 3472 3472 3472 3472

92222 90972 91472 92722 95972 101222 135722 156972 206472

172 672 472 28 1328 3428 17228 25728 45528

675 874 932 953 952 921 855 401 0

0 0 0 0 0 0 0 0 80

503 202 460 981 2280 4349 18083 26129 45448

176 71 161 343 798 1522 6329 9145 15907

327 132 299 637 1482 2827 11754 16984 29541

12162 12294 12593 13231 14713 17540 29294 46278 75819

199895 211494 215548 215369 209279 196033 105282 25000 25000

179275 169924 170232 175953 190702 216221 361505 494351 721700

167700 169000 172250 180700 194350 284050 339300 468000 274300

546871 550419 558031 572022 594331 696304 806087 987351 1021000

625000 625000 625000 625000 625000 625000 625000 625000 625000

55555 59027 62499 65971 69443 72915 76387 79859 83331

569445 565973 562501 559029 555557 552085 548613 545141 541669

1116316 1116392 1120532 1131051 1149888 1248389 1354700 1532492 1562669

0 0 0 0 0 0 0 8042 146036

167700 169000 172250 180700 194350 284050 339300 468000 274300

88926 87571 88161 89593 93298 99272 138579 162645 218987

256626 256571 260411 270293 287648 383322 477879 638687 639323

800000 800000 800000 800000 800000 800000 800000 800000 800000

59689 59821 60120 60758 62240 65067 76821 93805 123346

859689 859821 860120 860758 862240 865067 876821 893805 923346

1116316 1116392 1120532 1131051 1149888 1248389 1354700 1532492 1562669

327 132 299 637 1482 2827 11754 16984 29541

3472 3472 3472 3472 3472 3472 3472 3472 3472

42879 8051 3558 14170 28399 115220 200534 261546 33649

6843 55 3840 9882 17355 95674 94557 152766 137358

39835 11599 4054 179 6091 13246 90751 88324 137994

0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 8042 137994

39835 11599 4054 179 6091 13246 90751 80282 0

160060 199895 211494 215548 215369 209279 196033 105282 25000

199895 211494 215548 215369 209279 196033 105282 25000 25000

186 Understanding the Numbers

For a manufacturing company, cost of goods sold is computed similarly, but

in place of purchases we have the cost of the raw materials together with the

labor and overhead incurred in the manufacturing process. Beginning and ending

inventories consist of raw materials, work-in-process, and finished goods.

Administrative Expense Budget (7–10)

The expected administrative costs for an organization are presented in the administrative

expense budget. This budget may contain many fixed costs, some

of which may be avoidable if subsequent operations indicate some cost cuts are

necessary. These avoidable costs, sometimes called discretionary fixed costs,

include such items as research and development, employee education and

training programs, and portions of the personnel budget. Fixed costs that cannot

be avoided during the period are called committed fixed costs. Mortgage

payments, bond interest payments, and property taxes are classified as committed

costs. Variable administrative costs may include some personnel costs, a

portion of the utility costs, computer service bureau costs, and supplies costs.

Fixed and variable costs and the application of these concepts to the budget

process is discussed in detail in Chapters 3 and 7.

C&G's Gift Shop budgets selling expenses at 15% of sales. These are variable

costs since they change in proportion to changes in sales. You might think

of these as commissions paid to the sales personnel as a percent of the sales

made during the period. The fixed portion of administration expense is budgeted

as $23,000 per month. These expenses might be rent, salaries of administrative

personnel, and so forth. The administrative expense also contains a

variable component, budgeted at 10% of sales. Finally, depreciation is computed

on a straight-line basis over 15 years and is a fixed expense budgeted at

$3,472 per month.

Budgeted Income Statement (3 –18)

The budgeted income statement shows the expected revenues and expenses

from operations during the budget period. Budgeted income is a key figure in

the firm's profit plan and ref lects a commitment of most of the firm's talent,

time, and resources for the period.

A firm may have budgeted nonoperating items such as interest on investments

or gains or losses on the sale of fixed assets. Usually they are relatively

small, although in large firms the dollar amounts can be sizable. If nonoperating

items are expected, they should be included in the firm's budgeted income

statement. Income taxes are levied on actual, not budgeted, net income, but

the budget should include expected taxes; therefore, the last figure in the budgeted

income statement is budgeted after-tax net income.

Nonoperating items in C&G's income statement include interest income

and interest expense. Amounts borrowed carry an interest rate of 12% (1% per

month), and cash in excess of the $25,000 required for daily transactions is inForecasts

and Budgets 187

vested in marketable securities earning an investment return of 6% per annum

(0.5% per month). Finally, taxes are levied at the rate of 35% on pre-tax income.

The Financial Budget

The financial budget presents the plans for financing the operating activities

of the firm. The financial budget is made up of the budgeted balance sheet

and the budgeted statement of cash f lows, each providing essential financial

information.

Budgeted Balance Sheet (20 –41)

The budgeted balance sheet for the coming accounting period is derived

from the actual balance sheet at the beginning of the current budget period

and the expected changes in the account balances of the operating, capitalexpenditure,

and cash budgets.

The budgeted balance sheet is more than a collection of residual balances

resulting from other budget estimates. Undesirable projected balances and account

relationships may cause management to change the operating plan. For

instance, if a lending institution requires a firm to maintain a certain relationship

between current assets and current liabilities, the budget must ref lect

these requirements. If it does not, the operating plan must be changed until

the agreed requirements are met.

Budgeted Accounts Receivable (22)

Budgeted accounts receivable are a function of expected sales on open account

and the period of time that the receivables are expected to be outstanding. For

C&G's Gift Shop, all sales are assumed to be on open account to other businesses.

The company expects that 65% of the sales during the period will be

collected in the following month, and 35% will be collected in the next month.

For this exercise, we have assumed that all of the accounts are collectible. If

not, the company would have to build in a provision for uncollectible accounts

that would reduce expected collections and be ref lected in the income statement

as bad debt expense.

Budget of Ending Inventories (23)

Inventories comprise a major portion of the current assets of many manufacturing

firms. Separate decisions about inventory levels must be made for raw

materials, work-in-process, and finished goods. Raw material scarcities, management's

attitude about inventory levels, inventory carrying costs, inventory

ordering costs, and other variables may all affect inventory-level decisions.

C&G's Gift Shop has a policy to maintain inventory on hand equal to the

next month's expected cost of goods sold.

188 Understanding the Numbers

Capital Expenditure Budget (26)

The capital expenditure budget is one of the components of the financial budget.

Each of the components has its own unique contribution to make toward

the effective planning and control of business operations. Some components,

however, are particularly crucial in the effective management of businesses,

such as the cash and capital expenditure budgets.

Capital budgeting is the process of identifying, evaluating, planning, and

financing an organization's major investment projects. Decisions to expand

production facilities, acquire new production machinery, buy a new computer,

or remodel the office building are all examples of capital-expenditure decisions.

Capital-budgeting decisions made now determine to a large degree how

successful an organization will be in achieving its goals and objectives in the

years ahead. Capital budgeting plays an important role in the long-range success

of many organizations because of several characteristics that differentiate

it from most other elements of the master budget.

First, most capital budgeting projects require relatively large commitments

of resources. Major projects, such as plant expansion or equipment replacement,

may involve resource outlays in excess of annual net income.

Relatively insignificant purchases are not treated as capital budgeting projects

even if the items purchased have long lives. For example, the purchase of 100

calculators at $15 each for use in the office would be treated as a period expense

by most firms, even though the calculators may have a useful life of several

years.

Second, most capital expenditure decisions are long-term commitments.

The projects last more than 1 year, with many extending over 5, 10, or even 20

years. The longer the life of the project, the more difficult it is to predict revenues,

expenses, and cost savings. Capital-budgeting decisions are long-term

policy decisions and should ref lect clearly an organization's policies on growth,

marketing, industry share, social responsibility, and other goals. This is discussed

in greater depth in Chapter 10.

For purposes of this exercise, we have assumed that C&G's Gift Shop will

not be making any capital expenditures in the upcoming year. As a result, property,

plant, and equipment (PP&E; line 26) remains constant. Net PP&E (line

28), however, is reduced each period by the addition of depreciation expense

to accumulated depreciation.

Budgeted Accounts Payable (33)

Accounts payable represent amounts owed to other businesses for the purchase

of goods and services. These are usually non-interest bearing. We have assumed

that all the inventories are purchased on open account and that the

terms of credit require payment in full in the following month. As a result, accounts

payable are equal to the cost of inventories in this example.

Forecasts and Budgets 189

Budgeted Accrued Expenses (34)

Expenses are recognized in the income statement when incurred, regardless of

the period in which they are paid. For this example, we assume that all of the

operating expenses incurred and recognized during the month are paid in the

following month. These expenses include selling expenses, administrative expenses

other than depreciation, interest expense, and taxes.

Bank Loan (Line of Credit) (32)

Businesses require cash to cover the portion of inventories and accounts receivable

that are not financed by trade accounts payable and accrued expenses.

This is very pronounced in seasonable businesses. For example, C&G's Gift

Shop must purchase inventories one month in advance of sales. And when

these inventories are sold, 65% of the proceeds are collected in the subsequent

month and 35% in the month thereafter. As a result, C&G has a considerable

amount of cash invested in the business that is not recouped for at least two

months.

Typically, short-term cash needs such as the needs of seasonal businesses

are met with a bank line of credit that allows the company to borrow funds up

to a predetermined maximum and to repay those loans at a later date. In this

case, funds are borrowed to finance the purchase of inventories and these

amounts are repaid when the receivables are collected.

Stockholders' Equity (37–39)

No sales of common stock are budgeted. Since no dividends are projected, retained

earnings (38) increase by the amount of profit for the month.

Cash Budget

Of all the components of the master budget, none is more important than the

cash budget. Of the two major goals of most profit-seeking firms—to earn a

satisfactory profit and to remain liquid—liquidity is more important. Many

companies lose money for many years, but with adequate financing they are

able to remain in business until they can become profitable. Firms that cannot

remain liquid, in contrast, are unable to pay their bills as they come due. In

such cases, creditors can and often do force firms out of business. Even government

and nonprofit organizations such as churches and charities must pay

their bills and other obligations on time.

Meeting cash obligations as they come due is not as simple as it may appear.

Profitability and liquidity do not necessarily go hand-in-hand. Some firms

experience their most critical liquidity problems when they go from a breakeven

position to profitability. At that time growing receivables, increased inventories,

and growing capacity requirements may create cash shortages.

190 Understanding the Numbers

The cash budget is a very useful tool in cash management. Managers estimate

all expected cash f lows for the budget period. The typical starting point

is cash from operations, which is net income adjusted for non-cash items, such

as depreciation, and required investment in net working capital (accounts receivable

and inventories less accounts payable). All nonoperating cash items are

also included. Purchase of land and equipment, sales of bonds and common

stock, and the acquisition of treasury stock are a few examples of nonoperating

items affecting the cash budget. The net income figure for an accounting period

usually is very different from the cash f low for the period because of nonoperating

cash f low items or changes in working capital.

Often, cash budgets are prepared much more frequently than other budgets.

For example, a company may prepare quarterly budgets for all of its operating

budget components such as sales and production and also for its other

financial budget components such as capital expenditures. For its cash budget,

however, the firm prepares weekly budgets to ensure that it has cash available

to meet its obligations each week and that any excess cash is properly invested.

In companies with very critical cash problems, even daily cash budgets may

be necessary to meet management's information requirements. The frequency

of cash budgets depends on management's planning needs and the potential for

cash management problems.

Cash management is intended to optimize cash balances; this means having

enough cash to meet liquidity needs but not so much that profitability is

sacrificed. Excess cash should be invested in earning assets and should not be

allowed to lie idly in the cash account. Cash budgeting is useful in dealing with

both types of cash problems.

Budgeted Statement of Cash Flows—

Indirect Method (42–55)

The final element of the master budget package is the statement of cash f lows.

The increased emphasis by management in recent years on cash and the

sources and uses of cash has made this an ever more useful management tool.

This statement is usually prepared from data in the budgeted income statement

and changes between the estimated balance sheet at the beginning of the budget

period and that at the end of the budget period.

The statement of cash f lows consists of three sections, net cash flows

from operations, net cash f lows from investing activities, and net cash flows

from financing activities. Net cash f lows from operations are equal to net income

plus depreciation expense plus or minus changes in current assets (other

than cash) and current liabilities (other than bank loans). Increases (decreases)

in current assets are treated as cash outf lows (inf lows), and increases (decreases)

in current liabilities are treated as cash inf lows (outf lows).

Net cash f lows from investing activities consist of changes in long-term

assets. Since we do not project any capital expenditures, net cash f lows from

investing activities are equal to zero in all months.

Forecasts and Budgets 191

Net cash f lows from financing activities consist of changes in borrowed

funds (short and long term), changes in other long-term liabilities, changes in

common stock, and dividends paid. The only financing activities in this example

are increases (decreases) in bank loans outstanding. The bank line of credit

is the buffer that keeps assets equal to liabilities and stockholders' equity. As

assets grow with increases in inventories and accounts receivable, bank loans

increase as well to finance this growth. And as the inventories are sold and the

receivables collected during slower periods, the excess cash is used to repay

the amounts borrowed. Banks typically require that the line of credit be paid

in full at some point during the year. Any excess funds generated after repayment

of the bank loans are invested in short-term marketable securities until

required again to finance seasonal growth in assets.

FORECASTING

Sales budgets are inf luenced by a wide variety of factors, including general

economic conditions, pricing decisions, competitor actions, industry conditions,

and marketing programs. Often the sales budget starts with individual sales

representatives or sales managers predicting sales in their particular areas. The

basic sales data are aggregated to arrive at a raw sales forecast that is then

modified to ref lect many of the variables mentioned previously. The resulting

sales budget is expressed in dollars and must include sufficient detail on product

mix and sales patterns to support decisions about changes in inventory levels

and production quantities.

In addition to the input from sales personnel, companies frequently utilize

a number of statistical techniques to estimate future sales. For example,

Exhibit 6.6 is a graph of the quarterly sales of Kellogg Company from 1990 to

2000.

The sales appear to demonstrate some variation around an upward trend.

How would one forecast sales for the next 12 quarters? Projecting from the

most recent sales level might overstate the estimates if the last quarter was

unusually high because of, say, the effects of a major advertising campaign or

new-product introduction, or seasonal increases. An alternative is to estimate

the underlying trend in quarterly sales. Exhibit 6.7 presents such a graph.

In Exhibit 6.7, I have estimated a trend line for Kellogg's quarterly sales

using a statistical technique called regression analysis. This line was estimated

with a statistical software package called Minitab, but the analysis is also available

in Microsoft Excel and many other software programs. The equation for

the trend line is

where Salest is the sales for time t (t = 41 for the first quarter estimated, since

our data ended at quarter number 40). Our forecasts for the next 12 quarters

Salest = $1,475, 002 + $8, 357.73 × t

192 Understanding the Numbers

extend linearly with a continuation of the same slope that was estimated in the

trend line fit through the data.

A potential problem with fitting a trend line through the data with regression

analysis is that each observation is treated the same way. That is, we

are not weighting the information contained in the latest set of observations

more heavily than those that occurred 30 quarters ago. Other statistical techniques

are available to address this concern. One of these is exponential

smoothing. Exhibit 6.8 presents the same quarterly sales data with a trend line

that has been exponentially smoothed.

EXHIBIT 6.6 Kellogg company's quarterly sales (1990 –2000).

Index 10 20 30 40

Sales ($)

Quarters

1,900,000

1,800,000

1,700,000

1,600,000

1,500,000

1,400,000

EXHIBIT 6.7 Trend analysis for Kellogg company's quarterly sales

(1990 –2000).

Actual

Fits

Forecasts

0 10 20 30 40 50

Quarters

Sales t = $1,475,002 + $8,357.73 × t

MAPE:

MAD:

MSD:

Linear Trend Model

Sales ($)

1,900,000

1,800,000

1,700,000

1,600,000

1,500,000

1,400,000 4

67,504

7.65E+09

Forecasts and Budgets 193

Notice how the estimated trend line reacts to changes in quarterly sales.

This technique weights recent observations more heavily than those in the distant

past. The result is a trend line whose slope changes over time to ref lect

changes in sales growth. Our projections for the next 12 quarters, then, begin

from the last estimate of the underlying trend and at the most recent slope indicated

by the data.

Many other statistical techniques can also be brought to bear on this

problem. These provide an objective estimate of future sales from the data itself.

Their advantage is that they are not prone to biases from wishful thinking

or undue pessimism. Their drawback is that they cannot take into account all

of the variables witnessed by our sales personnel and therefore, do not have as

much of a "feel" for the market. Companies must utilize a variety of inputs

into the projection process, and they derive some level of comfort when several

different approaches yield similar results.

Projection is a critical part of the budgeting process. It follows from our

SWOT analysis and the resulting strategic and tactical plan. Once these are

formulated, sales projections and the subsequent budgeting process outlined

above provide an evaluation of the effectiveness of the business plan.

FIXED VERSUS FLEXIBLE BUDGETS

Many organizations operate in an environment where they can predict with

great accuracy the volume of business they will experience during the upcoming

budget period. In such cases, budgets prepared for a single level of activity

typically are very useful in planning and controlling business activities. Budgets

prepared for a single level of activity are called fixed budgets.

EXHIBIT 6.8 Double exponential smoothing of Kellogg company's

quarterly sales (1990 –2000).

0 10 20 30 40 50

Quarters

Gamma (trend):

Alpha (level):

Smoothing Constants

Double Exponential Smoothing

Sales ($)

2,150,000

1,900,000

1,650,000

1,400,000

Actual

Predicted

Forecasts

MAPE:

MAD:

MSD:

5

79,481

0.200

9.08E+09

0.200

194 Understanding the Numbers

Organizations that have trouble predicting accurately the volume of activity

they will experience during the budget period often find that a budget

prepared for only one level of activity is not very helpful in planning and controlling

their business activities. These organizations can operate better with a

budget prepared for several levels of activity covering a range of possible levels

of activity. This type of budget is called a f lexible budget.

Fixed Budgets

A fixed budget, or static budget, contains budget data for only one specific volume

of activity. Because fixed budgets use only one volume of activity in determining

all budgeted data, the fact that some costs are fixed and some costs

are variable has no impact on the budgeted figures. The budget data used in

preparing the budget for the planning phase of the process are also used in

budget performance reports during the control phase of the budget process regardless

of whether the volume of activity is actually achieved.

The planning and control framework provided by a budgeting system is an

essential element of effective management. In many organizations, fixed budgets

are tools that offer managers the ability to plan and control operations and

to evaluate performance. If, however, the actual volume of activity achieved

by a firm is sufficiently different from the volume planned in the fixed budget,

the fixed budget may be a very poor measure on which to base the performance

of employees.

Flexible Budgets

A f lexible budget, also called a dynamic budget, is prepared for more than one

level of activity. For example, a firm may prepare budgets for 10,000, 11,000,

and 12,000 units produced. The purpose of preparing budgets for multiple activity

levels is to provide managers with information about a range of activity

in case the actual volume of activity differs from the expected level. For planning

material acquisitions, labor needs, and other resource requirements, managers

continue to rely heavily on the budget based on the expected level of

activity, but the f lexible budget provides additional information useful in modifying

plans if operating data indicate that some other level of activity will

occur. When performance reports are prepared, actual results are compared

with a budget based specifically on the level of activity actually achieved.

Actual activity may differ significantly from budgeted activity because of

an unexpected strike, cancellation of a large order, an unexpected new contract,

or other factors. In a business that frequently experiences variations in

its volume of activity, a f lexible budget may be more useful than a fixed budget.

Flexible budgets provide managers with more useful information for planning

and a better basis for comparing performance when activity levels

f luctuate than is available from a fixed budget. Flexible budgets are discussed

in more detail in Chapter 7.

Forecasts and Budgets 195

The Profit Plan

Though the term profit plan is sometimes used to refer to a master budget, it

probably best describes the operating part of the master budget of a forprofit

firm. It can be argued, however, that the entire master budget of such

firms is the total profit plan for the firm. The operating budget shows details

of budgeted net income, but the financial budgets, such as cash and capital

expenditure budgets, are also an integral part of the overall profit planning of

the firm.

Naturally, the term profit plan is not suitable for public-sector firms. Organizations

such as a fire department do not generate a net income. For publicsector

organizations, master budget is the more logical term for the total

budget package. Because we are concerned with both public- and privatesector

organizations, we use master budget predominantly. However, be aware

of profit plan because it is used occasionally in practice.

THE BUDGET REVIEW PROCESS

The budget plan determines the allocation of resources within the organization.

Typically, the resources available are less than the demand for the resources.

Consequently, there should be some systematic process for evaluating

all proposals relating to the budget. The process of systematically evaluating

budget proposals is referred to as the budget review process.

In the early planning stages, budget review may not be a formal process.

Sometimes a few people (or even a single individual) make the budgeting decisions.

For example, production-line supervisors may determine resource allocations

within their department. Next, a plant budget committee may evaluate

budget proposals for all production supervisors. The budget proposals for the

entire plant go to a division budget committee, and the final budget review is

made by a budget committee of the controller and corporate vice presidents.

The budget review process varies among organizations. Even within a single

firm, different budget review processes may be used in various segments of

the firm, and at various levels of responsibility. However, the basic review process

is fairly standard.

Accountants and financial managers participate in the preparation and

implementation of the budget, but all business managers, including marketing

managers, production supervisors, purchasing officers, and other nonfinancial

managers are interested in developing budgets for their particular part of the

business. In addition, each functional manager must be keenly interested in

selling her or his budget to higher-level management. Selling the budget means

convincing the budget review committee that a particular budget proposal

should be accepted. For some managers, selling the budget is the single most

important activity in their job, because if they fail at this task, even a tremendous

management effort cannot obtain desired results.

196 Understanding the Numbers

With such an awesome description of the importance of selling the budget,

one might conclude that it is an exceedingly difficult process. Not so. Actually,

the process requires a mixture of logic and diligence. There is no precise

formula for success, but some common suggestions are:

1. Know your audience.

2. Make a professional presentation.

3. Quantify the material.

4. Avoid surprises.

5. Set priorities.

Know Your Audience

A large part of a budget-selling strategy may depend on the budget review audience,

whether it is one person or a group of people. Information that may

prove essential to the successful budget approval effort includes: Strategies

that have succeeded or failed in the past; pet peeves or special likes of review

members; and a variety of other committee characteristics.

Make a Professional Presentation

A professional presentation is critical to gaining acceptance of the proposal.

This typically includes:

• An enthusiastic and polished presentation.

• A neat, concise, and understandable budget proposal.

• Ample supporting documentation.

• A willingness and ability to answer relevant questions.

Quantify the Material

Because most resource allocation decisions are in some way affected by their

cost-benefit relationships, it is necessary to quantify both the costs and benefits

of virtually all budget proposals. Cost estimation is seldom easy, but it is usually

far easier than the measurement of benefits. Even in the private sector, benefits

are not always easy to measure in terms of the corporate goals of profitability

and liquidity. In the nonprofit sector, benefit measurement is even more

difficult. For example, how does one measure the benefits of 20 new park

rangers, 10 new police cars, or a decorative fountain in the city park? Obviously

the quantification process would be different for each of these, and direct comparisons

could be inconclusive. Yet, such comparisons may be necessary in arriving

at final budget allocations.

It is easy to dismiss the value of quantification when the resulting numbers

are hard to compare with other budget proposals or the numbers are hard

to verify. Nevertheless, some quantitative support typically is better than just

Forecasts and Budgets 197

general statements about the desirability of the budget proposal. Budget salesmanship

should be approached with the same ingenuity that is found in the external

marketing effort. If certain budget proposals have benefits that are

difficult to quantify directly, various types of statistics might support the projects

in an indirect way. For example, if a police department wants to justify 10

new police officers, it might offer supporting statistics on rising population

in the community, rising crime rates, or relatively low per-capita police cost

ratios. Although none of the suggested statistics measures direct benefits, they

may be more useful in swaying a budget review committee than some vague

statement about the value of more officers. Statistics that are not direct measures

of benefits are used widely in both the public and private sectors when

supporting budget proposals.

Avoid Surprises

Avoid surprising either review committee or those who present the budget.

New proposals and information are hard to sell to a budget review committee

and should be introduced and developed long before the final review process.

Surprises to managers presenting the budgets most often occur during

the questioning process or when a budget proposal is more detailed than prior

budgets. To minimize this problem, budget presentations should be carefully

rehearsed. The rehearsal might include a realistic or even pessimistic mock review

committee. The mock review should ask pointed and difficult questions.

Sometimes knowing the answer to a relatively immaterial question is enough

to secure a favorable opinion.

Set Priorities

Few managers receive a totally favorable response to all budget requests. In a

world of limited resources, wants exceed available resources, and managers

should be prepared for a budget allocation that is somewhat different from the

initial request. Typically, all proposed budget items are not equally desirable.

Some projects and activities are essential; others are highly desirable. Some

would be nice but are really not essential.

Priority systems established by the managers of each budgeting entity

before the review process starts aid in structuring the budget proposal so that

important items are funded first. Setting priorities avoids embarrassing questions

and last-minute decision crises that affect the quality of a professional

presentation.

FOR FURTHER READING

Brownell, P., "Participation in Budgeting, Locus of Control, and Organizational Effectiveness,"

The Accounting Review, 56, no. 4 (Oct. 1981): 844–861.

198 Understanding the Numbers

Carruth, Paul J., and Thurrel 0. McClendon, "How Supervisors React to Meeting the

Budget Pressure," Management Accounting, 66 (Nov. 1984): 50.

Chandler, John S., and Thomas N. Trone, "Bottom Up Budgeting and Control," Management

Accounting, 63 (Feb. 1982): 37.

Chandler, Susan, "Land's End Looks for Terra Firma," Business Week, July 8, 1996,

130–131.

Collins, Frank, Paul Munter, and Don W. Finn, "The Budgeting Games People Play,"

The Accounting Review, 62 (Jan. 1987): 29.

Leitch, Robert A., John B. Barrack, and Sue H. McKinley, "Controlling Your Cash Resources,"

Management Accounting, 62 (Oct. 1980): 58.

Merchant, Kenneth A., "The Design of the Corporate Budgeting System: Inf luences

on Managerial Behavior and Performance," The Accounting Review, 56 (Oct.

1981): 813.

and J. Manzoni, "The Achievability of Budget Targets in Profit Centers: A

Field Study," The Accounting Review, 64, no. 3 (July 1989): 539–558.

Merewitz, Leonard, and Stephen H. Sosnick, The Budget's New Clothes (Chicago:

Markham Publishing Company, 1973).

Penne, Mark, "Accounting Systems, Participation in Budgeting, and Performance

Evaluation," The Accounting Review, 65, no. 2 (April 1990): 303–314.

"Tenneco CEO Mike Walsh's Fight of His Life," Business Week, September 20,

1993, 62.

Trapani, Cosmo S., "Six Critical Areas in the Budgeting Process," Management Accounting,

64 (Nov. 1982): 52.

Wildavsky, Aaron, The Politics of the Budgetary Process, 2nd ed. (Boston: Little,

Brown, 1974).

199

7 MEASURING

PRODUCTIVITY

Michael F. van Breda

"Control is what we need. Cost control. And urgently," said owner-manager

Dana Jackson emphatically to her management team. "Just a glance at these

reports tells me that our costs are going up faster than our revenues. We won't

survive much longer on that basis."

"Well, we could try using cheaper inks and lower quality paper," said Tom

Dodge, production manager of Jackson Printing, half-facetiously.

"That's not the answer," exclaimed marketing manager Ahmad Grande.

"We're having a hard enough time as it is selling in this competitive market. If

we start to produce an inferior product, our sales will tumble even further. Nobody

is going to pay our prices and take cheaper quality."

"Ahmad's right," said Dana. "Our aim should not be to reduce costs so

much as to control them. Remember that we have a goal to meet in this organization—

to produce the best-quality products that we can. If we don't keep our

eyes on that goal we won't be effective as an organization.

"What I'm really after is efficiency. I want to see us produce quality

products as cheaply as possible—but I don't want us to produce cheap products.

We must improve productivity.

"To get the ball rolling, I want Tom to draw up a set of standards for production.

Our attorney has been explaining the new system they have installed

in their office to control their billable hours. We could do something similar in

our business."

As eyes rolled, Dana explained what their law firm had done. "I was

telling their senior partner about our concerns and he related to me his own

200 Understanding the Numbers

conversation with one of his associates. She was expected to bill approximately

500 hours each quarter to clients. She had actually reported 570 hours, which

pleased him, but she had only brought in $70,500 when he would have expected

$85,500 based on her standard billing rate of $150 per billable hour.

That was $15,000 below his expectations.

"She explained to him that on the Prescot case the partner that she was

assisting had asked her to do some library research on an alternative theory of

liability. She spent 80 hours working on this research, but in the end the partner

decided not to adopt that alternative theory. The partner instructed her

not to charge those 80 hours out, so, at her hourly billing rate of $150, that was

$12,000 of the total shortfall.

"As for the other $3,000, she explained that on the Klinger case the client

felt that the $150 per hour was an excessive rate to charge for an inexperienced

lawyer like her. The partner in charge of this case agreed to cut her hourly rate

to $125. She spent 120 hours on that case, so, at $25 per hour not billed, there

was the other $3,000. He summarized her results for me like this:

"In other words, as he explained it, she actually put in only 490 billable hours,

even though she worked 570 hours, as opposed to the expected 500 hours. She

charged an average $143.88 instead of the expected $150. They use these numbers

to break their total variance into two parts: a volume variance and a rate

variance computed as follows:

"They like to do this in percentage or index terms, too.

"So they know not only the total amount that their actual costs differed from

the budget but also causes of this difference, namely the drop in 10 hours and

the drop in the rate of $6.12, and they can identify the effect of each cause on

their costs in dollars and percentage terms. That way they can pinpoint the

areas that need particular investigation. Things that don't need attention can

be safely neglected, leaving time to more carefully manage the exceptions.

"The percentage approach also enables them to introduce two other

indices, that of the hours billed to the hours actually worked, namely 490/570

or 86%, and the hours actually worked to those budgeted, 570/500 or 114%. In

other words, this associate worked 14% more than she should have but actually

Volume Index or a 2% drop

Rate Index or a 4% drop

= =

= =

.

.

.

490

500

0 98

143 88

150

0 96

Volume Variance hours $150.00 =$1, 500

Rate Variance 490 hours =$3, 000

= − ×

= − ×

( )

$( . . )

500 490

150 00 143 88

Actual Billings billable hours per hour

Budgeted Billings billable hours per hour

Total Variance billable hours unfavorable

= = ×

= = ×

= − =

$ , $ .

$ , $ .

$ , $ , $ ,

70 500 490 143 88

75 000 500 150 00

70 500 75 000 4 500

Measuring Productivity 201

billed only 86% of those hours. As he noted, that suggests a serious problem,

especially when one compares her with the firm average.

"Their firm," continued Dana, "does this for every one of their associates.

They can thereby track the actual revenues of their firm and compare it with

the budgeted revenues. They can see whether any shortfalls or overages are

due to charging out more or fewer billable hours than expected, or to charging

clients more or less than the standard rate, or to some combination of the two.

It gives them an excellent tool to see how their firm is doing. They can also analyze

productivity in the firm: in total, month by month, as well as by departments

within the law firm, such as trust and estate, corporate, litigation, family

law, and so on, right down to individual lawyers in the firm. And knowing what

has happened in the past, they have an excellent tool for beginning to plan for

the future. I think we should be doing something similar!

"If we do, we'll have an idea whether the production staff is working efficiently.

If we have those standards in hand, then we can check how much our

product should be costing us. And, we'll be able to compare that figure with actual

product cost. Checking the difference between actual and budget will tell

us where our big problems are. With that information in hand, we should be

able to get our costs much more under control and our productivity up."

"Agreed," responded Ahmad. "People will pay for a quality product if it is

competitively priced. We've just got to make sure that we're working as efficiently

as our competition, and we'll be fine. That means, when we draw up

a price quote, we need to be able to come in at or below the quotes of our

competitors."

"That's all very well for you to say," said Tom, feeling a little aggrieved.

"You're not the one who has to draw up these productivity standards. I've tried

doing this before and it's not easy, let me tell you. For starters everyone seems

to want perfection."

"The other thing that I think we need to be aware of," added Ahmad, "is

that variance analysis is just a start. We need a range of performance measures

that capture not only our productivity but also the value that we are adding to

our customers. For instance, we know from the newspapers that the firm saved

the Prescots tens of thousands of dollars. That was a very successful case for

them, and that needs noting. What we really need is a balanced scorecard that

adds a customer perspective to our more internal focus."1

With that the meeting broke up. Tom went back to his office, realizing

that he was not quite sure where to begin. For one thing, he hadn't shared the

fact that he had not succeeded in his last attempt to install a standard cost system.

What chance did he have this time? A call to a friend of his, Jane Halverson,

who had just completed her MBA, seemed in order.

BUDGETARY CONTROL

"Jane, I need your help badly," Tom pleaded. "My boss is after a set of production

standards and I don't know what to do or where to begin!"

202 Understanding the Numbers

Def ining Standards

That evening Tom went over to Jane's home, and she pulled out her cost accounting

textbook. "Tell me everything you think I need to know about standard

costs," Tom said.

"Okay. First, Tom, let's get straight what we mean by a standard and

why we're calculating it. A standard is a basis of comparison; it's a norm, if

you will, or a yardstick. Some like to compare it to a gauge—a gauge to measure

efficiency.

"But a standard is more than that really because it is also the basis for control.

Standards enable management to keep score. The difference between

standards and actuals directs management's attention to areas requiring their

efforts. In that sense, standards are attention getters. They form the heart of

what is known as management by exception, the concept that one does not

watch everything all the time; instead one focuses one's attention on the exceptions,

the events that are unexpected."

Tom smiled knowingly. "I've experienced this and it's terrible. My boss at

my last job never noticed the good job that I did every day. But, when something

went wrong, he was down like a shot to bawl me out!"

"That's one of the traps of managing by exception," said Jane. "But you're

smart enough as a manager to know that people need to be rewarded for their

regular jobs. You also know that the exceptions are highlighted so that you can

help them remedy things—not shout at them. Also, outstanding performance

should be rewarded, and so, by means of management by exception, favorable

results are highlighted, allowing high performers to receive praise."

Types of Standards

"Then you have to realize," Jane went on, "that there are different kinds of

standards. First you have your basic standards. These are the one's that are unchanging

over long periods of time. Many of these are captured in policy statements

and may ref lect things like the percentage of waste that is permitted or

the amount of time one might be away from a workstation. Basic standards are

not much use in forming costs, though, because the work environment tends to

change too much.

"At the other extreme there are theoretical or ideal standards. These get

set by engineers and are the ideals to which one is expected to strive. These are

the standards that I think you feel are unrealistic."

"Hear! Hear!" broke in Tom. "My guys never would accept those standards—

that's the perfection mentality I was telling you about."

"But," asked Jane, "aren't the Japanese always striving towards ideal

standards?"

"True, but the difference between them and us is that their system of

lifetime employment provides a more supportive atmosphere in which they can

strive for perfection and not feel they are going to get fired if they don't quite

Measuring Productivity 203

make it this time around. It's not enough to look at standards in isolation. One

must view them in the context of total management."

"Right," said Jane approvingly. "And that means that your best norms to

develop are probably what are called currently attainable standards. These are

standards that can be met but still represent a challenging goal. Let me read

you a quote:

Such standards provide definite goals, which employees can usually be expected

to reach, and they also appear to be fair bases from which to measure

deviations for which the employees are held responsible. A standard set at a

level which is high yet still attainable with reasonably diligent effort and attention

to the correct methods of doing the job may also be effective for stimulating

efficiency.2

I think that's the kind of standard you are after."

"You're right. And, I tell you there are real advantages to standards set at

this level. My guys find them very motivating. Also, when it comes time to costing

jobs out for pricing purposes, we have a reasonable shot at making those

standards. Of course, that wouldn't stop us from trying for perfection. It's just

that we wouldn't have management breathing down our necks when we didn't

make it."

Budgets

"Tell me one more thing, though," said Tom. Why do we have to go to all this

bother to develop standards. Why can't top management just use last year's

numbers? That will give them a base for comparison."

"True," said Jane. "But you've got to remember that last year's actuals ref

lect last year's circumstances. Things may have changed this year so much

that last year is not a fair comparison. How would you like it if they didn't adjust

your materials budget for inf lation but expected you to produce as much

this year as you did last?"

"Okay—you've made your point. But, why can't they just get our controller

to draw up a budget at the start of the year. Why do I have to get

involved?"

"Two reasons. One is that the controller can't draw up a budget without

standards. Standard costs are the unit costs that go into a budget. The budget

contains your standards multiplied by the expected volume of sales provided

by the marketing department.

"The other reason you need to get involved is that the budget needs to be

adjusted for volume. You want them to evaluate you on the basis of a f lexible

budget, as opposed to a static budget. The only way to be fair to people is to use

a f lexible budget. Look at these numbers for instance." Jane scribbled down

the numbers appearing in Exhibit 7.1.

"Notice how the budget is drawn up in the first column: You estimate the

volume for the year and multiply it by the estimated unit selling price or the

204 Understanding the Numbers

estimated unit cost, the standard cost. Fixed costs remain the same, of course,

and are just inserted into the budget. The last column shows the actual revenues

and actual costs: To get them you multiply the actual selling or the actual

unit cost by the actual volume. The middle column shows the estimated selling

price and the estimated unit costs multiplied by the actual volume.

"Note that the only difference between the f lexible budget in column 2

and the static budget in column 1 lies in the volume being used. The static budget

uses the expected volume while the f lexible budget uses the actual volume.

In other words, the difference between f lexible and static may be attributed

entirely to changing activity levels. The difference is, therefore, dubbed an activity

variance.

"The unit price and cost terms for the actual revenues and costs in column

3 differ from the corresponding price and cost terms for the f lexible budget

in column 2; however, the activity level is the same: Both use the actual

level of sales. In other words, the difference between actual and f lexible may

be attributed to changing selling and cost prices. These differences are dubbed

the price variances. Let's summarize the definitions of these terms.

"Now look what happens if all you have is the budget from the beginning of the

year. The variable costs, for which you are responsible, are $1,400 above budget.

You could reasonably expect to have your boss down here chewing you out

for not controlling your costs. But, if you know your standard costs, you can adjust

the budget for volume and give him the number in the second column.

That comparison shows that you actually got your costs down by $900. Let me

show you what I mean in more depth."

Price Variance Actual Results Flexible Budget

Activity Variance Flexible Budget Static Budget

Price Index

Actual Results

Flexible Budget

Activity Index =

Flexible Budget

Static Budget

= −

= −

=

EXHIBIT 7.1 Static versus f lexible budgets.

Budget (Static) Budget (Flexible) Actual

Volume in reams 1,000 1,200 1,200

Revenues $12,000 $14,400 $13,800

at $12/ream at $12/ream at $11.50/ream

Variable costs $7,000 $8,400 $7,500

at $7.00/ream at $7.00/ream at $6.25/ream

Fixed costs $4,000 $4,000 $4,680

Net income $1,000 $2,000 $1,620

Measuring Productivity 205

With that Jane started to prepare Exhibit 7.2. First, to prepare Panel A

she compared the actual results with the original budget, the static budget. She

derived the percentage change by dividing the actual by the budget, subtracting

one from the result, and multiplying the remainder by 100. For instance, in

the case of revenue:

She did similar computations for the other lines and other panels.

Step 1.

Step 2.

Step 3.

13 800

12 000

1 15

1 15 1 0 15

0 15 100 15

,

,

.

. .

. %

=

− =

× =

EXHIBIT 7.2 Comparing the budgets.

Panel A

Actual versus Static Budget

Static Percentage

Budget Actual Indixes Change

Revenue $12,000 $13,800 1.15 15

Variable costs 7,000 7,500 1.07 7

Contribution $ 5,000 $ 6,300 1.26 26

Fixed costs 4,000 4,680 1.17 17

Net income $ 1,000 $ 1,620 1.62 62

Panel B

Actual versus Flexible Budget

Flexible Percentage

Budget Actual Indixes Change

Revenue $14,400 $13,800 0.96 (4)

Variable costs 8,400 7,500 0.89 (11)

Contribution $ 6,000 $ 6,300 1.05 5

Fixed costs 4,000 4,680 1.17 17

Net income $ 2,000 $ 1,620 0.81 (19)

Panel C

Static versus Flexible Budget

Static Flexible Percentage

Budget Budget Indixes Change

Revenue $12,000 $14,400 1.20 20

Variable costs 7,000 8,400 1.20 20

Contribution $ 5,000 $ 6,000 1.20 20

Fixed costs 4,000 4,000 1.00 0

Net income $ 1,000 $ 2,000 2.00 100

206 Understanding the Numbers

Price Indices

"If you only examine Panel A of Exhibit 7.2," Jane said, "you will think that net

income leaped 62% and that the reason for the dramatic increase lies in the relatively

sharp increase of 15% in revenue. This increase in revenue appears to

have more than compensated for the apparent increase in variable costs of 7%

and fixed costs of 17%. You might be tempted to attribute the increase in net

income to the superior ability of the sales staff."

"The fallacy of this interpretation is apparent when you examine Panel B,

which compares the actual results with the f lexible budget. Now, after adjusting

for sales volume, we find that instead of that dramatic increase of 62% in

net income, there was a 19% drop in net income from budget. Using that same

basis of comparison, revenue actually fell by 4% instead of our earlier increase

of 15%. Now you can also see that, after adjusting for sales activity, variable

costs actually showed a steep decline of 11% rather than the increase of 7%

shown in Panel A. In other words, at the actual volume of 1,200 units as opposed

to the budgeted volume of 1,000 units, you should have budgeted more

for variable costs than at first expected. The $8,400 is, in retrospect, the more

appropriate budget figure.

"The apparent rise in revenues shown in Panel A melts away in Panel B, as

does the apparent rise in variable costs shown in Panel A. The result is a whole

new story. Volume rose perhaps because of the efforts of the sales staff but

more probably because of the fall in the selling price from $12 per unit to

$11.50 per unit.

"Fortunately," Jane said with a broad grin on her face, "the loss was partially

offset by the heroic efforts of the production staff in getting their perunit

costs down by 11%."

"I like that heroic part," said Tom approvingly.

"You should, because with the volume effect eliminated, all of the fall in

variable costs must be attributed to a fall in unit variable costs. More precisely,

standard variable costs were $7.00 but actual unit variable costs were just

$6.25. Dividing the actual unit cost of $6.25 by the standard variable cost of

$7.00 yields an index of 0.89, or precisely the 11% decrease in variable costs

noted earlier."

Activity Indices

"Now look at Panel C," said Jane. "This compares the f lexible budget with the

static budget. The only factor that changes between the two is sales activity, so

the percentages measure the change in the number of units sold. As there is

only one measure of activity, it is not surprising that all the activity-based indices

show an increase of 20%, that is, 200 units extra on a base of 1,000. Fixed

costs, though, are independent of activity levels. Net income, which is a combination

of activity-related and activity-independent numbers, shows an increase

that ref lects its mixed nature."

Measuring Productivity 207

Market Effects

"The rise in volume may or may not be attributable to good management. One

possibility is that it was driven by an increase in the total market. For instance,

one can imagine the larger market to have an expected 8,000 units in sales. The

company was expecting to get 12.5% of the market. If one now assumes that

the market grew to 12,000 units, then the company's sales of 1,200 units actually

represents a decrease in market share. Writing this out more formally:

In other words, given this scenario, the sales staff really should be queried on

why they had a decrease of 20% in market share in a market that increased

50%."

Summary

"Finally, let's try to summarize what we have learned to this point. First, note

that Panel B confirms that the price index in any variance computation can be

derived by dividing the actual figure by the f lexible budget figure. Panel C

demonstrates that the activity index can be derived by dividing the f lexible figure

by the static figure. In short, the relationship between the overall index of

the change from budget to actual is given by:

To summarize, then, in the example shown in Exhibits 7.1 and 7.2, one has the

following relationships connecting the actual results back to the static, through

the f lexible budget:

Overall Index Price Index Activity Index

Revenue:

Variable Cost:

Fixed Cost:

= ×

= ×

= ×

= ×

1 15 0 96 1 20

1 07 0 89 1 20

1 17 1 17 1 00

. . .

. . .

. . .

Overall Index

Actual

Static

Actual

Flexible

Flexible

Static

Price Index Activity Index

=

=

   

×

 

 

= ×

Sales Activity Index =

=

×

×

=

 

 

×

 

 

= ×

1 200

1 000

10 12 000

12 5 8 000

10

12 5

12 5

8 000

0 80 1 50

,

,

( % , )

( . % , )

%

. %

. %

,

. .

208 Understanding the Numbers

So, as you can see, the pieces fit together quite logically. The points underlying

these pieces can be summarized quite brief ly:

1. First, we saw the need to distinguish between basic, ideal, and currently

attainable standards.

2. Second, we saw the wisdom of distinguishing f lexible from static budgets.

3. Third, we noted that our standards are the foundation stones on which

these budgets are based.

4. We noted that all cost variances follow one simple formula: Actual Cost

less Budgeted Cost equals Standard Cost Variance.

5.

6. Flexible budgets adjust variable cost and their variances for volume.

7. Volume has no effect on fixed costs or the variances derived from fixed

costs.

VARIABLE COST BUDGETS

"That's fine, but what am I going to do with these variances?" Tom asked a little

impatiently. "Everything that I've seen so far may help top management, but

it's not much help to me."

"Good point, Tom. That's why we need to examine productivity, which

is the relationship between inputs and outputs. We'll enhance your productivity

and your control over costs if we can focus on the elements that go into

your costs."

With that Jane began to explain how in a typical cost accounting system

the variable cost of a product or service is a function of:

1. The hours of labor (both direct and indirect) that go into a product.

2. The units of material that are used.

3. The other components of overhead.

4. The unit cost of each of these items.

"Let's call the amount of input that goes into one unit of output the productivity

rate. For instance, one might need 500 pages or sheets of paper and

16 minutes of labor to produce a ream of letterhead. The material productivity

rate is 500 pages per ream; the labor productivity rate is 18 minutes or 0.30

hour per ream. When the expected cost of the inputs is attached to the expected

productivity rates, a standard cost is said to result. The productivity

Activity Variances Flexible Budget Static Budget

Price Variances Actual Results Flexible Budget

Activity Indices

Flexible Budget

Static Budget

Price Indices

Actual Results

Flexible Budget

= −

= −

=

=

Measuring Productivity 209

rates themselves are also known as standards. They are typically established by

engineers."

As before, Jane began sketching out a numerical illustration of the points

that she was making. Her sketches appear in Exhibit 7.3. "These are the standards,"

she said, "that determine the variable portion of the budget for production.

Note the assumption here that variable overhead is a function of

machine hours, or how long the machine runs. Other assumptions are possible

but we will stick with this one in our example.

"Fixed overhead is a little different because it does not really have a productivity

rate. Let's just put down the fixed overhead on a budgeted and an actual

basis, and we can come back and discuss the details later." From these

standards she began to derive the standard variable cost of the product; also its

actual variable cost:

Standard Cost Material Cost Labor Cost Variable Overhead Cost

pages per page) hours $5.00 per hour)

( . hours $ . per hour)

per ream

Actual Cost Material Cost Labor Cost Variable Overhead Cost

pages per page) hours $6.00 per hour)

( . hours $ . per hour)

= + +

= × + ×

+ ×

= + +

=

= + +

= × + ×

+ ×

= +

( $. ( .

$ . $ . $ .

$ .

( $. ( .

$ . $

500 0 008 0 30

0 10 15 00

4 00 1 50 1 50

7 00

500 0 007 0 25

0 125 10 00

3 50 1 50 1 25

6 25

. $.

$ .

+

= per ream

EXHIBIT 7.3 Standards and actuals for letterhead paper.

Budgeted Actual

Material:

Productivity rate (pages per ream) 500 500

Cost per unit of input (per page) $0.008 $0.007

Cost per unit of output (per ream) $4.00 $3.50

Labor:

Productivity rate (labor hours per ream) 0.30 0.25

Wage per unit of input (per labor hour) $5.00 $6.00

Wage per unit of output (per ream) $1.50 $1.50

Variable Overhead:

Productivity rate (machine hours per ream) 0.10 0.125

Cost per unit of input (per machine hour) $15.00 $10.00

Cost per unit of output (per ream) $1.50 $1.25

210 Understanding the Numbers

Jane then used these numbers to show how the budgeted and actual variable

costs in Exhibit 7.1 were derived. For the static budget:

For the f lexible budget:

For the actual costs:

Material Indices

Jane also used the standards in Exhibit 7.3 to show Tom how indices for each of

the components of the variable costs could be determined and interpreted.

Consider first the material costs:

In words, the material portion of the variable cost fell 12.5% from the f lexible

budget to the actual because of the 12.5% decrease in the cost of paper

from $0.008 per page to $0.007 per page. There were no efficiencies or

Material Index

Actual Costs

Flexible Budget

per page pages per ream reams)

per page pages per ream reams)

=

=

=

× ×

× ×

=

 

 

×

 

 

×

 

 

= × ×

=

$ ,

$ ,

($ . ,

($ . ,

.

.

,

,

. . .

.

4 200

4 800

0 007 500 1 200

0 008 500 1 200

0 007

0 008

500

500

1 200

1 200

0 875 1 00 1 00

0 875

Material Costs per ream reams

Labor Costs per ream reams

Variable OH per ream reams

Total Variable Costs as reported in Exhibit 7.1

= × =

= × =

= × =

=

$ . , $ ,

$ . , $ ,

$ . , $ ,

$ ,

3 50 1 200 4 200

1 50 1 200 1 800

1 25 1 200 1 500

7 500

Material Costs per ream reams

Labor Costs per ream reams

Variable OH per ream reams

Total Variable Costs as reported in Exhibit 7.1

= × =

= × =

= × =

=

$ . , $ ,

$ . , $ ,

$ . , $ ,

$ ,

4 00 1 200 4 800

1 50 1 200 1 800

1 50 1 200 1 800

8 400

Material Costs per ream reams

Labor Costs per ream reams

Variable OH per ream reams

Total Variable Costs as reported in Exhibit 7.1

= × =

= × =

= × =

=

$ . , $ ,

$ . , $ ,

$ . , $ ,

$ ,

4 00 1 000 4 000

1 50 1 000 1 500

1 50 1 000 1 500

7 000

Measuring Productivity 211

inefficiencies in the use of the paper: The number of pages actually used per

ream was equal to budget.

Labor Indices

Jane then performed an identical analysis for labor costs:

In words, the labor portion of the variable cost remained the same from flexible

to actual because the rise of 20% in the hourly wage was exactly offset by

the 16.67% decrease in the time to produce a ream of letterhead.

"I've just realized that what we have here," said Tom, "is a great way to

measure increases in productivity. Dana keeps on talking about how our productivity

is falling. One way to counteract that is to check how efficiently

people are working. Before one measures physical productivity, though, one

has to eliminate the wage effect, which is just what you have shown me how

to do here."

Variable Overhead Indices

"I think I can now do the variable overhead analysis myself," said Tom. "I just

take the three components of the actual cost and divide that by the three components

of the f lexible budget. Check me if you will."

Variable OH Index

Actual Costs

Flexible Budget

$ 0. .1 5 )

$1 . . 0 )

=

=

= × ×

× ×

= × ×

= × ×

=

$ ,

$ ,

( ,

( ,

$ .

$ .

.

.

,

,

. . .

.

1 500

1 800

1 00 0 2 1 200

5 00 0 1 1 200

10 00

15 00

0 125

0 10

1 200

1 200

0 667 1 25 1 00

0 833

Labor Index

Actual Costs

Flexible Budget

$ . per hour . 5 hours per ream reams)

$ . per hour . 0 hours per ream reams)

=

=

= × ×

× ×

= × ×

= × ×

=

$ ,

$ ,

( ,

( ,

$ .

$ .

.

.

,

,

. . .

.

1 800

1 800

6 00 0 2 1 200

5 00 0 3 1 200

6 00

5 00

0 25

0 30

1 200

1 200

1 20 0 833 1 00

1 00

212 Understanding the Numbers

"I can even tell you what that means in words: The overhead portion of the

variable cost declined 16.67% from the f lexible budget because the hourly

overhead rate fell by 33.33% while the overhead used per ream rose 25%. How

do you like that explanation?"

Variance Analysis

"Another way, in fact the more traditional way, to think about this," said Jane,

"is to focus on the numbers rather than the percentages. The cost of the paper

fell 0.001 cents per page while the company used 600,000 pages (500 pages per

ream × 1,200 reams.) This price drop saved $600; since this price variance is

favorable, it's denoted by an F. The company used the amount of paper that was

budgeted, so the usage variance is zero.

"In the case of labor, the wage paid was $1.00 per hour more than

planned, which over the 300 hours that were worked meant an unfavorable

wage variance of $300 denoted by a U. Employees actually worked 300 hours

(0.25 hours per ream × 1,200 reams), whereas the plan was for them to work

360 hours (0.30 × 1,200 reams). That saved 60 hours, which, at the standard

wage rate of $5.00, saved $300. The wage variance and the use variance offset

one another here.

"Finally, the variable overhead rate was $5.00 per machine hour less than expected.

This gives a favorable rate variance of $750 or $5.00 × 150 actual machine

hours. The base on which variable overhead was applied, namely

machine hours, increased by 30 hours since the budget called for just 120 machine

hours. At the standard rate of $15.00 per hour this gives an unfavorable

usage variance of $450 or $15.00 × 30 machine hours. This leaves a favorable

difference of $300.

"All this is summarized in Exhibit 7.4."

Overhead Variance 150 0 hours $15.00 per hour

10.00 per hour 1 0 hours

= [( ) × ]

+ [ ( ) × ]

=

12

15 00 5

300

$ .

$

Labor Variance 300 60 hours $5.00 per hour

6.00 per hour 300 hours

= [( ) × ]

+ [ ( ) × ]

=

3

5 00

0

$ .

$

Materials Variance 600, 000 600, 000 pages $0.008 per page

0.007 per page 600, 000 pages

= [( ) × ]

+ [ ( ) × ]

=

$ .

$

0 008

600 F

Measuring Productivity 213

Review

"One last question, Jane: Where do these variable overhead rates come from?"

"That's another subject altogether," said Jane. "Do you want a cup of coffee?

I'm bushed. But before we break, let's summarize what we've learned.

1. The cost of a product consists of material, labor, and overhead.

2. Each of these components is made up of a productivity rate multiplied by

a unit cost for that component.

3. Standard Costs = Standard Productivity Rates × Standard Unit Costs

4. Actual Costs = Actual Productivity Rates × Actual Unit Costs

5. Price Indices = Actual Unit Costs/Standard Costs

6. Activity Indices = Actual Productivity Rate/Standard Productivity Rate."

COLLECTING STANDARDS

After their coffee break, Jane and Tom shifted their conversation to how to develop

these standard costs. Jane reminded Tom that standard costs are made up

of two parts:

1. A standard cost per unit times.

2. A standard usage, or quantity of units of input per unit of output.

She pointed out that he was responsible for defining the amount of material

and labor that should go into the product. The purchasing department was

responsible for determining the amount that should be paid for materials, the

personnel department determined wages. There are, as she explained, several

ways to determine the appropriate usage.

Engineering Studies

"First, one can do an engineering study. In other words, one can look at the

specifications of the product. Many products that are designed by engineers

have quite detailed and explicit instructions on what materials should go into

them. These standards often include an allowance for waste, though this

isn't necessary. Where they do not include such an allowance they border on

the ideal.

EXHIBIT 7.4 Variance analysis.

Rate Variance Usage Variance Total Variance

Materials $600 F $0 $600 F

Labor 300 U 300 F 0

Variable overhead 450 U 750 F 300 F

214 Understanding the Numbers

"To take an obvious example, most automobiles have one battery, and an

engineering statement would so state. A perfection standard would call for 1

battery per automobile. When it comes to actual production, however, it would

not be unusual for one or more batteries to be damaged during installation.If

10,100 batteries are used in the manufacture of 10,000 cars, then it might appear

as if each automobile actually had 1.01 batteries. One might, therefore,

want to set as one's standard a currently attainable goal of 1.01 batteries on average,

thus providing a 1% allowance for wastage."

Time and Motion Studies

"Time and motion studies are the usual way in which engineering standards are

set for the labor component," Jane explained. "An engineer watches over laborers

as they work and determines how much time it should take for each part of

the production process. When doing this, it is vital that the engineer gain

labor's cooperation. If not, disastrous results can occur. I love the following

quotation:"

You got to use your noodle while you're working and think your work out ahead

as you go along! You got to add in movements you know you ain't going to make

when you're running the job! Remember, if you don't screw them, they're going

to screw you! . . . Every moment counts! . . .

When the time-study man came around, I set the speed at 180. I knew

damn well he would ask me to push it up, so I started low enough. He finally

pushed me up to 445, and I ran the job later at 610. If I'd started out at 445,

they'd have timed it at 610. Then I got him on the reaming, too. I ran the

reamer for him at 130 speed and .025 feed. He asked me if I couldn't run the

reamer any faster than that, and I told him I had to run the reamer slow to keep

the hole size. I showed him two pieces with oversize holes that the day man

ran. I picked them out for the occasion! But later on I ran the reamer at 610

speed and .018 feed, same as the drill. So I didn't have to change gears.3

Tom smiled appreciatively at the story. As an old f loor hand, he understood the

sentiments completely.

Motivation

"This raises a broader question, you know," said Tom. "Should we invite people

to participate in setting the standards? Will it make them more motivated? I've

pondered this from a variety of angles. What's interesting about it is that participation

doesn't always work.

"What I have discovered from my reading around the topic is that many

people prefer to be told what to do. This seems to be particularly true for people

who find their jobs boring and for those with a more authoritarian personality.

So one has to be really careful when inviting people to participate."

"You know more about this than I do," responded Jane. "How do you handle

feedback, then. That's a sort of after-the-fact participation isn't it."

Measuring Productivity 215

"Well, I don't know about after the fact, but everyone that I've read—and

my own experience for that matter—indicates that timely feedback is essential

and a good motivator. People really need to know, and know as soon as possible,

how they have done. That's especially true when they've done a good job,

because it really builds their self-esteem. And in some cases, it makes them

want to participate more before the fact in the next round.

"Of course, I don't want to lead you to think that a little participation and

a lot of feedback is all one needs. These are what the psychologists call intrinsic

motivators. People need these, but they also need extrinsic motivators like

better pay for doing a better job.

"And, the other problem that I've encountered is that the more you focus

people's attention on one goal, the more they tend to ignore other goals. It's

only human nature: Ask salespeople to increase their turnover, and they'll sell

goods at a loss.

"That's one of the reasons why I have misgivings about calling in a bunch

of engineers to set standards. It's much easier to time how long a job should

take and reward people for quantity than to measure and to reward quality. I

really rely upon the innate good sense of my staff to provide quality products.

Too much emphasis on measurement can make my task of maintaining quality

much more difficult."

Past Data

"Probably, then, an easier way," Jane said, "to get the data you need for your

business is to go back over your past records to see how much time various jobs

have taken and how much material was used in the past. Some of that will have

to be adjusted for changes in machines, changes in personnel, different kinds of

material, and so on. But you know all that better than I do."

"Enough!" Tom exclaimed. "Enough for now! I'll come over tomorrow

night and we can talk some more. We still need to discuss fixed overheads as

you promised."

FIXED COST BUDGETS

"Fixed costs," Jane started out the next night after the two had gathered again,

"are both easier and more difficult to control than variable costs. They are easier

because there are no components into which to break them. Their variance

is simply:

Their index is simply:

Actual Fixed Costs

Budgeted Fixed Costs

Actual Fixed Costs Budgeted Fixed Costs

216 Understanding the Numbers

In our case, the budgeted fixed costs were $4,000 and the actual fixed costs

were $4,680. The variance was simply $680, which means a 17% increase.

"Fixed costs are more difficult to control than variable costs because one

cannot create an illusion of control through the elaborate computation of price,

mix, and usage variances or indices."

"How, then, does one control fixed costs?" asked Tom.

"First," Jane replied, "one must recognize that if costs are truly fixed,

there is no reason to control them. Consider depreciation costs as an example.

Once one has purchased an item, the total depreciation costs are set—unless

one disposes of the machinery when a disposal cost will substitute for the depreciation

cost. No control is possible here. The control in this case has to be

exerted when the machinery is purchased. Thereafter, it is a sunk cost that

cannot be controlled. In other words, controlling fixed costs is in the first place

a matter of timing.

"Traditional variance analysis uses one cost driver only, the volume of

production. More modern variance analysis, such as that in activity based costing,

uses multiple cost drivers.4 For example, setup costs may not vary with volume

of production but might vary with the number of batches. What appears

at first glance to be a fixed cost may just be variable with respect to some other

driver. The analysis of variance proceeds exactly as before except that one

changes the driver from units produced to number of batches. One converts

the fixed cost into a quasi-variable cost by finding and using the appropriate

cost driver.

"Controlling fixed costs is also a matter of scale. Consider the machine

again. Assume one has just one machine with a capacity of 1,000 boxes of

greeting cards per day. Its cost is certainly fixed within this range. However, if

the analysis is being done in terms of tens of thousands of boxes, and if the

corporation has a hundred of these machines, then it is possible to think of machine

costs as being a variable. One can ask, in other words, what the cost

would be to produce an additional 'unit' of 1,000 boxes.

"This last question points to the fact that most fixed costs are usually only

fixed within the context of a particular analysis. Consider, for instance, the ink

you use in production. Assume its price is reset by a cartel every three months.

Assume also that its planned usage is reset at the same time. A budgetary control

system that computed variances every month and set the budgeted price

and quantity to those of the latest quarter might show a variance of zero each

month. This might lead everyone to believe that they were dealing with a fixed

cost. However, were the same analysis to be done on an annual basis, with

prices and quantities set at the start of the year, a substantial variance could

arise. The example points up the old truism that all costs are variable in the

long run.

"The example above also points up the need to set your net large enough

to catch the fish you want. Many fixed costs cannot be controlled by a monthly,

or even annual, budget system because they change too slowly. One needs a

coarser net, that is, an annual, triennial, or even longer budgetary system to

Measuring Productivity 217

capture their change. The reverse is also true. A net that is too fine can capture

a great deal of random noise. Consider, for instance, a product whose price

f luctuates randomly around a fixed mean. If all you want is to see the true exceptions,

then you should set the net to capture only those f luctuations that are

greater than a certain number of standard deviations away from the mean.

"In short, fixed costs are best controlled in the long run and at a more aggregate

level. In other words, it is important in the budgetary control of fixed

costs to establish appropriate time and space horizons for one's analysis."

"Those are all good points," said Tom, "and it's good to be reminded of

them. What you haven't yet told me, though, is whether there is a fixed overhead

rate like the variable overhead rate that you had in Exhibit 7.3 and how

the fixed overhead rate fits into the whole picture."

"Well, fixed overhead does and doesn't have a rate," responded Jane.

"The rate itself comes from knowing the total fixed overhead and dividing it by

the volume; for example, the budgeted fixed overhead of $4,000 divided by the

budgeted 1,000 units gives us a fixed overhead rate of $4.00. In a sense, fixed

overhead rates are secondary—unlike variable overhead rates, which are primary,

meaning that fixed overhead rates are computed by dividing the total

overhead by volume. Total variable overhead, on the other hand, is computed

by multiplying the variable overhead rate by the volume. In other words, fixed

overhead computes just the other way round from variable overhead.

"Variable overhead rates are used in computing variances and indices.

Fixed overhead rates are completely ignored in this context. Their main purpose

is to give you an estimate of the total product cost. We computed earlier

that the estimated variable cost of a ream of letterhead was $7.00. We can now

add the $4.00 fixed cost in and say the estimated total cost of a ream is $11.00.

So fixed overhead rates fit in when calculating unit product costs. It's just that

they don't fit into the rest of the budgetary control systems. But let's talk about

standard cost systems when all this might become clearer. Let's pick it up tomorrow

when we are both fresher."

STANDARD COST ACCOUNTING SYSTEMS

"Companies rarely enter their budgets into their ledgers. Usually budgetary

control takes place outside of the books of the company. In other words, the

budget is typically drawn up using spreadsheets outside of the general ledger

system. At the end of the period under investigation, the actual results are

drawn out of the ledger and transferred to the spreadsheet where the comparisons

are done. Two exceptions to this general rule occur."

Government Accounting

"The first exception does not affect private companies but does affect state

and local governments. It is common practice in their accounting systems to

218 Understanding the Numbers

enter a budgeted number in the ledgers in anticipation of an actual number. For

instance, city governments will enter budgeted revenues as a debit on the left

side of the ledger account. Then when the sales are actually made, they will

enter the actual revenues as a credit on the right column of the ledger account.

The effect is that at the end of the year, only variances are left in accounts. For

instance, sales greater than expected would leave a credit variance."

Standard Variable Costs

"The second exception involves so-called standard cost systems. In a typical

implementation, the standard cost of a product, not the actual cost incurred, is

entered into the work-in-process account. The difference between the standard

cost and the actual cost creates a variance—in the actual accounts. For

example, in the case of paper used, the inventory account would be charged

with the standard $4.00 for every ream used but only $3.50 would be paid to

the supplier. The difference of $0.50 would be shown in a separate variance

account in the books of the company.

"The existence of a credit variance in the accounts indicates that the budgeted

unit cost exceeds the actual unit cost, that is, there is a favorable variance.

Were the variance a debit, it would be unfavorable.

"By the end of the job, after they have produced 1,200 reams, they will

show in their accounts a variance of $0.50 per ream on all their variable costs

times 1,200 reams, or a credit of $600. This is the same favorable $600 variance

that we saw in Exhibit 7.4 when we subtracted the actual cost from the f lexible

budget. Standard cost systems, in other words, track the f lexible budget.

"Each of these variances is identical to the variances computed above;

each can be stated in percentage terms to indicate their relative size, that is,

material costs are down 12.5%, labor costs are even, and variable overhead

costs are down 16.67%. The key point to realize is that variances generated by

a standard cost system are identical to those generated by a budgetary control

system—once one removes the volume effect."

Standard Fixed Costs

"The parallels between standard cost systems and budgetary control systems

do not extend to fixed costs, unfortunately. The reason lies in the way fixed

costs are applied to products. In a standard cost system, a fixed overhead rate

is established at the start of a period by dividing the budgeted fixed overhead

by the budgeted volume. In our case, the predetermined fixed overhead rate

was $4,000 divided by 1,000 reams, which equals $4.00 per ream. The predetermined

fixed overhead rate is therefore based on the static budget.

"Fixed overhead is then applied to goods as they are produced by multiplying

the number of reams produced by this overhead rate. In this case, one

charges $4.00 of fixed overhead to each of the 1,200 reams produced. The result

is $4,800, which is known as the applied overhead. The problem is that this

Measuring Productivity 219

is neither actual nor budgeted. It is really a miscomputed number. If the number

of actual reams had been known in advance, one should have divided the

$4,000 by 1,200 reams, giving $3.33 per ream. In other words, one should have

used the f lexible budget. Using that rate would have led to the application of

$4,000 of fixed overhead exactly. The difference between the budgeted

amount of $4,000 and the amount actually applied, namely $800, is said to have

been over-applied—one might say over-applied in error. A correcting entry is

typically made in the accounting system to fix this error.

"The accounts of the company record that it actually had fixed overhead

costs of $4,680 and applied overhead of $4,800. This generates a credit variance

of $120 in the accounts. Regardless of what appears in the accounts, the

spending variance that should be reported is an unfavorable $680—not a favorable

$120. No matter the confusions in the ledger, the only variance that one is

interested in is:

"The difference between the variance produced by a standard cost system and

the variance wanted for budgetary control purposes is:

"In short, the error in the fixed overhead variance appearing in a standard cost

system is due to volume changing from 1,000 units to 1,200 units. The result is

a variance in the standard cost system that is useless for control purposes.

"The budgeted overhead will be equal to the applied overhead only when

the actual volume equals the budgeted volume, which rarely happens. More

commonly, a fixed cost variance is found in the ledger, but this is of no interest

for budgetary control. For control purposes, you should compute the spending

variance directly and simply ignore the net overhead variance derived in the

books."

"Now I see why you ignored the fixed overhead when doing the variances

originally," said Tom. "Let's hope that my management understands this as well

as you seem to do!"

BUDGETARY CONTROL REVISITED

"Budgetary control, as we noted at the outset," Jane continued, "consists of

comparing actual results with budget estimates. When doing this one is advised

to distinguish between revenues and costs that vary with volume and those that

are fixed with respect to volume changes. A revised budget, adjusted for the

actual volumes rather than the predicted volumes, yields a f lexible budget as

opposed to the original or static budget.

Budgeted OverheadApplied Overhead = −

= × − ×

= ×

$ , $ ,

($ , ) ($ , )

$

4 000 4 800

4 1 000 4 1 200

4 200

Applied OverheadBudgeted Overhead = $4,680 $4, 000

220 Understanding the Numbers

"Since the static and the f lexible budgets for fixed costs are identical, the

fixed-cost spending variance is simply the difference between the actual and

the original budget. The spending index for fixed costs is their quotient.

"In the case of variable costs and revenues, a few simple rules emerge.

The ratio between the f lexible and the static budgets indicates the difference

in the quantities expected and the quantities actually experienced. The ratio

between the actual results and the f lexible budget indicates the change in costs

or revenues that can be attributed to changes in unit costs or selling prices.

"In the case of multiple outputs or multiple inputs, the quantity indices

can be further refined. They break into at least two indices. The first reveals

the effect of changing mixes of either outputs or inputs. The second reveals

the effect of changing the overall volume. The mix variance may be computed

directly or simply by dividing the quantity index by the volume index. In the

case of variable costs, it is usually possible to draw out another index indicating

the total yield, that is, the amount of input required to produce a given amount

of output.

"All these indices can be computed using an accounting system that collects

only actual costs and comparing these in a spreadsheet with the budgeted

costs. Alternatively, they may be derived by keeping a standard cost system.

The variances that emerge as one enters standard costs into work-in-process

and credits the corresponding asset or liability account at actual are identical

to those derived from a f lexible budgeting control system. The one exception

to this identity is fixed costs, but the difference here is easily reconciled.

"In short, budgetary control analysis provides one vehicle for controlling

a business. The budget ref lects, ideally, a company's strategies and objectives.

As actual results emerge they are compared with the budget to see to what extent

the enterprise has met its goals and productivity targets. Any difference

encountered can be decomposed to determine whether it was due to a change

in usage or a change in price. Where inputs or outputs are substitutable, one

can also examine the changing mix for further insight into how one achieved

one's goals.

"In each case, the index derived is neither good nor bad. It simply indicates

a change. As noted earlier, the same rise in sales may be a matter for congratulation

when markets are declining and a matter for concern when markets

are expanding faster than one's sales. All that the index does is to point one to

where still more information must be gathered."

FOR FURTHER READING

Anthony, Robert N., David F. Hawkins, and Kenneth A. Merchant, Accounting: Text

and Cases, 10th ed. (New York: Irwin/McGraw-Hill, 1999), esp. chs. 19 and 20.

Davidson, Sidney, and Roman L. Weil, Handbook of Cost Accounting (New York:

McGraw-Hill, 1978), esp. chs. 15 and 16.

Measuring Productivity 221

Ferris, Kenneth R., and J. Leslie Livingstone, eds., Management Planning and

Control: The Behavioral Foundations (Columbus, OH: Century VII, 1989), esp.

chs. 3, 8, and 9.

Horngren, Charles T., Gary L. Sundem, and William O. Stratton, Introduction

to Management Accounting, 11th ed. (Englewood Cliffs, NJ: Prentice-Hall,

1999), esp. chs. 7 and 8.

Kaplan, Robert S., and Anthony A. Atkinson, Advanced Management Accounting, 3rd

ed. (Englewood Cliffs, NJ: Prentice-Hall, 1998), esp. chs. 9 and 10.

Maher, Michael W., Clyde Stickney, Roman L. Weil, and Sidney Davidson, Managerial

Accounting (Fort Worth, TX: Harcourt College Publishers, 1999), esp.

chs. 10 and 11.

Shank, J.K., and N.C. Churchill, "Variance Analysis: A Management-Oriented Approach,"

The Accounting Review, 52 (Oct. 1977): 950–957.

Welsch, Glenn A., Ronald W. Hilton, and Paul N. Gordon, Budgeting: Profit Planning

and Control, 5th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1988), esp. ch. 16.

INTERNET LINKS

Internet links and Web sites have an uncomfortable way of disappearing. The

reader is advised, therefore, to do her or his own search under key words

such as "variance analysis" and "standard costing." This will turn up sites such

as Conoco's and Corn Products International's discussions of their results at

www.conoco.com and www.cornproducts.com. Both make excellent use of

variance analysis. The U.S. Army Cost and Economic Analysis Center at

www.ceac.army.mil/web/default.html provides a good discussion of standards,

while the Association of Accounting Technicians, at www.aat.co.uk, provides

an excellent forum for questions and answers on this and many other accounting

topics. The Institute of Management Accountants maintains a site at www

.imanet.org that provides all kinds of managerial accounting resources. Finally,

the reader is invited to visit my own site, at www.smu.edu/mvanbred, with its

many links and notes on both financial and managerial accounting.

NOTES

1. R. Kaplan and D. Norton, "The Balanced Scorecard—Measures That Drive

Performance," Harvard Business Review, 70 (Jan.–Feb. 1992): 71–79.

2. National Association of Accountants, Standard Costs and Variance Analysis

(New York: NAA, 1974): 9.

3. Whyte, W.F., ed., Money and Motivation: An Analysis of Incentives in Industry

(New York: Harper & Row, 1955).

4. Cooper, Robin, and Robert S. Kaplan, "How Cost Accounting Distorts Product

Costs," Management Accounting, 69 (Apr. 1988): 20–27.

 

PART TWO

PLANNING AND

FORECASTING

 

225

8 CHOOSING A

BUSINESS FORM

Richard P. Mandel

THE CONSULTING FIRM

Jennifer, Jean, and George had earned their graduate business degrees together

and had paid their dues in middle management positions in various large

corporations. Despite their different employers, the three had maintained

their friendship and were now ready to realize their dream of starting a consulting

practice. Their projections showed modest consulting revenue in the

short term offset by expenditures for supplies, a secretary, a small library, personal

computers, and similar necessities. Although each expected to clear no

more than perhaps $25,000 for his or her efforts in their first year in business,

they shared high hopes for future growth and success. Besides, it would be a

great pleasure to run their own company and have sole charge of their respective

fates.

THE SOFTWARE ENTREPRENEUR

At approximately the same time that Jennifer, Jean, and George were hatching

their plans for entrepreneurial independence, Phil was cashing a seven-figure

check for his share of the proceeds from the sale of the computer software

firm he had founded seven years ago with four of his friends. Rather than rest

on his laurels, however, Phil saw this as an opportunity to capitalize on a complex

piece of software he had developed in college. Although Phil was convinced

that there would be an extensive market for his software, there was

226 Planning and Forecasting

much work to be done before it could be brought to market. The software had

to be converted from a mainframe operating system to the various popular microcomputer

systems. In addition, there was much marketing to be done prior

to its release. Phil anticipated that he would probably spend over $300,000 on

programmers and salespeople before the first dollar of royalties would appear.

But he was prepared to make that investment himself, in anticipation of retaining

all the eventual profit.

THE HOTEL VENTURE

Bruce and Erika were not nearly as interested in high technology. Directly following

their graduation from business school, they were planning to construct

and operate a resort hotel near a popular ski area. They had chosen as their

location a beautiful parcel of land in Colorado owned by their third partner,

Michael. Rich in ideas and enthusiasm, the three lacked funds. They were certain,

however, that they could attract investors to their enterprise. The location,

they were sure, would virtually sell itself.

THE PURPOSE OF THIS CHAPTER

Each of these three groups of entrepreneurs would soon be faced with what

might well be the most important decision of the initial years of their businesses:

which of the various legal business forms to choose for the operation of

their enterprises. It is the purpose of this chapter to describe, compare, and

contrast the most popular of these forms in the hope that the reader will then

be able to make such choices intelligently and effectively. After discussing the

various business forms, we will revisit our entrepreneurs and analyze their

choices.

BUSINESS FORMS

Two of the most popular business forms could be described as the default

forms because the law will deem a business to be operating under one of these

forms unless it makes an affirmative choice otherwise. The first of these forms

is the sole proprietorship. Unless he or she has actively chosen another form,

the individual operating his or her own business is considered to be a sole proprietor.

Two or more persons operating a business together are considered a

partnership (or general partnership), unless they have elected otherwise. Both

of these forms share the characteristic that for all intents and purposes they

are not entities separate from their owners. Every act taken or obligation assumed

as a sole proprietorship or partnership is an act taken or obligation assumed

by the business owners as individuals.

Choosing a Business Form 227

Many of the rules applicable to the operation of partnerships are set forth

in the Uniform Partnership Act, which has been adopted in one form or another

by 49 states. That Act defines a partnership as "an association of two or more

persons to carry on as co-owners a business for profit." Notice that the definition

does not require that the individuals agree to be partners. Although most

partnerships can point to an agreement between the partners (whether written

or oral), the Act applies the rules of partnership to any group of two or more

persons whose actions fulfill the definition. Thus, the U.S. Circuit Court of Appeals

for the District of Columbia, in a rather extreme case, held, over the defendant's

strenuous objections, that she was a partner in her husband's burglary

"business" (for which she kept the books and upon whose proceeds she lived),

even though she denied knowing what her husband was doing at nights. As a result

of this status, she was held personally liable for damages to the wife of a

burglary victim her husband had murdered during a botched theft.

In contrast, a corporation is a legal entity separate from the legal identities

of its owners, the shareholders. In the words James Thurber used to describe a

unicorn, the corporation "is a mythical beast," created by the state at the request

of one or more business promoters upon the filing of a form and the payment

of the requisite, modest fee. Thereupon, in the eyes of the law, the corporation

becomes for most purposes a "person" with its own federal identification

number! Of course, one cannot see, hear, or touch a corporation, so it must interact

with the rest of the world through its agents, the corporation's officers

and employees.

Corporations come in different varieties. The so-called professional corporation

is available in most states for persons conducting professional practices,

such as doctors, lawyers, architects, psychiatric social workers, and the

like. A subchapter S corporation is a corporation that is the same as a regular

business corporation in all respects other than taxation. These variations are

discussed later.

A fourth common form of business organization is the limited partnership,

which may best be described as a hybrid of the corporation and the general

partnership. The limited partnership consists of one or more general

partners—who manage the business much in the same way as do the partners

in a general partnership—and one or more limited partners, who are essentially

silent investors with no control over business operations. Like the general

partnership, limited partnerships are governed in part by a statute, the Uniform

Limited Partnership Act (or its successor, the Revised Uniform Limited

Partnership Act), which has also been adopted in one form or another by

49 states.

The limited liability company (LLC), is now available to entrepreneurs in

all 50 states. The LLC is a separate legal entity owned by "members" who may,

but need not, appoint one or more "managers" (who may but need not be members)

to operate the business. A few states require that there be more than

one member, but the trend is toward allowing single-member LLCs. An LLC

is formed by filing an application with the state government and paying the

228 Planning and Forecasting

prescribed fee. The members then enter into an operating agreement setting

forth their respective rights and obligations with respect to the business. Most

states that have adopted the LLC have also authorized the limited liability

partnership, which allows general partnerships to obtain limited liability for

their partners by filing their intention to do so with the state. This form of

business entity is normally used by professional associations that previously operated

as general partnerships, such as law and accounting firms.

COMPARISON FACTORS

The usefulness of the five basic business forms could be compared on a virtually

unlimited number of measures, but the most effective comparisons will

likely result from employing the following eight:

1. Complexity and cost of formation. What steps must be taken before your

business can exist in each of these forms?

2. Barriers to operation across state lines. What steps must be taken to move

your business to other states? What additional cost may be involved?

3. Recognition as a legal entity. Who does the law recognize as the operative

entity? Who owns the assets of the business? Who can sue and be sued?

4. Continuity of life. Does the legal entity outlive the owner? This may be

especially important if the business wishes to attract investors or if the

goal is an eventual sale of the business.

5. Transferability of interest. How does one go about selling or otherwise

transferring one's ownership of the business?

6. Control. Who makes the decisions regarding the operation, financing,

and eventual disposition of the business?

7. Liability. Who is responsible for the debts of the business? If the company

cannot pay its creditors, must the owners satisfy these debts from

their personal assets?

8. Taxation. How does the choice of business form determine the tax

payable on the profits of the business and the income of its owners?

FORMATION OF SOLE PROPRIETORSHIPS

Ref lecting its status as the default form for the individual entrepreneur, the

sole proprietorship requires no affirmative act for its formation. One operates

a sole proprietorship because one has not chosen to operate in any of the other

forms. The only exception to this rule arises in certain states when the owner

chooses to use a name other than his own as the name of his business. In such

event, he may be required to file a so-called d /b/a certificate with the local

authorities, stating that he is "doing business as" someone other than himself.

Choosing a Business Form 229

This allows creditors and those otherwise injured by the operation of the business

to determine who is legally responsible.

FORMATION OF PARTNERSHIPS

Similarly, a general partnership requires no special act for its formation other

than a d /b/a certificate if a name other than that of the partners will be used.

If two or more people act in a way which fits the definition set forth in the

Uniform Act, they will find themselves involved in a partnership. However, it is

strongly recommended that prospective partners consciously enter an agreement

(preferably in writing) setting forth their understandings on the many

issues which will arise in such an arrangement. Principal among these are the

investments each will make in the business, the allocation and distribution of

profits (and losses), the method of decision making (i.e., majority or unanimous

vote), any obligations to perform services for the business, the relative compensation

of the partners, and so on. Regardless of the agreements that may

exist among the partners, however, the partnership will be bound by the actions

and agreements of each partner—as long as these actions are reasonably

related to the partnership business, and even if they were not properly authorized

by the other partners pursuant to the agreement. After all, third parties

have no idea what the partners' internal agreement says and are in no way

bound by it.

CORPORATIONS

In order to form a corporation, in contrast, one must pay the appropriate fee

and must complete and file with the state a corporate charter (otherwise

known as a Certificate of Incorporation, Articles of Incorporation, or similar

name in the various states). The fee is payable both at the outset and annually

thereafter (often approximately $200). A promoter may form a corporation

under the laws of whichever state she wishes; she is not required to form the

corporation under the laws of the state in which she intends to conduct most

of her business. This partially explains the popularity of the Delaware corporation.

Delaware spent most of the last century competing with other states

for corporation filing fees by repeatedly amending its corporate law to make it

increasingly favorable to management. By now, the Delaware corporation has

taken on an aura of sophistication, so that many promoters form their companies

in Delaware just to appear to know what they are doing! In addition, it

is often less expensive under Delaware law to authorize large numbers of

shares for future issuance than it would be in other states. Nevertheless, the

statutory advantages of Delaware apply mostly to corporations with many

stockholders (such as those which are publicly traded) and will rarely be significant

to a small business such as those described at the beginning of this

230 Planning and Forecasting

chapter. Also, formation in Delaware (or any state other than the site of the

corporation's principal place of business) will subject the corporation to additional,

unnecessary expense. It is thus usually advisable to incorporate in the

company's home state.

The charter sets forth the corporation's name (which cannot be confusingly

similar to the name of any other corporation operating in the state) as

well as its principal address. The names of the initial directors and officers of

the corporation are often listed. Most states also require a statement of corporate

purpose. Years ago this purpose defined the permitted scope of the corporation's

activities. A corporation which ventured beyond its purposes risked

operating "ultra vires," resulting in liability of its directors and officers to its

stockholders and creditors. Today virtually all states allow a corporation to define

its purposes extremely broadly (e.g., "any activities which may be lawfully

undertaken by a corporation in this state"), so that operation ultra vires is generally

impossible. Still directors are occasionally plagued by lawsuits brought

by stockholders asserting that the diversion of corporate profits to charitable

or community activities runs afoul of the dominant corporate purpose, which

is to generate profits for its stockholders. The debate over the responsibility

of directors to so-called corporate "stakeholders" (employees, suppliers, customers,

neighbors, and so forth) currently rages in many forms but is normally

not a concern of the beginning entrepreneur.

Corporate charters also normally set forth the number and classes of equity

securities that the corporation is authorized to issue. Here an analysis of a

bit of jargon may be appropriate. The number of shares set forth in the charter

is the number of shares authorized, that is, the number of shares that the directors

may issue to stockholders at the directors' discretion. The number of

shares issued is the number that the directors have in fact issued and is obviously

either the same or smaller than the number authorized. In some cases, a

corporation may have repurchased some of the shares previously issued by the

directors. In that case, only the shares which remain in the hands of shareholders

are outstanding (a number obviously either the same or lower than the

number issued). Only the shares outstanding have voting rights, rights to

receive dividends, and rights to receive distributions upon full or partial liquidation

of the corporation. Normally, we would expect an entrepreneur to authorize

the maximum number of shares allowable under the state's minimum

incorporation fee (e.g., 200,000 shares for $200 in Massachusetts) and then

issue only 10,000 or so, leaving the rest on the shelf for future financings, employee

incentives, and so forth.

The charter also sets forth the par value of the authorized shares, another

antiquated concept of interest mainly to accountants. The law requires only

that the corporation not issue shares for less than the par value, but it can, and

usually does, issue the shares for more. Thus, typical par values are $0.01 per

share or even "no par value." Shares issued for less than par are watered stock,

subjecting both the directors and holders of such stock to liability to other

stockholders and creditors of the corporation.

Choosing a Business Form 231

Corporations also adopt bylaws, which are not filed with the state but are

available for inspection by stockholders. These are usually fairly standard documents

describing the internal governance of the corporation and setting forth

such items as the officers' powers and notice periods for stockholders' meetings.

LIMITED PARTNERSHIPS

As you might expect, given the limited partnership's hybrid nature, the law requires

both a written agreement among the various general and limited partners

and a Certificate of Limited Partnership to be filed with the state, along

with the appropriate initial and annual fees. The agreement sets forth the partners'

understanding of the items discussed earlier regarding general partnerships.

The certificate sets forth the name and address of the partnership, its

purposes, and the names and addresses of its general partners. In states where

the Revised Uniform Limited Partnership Act has been adopted, it is no longer

necessary to reveal the names of the limited partners, just as the names of corporate

stockholders do not appear on a corporation's incorporation documents.

LIMITED LIABILITY COMPANIES

The LLC is formed by filing a charter (e.g., a Certificate of Organization) with

the state government and paying a fee (usually similar to that charged for the

formation of a corporation). The charter normally sets forth the entity's name

and address, its business purpose, and the names and addresses of its managers

(or persons authorized to act for the entity vis-a-vis the state if no managers

are appointed). The same broad description of the entity's business which is

allowable for modern corporations is acceptable for LLCs. The members of

the LLC are also required to enter into an operating agreement that sets forth

their rights and obligations with regard to the business. These agreements are

generally modeled after the agreements signed by the partners in a general or

limited partnership.

OUT OF STATE OPERATION OF SOLE

PROPRIETORSHIPS AND PARTNERSHIPS

Partly as a result of both the Commerce clause and Privileges and Immunities

clause of the U.S. Constitution, states may not place limits or restrictions on

the operations of out-of-state sole proprietors or general partnerships that are

different from those placed on domestic businesses. Thus, a state cannot force

registration of a general partnership simply because its principal office is located

elsewhere, but it can require an out-of-state doctor to undergo the same

licensing procedures it requires of its own residents.

232 Planning and Forecasting

OUT OF STATE OPERATION OF

CORPORATIONS, LIMITED PARTNERSHIPS,

AND LIMITED LIABILITY COMPANIES

Things are different, however, with corporations, limited partnerships, and

LLCs. As creations of the individual states, they are not automatically entitled

to recognition elsewhere. All states require (and routinely grant) qualification

as a foreign corporation, limited partnership, or LLC to nondomestic entities

doing business within their borders. This procedure normally requires the

completion of a form very similar to a corporate charter, limited partnership

certificate, or LLC charter, and the payment of an initial and annual fee similar

in amount to the fees paid by domestic entities. This requirement, incidentally,

is one reason not to form a corporation in Delaware if it will operate

principally outside that state. Much litigation has occurred over what constitutes

"doing business" within a state for the purpose of requiring qualification.

Similar issues arise over the obligation to pay income tax, collect sales tax, or

accept personal jurisdiction in the courts of a state. Generally these cases turn

on the individualized facts of the particular situation, but courts generally look

for offices or warehouses, company employees, widespread advertising, or

negotiation and execution of contracts within the state.

Perhaps more interesting may be the penalty for failure to qualify. Most

states will impose liability for back fees, taxes, interest, and penalties. More

important, many states will bar a nonqualified foreign entity from access to its

courts and, thus, from the ability to enforce obligations against its residents.

In most of these cases, the entity can regain access to the courts merely by paying

the state the back fees and penalties it owes, but in a few states access will

then be granted only to enforce obligations incurred after qualification was

achieved, leaving all prior obligations unenforceable.

RECOGNITION OF SOLE PROPRIETORSHIPS

AS A LEGAL ENTITY

By now it probably goes without saying that the law does not recognize a sole

proprietorship as a legal entity separate from its owner. If Phil, our computer

entrepreneur, were to choose this form, he would own all the company's assets;

he would be the plaintiff in any suits it brought, and he would be the defendant

in any suits brought against it. There would be no difference between Phil, the

individual, and Phil, the business.

RECOGNITION OF PARTNERSHIPS AS A LEGAL ENTITY

A general partnership raises more difficult issues. Although most states allow

partnerships to bring suit, be sued, and own property in the partnership name,

this does not mean that the partnership exists for most purposes separately from

Choosing a Business Form 233

its partners. As will be seen, especially in the areas of liability and taxation, partnerships

are very much collections of individuals, not separate entities.

Ownership of partnership property is a particularly problematic area. All

partners own an interest in the partnership, which entitles them to distributions of

profit, much like stock in a corporation. This interest is the separate property of

each partner and is attachable by the individual creditors of a partner in the form

of a "charging order." Each partner also owns the assets of the partnership jointly

with his other partners. This form of ownership (similar to joint ownership of a

family home by two spouses) is called tenancy in partnership. Each partner may

use partnership assets only for the benefit of the partnership's business; such assets

are exempt from attachment by the creditors of an individual partner, although not

from the creditors of the partnership. Tenancy in partnership also implies that, in

most cases of dissolution of a partnership, the ownership of partnership assets devolves

to the remaining partners, to the exclusion of the partner who leaves in violation

of the partnership agreement or dies. The former partner is left only with

the right to a dissolution distribution in respect of her partnership interest.

RECOGNITION OF CORPORATIONS AND LIMITED

LIABILITY COMPANIES AS LEGAL ENTITIES

The corporation and LLC are our first full-f ledged separate legal entities.

Ownership of business assets is vested solely in the corporation or LLC as a

separate legal entity. The corporation or LLC itself is plaintiff or defendant in

suits and is the legally contracting party in all its transactions. Stockholders and

members own only their stock or membership interests and have no direct

ownership rights in the business's assets.

RECOGNITION OF LIMITED PARTNERSHIPS AS

A LEGAL ENTITY

The limited partnership, as a hybrid, is a little of both partnership and corporation.

The general partners own the partnership's property as tenants in partnership

operating in the same manner as partners in a general partnership. The

limited partners, however, have only their partnership interests and no direct

ownership of the partnership's property. This is logically consistent with their

roles as silent investors. If they directly owned partnership property, they

would have to be consulted with regard to its use.

CONTINUITY OF LIFE

The issue of continuity of life is one which should concern most entrepreneurs,

because it can affect their ability to sell the business as a unit when it comes

234 Planning and Forecasting

time to cash in on their efforts as founders and promoters. The survival of the

business as a whole in the form of a separate entity must be distinguished from

the survival of the business's individual assets and liabilities.

Sole Proprietorships

Although a sole proprietorship does not survive the death of its owner, its individual

assets and liabilities do. In Phil's case, for example, to the extent that

these assets consist of the computer program, filing cabinets, and the like, they

would all be inherited by Phil's heirs, who could then choose to continue the

business or liquidate the assets as they pleased. Should they decide to continue

the business, they would then have the same choices of business form which

confront any entrepreneur. However, if Phil's major asset were a government

license, qualification as an approved government supplier, or a contract with a

software publisher, the ability of the heirs to carry on the business might be

entirely dependent upon the assignability of these items. If the publishing contract

is not assignable, Phil's death may terminate the business's major asset. If

the business had operated as a corporation, Phil's death would likely have been

irrelevant (other than to him); the corporation, not Phil, would have been party

to the contract.

Partnerships

Consistent with the general partnership's status as a collection of individuals,

not an entity separate from its owners, a partnership is deemed dissolved upon

the death, incapacity, bankruptcy, resignation, or expulsion of a partner. This

is true even if a partner's resignation violates the express terms of the partnership

agreement. Those assets of the partnership that may be assigned devolve

to those partners who are entitled to ownership, pursuant to the rules of tenancy

in partnership. These rules favor the remaining partners if the former

partner has died, become incapacitated or bankrupt, been expelled, or resigned

in violation of the partnership agreement. If the ex-partner resigned

without violating the underlying agreement, she or he retains ownership rights

under tenancy in partnership. Those who thus retain ownership may continue

the business as a new partnership, corporation, or LLC with the same or new

partners and investors or may liquidate the assets at their discretion. The sole

right of any partner who has forfeited direct ownership rights is to be paid

a dissolution distribution after the partnership's liabilities have been paid or

provided for.

Corporations

Corporations, in contrast, normally enjoy perpetual life. Unless the charter

contains a stated dissolution date (extremely rare), and as long as the corporation

pays its annual fees to the state, it will go on until and unless it is voted out

Choosing a Business Form 235

of existence by its stockholders. The death, incapacity, bankruptcy, resignation,

or expulsion of any stockholder is entirely irrelevant to the corporation's

existence. Such a stockholder's stock continues to be held by the stockholder, is

inherited by his heirs, or is auctioned by creditors as the circumstances demand,

with no direct effect on the corporation.

Limited Partnerships

As you may have guessed, the hybrid nature of the limited partnership dictates

that the death, incapacity, bankruptcy, resignation, or expulsion of a limited

partner will have no effect on the existence of the limited partnership. The

limited partner's partnership interest is passed in the same way as that of a

stockholder's. However, the death, incapacity, bankruptcy, resignation, or expulsion

of a general partner does automatically dissolve the partnership in the

same way as it would in the case of a general partnership. This automatic dissolution

can be extremely inconvenient if the limited partnership is conducting a

far-f lung enterprise with many limited partners. Thus, in most cases the partners

agree in advance in their limited partnership agreement that upon such a

dissolution the limited partnership will continue under the management of a

substitute general partner chosen by those general partners who remain. In

such a case, the entity continues until it is voted out of existence by its partners,

in accordance with their agreement, or until the arrival of a termination

date specified in its certificate.

Limited Liability Companies

The laws of the several states generally impose dissolution on an LLC upon the

occurrence of a list of events similar to those which result in the dissolution of

a limited partnership. However, these laws usually allow the remaining members

to vote to continue the LLC's existence notwithstanding an event of dissolution.

Under such laws, the LLC may effectively have perpetual life in the

same manner as corporations.

TRANSFERABILITY OF INTEREST

To a large extent, transferability of an owner's interest in the business is similar

to the continuity of life issue.

Sole Proprietorships

A sole proprietor has no interest to transfer because he and the business are

one and the same, and thus he must be content to transfer each of the assets of

the business individually—an administrative nightmare at best and possibly

236 Planning and Forecasting

impractical in the case of nonassignable contracts, licenses, and government

approvals.

Partnerships

To discuss transferability in the context of a general partnership, one must

keep in mind the difference between ownership of partnership assets as tenants

in partnership and ownership of an individual's partnership interest. A

partner has no right to transfer partnership assets except as may be authorized

by vote in accordance with the partnership agreement and in furtherance of

the partnership business. However, a partner may transfer her partnership interest,

and it may be attached by individual creditors pursuant to a charging

order. This transfer does not make the transferee a partner in the business, because

partnerships can be created only by agreement of all parties. Rather, it

sets up the rather awkward situation in which the original partner remains, but

his or her economic interest is, at least temporarily, in the hands of another. In

such cases, the Uniform Partnership Act gives the remaining partners the right

to dissolve the partnership by expelling the transferor partner.

Corporations

No such complications attend the transfer of one's interest in a corporation.

Stockholders simply sell or transfer their shares. Since stockholders (solely as

stockholders) have no day-to-day involvement in the operation of the business,

the transferee becomes a full-f ledged stockholder upon the transfer. This

means that if Bruce, Erika, and Michael decide to operate as a corporation,

each risks waking up one day to find that he or she has a new "partner" if one

of the three has sold his or her shares. To protect themselves against this eventuality,

most closely-held corporations include restrictions on stock transfer in

their charter, their bylaws, or in stockholder agreements. These restrictions set

forth some variation of a right of first refusal either for the corporation or the

other stockholders whenever a transfer is proposed. In addition, corporate

stock, as well as most limited partnership interests and LLC membership interests,

is a security under the federal and state securities laws, and because the

securities of these entities will not initially be registered under any of these

laws, their transfer is closely restricted.

Limited Partnerships

Just as with general partnerships, the partners of limited partnerships may

transfer their partnership interests. The rules regarding the transfer of the interests

of the general partners are similar to those governing general partnerships

described earlier. Limited partners may usually transfer their interests

(subject to securities laws restrictions) without fear of dissolution, but transferees

normally do not become substituted limited partners without the consent

of the general partners.

Choosing a Business Form 237

Limited Liability Companies

As previously mentioned, although a membership interest in an LLC may be

freely transferable under applicable state law, most LLCs require the affirmative

vote of at least a majority of the members or managers before a member's

interest may be transferred. Furthermore, membership interests in an LLC

will usually qualify as securities under relevant securities laws and will therefore

be subject to the restrictions on transfer imposed by such laws.

CONTROL

Simply put, control in the context of a business entity means the power to make

decisions regarding all aspects of its operations. But the implications of control

extend to many levels. These include control of the equity or value of the business,

control over distribution of profits, control over day-to-day and long-term

policy making, and control over distribution of cash flow. Each of these is

different from the others, and control over each can be allocated differently

among the owners and other principals of the entity. This can be seen either as

complexity or f lexibility, depending upon one's perspective.

Sole Proprietorships

No such debate over allocation exists for the sole proprietorship. In that business

form, control over all these factors belongs exclusively to the sole proprietor.

Nothing could be simpler or more straightforward.

Partnerships

Things are not so simple in the context of general partnerships. It is essential to

appreciate the difference between the partners' relationships with each other

(internal relationships) and the partnership's relations with third parties (external

relationships).

Internally, the partnership agreement governs the decision-making process

and sets forth the agreed division of equity, profits, and cash flows. Decisions

made in the ordinary course of business are normally made by a majority

vote of the partners, whereas major decisions, such as changing the character

of the partnership's business, may require a unanimous vote. Some partnerships

may weight the voting in proportion to each partner's partnership interest,

while others delegate much of the decision-making power to an executive

committee or a managing partner. In the absence of an agreement, the Uniform

Partnership Act prescribes a vote of the majority of partners for most

issues and unanimity for certain major decisions.

External relationships are largely governed by the law of agency; that is,

each partner is treated as an agent of the partnership and, derivatively, of the

other partners. Any action that a partner appears to have authority to take will

238 Planning and Forecasting

be binding upon the partnership and the other partners, regardless of whether

such action has been internally authorized (see Exhibit 8.1).

Thus, if Jennifer purchases a subscription to the Harvard Business Review

for the partnership, and such an action is perceived to be within the ordinary

course of the partnership's business, that obligation can be enforced

against the partnership, even if Jean and George had voted against it. Such

would not be the case, however, if Jennifer had signed a purchase and sale

agreement for an office building in the name of the partnership, because reasonable

third parties would be expected to know that such a purchase was not

in the ordinary course of business.

These rules extend to tort liability, as well. If Jean were wrongfully to induce

a potential client to breach its consulting contract with a competitor, the

partnership would be liable for interference with contractual relations, even if

the other two partners were not aware of Jean's actions. Such might not be the

case, however, if Jean decided to dynamite the competition's offices, because

such an act could be judged to be outside the normal scope of her duties as

a partner.

These obligations to third parties can even extend past the dissolution of

the partnership if an individual partner has not given adequate notice that he

or she is no longer associated with the others. Thus, a former partner can be

held liable for legal fees incurred by the other former partners, if he has not

notified the partnership's counsel about leaving the firm.

It should also be noted that agency law reaches into the internal relationships

of partners. The law imposes upon partners the same obligations of fiduciary

loyalty, noncompetition, and accountability as it does upon agents with

respect to their principals.

Corporations

There can be much f lexibility and complexity in the allocation of control in

the partnership form, but not nearly so much as in the corporate form. Many

EXHIBIT 8.1 Principal and agent.

Principal

Agent Agent

Principal

Outsider

Governed

by:

Agreement

and

Fiduciary

Principles

Express,

Apparent Authority,

and

Scope of Employment

Choosing a Business Form 239

aspects of the corporate form have been designed specifically for the purpose

of splitting off individual aspects of control and allocating them differently.

Stockholders

At its simplest, a corporation is controlled by its stockholders. Yet, except in

those states which have specific (but rarely used) close corporation statutes

governing corporations with very few stakeholders, the decision-making function

of stockholders is exercised only derivatively. Under most corporate

statutes, a stockholder vote is required only with respect to four basic types of

decisions: an amendment to the charter, a sale of the company, a dissolution

of the company, and an election of the board of directors.

Charter amendments may sound significant, until one remembers what

information is normally included in the charter. A name change, a change in

purpose (given the broad purpose of clauses now generally employed), and an

increase in authorized shares (given the large amounts of stock normally left

on the shelf ) are neither frequent nor usually significant decisions. Certainly, a

sale of the company is significant, but it normally can occur only after the recommendation

of the board and will happen only once, if at all. The same can

be said of the decision to dissolve. It is the board of directors that makes all the

long-term policy decisions for the corporation. Thus, the right to elect the

board is significant but indirectly so. Day-to-day operation of the corporation's

business is accomplished by its officers, who are normally elected by the board,

not the stockholders.

Even given the relative unimportance of voting power for stockholders,

the corporation provides many opportunities to differentiate voting power

from other aspects of control and allocate it differently. Assume Bruce and

Erika (our hotel developers) were willing to give Michael a larger piece of the

equity of their operation to ref lect his contribution of the land but wished to

divide their voting rights equally. They could authorize a class of nonvoting

common stock and issue, for example, 1,000 shares of voting stock to each of

themselves and an additional 1,000 shares of nonvoting stock to Michael. As a

result, each would have one-third of the voting control, but Michael would have

one-half of the equity interest.

Alternatively, Michael could be issued a block of preferred stock representing

the value of the land. This would guarantee him a fair return on his

investment before any dividends could be declared to the three of them as

holders of the common stock. As a holder of preferred stock, Michael would

also receive a liquidation preference upon dissolution or sale of the business, in

the amount of the value of his investment, but any additional value created by

the efforts of the group would be ref lected in the increasing value of the common

shares.

The previous information illustrates how one can separate and allocate

decision-making control differently from that of the equity in the business, as

well as from the distribution of profits. Distribution of cash flow can, of

240 Planning and Forecasting

course, be accomplished totally separately from the ownership of securities,

through salaries based upon the relative efforts of the parties, rent payments

for assets leased to the entity by the principals, or interest on loans to the

corporation.

Stockholders exercise what voting power they have at meetings of the

stockholders, held at least annually but more frequently if necessary. Each

stockholder of record, on a future date chosen by the party calling the meeting,

is given a notice of the meeting containing the date, time, and purpose of

the meeting. Such notice must be sent at least 7 to 10 days prior to the date

of the meeting depending upon the individual state's corporate law, although

the Securities and Exchange Commission requires 30 days' notice for publicly

traded corporations. No action may be taken at a meeting unless a majority of

voting shares is represented (known as a quorum). This results in the aggressive

solicitation of proxy votes in most corporations with widespread stock

ownership. Unless otherwise provided (as for a sale or dissolution of the company,

for which most states require a two-thirds vote of all shares), a resolution

is carried by a majority vote of those shares represented at the meeting.

The preceding rules require the conclusion that the board of directors

will be elected by the holders of a majority of the voting shares. Thus, in the

earlier scenario, even though Bruce and Erika may have given Michael onethird

of the voting shares of common stock, as long as they continue to vote

together, Bruce and Erika will be able to elect the entire board. To prevent

this result, prior to investing Michael could insist upon a cumulative voting

provision in the charter (under those states' corporate laws that allow it).

Under this system, each share of stock is entitled to a number of votes equal to

the number of directors to be elected. By using all their votes to support a single

candidate, individuals with a significant minority interest can guarantee

themselves representation on the board.

More directly (and in states which do not allow cumulative voting),

Michael could insist upon two different classes of voting stock, differing only

in voting rights. Bruce and Erika would each own 1,000 shares of class A stock

and elect two directors. Michael, the sole owner of the 1,000 outstanding

shares of class B stock, would elect a third director. Of course, the board also

acts by majority, so Bruce and Erika's directors could dominate board decisions

in any case, but at least Michael would have access to the deliberations.

In the absence of a meeting, stockholders may vote by unanimous written

consent, where each stockholder indicates his approval of a written resolution

by signing it. This eliminates the need for a meeting and is very effective in

corporations with only a few stockholders (such as our hotel operation). Unlike

the rules governing stockholders' meetings, however, in most states unanimity

is required to adopt resolutions by written consent. This apparently ref lects the

belief that a minority stockholder is owed an opportunity to sway the majority

with his arguments. A few states, notably Delaware, permit written consents of

a majority, apparently reacting to the dominance of proxy voting at most meetings

of large corporations, where the most eloquent of minority arguments

would fall upon deaf ears (and proxy cards).

Choosing a Business Form 241

Directors

At the directors' level, absent a special provision in the corporation's charter,

all decisions are made by majority vote. Typically, directors concentrate on

long-term and significant decisions, leaving day-to-day management to the officers

of the corporation. Decisions are made at regularly scheduled directors'

meetings or at a special meeting if there is need to respond to a specific situation.

Under most corporate laws, no notice need be given for regular meetings,

and only very short notice need be given for special meetings (24 to 48 hours).

The notice must be sent to all directors and must contain the date, time, and

place of the meeting but, unlike stockholders' notices, need not contain the

purpose of the meeting. It is assumed that directors are much more involved in

the business of the corporation and do not need to be warned about possible

agenda items or given long notice periods.

At the meeting itself, no business can be conducted in the absence of a

quorum, which, unless increased by a charter or bylaw provision, is a majority

of the directors then in office. Ref lecting recent advances in technology, many

corporate statutes allow directors to attend meetings by conference call or

teleconference as long as all directors are able to hear and speak to each other

at all times during the meeting. Individual telephone calls to each director will

not suffice. Unlike stockholders, directors cannot vote by proxy, because each

director owes to the corporation his or her individual judgment on items coming

before the board. The board of directors can also act by written consent,

but, even in Delaware, such consent must be unanimous, in recognition that

the board is fundamentally a deliberative body.

Boards of directors, especially in publicly held corporations with larger

boards, frequently delegate some of their powers to executive committees, or

other committees formed for defined purposes. However, most corporate

statutes prohibit boards from delegating certain fundamental powers, such as

the declaration of dividends, the recommendation of charter amendments, or

sale of the company. The executive committee can, however, be a powerful organizational

tool to streamline board operations and increase efficiency and

responsiveness.

Although directors are not agents of the corporation—in that they cannot

bind the corporation to contract or tort liability through their individual actions—

they are subject to many of the obligations of agents discussed in the

context of partnerships, such as fiduciary loyalty. Directors are bound by the

so-called corporate opportunity doctrine, which prohibits them from taking

personal advantage of any business opportunity that may come their way, if the

opportunity would reasonably be expected to interest the corporation. In such

an event, the director must disclose the opportunity to the corporation, which

normally must consider it and vote not to take advantage before the director

may act on her or his own behalf.

Unlike stockholders, who under most circumstances can vote their shares

totally in their own self-interest, directors must use their best business judgment

and act in the corporation's best interest when making decisions for the

242 Planning and Forecasting

corporation. At the very least, the director must keep informed regarding the

corporation's operations, although he or she may in most circumstances rely on

the input of experts hired by the corporation, such as its attorneys and accountants.

Thus, when the widow of a corporation's founder accepted a seat on the

board as a symbolic gesture of respect to her late husband, she found herself liable

to minority stockholders for the misbehavior of her fellow board members.

Nonparticipation in the misdeeds was not enough to exempt her from liability;

she had failed to keep herself informed and exercise independent judgment.

Directors may also find themselves sued personally by minority stockholders

or creditors of the corporation for declaration of dividends or other

distributions to stockholders that render the corporation insolvent or for other

decisions of the board that have injured the corporation. Notwithstanding such

lawsuits, however, directors are not guarantors of the success of the corporation's

endeavors; they are required only to have used their best independent

"business judgment" in making their decisions. When individual directors cannot

be totally disinterested (such as the corporate opportunity issue or when

the corporation is being asked to contract with a director or an entity in which

a director has an interest), the interested director is required to disclose her or

his interest and is disqualified from voting. In many states, the director 's presence

will not even count for the maintenance of a quorum.

Apart from the question of the interested director, much of the modern

debate on the role of the corporate director has focused around which constituencies

a director may take into account when exercising his or her best

business judgment. The traditional view has been that the director's only concern

is to maximize return on the investment of the stockholders. More recently,

especially in the context of hostile takeovers, directors have been

allowed to take into account the effect of their decisions on other constituencies,

such as suppliers, neighboring communities, customers, and employees.

In an early case on this subject, the board of directors of the corporation

which owned Wrigley Field and the Chicago Cubs baseball team was judged to

have appropriately considered the effect on its neighbors and on the game of

baseball in voting to forgo the extra revenue that it would probably have earned

if it had installed lights for night games.

When the stockholders believe the directors have not been exercising

their best independent business judgment in a particular instance, the normal

procedure is to make a demand on the directors to correct the decision either

by reversing it or by reimbursing the corporation from their personal funds.

Should the board refuse (as it most likely will), the stockholders then bring a

derivative suit against the board on behalf of the corporation. They are, in effect,

taking over the board's authority to decide whether such a suit should be

brought in the corporation's name. The board's vote not to institute the suit is

not likely to be upheld on the basis of the business judgment rule, since the

board members are clearly interested in the outcome of the vote. As a result,

the well-informed board will delegate the power to make such a decision to an

independent litigation committee, usually composed of directors who were not

Choosing a Business Form 243

involved in the original decision. The decision of such a committee is much

more likely to be upheld in a court of law, although the decision is not immune

from judicial review.

A more detailed discussion on the board of directors is contained in

Chapter 15, "The Board of Directors."

Officers

The third level of decision making in the normal corporation is that of the

officers, who take on the day-to-day operational responsibilities. Officers are

elected by the board and consist, at a minimum, of a president, a treasurer, and

a secretary or clerk (keeper of the corporate records). Many corporations elect

additional officers such as vice presidents, assistant treasurers, CEOs, and

the like.

Thus, the decision-making control of the corporation is exercised on

three very different levels. Where each decision properly belongs may not be

entirely obvious in every situation. The decision to go into a new line of business

would normally be considered a board decision. Yet if by some chance the

decision requires an amendment of the corporate charter, a vote of stockholders

may be necessary. On the contrary, if the decision is merely to add a

twelfth variety of relish to the corporation's already varied line of condiments,

the decision may be properly left to a vice president of marketing.

Often persons who have been exposed to the preceding analysis of the

corporate-control function conclude that the corporate form is too complex for

any but the largest and most complicated publicly held companies. This is a

gross overreaction. For example, if Phil, our software entrepreneur, should decide

that the corporate form is appropriate for his business, it is very likely that

he will be the corporation's 100% stockholder. As such, he will elect himself

the sole director and his board will then elect him as the president, treasurer,

and secretary of the corporation. Joint meetings of the stockholders and directors

of the corporation may be held in the shower adjacent to Phil's bathroom

on alternate Monday mornings.

Limited Partnerships

As you might expect, the allocation of control in a limited partnership ref lects

its origin as a hybrid of the general partnership and the corporation. Simply

put, virtually all management authority is vested in the general partners. Like

outside stockholders in a corporation, the limited partners normally have little

or no authority. Third parties cannot rely on any apparent authority of a limited

partner because that partner's name will not appear, as a general partner's

name may, on the limited partnership's certificate on the public record.

General partners exercise their authority in the same way as they do in a

general partnership. Voting control is allocated internally as set forth in the

partnership agreement, but each general partner has the apparent authority to

244 Planning and Forecasting

bind the partnership to unauthorized contracts and torts to the same extent as

the partners in a general partnership.

Limited partners will normally have voting power over a very small list of

fundamental business events, such as amending the partnership agreement and

certificate, admitting new general partners, changing the basic business purposes

of the partnership, or dissolving the partnership. These are similar to the

decisions that must be put to a stockholders' vote in a corporation. The Revised

Uniform Limited Partnership Act, now accepted by most states, has widened

the range of decisions in which a limited partner may participate without losing

his or her status as a limited partner. However, this range is still determined

by the language of the agreement and certificate for each individual

partnership.

Limited Liability Companies

An LLC which chooses not to appoint managers is operated much like a general

partnership. The operating agreement sets forth the percentages of membership

interests required to authorize various types of actions on the LLC's

behalf, with the percentage normally varying according to the importance of

the act. Although the LLC is a relatively new phenomenon, courts can be expected

to deem members (in the absence of managers) to have apparent authority

to bind the entity to contracts (regardless of whether they have been

approved internally) and to expose the entity to tort liability for acts occurring

within the scope of the entity's business.

An LLC that appoints managers is operated much like a limited partnership.

The managers make most of the decisions on behalf of the entity, as do

the general partners of a limited partnership. The members are treated much

like limited partners and have voting rights only in rare circumstances involving

very significant events. It can be expected that apparent authority to act

for the entity will be reserved by the courts to the managers, as only their

names will appear on the Certificate of Organization.

LIABILITY

Possibly the factor that most concerns the entrepreneur is personal liability.

If the company encounters catastrophic tort liability, finds itself in breach of

a significant contract, or just plain can't pay its bills, must the owner reach

into her or his own personal assets to pay the remaining liability after the

company's assets have been exhausted? If so, potential entrepreneurs may

well believe that the risk of losing everything is not worth the possibility of

success, and their innovative potential will be diminished or lost to society.

Most entrepreneurs are willing to take significant risk, however, if the

amount of that risk can be limited to the amount they have chosen to invest in

the venture.

Choosing a Business Form 245

Sole Proprietorships

With the sole proprietorship, the owner has essentially traded off limitation of

risk in favor of simplicity of operation. Since there is no difference between

the entity and its owner, all the liabilities and obligations of the business are

also liabilities and obligations of its owner. Thus, all the owner's personal assets

are at risk. Failure of the business may well mean personal bankruptcy for the

owner.

Partnerships

The result may be even worse within a general partnership. There, each owner

is liable not only for personal mistakes but also for those of his or her partners.

Each partner is jointly and severally liable for the debts of the partnership remaining

after its assets have been exhausted. This means that a creditor may

choose to sue any individual partner for 100% of any liability. The partner may

have a right to sue the other partners for their share of the debt, as set forth in

the partnership agreement, but that is of no concern to a third party. If the

other partners are bankrupt or have f led the jurisdiction, the targeted partner

may end up holding the entire bag.

If our three consultants operate as a partnership, Jennifer is 100% personally

liable not only for any contracts she may enter into but also for any contracts

entered into by either Jean or George. What's more, she is liable for

those contracts, even if they were entered into in violation of the partnership

agreement, because, as was demonstrated earlier, each partner has the apparent

authority to bind the partnership to contracts in the ordinary course of the

partnership's business, regardless of the partners' internal agreement. Worse,

Jennifer is also 100% individually liable for any torts committed by either of

her partners as long as they were committed within the scope of the partnership's

business. The only good news in all this is that neither the partnership

nor Jennifer is liable for any debts or obligations of Jean or George incurred

in their personal affairs. If George has incurred heavy gambling debts in Las

Vegas, his creditors can affect the partnership only by obtaining a charging

order against George's partnership interest.

Corporations

Thus, we have the historical reason for the invention of the corporation. Unlike

the sole proprietorship and partnership, the corporation is recognized as

a legal entity separate from its owners. Its owners are thus not personally liable

for its debts; they are granted limited liability. If the corporation's debts

exhaust its assets, the stockholders have lost their investment, but they are

not responsible for any further amounts. In practice, this may not be as attractive

as it sounds, because sophisticated creditors, such as the corporation's

bank, will likely demand personal guarantees from major stockholders.

246 Planning and Forecasting

But the stockholders will normally escape personal liability for trade debt and,

most important, for torts.

This major benefit of incorporation does not come without some cost.

Creditors may, on occasion, be able to "pierce the corporate veil" and assert

personal liability against stockholders, using any one of three major arguments.

First, to claim limited liability behind the corporate shield, stockholders must

have adequately capitalized the corporation at or near its inception. There is no

magic formula with which to calculate the amount necessary to achieve adequate

capitalization, but the stockholders normally will be expected to invest

enough money or property and obtain enough liability insurance to offset the

kinds and amounts of liabilities normally encountered by a business in their industry.

Thus, the owner of a f leet of taxicabs did not escape liability by canceling

his liability insurance and forming a separate corporation for each cab. The

court deemed each such corporation inadequately capitalized and, in a novel

decision, pierced the corporate veil laterally by combining all the corporations

into one for purposes of liability.

It is necessary to capitalize only for those liabilities normally encountered

by corporations in the industry. The word normally is key because the

corporation obviously need not have resources adequate to handle any circumstance

no matter how unforeseeable. Also, adequate capitalization is necessary

only at the outset. A corporation does not expose its stockholders to personal

liability by incurring substantial losses and ultimately dissipating its initial

capitalization.

A second argument used by creditors to reach stockholders for personal liability

is failure to respect the corporate form. This may occur in many ways.

The stockholders may fail to indicate that they are doing business in the corporate

form by leaving the words "Inc." or "Corp." off their business cards and

stationery, thus giving the impression that they are operating as a partnership.

They may mingle the corporate assets in personal bank accounts or routinely

use corporate assets for personal business. They may fail to respect corporate

niceties such as holding annual meetings and filing the annual reports required

by the state. After all, if the stockholders don't take the corporate form seriously,

why should their creditors? Creditors are entitled to adequate notice

that they may not rely on the personal assets of the stockholders. Even Phil,

the software entrepreneur imagined earlier holding stockholder's and director's

meetings in his shower, would be well advised to record the minutes in a

corporate record book.

A third argument arises from a common mistake made by entrepreneurs.

Fearful of the expense involved in forming a corporation, they wait until they

are sure that the business will get off the ground before they spring for the attorneys'

and filing fees. In the meantime, they may enter into contracts on behalf

of the corporation and perhaps even commit a tort or two. Once the

corporation is formed, they may even remember to have it expressly accept all

liabilities incurred by the promoters on its behalf. Under simple agency law,

however, one cannot act as an agent of a nonexistent principal. And a later

Choosing a Business Form 247

assignment of one's liabilities to a newly formed corporation does not act to release

the original obligor without the consent of the obligee. The best advice

here is to form the corporation before incurring any liability on its behalf. Most

entrepreneurs are surprised at how little it actually costs to get started.

Limited Partnerships

In keeping with its hybrid nature, a limited partnership borrows some of its aspects

from the corporation and some from the general partnership. In summary,

each general partner has unlimited joint and several liability for the

debts and obligations of the limited partnership after exhaustion of the partnership's

assets. In this respect, the rules are identical to those governing the

partners in a general partnership. Limited partners are treated as stockholders

in a corporation. They have risked their investment, but their personal assets

are exempt from the creditors of the partnership.

As you might expect, however, things aren't quite as simple as they may

initially appear. In limited partnerships, it is rather common for limited partners

to make their investments in the form of a cash down payment and a

promissory note for the rest, partly for reasons of cash flow and partly for purposes

of tax planning. This arrangement is much less common in corporations

because many corporate statutes do not permit it and because the tax advantages

associated with this arrangement are generally not available in the corporate

form. Should the limited partnership's business fail, limited partners will

be expected, despite limited liability, to honor their commitments to make future

contributions to capital.

In addition, it is fundamental to the status of limited partners that they

have acquired limited liability in exchange for foregoing virtually all management

authority over the business. The corollary to that rule is that a limited

partner who excessively involves her- or himself in management may forfeit

limited liability and be treated, for the purposes of creditors, as a general partner,

with unlimited personal liability. Mitigating this somewhat harsh rule, the

Revised Uniform Limited Partnership Act increased the categories of activities

in which a limited partner may participate without crossing the line. Furthermore,

and perhaps more fundamentally, in states that have adopted the

Revised Act, the transgressing limited partner is now only personally liable to

those creditors who were aware of the limited partner's activities and detrimentally

relied upon his or her apparent status as a general partner.

Limited Liability Companies

One of the major benefits of employing the LLC form is that it shields all

members and managers from personal liability for the debts of the business.

However, even though the LLC is relatively new on the legal scene, courts

can be expected to apply most of the same doctrines they use in piercing the

corporate veil to pierce the veil of the LLC as well. Furthermore, it can be

248 Planning and Forecasting

expected that the managers of an LLC will be held to the same fiduciary standards

as corporate directors and general partners of limited partnerships, resulting

in their potential personal liability to the members.

TAXATION

Entrepreneurs make a remarkable number of significant business decisions

without first taking into account the tax consequences. Tax consequences

should almost never be allowed to force an entrepreneur to take actions he or

she otherwise would not have considered. But often tax considerations lead one

to do what one wants in a different manner and to reap substantial savings as a

consequence. Such is often the case in the organization of a business. The following

discussion will be confined to the federal income tax, the tax with the

largest and most direct effect upon organizational issues. Each entrepreneur

would be well advised to consult a tax adviser regarding this tax as well as state

income, estate, payroll, and other taxes to find out how they might impact a

specific business.

Sole Proprietorships

Not surprisingly given the factors already discussed, a sole proprietorship is

not a separate taxable entity for federal income tax purposes. The taxable income

and deductible expenses of the business are set forth on Schedule C

of the entrepreneur's Form 1040 and the net profit (loss) is carried back to

page 1, where it is added to (or subtracted from) all the taxpayer's other income.

The net effect of this is that the sole proprietor will pay tax on the income

from this business at his highest marginal rate, possibly as high as 39.1%

(in 2001), depending upon the amount of income received from this and other

sources (see Exhibit 8.2).

In Phil's case, for example, if his software business netted $100,000 in

2001, that amount would be added to the substantial interest and dividend income

from his other investments, so that he would likely owe the IRS $39,100

on this income. If Phil's business were run as a separate taxable corporation,

the income generated from it would be taxed at the lowest levels of the tax-rate

structure, because this corporate income would not be added to any other income.

The first $50,000 of income would be taxed at only 15% and the next

$25,000 at only 25% (see Exhibit 8.3).

This argument is turned on its head, however, if a business anticipates

losses in the short term. Using Phil again as an example, if his business operated

at a $100,000 loss and as a separate taxable entity, the business would pay

no tax in its first year and would be able to net its early losses only against

profits in future years and only if it ever realized such profits. At best, the

value of this tax benefit is reduced by the time value of money: At worst, the

loss may never yield a tax benefit if the business never does more than break

Choosing a Business Form 249

even. If Phil operated the business as a sole proprietorship, by contrast, the

loss calculated on his Schedule C would be netted against the dividend and

interest income generated by his investments, thus effectively rendering

$100,000 of that income tax free. One can strongly argue, therefore, that the

form in which one should operate one's business is dictated in part by the

likelihood of its short-term success and the presence or absence of other income

flowing to its owner.

EXHIBIT 8.2 Individual federal income tax rates.

Under

$6,000

Over

$27,050

Over

$65,550

Over

$136,750

Over

$297,350

Marginal tax rate (percent)

Individual income 2001

0

10

20

30

40

50

Over

$6,000

EXHIBIT 8.3 Corporate federal income tax rates.

Below $50 >$50 >$75 >$100 >$335 >$10,000 >$15,000 >$18,333

Marginal tax rate (percent)

Corporate income (thousands)

0

10

20

30

40

50

250 Planning and Forecasting

Partnerships

Partnerships are also not separate taxable entities for the purposes of the federal

income tax, although, in most cases, they are required to file informational

tax returns with the IRS. Any profits generated by a partnership appear on the

federal income tax returns of the partners, generally in proportions indicated

by the underlying partnership agreement. Thus, as with sole proprietorships,

this profit is taxed at the individual partner's highest marginal tax rate, and the

lower rates for the initial income of a separate taxable entity are forgone. In addition,

each partner is taxed upon his or her proportion of the income of the

partnership regardless of whether that income was actually distributed.

As an example, if Bruce and Erika, our hotel magnates, were to take

$50,000 of a year's profits to add a deck to one of their properties, this expenditure

would not lower the business's profits by that amount. As a capital expense

it may be deducted over time only in the form of depreciation. Thus,

assuming they were equal partners, even if Michael had objected to this expenditure,

each of the three, including Michael, would be forced to pay a tax

on $16,667 (minus that year's depreciation) despite having received no funds

with which to make such a payment. The result would be the same in a sole

proprietorship, but this obligation is considered less of a problem since it can

be expected that the owner would manage cash f low in a way which would minimize

this negative effect upon her- or himself.

As with a sole proprietorship, this negative result becomes a positive one

if the partnership is losing money. The losses appear on the partners' individual

tax returns in the proportions set forth in the partnership agreement and

render an equal amount of otherwise taxable income tax free. In addition, not

all losses suffered by businesses result from the dreaded negative cash flow. As

illustrated earlier in the case of the deck, the next year the hotel business

might well break even or show a small profit on a cash-flow basis, but the depreciation

generated by the earlier addition of the deck might well result in a

loss for tax purposes. Thus, with enough depreciation a partner might have the

double benefit of a tax sheltering loss on his tax return and ownership of a

growing, profitable business. This is especially true regarding real estate, such

as the hotel itself. While generating a substantial depreciation loss each year,

the value of the building may well be increasing, yielding the partners a current

tax-sheltering loss while generating a long-term capital gain for a few years

hence.

Corporations

Corporations are treated as separate entities for federal income tax purposes,

consistent with their treatment for most other purposes. They have their own

set of progressive tax rates, moving from 15% for the first $50,000 of income,

through 25% for the next $25,000, to 34% and 35% for amounts above

that. There are also 5% and 3% additional taxes at higher levels of income to

Choosing a Business Form 251

compensate for the lower rates in the lower brackets. Certain "professional

service corporations" have only a f lat 35% rate at all levels of income. Also,

losses currently generated by a corporation may be carried back as many as 2

years to generate a tax refund or carried forward as many as 20 years to shelter

future income.

Although corporate rates may be attractive at lower levels of income, the

common fear of using the corporate form is the potential for double taxation.

Simply put, the corporation pays tax upon its profits and then distributes the

remaining profit to its stockholders as nondeductible dividends. The stockholders

then pay tax on the receipt of the dividends, thus amounting to two taxes on

the same money. In 2001, for a corporation in the 34% bracket with stockholders

in the 27.5% bracket, the net effect is a combined tax rate of 52.15%. Yet

double taxation is rarely a concern for the small business. Such businesses

generally manage compensation to their employees, who are usually their

shareholders, in such a way that there is rarely much, if any, corporate profit

remaining at the end of the year. Since compensation (as opposed to dividends)

is deductible, the only level of taxation incurred by such businesses is at the

stockholder level. Other opportunities for legitimate deductible payments to

stockholders that have the effect of eliminating corporate profit include rental

payments on assets leased by a stockholder to the corporation and interest on

that portion of a stockholder's investment made in the form of debt.

Thus, the existence of the separate corporate entity with its own set of

tax rates presents more of an opportunity for tax planning than a threat of double

taxation. If the corporation intends to distribute all of its excess cash to its

owners, it should manage compensation and other payments so as to show little

profit and incur taxation only on the stockholder level. If the corporation intends

to retain some of its earnings in the form of capital acquisitions (thus resulting

in an unavoidable profit for tax purposes), it can take advantage of the

lower corporate rates without subjecting its stockholders to taxation at their

level. Contrast this to a partnership where the partners would be required to

pay tax at their highest marginal rates on profits that they never received.

There are limits to the usefulness of these strategies. To begin with, one

cannot pay salaries and bonuses to nonemployee stockholders who are not performing

services for the corporation. Dividends may be the only way to give

such shareholders a return on their investment. In addition, the Internal Revenue

Service will not allow deductions for what it considers to be unreasonable

compensation (as measured by compensation paid to comparable employees in

the same industry). Thus, a highly profitable corporation might find some of its

excessive salaries to employee-stockholders recharacterized as nondeductible

dividends. Lastly, even profits retained at the corporate level will eventually

be indirectly taxed at the stockholder level as increased capital gain when the

stockholders sell their shares.

For most startup businesses, however, this corporate tax planning strategy

will be useful, at least in the short term. In addition, entrepreneurs will find

certain employee benefits are better offered in the corporate form because

252 Planning and Forecasting

they are deductible to employers but excluded from income only for employees.

Since a sole proprietor or partner is not considered an employee, the value of

benefits such as group medical insurance, group life insurance, and disability

insurance policies would be taxable income to them but tax free to the officers

of a corporation.

Professional Corporations

There are two common variations of the corporate form. The first of these is

the professional corporation. Taxation played a major part in its invention.

Originally, limitations on the amounts of money that could be deducted as a

contribution to a qualified retirement plan varied greatly depending upon

whether the business maintaining the plan was a corporation, a partnership, or

a sole proprietorship. The rules greatly favored the corporation. Partnerships

and sole proprietorships were required to adopt Keogh plans with their substantially

lower limits on deductibility. However, doctors, lawyers, architects,

and other professionals, who often could afford large contributions to retirement

plans, were not allowed to incorporate under applicable state laws. The

states were offended by the notion that such professionals could be granted

limited liability for the harms caused by their businesses.

Eventually, a compromise was struck and the "professional corporation"

was formed. Using that form, professionals could incorporate their businesses,

thus qualifying for the higher retirement plan deductions but giving up any

claim to limited liability. As time went by, however, the Internal Revenue

Code was amended to eliminate most of the differences between the deductions

available to Keogh plans and those available to corporate pension and

profit-sharing plans. Today, professional corporations are subject to virtually

all the same rules as other corporations, with the exception that most are classified

as professional service corporations and therefore taxed at a f lat 35%

rate on undistributed profit.

As the tax incentive for forming professional corporations has decreased,

many states, perhaps with an eye toward maintaining the flow of fees from

these corporations, have greatly liberalized the availability of limited liability

for these corporations. Today in many states professional corporations now

afford their stockholders protection from normal trade credit as well as tort liability

arising from the actions of their employees or other stockholders. Of

course, even under the normal business corporation form, a stockholder is personally

liable for torts arising from his or her own actions.

Subchapter S Corporations

The second common variation is the subchapter S corporation, named for the

sections of the Internal Revenue Code that govern it. Although indistinguishable

from the normal (or subchapter C) corporation in all other ways, including limited

liability for its stockholders, the subchapter S corporation has affirmatively

Choosing a Business Form 253

elected to be taxed similarly to a partnership. Thus, like the partnership, it is

not a separate taxable entity and files only an informational return. Profits appear

on the tax returns of its stockholders in proportion to shares of stock

owned, regardless of whether those profits were distributed to the stockholders

or retained for operations. Losses appear on the returns of the stockholders

and may potentially be used to shelter other income.

Although the subchapter S corporation is often referred to as a small

business corporation, the size of the business has no bearing on whether this

election is available. Any corporation that meets the following tests may, but

need not, elect to be taxed as a subchapter S corporation:

1. It must have 75 or fewer stockholders.

2. It may have only one class of stock (although variations in voting rights

are acceptable).

3. All stockholders must be individuals (or certain kinds of trusts).

4. No stockholder may be a nonresident alien.

5. With certain exceptions, it may not own or be owned by another

corporation.

The subchapter S corporation is particularly suited to resolving problems

presented by certain discrete situations. For example, if a corporation is concerned

that its profits are likely to be too high to eliminate double taxation

through compensation to its stockholders, the subchapter S election eliminates

the worry over unreasonable compensation. Since there is no tax at the corporate

level, it is not necessary to establish the right to a compensation deduction.

Similarly, if a corporation has nonemployee stockholders who insist upon

current distributions of profit, the subchapter S election would allow declaration

of dividends without the worry of double taxation. This would undoubtedly

be attractive to most publicly traded corporations were it not for the

75-stockholder limitation.

Many entrepreneurs have turned to the subchapter S election to eliminate

the two layers of tax otherwise payable upon sale or dissolution of a corporation.

The corporate tax otherwise payable upon the gain realized on the sale of corporate

assets is eliminated by the use of the subchapter S election as long as the

election has been in effect for 10 years or, if less, since the corporation's inception.

Finally, many entrepreneurs elect subchapter S status for their corporations

if they expect to show losses in the short term. These losses can then be passed

through to their individual tax returns to act as a shelter for other income. When

the corporation begins to show a profit, the election can be reversed.

Limited Partnerships

The tax treatment of limited partnerships is much the same as general partnerships.

The profits and losses of the business are passed through to the partners in

the proportions set forth in the partnership agreement. It must be emphasized

254 Planning and Forecasting

that these profits and losses are passed through to all partners, including limited

partners, even though one could argue that those profits and losses are derived

entirely from the efforts of the general partners. It is this aspect of the

limited partnership which made it the form of choice for tax-sheltered investments.

The loss incurred by the business (much of which was created on paper

through depreciation and the like) could be passed through to the limited partners,

who typically had a considerable amount of other investment and compensation

income to be sheltered.

Although the tax treatments of limited partnerships and subchapter S

corporations are similar, there are some differences that drove the operators of

tax shelters to use partnerships over the corporate form even at the risk of

some unlimited liability. For one, although profits and losses must be allocated

according to stock ownership in the subchapter S corporation, they are allocated

by agreement in the limited partnership. Thus, in order to give the investors

the high proportion of losses they demand, promoters did not

necessarily have to give them an identically high proportion of the equity. The

IRS will attack economically unrealistic allocations, but reasonable allocations

will be respected. In addition, whereas the amount of loss the investor can use

to shelter other income is limited to the tax basis in both types of entities, the

tax basis in subchapter S stock is essentially limited to direct investment in

the corporation, while in a limited partnership it is augmented by certain types

of debt incurred by the entity itself.

Both types of entities are aff licted by the operation of the passive loss

rules, added by the Tax Reform Act of 1986 in an attempt to eliminate the tax

shelter. Thus, unless one materially participates in the operations of the entity

(virtually impossible, by definition, for a limited partner), losses generated by

those operations can normally be applied only against so-called passive income

and not against active (salaries and bonuses) or portfolio (interest and dividend)

income. Furthermore, owners of most tax pass-through real estate ventures

are treated as subject to the passive loss rules, regardless of material

participation.

Limited Liability Companies

LLCs are taxed in a manner substantially identical to limited partnerships. This

combination of limited liability for all members (without the need to construct

the unwieldy, double-entity, limited partnership with a corporate general partner)

and a pass-through of all tax effects to the members' personal returns,

makes the LLC the ideal vehicle for whatever tax shelter activity remains after

the imposition of the passive-activity rules.

Technically, under recently adopted "check the box" regulations, LLCs,

limited partnerships, and all other unincorporated business entities may

choose to be taxed either as partnerships or as taxable corporations. Recognizing

that the vast majority of these entities are formed to take advantage of the

opportunity to have taxable income or loss pass through to the owners, these

Choosing a Business Form 255

regulations provide that these entities will be taxed as partnerships unless the

entity affirmatively chooses to be taxed as a corporation. Most corporations

have already achieved that level of comfort through the availability of the subchapter

S election.

Although the LLC would seem to have the advantage of affording tax

pass-through treatment without the limitations of the subchapter S corporation

rules, there are some disadvantages as well. Since the nonelecting LLC is not a

corporation, it is not eligible for certain provisions the Internal Revenue Code

grants only to the corporate entity. Among these privileges are the right to

grant incentive stock options (ISOs) to employees and the right to take advantage

of tax-free reorganizations when selling the company. LLCs must be converted

to taxable entities well before relying on these provisions.

CHOICE OF ENTITY

The sole proprietorship, partnership, corporation (including the professional

corporation and subchapter S corporation), the limited partnership, and the

LLC are the most commonly used business forms. Other forms exist, such as

the so-called Massachusetts business trust, in which the business is operated by

trustees for the benefit of beneficiaries who hold transferable shares. But these

are generally used for limited, specialized purposes. Armed with this knowledge

and the comparative factors discussed previously, how should our budding

entrepreneurs operate their businesses?

Consulting Firm

It will be obvious to Jennifer, Jean, and George that they can immediately

eliminate the sole proprietorship and limited partnership as choices for their

consulting business. The sole proprietorship, by definition, allows for only one

owner, and there does not seem to be any need for the passive silent investors

who would serve as limited partners. Certainly, none of the three would be

willing to sacrifice the control and participation necessary to achieve limited

partnership status.

The corporation gives the consultants the benefit of limited liability, not

for their own mistakes but for the mistakes of each other and their employees.

It also protects them from personal liability for trade debt. This protection,

however, comes at the cost of additional complexity and expense, such as additional

tax returns, annual reports to the state, and annual fees. Ease of transferability

and enhanced continuity do not appear to be deciding factors,

because a small consulting firm is often intensely personal and not likely to be

transferable apart from its principals. Also, fear of double taxation does not

appear to be a legitimate concern, since it is likely that the stockholders will

be able to distribute any corporate profit to themselves in the form of

compensation. In fact, to the extent that they may need to make some capital

256 Planning and Forecasting

expenditures for word-processing equipment and office furniture, the corporate

form would afford them access to the lower corporate tax brackets for

small amounts of income (unless they were characterized as a personal service

corporation). Furthermore, if the consultants earn enough money to purchase

various employee benefits, such as group medical insurance and group life and

disability, they will qualify as employees of the corporation and can exclude

the value of such benefits from their taxable income, while the corporation

deducts these amounts.

These positive aspects of choosing the corporate form argue strongly

against making the subchapter S election. That election would eliminate the

benefit of the low-end corporate tax bracket and put our consultants in the position

of paying individual income tax on the capital purchases made. The election

would also eliminate the opportunity to exclude the value of employee

benefits from their personal income tax. The same problems argue against the

choice of an LLC for this business.

The other possibility would be the general partnership. In essence, by

choosing the partnership the consultants would be trading away limited liability

for less complexity. The partnership would not be a separate taxable entity

and would not be required to file annual reports and pay annual fees. From a

tax point of view, the partnership presents the same disadvantages as the subchapter

S corporation and LLC.

In summary, it appears that our consultants will be choosing between the

subchapter C corporation and the partnership. The corporation adds complexity

but grants limited liability. And it certainly is not necessary for a business to

be large in order to be incorporated. One might question, however, how much

liability exposure a consulting firm is likely to face. In addition, although the

corporation affords them the tax benefits associated with employee benefits

and capital expenditures, it is not likely that our consultants will be able to afford

much in the way of employee benefits and capital expenditures in the

short term. Further, these consultants will not likely have personal incomes

placing them in tax brackets considerably higher than the corporation's. A

strong case can be made for either the C corporation or the partnership in this

situation. One can always incorporate the partnership in the future if the business

grows to the point that some of the tax benefits become important.

It may also be interesting to speculate on the choice that would be made if

our three consultants were lawyers or doctors. Then the choice would be

between the partnership and the professional corporation. The comparisons

would be the same except that, as a personal service corporation, the professional

corporation does not have the benefit of the low-end corporate tax brackets.

Software Entrepreneur

Phil can easily eliminate the partnership and the limited partnership. Phil is

clearly the sole owner of his enterprise and will not brook any other controlling

persons. In addition, his plan to finance the enterprise with earnings from his

Choosing a Business Form 257

last business eliminates the need for limited partner investors. Almost as easily,

Phil can eliminate the sole proprietorship since it would seem highly undesirable

to assume personal liability for whatever damage may be done by a product

manufactured and distributed to thousands of potential plaintiffs. The

corporation, therefore, appears to be Phil's obvious choice. It gives the benefit

of limited liability, as well as the transferability and continuity essential to a

business that seems likely to be an acquisition candidate in the future. Again,

the lack of size is not a factor in this choice. Phil will likely act as sole director,

president, treasurer, and secretary.

There remains, however, the choice between subchapters C and S. As

may well be obvious by now, Phil's corporation fits the most common profile of

the subchapter S candidate. For the first year or more, the corporation will suffer

serious losses as Phil pays programmers and marketers to develop and presell

his product. Subchapter S allows Phil to show these losses on his personal

tax return, where they will shelter his considerable investment income. The

passive loss limitations will not affect Phil's use of these losses, since he is

clearly a material participant in his venture.

Phil could achieve much the same results by choosing an LLC, rather

than a subchapter S corporation. Unfortunately, however, many states require

that an LLC have two or more members, making Phil's business ineligible. In

states which allow single-member LLCs, there would be little to recommend

one choice over the other. Phil might feel more comfortable with an S corporation,

however, if he fears that suppliers, customers, and potential employees

might be put off by the relative novelty of the LLC. This might especially be

true if he has any plans to eventually go public, as the LLC has not gained wide

acceptance in the public markets. An S corporation can then usually revoke its

S election without undue negative tax effect. Beginning as an S corporation

would also eliminate the need to reincorporate as a corporation prior to selling

the business in a potentially tax-free transaction.

Hotel Venture

The hotel venture contemplated by Bruce, Erika, and Michael presents the opportunity

for some creative planning. One problem they may encounter in making

their decision is the inherent conf lict presented by Michael's insistence

upon recognition and reasonable return for his contribution of the land. Also,

Bruce and Erika fear being unduly diluted by Michael's share, in the face of

their more than equal contribution to the ongoing work.

One might break this logjam by looking to one of the ways of separating

cash f low from equity. Michael need not contribute the real estate to the business

entity at all. Instead, the business could lease the land from Michael on a

long-term (99-year) basis. This would give Michael his return in the form of

rent without distorting the equity split among the three entrepreneurs. From a

tax point of view, this plan also changes a nondepreciable asset (land) into deductible

rent payments for the business. As their next move, the three may

258 Planning and Forecasting

decide to form an entity to construct and own the hotel building, separate from

the entity that manages the ongoing hotel business.

This plan would convert a rather confusing real estate/operating venture

into a pure real estate investment opportunity for potential investors. The real

estate entity would receive enough revenue from the management entity to

cover its cash f low and would generate tax losses through depreciation, interest,

and real estate taxes. These short-term losses would eventually yield long-term

capital gains when the hotel is sold, so this entity would attract investors looking

for short-term losses and long-term capital appreciation. For the short-term

losses to be attractive, however, they must be usable by the investors on their

personal returns and not trapped at the business entity level.

All these factors point inevitably to the use of either the limited partnership,

LLC, or subchapter S corporation for the hotel building entity. All three

entities allow the tax losses to pass through to the owners for use on their personal

returns. Among these three choices, the limited partnership and LLC

allow more f lexibility in allocating losses to the investors, and away from

Bruce, Erika, and Michael (who most likely do not need them), and they provide

higher limits on the amounts of losses each investor may use.

In past years, our entrepreneurs would thus face the unenviable choice

between losing the tax advantages of the limited partnership to preserve the

limited liability offered by the subchapter S corporation or preserving the tax

advantages (and the ability to attract investors) by either accepting personal liability

as general partners or attempting to adequately capitalize a corporate

general partner. This choice is no longer necessary with the advent of the LLC,

which solves the problem by offering the tax advantages of the limited partnership

and the liability protection of the subchapter S corporation. However, the

passive loss limitations will still impact upon the usefulness of the losses for the

members who do not have significant passive income, making this project (as

is the case with most real estate investments in today's climate) more difficult

to sell.

This leaves the entity which will operate the hotel business itself. The

presence of our three principals immediately eliminates the sole proprietorship

as a possibility. Because all the investment capital has already been raised for

the real estate entity, there does not seem to be a need for further investors,

thus eliminating the limited partnership as a possibility. The partnership seems

inapplicable, since it is unlikely that any of the principals would wish to expose

himself or herself to unlimited liability in such a consumer-oriented business.

Thus, the corporation and LLC with their limited liability, continuity,

and transferability, seem to be the obvious choices for this potentially growing

and successful business. As with Phil, it becomes necessary to decide whether

to make the subchapter S election or choose an LLC to achieve tax passthrough.

This decision will be made on the basis of the parties' projections.

Are there likely to be serious losses in the short-term, which might be usable on

their personal tax returns? Will there be a need for significant capital expenditures,

thus indicating a need for the low-end corporate tax rates? Will the

Choosing a Business Form 259

company offer a variety of employee benefits, which our principals would wish

to exclude from their taxable income? Is the company likely to generate more

profit than can be distributed in the form of "reasonable" compensation, thus

calling for the elimination of the corporate-level tax. If these factors seem to

favor a tax pass-through entity, the principals will likely analyze the choice between

subchapter S and LLC in a manner similar to Phil. In addition, they may

find the LLC's lack of eligibility rules attractive in the short run should they

ever consider the possibility of corporate or foreign investors, or creative divisions

of equity.

CONCLUSION

These and the many other factors described in this chapter deserve careful

consideration by the thousands of entrepreneurs forming businesses every

month. After the basic decision to start a new business itself, the choice of the

appropriate form for the business may well be the most significant decision

facing the entrepreneur in the short run.

FOR FURTHER READING

Bischoff, William, Choosing the Right Business Entity (New York: Harcourt Brace,

1997).

Burstiner, Irving, The Small Business Handbook: A Comprehensive Guide to Starting

and Running Your Own Business (New Jersey: Fireside, 1997).

Diamond, Michael R., How to Incorporate (New York: John Wiley, 1996).

Pressment, Stanley, Choice of Business Entity Answer Book (Gaithersburg, MD:

Aspen, 1998).

Shenkman, Martin M., Starting a Limited Liability Company (New York: John Wiley,

1996).

INTERNET LINKS

www.tannedfeet.com

/choice_of_entity.htm Entrepreneurs' Help Page

www.smallbiz.findlaw.com

/book/su_structures/articles/01.html Findlaw Small Business Center

www.lexspace.com/html Lexspace-Business Entity

/formation.html Formation

260

9 THE BUSINESS PLAN

Andrew Zacharakis

The sole purpose of a business plan is to explore and answer questions—critical

questions starting with whether the business idea is a viable opportunity.

During the dot-com boom of the late 1990's, many entrepreneurs and venture

capitalists questioned the importance of the business plan. Typical of

this hyperstartup phase are stories like James Walker. He generated financing

on a 10-day-old company based on "a bunch of bullet points on a piece of

paper." He added, "It has to happen quick" in the hypercompetitive wireless-

Internet-technology world. "There's a revolution every year and a half now,"

Mr. Walker said.1

Media stories abounded of the whiz kid college dropout who received

venture capital, zoomed to IPO (initial public offering), and cashed out a multimillionaire

in 18 months or less. The mythology of the dot-com entrepreneur

was that he didn't have a business plan, only a couple of PowerPoint slides.

That was all it took to identify the opportunity, secure venture backing, and go

public. Why spend the 200 hours or so that a solid business plan often takes?

The NASDAQ crash of March 2000 and the subsequent death of many dot-com

high f lyers provides the clearest answer. Many of these businesses didn't have

the potential to make profits—not then, not now, and not anytime in the future.

The easy money and quick returns of the late nineties have disappeared,

and what we are left with is the fact that good opportunities need good execution

in order to succeed and a rigorous business plan process can assist in the

pursuit of entrepreneurial gold.

There is a common misperception that a business plan is primarily used

for raising capital. Although a good business plan assists in raising capital, the

The Business Plan 261

primary purpose of the process is to help the entrepreneur gain deep understanding

of the opportunity he or she is envisioning. A business plan tests the

feasibility of an idea. Is it truly an opportunity? Many a would-be entrepreneur

has doggedly pursued ideas that are not opportunities; the time invested in a

business plan would save thousands of dollars and hours spent on such wild

goose chases. For example, if a person makes $100,000 a year, spending 200

hours on a business plan equates to a $10,000 investment in time spent ($50/hour

times 200 hours). However, the costs of launching a f lawed business concept can

quickly accelerate into the millions. Most entrepreneurial ventures raise enough

money to survive two years even if the business ultimately fails. Assuming that

the only expense is the time value of the lead entrepreneur, a two-year investment

equates to $200,000, not to mention the lost opportunity cost and the likelihood

that other employees were hired and paid and that other expenses were

incurred. So do yourself a favor and spend the time and money up front.

The business plan process can not only prevent entrepreneurs from pursuing

a bad opportunity but also help them reshape their original visions into

better opportunities. As we will explore in the remainder of this chapter, the

business plan process involves raising a number of critical questions and then

seeking answers. Part of that question-answering process involves talking to

target customers and gauging what is their "pain." These conversations with

customers as well as other trusted advisors can assist in better targeting the

features and needs that customers most want in a good or service. This

prestartup work saves untold effort and money otherwise spent trying to reshape

the product after the launch has occurred. This is not to say that new

ventures don't adjust their offering based upon customer feedback, but the

business plan process can anticipate some of these adjustments in advance of

the initial launch.

Perhaps the greatest benefit of the business plan is that it allows the entrepreneur

to articulate the business opportunity to various stakeholders in

the most effective manner. The plan provides the background to enable the

entrepreneur to communicate the upside potential and attract equity investment,

and the validation needed to convince potential employees to leave their

current jobs for the uncertain future of a new venture. It is also the instrument

that can secure a strategic partner, key customer, or key supplier. In

short, the business plan provides the entrepreneur the deep understanding he

needs to answer the critical questions that various stakeholders will ask, even

if the stakeholders don't actually read the written plan. Completing a wellfounded

business plan gives the entrepreneur credibility in the eyes of various

stakeholders.

TYPES OF PLANS

A business plan can take a number of forms depending on its purpose. The primary

difference between business plan types is length. If outside capital is

262 Planning and Forecasting

needed, a business plan geared towards equity investors or debt providers typically

is 25 to 40 pages long. Professional equity investors such as venture capitalists

and professional debt providers such as bankers will not read the entire

plan from front to back. Recognizing this fact, the entrepreneur needs to produce

the plan in a format that facilitates spot reading. We will investigate the

major sections that comprise business plans throughout this chapter. My general

rule of thumb is that less is more. For instance, I've seen a number of plans

receive venture funding that were closer to 25 pages than 40 pages.

A second type of business plan, the operational plan, is primarily for the

entrepreneur and his team to guide the development, launch, and initial growth

of the venture. There really is no length specification for this type of plan;

however, it is common for these plans to exceed 80 pages. The basic organization

format between the two types of plans is the same, however the level of

detail tends to be much greater in an operational plan. This effort is where the

entrepreneur really gains the deep understanding important in discerning how

to build and run the business.

The last type of plan is called a dehydrated business plan. This type is

considerably shorter than the previous two, typically no more than 10 pages.

Its purpose is to provide an initial conception of the business. As such, it can be

used to test initial reaction to the entrepreneur's idea and can be shared with

his confidants to obtain feedback before he invests significant time and effort

on a longer business plan.

FROM GLIMMER TO ACTION: THE PROCESS

Perhaps the hardest part of writing any business plan is getting started. Compiling

the data, shaping it into an articulate story, and producing the finished

product can be a daunting task. The best way to attack a business plan, therefore,

is in steps. First, write a four-to-five-page summary of your current vision.

This provides a roadmap for you and others to follow as you complete the

rest of the plan. Second, start attacking major sections of the plan. Although all

of the sections interact and inf luence every other section, it is often easiest for

entrepreneurs to write the product /service description first. This is usually the

most concrete component of the entrepreneur's vision. Keep in mind, however,

that writing a business plan isn't purely a sequential process. You will be filling

in different parts of the plan simultaneously or in whatever order makes the

most sense in your mind. Finally, after completing a first draft of all the major

sections, come back and rewrite a shorter, more concise executive summary

(one to two pages). Not too surprisingly, the executive summary will be quite

different from the original summary because of all the learning and reshaping

that the business plan process facilitates.

Common wisdom is that the business plan is a living document. Although

your first draft will be polished, most business plans are obsolete the day they

come off the presses. That means that entrepreneurs are continuously updating

The Business Plan 263

and revising their business plan. Again, the importance of the business plan

isn't the final product but the learning that is gleaned from going through the

process. The business plan is the story line of your vision. It articulates what

you see in your mind and crystallizes that vision for you and your team. It also

provides a history, a photo album, if you will, of the birth, growth, and maturity

of your business. Each major revision should be kept and filed and occasionally

looked back upon for the lessons you have learned. I find writing

a business plan, although daunting, exciting and creative, especially if I am

working on it with a founding team. Whether it is over a glass of wine, beer, or

coffee, talking about your business concept with your founding team is invigorating,

and the business plan is a critical outcome of these discussions. So now

let us dig in and examine how to write effective business plans.

THE STORY MODEL

One of the major goals for business plans is to attract and convince various

stakeholders of the potential of your business. You have to keep in mind, therefore,

how these stakeholders will interpret your plan. The guiding principal is

that you are writing a story. All good stories have a plot line, a unifying thread

that ties the characters and events together. If you think about the most successful

businesses in America, they all have well-publicized plot lines, more

appropriately called taglines. When you hear these taglines, you immediately

connect them to the business. For example, when you hear "absolutely, positively

has to be there overnight," you probably connect that tagline to Federal

Express and package delivery. Similarly, "Just do it" is intricately linked to

Nike and the image of athletic proficiency (see Exhibit 9.1). A tagline is a sentence

or fragment of a sentence that summarizes the pure essence of your business.

It is the plot line that every sentence, paragraph, page, diagram, and other

part of your business plan should correlate to. One useful tip that I share with

every entrepreneur I work with is to put that tagline in a footer that runs on the

bottom of every page. Most word-processing packages, such as Microsoft Word,

enable you to insert a footer that you can see as you type. As you are writing, if

the section doesn't build on, explain, or otherwise directly relate to the tagline,

it most likely isn't a necessary component to the business plan. Rigorous adherence

to the tagline facilitates writing a concise business plan.

EXHIBIT 9.1 Taglines.

Nike Just do it!

Federal Express Absolutely, positively has to be there overnight.

McDonalds We love to see you smile.

Cisco Systems Discover all that's possible on the Internet.

Microsoft Where do you want to go today.

264 Planning and Forecasting

The key to beginning the story model is capturing the reader's attention.

The tagline is the foundation, but in writing the plan you want to create a number

of visual catch points. Too many business plans are dense, text-laden manifestos.

Only the most diligent reader will wade through all that text to find the

nuggets of value. Help the reader by highlighting different key points throughout

the plan. How do you create these catch points? Some effective techniques

include extensive use of headings and subheadings, strategically placed bulletpoint

lists, diagrams, charts, and the use of sidebars.2 The point is to make the

document not only content rich but visually attractive.

Now, let's take a look at the major sections of the plan (see Exhibit 9.2).

Keep in mind that although there are some different variations, most plans

have these components. It is important to keep your plan as close to this format

as possible because many stakeholders are used to the format and it facilitates

EXHIBIT 9.2 Business plan outline.

I. Cover

II. Title Page

III. Executive Summary

a. Hook—potential size of

opportunity

b. Business Concept—company and

products

c. Industry Overview

d. Target Market

e. Competitive Advantage

f. Business Model

g. Team

h. Offering

IV. Industry, Customer, and Competitor

Analysis

a. Industry

i. Overview—Market Demand,

Market Size and Structure,

and Margin Analysis

ii. Trends

iii. Market Space or Segment you

will compete in

b. Customer Analysis

c. Competitor Analysis

V. Company and Product Description

a. Company Description

b. Product Description

c. Competitive Advantage

d. Entry Strategy

e. Growth Strategy

VI. Marketing Plan

a. Target Market Strategy

b. Product /Service Strategy

c. Pricing Strategy

d. Distribution Strategy

e. Advertising and Promotion Strategy

f. Sales Strategy

g. Sales and Marketing Forecasts

VII. Operations Plan

a. Operations Strategy

b. Scope of Operations

c. Ongoing Operations

VIII. Development Plan

a. Development Strategy

b. Development Timeline

IX. Team

a. Team Bios and Roles

b. Advisory Boards, Board of

Directors, Strategic Partners,

External Members

c. Compensation and Ownership

X. Critical Risks

a. Market Interest and Growth

Potential

b. Competitor Actions and Retaliation

c. Time and Cost of Development

d. Operating Expenses

e. Availability and Timing of

Financing

f. Other Risks

XI. Offering

XII. Financial Plan

a. Description of Financial

Assumptions

b. Income Statement

c. Cash Flow Statement

d. Balance Sheet

XIII. Appendices

The Business Plan 265

spot reading. So if you are seeking venture capital, for instance, you want to facilitate

quick perusal because venture capitalists often spend, research shows,

as little as five minutes on a plan before rejecting it or putting it aside for later

study. If a venture capitalist becomes frustrated with an unfamiliar format, he

will more likely reject it than try to pull out the pertinent information.

THE BUSINESS PLAN

We will progress through the sections in the order that they typically appear,

but keep in mind that you can work on the sections in any order that you wish.

The Cover

The plan's cover should include the following information: company name,

tagline, contact person and address, phone, fax, e-mail address, date, disclaimer,

and copy number. Most of the information is self-explanatory, but I

should point out a few things (see Exhibit 9.3). First, the contact person for a

new venture should be the president or some other founding team member. I

have seen some business plans that failed to have the contact person's name

and phone on the cover. Imagine the frustration of an excited potential investor

who can't find out how to contact the entrepreneur to gain more information;

such plans usually end up in the rejected pile. Second, business plans

should have a disclaimer along these lines:

This business plan has been submitted on a confidential basis solely to selected,

highly qualified investors. The recipient should not reproduce this plan nor distribute

it to others without permission. Please return this copy if you do not

wish to invest in the company.

Controlling distribution is particularly important when seeking investment

capital, especially to comply with Regulation A of the Securities and Exchange

Commission, which specifies that you must solicit qualified investors (high

net-worth and income individuals).

The cover should also have a line specifying the copy number. You will

often see on the bottom right portion of the cover a line that says something

like "Copy 1 of 5 copies." Entrepreneurs should keep a log of who has copies so

that they can control for unexpected distribution.

Finally, the cover should be eye-catching. If you have a product or prototype,

a picture of it can draw the reader in. Likewise, a catchy tagline draws attention

and encourages the reader to look further.

Table of Contents

Continuing the theme of making the document easy to read, a detailed table of

contents is critical. It should list major sections, subsections, exhibits, and appendices.

The table provides the reader a roadmap to your plan (see Exhibit 9.4).

266 Planning and Forecasting

Note that the table of contents is customized to the specific business so that it

doesn't perfectly correlate to the business plan outline presented in Exhibit 9.2.

Nonetheless, a look at Exhibit 9.4 shows that the company's business plan includes

most of the elements highlighted in the business outline and that the

order of information is basically the same as well.

EXHIBIT 9.3 Cover of PurePlay Golf business plan.

Bringing Information to the Golfer's Palm

www.PurePlayGolf.com

Prepared by:

Amy Ball, Michael Bear, Christy Long,

Geoff Mall, and Hilary Tabor

Contact: Geoff Mall, gmall@PurePlayGolf.com

PurePlayGolf.com

Reynolds Center, Suite 1

Babson Park, MA 02457

(781) 555-5252

(781) 555-5253 (fax)

Draft: December 6, 2000

The information in this Business Plan is highly confidential and is provided to you conditioned on your agreement

not to disclose or use this information for any purpose other then contemplating an investment in PurePlay Golf.

Do not copy, fax, reproduce, or distribute without permission.

Copy 5 of 5.

The Business Plan 267

Executive Summary (1–3 pages)

This section is the most important part of the business plan. If you don't capture

readers' attention in the executive summary, it is unlikely that they will

read any other parts of the plan. Therefore, you want to hit them with the most

compelling aspects of your business opportunity right up front.

EXHIBIT 9.4 Sample table of contents.

1.0 Executive Summary 3

2.0 Market Analysis 6

2.1 Entertainment Industry 6

2.2 Accessing Music Online 7

2.3 Telematics Industry 8

2.5 Market Research 11

3.0 Competition 13

3.1 Direct Competition 13

3.2 Indirect Competition 15

4.0 Company Description and Services 16

4.1 The Personal Radio Station 16

4.2 Listener 's Choice 16

4.3 The Personal Music Collection 17

4.4 Recurring Royalties 17

4.5 Listener Consumption Data 17

5.0 Strategic Partners 20

5.1 Device Partners 20

5.2 Content Partners 21

5.3 Service Providers and Other 22

6.0 Development Strategy 23

6.1 Engineering Activities 23

6.2 Business Development Activities 24

7.0 Marketing and Sales Activities 25

8.0 Operations 27

8.1 VMC Core of Engineers 27

8.2 VMC Live Services 27

8.3 VMC Customer Service 27

9.0 Management Team 28

9.1 Founding Team 28

9.2 Advisors 29

10.0 Critical Risk Factors 30

11.0 Financials 31

11.1 Economics of the Business 31

11.2 VMC Consumer Assumptions 32

11.3 Service Assumptions 32

11.4 Personal Radio Station Assumptions 32

11.5 Listener 's Choice Assumptions 33

11.7 Break-Even/Positive Cash Flow 34

11.8 Sources and Uses Schedule 35

11.9 Headcount Schedule 35

268 Planning and Forecasting

Hook the Reader

That means having the first sentence or paragraph highlight the potential of

the opportunity. I have read too many plans that start with "Company XYZ, incorporated

in the state of Delaware, will develop and sell widgets." Ho-hum.

That doesn't excite me; but if, in contrast, the first sentence states, "The current

market for widgets is $50 million and is growing at an annual rate of 20%.

The emergence of the Internet is likely to accelerate this market's growth.

Company XYZ is positioned to capture this wave with its proprietary technology—

the secret formula VOOM." This creates the right tone. It tells me that

the potential opportunity is huge and that company XYZ has some competitive

advantage that enables it to become a big player in this market. I don't really

care at this point whether the business is incorporated or that it is a Delaware

corporation (aren't they all?).

Common subsections within the executive summary include: description

of opportunity, business concept, industry overview, target market, competitive

advantage, business model and economics, team, and offering. Remember

that, since this is an executive summary, all these components are covered

in the body of the plan. We will explore them in greater detail as we progress

through the sections.

Since the executive summary is the most important part of the finished

plan, it should be written after you have gained your deep learning by going

through all the other sections.3 The summary should be 1 to 3 pages, although

I prefer executive summaries be no more than 2 pages.

Industry, Customer, and Competitor

Analysis (3 – 6 pages)

Industry

The goal of this section is to illustrate the opportunity and how you are going to

capture that opportunity. A useful framework for visualizing the opportunity is

Timmons's model of opportunity recognition.4 Using the "3Ms" helps quantify

an idea and assess how strong an opportunity the idea is. First, examine Market

demand. If the market is growing at 20% or better, the opportunity is more exciting.

Second, we look at Market size and structure. A market that is currently

$50 million with $1 billion potential is attractive. This often is the case in

emerging markets, those that appear poised for rapid growth and have the potential

to change how we live and work. For example, the PC, disk drive, and

computer hardware markets of the eighties were very hot. Many new companies

were born and rode the wave of the emerging technology, including

Apple, Microsoft, and Intel. In the nineties, it was anything dealing with the

Internet. As we enter the twenty-first century, it appears that wireless communications

may be the next big market. Another market structure that tends to

have promise is a fragmented market where many small, dispersed competitors

The Business Plan 269

compete on a regional basis. Many of the big names in retail revolutionized

fragmented markets. For instance, category killers such as Wal-Mart, Staples,

and Home Depot consolidated fragmented markets by providing quality products

at lower prices. These firms replaced the dispersed regional and local

discount, office-supply, and hardware stores. The final M is Margin analysis.

Do firms in the industry enjoy high gross margins (revenues minus cost of

goods sold) of 40% or greater? Higher margins allow for higher returns, which

again leads to greater potential business.

The 3Ms help distinguish opportunities and as such should be highlighted

as early as possible in your plan. Describe your overall industry in

terms of revenues, growth, and pertinent future trends. Avoid in this section

discussing your concept, the proposed product or service you will offer. Instead,

use dispassionate, arms-length analysis of the industry with the goal of

highlighting a space or gap that is underserved. Thus, how is the industry segmented

currently, and how will it be segmented in the future? After identifying

the relevant industry segments, identify the segment that your product

will target. Again, what are the important trends that will shape the segment

in the future?

Customer

Once the plan has defined the market space it plans to enter, the target customer

needs to be examined in detail. The entrepreneur needs to define who

the customer is by using demographic and psychographic information. The better

the entrepreneur can define his customer, the more apt he is to deliver a

product that the customer truly wants. A venture capitalist recently told me

that the most impressive entrepreneur is the one who not only identifies who

the customer is in terms of demographics and psychographics but can also

name who that customer is by address, phone number, and e-mail address.

When you understand who your customer is, you can assess what compels them

to buy, how your company can sell to them (direct sales, retail, Internet, direct

mail, etc.), how much acquiring and retaining that customer will cost, and so

forth. A schedule inserted into the text describing customers on these basic parameters

communicates a lot of data quickly and can be very powerful.

Competition

The competition analysis follows directly from the customer analysis. You have

just identified your market segment, described what the customer looks like,

and what the customer wants. Now the key factor leading to competitive analysis

is what the customer wants in a particular product. These product attributes

form a basis of comparison against your direct and indirect competitors. A

competitive profile matrix not only creates a powerful visual catch point, it

conveys information regarding your competitive advantage and also the basis

for your company's strategy (see Exhibit 9.5). The competitive profile matrix

270 Planning and Forecasting

should lead the section and be followed by text describing the analysis and its

implications.

Finding information about your competition can be easy if the competing

company is public, harder if it is private, and very difficult if it is operating in

"stealth" mode (i.e., it hasn't yet announced itself to the world). Most libraries

have access to databases that contain a mother lode of information about publicly

traded companies (see Exhibit 9.6 for some sample sources), but privately

held companies or stealth ventures represent a greater challenge. The best way

for savvy entrepreneurs to gather this information is through their network and

via trade shows. Who should be in the entrepreneur's network? First and foremost

are the customers the entrepreneur hopes to sell to in the near future.

Just as you are (or should be) talking to your potential customers, your existing

competition is interacting with the customers every day, and your customers

are likely aware of the stealth competition on the horizon. Although many entrepreneurs

are fearful (verging sometimes on the brink of paranoia) that valuable

information will fall in the wrong hands and lead to new competition that

invalidates the current venture, the reality is that entrepreneurs who operate in

a vacuum (don't talk to customers, attend tradeshows, etc.) fail far more often

than those who are talking to everyone they can. Talking allows entrepreneurs

to get invaluable feedback that enables them to reshape their product offering

prior to launching a product that may or may not be accepted by the marketplace.

So you should network not only to find out about your competition but

also to improve your own venture concept.

EXHIBIT 9.5 Competitive profile matrix.

VMC Napster Mp3.com MYRadio SonicNet XM Radio

Have to be online to listen to music No No No No Yes No

Customized ads to individual users Yes N/A No N/A No No

Can purchase physical media on

Web site No No Yes No Yes No

Can access personal music collection

from remote location Yes No No No No No

Automatic play list generation Yes No No Yes Yes Yes

Offers a service without ads Yes N/A No No No Yes

Can choose to play specific songs on

demand Yes Yes No No No No

Easy feedback for enhanced listening

experience Yes No No No Yes No

Streams media Yes No Yes N/A Yes Yes

Download media Yes Yes Yes N/A No No

Can distribute user collections to

other people No Yes No No Yes No

Offers portable device player option Yes Yes Yes Yes No Yes

Offers a free service Yes Yes Yes Yes Yes No

Offers service in telematics industry Yes No No No No Yes

The Business Plan 271

Company and Product Description (1–2 pages)

Completing the dispassionate analysis described in the previous section lays

the foundation for describing your company and concept. In one paragraph

identify the company name, where it is incorporated, and a brief overview of

the company concept. Also highlight in this section what the company has

achieved to date—what milestones have you accomplished that show progress.

More space should be used to describe the product. Again, graphic representations

can be visually powerful (see Exhibit 9.7). Highlight how your product

fits into the customer value proposition. What is incorporated in your

product and what value do you add to the customer? This section should clearly

and forcefully identify your venture's competitive advantage. Based upon your

competitive analysis, why is your product better, cheaper, faster than what

customers currently have? Your advantage may be a function of proprietary

technology, patents, distribution. In fact, the most powerful competitive advantages

are derived from a bundle of factors because this makes them more

difficult to copy.

Entrepreneurs also need to identify their entry and growth strategies.

Since most new ventures are resource constrained, especially in terms of available

capital, it is crucial that the lead entrepreneur establish the most effective

way to enter the market. Based upon analysis in the market and customer sections,

entrepreneurs need to identify their primary target audience (PTA). Focusing

on a particular subset of the overall market niche allows new ventures

to utilize scarce resources to reach those customers and prove the viability of

their concept.

EXHIBIT 9.6 Sample source for information on public/private companies.

Infotrac Index /abstracts of journals, general business and finance magazines; market

overviews; and profiles of public and private firms.

Dow Jones Interactive Searchable index of articles from over 3,000 newspapers.

Lexis/Nexis Searchable index of articles.

Dun's Principal International Business International business directory.

Dun's One Million Dollar Premium Database of public and private firms with revenues

greater than $1 million or more than eight employees.

Hoover's Online Profiles of private and public firms with links to Web sites, etc.

Corp Tech Profiles of high technology firms.

Bridge Information Services Detailed financial information on 1.4 million international

securities that can be manipulated in tables and graphs.

RDS Bizsuite Linked databases providing data and full-text searching on firms.

Bloomberg Detailed financial data and analyst reports.

272 Planning and Forecasting

EXHIBIT 9.7 Product/concept/description.

Video or

audio

content

customized

ads

Commercial tower

PDA Computer

Satellite dish

Automobile

VMC Detailed Network Overview

Example of advertisers

Example of digital audio and video

content libraries

VMC

B2B

Exchange

VMC

B2C

Distribution

B2B intranet

Customer profile management

(Web site)

Content

information

database

(ratings,

availability,

etc.)

Consumer

usage and

advertising

database

Consumer

profile

database

Customized

advertising

data

Catalog

Receiver

Routing and

transmitting

VMC

compliant

device

component

Home

entertainment

system

T.V.

Portable

audio

device

Consumer

data

Time

Warner

BVG Sony EMI

NPR

CBS TMP

World Wide

CKS Omnicom

Group Inc.

Dentsu Interpublic

The Business Plan 273

The business plan should also sell the entrepreneur's vision for growth because

that vision indicates the business's true potential. Thus, a paragraph or

two should be devoted to the firm's growth strategy. If the venture achieves

success in its entry strategy, it will either generate internal cash f low that can

be used to fuel the growth strategy or attract further equity financing at improved

valuations. The growth strategy should talk about the secondary target

audience and tertiary target audiences that the firm will pursue. For example,

if I were starting a restaurant, my entry strategy might be to establish a presence

in Wellesley, Massachusetts, geared toward college students and young

professionals. Assuming that I achieved some success (e.g., generating sales and

high table turns), my growth strategy might be to open up five more restaurants

around the greater Boston area. If these restaurants also proved successful,

I might franchise the concept nationwide to achieve rapid growth with less

capital infusion than if I opened all company-owned restaurants. This in fact,

appears to be the strategy that Joey Crugnale, the founder of Steve's Ice

Cream, Bertucci's Brick Oven Pizza, and more recently the Naked Fish, is following.

Crugnale opened the first Naked Fish in May 1999. After testing

and refining the concept, he has opened another nine outlets (as of December

2000). The establishment of nine Naked Fish restaurants shows growth and

success and enables Mr. Crugnale to attract further financing to grow the concept

around Boston and beyond.

Marketing Plan (4 – 6 pages)

To this point, we have laid the stage for your company's potential to enter a

market successfully and grow. Now we need to devise the strategy that will

allow the company to reach its potential. The primary components of this section

include a description of the target market strategy, product /service strategy,

pricing strategy, distribution strategy, advertising and promotion, sales

strategy, and sales and marketing forecasts. Let's take a look at each of these

subsections in turn.

Target Market Strategy

Every marketing plan needs some guiding principals. Based on the knowledge

gleaned from the target market analysis, entrepreneurs need to position their

product. All product strategies fall somewhere on the continuum between "rational

purchase" and "emotional purchase." As an example, when I buy a new

car, the rational purchase might be a low-cost reliable car such as the Ford Aspire.

However, there is an emotional element as well. I want the car to be an extension

of my personality, so based on my economic means and self-perception,

I will buy a BMW or Audi because of the emotional benefits I derive from

owning a high-status car. Within every product space, there is room for products

at different points along the continuum. Entrepreneurs need to decide

274 Planning and Forecasting

where their product fits or where they would like to position it, because this

position determines the other aspects of the marketing plan.

Product/Service Strategy

Building from the target market strategy, this section of the plan describes

how your product is differentiated from the competition. Discuss why customers

will switch to your product and how you will retain them so that they

don't switch to your competition in the future. Using the attributes defined in

your customer profile matrix, a powerful visual is a product attribute map

showing how your firm compares to the competition. It is best to focus on the

two most important attributes, one on the x-axis and the other on the y-axis.

The map should show that your product is clearly distinguishable from your

competition on desirable attributes (see Exhibit 9.8).

This section should also address how you will service the customer. What

type of technical support will you provide? Will you offer warranties? What

kind of product upgrades will be available and when? It is important to detail

all these efforts and account for each in the pricing of the product. Entrepreneurs

frequently underestimate the costs of these services, which leads to a

drain on cash flow and can ultimately lead to bankruptcy.

Pricing Strategy

Determining how to price your product is always difficult. The two primary

approaches are the "cost-plus" approach and the "market demand" approach. I

advise entrepreneurs to avoid cost-plus pricing for a number of reasons. First,

it is difficult to accurately determine your actual cost, especially if this is a

new venture with a limited history. New ventures consistently underestimate

the true cost of developing their products. For example, how much did it really

EXHIBIT 9.8 Competitive map for PurePlay Golf.

IntelliGolf

Inforetech

PurePlay

ultraCaddie

Low High

High

Availability to consumers

Technology/functionality

The Business Plan 275

cost to write that software? The cost would include salaries and burden, computer

and other assets, overhead contribution, and so forth. Since most entrepreneurs

underestimate these costs, there is a tendency to underprice the

product. Often entrepreneurs claim that they are offering a low price so that

they can penetrate and gain market share rapidly. The problems with a low

price are that it may be difficult to raise later, may create demand that overwhelms

your ability to produce the product in sufficient volume, and may unnecessarily

strain cash flow. Therefore, the better method is to canvass the

market and determine an appropriate price based upon what the competition

is currently offering and how your product is positioned. If you are offering a

low-cost value product, price below market rates. If your product is of better

quality and has lots of features (the more common case), it should be priced

above market rates.

Distribution Strategy

This section identifies how you will reach the customer. For example, the

e-commerce boom of the late 1990s assumed that the growth in Internet usage

and purchases would create new demand for pure Internet companies. Yet the

distribution strategy for many of these firms did not make sense. Pets.com and

other online pet supply firms had a strategy where the pet owner would log on,

order the product from the site, and then receive delivery via UPS or U.S.

mail. In theory this works, but in practice the price the market would bear for

this product didn't cover the exorbitant shipping costs of a forty-pound bag of

dog food.

It is wise to examine how the customer currently acquires the product. If

I buy my dog food at Wal-Mart, then you should probably use primarily traditional

retail outlets to sell me a new brand of dog food. This is not to say that

entrepreneurs might not develop a multichannel distribution strategy, but if

they want to achieve maximum growth, at some point they will have to use

common distribution techniques, or reeducate the customer on a new buying

process (which can be very expensive).

If you determine that Wal-Mart is the best distribution channel, the next

question becomes whether you can access it. As a new startup in dog food, it

may be difficult to get shelf space at Wal-Mart. That may suggest an entry

strategy of boutique pet stores to build brand recognition. The key here is to

identify appropriate channels and then assess how costly it is to access them.

Advertising and Promotion

Communicating effectively to your customer requires advertising and promotion.

Referring again to the dot-com boom of the late nineties, the soon to be

defunct Computer.com made a classic mistake in its attempt to build brand

recognition. It blew over half of the venture capital it raised on a series of expensive

Super Bowl ads in January 2000 ($3 million of $5.8 million raised on

276 Planning and Forecasting

three Super Bowl ads).5 Resource-constrained entrepreneurs need to carefully

select the appropriate strategies. What avenues most effectively reach

your PTA (primary target audience)? If you can identify your PTA by names,

then direct mail may be more effective. Try to utilize grassroots techniques

such as public relations efforts geared toward mainstream media. Sheri Poe,

founder of Ryka shoes, geared towards women, appeared on the Oprah Winfrey

show touting shoes for women, designed by women. The response was

overwhelming. In fact, she was so besieged by demand that she couldn't supply

enough shoes.

As you develop a multipronged advertising and promotion strategy, create

detailed schedules that show which avenues you will pursue and the associated

costs (see Exhibits 9.9a and 9.9b). These types of schedules serve many purposes

including providing accurate cost estimates that will help in assessing

how much capital you need to raise. These schedules also build credibility in

the eyes of potential investors since it shows that you understand the nuances

of your industry.

Sales Strategy

This section provides the backbone that supports all of the above. Specifically,

it illustrates what kind and level of human capital you will devote to the effort.

How many salespeople, customer support staff, and the like do you need? Will

these people be internal to the organization or outsourced? Again, this section

builds credibility if the entrepreneur demonstrates an understanding of how

the business should operate.

Sales and Marketing Forecasts

Gauging the impact of the above efforts is difficult. Nonetheless, to build a

compelling story, entrepreneurs need to show projections of revenues well into

the future. How do you derive these numbers? There are two methods, the

comparable method and the buildup method. After detailed investigation of

EXHIBIT 9.9a Advertising schedule.

Promotional Tools Budget over 1 Year

Print advertising $1,426,440

Television advertising 780,000

Sales promotions 100,000

Direct marketing 100,000

Public relations 93,560

Total $2,500,000

The Business Plan 277

the industry and market, entrepreneurs know the competitive players and have

a good understanding of their history. The comparable method models sales

forecasts after what other companies have achieved, adjusting for age of company,

variances in product attributes, support services such as advertising and

promotion, and so forth. In essence, the entrepreneur monitors a number of

comparable competitors and then explains why her business varies from those

models. The one thing we know for certain is that these forecasts will be

wrong, but the question is the degree of error. Detailed investigation of comparable

companies reduces that error. The smaller the error, the less likely the

company will run out of cash. Also, rigorous comparable analysis builds credibility

with your investors.

What happens when the market space you are entering doesn't have comparable

companies because they are private or differ significantly on some

other major parameter? In such situations, entrepreneurs may be able to identify

similar business models in other industries, or what I call first-cousin

companies. If that proves difficult, the other avenue is the buildup method.

Starting with each revenue source, the entrepreneur estimates how much of

that revenue type he can generate per day or some other small time period. For

example, if Joey Crugnale was trying to estimate sales for his Naked Fish

restaurant, he might identify the following revenue sources along with the average

ticket price for each: bar, appetizers, entrees, and dessert. Then he might

estimate the number of people to come through the restaurant on a daily basis

and what percentage would purchase each revenue source. Those estimates can

then be aggregated into larger blocks of time (say, months, quarters, or years)

to generate rough estimates, which might be further adjusted based upon seasonality

in the restaurant industry.

The buildup technique is an imprecise method for the new startup with

limited operating history, but it is critically important to assess the viability

of the opportunity—so important, in fact, that I advise entrepreneurs to use

both the comparable and buildup techniques to assess how well they converge.

If the two methods widely diverge, go back through and try to determine why.

The deep knowledge you gain of your business model will greatly help you to

articulate the opportunity to stakeholders as well as to manage the business

when it is launched.

EXHIBIT 9.9b Magazine advertisement schedule.

Publication Circulation Ad Price Cost per Thousand

Golf Digest 1,550,000 $35,820 $23.11

Sports Illustrated 3,150,000 57,600 18.29

Golf Magazine 1,400,000 26,000 18.57

Fortune 775,000 21,600 27.87

Money Magazine 1,400,000 34,900 24.93

278 Planning and Forecasting

Operations Plan (2–3 pages)

The operations section of the plan has progressively shortened as more companies

outsource nonvital aspects of their operation. The key in this section is

to address how operations will add value to your customers and, furthermore,

to detail the production cycle so that you can gauge the impact on working capital.

For instance, when does the company pay for inputs? How long does it take

to produce the product? When does the customer buy the product and, more

importantly, when does the customer pay for the product? The time from the

beginning of this process until the product is paid for will drain cash flow and

has implications for financing. Counterintuitively, many rapidly growing new

companies run out of cash, even though they have increasing sales, because

they fail to properly finance the time that cash is tied up in the procurement,

production, sales, and receivables cycle.

Operations Strategy

The first subsection provides a strategy overview. How does your business

win/compare on the dimensions of cost, quality, timeliness, and f lexibility?

The emphasis should be on those aspects that provide your venture with a

comparative advantage.

You should also discuss geographic location of production facilities and

how this enhances the firm's competitive advantage. Discuss available labor,

local regulations, transportation, infrastructure, proximity to suppliers, and so

forth. The section should also provide a description of the facilities, how the

facilities will be acquired (bought or leased), and how future growth will be

handled (e.g., renting an adjoining building).

Scope of Operations

What is the production process for your product or service? A diagram powerfully

illustrates how your company adds value to the various inputs (see Exhibit

9.10a). Constructing the diagram also facilitates the decision of which production

aspects to keep in-house and which to outsource. Considering that cash

f low is king and that resource-constrained new ventures typically should minimize

fixed expenses on production facilities, the general rule is to outsource

as much production as possible. However, there is a major caveat to that rule:

Your venture should control aspects of production that are central to your competitive

advantage. Thus, if you are producing a new component with hardwired

proprietary technology, let's say a voice recognition security door entry,

it is wise to internally produce that hardwired component. The locking mechanism,

however, can be outsourced to your specifications. Outsourcing the aspects

that aren't proprietary reduces fixed cost for production equipment and

facility expenditures, which means that you have to raise less money and give

up less equity.

The Business Plan 279

The scope of operations should also discuss partnerships with vendors,

suppliers, partners, and the like. Again, the diagram should illustrate the supplier

and vendor relationships by category (or by name if the list isn't too long

and you have already identified your suppliers). The diagram helps you visualize

the various relationships and ways to better manage or eliminate them. The

operations diagram also helps entrepreneurs identify personnel needs. For example,

the diagram provides an indication of how many production workers

might be needed depending on the hours of operations, number of shifts, and

so forth.

Ongoing Operations

This section builds upon the scope of operations by providing details on day-today

activities. For example, how many units will be produced in a day and what

kind of inputs are necessary? An operating-cycle overview diagram graphically

illustrates the impact of production on cash f low (see Exhibit 9.10b). As entrepreneurs

complete this detail, they can start to establish performance parameters,

which will help them monitor and modify the production process in the

future. If this is an operational business plan the level of detail may include

specific job descriptions, but for the typical business plan this level of detail

would be much more than an investor, for example, would need or want to see

in the initial evaluation phase.

Development Plan (2–3 pages)

The development plan highlights the development strategy and also provides a

detailed development timeline. Many new ventures will require a significant

level of effort and time to launch the product or service. This section tells how

the business will be developed. For example, new software or hardware products

EXHIBIT 9.10a Operations f low diagram.

SOURCE: Adapted from Professor Bob Eng, Babson College.

Materials

from

vendor 2

Materials

from

vendor 3

Materials

from

vendor 1

Assembly

Finished

product

Shipping

department

Warehouse

280 Planning and Forecasting

often require months of development. Discuss what types of features you will

develop and tie them to the firm's competitive advantage. This section should

also talk about patent, trademark, or copyright efforts if applicable.

Development Strategy

What work remains to be completed? What factors need to come together for

development to be successful? What risks to development does the firm face?

For example, software development is notorious for taking longer and costing

more than most companies originally imagined. Detailing the necessary work

and the criteria for the work to be considered successful helps entrepreneurs to

understand and manage the risks involved. After you have laid out these details,

a development timeline is assembled.

EXHIBIT 9.10b Operating cycle overview diagram.

SOURCE: Adapted from Professor Bob Eng, Babson College.

Order

materials

Receive

materials Make

product

Pick/ship

product

Bill to

customer

Collect

money

from

customer

Days

Pay

supplier

Customer

order

received

Order

entered

X Days

Production flow

Order

Cash

The Business Plan 281

Development Timeline

A development timeline is a schedule that highlights major milestones and can

be used to monitor progress and make changes (see Exhibit 9.11). The timeline

helps entrepreneurs track major events and to schedule activities to best execute

on those events.

Team (2–3 pages)

Georges Doriot, the father of venture capital and founder of American Research

and Development Corporation (the first modern venture capital firm),

said that he would rather "back an 'A' entrepreneur with a 'B' idea than a 'B'

entrepreneur with an 'A' idea." The team section of the business plan is often

the section that professional investors read after the executive summary. Thus,

it is critical that the plan depict the members responsible for key activities and

convey that they are exceptionally skilled.

Team Bios and Roles

The best place to start is by identifying the key team members and their titles.

Often, the lead entrepreneur assumes a CEO role. However, if you are young

and have limited business experience, it is usually more productive to state

that the company will seek a qualified CEO as it grows. The lead entrepreneur

may then assume the role of chief technology officer (if he develops the technology)

or vice president of business development. However, don't let these options

confine you. The key is to convince investors that you have assembled the

best team possible and that your team can execute on the brilliant concept you

are proposing.

Once responsibilities and titles have been defined, names and a short bio

should be filled in. The bios should demonstrate records of success. If you have

previously started a business (even if it failed), highlight the company's accomplishments.

If you have no previous entrepreneurial experience, discuss your

achievements within your last job. For example, bios often contain a description

of the number of people the entrepreneur previously managed and, more

important, a measure of economic success, such as growing division sales by

20+%. The bio should demonstrate your leadership capabilities. To complement

this description, resumes are often included as an appendix.

Advisory Boards, Board of Directors, Strategic Partners,

External Members

To enhance the team's credentials, many entrepreneurs find that they are more

attractive to investors if they have strong advisory boards. In building an advisory

board, identify individuals with relevant experience within your industry.

282

EXHIBIT 9.11 Development timeline.

VMC engineering activities

2/1 1/1 1/1 3/1 4/1 5/1 6/1 8/1 9/1 10/1 11/1 12/1 1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 9/1 11/1 12/1

VMC

distribution

system

development

alpha

VMC

beta

Ongoing innovation and development

of VMC distribution system

Telematics

development

Telematics

beta

Innovation and

enhancement

October 2002

VMC telematics

service launch

Wireless device and

network appliance R&D

Record label

recruitment

Advertising

recruitment

Telematics

negotiations Wireless device and network appliance OEM

partnering

Content provider

recruiting

Business development

and sales activities

VMC marketing

campaign

July 2001

site launch

2001 2002 2003

10/1 7/1

The Business Plan 283

Industry experts provide legitimacy to your new business as well as strong

technical advice. Other advisory board members may bring financial, legal, or

management expertise. Thus, it is common to see lawyers, professors, accountants,

and others who can assist the venture's growth on advisory boards.

Moreover, if your firm has a strategic supplier or key customer, it may make

sense to invite him or her onto your advisory board. Typically, these individuals

are remunerated with a small equity stake and compensation for any organized

meetings.

By law, most organization types require a board of directors. This is different

than an advisory board (although these members can also provide

needed expertise). The board's primary role is to oversee the company on

behalf of the investors. Therefore, the business plan needs to brief ly describe

the size of the board, its role within the organization and any current board

members. Most major investors, such as venture capitalists, will require one

or more board seats. Usually, the lead entrepreneur and one or more inside

company members (e.g., chief financial officers, vice presidents) will also

have board seats.

Strategic partners, though not necessarily on your advisory board or

board of directors, may still provide credibility to your venture. In such cases,

it makes sense to highlight their involvement in your company's success. It is

also common to list external team members, such as the law firm and accounting

firm that your venture uses. The key in this section is to demonstrate that

your firm can successfully execute the concept. A strong team provides the

foundation on which your venture will implement the opportunity successfully.

Compensation and Ownership

The capstone to the team section should be a table containing key team members

by role, compensation, and ownership equity. A brief description of the

table should explain why the compensation is appropriate. Many entrepreneurs

choose not to pay themselves in the early months. Although this strategy

conserves cash flow, it would misrepresent the individual's worth to the

organization. Therefore, the table should contain what salary the employee is

due, and then, if necessary, that salary can be deferred until cash f low is

strong. Another column that can be powerful shows what the person's current

or most recent compensation was and what he will be paid in the new company.

I am most impressed by highly qualified entrepreneurs taking a smaller

salary than at their previous job. It suggests that the entrepreneur really believes

in the upside payoff the company's growth will generate. Of course,

the entrepreneur plans on increasing this salary as the venture grows and

starts to thrive. As such, the description of the schedule should underscore

the plan to increase salaries in the future. It is also a good idea to hold stock

aside for future key hires and to establish a stock option pool for lower-level

but critical employees, such as software engineers. Again, the plan should discuss

such provisions.

284 Planning and Forecasting

Critical Risks (1–2 pages)

Every new venture faces a number of risks that may threaten its survival. Although

the business plan, at this point, is creating a story of success, there are

a number of threats that readers will identify and recognize. The plan needs to

acknowledge these potential risks; otherwise, investors may believe that the

entrepreneur is naive or untrustworthy and therefore reject investment. How

should you present these critical risks without scaring your investor? Identify

the risk and then state your contingency plan (see Exhibit 9.12). Critical risks

are critical assumptions, factors that need to happen if your venture is to succeed.

The critical assumptions vary from one company to another, but some

common categories are: market interest and growth potential, competitor actions

and retaliation, time and cost of development, operating expenses, availability

and timing of financing.

Market Interest and Growth Potential

The biggest risk any new venture faces is that once the product is developed,

no one will buy it. Although there are a number of things that can be done to

minimize this risk, such as market research, focus groups, beta sites, and others,

it is difficult to gauge overall demand and growth of that demand until

your product hits the market. This risk must be stated but tempered with the

tactics and contingencies the company will undertake. For example, sales risk

can be reduced by an effective advertising and marketing plan or identifying

not only a primary target customer but secondary and tertiary target customers

that the company will seek if the primary customer proves less interested.

Competitor Actions and Retaliation

Having worked with entrepreneurs and student entrepreneurs over the years, I

have always been struck by the firmly held belief that direct competition either

didn't exist or that it was sleepy and slow to react. There have been many cases

EXHIBIT 9.12 Sample critical risk.

6.2 Group's lack of experience in starting own company Within our present team,

we realize that we lack the real world experience in starting up a company, but we feel that

this can be overcome in two different ways. First, we plan on hiring someone who has a

background in managing a startup company and has a history in working with e-commerce

businesses. Secondly, we will draw on family expertise within our group. William Smith's

family has started a successful golf retail store that has been in operation for nearly 20 years

and is just starting to utilize the Web to foster continued growth. Jim Meier 's father is the

managing partner of the largest public accounting firm in western Massachusetts. Mike

Santana's uncle is an investment banker and has some good friends in the venture capital firm

Canyon Partners in Beverly Hills. Pat Crown's father is the founder and president of Mathtech

Corporation in Boston, Massachusetts. Mr. Crown's company develops math software.

The Business Plan 285

where this is indeed true, but I caution against using it as a key assumption of

your venture's success. Most entrepreneurs passionately believe that they are

offering something new and wonderful that is clearly different from what

is currently being offered. They are confident that existing competition won't

attack their niche in the near future. The risk that this assessment is wrong

should be acknowledged. One counter to this threat is that the venture has

room in its gross margin and cash available to withstand and fight such attacks.

You should also identify some strategies to protect and reposition yourself

should an attack occur.

Time and Cost to Development

As mentioned in the development plan section, many factors can delay and add

to the expense of developing your product. The business plan should identify

the factors that may hinder development. For instance, during the extended

high-tech boom of the late nineties and into the new century, there has been

an acute shortage of skilled software engineers. One way to counter the resulting

risk in hiring and retaining the most qualified professionals might be to

outsource some development to the underemployed engineers in India. Compensation,

equity participation, f lexible hours, and other benefits that the firm

could offer might also minimize the risk.

Operating Expenses

Operating expenses have a way of growing beyond expectations. Sales and administration,

marketing, and interest expenses are some of the areas that the

entrepreneur needs to monitor and manage. The business plan should highlight

how these expenses were forecast (comparable companies and detailed analysis)

but also discuss contingencies such as slowing the hiring of support personnel,

especially if development or other key tasks take longer than expected.

Availability and Timing of Financing

I can't stress enough how important cash f low is to the survival and growth of

a new venture. One major risk that most new ventures face is that they will

have difficulty obtaining needed financing, both equity and debt. If the current

business plan is meant to attract investors and is successful, that first capital

infusion isn't a near-term risk, but most ventures will need multiple rounds

of financing. If the firm fails to make progress (or meet key milestones), it may

not be able to secure additional rounds of financing on favorable terms. To mitigate

this risk, the firm could identify alternative sources that are viable or

strategies to slow the "burn rate."6

There are a number of other risks that might apply to your business. Acknowledge

them and discuss how you can overcome them. Doing so generates

confidence in your investors.

286 Planning and Forecasting

Offering (12–1 page)

Based upon the entrepreneur's vision and estimates of the capital required to

get there, the entrepreneur can develop a "sources and uses schedule" (see Exhibit

9.13). The sources section details how much capital the entrepreneur

needs and the types of financing such as equity investment and debt infusions.

The uses section details how the money will be spent. Typically, the entrepreneur

should secure enough financing to last 12 to 18 months. Taking more capital

means that the entrepreneur gives up more equity. Taking less means that

the entrepreneur may run out of cash before reaching milestones that equate to

higher valuations.

Financial Plan (4 –8 pages)

If the preceding plan is your verbal description of the opportunity and how you

will execute it, the financial plan is the mathematical equivalent. The growth

in revenues speaks to the upside of your opportunity. The expenses illustrate

what you need to execute on that opportunity. Cash f low statements serve as

an early warning system to potential problems (or critical risks), and the balance

sheet enables monitoring and adjusting the venture's progress. That being

said, generating realistic financials is one of the most intimidating hurdles entrepreneurs

face. I will highlight a dual strategy to building your model: comparable

analysis and the buildup technique. Entrepreneurs should do both

approaches; with work and skill the two approaches allow the entrepreneur to

triangulate into a credible facsimile.

Entrepreneurs are notoriously overoptimistic in their projections. One

phrase that entrepreneurs overuse in their business plan, especially the financial

plan, is "conservative estimate." History proves that 99% of all entrepreneurs

are amazingly aggressive in their projections. Professional investors

recognize this problem and often discount financials up to 50% from the entrepreneur's

projections. How do you prevent that from happening? Validate

your projections by comparing your firm's pro forma financials to existing

firm's actual performance. Obviously, no two firms are exactly alike, and if you

were to launch an online bookstore, it would be unlikely that your firm would

perfectly mirror Amazon.com. However, the comparable method doesn't mean

that you substitute another firm's financials for your own; it means that you use

EXHIBIT 9.13 Sources and uses schedule.

Sources Uses

5,000,000 VC 1,688,750 Systems development

1,652,000 Equipment

1,125,000 Sales/business development

534,250 Working capital

5,000,000 Total 5,000,000

The Business Plan 287

that comparable firm as a starting point. Entrepreneurs then need to articulate

why their projections vary from the comparable firm, both in a positive and

negative manner. Continuing the online bookstore example, I would be insane

to believe that I could achieve the same rapid growth that Amazon.com experienced,

because there is now more competition, especially from Amazon.com.

On the f lip side, I should be able to argue that my expenses won't be as stif ling

as Amazon's, because I have studied and learned from their excesses. I would

also articulate how my fulfillment is more efficient than Amazon's. So the key

in the comparable method is to use other firms and industry standards as a

starting point and then adjust your projections based upon your strategy and

other factors.

Industry averages also provide useful comparable information. The Almanac

of Business and Industrial Financial Ratios, published by Prentice-

Hall, or Industry Norms and Key Business Ratios, published by Dun and

Bradstreet are excellent sources to use as starting points in building financial

statements relevant to your industry. Specifically, these sources help entrepreneurs

build income statements by providing industry averages for costs of

goods sold, salary expenses, interest expenses, and the like. Again, your firm

will differ from these industry averages, but you should be able to explain why

your firm differs.

The second method is the buildup method. This approach derives from

the scientific finding that people make better decisions by decomposing a

problem into smaller parts. For financial pro forma construction, this is relatively

easy. The place to start is the income statement. Identify all of your revenue

sources (usually the various product offerings). Instead of visualizing

what you will sell in a month or a year, break it down to the day. For example,

if I am starting a new restaurant, I would estimate how many customers I

might serve in a particular day and how much they would spend per visit

based upon the types of meals and beverages they would buy. In essence, I am

developing an average ticket price per customer. I then multiply that price by

the number of days of operation in the year. Once I have the typical day, I can

make adjustments for cyclical aspects of the business, such as slow days or

slow months. If I were, say, to open up a chain of restaurants, I could then

multiple my estimates by the number of restaurants. Once you have gone

through a couple of iterations of each approach, you should be able to reconcile

the differences.

One schedule that is particularly powerful in building up your cost estimates

is a headcount schedule. This table should have time across the top and

job categories down the side (see Exhibit 9.14). Next assign average salaries

and burden to these employees and then funnel them into the appropriate income

statement lines. Breaking down to this level of detail enables entrepreneurs

to more accurately aggregate up to their real headcount expenses, which

tend to be the major line item in most companies.

Going through the above exercises allows you to construct a realistic set

of pro forma financials. The financial statements that must be included in your

288 Planning and Forecasting

plan are the income statement, cash f low statement, and balance sheet. I typically

call for five years of financials, recognizing that the farther out one goes,

the less accurate the forecasts are. The rationale behind five years is that the

first two years show the firm surviving and the last three years show the upside

growth potential. The majority of new ventures lose money for the first two

years. Therefore, the income statement and cash flow statement should be

month-to-month during the first two years to show how much cash is needed

until the firm can become self-sustaining. Month-to-month analysis shows cash

f low decreasing and provides an early warning system as to when the entrepreneur

should seek the next round of financing. Years 3 through 5 need to be illustrated

only on an annual basis, because these projections communicate your

vision for growth but are likely to be less accurate because they are further out.

The balance sheet can be on an annual basis for all five years since it is reporting

a snapshot on the last day of a particular period.

Once the financial spreadsheets are completed, a two-to-three-page explanation

of the financials should be written and it should precede the statements.

Although you understand all the assumptions and comparisons that

went into building the financial forecast, the reader needs the background

spelled out. The explanation should have four subheadings: overview, income

statement, cash flow, and balance sheet. The overview section should highlight

the major assumptions that drive your revenue and expenses. This section

should explain several of the critical risks you identified earlier. The income

statement description goes into more detail as to some of the revenue and cost

drivers that haven't been discussed in the overview section. The cash flow description

talks about the timing of cash infusions, accounts payable, accounts

receivable, and so forth. The balance sheet description illustrates how major

ratios change as the firm grows.

Appendices (as many pages as necessary)

The appendices can include anything that you think further validates your

concept but doesn't fit or is too large to insert in the main parts of the plan.

EXHIBIT 9.14 Headcount chart.

Month Month Month Month Month Month Month

1 6 12 18 24 30 36

Business development 1 2 3 3 3 3 3

Sales and administration 2 2 6 10 10 14 14

Software developers 3 3 3 18 18 23 26

Customer service 0 2 3 5 5 10 10

Total head count 6 9 15 36 36 50 53

The Business Plan 289

Common inclusions would be one-page resumes of key team members, articles

that feature your venture, and technical specifications.

CONCLUSION

The business plan is more than just a document; it is a process. Although the

finished product is often a written plan, the deep thinking that goes into that

document provides the entrepreneur keen insight needed to marshal resources

and direct growth. The whole process can be painful, but the returns on a solid

effort almost always minimize the costs of starting a business, because the process

allows the entrepreneur to better anticipate, instead of reacting to, the

many issues the venture will face. More important, the business plan provides a

talking point so that entrepreneurs can get feedback from a number of experts,

including investors, vendors, and customers. Think of the business plan as one

of your first steps on the journey to entrepreneurial success.

OTHER RESOURCES

A number of resources exist for those seeking help to write business plans.

There are numerous software packages, but I find that generally the templates

are too confining. The text boxes asking for information box writers into a dull,

dispassionate tone. The best way to learn about business plans is digging out

the supporting data, writing sections as you feel compelled, and circulating

drafts among your mentors and advisors. I also think that the entrepreneur

should read as many other articles, chapters, and books about writing business

plans as possible. You will want to assimilate different perspectives so that you

can find your own personal voice. To that end, I want to suggest a number of

sources that you might want to check out.

FOR FURTHER READING

Timmons, J. A., New Venture Creation, 5th ed. (New York: Irwin/McGraw-Hill,

1999). Classic textbook on the venture creation process.

Tracy, J., How to Read a Financial Report, 5th ed. (New York: John Wiley, 1999).

Classic book on how to create pro forma financial statements and how these

statements tie together.

Sahlman, W., "How to Write a Great Business Plan," Harvard Business Review

(July–Aug. 1997): 98–108.

Bhide, A., "The Questions Every Entrepreneur Should Ask," Harvard Business Review

(Nov.–Dec. 1996): 120–130.

Kim, C., and R. Mauborgne, "Creating New Market Space," Harvard Business Review

(Jan.–Feb. 1999): 83–93.

290 Planning and Forecasting

INTERNET LINKS

Business Plan Sites

www.pasware.com

www.brs-inc.com

www.jian.com

Other Useful Sites

www.entreworld.org

www.babson.edu/entrep

NOTES

1. P. Thomas, "Rewriting the Rules: A New Generation of Entrepreneurs Find

Themselves in the Perfect Time and Place to Chart Their Own Course," Wall Street

Journal, May 22, 2000, R4.

2. Running sidebar is a visual device that is positioned down the right hand side

of the page that periodically highlights some of the key points in the plan. Don't

overload the sidebar, but one or two items per page can draw attention to highlights

that maintain reader interest.

3. Don't confuse the executive summary included in the plan with the expanded

executive summary that I suggested you write as the very first step of the business

plan process. Again, the two summaries are likely to be significantly different since

the later summary incorporates all the deep learning that you have gained throughout

the process.

4. J. Timmons, New Venture Creation, 5th ed. (New York: Irwin/McGraw-Hill,

1999).

5. O. Sacirbey, "Private Companies Temper IPO Talk," The IPO Reporter,

Dec. 18, 2000, 9.

6. Burn rate is how much more cash the company is expending each month than

earning in revenue.

291

10 PLANNING CAPITAL

EXPENDITURE

Steven P. Feinstein

A beer company is considering building a new brewery. An airline is deciding

whether to add f lights to its schedule. An engineer at a high-tech company has

designed a new microchip and hopes to encourage the company to manufacture

and sell it. A small college contemplates buying a new photocopy machine.

A nonprofit museum is toying with the idea of installing an education center for

children. Newlyweds dream of buying a house. A retailer considers building a

Web site and selling on the Internet.

What do these projects have in common? All of them entail a commitment

of capital and managerial effort that may or may not be justified by later

performance. A common set of tools can be applied to assess these seemingly

very different propositions. The financial analysis used to assess such projects

is known as "capital budgeting." How should a limited supply of capital and

managerial talent be allocated among an unlimited number of possible projects

and corporate initiatives?

THE OBJECTIVE: MAXIMIZE WEALTH

Capital budgeting decisions cut to the heart of the most fundamental questions

in business. What is the purpose of the firm? Is it to create wealth for investors?

To serve the needs of customers? To provide jobs for employees? To

better the community? These questions are fodder for endless debate. Ultimately,

however, project decisions have to be made, and so we must adopt a

292 Planning and Forecasting

decision rule. The perspective of financial analysis is that capital investment

belongs to the investors. The goal of the firm is to maximize investors' wealth.

Other factors are important and should be considered, but this is the primary

objective. In the case of nonprofit organizations, wealth and return on investment

need not be measured in dollars and cents but rather can be measured in

terms of benefits to society. But in the case of for-profit companies, wealth is

monetary.

A project creates wealth if it generates cash flows over time that are

worth more in present-value terms than the initial setup cost. For example,

suppose a brewery costs $10 million to build, but once built it generates a

stream of cash f lows that is worth $11 million. Building the brewery would create

$1 million of new wealth. If there were no other proposed projects that

would create more wealth than this, then the beer company would be well advised

to build the new brewery.

This example illustrates the "net present value" rule. Net present value

(NPV) is the difference between the setup cost of a project and the value of

the project once it is set up. If that difference is positive, then the NPV is

positive and the project creates wealth. If a firm must choose from several

proposed projects, the one with the highest NPV will create the most wealth,

and so it should be the one adopted. For example, suppose the beer company

can either build the new brewery or, alternatively, can introduce a new product—

a light beer, for example. There is not enough managerial talent to oversee

more than one new project, or maybe there are not enough funds to start

both. Let us assume that both projects create wealth: The NPV of the new

brewery is $1 million, and the NPV of the new-product project is $500,000. If

it could, the beer company should undertake both projects; but since it has to

choose, building the new brewery would be the right option because it has

the higher NPV.

COMPUTING NPV: PROJECTING CASH FLOWS

The first step in calculating a project's NPV is to forecast the project's future

cash flows. Cash is king. It is cash flow, not profit, that investors really care

about. If a company never generates cash flow, there can be no return to investors.

Also, profit can be manipulated by discretionary accounting treatments

such as depreciation method or inventory valuation. Regardless of

accounting choices, however, cash flow either materializes or does not. For

these reasons, cash f low is the most important variable to investors. A project's

value derives from the cash f low it creates, and NPV is the value of the future

cash f lows net of the initial cash outflow.

We can illustrate the method of forecasting cash flows with an example.

Let us continue to explore the brewery project. Suppose project engineers inform

you that the construction costs for the brewery would be $8 million. The

Planning Capital Expenditure 293

expected life of the new brewery is 10 years. The brewery will be depreciated

to zero over its 10-year life using a straight-line depreciation schedule. Land

for the brewery can be purchased for $1 million. Additional inventory to stock

the new brewery would cost $1 million. The brewery would be fully operational

within a year. If the project is undertaken, increased sales for the beer

company would be $7 million per year. Cost of goods sold for this beer would

be $2 million per year; and selling, administrative, and general expenses associated

with the new brewery would be $1 million per year. Perhaps advertising

would have to increase by $500,000 per year. After 10 years, the land can be

sold for $1 million, or it can be used for another project. After 10 years the salvage

value of the plant is expected to be $1.5 million. The increase in accounts

receivable would exactly equal the increase in accounts payable, at $400,000,

so these components of net working capital would offset one another and generate

no net cash flow.

No one expects these forecasts to be perfect. Paraphrasing the famous

words of baseball player Yogi Berra, making predictions is very difficult, especially

when they are about the future! However, when investors choose among

various investments, they too must make predictions. As a financial analyst,

you want the quality of your forecasts to be on a par with the quality of the

forecasts made by investors. Essentially, the job of the financial analyst is to estimate

how investors will value the project, because the value of the firm will

rise if investors decide that the new project creates wealth and will fall if investors

conclude that the project destroys wealth. If the investors have reason

to believe that sales will be $7 million per year, then that would be the correct

forecast to use in the capital budgeting analysis. Investors have to cope with

uncertainty in their forecasts. Similarly, the financial analyst conducting a capital

budgeting analysis must tolerate the same level of uncertainty.

Note that cash flow projections require an integrated team effort across

the entire firm. Operations and engineering personnel estimate the cost of

building and operating the new plant. The human resources department contributes

the labor data. Marketing people tell you what advertising budget is

needed and forecast revenue. The accounting department estimates taxes, accounts

payable, and accounts receivable and tabulates the financial data. The

job of the financial analyst is to put the pieces together and recommend that

the project be adopted or abandoned.

Initial Cash Outf low

The initial cash outflow required by the project is the sum of the construction

cost ($8 million), the land cost ($1 million), and the required new inventory

($1 million). Thus, this project requires an investment of $10 million to launch.

If accounts receivable did not equal accounts payable, then the new accounts

receivable would add to the initial cash outflow, and the new accounts payable

would be subtracted. These cash f lows are tabulated in Exhibit 10.1.

294 Planning and Forecasting

Cash Flows in Later Years

We find cash f low in years 1 through 10 by applying the following formula:

Notice that we already have most of the data needed for the cash-f low formula,

but we are missing the forecasts for income tax and windfall tax. Before we can

finalize the cash f low computation, we have to forecast taxes.

Income tax equals earnings before taxes (EBT) times the income tax rate.

EBT is computed using the following formula:

The formula for EBT is similar to the formula for cash-flow, with a few important

exceptions. The cash-f low calculation does not subtract out depreciation,

whereas the EBT calculation does. This is because depreciation is not a cash

f low; the firm never has to write a check payable to "depreciation." Depreciation

does reduce taxable income, however, because the government allows this

deduction for tax purposes. So depreciation inf luences cash f low via its impact

on income tax, but it is not a cash f low itself. The greater the allowable depreciation

is in a given year, the lower taxes will be, and the greater the resulting

cash f low to the firm.

Earnings before Taxes = Sales Cost of goods sold

Selling, administrative, and general expenses

Advertising

Depreciation

Cash Flow = Sales Cost of goods sold

Selling, administrative, and general expenses

Advertising

Income tax

+ Decrease in inventory (or increase)

+ Decrease in accounts receivable (or increase)

Decrease in accounts payable (or + increase)

+ Salvage

Windfall tax on salvage

EXHIBIT 10.1 Initial year cash f low for

brewery project ($1,000s).

Year 0

Construction $ (8,000)

Land (1,000)

Inventory (1,000)

Account receivable (400)

Accounts payable 400

Total cash f low $(10,000)

Planning Capital Expenditure 295

Treatment of Net Working Capital

Changes in inventory, accounts receivable, and accounts payable are included

in the cash-flow calculation but not in EBT. Changes in the components of

working capital directly impact cash flow, but they are not deductible for tax

purposes. When a firm buys inventory, it has essentially swapped one asset,

(cash) for another asset (inventory). Though this is a negative cash flow, it is not

considered a deductible expenditure for tax purposes.

Similarly, a rise in accounts receivable means that cash that otherwise

would have been in the company coffers is now owed to the company instead.

Thus, an increase in accounts receivable effectively sucks cash out of the company

and must be treated as a cash outflow. Increasing accounts payable has

the opposite effect.

One way to gain perspective on the impact of accounts payable and accounts

receivable on a company's cash f low is to think of them as adjustments

to sales and costs of goods sold. If a company makes a sale but the customer has

not yet paid, clearly there is no cash f low generated from the sale. Though the

sales variable will increase, the increase in accounts receivable will exactly offset

that increase in the cash f low computation. Similarly, if the company incurs

expenses in the manufacture of the goods sold but has not yet paid its suppliers

for the raw materials, the costs of goods sold will be offset by the increase in

accounts payable.

Depreciation

According to a straight-line depreciation schedule, depreciation in each year is

the initial cost of the plant or equipment divided by the number of years over

which the asset will be depreciated. So, the $8 million plant depreciated over

10 years generates depreciation of $800,000 each year. Land is generally not

depreciated. Straight-line depreciation is but one acceptable method for determining

depreciation of plant and equipment. The tax authorities often sanction

other methods and schedules.

Windfall Profit and Windfall Tax

In order to compute windfall profit and windfall tax, we must be able to track

an asset's book value over its life. Book value is the initial value minus all previous

depreciation. For example, the brewery initially has a book value of $8

million, but that value falls $800,000 per year due to depreciation. At the end

of the first year, book value falls to $7.2 million. By the end of the second year,

following another $800,000 of depreciation, the book value will be $6.4 million.

By the end of the tenth year, when the brewery is fully depreciated, the

book value will be zero.

Windfall profit is the difference between the salvage value and book

value. We are told the beer company will be able to sell the old brewery for

296 Planning and Forecasting

$1.5 million at the end of 10 years. By then, however, the book value of the

brewery will be zero. Thus, the beer company will realize a windfall profit of

$1.5 million. The government will want its share of that windfall profit. Multiplying

the windfall profit by the tax rate determines the windfall tax. In this

particular case, with a windfall profit of $1.5 million and a tax rate of 40%, the

windfall tax would equal $600 thousand (= $1.5 million × 40%).

Taxable Income and Income Tax

Exhibit 10.2 shows how taxable income and income tax are computed for the

brewery example. Income tax equals EBT times the company's income tax rate.

In each of years 1 through 10, EBT is $2.7 million, so income tax is $1,080,000

(= $2.7 million × 40%).

Interest Expense

Notice that the calculation of taxable income and income tax in Exhibit 10.2

does not deduct any interest expense. This is not an oversight. Even if the company

intends to finance the new project by selling bonds or borrowing from a

bank, we should not deduct any anticipated interest expense from our taxable

income, and we should not subtract interest payments in the cash f low computation.

We will take the tax shield of debt financing into account later when we

compute the company's cost of capital. The reason for omitting interest expense

at this stage cuts to the core of the purpose of capital budgeting. We are

trying to forecast how much cash is required from investors to start this project

and then how much cash this project will generate for the investors once the

project is up and running. Interest expense is a distribution of cash to one class

of investors—the debt holders. If we want the bottom line of our cash-flow

computation to ref lect how much cash will be available to all investors, we

must not subtract out cash f low going to one class of investors before we get to

that bottom line.

EXHIBIT 10.2 Income tax forecasts for brewery

project (thousands).

Years 1–10

Sales $ 7,000

Cost of goods sold (2,000)

Selling, administrative, and general expenses (1,000)

Advertising (500)

Depreciation (800)

Earnings before taxes $ 2,700

Income tax (40%) $(1,080)

Planning Capital Expenditure 297

Putting the Pieces Together to

Forecast Cash Flow

We now have all the puzzle pieces to construct our capital budgeting cash-flow

projection. These pieces and the resulting cash-flow projection are presented

in Exhibit 10.3. Cash f lows in years 1 through 9 are forecast to be $2.42 million,

and the cash f low in year 10 is expected to be $5.32 million. Year 10 has a

greater cash flow because of the recovery of the inventory and the assumed

sale of the land and plant.

GUIDING PRINCIPLES FOR

FORECASTING CASH FLOWS

The brewery example is one illustration of how cash f lows are forecast. Every

project is different, however, and the financial analyst must be keen to identify

all sources of cash flow. The following three principles can serve as a guide:

(1) Focus on cash flow, not on raw accounting data, (2) use expected values,

and (3) focus on the incremental.

Principle No. 1: Focus on Cash Flow

NPV analysis focuses on cash flows—that is, actual cash payments and receipts

flowing into or out of the firm. Recall that accounting profit is not the same

thing as cash flow. Accounting profit often mixes variables whose timings differ.

A sale made today may show up in today's profits, but since the cash receipt

for the sale may be deferred, the corresponding cash f low takes place

EXHIBIT 10.3 Cash f low projections for brewery project

(thousands).

Year: 0 1–9 10

Construction $ (8,000)

Land (1,000) $1,000

Inventory (1,000) 1,000

Account receivable (400) 400

Accounts payable 400 (400)

Sales $7,000 7,000

Cost of goods sold (2,000) (2,000)

Selling, admin., and general (1,000) (1,000)

Advertising (500) (500)

Income tax (1,080) (1,080)

Salvage 1,500

Windfall tax (600)

Total cash f low $(10,000) $2,420 $5,320

298 Planning and Forecasting

later. Since the cash f low is deferred, the true value of that sale to the firm is

somewhat diminished.

By focusing on cash flows and when they occur, NPV ref lects the true

value of increased revenues and costs. Consequently, NPV analysis requires

that accounting data be unraveled to reveal the underlying cash f lows. That is

why changes in net working capital must be accounted for and why depreciation

does not show up directly.

Principle No. 2: Use Expected Values

There is always going to be some uncertainty over future cash f lows. Future

costs and revenues cannot be known for sure. The analyst must gather as much

information as possible and assemble it to construct expected values of the

input variables. Although expected values are not perfect, these best guesses

have to be good enough. What is the alternative? The uncertainty in forecasting

the inputs is accounted for in the discount rate that is later used to discount

the expected cash f lows.

Principle No. 3: Focus on the Incremental

NPV analysis is done in terms of "incremental" cash flows—that is, the change

in cash flow generated by the decision to undertake the project. Incremental

cash f low is the difference between what the cash flow would be with the project

and what the firm's cash flow would be without the project. Any sales or

savings that would have happened without the project and are unaffected

by doing the project are irrelevant and should be ignored. Similarly, any costs

that would have been incurred anyway are irrelevant. It is often difficult yet

nonetheless important to focus on the incremental when calculating how cash

f lows are impacted by opportunity costs, sunk costs, and overhead. These troublesome

areas will be elaborated on next.

Opportunity Costs

Opportunity costs are opportunities for cash inf lows that must be sacrificed in

order to undertake the project. No check is written to pay for opportunity

costs, but they represent changes in the firm's cash f lows caused by the project

and must, therefore, be treated as actual costs of doing the project. For example,

suppose the firm owns a parking lot, and a proposed project requires use of

that land. Is the land free since the firm already owns it? No; if the project

were not undertaken then the company could sell or rent out the land. Use of

the company's land is, therefore, not free. There is an opportunity cost. Money

that could have been earned if the project were rejected will not be earned if

the project is started. In order to ref lect fully the incremental impact of the

proposed project, the incremental cash f lows used in NPV analysis must incorporate

opportunity costs.

Planning Capital Expenditure 299

Sunk Costs

Sunk costs are expenses that have already been paid or have already been committed

to. Past research and development are examples. Since sunk costs are

not incremental to the proposed project, NPV analysis must ignore them. NPV

analysis is always forward-looking. The past cannot be changed and so should

not enter into the choice of a future course of action. If research was undertaken

last year, the effects of that research might bear on future cash f lows,

but the cost of that research is already water under the bridge and so is not relevant

in the decision to continue the project. The project decision must be

made on the basis of whether the project increases or decreases wealth from

the present into the future. The past is irrelevant.

Overhead

The treatment of overhead often gives project managers a headache. Overhead

comprises expenditures made by the firm for resources that are shared by

many projects or departments. Heat and maintenance for common facilities are

examples. Management resources and shared support staff are other examples.

Overhead represents resources required for the firm to provide an environment

in which projects can be undertaken. Different firms use different formulas

for charging overhead expenses to various projects and departments. If

overhead charges accurately ref lect the shared resources used by a project,

then they should be treated as incremental costs of operating the project. If

the project were not undertaken, those shared resources would benefit another

moneymaking project, or perhaps the firm could possibly cut some of the

shared overhead expenditures. Thus, to the extent that overhead does represent

resources used by the project, it should be included in calculating incremental

cash f lows. If, on the other hand, overhead expense is unaffected by the

decision to undertake the new project, and no other proposed project could use

those shared resources, then overhead should be ignored in the NPV analysis.

Sometimes the formulas used to calculate overhead for budgeting purposes are

unrealistic and overcharge projects for their use of shared resources. If the financial

analyst does not correct this unrepresentative allocation of costs, some

worthwhile projects might incorrectly appear undesirable.

COMPUTING NPV: THE TIME VALUE OF MONEY

In deciding whether a project is worthwhile, one needs to know more than

whether it will make money. One must also know when it will make money.

Time is money! Project decisions involve cash f lows spread out over several periods.

As we shall see, cash f lows in different periods are distinct products in

the financial marketplace—as different as apples and oranges. To make decisions

affecting many future periods, we must know how to convert the different

periods' cash f lows into a common currency.

300 Planning and Forecasting

The concept that future cash f lows have a lower present value and the set

of tools used to discount future cash f lows to their present values are collectively

known as "time value of money" (TVOM) analysis. I have always thought

this to be a misnomer; the name should be the "money value of time." But

there is no use bucking the trend, so we will adopt the standard nomenclature.

You probably already have an intuitive grasp of the fundamentals of

TVOM analysis, as your likely answer to the following question illustrates:

Would you rather have $100 today or $100 next year? Why?

The answer to this question is the essence of TVOM. You no doubt answered

that you would rather have the money today. Money today is worth

more than money to be delivered in the future. Even if there were perfect certainty

that the future money would be received, we prefer to have money in

hand today. There are many reasons for this. Having money in hand allows

greater f lexibility for planning. You might choose to spend it before the future

money would be delivered. If you choose not to spend the money during the

course of the year, you can earn interest on it by investing it. Understanding

TVOM allows you to quantify exactly how much more early cash f lows are

worth than deferred cash f lows. An example will illuminate the concept.

Suppose you and a friend have dinner together in a restaurant. You order

an inexpensive sandwich. Your friend orders a large steak, a bottle of wine, and

several desserts. The bill arrives and your friend's share is $100. Unfortunately,

your friend forgot his wallet and asks to borrow the $100 from you. You

agree and pay. A year passes before your friend remembers to pay you back the

money. "Here is the $100," he finally says one day. Such events test a friendship,

especially if you had to carry a $100 balance on your credit card over the

course of the year on which interest accrued at a rate of 18%. Is the $100 that

your friend is offering you now worth the same as the $100 that he borrowed a

year earlier? Actually, no; a $100 cash f low today is not worth $100 next year.

The same nominal amount has different values depending on when it is paid. If

the interest rate is 18%, a $100 cash f low today is worth $118 next year and is

worth $139.24 the year after because of compound interest. The present value

of $118 to be received next year is exactly $100 today. Your friend should pay

you $118 if he borrowed $100 from you a year earlier.

The formula for converting a future value to a present value is:

where PV stands for present value, FV is future value, n is the number of periods

in the future that the future cash f low is paid, and r is the appropriate interest

rate or discount rate.

Discounting Cash Flows

Suppose in the brewery example that the appropriate discount rate for translating

future values to present values was 20%. Recall that the brewery project

PV

FV

r

n =

(1 + )

Planning Capital Expenditure 301

was forecast to generate $2.42 million of cash in year 1. The present value of

that cash flow, as of year 0, is $2,016,670, computed as follows:

Similarly, the year-2 cash flow was forecast to be $2.42 million also. The present

value of that second-year cash f low is only $1,680,560:

The longer the time over which a cash f low is discounted, the lower is its present

value. Exhibit 10.4 presents the forecasted cash f lows and their discounted

present values for the brewery project.

Summing the Discounted Cash Flows

to Arrive at NPV

Finally, we can calculate the NPV. The NPV is the sum of all discounted cash

f lows, which in the brewery example equals $614,000. To understand precisely

what this means, observe that the sum of the discounted cash f lows from years

1 through 10 is $10,614,000. This means that the project generates future cash

f lows that are worth $10,614,000 today. The initial cost of the project is

$10,000,000 today. Thus, the project is worth $10,614,000 but costs only

$10,000,000 and therefore creates $614,000 of new wealth. The managers of

the beer company would be well advised to adopt this project, because it has a

positive NPV and therefore creates wealth.

PV =

( )

$ , , =

.

$ , ,

2 420 000

1 20

1 680 560 2

PV =

( )

$ , , =

.

$ , ,

2 420 000

1 20

2 016 670 1

EXHIBIT 10.4 Discounted cash f lows for

brewery project (thousands).

Year Cash Flow Discounted Cash Flow

0 $(10,000) $(10,000)

1 2,420 2,017

2 2,420 1,681

3 2,420 1,400

4 2,420 1,167

5 2,420 973

6 2,420 810

7 2,420 675

8 2,420 563

9 2,420 469

10 5,320 859

302 Planning and Forecasting

MORE NPV EXAMPLES

Consider two alternative projects, A and B. They both cost $1,000,000 to set

up. Project A returns $800,000 per year for two years starting one year after

setup. Project B also returns $800,000 per year for two years, but the cash

f lows begin two years after setup. The firm uses a discount rate of 20%. Which

is the better project, A or B?

Like project A, project C also costs $1,000,000 to set up, and it will pay

back $1,600,000. For both A and C, the firm will earn $800,000 per year for

two years starting one year after setup. However, C costs $500,000 initially and

the other $500,000 need only be paid at the termination of the project (it may

be a cleanup cost, for example). Project A requires the initial outlay all at once

at the outset. Which is the better project, A or C? Of projects A, B, and C,

which project(s) should be undertaken?

We should make the project decision only after analyzing each project's

NPV. Exhibit 10.5 tabulates each project's cash f lows, discounted cash f lows,

and NPVs. The NPVs of Projects A, B, and C, are, respectively, $222,222,

$151,235, and $375,000. Project C has the highest NPV. Therefore, if only

one project can be selected, it should be project C. If more than one project

can be undertaken, then both A and C should be selected since they both have

positive NPVs. Project B should be rejected since it has a negative NPV and

would therefore destroy wealth.

It makes sense that project C should have the highest NPV, since its cash

outf lows are deferred relative to the other projects, and its cash inf lows are

early. Project B, alternatively has all costs up front, but its cash inf lows are

deferred.

Suppose a project has positive NPV, but the NPV is small, say, only a few

hundred dollars. The firm should nevertheless undertake that project if there

are no alternative projects with higher NPV. The reason is that a firm's value

is increased every time it undertakes a positive-NPV project. The firm's value

increases by the amount of the project NPV. A small NPV, as long as it is positive,

is net of all input costs and financing costs. So, even if the NPV is low,

EXHIBIT 10.5 Cash f lows and discounted cash f lows for three

alternative projects (thousands).

Project A Project B Project C

Project A Discounted Project B Discounted Project C Discounted

Year Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow

0 $(1,000,000) $(1,000,000) $(1,000,000) $(1,000,000) $(500,000) $(500,000)

1 800,000 666,667 0 0 800,000 666,667

2 800,000 555,556 0 0 300,000 208,333

3 0 0 800,000 462,963 0 0

4 0 0 800,000 385,802 0 0

NPV = $0,(222,222 $0,(151,235) $ 375,000

Planning Capital Expenditure 303

the project covers all its costs and provides additional returns. If accepting

the small-NPV project does not preclude the undertaking of a higher-NPV

project, then it is the best thing to do. A firm that rejects a positive-NPV project

is rejecting wealth.

Of course, this does not mean a firm should jump headlong into any project

that at the moment appears likely to provide positive NPV. Future potential

projects should be considered as well, and they should be evaluated as

potential alternatives. The projects, current or future, that have the highest

NPV should be the projects accepted. For maximum wealth-creation efficiency,

the firm's managerial resources should be committed toward undertaking

maximum NPV projects.

THE DISCOUNT RATE

At what rate should cash f lows be discounted to compute net present values? In

most cases, the appropriate rate is the firm's cost of funds for the project. That

is, if the firm secures financing for the project by borrowing from a bank, the

after-tax interest rate should be used to discount cash f lows. If the firm obtains

funds by selling stock, then an equity financing rate should be applied. If the

financing combines debt and equity, then the appropriate discount rate would

be an average of the debt rate and the equity rate.

Cost of Debt Financing

The after-tax interest rate is the interest rate paid on a firm's debt less the impact

of the tax break they get from issuing debt. For example, suppose that a

firm pays 10% interest on its debt and the firm's income tax rate is 40%. If the

firm issues $100,000 of debt, then the annual interest expense will be $10,000

(10% × $100,000). But this $10,000 of interest expense is tax deductible, so the

firm would save $4,000 in taxes (40% × the $10,000 interest). Thus, net of the

tax break, this firm would be paying $6,000 to service a $100,000 debt. Its

after-tax interest rate is 6% ($6,000/$100,000 principal).

The formula for after-tax interest rate (RD, af ter-tax) is:

where RD is the firm's pretax interest rate, and รด is the firm's income tax rate.

Borrowing from a bank or selling bonds to raise funds is known as "debt

financing." Issuing stock to raise funds is known as "equity financing." Equity

financing is an alternative to debt financing, but it is not free. When a firm sells

equity, it sells ownership in the firm. The return earned by the new shareholders

is a cost to the old shareholders. The rate of return earned by equity investors

is found by adding dividends to the change in the stock price and then

dividing by the initial stock price:

RD, RD( ) after -tax= 1 − รด

304 Planning and Forecasting

where RE is the return on the stock and also the cost of equity financing, D is

the dollar amount of annual dividends per share paid by the firm to stockholders,

P0 is the stock price at the beginning of the year, and P1 is the stock price

at the end of the year. For example, suppose the stock price is $100 per share at

the beginning of the year and $112 at the end of the year, and the dividend is

$8 per share. The stockholders would have earned a return of 20%, and this

20% is also the cost of equity financing:

The capital asset pricing model (CAPM) is often used to estimate a firm's

cost of equity financing. The idea behind the CAPM is that the rate of return

demanded by equity investors will be a function of the risk of the equity,

where risk is measured by a variable beta (รข). According to the CAPM, รข and

cost of equity financing are related by the following equation:

where RF is a risk-free interest rate, such as a Treasury bill rate, and RM is the

expected return for the stock market as a whole. For example, suppose the expected

annual return to the overall stock market is 12%, and the Treasury bill

rate is 4%. If a stock has a รข of 2, then its cost of equity financing would be

20%, computed as follows:

Analysts often use the Standard & Poor's 500 stock portfolio as a proxy

for the entire stock market when estimating the expected market return. The

รขs for publicly traded firms are available from a variety of sources, such as

Bloomberg, Standard & Poor's, or the many companies that provide equity research

reports. How รข is computed and the theory behind the CAPM are beyond

the scope of this chapter, but the textbooks listed in the bibliography to

this chapter provide excellent coverage.

Weighted Average Cost of Capital

Most firms use a combination of both equity and debt financing to raise money

for new projects. When financing comes from two sources, the appropriate discount

rate is an average of the two financing rates. If most of the financing is

debt, then debt should have greater weight in the average. Similarly, the weight

given to equity should ref lect how much of the financing is from equity. The

RE = 4%+ [2 × (12%4%)] = 20%

R R R R E F M F = + รข( )

RE = $ + $ $ =

$

%

8 112 100

100

20

R

D P P

P E =

+ − 1 0

0

Planning Capital Expenditure 305

resulting number, the "weighted average cost of capital" (WACC), ref lects the

firm's true cost of raising funds for the project:

where WE is the proportion of the financing that is equity, WD is the proportion

of the financing that is debt, RE is the cost of equity financing, RD is the

pretax cost of debt financing, and รด is the tax rate.

For example, suppose a firm acquires 70% of the funds needed for a project

by selling stock. The remaining 30% of financing comes from borrowing.

The cost of equity financing is 20%, the pretax cost of debt financing is 10%,

and the tax rate is 40%. The weighted average cost of capital would then be

15.8%, computed as follows:

This 15.8% rate should then be used for discounting the project cash f lows.

Most often the choice of the discount rate is beyond the authority of the

project manager. Top management will determine some threshold discount rate

and dictate that it is the rate that must be used to assess all projects. When this

is the policy, the rate is usually the firm's WACC with an additional margin

added to compensate for the natural optimism of project proponents. A higher

WACC makes NPV lower, and this biases management toward rejecting projects.

The Effects of Leverage

Leverage refers to the amount of debt financing used: the greater the ratio of

debt to equity in the financing mix, the greater the leverage. The following example

illustrates how leverage impacts the returns generated by a project. Suppose

we have two companies that both manufacture scooters. One company is

called NoDebt Inc., and the other is called SomeDebt Inc. As you might guess

from its name, NoDebt never carries debt. SomeDebt is financed with equal

parts of debt and equity. Neither company knows whether the economy will be

good or bad next year, but they can make projections contingent on the state of

the economy. Exhibit 10.6 presents balance-sheet and income-statement data

for the two companies for each possible business environment.

Each company has $1 million of assets. Therefore, the value of NoDebt's

equity is $1 million, since debt plus equity must equal assets—the balancesheet

equality. Since SomeDebt is financed with an equal mix of debt and equity,

its debt must be worth $500,000, and its equity must also be worth

$500,000. Aside from capital structure—that is, the mix of debt and equity used

to finance the companies—the two firms are identical. In good times both companies

make $1 million in sales. In bad times sales fall to $200,000. Cost of

goods sold is always 50% of sales. Selling, administrative, and general expenses

are a constant $50,000. For simplicity we assume there is no depreciation.

WACC = (0.7 × 20%)+ 0.3 × [10%× (1 40%)] = 15.8%

WACC W R W R E E D D = + [ (1 − รด)]

306 Planning and Forecasting

Earnings before interest and taxes (EBIT) is thus $450,000 for both companies

in good times, and $50,000 for both in bad times. So far, this example illustrates

an important lesson about leverage: Leverage has no impact on EBIT. If

we define return on assets (ROA)1 as EBIT divided by assets, then leverage has

no impact on ROA.

If the pre-tax interest rate is 10%, however, then SomeDebt must pay

$50,000 of interest on its outstanding $500,000 of debt, regardless of whether

business is good or bad. NoDebt, of course, pays no interest. Because this is a

standard income statement, not a capital budgeting cash-f low computation, we

must account for interest. EBT (earnings before taxes, which is the same thing

as taxable income) for NoDebt is the same as its EBIT: $450,000 in good times

and $50,000 in bad times. For SomeDebt, however, EBT will be $50,000 less in

both states: $400,000 in good times and zero in bad times. Income tax is 40% of

EBT, so it must be $180,000 for NoDebt in good times, $20,000 for NoDebt

in bad times, $160,000 for SomeDebt in good times, and zero for SomeDebt in

bad times. Here we see the second important lesson about leverage: Leverage

reduces taxes.

Net earnings is EBT minus taxes. For NoDebt, net earnings is $270,000 in

good times and $30,000 in bad times. For SomeDebt, net earnings is $240,000

in good times and zero in bad times. Return on equity (ROE) equals net earnings

divided by equity. ROE is the profit earned by the equity investors as a

function of their equity investment. If, as in this example, there is no depreciation,

no changes in net working capital, and no capital expenditures, then net

earnings would equal the cash flow received by equity investors, and ROE

would be that year's cash return on their equity investment. Notice that ROE

for NoDebt is 27% in good times and 3% in bad times. ROE for SomeDebt is

much more volatile: 48% in good times and 0% in bad times. This is the third

EXHIBIT 10.6 Performance of NoDebt Inc. and SomeDebt Inc.

NoDebt Inc. (thousands) SomeDebt Inc. (thousands)

Net Earnings Good Times Bad Times Good Times Bad Times

Assets $1,000 $1,000 $1,000 $1,000

Debt 0 0 500 500

Equity $1,000 $1,000 $1,500 $1,500

Revenue $1,000 $1,200 $1,000 $1,200

COGS 500 100 500 100

SAG 50 50 50 50

EBIT 450 50 450 50

Interest 0 0 50 50

EBT 450 50 400 0

Tax (40%) 180 20 160 0

Net Earnings $1,270 $1,030 $1,240 $11,00

ROA 45.0% 5.0% 45.0% 5.0%

ROE 27.0% 3.0% 48.0% 0.0%

Planning Capital Expenditure 307

and most important lesson to be learned about leverage from this example: For

the equity investors, leverage makes the good times better and the bad times

worse. One student of mine, upon hearing this, exclaimed, "Leverage is a lot

like beer!"

Because leverage increases the riskiness of the cash f lows to equity investors,

leverage increases the cost of equity capital. But for moderate amounts

of leverage, the impact of the tax shield on the cost of debt financing overwhelms

the rising cost of equity financing, and leverage reduces the WACC.

Economists Franco Modigliani and Merton Miller were each awarded the

Nobel Prize in economics (in 1985 and 1990, respectively) for work that included

research on this very issue. Modigliani and Miller proved that in a world

where there are no taxes and no bankruptcy costs the WACC is unaffected by

leverage. What about the real world in which taxes and bankruptcy exist? What

we learn from their result, known as the Modigliani-Miller irrelevance theorem,

is that as leverage is increased WACC falls because of the tax savings, but

eventually WACC starts to rise again due to the rising probability of bankruptcy

costs. The choice of debt versus equity financing must balance these

countervailing concerns, and the optimal mix of debt and equity depends on

the specific details of the proposed project.

Divisional versus Firm Cost of Capital

Suppose the beer company is thinking about opening a restaurant. The risk inherent

in the restaurant business is much greater than the risk of the beer

brewing business. Suppose the WACC for the brewery has historically been

20%, but the WACC for stand-alone restaurants is 30%. What discount rate

should be used for the proposed restaurant project?

Considerable research, both theoretical and empirical, has been applied

to this question, and the consensus is that the 30% restaurant WACC should be

used. A discount rate must be appropriate for the risk and characteristics of

the project, not the risk and characteristics of the parent company. The reason

for this surprising result is that the volatility of the project's cash flows and

their correlation with other risky cash f lows are the paramount risk factors in

determining cost of capital, not simply the likelihood of default on the company's

obligations. The financial analyst should estimate the project's cost of

capital as if it were a new restaurant company, not an extension of the beer

company. The analyst should examine other restaurant companies to determine

the appropriate รข, cost of equity capital, cost of debt financing, financing mix,

and WACC.

OTHER DECISION RULES

Some firms do not use the NPV decision rule as the criterion for deciding

whether a project should be accepted or rejected. At least three alternative decision

rules are commonly used. As we shall see, however, the alternative rules

308 Planning and Forecasting

are f lawed. If the objective of the firm is to maximize investors' wealth, the alternative

rules sometimes fail to identify projects that further this end and in

fact sometimes lead to acceptance of projects that destroy wealth. We will examine

the payback period rule, the discounted payback rule, and the internal

rate of return rule.

The Payback Period

The payback period rule stipulates that cash flows must completely repay the

initial outlay prior to some cutoff payback period. For example, if the payback

cutoff were three years, the payback rule would require that all projects return

the initial outlay within three years. Projects that satisfy the rule would be accepted;

projects that do not satisfy the rule would be rejected.

For example, suppose a project initially costs $100,000 to set up. Suppose

the cash f lows in the first three years were $34,000 each. The sum of the first

three years' cash f lows is $102,000. This is greater than the initial $100,000

outlay, and so this project would be accepted under the payback period rule.

There are two major problems with the payback period rule. First, it does

not take into account the time value of money. Second, it ignores what happens

after the payback. Because of these two failings, the payback rule sometimes

accepts projects that should be rejected and rejects projects that should be accepted.

A project that costs $100,000 to set up and returns $34,000 for three

years would have a negative NPV at a 10% discount rate, since the $102,000 in

deferred cash f lows are worth less than the initial $100,000 outlay. Yet, the

project would be adopted under the payback rule criterion.

Consider a project that costs $100,000 to set up, returns nothing for three

years, and then returns $10 million in year 4. This project would have a positive

NPV at any reasonable discount rate, yet would be rejected by the payback

rule. The rejection stems from the fact that the payback rule is myopic, that is,

it fails to take into account what happens after the payback period. Empirical

studies have shown that, contrary to popular perceptions, stockholders do reward

firms that take the longer view, NPV approach to project analysis.

The Discounted Payback Period

An improved, though still f lawed, variant of the payback period rule is the discounted

payback period rule. The discounted payback rule stipulates that the

discounted cash f lows from a project over some payback horizon must exceed

the initial outlay. If the horizon were three years, the rule would require that

the discounted present value of a project's first three years of cash flows be

greater than the initial outlay. Although this rule explicitly takes into account

the time value of money, it still ignores what might happen after the payback

horizon. A project may be rejected even if the expected cash f lows from the

fourth year and beyond are very large, as might be the case in a research and

development project. A project might be accepted even if there is a large

Planning Capital Expenditure 309

cleanup cost that would have to be paid after the payback horizon. Although the

rule incorporates the time value of money, it is still shortsighted. One might

conjecture that the payback and discounted payback rules are popular since

they are easy to apply. Yet, this ease is paid for in lost opportunities for creating

wealth and occasional misallocation of resources into wasteful projects.

Internal Rate of Return

A project's internal rate of return (IRR) is the interest rate that the project essentially

pays out. It is the interest rate that a bank would have to pay so that

the project's cash outflows would exactly finance its cash inf lows. Instead of

investing money in the project, one could invest money in a bank paying a rate

of interest equal to the project's IRR and receive the same cash flows. One can

think of the IRR as an interest rate that a project pays to its investors. For example,

a project that costs $100,000 to set up but then returns $10,000 every

year forever has an IRR of 10%. If a project costs $100,000 to set up and then

ends the following year when it pays back $105,000, that project would have an

IRR of 5%. The IRR is the rate of return generated by the project.

Most financial calculators and spreadsheet programs have functions that

find IRR using cash f lows supplied by the user. For example, consider a project

that requires a cash outf low of $100 in year 0 and produces cash inf lows of $40

for each of four years. To find the IRR using a financial calculator one must

specify that the present value equals $100, annual payments equal +$40, and

n, the number of years, equals 4. The present value and the annuity payments

must have opposite signs in order to indicate to the calculator that the direction

of cash f lows has changed. The last step is to issue the instruction for the

calculator to find the interest rate that allows these cash flows to make sense.

The answer is the IRR, which in this example is 21.9%. For the beer brewery

cash f lows specified in Exhibit 10.4, the IRR is 21.7%.

Most TOVM problems involve specifying an interest rate and some of the

cash flows and then instructing the calculator to find the missing cash flow

variable—either present value, future value, or annual payment. IRR calculations

involve specifying all of the cash flows and instructing the calculator to

find the missing interest rate.

The IRR also happens to be the discount rate at which the project's cash

f lows have an NPV of zero. This relationship can be used to verify that an IRR

is correct. First calculate NPV at a guessed IRR. If the resulting NPV is zero,

the guessed IRR is in fact correct. If not, guess again. The IRR eventually can

be found by trial and error.

For example, consider again the case in which the initial cash outf low is

$100, followed by four annual cash inf lows of $40. To use the trial and error

method, one should calculate the NPV at a guessed discount rate. When we

find the discount rate at which the NPV is zero, we will have identified the

IRR. If we guess 10%, the NPV is $26.79. Apparently, the guessed discount

rate is too low. A higher discount rate will give a lower NPV. So guess again,

310 Planning and Forecasting

maybe 30% this time. At 30%, the NPV is $13.35. Apparently, 30% is too

high. The next guess should be lower. Following this algorithm, the IRR of

21.9% will eventually be located.

The IRR rule stipulates that a project should be accepted if its IRR is

greater than some agreed-on threshold, and rejected otherwise. That is, to be accepted

a project must produce percentage returns higher than some companymandated

minimum. Often the minimum threshold is set equal to the firm's cost

of capital. If the IRR beats the WACC, then the project is accepted. If the IRR

is less than the WACC, the project is rejected.

For example, suppose a project costs $1,000 to set up, and then produces

a one-time cash inf low of $1,100 one year later. The IRR of this project is 10%.

If the company imposes a minimum threshold of 20%, this project will be rejected.

If the company's threshold is 8%, this project will be accepted. We saw

previously that the brewery project IRR was 21.7%. If the agreed threshold is

the brewery's 20% WACC, then the IRR rule would indicate that the project

should be accepted.

The IRR rule is appealing in that it usually gives the same guidance as

the NPV rule when the threshold equals the company's cost of capital. If a

project's IRR exceeds the firm's cost of capital, the project must be creating

wealth for the firm. The project would produce returns greater than the firm's

financing costs, and the spread would be adding wealth for the investors. Unfortunately,

the IRR rule frequently breaks down and gives misleading advice.

The IRR rule suffers from two f laws. First, it ignores the relative sizes of

alternative projects. For example, suppose a firm had to choose between two

projects, each of which lasts one year. The first project costs $10,000 to set up

but then pays back $16,000 one year later. The second project costs $100,000

to set up but pays back $120,000 one year later. Clearly the IRR of the first

project is 60%, and the IRR of the second project is 20%. On the basis of IRR

the first project seems to be superior. However, if the firm's cost of capital is

10%, the first project has an NPV of $4,454, whereas the second project has

an NPV of $9,091. Clearly the second project creates more wealth. The first

project has a higher rate of return but on a smaller investment. The second

project's lower return on a larger scale is a better use of the firm's scarce

managerial resources.

The second f law in the IRR rule stems from the fact that a given project

may have multiple IRRs. IRR is not always a single, unique value. Consider a

two-year project. Initially the project costs $1,000 to set up. In the first year it

returns $3,000. In the second year there is a cleanup costing $2,000. It is easy

to verify that 0% is one correct value for the firm's IRR: Discounting at 0%

and adding up all the discounted cash f lows gives an NPV of zero. Notice, however,

that 100% is another correct value for the IRR: Discounting all cash

flows at 100% per year also gives an NPV of zero. If the firm's cost of capital

is 10%, should this project be accepted or rejected? Ten percent is greater than

0%, but less than 100%. Only by computing the NPV at the discount rate of

10% do we find out that this project has a positive NPV of $74 and so should be

Planning Capital Expenditure 311

accepted. When a project has two or more IRRs, the analyst would have no way

of knowing which was the correct one to use if he or she did not also compute

the NPV and apply the NPV rule. If the analyst only computed the IRR of

100%, then she or he would reject this valuable project.

It turns out that a project will have one IRR for every change in sign in its

cash f lows. If a project has an initial outlay and then subsequently all cash

f lows are positive inf lows, there will be one unique IRR. If a project has an

initial outlay, a string of positive inf lows, and then a cleanup cost at the end,

there will be two IRRs since the direction of cash flow changed twice. If there

were an initial outlay, a positive inflow, another net outflow during a retooling

year, followed by a positive inflow, the three sign changes would produce three

different IRRs. The IRR rule would provide little guidance in such a scenario

and could possibly lead to an incorrect judgment of the project's worth.

In situations where its two fatal f laws are not an issue, the IRR rule gives

the same result as the NPV rule. If the project's cash flows change sign only

once, there is no problem of multiple IRRs. If all competing projects are of the

same magnitude or if there is only one project under consideration, the size

issue will not be a problem either. In such a situation, the firm would be justified

in selecting the project on the basis of IRR.

One circumstance in which alternative projects are of equal size and cash

flows only change direction once is in the analysis of alternative mortgage

plans. These days, a person financing a home may choose from a multitude of

mortgage plans. A variety of payment schedules are available and some plans

charge points in exchange for lower monthly payments. Since all mortgages

considered by the homebuyer finance the same house, the size issue is not a

concern. Also, the typical home mortgage involves a cash inf low at the beginning

and then only cash outf lows over the period when the borrower must pay

back the loan. Thus, there is only one sign change among the cash f lows. A borrower

can thus compare mortgages on the basis of their IRRs. The borrower

should calculate the cash flows over the horizon during which he or she expects

to pay back the mortgage, and should then choose the lowest IRR mortgage

from among those whose monthly payments are affordable. The annual

percentage rate (APR) quoted by mortgage companies is the IRR of the mortgage

calculated after factoring in points and origination fees and assuming the

mortgage will not be prepaid.

RECENT INNOVATIONS IN CAPITAL BUDGETING

Recent years have seen the introduction of two new capital budgeting paradigms.

The fact that new approaches are still being invented tells us that NPV

is not the last word in capital budgeting. Analysts and investors are constantly

looking for better tools for making long-range capital decisions. One new approach,

known as economic value added (EVA), was introduced by the consulting

firm Stern Stewart & Company, which owns the term as a registered

312 Planning and Forecasting

trademark. The second new paradigm we will brief ly examine is known as "real

options."

Economic Value Added

Economic value added (EVA™) is an accounting metric that aims to capture

how much wealth a company creates in a given year. EVA is the amount of invested

capital multiplied by the spread between the company's return on invested

capital and its cost of capital. EVA aims to measure wealth creation in a

given year rather than over the life of a project. EVA's advocates advise managers

to adopt projects that maximize EVA and manage projects so as to maximize

EVA each year. Managers should monitor projects and make modifications,

award incentives, and impose penalties to continuously boost EVA.

Real Options

The real options paradigm seeks to measure not only the value of a project's

forecasted cash flows but also the value of strategic f lexibility that a project

creates for a company. For example, suppose a company is contemplating an initiative

to market its wares on the Internet. The forecast cash flows may be

weak, but establishing a presence on the Internet may be valuable in that it

wards off potential competition and creates opportunities that can later be exploited.

The option to expand or the f lexibility to later pursue a wide range of

initiatives is captured using the real option paradigm, whereas the value of

these options is usually missed completely in the standard NPV approach. The

real options paradigm entails identifying the strategic options inherent in a proposed

project and then valuing them using modern mathematical optionpricing

formulas. If the value of a proposed project complete with its real

options is greater than the cost of initiating the project, then the project should

be given the go-ahead.

SUMMARY AND CONCLUSIONS

Capital budgeting is the process by which a firm chooses which projects to

adopt and which to reject. It is an extremely important endeavor because it ultimately

shapes the firm and the economy as a whole. The fundamental principal

underlying capital budgeting is that a firm should adopt the projects that

create the most wealth. Net present value (NPV) measures how much wealth a

project creates. NPV is computed by forecasting a project's cash f lows, discounting

those cash f lows at the project's weighted average cost of capital

(WACC), and then summing the discounted cash flows. The cost of capital

used to discount the cash f lows is a function of the riskiness of the project and

the financing mix selected.

Planning Capital Expenditure 313

Measures such as payback period, discounted payback period, and internal

rate of return (IRR) give rise to alternative project decision rules. These

rules, however, are f lawed and can potentially lead a company to adopt an inferior

project or reject an optimal one. Economic value added is a new tool recently

introduced to help managers choose among projects and then manage

the projects once started. The real options paradigm is another recent innovation

that aims to capture the value of strategic f lexibility created by projects.

The tools of capital budgeting can be applied to large-scale corporate decisions,

such as whether or not to build a new plant, but they can also be applied

to smaller personal decisions, such as which home mortgage program to choose

or whether to invest in new office equipment. Learning the language and tools

of capital budgeting can help entrepreneurs better pitch their projects to investors

or to the top executives at their own firms. Whether the decision is

large or small, the fundamental principle is the same: A good project is ultimately

worth more than it costs to set up and thereby generates wealth.

FOR FURTHER READING

Amram, Martha, and Nalin Kulatilaka, Real Options: Managing Strategic Investment

in an Uncertain World (Boston: Harvard Business School Press, 1999).

Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-Hall,

2000).

Brealey, Richard A., and Stewart C. Myers, Principles of Corporate Finance (New

York: Irwin/McGraw-Hill, 2000).

Brigham, Eugene F., Michael C. Ehrhardt, and Louis C. Gapenski, Financial Management:

Theory and Practice (New York: Dryden Press, 1999).

Dixit, Avinash K., and Robert S. Pindyck, "The Options Approach to Capital Investment,"

Harvard Business Review, 73(3) (May/June 1995): 105–115.

Emery, Douglas R., and John D. Finnerty, Corporate Financial Management (Upper

Saddle River, NJ: Prentice-Hall, 1997).

Higgins, Robert C., Analysis for Financial Management (New York: Irwin/McGraw-

Hill, 2001).

Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance

(New York: Irwin/McGraw-Hill, 1999).

Trigeorgis, Lenos, Real Options: Managerial Flexibility and Strategy in Resource Allocation

(Cambridge, MA: MIT Press, 1997).

NOTE

1. This is one definition of ROA; another definition is net earnings divided by

total assets. Given the second definition, ROA would be affected by leverage.

314

11

TAXES AND

BUSINESS

DECISIONS

Richard P. Mandel

It is not possible to fully describe the federal taxation system in the space of

one book chapter. It may not even be realistic to attempt to describe federal

taxation in a full volume. After all, a purchaser of the Internal Revenue Code

(the Code) can expect to carry home at least two volumes consisting of more

than 6,000 pages, ranging from Section 1 through Section 9,722, if one includes

the estate and gift tax and administrative provisions. And this does not even

begin to address the myriad Regulations, Revenue Rulings, Revenue Procedures,

Technical Advice Memoranda, private letter rulings, court decisions,

and other sources of federal tax law that have proliferated over the better part

of the twentieth century.

Fortunately, most people who enroll in a federal tax course during their

progression toward an MBA have no intention of becoming professional tax

advisers. An effective tax course, therefore, rather than attempting to impart

encyclopedic knowledge of the Code, instead presents taxation as another

strategic management tool, available to the manager or entrepreneur in his or

her quest to reach business goals in a more efficient and cost-effective manner.

After completing such a course, the businessperson should always be conscious

that failure to consider tax consequences when structuring a transaction may

result in needless tax expense.

It is thus the purpose of this chapter to illustrate the necessity of taking

taxation into account when structuring most business transactions, and of consulting

tax professionals early in the process, not just when it is time to file the

return. This purpose will be attempted by describing various problems and opportunities

encountered by a fictitious business owner as he progresses from

Taxes and Business Decisions 315

early successes, through the acquisition of a related business, to intergenerational

succession problems.

THE BUSINESS

We first encounter our sample business when it has been turning a reasonable

profit for the past few years under the wise stewardship of its founder and sole

stockholder, Morris. The success of his wholesale horticultural supply business

(Plant Supply Inc.) has been a source of great satisfaction to Morris, as has the

recent entry into the business of his daughter, Lisa. Morris paid Lisa's business

school tuition, hoping to groom her to take over the family business, and his investment

seems to be paying off as Lisa has become more and more valuable to

her father. Morris (rightly or wrongly) does not feel the same way about his

only other offspring, his son, Victor, the violinist, who appears to have no interest

whatsoever in the business except for its potential to subsidize his attempts

to break into the concert world.

At this time, Morris was about to score another coup: Plant Supply purchased

a plastics molding business so it could fabricate its own trays, pots, and

other planting containers instead of purchasing such items from others. Morris

considered himself fortunate to secure the services of Brad (the plant manager

of the molding company) because neither he nor Lisa knew very much about

the molding business. He was confident that negotiations then underway would

bring Brad aboard with a satisfactory compensation package. Thus, Morris

could afford to turn his attention to the pleasant problem of distributing the

wealth generated by his successful business.

UNREASONABLE COMPENSATION

Most entrepreneurs long for the day when their most pressing problem is figuring

out what to do with all the money their business is generating. Yet this very

condition was now occupying Morris's mind. Brad did not present any problems

in this context. His compensation package would be dealt with through ongoing

negotiations, and, of course, he was not family. But Morris was responsible for

supporting his wife and two children. Despite what Morris perceived as the

unproductive nature of Victor's pursuits, Morris was determined to maintain

a standard of living for Victor befitting the son of a captain of industry. Of

course, Lisa was also entitled to an aff luent lifestyle, but surely she was additionally

entitled to extra compensation for her long hours at work.

The simple and natural reaction to this set of circumstances would be to

pay Lisa and Morris a reasonable salary for their work and have the corporation

pay the remaining distributable profit (after retaining whatever was necessary

for operations) to Morris. Morris could then take care of his wife and Victor as

he saw fit. Yet such a natural reaction would ignore serious tax complications.

316 Planning and Forecasting

The distribution to Morris beyond his reasonable salary would likely be

characterized by the IRS as a dividend to the corporation's sole stockholder.

Since dividends cannot be deducted by the corporation as an expense, both the

corporation and Morris would pay tax on these monies (the well-known bugaboo

of corporate double taxation). A dollar of profit could easily be reduced to

as little as $0.40 of after-tax money in Morris's pocket (Exhibit 11.1).

Knowing this, one might argue that the distribution to Morris should be

characterized as a year-end bonus. Since compensation is tax deductible to the

corporation, the corporate level of taxation would be removed. Unfortunately,

Congress has long since limited the compensation deduction to a "reasonable"

amount. The IRS judges the reasonableness of a payment by comparing it to

the salaries paid to other employees performing similar services in similar

businesses. It also examines whether such amount is paid as regular salary or as

a year-end lump sum when profit levels are known. The scooping up by Morris

of whatever money was not nailed down at the end of the year would surely

come under attack by an IRS auditor. Why not then put Victor on the payroll

directly, thus reducing the amount that Morris must take out of the company

for his family? Again, such a payment would run afoul of the reasonableness

standard. If Morris would come under attack despite his significant efforts for

the company, imagine attempting to defend payments made to an "employee"

who expends no such efforts.

Subchapter S

The solution to the unreasonable compensation problem may lie in a relatively

well-known tax strategy known as the subchapter S election. A corporation

making this election remains a standard business corporation for all purposes

other than taxation (retaining its ability to grant limited liability to its stockholders,

for example). The corporation elects to forgo taxation at the corporate

level and to be taxed similarly to a partnership. This means that a corporation

that has elected subchapter S status will escape any taxation on the corporate

level, but its stockholders will be taxed on their pro rata share of the corporation's

profits, regardless of whether these profits are distributed to them.

Under this election, Morris's corporation would pay no corporate tax, but Morris

would pay income tax on all the corporation's profits, even those retained

for operations.

EXHIBIT 11.1 Double taxation.

$1.00 Earned

−0.34 Corporate tax at 34%

0.66 Dividend

−0.25 Individual tax at 39.1%*

0.41 Remains

* Highest federal income tax rate in 2001.

Taxes and Business Decisions 317

This election is recommended in a number of circumstances. One example

is the corporation that expects to incur losses, at least in its start-up phase.

In the absence of a subchapter S election, such losses would simply collect at

the corporate level, awaiting a time in the future when they could be "carried

forward" to offset future profits (should there ever be any). If the election is

made, the losses would pass through to the stockholders in the current year and

might offset other income of these stockholders such as interest, dividends

from investments, and salaries.

Another such circumstance is when a corporation expects to sell substantially

all its assets sometime in the future in an acquisition transaction. Since

the repeal of the so-called General Utilities doctrine, such a corporation would

incur a substantial capital gain tax on the growth in the value of its assets from

their acquisition to the time of sale, in addition to the capital gain tax incurred

by its stockholders when the proceeds of such sale are distributed to them.

The subchapter S election (if made early enough), again eliminates tax at the

corporate level, leaving only the tax on the stockholders.

The circumstance most relevant to Morris is the corporation with too

much profit to distribute as reasonable salary and bonuses. Instead of fighting

the battle of reasonableness with the IRS, Morris could elect subchapter S status,

thus rendering the controversy moot. It will not matter that the amount

paid to him is too large to be anything but a nondeductible dividend, because it

is no longer necessary to be concerned about the corporation's ability to deduct

the expense. Not all corporations are eligible to elect subchapter S status.

However, contrary to a common misconception, eligibility has nothing to do

with being a "small business." In simplified form, to qualify for a subchapter S

election, the corporation must have 75 or fewer stockholders holding only one

class of stock, all of whom must be individuals who are either U.S. citizens or

resident aliens. Plant Supply qualifies on all these counts.

Alternatively, many companies have accomplished the same tax results,

while avoiding the eligibility limitations of subchapter S, by operating as limited

liability companies (LLCs). Unfortunately for Morris, however, a few

states require LLCs to have more than one owner.

Under subchapter S, Morris can pay himself and Lisa a reasonable salary

and then take the rest of the money either as salary or dividend without fear of

challenge. He can then distribute that additional money between Lisa and Victor,

to support their individual lifestyles. Thus, it appears that the effective use

of a strategic taxation tool has solved an otherwise costly problem.

Gif t Tax

Unfortunately, like most tax strategies, the preceding solution may not be cost

free. It is always necessary to consider whether the solution of one tax problem

may create others, sometimes emanating from taxes other than the income tax.

To begin with, Morris needs to be aware that under any strategy he adopts, the

gifts of surplus cash he makes to his children may subject him to a federal gift

318 Planning and Forecasting

tax. This gift tax supplements the federal estate tax, which imposes a tax on the

transfer of assets from one generation to the next. Lifetime gifts to the next

generation would, in the absence of a gift tax, frustrate estate tax policy. Fortunately,

to accommodate the tendency of individuals to make gifts for reasons

unrelated to estate planning, the gift tax exempts gifts by a donor of up to

$10,000 per year to each of his or her donees. That amount will be adjusted for

inf lation as years go by. Furthermore it is doubled if the donor's spouse consents

to the use of her or his $10,000 allotment to cover the excess. Thus, Morris

could distribute up to $20,000 in excess cash each year to each of his two

children if his wife consented.

In addition, the federal gift tax does not take hold until the combined

total of taxable lifetime gifts in excess of the annual exclusion amount exceeds

$675,000 in 2001. This amount will increase to $1 million in 2002. Thus, Morris

can exceed the annual $20,000 amount by quite a bit before the government

will get its share.

These rules may suggest an alternate strategy to Morris under which he

may transfer some portion of his stock to each of his children and then have

the corporation distribute dividends to him and to them directly each year.

The gift tax would be implicated to the extent of the value of the stock in the

year it is given, but, from then on, no gifts would be necessary. Such a strategy,

in fact, describes a fourth circumstance in which the subchapter S election is

recommended: when the company wishes to distribute profits to nonemployee

stockholders for whom salary or bonus in any amount would be considered

excessive. In such a case, like that of Victor, the owner of the company can

choose subchapter S status for it, make a gift to the nonemployee of stock, and

adopt a policy of distributing annual dividends from profits, thus avoiding any

challenge to a corporate deduction based on unreasonable compensation.

MAKING THE SUBCHAPTER S ELECTION

Before Morris rushes off to make his election, however, he should be aware of

a few additional complications. Congress has historically been aware of the potential

for corporations to avoid corporate-level taxation on profits and capital

gains earned prior to the subchapter S election but not realized until afterward.

Thus, for example, if Morris's corporation has been accounting for its

inventory on a last in, first out (LIFO) basis in an inf lationary era (such as virtually

any time during the past 50 years), taxable profits have been depressed

by the use of higher cost inventory as the basis for calculation. Earlier lowercost

inventory has been left on the shelf (from an accounting point of view),

waiting for later sales. However, if those later sales will now come during a

time when the corporation is avoiding tax under subchapter S, those higher taxable

profits will never be taxed at the corporate level. Thus, for the year just

preceding the election, the Code requires recalculation of the corporation's

profits on a first in, first out (FIFO) inventory basis to capture the amount

Taxes and Business Decisions 319

that was postponed. If Morris has been using the LIFO method, his subchapter

S election will carry some cost.

Similarly, if Morris's corporation has been reporting to the IRS on a cash

accounting basis, it has been recognizing income only when collected, regardless

of when a sale was actually made. The subchapter S election, therefore, affords

the possibility that many sales made near the end of the final year of

corporate taxation will never be taxed at the corporate level, because these receivables

will not be collected until after the election is in effect. As a result,

the IRS requires all accounts receivable of a cash-basis taxpayer to be taxed as

if collected in the last year of corporate taxation, thus adding to the cost of

Morris's subchapter S conversion.

Of course, the greatest source of untapped corporate tax potential lies in

corporate assets that have appreciated in value while the corporation was subject

to corporate tax but are not sold by the corporation until after the subchapter

S election is in place. In the worst nightmares of the IRS, corporations

that are about to sell all their assets in a corporate acquisition first elect subchapter

S treatment and then immediately sell out, avoiding millions of dollars

of tax liability.

Fortunately for the IRS, Congress has addressed this problem by imposing

taxation on the corporate level of all so-called built-in gain realized by a

converted S corporation within the first 10 years after its conversion. Built-in

gain is the untaxed appreciation that existed at the time of the subchapter S

election. It is taxed not only upon a sale of all the corporation's assets, but any

time the corporation disposes of an asset it owned at the time of its election.

This makes it advisable to have an appraisal done for all the corporation's assets

as of the first day of subchapter S status, so that there is some objective

basis for the calculation of built-in gain upon sale somewhere down the line.

This appraisal will further deplete Morris's coffers if he adopts the subchapter

S strategy. Despite these complications, however, it is still likely that Morris

will find the subchapter S election to be an attractive solution to his family and

compensation problems.

Pass-Through Entity

Consider how a subchapter S corporation might operate were the corporation

to experience a period during which it were not so successful. Subchapter S

corporations (as well as most LLCs, partnerships, and limited partnerships) are

known as pass-through entities because they pass through their tax attributes

to their owners. This feature not only operates to pass through profits to the tax

returns of the owners (whether or not accompanied by cash) but also results in

the pass-through of losses. As discussed earlier, these losses can then be used

by the owners to offset income from other sources rather than having the losses

frozen on the corporate level, waiting for future profit.

The Code, not surprisingly, places limits on the amount of loss which can

be passed through to an owner's tax return. In a subchapter S corporation, the

320 Planning and Forecasting

amount of loss is limited by a stockholder's basis in his investment in the corporation.

Basis includes the amount invested as equity plus any amount the

stockholder has advanced to the corporation as loans. As the corporation operates,

the basis is raised by the stockholder's pro rata share of any profit made

by the corporation and lowered by his pro rata share of loss and any distributions

received by him.

These rules might turn Morris's traditional financing strategy on its head

the next time he sits down with the corporation's bank loan officer to negotiate

an extension of the corporation's financing. In the past, Morris has always attempted

to induce the loan officer to lend directly to the corporation. This way

Morris hoped to escape personal liability for the loan (although, in the beginning

he was forced to give the bank a personal guarantee). In addition, the corporation

could pay back the bank directly, getting a tax deduction for the

interest. If the loan were made to Morris, he would have to turn the money

over to the corporation and then depend upon the corporation to generate

enough profit so it could distribute monies to him to cover his personal debt

service. He might try to characterize those distributions to him as repayment

of a loan he made to the corporation, but, given the amount he had already advanced

to the corporation in its earlier years, the IRS would probably object to

the debt to equity ratio and recharacterize the payment as a nondeductible

dividend fully taxable to Morris. We have already discussed why Morris would

prefer to avoid characterizing the payment as additional compensation: His

level of compensation was already at the outer edge of reasonableness.

Under the subchapter S election, however, Morris no longer has to be

concerned about characterizing cash f low from the corporation to himself in a

manner that would be deductible by the corporation. Moreover, if the loan is

made to the corporation, it does not increase Morris's basis in his investment

(even if he has given a personal guarantee). This fact limits his ability to pass

losses through to his return. Thus, the subchapter S election may result in the

unseemly spectacle of Morris begging his banker to lend the corporation's

money directly to him, so that he may in turn advance the money to the corporation

and increase his basis. This would not be necessary in an LLC, since

most loans advanced to this form of business entity increase the basis of its

owners.

Passive Losses

No discussion of pass-through entities should proceed without at least touching

on what may have been the most creative set of changes made to the Code in recent

times. Prior to 1987, an entire industry had arisen to create and market

business enterprises whose main purpose was to generate losses to pass through

to their wealthy investor/owners. These losses, it was hoped, would normally be

generated by depreciation, amortization, and depletion. These would be mere

paper losses, incurred while the business itself was breaking even or possibly

generating positive cash flow. They would be followed some years in the future

Taxes and Business Decisions 321

by a healthy long-term capital gain. Thus, an investor with high taxable income

could be offered short-term pass-through tax losses with a nice long-term gain

waiting in the wings. In those days, long-term capital gain was taxed at only 40%

of the rate of ordinary income, so the tax was not only deferred but substantially

reduced. These businesses were known as tax shelters.

The 1986 Act substantially reduced the effectiveness of the tax shelter by

classifying taxable income and loss in three major categories: active, portfolio,

and passive. Active income consists mainly of wages, salaries, and bonuses;

portfolio income is mainly interest and dividends; while passive income and

loss consist of distributions from the so-called pass-through entities, such as

LLCs, limited partnerships, and subchapter S corporations. In their simplest

terms, the passive activity loss rules add to the limits set by the earlier described

basis limitations (and the similar so-called at-risk rules), making it impossible

to use passive losses to offset active or portfolio income. Thus, tax

shelter losses can no longer be used to shelter salaries or investment proceeds;

they must wait for the taxpayer's passive activities to generate the anticipated

end-of-the-line gains or be used when the taxpayer disposes of a passive activity

in a taxable transaction (see Exhibit 11.2).

Fortunately for Morris, the passive activity loss rules are unlikely to affect

his thinking for at least two reasons. First, the Code defines a passive activity

as the conduct of any trade or business "in which the taxpayer does not

materially participate." Material participation is further defined in a series of

Code sections and Temporary Regulations (which mock the concept of tax

simplification but let Morris off the hook) to include any taxpayer who participates

in the business for more than 500 hours per year. Morris is clearly materially

participating in his business despite his status as a stockholder of a

subchapter S corporation, and thus the passive loss rules do not apply to him.

EXHIBIT 11.2 Passive activity losses.

Active Portfolio Passive

Material

participation

Pass-throughs

from

partnerships,

Subchapter S,

LLCs, and so on

Passive loss

Salary,

bonus,

and so on

Interest,

dividends,

and so on

322 Planning and Forecasting

The second reason Morris is not concerned is that he does not anticipate any

losses from this business; historically, it is very profitable. Therefore, let us depart

from this detour into unprofitability and consider Morris's acquisition of

the plastics plant.

ACQUISITION

Morris might well believe that the hard part of accomplishing a successful acquisition

is locating an appropriate target and integrating it into his existing operation.

Yet, once again, he would be well advised to pay some attention to the

various tax strategies and results available to him when structuring the acquisition

transaction.

To begin with, Morris has a number of choices available to him in acquiring

the target business. Simply put, these choices boil down to a choice among

acquiring the stock of the owners of the business, merging the target corporation

into Plant Supply, or purchasing the assets and liabilities of the target. The

choice of method will depend on a number of factors, many of which are not

tax related. For example, acquisition by merger will force Plant Supply to acquire

all the liabilities of the target, even those of which neither it nor the target

may be aware. Acquisition of the stock of the target by Plant Supply also

results in acquisition of all liabilities but isolates them in a separate corporation,

which becomes a subsidiary. (The same result would be achieved by merging

the target into a newly formed subsidiary of Plant Supply—the so-called

triangular merger.) Acquisition of the assets and liabilities normally results

only in exposure to the liabilities Morris chooses to acquire and is thus an attractive

choice to the acquirer (Exhibit 11.3).

Yet tax factors normally play a large part in structuring an acquisition. For

example, if the target corporation has a history of losses and thus boasts a taxloss

carryforward, Morris may wish to apply such losses to its future profitable

operations. This application would be impossible if he acquired the assets and

liabilities of the target for cash since the target corporation would still exist

after the transaction, keeping its tax characteristics to itself. Cash mergers are

treated as asset acquisitions for tax purposes. However, if the acquirer obtains

the stock of the target, the acquirer has taken control of the taxable entity itself,

thus obtaining its tax characteristics for future use. This result inspired a

lively traffic in tax-loss carryforwards in years past, where failed corporations

were marketed to profitable corporations seeking tax relief.

Congress has put a damper on such activity by limiting the use of a taxloss

carryforward in each of the years following an ownership change of more

than 50% of a company's stock. The amount of that limit is the product of the

value of the business at acquisition (normally its selling price) times an interest

rate linked to the market for federal treasury obligations. This amount of taxloss

carryforward is available each year, until the losses expire (15 to 20 years

Taxes and Business Decisions 323

after they were incurred). Since a corporation with significant losses would

normally be valued at a relatively low amount, the yearly available loss is likely

to be relatively trivial.

Acquisition of the corporation's assets and liabilities for cash or through a

cash merger eliminates any use by the acquirer of the target's tax-loss carryforward,

leaving it available for use by the target's shell. This may be quite useful

to the target because, as discussed earlier, if it has not elected subchapter S

status for the past 10 years (or for the full term of its existence, if shorter), it is

likely to have incurred a significant gain upon the sale of its assets. This gain

would be taxable at the corporate level before the remaining portion of the

purchase price could be distributed to the target's shareholders (where it will

be taxed again).

EXHIBIT 11.3 Acquisition strategies.

T

Owned by

T's stockholders

Owned by

T's stockholders

Owned by

T's stockholders

Owned by

T's stockholders

Owned by

T's stockholders

Owned by

T's stockholders

Before After

A

Target Acquirer

T

T's assets

T

T

A

A

T

A A

T's assets

Merger

Acquisition

of stock

Purchase

of assets

324 Planning and Forecasting

The acquirer may have lost any carryforwards otherwise available, but it

does obtain the right to carry the acquired assets on its books at the price paid

(rather than the amount carried on the target's books). This is an attractive

proposition because the owner of assets used in business may deduct an annual

amount corresponding to the depreciation of those assets, subject only to the requirement

that it lower the basis of those assets by an equal amount. The amount

of depreciation available corresponds to the purchase price of the asset. This is

even more attractive because Congress has adopted available depreciation

schedules that normally exceed the rate at which assets actually depreciate.

Thus, these assets likely have a low basis in the hands of the target (resulting in

even more taxable gain to the target upon sale). If the acquirer were forced to

begin its depreciation at the point at which the target left off (as in a purchase of

stock), little depreciation would likely result. All things being equal (and especially

if the target has enough tax-loss carryforward to absorb any conceivable

gain), Morris would likely wish to structure his acquisition as an asset purchase

and allocate all the purchase price among the depreciable assets acquired.

This last point is significant because Congress does not recognize all assets

as depreciable. Generally speaking, an asset will be depreciable only if it

has a demonstrable "useful life." Assets that will last forever or whose lifetime

is not predictable are not depreciable, and the price paid for them will not result

in future tax deductions. The most obvious example of this type of asset is

land. Unlike buildings, land has an unlimited useful life and is not depreciable.

This distinction has spawned some very creative theories, including one enterprising

individual who purchased a plot of land containing a deep depression

that he intended to use as a garbage dump. The taxpayer allocated a significant

amount of his purchase price to the depression and took depreciation deductions

as the hole filled up.

Congress has recognized that the above rules give acquirers incentive to

allocate most of their purchase price to depreciable assets like buildings and

equipment and very little of the price to nondepreciable assets such as land.

Additional opportunities include allocating high prices to acquired inventory so

that it generates little taxable profit when sold. This practice has been limited

by legislation requiring the acquirer to allocate the purchase price in accordance

with the fair market value of the individual assets, applying the rest to

goodwill (which may now be depreciated over 15 years).

Although this legislation will limit Morris's options significantly, if he

chooses to proceed with an asset purchase, he should not overlook the opportunity

to divert some of the purchase price to consulting contracts for the previous

owners. Such payments will be deductible by Plant Supply over the life of

the agreements and are, therefore, just as useful as depreciation. However, the

taxability of such payments to the previous owners cannot be absorbed by the

target's tax-loss carryforward. And the amount of such deductions will be limited

by the now familiar "unreasonable compensation" doctrine. Payments for

agreements not to compete are treated as a form of goodwill and are deductible

over 15 years regardless of the length of such agreements.

Taxes and Business Decisions 325

EXECUTIVE COMPENSATION

Brad's compensation package raises a number of interesting tax issues that may

not be readily apparent but deserve careful consideration in crafting an offer to

him. Any offer of compensation to an executive of his caliber will include, at

the very least, a significant salary and bonus package. These will not normally

raise any sophisticated tax problems; the corporation will deduct these payments,

and Brad will be required to include them in his taxable income. The

IRS is not likely to challenge the deductibility of even a very generous salary,

since Brad is not a stockholder or family member and, thus, there is little likelihood

of an attempt to disguise a dividend.

Business Expenses

However, even in the area of salary, there are opportunities for the use of tax

strategies. For example, Brad's duties may include the entertainment of clients

or travel to suppliers and other business destinations. Brad could conceivably

fund these activities out of his own pocket on the theory that such amounts

have been figured into his salary. Such a procedure avoids the need for the

bookkeeping associated with expense accounts. If his salary ref lects these expectations,

Brad may not mind declaring the extra amount as taxable income,

since he will be entitled to an offsetting deduction for these business expenses.

Unfortunately, however, Brad would be in for an unpleasant surprise

under these circumstances. First of all, these expenses may not all be deductible

in full. Meals and entertainment expenses are deductible, if at all, only

to the extent they are not "lavish and extravagant," and even then they are deductible

only for a portion of the amount expended. In addition, Brad's business

expenses as an employee are considered "miscellaneous deductions"; they

are deductible only to the extent that they and other similarly classified deductions

exceed 2% of Brad's adjusted gross income. Thus, if Brad's adjusted gross

income is $150,000, the first $3,000 of miscellaneous deductions will not be

deductible.

Moreover, as itemized deductions, these deductions are valuable only to

the extent that they along with all other itemized deductions available to Brad

exceed the "standard deduction," an amount Congress allows each taxpayer to

deduct, if all itemized deductions are foregone. Furthermore, until 2010, itemized

deductions that survive the above cuts are further limited for taxpayers

whose incomes are over $132,950 (the 2001 inf lation-adjusted amount). The

deductibility of Brad's business expenses is, therefore, greatly in doubt.

Knowing all this, Brad would be well advised to request that Morris revise

his compensation package. Brad should request a cut in pay by the amount of

his anticipated business expenses, along with a commitment that the corporation

will reimburse him for such expenses or pay them directly. In that case,

Brad will be in the same economic position, since his salary is lowered only

by the amount he would have spent anyway. In fact, his economic position is

326 Planning and Forecasting

enhanced, since he pays no taxes on the salary he does not receive and escapes

from the limitations on deductibility described previously.

The corporation pays out no more money this way than it would have if

the entire amount were salary. From a tax standpoint, the corporation is only

slightly worse off, since the amount it would have previously deducted as salary

can now still be deducted as ordinary and necessary business expenses (with

the sole exception of the limit on meals and entertainment). In fact, were

Brad's salary below the Social Security contribution limit (FICA), both Brad

and the corporation would be better off because what was formerly salary (and

thus subject to additional 7.65% contributions to FICA by both employer and

employee) would now be merely business expenses and exempt from FICA.

Before Brad and Morris adopt this strategy, however, they should be aware

that in recent years, Congress has turned a sympathetic ear to the frustration

the IRS has expressed about expense accounts. Legislation has conditioned the

exclusion of amounts paid to an employee as expense reimbursements upon the

submission by the employee to the employer of reliable documentation of such

expenses. Brad should get into the habit of keeping a diary of such expenses for

tax purposes.

Deferred Compensation

Often, a high-level executive will negotiate a salary and bonus that far exceed

her current needs. In such a case, the executive might consider deferring some

of that compensation until future years. Brad may feel, for example, that he

would be well advised to provide for a steady income during his retirement

years, derived from his earnings while an executive of Plant Supply. He may be

concerned that he would simply waste the excess compensation and consider a

deferred package as a form of forced savings. Or, he may wish to defer receipt

of the excess money to a time (such as retirement) when he believes he will be

in a lower tax bracket. This latter consideration was more common when the

federal income tax law encompassed a large number of tax brackets and the

highest rate was 70%.

Whatever Brad's reasons for considering a deferral of some of his salary,

he should be aware that deferred compensation packages are generally classified

as one of two varieties for federal income tax purposes. The first such

category is the qualified deferred compensation plan, such as the pension,

profit-sharing, or stock bonus plan. All these plans share a number of characteristics.

First and foremost, they afford taxpayers the best of all possible

worlds by granting the employer a deduction for monies contributed to the plan

each year, allowing those contributions to be invested and to earn additional

monies without the payment of current taxes, and taxing the employee only

upon withdrawal of funds in the future. However, in order to qualify for such

favorable treatment, these plans must conform to a bewildering array of conditions

imposed by both the Code and the Employee Retirement Income Security

Act (ERISA). Among these requirements is the necessity to treat all

Taxes and Business Decisions 327

employees of the corporation on a nondiscriminatory basis with respect to the

plan, thus rendering qualified plans a poor technique for supplementing a compensation

package for a highly paid executive.

The second category is nonqualified plans. These come in as many varieties

as there are employees with imaginations, but they all share the same disfavored

tax treatment. The employer is entitled to its deduction only when the

employee pays tax on the money, and if money is contributed to such a plan the

earnings are taxed currently. Thus, if Morris were to design a plan under which

the corporation receives a current deduction for its contributions, Brad will

pay tax now on money he will not receive until the future. Since this is the

exact opposite of what Brad (and most employees) have in mind, Brad will most

likely have to settle for his employer's unfunded promise to pay him the deferred

amount in the future.

Assuming Brad is interested in deferring some of his compensation, he

and Morris might well devise a plan which gives them as much f lexibility as

possible. For example, Morris might agree that the day before the end of each

pay period, Brad could notify the corporation of the amount of salary, if any,

he wished to defer for that period. Any amount thus deferred would be carried

on the books of the corporation as a liability to be paid, per their agreement,

with interest after Brad's retirement. Unfortunately, such an arrangement

would be frustrated by the "constructive receipt" doctrine. Using this potent

weapon, the IRS will impose a tax (allowing a corresponding employer deduction)

on any compensation that the employee has earned and might have chosen

to receive, regardless of whether he so chooses. The taxpayer may not turn his

back upon income otherwise unconditionally available to him.

Taking this theory to its logical conclusion, one might argue that deferred

compensation is taxable to the employee because he might have received it if

he had simply negotiated a different compensation package. After all, the impetus

for deferral in this case comes exclusively from Brad; Morris would have

been happy to pay the full amount when earned. But the constructive receipt

doctrine does not have so extensive a reach. The IRS can tax only monies the

taxpayer was legally entitled to receive, not monies he might have received if

he had negotiated differently. In fact, the IRS will even recognize elective deferrals

if the taxpayer must make the deferral election sufficiently long before

the monies are legally earned. Brad might, therefore, be allowed to choose deferral

of a portion of his salary if the choice must be made at least six months

before the pay period involved.

Frankly, however, if Brad is convinced of the advisability of deferring a

portion of his compensation, he is likely to be concerned less about the irrevocability

of such election than about ensuring that the money will be available to

him when it is eventually due. Thus, a mere unfunded promise to pay in the future

may result in years of nightmares over a possible declaration of bankruptcy

by his employer. Again, left to their own devices, Brad and Morris might well

devise a plan under which Morris contributes the deferred compensation to a

trust for Brad's benefit, payable to its beneficiary upon his retirement. Yet such

328 Planning and Forecasting

an arrangement would be disastrous to Brad, since the IRS would currently assess

income tax to Brad on such an arrangement, using the much criticized "economic

benefit" doctrine. Under this theory, monies irrevocably set aside for

Brad grant him an economic benefit (presumably by improving his net worth or

otherwise improving his creditworthiness) upon which he must pay tax.

If Brad were aware of this risk, he might choose another method to protect

his eventual payout by requiring the corporation to secure its promise to

pay with such devices as a letter of credit or a mortgage or security interest in

its assets. All of these devices, however, have been successfully taxed by the

IRS under the same economic benefit doctrine. Very few devices have survived

this attack. However, the personal guarantee of Morris himself (merely

another unsecured promise) would not be considered an economic benefit by

the IRS.

Another successful strategy is the so-called rabbi trust, a device first

used by a rabbi who feared his deferred compensation might be revoked by a

future hostile congregation. This device works similarly to the trust described

earlier except that Brad would not be the only beneficiary of the

money contributed. Under the terms of the trust, were the corporation to experience

financial reverses, the trust property would be available to the corporation's

creditors. Since the monies are thus not irrevocably committed to

Brad, the economic benefit doctrine is not invoked. This device does not protect

Brad from the scenario of his bankruptcy nightmares, but it does protect

him from a corporate change of heart regarding his eventual payout. From

Morris's point of view, he may not object to contributing to a rabbi trust,

since he was willing to pay all the money to Brad as salary, but he should be

aware that since Brad escapes current taxation the corporation will not receive

a deduction for these expenses until the money is paid out of the trust

in the future.

Interest-Free Loans

As a further enticement to agree to work for the new ownership of the plant,

Morris might additionally offer to lend Brad a significant amount of money to

be used, for example, to purchase a new home or acquire an investment portfolio.

Significant up-front money is often part of an executive compensation

package. While this money could be paid as a bonus, Morris might well want

some future repayment (perhaps as a way to encourage Brad to stay in his new

position). Brad might wish to avoid the income tax bite on such a bonus so he

can retain the full amount of the payment for his preferred use. Morris and

Brad might well agree to an interest rate well below the market or even no interest

at all to further entice Brad to take his new position. Economically, this

would give Brad free use of the money for a period of time during which it

could earn him additional income with no offsetting expense. In a sense, he

would be receiving his salary in advance while not paying any income tax until

he earned it. Morris might well formalize the arrangement by reserving the

Taxes and Business Decisions 329

right to offset loan repayments against future salary. The term of the loan

might even be accelerated should Brad leave the corporation's employ.

This remarkable arrangement was fairly common until fairly recently.

Under current tax law, however, despite the fact that little or no interest passes

between Brad and the corporation, the IRS deems full market interest payments

to have been made and further deems that said amount is returned to

Brad by his employer. Thus, each year, Brad is deemed to have made an interest

payment to the corporation for which he is entitled to no deduction. Then,

when the corporation is deemed to have returned the money to him, he realizes

additional compensation on which he must pay tax. The corporation

realizes additional interest income but gets a compensating deduction for additional

compensation paid (assuming it is not excessive when added to Brad's

other compensation).

Moreover, the IRS has not reserved this treatment for employers and employees

only. The same treatment is given to loans between corporations and

their shareholders and loans between family members. In the latter situation,

although there is no interest deduction for the donee, the deemed return of

the interest is a gift and is thus excluded from income. The donor receives interest

income and has no compensating deduction for the return gift. In fact, if

the interest amount is large enough, he may have incurred an additional gift tax

on the returned interest. The amount of income created for the donor, however,

is limited to the donee's investment income except in very large loans. In

the corporation/stockholder situation, the lender incurs interest income and

has no compensating deduction as its deemed return of the interest is characterized

as a dividend. Thus the IRS gets increased tax from both parties unless

the corporation has elected subchapter S (see Exhibit 11.4).

All may not be lost in this situation, however. Brad's additional income tax

arises from the fact that there is no deduction allowable for interest paid on unsecured

personal loans. Interest remains deductible, however, in limited

amounts on loans secured by a mortgage on either of the taxpayer's principal or

EXHIBIT 11.4 Taxable interest.

Employer

Interest

income

Deductible

compensation

Nondeductible

interest

Taxable

compensation

Employee

Employer

Interest

income

Nondeductible

compensation

Nondeductible

interest

Dividend

income

Stockholder

Employer

Interest

income

Nondeductible

gift (gift tax)

Nondeductible

interest

Nontaxable

gift

Donee

330 Planning and Forecasting

secondary residence. If Brad grants Plant Supply a mortgage on his home to secure

the repayment of his no- or low-interest loan, his deemed payment of

market interest may become deductible mortgage interest and may thus offset

his additional deemed compensation from the imaginary return of this interest.

Before jumping into this transaction, however, Brad will have to consider the

limited utility of itemized deductions described earlier as well as certain limits

on the deductibility of mortgage interest.

SHARING THE EQUITY

If Brad is as sophisticated and valuable an executive employee as Morris believes

he is, Brad is likely to ask for more than just a compensation package, deferred

or otherwise. Such a prospective employee often demands a "piece of

the action," or a share in the equity of the business so that he may directly

share in the growth and success he expects to create. Morris may even welcome

such a demand because an equity share (if not so large as to threaten

Morris's control) may serve as a form of golden handcuffs giving Brad additional

reason to stay with the company for the long term.

Assuming Morris is receptive to the idea, there are a number of different

ways to grant Brad a share of the business. The most direct way would be to

grant him shares of the corporation's stock. These could be given to Brad without

charge, for a discount from fair market value or for their full value, depending

upon the type of incentive Morris wishes to design. In addition, given

the privately held nature of Morris's corporation, the shares would probably

carry restrictions designed to keep the shares from ending up in the hands of

persons who are not associated with the company. Thus, the corporation would

retain the right to repurchase the shares should Brad ever leave the corporation's

employ or want to sell or transfer the shares to a third party. Finally, in

order to encourage Brad to stay with the company, the corporation would probably

reserve the right to repurchase the shares from Brad at cost should Brad's

employment end before a specified time. As an example, all the shares (called

restricted stock) would be subject to forfeiture at cost (regardless of their then

actual value) should Brad leave before one year; two-thirds would be forfeited

if he left before two years; and one-third if he left before three years. The

shares not forfeited (called vested shares) would be purchased by the corporation

at their full value should Brad ever leave or attempt to sell them.

One step back from restricted stock is the stock option. This is a right

granted to the employee to purchase a particular number of shares for a fixed

price over a defined period of time. Because the price of the stock does not

change, the employee has effectively been given the ability to share in whatever

growth the company experiences during the life of the option, without

paying for the privilege. If the stock increases in value, the employee will exercise

the option near the end of the option term. If the stock value does not

grow, the employee will allow the option to expire, having lost nothing. The

Taxes and Business Decisions 331

stock option is a handy device when the employee objects to paying for his

piece of the action (after all, he is expecting compensation, not expense) but

the employer objects to giving the employee stock whose current value represents

growth from the period before the employee's arrival. Again, the exercise

price can be more than, equal to, or less than the fair market value of the stock

at the time of the grant, depending upon the extent of the incentive the employer

wishes to give. Also, the exercisability of the option will likely vest

in stages over time.

Often, however, the founding entrepreneur cannot bring herself to give

an employee a current or potential portion of the corporation's stock. Although

she has been assured that the block of stock going to the employee is too small

to have any effect on her control over the company, the objection may be psychological

and impossible to overcome. Or, in the case of a subchapter S corporation

operating in numerous states, the employee may not want to have to

file state income tax returns in all those jurisdictions. The founder seeks a device

which can grant the employee a growth potential similar to that granted

by stock ownership but without the stock. Such devices are often referred to as

phantom stock or stock appreciation rights (SARs). In a phantom stock plan,

the employee is promised that he may, at any time during a defined period so

long as he remains employed by the corporation, demand payment equal to the

then value of a certain number of shares of the corporation's stock. As the corporation

grows, so does the amount available to the employee just as would be

the case if he actually owned some stock. SARs are very similar except that the

amount available to the employee is limited to the growth, if any, that the

given number of shares has experienced since the date of grant.

Tax Effects of Phantom Stock and SARs

Having described these devices to Morris and Brad, it is, of course, important

to discuss their varying tax impacts upon employer and employee. If Brad has

been paying attention, he might immediately object to the phantom stock and

SARs as vulnerable to the constructive receipt rule. After all, if he may claim

the current value of these devices at any time he chooses, might not the IRS insist

that he include each year's growth in his taxable income as if he had

claimed it? Although the corporation's accountants will require that these devices

be accounted for in that way on the corporation's financial statements,

the IRS has failed in its attempts to require inclusion of these amounts in taxable

income because the monies are not unconditionally available to the taxpayer.

In order to receive the money, one must give up any right to continue to

share in the growth represented by one's phantom stock or SAR. If the right is

not exercisable without cost, the income is not constructively received.

However, there is another good reason for Brad to object to phantom

stock and SARs from a tax point of view. Unlike stock and stock options, both

of which represent a recognized form of intangible capital asset, phantom

stock and SARs are really no different from a mere promise by the corporation

332 Planning and Forecasting

to pay a bonus based upon a certain formula. Since these devices are not recognized

as capital assets, they are not eligible to be taxed as long-term capital

gains when redeemed. This difference is quite meaningful since the maximum

tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is

20%. Thus, Brad may have good reason to reject phantom stock and SARs and

insist on the real thing.

Taxability of Stock Options

If Morris and Brad resolve their negotiations through the use of stock options,

careful tax analysis is again necessary. The Code treats stock options in three

ways depending on the circumstances, and some of these circumstances are

well within the control of the parties (see Exhibit 11.5).

If a stock option has a "readily ascertainable value," the IRS will expect

the employee to include in his taxable income the difference between the

value of the option and the amount paid for it (the amount paid is normally

zero). Measured in that way, the value of an option might be quite small, especially

if the exercise price is close or equal to the then fair market value of the

underlying stock. After all, the value of a right to buy $10 of stock for $10 is

only the speculative value of having that right when the underlying value has

increased. That amount is then taxed as ordinary compensation income, and

the employer receives a compensating deduction for compensation paid. When

the employee exercises the option, the Code imposes no tax, nor does the employer

receive any further deduction. Finally, should the employee sell the

stock, the difference between, on the one hand, the price received and on the

other the total of the previously taxed income and the amounts paid for the option

and the stock is included in his income as a capital gain. No deduction is

then granted to the employer since the employee's decision to sell his stock is

not deemed to be related to the employer's compensation policy.

This taxation scenario is normally quite attractive to the employee because

she is taxed upon a rather small amount at first, escapes tax entirely upon

EXHIBIT 11.5 Taxation of stock options.

Grant Exercise Sale

Readily Ascertainable Value

Employee Tax of value No tax Capital gain

Employer Deduction No deduction No deduction

No Readily Ascertainable Value

Employee No tax Tax on spread Capital gain

Employer No deduction Deduction No deduction

ISOP

Employee No tax No tax Capital gain

Employer No deduction No deduction No deduction

Taxes and Business Decisions 333

exercise, and then pays tax on the growth at a time when she has realized cash

with which to pay the tax at a lower long-term capital gain rate. Although the

employer receives little benefit, it has cost the employer nothing in hard assets,

so any benefit would have been a windfall.

Because this tax scenario is seen as very favorable to the employee, the

IRS has been loathe to allow it in most cases. Generally, the IRS will not recognize

an option as having a readily ascertainable value unless the option is

traded on a recognized exchange. Short of that, a case has occasionally been

made when the underlying stock is publicly traded, such that its value is readily

ascertainable. But the IRS has drawn the line at options on privately held

stock and at all options that are not themselves transferable. Since Morris's corporation

is privately held and since he will not tolerate Brad's reserving the

right to transfer the option to a third party, there is no chance of Brad's taking

advantage of this beneficial tax treatment.

The second tax scenario attaches to stock options which do not have a

readily ascertainable value. Since, by definition, one cannot include their value

in income on the date of grant (it is unknown), the Code allows the grant to escape

taxation. However, upon exercise, the taxpayer must include in income

the difference between the then fair market value of the stock purchased

and the total paid for the option and stock. When the purchased stock is later

sold, the further growth is taxed at the applicable rate for capital gain. The employer

receives a compensation deduction at the time of exercise and no deduction

at the time of sale. Although the employee receives a deferral of

taxation from grant to exercise in this scenario, this method of taxation is generally

seen as less advantageous to the employee, since a larger amount of income

is exposed to ordinary income rates, and this taxation occurs at a time

when the taxpayer has still not received any cash from the transaction with

which to pay the tax.

Recognizing the harshness of this result, Congress invented a third taxation

scenario which attaches to incentive stock options (ISOs). The recipient of

such an option escapes tax upon grant of the option and again upon exercise.

Upon sale of the underlying stock, the employee includes in taxable income the

difference between the price received and the total paid for the stock and option

and pays tax on that amount at long-term capital gain rates. This scenario is

extremely attractive to the employee who defers all tax until the last moment

and pays at a lower rate. Under this scenario, the employer receives no deduction

at all, but since the transaction costs him nothing, that is normally not a

major concern. Lest you believe that ISOs are the perfect compensation device,

however, be aware that, although the employee escapes income taxation

upon exercise of the option, the exercise may be deemed taxable under the alternative

minimum tax described later in this chapter.

The Code imposes many conditions upon the grant of an incentive stock

option. Among these are that the options must be granted pursuant to a written

plan setting forth the maximum number of shares available and the class of

employees eligible; only employees are eligible recipients; the options cannot

334 Planning and Forecasting

be transferable; no more than $100,000 of underlying stock may be initially exercisable

in any one year by any one employee; the exercise price of the options

must be no less than the fair market value of the stock on the date of grant; and

the options must expire substantially simultaneously with the termination of

the employee's employment. Perhaps most important, the underlying stock may

not be sold by the employee prior to the expiration of two years from the option

grant date or one year from the exercise date, whichever is later.

This latter requirement has led to what was probably an unexpected consequence.

Assume that Plant Supply has granted an incentive stock option to

Brad. Assume further that Brad has recently exercised the option and has plans

to sell the stock he received. It may occur to Brad that by waiting a year to resell,

he will be risking the vagaries of the market for a tax savings which cannot

exceed 19.1% (the difference between the maximum income-tax rate of 39.1%

and the maximum capital-gain rate of 20%). By selling early, Brad will lose the

chance to treat the option as an incentive stock option but will pay, at worst,

only a marginally higher amount at a time when he does have the money to pay

it. Furthermore, by disqualifying the options, he will be giving his employer a

tax deduction at the time of exercise. An enterprising employee might go so far

as to offer to sell early in exchange for a split of the employer's tax savings.

Tax Impact on Restricted Stock

The taxation of restricted stock is not markedly different from the taxation

of nonqualified stock options without a readily ascertainable value (see Exhibit

11.6). Restricted stock is defined as stock that is subject to a condition

that affects its value to the holder and which will lapse upon the happening of

an event or the passage of time. The Code refers to this as "a substantial risk of

forfeiture." Since the value of the stock to the employee is initially speculative,

the receipt of the stock is not considered a taxable event. In other words, since

Brad may have to forfeit whatever increased value his stock may acquire, if he

leaves the employ of the corporation prior to the agreed time, Congress has allowed

him not to pay the tax until he knows for certain whether he will be able

to retain that value. When the stock is no longer restricted (when it "vests"),

EXHIBIT 11.6 Restricted stock tax impact.

Grant Restriction Removed Sale

Restricted Stock

Employee No tax Tax based on current value Capital gain

Employer No Deduction Deduction No deduction

Restricted Stock 83(b) Election

Employee Tax based on value without No tax Capital gain

restriction

Employer Deduction No deduction No deduction

Taxes and Business Decisions 335

the tax is payable. Of course, Congress is not being entirely altruistic in this

case; the amount taxed when the stock vests is not the difference between

what the employee pays for it and its value when first received by the employee

but the difference between the employee's cost and the stock's value at the

vesting date. If the value of the stock has increased, as everyone involved has

hoped, the IRS receives a windfall. Of course, the employer receives a compensating

deduction at the time of taxation, and further growth between the

vesting date and the date of sale is taxed upon sale at appropriate capital gain

rates. No deduction is then available to the employer.

Recognizing that allowing the employee to pay a higher tax at a later time

is not an unmixed blessing, Congress has provided that an employee who receives

restricted stock may, nonetheless, elect to pay ordinary income tax on

the difference between its value at grant and the amount paid for it, if the employee

files notice of that election within 30 days of the grant date (the socalled

83b election). Thus, the employee can choose for herself which gamble

to accept.

This scenario can result in disaster for the unaware employee. Assume

that Morris and Brad resolve their differences by allowing Brad to have an equity

stake in the corporation, if he is willing to pay for it. Thus, Brad purchases

5% of the corporation for its full value on the date he joins the corporation,

say, $5.00 per share. Since this arrangement still provides incentive in the form

of a share of growth, Morris insists that Brad sell the stock back to the corporation

for $5.00 per share should he leave the corporation before he has been

employed for three years. Brad correctly believes that since he has bought

$5.00 shares for $5.00 he has no taxable income, and he reports nothing on his

income tax return that year.

Brad has failed to realize that despite his paying full price, he has received

restricted stock. As a result, Congress has done him the favor of imposing

no tax until the restrictions lapse. Three years from now, when the shares

may have tripled in value and have finally vested, Brad will discover to his horror

that he must include $10.00 per share in his taxable income for that year.

Despite the fact that he had no income to declare in the year of grant, Brad

must elect to include that nullity in his taxable income for that year by filing

such an election with the IRS within 30 days of his purchase of the stock.

In situations in which there is little difference between the value of stock

and the amount an employee will pay for it (e.g., in start-up companies when

stock has little initial value), a grant of restricted stock accompanied by an 83b

election may be preferable to the grant of an ISO, since it avoids the alternative

minimum tax which may be imposed upon exercise of an ISO.

VACATION HOME

Morris had much reason to congratulate himself on successfully acquiring the

plastics-molding operation as well as securing the services of Brad through an

336 Planning and Forecasting

effective executive compensation package. In fact, the only real disappointment

for Morris was that the closing of the deal was scheduled to take place

during the week in which he normally took his annual vacation.

Some years ago, Morris had purchased a country home for use by himself

and his wife as a weekend getaway and vacation spot. With the press of business,

however, Morris and his wife had been able to use the home only on occasional

weekends and for his two-week summer vacation each year. Morris

always took the same two weeks for his vacation so he could indulge his love of

golf. Each year, during those two weeks, the professional golfers would come to

town for their annual tournament. Hotels were always booked far in advance,

and Morris felt lucky to be able to walk from his home to the first tee and enjoy

his favorite sport played by some of the world's best.

Some of Morris's friends had suggested that Morris rent his place during

the weeks that he and his wife didn't use it. Even if such rentals would not

generate much cash during these off-season periods, it might allow Morris to

deduct some of the expenses of keeping the home, such as real estate taxes,

mortgage payments, maintenance, and depreciation. Morris could see the benefit

in that, since the latter two expenses were deductible only in a business

context. Although taxes and mortgage interest were deductible as personal expenses

(assuming, in the case of mortgage interest, that Morris was deducting

such payments only with respect to this and his principal residence and no

other home), the previously mentioned limits on the use of itemized deductions

made the usefulness of these deductions questionable.

However, in addition to the inconvenience of renting one's vacation home,

Morris had discovered a few unfortunate tax rules which had dissuaded him

from following his friends' advice. First, the rental of a home is treated by the

Code in a fashion similar to the conduct of a business. Thus, Morris would generate

deductions only to the extent that his expenses exceeded his rental income.

In addition, to the extent he could generate such a loss, the rental of real

estate is deemed to be a passive activity under the Code, regardless of how

much effort one puts into the process. Thus, in the absence of any relief provision,

these losses would be deductible only against other passive income and

would not be usable against salary, bonus, or investment income.

Such a relief provision does exist, however, for rental activities in which

the taxpayer is "actively" involved. In such a case, the taxpayer may deduct up

to $25,000 of losses against active or portfolio income, unless his total income

(before any such deduction) exceeds $100,000. The amount of loss which may

be used by such taxpayer, free of the passive activity limitations, is then lowered

by $1 for every $2 of additional income, disappearing entirely at $150,000.

Given his success in business, the usefulness of rental losses, in the absence of

passive income, seemed problematic to Morris, at best.

Another tax rule appeared to Morris to limit the usefulness of losses even

further. Under the Code, a parcel of real estate falls into one of three categories:

personal use, rental use, or mixed use. A personal use property is one

which is rented 14 days or less in a year and otherwise used by the taxpayer and

Taxes and Business Decisions 337

his family. No expenses are deductible for such a facility except taxes and mortgage

interest. A rental use property is used by the taxpayer and his family for

less than 15 days (or 10% of the number of rental days) and otherwise offered

for rental. All the expenses of such an activity are deductible, subject to the

passive loss limitations. A mixed use facility is one that falls within neither of

the other two categories.

If Morris were to engage in a serious rental effort of his property, his occasional

weekend use combined with his two-week stay around the golf tournament

would surely result in his home falling into the mixed use category. This

would negatively impact him in two ways. The expenses that are deductible

only for a rental facility (such as maintenance and depreciation) would be deductible

only on a pro rata basis for the total number of rental days. Worse

yet, the expenses of the rental business would be deductible only to the extent

of the income, not beyond. Expenses which would be deductible anyway (taxes

and mortgage interest) are counted first in this calculation, and only then are

the remaining expenses allowed. The result of all this is that it would be impossible

for Morris to generate a deductible loss, even were it possible to use

such a loss in the face of the passive loss limitations.

Naturally, therefore, Morris had long since decided not to bother with attempting

to rent his country getaway when he was unable to use it. However,

the scheduling of the closing this year presents a unique tax opportunity of

which he may be unaware. In a rare stroke of fairness, the Code, though denying

any deduction of not otherwise deductible expenses in connection with a

home rented for 14 days or less, reciprocates by allowing taxpayers to exclude

any rental income should they take advantage of the 14-day rental window.

Normally, such an opportunity is of limited utility, but with the tournament

coming to town and the hotels full Morris is in a position to make a killing by

renting his home to a golfer or spectator during this time at inf lated rental

rates. All that rental income would be entirely tax-free. Just be sure the tenants

don't stay beyond two weeks.

LIKE-KIND EXCHANGES

Having acquired the desired new business and secured the services of the individual

he needed to run it, Morris turned his attention to consolidating his

two operations so that they might function more efficiently. After some time,

he realized that the factory building acquired with the plastics business was

not contributing to increased efficiency because of its age and, more important,

because of its distance from Morris's home office. Morris located a more

modern facility near his main location that could accommodate both operations

and allow him to eliminate some amount of duplicative management.

Naturally, Morris put the molding facility on the market and planned to

purchase the new facility with the proceeds of the old one plus some additional

capital. Such a strategy will result in a tax on the sale of the older facility equal

338 Planning and Forecasting

to the difference between the sale price and Plant Supply's basis in the building.

If Morris purchased the molding company by merging or purchasing its

assets for cash, then the capital gain to be taxed here may be minimal because

it would consist only of the growth in value since this purchase plus any

amount depreciated after the acquisition. If, however, Morris acquired the

molding company through a purchase of stock, his basis would be the old company's

preacquisition basis, and the capital gain may be considerable. Either

way, it would surely be desirable to avoid taxation on this capital gain.

The Code affords Morris the opportunity to avoid this taxation if, instead

of selling his old facility and buying a new one, he can arrange a trade of the old

for the new so that no cash falls into his hands. Under Section 1031 of the

Code, if properties of "like kind" used in a trade or business are exchanged, no

taxable event has occurred. The gain on the disposition of the older facility is

merely deferred until the eventual disposition of the newer facility. This deferral

is accomplished by calculating the basis in the newer facility, starting with

its fair market value on the date of acquisition, and subtracting from that

amount the gain not recognized on the sale of the older facility. That process

builds the unrecognized gain into the basis of the newer building so that it will

be recognized (along with any future gain) upon its later sale. There has been

considerable confusion and debate over what constitutes like-kind property

outside of real estate, but there is no doubt that a trade of real estate used in

business for other real estate to be used in business will qualify under Section

1031.

Although undoubtedly attracted by this possibility, Morris would quickly

point out that such an exchange would be extremely rare since it is highly unlikely

that he would be able to find a new facility which is worth exactly the

same amount as his old facility, and thus any such exchange would have to involve

a payment of cash as well as an exchange of buildings. Fortunately, however,

Section 1031 recognizes that reality by providing that the exchange is still

nontaxable to Morris so long as he does not receive any non-like-kind property

(i.e., cash). Such non-like-kind property received is known as boot, and would

include, besides cash, any liability of Morris's (such as his mortgage debt) assumed

by the exchange partner. The facility he is purchasing is more expensive

than the one he is selling, so Morris would have to add some cash, not receive

it. Thus, the transaction does not involve the receipt of boot and still qualifies

for tax deferral. Moreover, even if Morris did receive boot in the transaction,

he would recognize gain only to the extent of the boot received, so he might

still be in a position to defer a portion of the gain involved. Of course, if he received

more boot than the gain in the transaction, he would recognize only the

amount of the gain, not the full amount of the boot.

But Morris has an even more compelling, practical objection to this plan.

How often will the person who wants to purchase your facility own the exact facility

you wish to purchase? Not very often, he would surmise. In fact, the proposed

buyer of his old facility is totally unrelated to the current owner of the

facility Morris wishes to buy. How then can one structure this as an exchange of

Taxes and Business Decisions 339

the two parcels of real estate? It would seem that a taxable sale of the one followed

by a purchase of the other will be necessary in almost every case.

Practitioners have, however, devised a technique to overcome this problem,

known as the three-corner exchange. In a nutshell, the transaction is

structured by having the proposed buyer of Morris's old facility use his purchase

money (plus some additional money contributed by Morris) to acquire

the facility Morris wants to buy, instead of giving that money to Morris. Having

thus acquired the new facility, he then trades it to Morris for Morris's old facility.

When the dust settles, everyone is in the same position he would have occupied

in the absence of an exchange. The former owner of the new facility

has his cash; the proposed buyer of Morris's old facility now owns that facility

and has spent only the amount he proposed to spend; and Morris has traded the

old facility plus some cash for the new one. The only party adversely affected is

the IRS, which now must wait to tax the gain in Morris's old facility until he

sells the new one.

This technique appears so attractive that when practitioners first began

to use it, they attempted to employ the technique even when the seller of the

old facility had not yet found a new facility to buy. They merely had the buyer

of the old facility place the purchase price in escrow and promise to use it to

buy a new facility for the old owner as soon as she picked one out. Congress has

since limited the use of these so-called delayed like-kind exchanges by requiring

the seller of the old facility to identify the new facility to be purchased

within 45 days of the transfer of the old one and by further requiring that the

exchange be completed within six months of the first transfer.

DIVIDENDS

Some time after Morris engineered the acquisition of the molding facility, the

hiring of Brad to run it, and the consolidation of his company's operations

through the like-kind exchange, Plant Supply was running smoothly and profitably

enough for Morris's thoughts to turn to retirement. Morris intended to

have a comfortable retirement funded by the fruits of his lifelong efforts on

behalf of the company, so it was not unreasonable for him to consider funding

his retirement through dividends on what would still be his considerable holdings

of the company's stock. Although Brad already held some stock and Morris

expected that Lisa and Victor would hold some at that time, he still expected to

have a majority position and thus sufficient control of the board of directors to

ensure such distributions.

Morris also knew enough about tax law, however, to understand that such

distributions would cause considerable havoc from a tax viewpoint. We have already

discussed how characterizing such distributions as salary or bonus would

avoid double taxation, but with Morris no longer working for the company such

characterization would be unreasonable. These payments would be deemed

dividends on his stock. They would be nondeductible to the corporation (if it

340 Planning and Forecasting

were not a subchapter S corporation at the time) and would be fully taxable to

him. But Morris had another idea. He would embark on a strategy of turning in

small amounts of his stock on a regular basis in exchange for the stock's value.

Although not a perfect solution, the distributions to him would no longer be

dividends but payments in redemption of stock. Thus, they would be taxable

only to the extent they exceeded his basis in the stock and, even then, only at

long-term capital gain rates (not as ordinary income). Best of all, if such redemptions

were small enough, he would retain his control over the company for

as long as he retained over 50% of its outstanding stock.

However, the benefits of this type of plan have attracted the attention of

Congress and the IRS over the years. If an individual can draw monies out of a

corporation, without affecting the control he asserts through the ownership of

his stock, is he really redeeming his stock or simply engaging in a disguised dividend?

Congress has answered this question with a series of Code sections purporting

to define a redemption.

Substantially Disproportionate Distributions

Most relevant to Morris is Section 302(b)(2), which provides that a distribution

in respect of stock is a redemption (and thus taxable as a capital gain after subtraction

of basis), only if it is substantially disproportionate. This is further defined

by requiring that the stockholder hold, after the distribution, less than

half of the total combined voting power of all classes of stock and less than

80% of the percentage of the company's total stock that he owned prior to the

distribution.

Thus, if Morris intended to redeem 5 shares of the company's stock at a

time when he owned 85 of the company's outstanding 100 shares, he would be

required to report the entire distribution as a dividend. His percentage of

ownership would still be 50% or more (80 of 95, or 84%), which in itself dooms

the transaction. In addition, his percentage of ownership will still be 80% or

more than his percentage before the distribution (dropping only from 85% to

84%—99% of his percentage prior to the distribution).

To qualify, Morris would have to redeem 71 shares, since only that

amount would drop his control percentage below 50% (14 of 29, or 48%). And

since his percentage of control would have dropped from 85% to 48%, he

would retain only 56% of the percentage he previously had (less than 80%).

Yet, even such a draconian sell-off as thus described would not be sufficient

for the Code. Congress has taken the position that the stock ownership of

persons other than oneself must be taken into account in determining one's

control of a corporation. Under these so-called attribution rules, a stockholder

is deemed to control stock owned not only by himself but also by his spouse,

children, grandchildren, and parents. Furthermore, stock owned by partnerships,

estates, trusts, and corporations affiliated with the stockholder may also

be attributed to him. Thus, assuming that Lisa and Victor owned 10 of the remaining

15 shares of stock (with Brad owning the rest), Morris begins with

Taxes and Business Decisions 341

95% of the control and can qualify for a stock redemption only by selling all his

shares to the corporation.

Complete Termination of Interest

Carried to its logical conclusion, even a complete redemption would not qualify

for favorable tax treatment, since Lisa and Victor's stock would still be attributed

to Morris, leaving him in control of 67% of the corporation's stock.

Fortunately, however, Code Section 302(b)(3) provides for a distribution to be

treated as a redemption if the stockholder's interest in the corporation is completely

terminated. The attribution rules still apply under this section, but they

may be waived if the stockholder files a written agreement with the IRS requesting

such a waiver. In such an agreement, Morris would be required to divest

himself of any relationship with the corporation other than as a creditor

and agree not to acquire any interest in the corporation for a period of 10 years.

In addition to the two safe harbors described in Sections 302(b)(2) and

(3), the Code, in Section 302(b)(1), grants redemption treatment to distributions

which are "not essentially equivalent to a dividend." Unlike the previous

two sections, however, the Code does not spell out a mechanical test for this

concept, leaving it to the facts and circumstances of the case. Given the obvious

purpose of this transaction to transfer corporate assets to a stockholder on

favorable terms, it is unlikely that the IRS under this section would recognize

any explanation other than that of a dividend.

Thus, Morris's plan to turn in his stock and receive a tax-favored distribution

for his retirement will not work out as planned unless he allows the redemption

of all his stock; resigns as a director, officer, employee, consultant,

and so forth; and agrees to stay away for a period of 10 years. He may, however,

accept a promissory note for all or part of the redemption proceeds and

thereby become a creditor of the corporation. Worse yet, if Lisa obtained her

shares from Morris within the 10 years preceding his retirement, even this

plan will not work unless the IRS can be persuaded that her acquisition of the

shares was for reasons other than tax avoidance. It may be advisable to ensure

that she acquires her shares from the corporation rather than from Morris, although

one can expect, given the extent of Morris's control over the corporation,

that the IRS would fail to appreciate the difference.

Employee Stock Ownership Plans

Although Morris should be relatively happy with the knowledge that he may be

able to arrange a complete redemption of his stock to fund his retirement and

avoid being taxed as if he had received a dividend, he may still believe that the

tax and economic effects of such a redemption are not ideal. Following such a

plan to its logical conclusion, the corporation would borrow the money to pay

for Morris's stock. Its repayments would be deductible only to the extent of the

interest. At the same time, Morris would be paying a substantial capital gain

342 Planning and Forecasting

tax to the government. Before settling for this result, Morris might well wish

to explore ways to increase the corporation's deduction and decrease his own

tax liability.

Such a result can be achieved through the use of an employee stock ownership

plan (ESOP), a form of qualified deferred compensation plan as discussed

earlier in the context of Brad's compensation package. Such a plan

consists of a trust to which the corporation makes deductible contributions of

either shares of its own stock or cash to be used to purchase such stock. Contributions

are divided among the accounts of the corporation's employees (normally

in proportion to their compensation for that year), and distributions are

made to the employees at their retirement or earlier separation from the company

(if the plan so allows). ESOPs have been seen as a relatively noncontroversial

way for U.S. employees to gain more control over their employers, and

they have been granted a number of tax advantages not available to other qualified

plans, such as pension or profit-sharing plans. One advantage is illustrated

by the fact that a corporation can manufacture a deduction out of thin air by issuing

new stock to a plan (at no cost to the corporation) and deducting the fair

market value of the shares.

A number of attractive tax benefits would f low from Morris's willingness

to sell his shares to an ESOP established by his corporation rather than to the

corporation itself. Yet, before he could appreciate those benefits, Morris would

have to be satisfied that some obvious objections would not make such a transaction

inadvisable.

To begin with, the ESOP would have to borrow the money from a bank in

the same way the corporation would; yet the ESOP has no credit record or assets

to pledge as collateral. This is normally overcome, however, by the corporation's

giving the bank a secured guarantee of the ESOP's obligation. Thus,

the corporation ends up in the same economic position it would have enjoyed

under a direct redemption.

Morris might also object to the level of control an ESOP might give to

lower-level employees of Plant Supply. After all, his intent is to leave the corporation

under the control of Lisa and Brad, but qualified plans must be operated

on a nondiscriminatory basis. This objection can be addressed in a number

of ways. First, the allocation of shares in proportion to compensation, along

with standard vesting and forfeiture provisions, will tilt these allocations toward

highly compensated, long-term employees, such as Lisa and Brad. Second,

the shares are not allocated to the employees' accounts until they are paid

for. While the bank is still being paid, an amount proportional to the remaining

balance of the loan would be controlled by the plan trustees (chosen by management).

Third, even after shares are allocated to employee accounts, in a

closely held company, employees are allowed to vote those shares only on questions

which require a two-thirds vote of the stockholders, such as a sale or

merger of the corporation. On all other more routine questions (such as election

of the board) the trustees still vote the shares. Fourth, upon an employee's

retirement and before distribution of his shares, a closely held corporation

Taxes and Business Decisions 343

must offer to buy back the distributed shares at fair market value. As a practical

matter, most employees will accept such an offer rather than moving into

retirement with illiquid, closely held company stock.

If Morris accepts these arguments and opts for an ESOP buyout, the

following benefits accrue. Rather than being able to deduct only the interest

portion of its payments to the bank, the corporation may now contribute the

full amount of such payment to the plan as a fully deductible contribution to

a qualified plan. The plan then forwards it to the bank as a payment of its

obligation.

Furthermore, the Code allows an individual who sells stock of a corporation

to the corporation's ESOP to defer paying any tax on the proceeds of such

sale, if the proceeds are rolled over into purchases of securities. No tax is then

paid until the purchased securities are ultimately resold. Thus, if Morris takes

the money received from the ESOP and invests it in the stock market, he pays

no tax until and unless he sells any of these securities, and then only on those

sold. In fact, if Morris purchases such securities and holds them until his death

(assuming he dies prior to 2010), his estate will receive a step-up in basis for

such securities and thus will avoid income tax on the proceeds of his company

stock entirely (see Exhibit 11.7).

ESTATE PLANNING

Should Morris rebel at the thought of retiring from the company, his thoughts

may naturally turn to the tax consequences of his remaining employed by the

company in some capacity until his death. Morris's lifelong efforts have made

him a rather wealthy man, and he knows that the government will be looking

to reap a rather large harvest from those efforts upon his death. He would no

doubt be rather disheartened to learn that after a $675,000 exemption (which

increases to as much as $3.5 million in 2009), the federal government will receive

37% to anywhere from 45% to 55% of the excess upon his death, depending

upon the year in which he dies. Proper estate planning can double the

amount of that grace amount by using the exemptions of both Morris and his

wife, but the amount above the exemptions appears to be at significant risk. It

should further be noted that the federal estate tax is currently scheduled for repeal

in 2010, but, under current law, will be reinstated in 2011.

EXHIBIT 11.7 Corporate redemption versus ESOP

purchase.

Corporate Redemption ESOP Purchase

Only interest deductible Principal and interest deductible

Capital gain Gain deferred if proceeds rolled over

344 Planning and Forecasting

Redemptions to Pay Death Taxes and

Administrative Expenses

Since much of the money to fund this estate tax liability would come from redemption

of company stock, if Morris had not previously cashed it in, Morris

might well fear the combined effect of dividend treatment and estate taxation.

Of course, if Morris's estate turned in all his stock for redemption at death,

dividend treatment would appear to have been avoided and redemption treatment

under Section 302(b)(3) would appear to be available, since this would

amount to a complete termination of his interest in the company and death

would appear to cut off Morris's relationship with the company rather convincingly.

However, if the effect of Morris's death on the company or of other circumstances

made a wholesale redemption inadvisable or impossible, Morris's

estate could be faced with paying both ordinary income and estate tax rates on

the full amount of the proceeds.

Fortunately for those faced with this problem, Code Section 303 allows

capital gain treatment for a stock redemption if the proceeds of the redemption

do not exceed the amount necessary to pay the estate's taxes and those further

expenses allowable as administrative expenses on the estate's tax return.

To qualify for this treatment, the company's stock must equal or exceed 35% of

the value of the estate's total assets. Since Morris's holdings of company stock

will most likely exceed 35% of his total assets, if his estate finds itself in this

uncomfortable position, it will at least be able to account for this distribution

as a stock redemption instead of a dividend. This is much more important than

it may first appear and much more important than it would have been were

Morris still alive. The effect, of course, is to allow payment at long-term capital

gain rates (rather than ordinary income tax rates) for only the amount received

in excess of the taxpayer's basis in the stock (rather than the entire

amount of the distribution). Given that the death of the taxpayer prior to 2010

increases his basis to the value at date of death, the effect of Section 303 is to

eliminate all but that amount of gain occurring after death, thus eliminating

virtually all income tax on the distribution. This step-up of basis will be significantly

less generous for taxpayer's dying after 2009.

Of course, assuring sufficient liquidity to pay taxes due upon death is one

thing; controlling the amount of tax actually due is another. Valuation of a majority

interest in a closely held corporation is far from an exact science, and the

last thing an entrepreneur wishes is to have his or her spouse and other heirs

engage in a valuation controversy with the IRS after his or her death. As a result,

a number of techniques have evolved over the years which may have the

effect of lowering the value of the stock to be included in the estate or, at least,

making such value more certain for planning purposes.

Family Limited Partnerships

One such technique that has recently gained in popularity is the so-called family

limited partnership. This strategy allows an individual to decrease the size

Taxes and Business Decisions 345

of his taxable estate through gifts to his intended beneficiaries both faster and

at less tax cost than would otherwise be possible, while at the same time retaining

effective control over the assets given away. Were Morris interested in

implementing this strategy, he would form a limited partnership, designating

himself as the general partner and retaining all but a minimal amount of the

limited partnership interests for himself. He would then transfer to the partnership

a significant portion of his assets, such as stock in the company, real estate,

or marketable securities. Even though he would have transferred these

interests out of his name, he would be assured of continued control over these

assets in his role as general partner. The general partner of a limited partnership

exercises all management functions; limited partners sacrifice all control

in exchange for limited liability.

Morris would then embark on a course of gifting portions of the limited

partnership interests to Lisa, Victor, and perhaps even Brad. You will remember

that in each calendar year, Morris and his wife can combine to give no

more than $20,000 to each beneficiary before eating into their lifetime gift tax

exemption. The advantage of the family limited partnership, besides retaining

control over the assets given away, is that the amounts which may be given

each year are effectively increased. For example, were Morris and his wife to

give $20,000 of marketable securities to Lisa in any given year, that would use

up their entire annual gift tax exclusion. However, were they instead to give

Lisa a portion of the limited partnership interest to which those marketable securities

had been contributed, it can be argued that the gift should be valued

at a much lower amount. After all, while there was a ready market for the securities,

there is no market for the limited partnership interests; and while Lisa

would have had control over the securities if they had been given to her, she

has no control of them through her limited partnership interest. These discounts

for lack of marketability and control can be substantial, freeing up more

room under the annual exclusion for further gifting. In proper circumstances,

one might use this technique when owning a rapidly appreciating asset (such as

a pre-IPO stock) to give away more than $20,000 in a year, using up all or part

of the lifetime exclusion, to remove the asset from your estate at a discount

from its present value, rather than having to pay estate tax in the future on a

highly inf lated value.

Of course, the IRS has challenged these arrangements when there was

no apparent business purpose other than tax savings or when the transfer occurred

just before the death of the transferor. And you can expect the IRS to

challenge an overly aggressive valuation discount. But if Morris is careful in his

valuations, he might find this arrangement attractive, asserting the business

purpose of centralizing management while facilitating the grant of equity incentives

to his executive employees.

Buy-Sell Agreements

Short of establishing a family limited partnership, Morris might be interested

in a more traditional arrangement requiring the corporation or its stockholders

346 Planning and Forecasting

to purchase whatever stock he may still hold at his death. Such an arrangement

can be helpful with regard to both of Morris's estate-planning goals: setting a

value for his stock that would not be challenged by the IRS and assuring sufficient

liquidity to pay whatever estate taxes may ultimately be owed.

There are two basic variations of these agreements. Under the most common,

Morris would agree with the corporation that it would redeem his shares

upon his death for a price derived from an agreed formula. The second variation

would require one or more of the other stockholders of the corporation

(e.g., Lisa) to make such a purchase. In both cases, in order for the IRS to respect

the valuation placed upon the shares, Morris will need to agree that he

will not dispose of the shares during his lifetime without first offering them to

the other party to his agreement at the formula price. Under such an arrangement,

the shares will never be worth more to Morris than the formula price, so

it can be argued that whatever higher price the IRS may calculate is irrelevant

to him and his estate.

This argument led some stockholders in the past to agree to formulas that

artificially depressed the value of their shares when the parties succeeding to

power in the corporation were also the main beneficiaries of the stockholders'

estates. Since any value forgone would end up in the hands of the intended beneficiary

anyway, only the tax collector would be hurt. Although the IRS long

challenged this practice, this strategy has been put to a formal end by legislation

requiring that the formula used result in a close approximation to fair market

value.

Which of the two variations of the buy-sell agreement should Morris

choose? If we assume for the moment that Morris owns 80 of the 100 outstanding

shares and Lisa and Brad each own 10, a corporate redemption agreement

leaves Lisa and Brad each owning half of the 20 outstanding shares

remaining. If, however, Morris chooses a cross-purchase agreement with Lisa

and Brad, each would purchase 40 of his shares upon his death, leaving them as

owners of 50 shares each. Both agreements leave the corporation owned by

Lisa and Brad in equal shares, so there does not appear to be any difference between

them.

Once again, however, significant differences lie slightly below the surface.

To begin with, many such agreements are funded by the purchase of a life

insurance policy on the life of the stockholder involved. If the corporation

were to purchase this policy, the premiums would be nondeductible, resulting

in additional taxable profit for the corporation. In a subchapter S corporation,

such profit would pass through to the stockholders in proportion to their shares

of stock in the corporation. In a C corporation, the additional profit would

result in additional corporate tax. If, instead, Lisa and Brad bought policies

covering their halves of the obligation to Morris's estate, they would be paying

the premiums with after-tax dollars. Thus, a redemption agreement will cause

Morris to share in the cost of the arrangement, whereas a cross-purchase

agreement puts the entire onus on Lisa and Brad. This burden can, of course,

be rationalized by arguing that they will ultimately reap the benefit of the

Taxes and Business Decisions 347

arrangement by succeeding to the ownership of the corporation. Or, their compensation

could be adjusted to cover the additional cost.

If the corporation is not an S corporation, however, there is an additional

consideration that must not be overlooked. Upon Morris's death, the receipt of

the insurance proceeds by the beneficiary of the life insurance will be excluded

from taxable income. However, a C corporation (other than certain

small businesses) is also subject to the alternative minimum tax. Simply described,

that tax guards against individuals and profitable corporations paying

little or no tax by "overuse" of certain deductions and tax credits otherwise

available. To calculate the tax, the taxpayer adds to its otherwise taxable income,

certain "tax preferences" and then subtracts from that amount an exemption

amount ($40,000 for most corporations). The result is taxed at 20% for

corporations (26% and 28% for individuals). If that tax amount exceeds the income

tax otherwise payable, the higher amount is paid. The result of this is additional

tax for those taxpayers with substantial tax preferences.

Among those tax preferences for C corporations is a concept known as adjusted

current earnings. This concept adds as a tax preference, three-quarters

of the difference between the corporation's earnings for financial reporting

purposes and the earnings otherwise reportable for tax purposes. A major

source of such a difference would be the receipt of nontaxable income. And the

receipt of life insurance proceeds is just such an event. Therefore, the receipt

of a life insurance payout of sufficient size would ultimately be taxed, at least

in part, to a C corporation, whereas it would be completely tax free to an S corporation

or the remaining stockholders.

An additional factor pointing to the stockholder cross-purchase agreement

rather than a corporate redemption is the effect this choice would have

on the taxability of a later sale of the corporation after Morris's death. If the

corporation were to redeem Morris's stock, Lisa and Brad would each own onehalf

of the corporation through their ownership of 10 shares each. If they then

sold the company, they would be subject to tax on capital gain measured by the

difference between the proceeds of the sale and their original basis in their

shares. However, if Lisa and Brad purchased Morris's stock at his death, they

would each own one-half of the corporation through their ownership of 50

shares each. Upon a later sale of the company, their capital gain would be measured

by the difference between the sale proceeds and their original basis in

their shares plus the amount paid for Morris's shares. Every dollar paid to Morris

lowers the taxable income received upon later sale. In a redemption agreement,

these dollars are lost (see Exhibit 11.8).

SPIN-OFFS AND SPLIT-UPS

Morris's pleasant reverie caused by thoughts of well-funded retirement

strategies and clever estate plans was brought to a sudden halt a mere two

years after the acquisition of the molding operation, when it became clear

348 Planning and Forecasting

that the internecine jealousies between Brad and Lisa were becoming unmanageable.

Ruefully, Morris conceded that it was not unforeseeable that the

manager of a significant part of his business would resent the presence of a

rival who would be perceived as having attained her present position simply

by dint of her relationship to the owner. This jealousy was, of course, inf

lamed by the thought that Lisa might succeed to Morris's stock upon his

death and become Brad's boss.

After some months of attempting to mediate the many disputes between

Lisa and Brad, which were merely symptoms of this underlying disease, Morris

came to the conclusion that the corporation could not survive with both of

them vying for power and inf luence. He determined that the only workable solution

would be to break the two businesses apart once again, leaving the two

rivals in charge of their individual empires, with no future binding ties.

Experienced in corporate transactions by this time, Morris gave the problem

some significant thought and devised two alternate scenarios to accomplish

his goal. Both scenarios began with the establishment of a subsidiary

corporation wholly owned by the currently existing company. The assets, liabilities,

and all other attributes of the molding operation would then be transferred

to this new subsidiary in exchange for its stock. At that point in the first

scenario (known as a spin-off ), the parent corporation would declare a dividend

of all such stock to its current stockholders. Thus, Morris, Lisa, and Brad

EXHIBIT 11.8 Corporate redemption versus cross-purchase agreement.

Corporate Redemption Cross-Purchase

(Assume all parties purchased stock at $100 per share.

Current fair market value, is $200 per share.)

Morris Lisa Brad Morris Lisa Brad

80

shares

10

shares

10

shares

80

shares

10

shares

10

shares

10

shares

10

shares

$8,000 $1,000 $1,000

Cost

$8,000 $8,000

+ +

Total basis: $1,000 $1,000 Total basis: $9,000 $9,000

$8,000 $1,000 $1,000

Cost

Taxes and Business Decisions 349

would own the former subsidiary in the same proportions in which they owned

the parent. Morris, as the majority owner of the new corporation, could then

give further shares to Brad, enter into a buy-sell agreement with him, or sell

him some shares. In any case, upon Morris's death, Brad would succeed to unquestioned

leadership in this corporation. Lisa would stay as a minority stockholder

or, if she wished, sell her shares to Morris while he was alive. Lisa would

gain control of the former parent corporation upon Morris's death.

In the second scenario (known as a split-off ), after the formation of the

subsidiary, Brad would sell his shares of Plant Supply to that parent corporation

in exchange for stock affording him control of the subsidiary. Lisa would

remain the only minority stockholder of the parent corporation (Brad's interest

having been removed) and would succeed to full ownership upon Morris's

death through one of the mechanisms discussed earlier.

Unfortunately, when Morris brought his ideas to his professional advisers,

he was faced with a serious tax objection. In both scenarios, he was told, the

IRS would likely take the position that the issuance of the subsidiary's stock to

its eventual holder (Morris in the spin-off and Brad in the split-off ) was a taxable

transaction, characterized as a dividend. After all, this plan could be used

as another device to cash out the earnings and profits of a corporation at favorable

rates and terms. Instead of declaring a dividend of these profits, a corporation

could spin off assets, with the fair market value of these profits, to a

subsidiary. The shares of the subsidiary could then be distributed to its stockholders

as a nontaxable stock dividend, and the stockholders could sell these

shares and treat their profits as capital gain. The second scenario allows Brad

to receive the subsidiary's shares and then make a similar sale of these shares

at favorable rates and terms.

As a result, the Code characterizes the distribution of the subsidiary's

shares to the parent's stockholders as a dividend, taxable to the extent of the

parent's earnings and profits at the time of the distribution. This would certainly

inhibit Morris if he were the owner of a profitable C corporation. It

would be less of a concern if his corporation were operating as an S corporation,

although even then he would have to be concerned about undistributed

earnings and profits dating from before the S election.

Recognizing that not all transactions of this type are entered into to disguise

the declaration of a dividend, the Code does allow spin-offs and splitoffs

to take place tax-free, under the limited circumstances described in

Section 355. These circumstances track the scenarios concocted by Morris, but

are limited to circumstances in which both the parent and subsidiary will be

conducting an active trade or business after the transaction. Moreover, each

trade or business must have been conducted for a period exceeding five years

prior to the distribution and cannot have been acquired in a taxable transaction

during such time. Since Morris's corporation acquired the molding business

only two years previously and such transaction was not tax free, the benefits of

Section 355 are not available now. Short of another solution, it would appear

350 Planning and Forecasting

that Morris will have to live with the bickering of Brad and Lisa for another

three years.

SALE OF THE CORPORATION

Fortunately for Morris, another solution was not long in coming. Within months

of the failure of his proposal to split up the company, Morris was approached

by the president of a company in a related field, interested in purchasing Plant

Supply. Such a transaction was very intriguing to Morris. He had worked very

hard for many years and would not be adverse to an early retirement. A purchase

such as this would relieve him of all his concerns over adequate liquidity

for his estate and strategies for funding his retirement. He could take care of

both Lisa and Victor with the cash he would receive, and both Lisa and Brad

would be free to deal with the acquirer about remaining employed and collecting

on their equity.

However, Morris knew better than to get too excited over this prospect

before consulting with his tax advisers. His hesitance turned out to be justified.

Unless a deal was appropriately structured, Morris was staring at a significant

tax bite, both on the corporate and the stockholder levels.

Morris knew from his experience with the molding plant that a corporate

acquisition can be structured in three basic ways: a merger, a sale of stock, and

a purchase of assets. In a merger, the target corporation disappears into the acquirer

by operation of law, and the former stockholders of the target receive

consideration from the acquirer. In the sale of stock, the stockholders sell their

shares directly to the acquiring corporation. In a sale of assets, the target sells

its assets (and most of its liabilities) to the acquirer, and the proceeds of the

sale are then distributed to the target's stockholders through the liquidation of

the target. A major theme of all three of these scenarios involves the acquirer

forming a subsidiary corporation to act as the acquirer in the transaction.

In each case, the difference between the proceeds received by the target's

stockholders and their basis in the target's stock would be taxable as capital

gain. Morris was further informed that this tax at the stockholder level

could be avoided if these transactions qualified under the complex rules that

define tax-free reorganizations. In each case, one of the requirements would be

that the target stockholders receive largely stock of the acquirer rather than

cash. Since the acquirer in this case was closely held and there was no market

for its stock, Morris was determined to insist upon cash. He thus accepted the

idea of paying tax on the stockholder level.

Morris was quite surprised, however, to learn that he might also be exposed

to corporate tax on the growth in the corporation's assets over its basis in

them if they were deemed to have been sold as a result of the acquisition transaction.

For one thing, he had been under the impression that a corporation was

exempt from such tax if it sold its assets as part of the liquidation process. He

was disappointed to learn that this exemption was another victim of the repeal

Taxes and Business Decisions 351

of the General Utilities doctrine. He was further disappointed when reminded

that even subchapter S corporations recognize all built-in gain that existed at

the time of their subchapter S election, if their assets are sold within 10 years

after their change of tax status.

As a result of the previous considerations, Morris was determined to avoid

structuring the sale of his corporation as a sale of its assets and liabilities, to

avoid any tax on the corporate level. He was already determined not to structure

it as a sale of stock by the target stockholders, because he was not entirely sure

Brad could be trusted to sell his shares. If he could structure the transaction at

the corporate level, he would not need Brad's minority vote to accomplish it.

Thus, after intensive negotiations, he was pleased that the acquiring corporation

had agreed to structure the acquisition as a merger between Plant Supply and a

subsidiary of the acquirer (to be formed for the purpose of the transaction). All

stockholders of Plant Supply would receive a cash down payment and a fiveyear

promissory note from the parent acquirer in exchange for their stock.

Yet even this careful preparation and negotiation leaves Morris, Lisa, and

Brad in jeopardy of unexpected tax exposure. To begin with, if the transaction

remains as negotiated, the IRS will likely take the position that the assets of

the target corporation have been sold to the acquirer, thus triggering tax at the

corporate level. In addition, the target's stockholders will have to recognize as

proceeds of the sale of their stock both the cash and the fair market value of

the promissory notes in the year of the transaction, even though they will receive

payments on the notes over a period of five years.

Under the General Utilities doctrine, a corporation that was selling substantially

all its assets needed to adopt a "plan of liquidation" prior to entering

into the sale agreement to avoid taxation at the corporate level. The repeal of

the doctrine may have left the impression that the adoption of such a liquidation

plan is unnecessary because the sale will be taxed at the corporate level in

any event. Yet, the Code still requires such a liquidation plan if the stockholders

wish to recognize notes received upon the dissolution of the target corporation

on the installment basis. Moreover, the liquidation of the corporation

must be completed within 12 months of adoption of the liquidation plan.

Thus, Morris's best efforts may still have led to disaster. Fortunately, a

small adjustment to the negotiated transaction can cure most of these problems.

Through an example of corporate magic known as the reverse triangular

merger, the newly formed subsidiary of the acquirer may disappear into Morris's

target corporation, but the target's stockholders can still be jettisoned for

cash, leaving the acquirer as the parent. In such a transaction, the assets of the

target have not been sold; they remain owned by the original corporation. Only

the target's stockholders have changed. In effect, the parties have sold stock

without the necessity of getting Brad's approval. Because the assets have not

changed hands, there is no tax at the corporate level. In addition, since the target

corporation has not liquidated, no plan of liquidation is required, and the

target stockholders may elect installment treatment as if they had sold their

shares directly (see Exhibit 11.9).

352 Planning and Forecasting

CONCLUSION

Perhaps no taxpayer will encounter quite as many cataclysmic tax decisions in

as short a time as did Morris and Plant Supply. Yet, Morris's experience serves

to illustrate that tax issues lurk in almost every major business decision made

by a corporation's management. Many transactions can be structured to avoid

unnecessary tax expense if proper attention is paid to tax implications. To be

unaware of these issues is to play the game without knowing the rules.

FOR FURTHER READING

Gevurtz, Franklin A., Business Planning (New York: Foundation Press, 1995).

Jones, Sally M., Federal Taxes and Management Decisions (New York: Irwin/

McGraw-Hill, 1998).

Painter, William H., Problems and Materials in Business Planning, 3rd ed. (Connecticut:

West /Wadsworth, 1994).

Scholes, Myron S. et al., Taxes and Business Strategy (Upper Saddle River, NJ:

Prentice-Hall, 2001).

INTERNET LINKS

http://smallbiz.biz.findlaw.com FindLaw for Business

/sections/fn_taxes/articles.html

http://www.dtonline.com Deloitte and Touche Tax Planning Guide

/taxguide99/cover.htm

http://www.smartmoney.com/tax Smart Money.com tax guide

EXHIBIT 11.9 Reverse triangle merger.

Owned by

T's stockholders Owned by

T's stockholders

T SUB

S stock

Owned by

T

A A

S

Before After

353

12 GLOBAL FINANCE

Eugene E. Comiskey

Charles W. Mulford

MANAGERIAL AND FINANCIAL REPORTING ISSUES AT

SUCCESSIVE STAGES IN THE FIRM'S LIFE CYCLE

Fashionhouse Furniture started as a small southern retailer of furniture purchased

mainly in bordering southeastern states. With a growing level of both

competition and aff luence in its major market areas, Fashionhouse decided

that its future lay in a niche strategy involving specialization in a high quality

line of Scandinavian furniture. Its suppliers were mainly located in Denmark,

and they followed the practice of billing Fashionhouse in the Danish krone.

Title would typically pass to Fashionhouse when the goods were dropped on

the dock in Copenhagen. Payment for the goods was required within periods

ranging from 30 to 90 days. As its business expanded and prospered, Fashionhouse

became convinced that it needed to exercise greater control over its

furniture supply. This control was accomplished through the purchase of its

principal Danish supplier. Because this supplier also had a network of retail

units in Denmark, the manufacturing operations in Denmark supplied both

the local Danish market as well as the U.S. requirements of Fashionhouse.

More recently, Fashionhouse has been searching for ways to increase

manufacturing efficiency and lower product costs. It is contemplating a relocation

of part of its manufacturing activity to a country with an ample and

low-cost supply of labor. However, Fashionhouse has noted that many such

countries experience very high levels of inf lation and other potentially disruptive

economic and political conditions. It has also become aware that in some of

354 Planning and Forecasting

the countries under consideration business practices are occasionally employed

that could be a source of concern to Fashionhouse management. In some cases,

the practices raise issues that extend beyond simply ethical considerations.

Fashionhouse could become involved in activities that could place it in violation,

not of local laws, but of U.S. laws. Fashionhouse management is still attempting

to determine how to evaluate and deal with some of the identified

managerial and financial issues associated with this contemplated move.

Each of the new stages in the evolution of the Fashionhouse strategy creates

new challenges that have important implications for both management and

financial reporting. The evolution from a strictly domestic operation to one involving

the purchase of goods abroad thrusts Fashionhouse into the global

marketplace, with its attendant risks and rewards. It is common for U.S. firms

with foreign activities to enumerate some of these risks. These disclosures are

normally made, at least in part, to comply with disclosure requirements of the

Securities and Exchange Commission (SEC). As an example, consider the disclosures

made by Western Digital Corporation of risk factors associated with

its foreign manufacturing operations:

• Obtaining requisite U.S. and foreign governmental permits and approvals.

• Currency exchange-rate f luctuations or restrictions.

• Political instability and civil unrest.

• Transportation delays or higher freight fees.

• Labor problems.

• Trade restrictions or higher tariffs.

• Exchange, currency, and tax controls and reallocations.

• Loss or nonrenewal of favorable tax treatment under agreements or

treaties with foreign tax authorities.1

While not listed above as a specific concern, there is the risk that a foreign

government will expropriate the assets of a foreign operation. There were

major expropriations of U.S. assets, for instance, located in Cuba when Fidel

Castro came to power. There were also expropriations by Iran surrounding the

hostage taking at the U.S. embassy in Tehran. Moreover there has been turmoil

in Ecuador in recent years. Baltek, a New Jersey corporation with most of its

operations in Ecuador, disclosed that it had taken out expropriation insurance

to deal with this risk:

All of the Company's balsa and shrimp are produced in Ecuador. The dependence

on foreign countries for raw materials represents some inherent risks.

However, the Company, or its predecessors, has operated without interruption

in Ecuador since 1940. Operating in Ecuador has enabled the Company to produce

raw materials at a reasonable cost in an atmosphere that has been favorable

to exporters such as the Company. To mitigate the risk of operating in

Ecuador, in 1999 the Company obtained a five-year expropriation insurance

policy. This policy provides the Company coverage for its assets in Ecuador

Global Finance 355

against expropriatory conduct (as defined in the policy) by the government of

Ecuador.2

Some of the important issues implicit in the Fashionhouse scenario outlined

above are identified below and are discussed and illustrated in the balance

of this chapter:

1. Fashionhouse incurs a foreign-currency obligation when it begins to acquire

furniture from its Danish suppliers. A decrease in the value of the

dollar between purchase and payment date increases the dollars required

to discharge the Danish krone obligation and results in a foreign-currency

transaction loss.

Financial reporting issue: How are the foreign-currency obligations

initially recorded and subsequently accounted for in the Fashionhouse

books, which are maintained in U.S. dollars?

Management issue: What methods are available to avoid the currency

risk associated with purchasing goods abroad and also being invoiced

in the foreign currency, and should they be employed?

2. The purchase of one of its Danish suppliers requires that this firm henceforth

be consolidated into the financial statements of Fashionhouse and

its U.S. operations.

Financial reporting issues: (a) How are the Danish statements converted

from the krone in order to consolidate them with the U.S. dollar

statements of Fashionhouse? (b) What differences in accounting

practices, if any, exist between Denmark and the United States and

what must be done about such differences?

Management issues: (a) Is there currency risk associated with the Danish

subsidiary comparable to that described previously with the foreign

purchase transactions? Are there methods available to avoid the

currency risk associated with ownership of a foreign subsidiary and

should they be employed? (b) How will the financial aspects of the

management of the Danish subsidiary be evaluated in view of (1) the

availability of two different sets of financial statements, those expressed

in krone and those in U.S. dollars, and (2) the fact that most of

its sales are to Fashionhouse, its U.S. parent?

3. Fashionhouse relocates its manufacturing to a high-inf lation and lowlabor

cost country.

Financial reporting issues: How will inf lation affect the local-country

financial statements and their usefulness in evaluating the performance

of the company and its management?

Management issues: (a) Are their special risks associated with locating

in a highly inf lationary country and how can they be managed?

(b) What are the restrictions on U.S. business practices related to dealing

with business and governmental entities in other countries?

356 Planning and Forecasting

For clarification and to indicate their order of treatment in the subsequent

discussion, the issues raised above are enumerated below, without distinction

between those that are mainly financial reporting as opposed to

managerial issues:

1. Financial reporting of foreign-currency denominated transactions.

2. Risk management alternatives for foreign-currency denominated transactions.

3. Translation of the financial statements of foreign subsidiaries.

4. Managing the currency risk of foreign subsidiaries.

5. Dealing with differences between U.S. and foreign accounting policies.

6. Evaluation of the performance of foreign subsidiaries and their

management.

7. Assessing the effects of inf lation on the financial performance of foreign

subsidiaries.

8. Complying with U.S. restrictions on business practices associated with

foreign subsidiaries and governments.

FINANCIAL REPORTING OF FOREIGN-CURRENCY

DENOMINATED TRANSACTIONS

When a U.S. company buys from or sells to a foreign firm, a key issue is the currency

in which the transaction is to be denominated.3 In the case of Fashionhouse,

its purchases from Danish suppliers were invoiced to Fashionhouse in

the Danish krone. This creates a risk, which is born by Fashionhouse and not its

Danish supplier, of a foreign exchange transaction loss should the dollar fall in

value. Alternatively, a gain would result should the dollar increase between the

time the furniture is dropped on the dock in Copenhagen and the required

payment date. With a fall in the value of the dollar, the Fashionhouse dollar

cost for the furniture will be more than the dollar obligation it originally

recorded. Fashionhouse is said to have liability exposure in the Danish krone.

If, instead, Fashionhouse had been invoiced in the U.S. dollar, then it would

have had no currency risk. Rather, its Danish supplier would bear the currency

risk associated with a claim to U.S. dollars, in the form of a U.S. dollar account

receivable. If the dollar were to decrease in value, the Danish supplier would

incur a foreign exchange transaction loss, or a gain should the dollar increase

in value. The Danish firm would have asset exposure in a U.S. dollar account

receivable.

The essence of foreign-currency exposure or currency risk is that existing

account balances or prospective cash f lows can expand or contract simply as a

result of changes in the values of currencies. A summary of foreign exchange

gains and losses, by type of exposure, due to exchange rate movements is provided

in Exhibit 12.1. To illustrate some of the computational aspects of the

Global Finance 357

patterns of gains and losses in Exhibit 12.1, and the nature of exchange rates,

assume that Fashionhouse recorded a 100,000 krone purchase when the exchange

rate for the krone was $0.1180. That is, it takes 11.8 cents to purchase

one krone. This expression of the exchange rate, dollars per unit of the foreign

currency, is referred to as the direct rate. Alternatively, expressing the rate in

terms of kroner per dollar is referred to as the indirect rate. In this case, the

indirect rate is 1/0.1180, or K8.475. It requires 8.475 kroner to purchase one

dollar. Both the direct and indirect rates are typically provided in the tables of

exchange rates found in the financial press. The rates at which currencies are

currently trading are called the spot rates.

When Fashionhouse records the invoice received from its Danish supplier,

it must do so in its U.S. dollar equivalent. With the direct rate at $0.1180,

the dollar equivalent of K100,000 is $0.1180 × K100,000, or $11,800. That is,

Fashionhouse records an addition to inventory and an offsetting account

payable for $11,800. Assume that Fashionhouse pays this obligation when the

dollar has fallen to $0.1190. It will now take $11,900 dollars to acquire the

K100,000 needed to pay off the account payable. The combination of liability

exposure and a decline in the value of the dollar results in a foreign-currency

transaction loss. This result is summarized below:

The exchange rate is $0.1190 when the account payable from the purchase is

paid.

Dollar amount of obligation at payment date, 100,000 × $0.1190 $11,900

Dollar amount of obligation at purchase date, 100,000 × $0.1180 11,800

Foreign exchange transaction loss $ 100

The dollar depreciated against the krone during the time when Fashionhouse

had liability exposure in the krone. As a result, it took $100 more to discharge

the account payable than the amount at which the liability was originally

recorded by Fashionhouse.

If the foreign exchange losses incurred were significant, it might prove

difficult to pass on this increased cost to Fashionhouse customers, and it could

cause its furniture to be somewhat less competitive than that offered by other

U.S. retailers with domestic suppliers. Fashionhouse might attempt to avoid

the currency risk by convincing its Danish suppliers to invoice it in the dollar.

However, this means that the Danish suppliers would bear the currency risk.

EXHIBIT 12.1 Type of foreign currency

exposure.

Change in Foreign Exposure

Currency Value Asset Liability

Appreciates Gain Loss

Depreciates Loss Gain

358 Planning and Forecasting

Experience indicates that such suppliers would expect to be compensated

for bearing this risk and would charge more for their products.4 An alternative

approach, the use of various hedging procedures, is the more common method

employed to manage the risk of foreign-currency exposure.

RISK MANAGEMENT ALTERNATIVES

FOR FOREIGN-CURRENCY

DENOMINATED TRANSACTIONS

Hedging is designed to protect the dollar value of a foreign-currency asset position

or to hold constant the dollar burden of a foreign-currency liability.5 At

the same time, the volatility of a firm's cash flow or earnings stream is also

reduced. This reduction is accomplished by maintaining an offsetting position

that produces gains when the asset or liability position is creating losses, and

vice versa. These offsetting positions may be created as a result of arrangements

involving internal offsetting balances created through operational activities,

or they may entail specialized external transactions with financial firms

or markets.

Hedging with Internal Offsetting Balances

or Cash Flows

Firms generally attempt to close out as much foreign-currency exposure as possible

by relying upon their own operations. These arrangements are often referred

to as natural hedges. As an example, consider the following commentary

about currency exposure from the 1999 annual report of Air Canada:

Foreign exchange exposure on interest obligations in Swiss francs and Deutsche

marks is fully covered by surplus cash f lows in European currencies, while yendenominated

cash f low surpluses provide a natural hedge to fully cover yen interest

expense.6

Air Canada is able to prevent net exposure in the identified foreign currencies

by having offsetting cash f lows in the same currencies or in currencies whose

values move in parallel to the currencies in which Air Canada has interest obligations.

With the full transition to the Euro in 2002, Air Canada's currency exposure

should be markedly reduced because most of the European Community

countries will share the Euro as their currency.7 This will not, of course, alter

their exposure in the case of Asian currencies.

A sampling of other arrangements that could be characterized as natural

hedges is provided in Exhibit 12.2. Virtually all of these examples illustrate the

offsetting of exposure through the results of normal operations. In the cases of

Baldwin Technologies and Interface, the hedges could be seen to be seminatural

if they result from a conscious action to create offsetting exposure. That is,

does Baldwin Technology determine the cash balances to maintain after first

Global Finance 359

determining the extent of their liability exposure? Similarly, does Interface

make decisions about the currency in which to borrow depending upon its existing

asset exposure?8

Being the product of calculation and design does not make the seminatural

hedges any less effective or desirable. In fact, their existence prompts

management to be proactive in identifying hedging opportunities that do not

EXHIBIT 12.2 Natural foreign currency hedges.

Company Natural Hedge

Adobe Systems Inc. (1999) We currently do not use financial instruments to hedge

local currency denominated operating expenses in

Europe. Instead, we believe that a natural hedge exists,

in that local currency revenue from product upgrades

substantially offsets the local currency denominated

operating expenses.

Armstrong World Industries Inc. Armstrong's global manufacturing and sales provide a

(1999) natural hedge of foreign currency exchange-rate

movements as foreign currency revenues are offset by

foreign currency expenses.

Baldwin Technology Company The Company also maintains certain levels of cash

Inc. (1999) denominated in various currencies which acts as a

natural hedge.

Baltek Corporation (1998) During 1997, the Company began borrowing in Ecuador

in local currency (sucre) denominated loans as a natural

hedge of the net investments in Ecuador.

Interface Inc. (1999) During 1998, the Company restructured its borrowing

facilities which provided for multi-currency loan

agreements resulting in the Company's ability to borrow

funds in the countries in which the funds are expected to

be utilized. Further, the advent of the Euro has provided

additional currency stability with the Company's

European markets. As such, these events have provided

the Company natural hedges of currency f luctuations.

Pall Corporation (2000) About one quarter of Pall's sales are in countries tied to

the Euro. At current exchange rates, this could reduce our

sales by close to 4%. Fortunately, many of our costs in

Europe are also reduced by a weak Euro. The weak

British Pound also reduces our exposure as most Pall sales

to Europe are manufactured in England. This provides a

natural hedge and helps preserve profitability.

Telef lex Inc. (1999) Approximately 65% of the company's total borrowings of

$345 million are denominated in currencies other than the

US dollar, principally Euro, providing a natural hedge

against f luctuations in the value of non-domestic assets.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

360 Planning and Forecasting

require, for example, the use of either exchange-traded or over-the-counter derivative

instruments.

While somewhat less contemporary, there are other examples of using a

firm's own operations and activities to offset foreign-currency exposure. For

example, California First Bank (now part of Union Bank) had a Swiss franc

borrowing in the amount of Sfr20 million.9 As this represented liability exposure

to California First, Exhibit 12.1 shows that an increase in the value of the

Swiss franc results in a foreign-currency transaction loss. The goal of the hedge

would be to create a gain in this circumstance to offset the loss on the Swiss

franc borrowing. Again, Exhibit 12.1 reveals that a gain would be produced

from asset exposure in the Swiss franc in the case where the Swiss franc appreciated

in value.

California First Bank sought an opportunity to establish an asset position

in the Swiss franc for the same amount and term as the existing Swiss franc

obligation. It created this offsetting position by making a loan and denominating

the loan in the Swiss franc. This apparently met the borrower's needs and

also served the hedging objective of California First Bank.

In an even more creative arrangement, Federal Express created a natural

hedge of a term loan that was denominated in the Japanese yen.10 This was accomplished

by a special structuring of transactions with its own customers. As

Federal Express explained:

To minimize foreign exchange risk on the term loan, the Company has commitments

from certain Japanese customers to purchase a minimum level of freight

services through 1993.

Federal Express needed Japanese yen to make periodic repayments on

the term loan. The arrangements with its Japanese customers ensured that yen

would be available to pay down the term loan. If the yen appreciates against

the dollar, the dollar burden of the Federal Express yen debt increases and results

in a transaction loss. However, this loss is offset in turn by the increase in

the dollar value of the stream of yen receipts from the freight-service contracts.

11 If instead the yen depreciates, a gain on the debt will be offset by

losses on the service contracts. A summary of the operation of this hedge is

provided in Exhibit 12.3.

California First and Federal Express both employed arrangements with

their customers in order to create hedges. In addition, purely natural hedges

EXHIBIT 12.3 Offsetting gains and losses produced by Federal Express

hedge.

Change in the value of Change in Dollar Value Change in Dollar Value

Foreign Currency of the Loan (Liability) of the Revenue (Asset)

Appreciates Increases (loss) Increases (gain)

Depreciates Decreases (gain) Decreases (loss)

Global Finance 361

may exist due to offsetting balances that result from ordinary business transactions

with no special arrangements being required. Several hedges that appear

to be of this nature were presented in Exhibit 12.2, for example, Adobe Systems

and Armstrong World Industries. Two other examples that appear to be

totally natural are the cases of Lyle Shipping and Australian mining companies.

Lyle Shipping, a Scottish firm, had borrowings in the U.S. dollar. An increase

in the value of the dollar would increase the pounds required to repay

Lyle's dollar debt and result in a transaction loss. However, because Lyle's

ships were chartered out at fixed rates in U.S. dollars, there would be an offsetting

increase in the pound value of future lease receipts—a transaction

gain.12 A similar natural hedge is generally held to exist for Australian mining

companies whose product is priced in U.S. dollars. Should the U.S. dollar depreciate,

the exposure to shrinkage in the Australian dollar value of U.S. receipts

(asset exposure) is offset by similar shrinkage in the Australian dollar

value of their U.S. dollar debt (liability exposure).13

Fashionhouse would probably find it difficult to duplicate the hedging

techniques used above by California First and Federal Express. Circumstances

giving rise to a natural hedge, as in the case of Lyle Shipping, may not exist. It

might have some capacity to hedge by applying the method of leading and lagging.

This method involves matching the cash f lows associated with foreigncurrency

payables and receivables by speeding up or slowing down their

payment or receipt. Moreover, once Fashionhouse has operations in Denmark,

it may be able to create at least a partial hedge of its asset exposure by funding

operations with Danish krone debt. If natural hedging opportunities are not

available, then Fashionhouse has the full range of both exchange-traded and

privately negotiated currency derivatives that it can use as a hedging instrument

to hedge currency risks.

The hedging requirements of the European operations of Fashionhouse

should be reduced by the introduction of the Euro. Even though Denmark is

not one of the original 11 members of the European Monetary Union (EMU),

its European exposure with the 11 countries will be reduced to a single currency,

the Euro.

Hedging with Foreign-Currency Derivatives

Foreign-currency derivatives are financial instruments that derive their value

from an underlying foreign-currency exchange rate. Some of the more common

currency derivatives include forward contracts to buy or sell currencies in the

future at fixed exchange rates, foreign-currency swaps, foreign-currency futures,

and options. The forward contracts and over-the-counter options have

the advantage of making it possible to tailor hedges to meet individual requirements

in terms of amounts and dates. The exchange-traded futures and options

have liquidity and a ready market, but a limited number of dates and contract

sizes. Examples of the use of both types of instruments, privately negotiated

and exchange traded, are discussed next.

362 Planning and Forecasting

Forward Exchange Contracts

A forward contract is an agreement to exchange currencies at some future date

at an agreed exchange rate. The exchange rate in a contract for either the purchase

or sale of a foreign currency is referred to as the forward rate. Forward

contracts are among the most popular of the foreign-currency derivatives, followed

by privately negotiated (over-the-counter) currency options.14 These privately

negotiated contracts can be tailored to meet the user's needs in term of

both the amount of currency and maturity of the contract. Exchange-traded

currency derivatives, such as options and futures, come in standard amounts of

currency and a limited number of relatively short maturities.

Forward-Contract Hedging Example An example may help to illustrate the

application of a forward contract to hedging currency exposure. Near the end

of 2000, the forward contract rate for the British pound sterling (£), with a

term of one month, was about $1.45. The $1.45 is the direct exchange rate because

it expresses the price of the foreign currency in terms of dollars. The

comparable indirect rate is found by simply taking the reciprocal of $1.45:

1/$1.45 equals 0.69. The dollar is worth 0.69 pounds.

If a U.S. firm had an account payable of 100,000 pounds due in 30 days, a

hedge of this liability exposure could be effected by entering into a forward

contract to buy £100,000 for delivery in 30 days. Buying the currency through

the forward contract is necessary because the firm needs the pound in 30 days

to satisfy its account payable. If the dollar were to decline to $1.48 against the

pound over this 30-day period, then the dollar value of the account payable

would increase, creating a foreign-currency transaction loss. That is, it would

take more dollars to purchase the £100,000. However, offsetting this loss would

be a gain from an increase in the value of the forward contract. The right to buy

£100,000 at the fixed forward rate of $1.45 increases in value as the value of

the pound increases to $1.48. The effects of this foreign-currency exposure and

associated forward-contract hedge are summarized in Exhibit 12.4. For the

EXHIBIT 12.4 Hedge of foreign-currency liability exposure with a

forward contract.

Item hedged: account payable of £100,000

Value of the account payable at payment date, £100,000 × $1.48 = $148,000

Value of the account payable when initially recorded, £100,000 × $1.45 = 145,000

Foreign currency transaction loss $ 3,000

Hedging instrument: forward contract to buy £100,000 @ $1.45, 30 days

Value of the forward contract at maturity, £100,000 × ($1.48 $1.45) = $ 3,000

Value of the forward contract at inception, £100,000 × ($1.45 $1.45) = 0

Gain on forward contract $ 3,000

Global Finance 363

sake of simplicity, we are assuming that the spot value of the pound is equal to

the forward rate at the inception of the forward contract.15

The gains and losses would be reversed if the U.S. firm in the above example

had a pound sterling accounting receivable. Moreover, the creation of a

hedge of this asset exposure in the pound sterling would call for the sale and

not the purchase of the pound sterling through the forward contract. Appreciation

of the pound sterling to $1.48 produces a transaction gain on the account

receivable for the U.S. firm. This would in turn be offset by a loss on the forward

contract. The value of the forward contract declines when the spot value

of the pound sterling, $1.48, is greater than the rate to be received through the

forward contract, $1.45.

Beckman Coulter Inc. provides a useful description of the offsetting gains

and losses created by hedges:

When we use foreign-currency contracts and the dollar strengthens against foreign

currencies, the decline in the value of the future foreign-currency cash

f lows is partially offset by the recognition of gains in the value of the foreigncurrency

contracts designated as hedges of the transactions. Conversely, when

the dollar weakens, the increase in the value of the future foreign-currency

cash f lows is reduced by . . . the recognition of any loss in the value of the forward

contracts designated as hedges of the transactions.16

Notice that Beckman Coulter talks of its future foreign-currency cash

f lows. This constitutes asset exposure to Beckman Coulter in the foreign currency.

If the dollar strengthens, then it follows that the foreign currency declines

in value. The dollar value of the steam of foreign cash flow decreases.

Because Beckman Coulter is long the cash flow, it would hedge this exposure

by selling (taking a short position) the foreign currency through the forward

contract.

Examples of Forward-Contract Hedging from Annual Reports A sampling of

firms that disclosed the use of forward contracts, and the types of exposure

they are hedging, is provided in Exhibit 12.5. There are a substantial number of

different hedge targets in this small set of companies. They include:

• Inter-company loans.

• Cash f lows associated with anticipated transactions.

• Bonds payable.

• Accounts payable.

• Accounts receivable.

• Net investments in foreign subsidiaries.

• Expected acquisition transaction.

Over-the-counter currency options are a close second in popularity as a

hedging instrument and their nature and use are discussed next.

364 Planning and Forecasting

EXHIBIT 12.5 Hedging with forward contracts.

Company Hedging Targets

Armstrong World Industries Inc. Armstrong also uses foreign currency forward exchange

(1999) contracts to hedge inter-company loans.

Arvin Industries Inc. (1999) Arvin manages the foreign currency risk of anticipated

transactions by forecasting such cash f lows at the operating

entity level, compiling the total Company exposure and

entering into forward foreign exchange contracts to lessen

foreign exchange exposures deemed excessive.

Dow Chemical Company (1999) The Company enters into foreign exchange forward

contracts and options to hedge various currency

exposures or create desired exposures. Exposures

primarily relate to assets and liabilities and bonds

denominated in foreign currencies, as well as economic

exposure, which is derived from the risk that the

currency f luctuations could affect the dollar value of

future cash f lows related to operating activities.

Tenneco Inc. (1999) Tenneco enters into foreign currency forward purchase

and sales contracts to mitigate its exposure to changes in

exchange rates on inter-company and third party trade

receivables and payables. Tenneco has from time to time

also entered into forward contracts to hedge its net

investments in foreign subsidiaries.

UAL Inc. (1999) United enters into Japanese yen forward exchange

contracts to minimize gains and losses on the revaluation

of short-term yen-denominated liabilities. The yen

forwards typically have short-term maturities and are

marked to fair value at the end of each accounting period.

Vishay Intertechnology Inc. In connection with the Company's acquisition of all the

(1999) common stock of TEMIC Semiconductor GmbH and

80.4% of the common stock of Siliconix, Inc., the

Company entered into a forward exchange contract in

December 1997 to protect against f luctuations in the

exchange rate between the U.S. dollar and the Deutsche

mark since the purchase price was denominated in

Deutsche marks and payable in U.S. dollars. At

December 31, 1997, the Company had an unrealized loss

on this contract of $5,295,000, which resulted from

marking the contract to market value. On March 2, 1998,

the forward contract was settled and the Company

recognized an additional loss of $6,269,000.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

Global Finance 365

Currency Option Contracts

A common feature of option contracts is that they provide the right, but not the

obligation, to either acquire or to sell the contracted items at an agreed price.

The agreed price is called the strike price. In addition, options are considered to

be in the money or out of the money based upon the relationship between the

strike price and the current price. The prices in the case of currency options are

currency exchange rates. For example, a currency option contract is out of the

money if the option provides the right to buy the Irish Punt at $1.12 when its

spot price is $1.10. Conversely, an option is in the money if it provides the right

to sell the German Mark at $0.45 when its spot value is $0.43.

An option contract that gives the holder the right to sell a currency at an

agreed rate, the strike price, is called a put option. The contract that provides

the right to purchase the currency at an agreed rate is termed a call option.

The cost of acquiring an option is termed the option premium. The option premium

is a function of a number of variables. These include the strike price,

the spot value of the currency, the time remaining to expiration of the option

and the volatility of currency and interest-rate levels. Option values are

estimated using methodologies such as the widely used Black-Scholes optionpricing

model.

Options Contrasted with Forwards Options are frequently characterized as

one-sided arrangements. Consider the case of a firm that wishes to hedge exposure

resulting from an Euro account receivable. The Euro amount of the receivable

is E62,500. Because the firm wishes to protect the dollar value of an

asset position (exposure) in the Euro, it would invest in a Euro put option, with

a maturity that is consistent with the collection date for the receivable. A single

exchange-traded option is acquired and the option premium is $1,000. The

spot value of the Euro is $0.88, resulting in a dollar valuation for the Euro receivable

of $55,000 ($0.88 × 62,500 = $55,000). The strike price is also $0.88,

meaning that the option contract is at the money, that is, the strike price and

spot value of the currency are the same.17 We will assume that at the expiration

date for the option contract the spot value of the Euro is, alternatively,

$0.84 and $0.92. The effects of these two different outcomes are summarized

in Exhibit 12.6.

Unlike the option contract, a forward contract does not permit the holder

to decline to fulfill the obligation simply because the hedged currency did not

move in an unfavorable direction. The forward contract is a symmetrical

arrangement. If a forward contract had been used to hedge the Euro exposure

in Exhibit 12.6, then there would be offsetting gains and losses on both the

Euro accounts receivable and on the forward contract, whether the Euro appreciated

or depreciated in value.

One-Sided Nature a Hedge with a Currency Option An option contract is

simply permitted to expire unexercised if an option contract is out of the

366 Planning and Forecasting

money at its maturity. The option contract is designed to protect the holder

against possible shrinkage in the dollar value of the Euro account receivable

that would result from a decline in the value of the Euro. In the first case,

where the spot value of the Euro did decline, then the option is exercised and

a gain of $2,500 is produced to offset the transaction loss of $2,500 on the

Euro account receivable. However, in the second case, where the spot value of

the Euro rose, the option is permitted to expire unexercised. After all, it permits

the sale of the Euro at $0.88 when the spot value of the Euro is $0.92.

The option contract expires without value.

Hedging a Euro receivable with a forward contract will result in a gain

on the forward contract when the Euro declines in value and a loss when the

Euro increases in value. These gains and losses will in turn offset the loss on

EXHIBIT 12.6 The operation of a currency option.

Expiration-date spot value of $0.84

Notional amount of the put-option contract, in Euros 62,500

Strike price of the Euro put option $0.88

Spot value of the Euro 0.84

Amount by which option is in the money .04 0.04

Contract gain $ 2,500

Initial dollar value of the Euro receivables

Accounts receivable in Euros 62,500

Times spot exchange rate $0.88

$55,000

Final dollar value of the Euro receivables

Accounts receivable in Euros 62,500

Times spot exchange rate $0.84 52,500

Transaction loss on accounts receivable $ 2,500

Expiration-date spot value of $0.92

Strike price of the Euro put option $0.88

Spot value of the Euro $0.92

The option is permitted to expire without being exercised. The contract provides the opportunity

to sell the Euro for $0.88 when its value in the spot market is $0.92. It has no value

upon its expiration.

Initial dollar value of the Euro receivables

Accounts receivable in Euros 62,500

Times spot exchange rate $0.88

$55,000

Final dollar value of the Euro receivables

Accounts receivable in Euros 62,500

Times spot exchange rate $0.92 57,500

Transaction gain on accounts receivable $ 2,500

Global Finance 367

the account receivable that results when the Euro declines in value and the

gain that results when the Euro increases in value. The behavior of a hedge

using a forward contract versus an option is summarized in Exhibit 12.7.

The symmetrical behavior of the forward contract in its hedging application

is evident in Exhibit 12.7. In each of the four combinations of exposure

and exchange rate movement the gains and losses on the balance sheet exposure

are offset in turn by the losses and gains on the forward contracts. However,

the option contracts produce offsetting gains and losses only in those

cases where the unfavorable exchange rate change takes place.18 Notice that a

gain is produced on the option contract to offset the loss on the balance sheet

asset exposure when the foreign currency depreciated. Currency depreciation

when the firm has asset exposure is an unfavorable rate movement. In the case

of liability exposure, notice that a gain is produced by the option contact when

the foreign currency appreciated. The corollary of appreciation of the foreign

currency is depreciation of the dollar. This is an unfavorable rate movement

because it causes the dollar value of the liability to increase. In the other two

cases, where the option contracts expire without value, the currency movements

are favorable: (a) asset exposure and the foreign currency appreciated

and (b) liability exposure and the foreign currency depreciated.

The positions taken in the forward and option contracts differ based upon

the nature of the foreign-currency exposure. With the forward contract, the

foreign currency is purchased in the case of liability exposure and sold in the

EXHIBIT 12.7 Behavior of hedge gains and losses with a forward

versus an option.

Type of Exposure Hedged Derivative Contract

Asset Forward Contract Put Option

Foreign currency appreciates

Gain on asset exposure Loss on the forward Contract expires with

contract neither gain nor loss; option

holder loses initial option

premium paid

Foreign currency depreciates

Loss on the asset exposure Gain on the forward Contract expires with a gain

contract

Liability Forward Contract Call Option

Foreign currency appreciates

Loss on the liability Gain on the forward Contract expires with a gain

exposure contract

Foreign currency depreciates

Gain on the liability Loss on the forward Contract expires with

exposure contract neither gain nor loss; option

holder loses initial option

premium paid

368 Planning and Forecasting

case of asset exposure. With the option contract, a call option is acquired in

the case of liability exposure and a put option in the case of asset exposure.

Some relevant commentary, in relation to the above discussion, on the

effects of hedging with currency options, is provided by the disclosures of Analog

Devices Inc.:

When the dollar strengthens significantly against the foreign currencies, the

decline in value of the future currency cash f lows is partially offset by the gains

in value of the purchased currency options designated as hedges. Conversely,

when the dollar weakens, the increase in value of the future foreign-currency

cash f lows is reduced only by the premium paid to acquire the options.19

The Analog commentary highlights the one-directional nature of a hedge

that employs a currency option as opposed to a forward contract. The corollary

of the decline in the dollar is a weakening of the foreign currency. This is the

unfavorable outcome that the hedge is designed to offset. Indeed, the above

comments indicate that a gain on the option contract is produced to offset the

decline in future cash f lows that result from a strengthening of the dollar. However,

when the dollar instead weakens, there is no offsetting loss, beyond "the

premium paid to acquire the options." The corollary of the weakening of the

dollar is the strengthening of the foreign currency. A strengthening of the foreign

currency is not the unfavorable currency movement that the currency

option was intended to protect against.

As with the forward contracts, a sampling of disclosures by companies

that are using currency options for hedging purposes is provided in Exhibit

12.8. Currency options are used less frequently than forward contracts.

Most of the options used are over-the-counter (OTC) as opposed to exchangetraded

options. Given the OTC character of these currency options, they share

the tailoring feature of the forward contracts. That is, unlike exchange traded

options that come in standard amounts of currency and limited maturities,

both forward contracts and options can be tailored in terms of currency

amount and maturity. However, unlike forward contracts, the currency options

do require an initial investment—the option premium. Little or no initial investment

is required in the case of the forward contract.

Forwards and options are the most popular currency derivatives, and it is

very common, as both Exhibits 12.5 and 12.8 reveal, for firms to use both instruments.

The last currency derivative that is only brief ly reviewed is the

futures contract. The futures contract shares the symmetrical gain and loss

feature of the forward contract.

Currency Futures

Currency futures are exchange-traded instruments. Entering into a futures

contract requires a margin deposit and a round-trip commission must also be

paid. As is true of exchange-traded currency options, futures contracts come in

fixed currency amounts and for a limited set of maturities. Futures contracts

Global Finance 369

also have the high level of liquidity that is characteristic of other exchangetraded

derivatives. They also share the symmetrical character of the forward

contract. That is, gains and losses will be produced by the futures contract to

offset losses and gains, respectively, on hedged positions. Currency futures are

used rather infrequently in the hedging of foreign-currency exposures.

Summary of Currency Exposure and Hedging Positions

It is common for firms to first attempt to reduce currency exposure by using

their own operating activities and other internal actions. This point is made in

the following comments from the disclosures of JLG Industries: "The Company

manages its exposure to these risks (interest and foreign-currency rates)

EXHIBIT 12.8 Hedging with option contracts.

Company Hedging Targets

Analog Devices Inc. (1999) The Company may periodically enter into foreign currency

option contracts to offset certain probable anticipated, but

no firmly committed, foreign exchange transactions related

to the sale of product during the ensuing nine months.

Arch Chemicals Inc. (1999) The Company enters into forward sales and purchases and

currency options to manage currency risk resulting from

purchase and sale commitments denominated in foreign

currencies (principally Euro, Canadian dollar, and Japanese

yen) relating to anticipated but not yet committed

purchases and sales expected to be denominated in those

currencies.

Olin Corporation (1999) The Company enters into forward sales and purchase

contracts and currency options to manage currency risk

resulting from purchase and sale commitments

denominated in foreign currencies (principally Australian

dollar and Canadian dollar) and relating to particular

anticipated but not yet committed purchases and sales

expected to be denominated in those currencies.

Polaroid Corporation (1999) The Company has limited f lexibility to increase prices in

local currency to offset the adverse impact of foreign

exchange. As a result, the Company primarily purchases

U.S. dollar call/foreign currency put options which allows

it to protect a portion of its expected foreign currency

denominated revenues from adverse currency exchange

movement.

Quaker Oats Company (1999) The Company uses foreign currency options and forward

contracts to manage the impact of foreign currency

f luctuations recognized in the Company's operating results.

York International Corporation To reduce this risk, the Company hedges its foreign

(1999) currency transaction exposure with forward contracts and

purchased options.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

370 Planning and Forecasting

principally through its regular operating and financing activities."20 These

approaches to reducing currency exposure are usually referred to as natural

hedges. A number of examples of natural hedges were provided in Exhibit 12.2.

When natural hedges do not close out sufficient currency exposure, it is common

for firms to turn to currency derivatives to reduce exposure still further.

Based upon the previous discussion of selected currency derivatives, the positions

to be taken in the face of asset versus liability exposure are summarized

in Exhibit 12.9.

The information in Exhibit 12.9 indicates how a number of different instruments

can be used to hedge currency risk. However, management must decide

whether, and to what extent, to hedge such risk. Some of the factors that

bear on the hedging decision are discussed next.

Influences on the Hedging Decision

The first hedging decision is whether or not to hedge currency exposure at all.

The decision of whether or not to hedge currency exposure is inf luenced, at

least in part, by the attitude of management towards the risk associated with

foreign-currency exposure. Other things equal, a highly risk-averse management

will be more inclined to hedge some or all currency-related risk. Moreover,

not all currency exposure is seen to be equal. Firms have different

demands for hedging based upon whether the exposure has the potential to affect

cash f lows and earnings, or simply the balance sheet. Finally, the materiality

of currency exposure as well as expected movement in exchange rates will

also inf luence the demand for hedging.

Is Currency Exposure Material?

A common disclosure made by firms with currency exposure is the effect that a

10% change in exchange rates would have on results. For example, Titan International,

Inc. has currency exposure from its net investment in foreign subsidiaries.

Titan discloses the potential loss associated with an adverse movement

in the exchange rates of these subsidiaries:

The Company's net investment in foreign subsidiaries translated into U.S. dollars

at December 31, 1999, is $55.4 million. The hypothetical potential loss in

EXHIBIT 12.9 Foreign currency exposure and hedging

decisions: Forwards, options, and futures.

Hedging Exposure

Instrument Asset Liability

Forward contract Sell foreign currency Buy foreign currency

Option Buy put options Buy call options

Futures Sell futures contract Buy futures contracts

Global Finance 371

value of the Company's investment in foreign subsidiaries resulting from a 10%

adverse change in foreign-currency exchange rates at December 31, 1999 would

amount to $5.5 million.21

Titan International disclosed no currency hedging activities. This is not surprising

given that the $5.5 million loss in investment value amounts to only

about 2% of its total shareholders' equity at the end of 1999. Beyond this, as

we will see in the subsequent discussion of the translation of the statements of

foreign subsidiaries, the potential reduction in Titan's investment value does

not affect either earnings or cash flow.22 This, combined with the immaterial

size of the potential loss in value, can easily explain the absence of hedging

activity.

What Are Hedging Motivations and Objectives?

Much information on hedging motivation is implicit in the information provided

in Exhibits 12.5 and 12.8. Recurrent themes are those of protecting

earnings and cash f low from the potential volatility produced by exchange rate

f luctuations. Information on the ranking of alternative hedging objectives,

from a survey conducted at the Wharton Business School, is provided in Exhibit

12.10. The dominance of the desire to protect cash f lows and earnings is

clearly the dominant motivator for hedging. However, as will be discussed in

the section on translation of the statements of foreign subsidiaries, there is

some level of hedging of balance-sheet exposure.

How Much Exposure Is Hedged?

The extent to which currency exposure is hedged ranges from zero to 100%. It

is common for firms to announce that they simply do not use currency derivatives

to hedge against currency risk. However, such firms may have already

reduced currency risk to tolerable levels through natural hedges. Again, the appetite

of management for bearing currency risk will in large measure determine

the extent of the hedging. The cost and availability of hedging instruments is

EXHIBIT 12.10 Rankings of alternative hedging objectives.

Percent of Respondents Ranking

Hedging Objective the Objective as Most Important

1. To manage volatility in cash f lows 49%

2. To manage volatility in accounting earnings 41

3. To manage market value of the firm 8

4. To manage balance sheet accounts or ratios 2

100%

SOURCE: G. Bodnar, G. Hayt, and R. Marston, "The Wharton Survey of Derivatives Usage by U.S.

Non-Financial Firms," Financial Management, 25 (Winter 1996), 114–115.

372 Planning and Forecasting

also a factor. As with insurance generally, closing out fully the possibility of loss

is more expensive.

Some firms provide information on the extent of their hedging through

schedules of net exposure. E.I. DuPont de Nemours & Company (DuPont) provides

such a schedule. A slightly abridged version is presented in Exhibit 12.11.

DuPont also declares the following about the objective of its hedging program:

The primary business objective of this hedging program is to maintain an

approximately balanced position in foreign currencies so that exchange gains

and losses resulting from exchange rate changes, net of related tax effects, are

minimized.23

Exhibit 12.11 reveals that DuPont has hedged almost all of its exposure.

The extent of their hedging means that their earnings and cash flows will not

be affected in a material way from the hedged exposures. This is reinforced by

the following disclosure:

Given the company's balanced foreign exchange position, a 10 per cent adverse

change in foreign exchange rates upon which these contracts are based would

result in exchange losses from these contracts that, net of tax, would, in all material

respects be fully offset by exchange gains on the underlying net monetary

exposures for which the contracts are designated as hedges.24

Other firms disclose more limited hedging activity. For example, The

Quaker Oats Company reported that about 60% of its net investment in foreign

subsidiaries was hedged. This disclosure is presented in Exhibit 12.12.25

Other Hedging Considerations

Discussed above are a number of factors that bear on the hedging decision,

such as whether or not to hedge, what to hedge, how to hedge, and how much

to hedge. Some other issues center on the cost and term or duration of hedging

arrangements. A sampling of company references to these issues is provided in

Exhibit 12.13.

EXHIBIT 12.11 Net currency exposure: E.I. DuPont de Nemours &

Company, December 31, 1999 (in millions).

After-Tax Net After-Tax

Monetary Open Contracts Net

Asset/(Liability) to Buy/(Sell) After-Tax Exposure

Currency Exposure Foreign Currency Asset/(Liability)

Brazilian real $ 109 $(101) $ 7

British pound (337) 334 (3)

Canadian dollar 514 (509) 5

Japanese yen 76 (71) 5

Taiwan dollar (136) 136 —

SOURCE: E.I. DuPont de Nemours & Company, annual report, December 1999, 37.

Global Finance 373

EXHIBIT 12.12 Disclosure of net investment hedge: The Quaker Oats

Company, December 31, 1999 (in millions).

Currency Net Investment Net Hedge Net Exposure

Dutch guilders $15.1 $ 9.1 $6.0

German marks 18.3 11.9 6.4

SOURCE: The Quaker Oats Company, annual report, December 1999, 56.

EXHIBIT 12.13 Company references to hedging cost and the terms of

currency derivatives.

Company Reference

Hedging Costs

Baxter International Inc. (1999) The Company's hedging policy attempts to manage these

risks to an acceptable level based on management's

judgment of the appropriate trade-off between risk,

opportunity, and costs. As part of the strategy to manage

risk while minimizing hedging costs, the Company utilizes

sold call options in conjunction with purchased put

options to create collars.

Compaq Computer Corporation The Company also sells foreign exchange option contracts,

(1999) in order to partially finance (reduce their cost) the

purchase of these foreign exchange option contracts.

Interface Inc. (1999) The Euro may reduce the exposure to changes in foreign

exchange rates, due to the netting effects of having assets

and liabilities denominated in a single currency.As a result,

the Company's foreign exchange hedging activity and

related costs may be reduced in the future.

Derivative Maturities

Blyth Industries Inc. (2000) The foreign exchange contracts outstanding at January 31,

2000 have maturity dates ranging from February 2000

through June 2000.

Compaq Computer Corporation The term of the Company's foreign exchange hedging

(1999) instruments currently does not extend beyond six months.

Johnson & Johnson (1999) The Company enters into forward foreign exchange

contracts maturing within five years to protect the value

of existing foreign currency assets and liabilities.

Pall Corporation (2000) The Company enters into forward exchange contracts,

generally with terms of 90 days or less.

Polaroid Corporation (1999) The term of these contracts (forward exchange contracts)

typically does not exceed six months.

Tenneco Inc. (1998) Tenneco uses derivative financial instruments, principally

foreign currency forward purchase and sale contracts,

with terms of less than one year.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

374 Planning and Forecasting

Hedging Costs There is little discussion in company reports about the cost of

hedging. In some cases cost issues surely underlie decisions of firms not to

hedge currency risk, but the consideration of cost is not reported. Also, the act

of using internal operations to reduce currency exposure can be seen as designed

to reduce the exposure that may then be hedged with currency derivatives—

thus reducing hedging costs. Clear efforts to reduce hedging costs are

represented by the activities of Baxter International and Compaq Computer.

Each sells (is a writer of the option) currency option contracts from which it

receives an option premium. They then use these amounts to reduce the cost of

currency options used for hedging and where, as the holder of the option, they

are paying an option premium.

Many firms report that they expect to be able to reduce hedging activity

and hedging costs as a result of the introduction of the Euro. This will result

from the replacement of 11 European currencies with the Euro. Transactions

can take place by one Euro country with up to 10 others without incurring any

currency exposure.

Terms of Currency Derivatives The terms of derivative contracts are kept

relatively short, usually less than one year. This partly ref lects the fact that the

maturity of the underlying item being hedged, an account payable or account

receivable, for example, is also quite short. Moreover, the typical maturity

of exchange traded derivatives are short. Also, the cost to acquire currency

through either a forward or option contract also increases with the maturity.

For example, the forward rate (rate at which the foreign currency can be purchased

for future delivery) for the British pound sterling was the following at

the end of 2000:

Contract Term Forward Rate

One month $1.4574

Three months $1.4588

Six months $1.4606

The prices of currencies in both futures and option contracts display the

same increasing cost as maturity lengthens.

The discussion to this point has focused on currency risk and actions that

management can take to reduce the effect of f luctuations in currency values on

the volatility of earnings and cash flow. The examples have centered on what

are normally termed transaction exposures. Examples of transaction exposure

include accounts payable, accounts receivable and bonds payable that are denominated

in foreign currencies. If left unhedged, increases and decreases in

exchange rates cause these balances to expand and contract. This expansion

and contraction produces transactional gains and losses.

Transaction gains and losses are also produced by the combination of

(1) positions in currency derivatives and (2) increases and decreases in exchange

rates. Offsetting losses and gains result when the derivatives are used

Global Finance 375

for hedging purposes. Holding a derivative contract for other than hedging

purposes is normally termed a speculation. It is common for companies to

declare that they do not hold derivatives for speculative purposes: "The Company

does not use financial instruments for speculative or trading purposes,

nor is the Company a party to leveraged derivatives."26 The disclaimer on the

use of currency derivatives, as well as leveraged derivatives, is the legacy of

huge losses incurred on certain derivative transactions in the late eighties and

early nineties.

Attention now turns to translation currency risk. Here, currency exposure

results from having foreign subsidiaries or investments in foreign firms that are

accounted for using the equity method.27

TRANSLATION OF THE STATEMENTS OF

FOREIGN SUBSIDIARIES

A number of new financial and managerial issues were added to the Fashionhouse

agenda when it purchased its former Danish supplier. Transactional

issues continue to the extent that (1) Fashionhouse continues to make some

of its purchases from foreign suppliers and (2) the foreign suppliers continue

to invoice Fashionhouse in the foreign currency. In addition, the Danish subsidiary

may also have its own transactional exposure. However, with the

emergence of the euro, the Danish subsidiary's currency exposure should be

limited to the extent that it deals mainly with countries that have adopted

the Euro.28

Since the Danish company is a wholly owned subsidiary, U.S. GAAP will

call for its consolidation. However, the financial statements of the Danish

subsidiary are in the Danish krone. This introduces a translational issue; the

Danish subsidiary statements must be restated into dollars before their consolidation

with its parent, Fashionhouse, can take place. To the extent that the accounting

practices used in preparing a subsidiary's statements differ from

those of their parent, the subsidiary's statements would need to be restated to

conform to the accounting practices of the parent.29 This would, of course, be

the case with Fashionhouse and its Danish subsidiary. International GAAP differences

are discussed in a subsequent section of this chapter.

FINANCIAL STATEMENT TRANSLATION

Translation means that the foreign-currency balances in the financial statements

of a foreign subsidiary are restated into U.S. dollars. There is no conversion

of currencies, which means that one currency is exchanged for another.

Translation is accomplished by simply multiplying the foreign-currency statement

balances by an exchange rate. Translation would be a nonevent if every

balance in the statements of the foreign subsidiary were multiplied by the

376 Planning and Forecasting

same exchange rate. Translation would simply amount to a scaling of the statements

of the foreign subsidiary.

However, each of the translation alternatives requires the translation of

some balances at different exchange rates. In accounting parlance, this throws

the books out of balance. The amount by which the books are thrown out of

balance by translation is termed the translation adjustment or remeasurement

gain or loss, depending upon the translation process being applied. In the process

of illustrating statement translation, the creation and interpretation of

these translation balances will be discussed.

TRANSLATION ALTERNATIVES

There are two different translation methods under current GAAP. However,

the second method is technically a remeasurement method as opposed to a

translation method. As translation methods, the two alternatives are called the

(1) all-current and (2) temporal methods, respectively. The key features of

these two methods are summarized in Exhibit 12.14.

Examples of accounting policy notes describing the use of each of these

translation policies are provided below:

The all-current translation method: H.J. Heinz Company (1999)

For all significant foreign operations, the functional currency is the local currency.

Assets and liabilities of these operations are translated at the exchange

rate in effect at each year-end. Income statement accounts are translated at the

average rate of exchange prevailing during the year. Translation adjustments

arising from the use of differing exchange rates from period to period are included

as a component of shareholders' equity.

The temporal remeasurement (translation) method:

Storage Technology Corp. (1999)

The functional currency for StorageTek's foreign subsidiaries is the U.S. dollar,

ref lecting the significant volume of intercompany transactions and associated

cash f lows that result from the fact that the majority of the Company's storage

products sold worldwide are manufactured in the United States. Accordingly,

monetary assets and liabilities are translated at year-end exchange rates, while

non-monetary items are translated at historical exchange rates. Revenue and expenses

are translated at the average exchange rates in effect during the year,

except for cost of revenue, depreciation, and amortization that are translated at

historical exchange rates.

The key to the determination of the use of the all-current translation

method by H.J. Heinz is its statement that the functional currency is the local

currency for its foreign subsidiaries. That is, these subsidiaries conduct their operations

in their local currency. The company does not identify its translation

method as all current, but the combination of (1) the use of year-end, or current,

Global Finance 377

exchange rates and (2) the inclusion of translation adjustments in shareholders'

equity marks it as using the all-current translation method.

Unlike H.J. Heinz, Storage Technology declares that the functional currency

of its foreign subsidiaries is the U.S. dollar, not the local foreign currency.

The explanation for this condition is found it its reference to significant

volume of inter-company transactions and the manufacture of most of its products

in the United States. As with H.J. Heinz, Storage Technology does not

identify the translation method it is using. However, the fact that the U.S. dollar

is the functional currency of its foreign subsidiaries determines that it must

be the temporal method. Moreover, it describes its method as translating monetary

assets and liabilities at year-end exchange rates and nonmonetary items at

EXHIBIT 12.14 Alternative translation methods.

All-Current Translation Method

The all-current translation method is the standard procedure applied to foreign subsidiaries

whose operations are conducted in the local foreign currency. That is, the local currency is the

subsidiary's functional currency. The local foreign currency is expected to be the functional

currency when the foreign subsidiary's operations are "relatively self-contained and

integrated within a particular country." A further requirement for use of the all-current

method is that the subsidiary not be located in a country that has experienced cumulative

inf lation over the previous three-year period of 100% or more. The logic is that meaningful

results cannot be produced under these conditions by simply multiplying the foreign

currency balances by current exchange rates.

• All asset and liability balances are translated at the current or end-of-period exchange

rate.

• Paid-in capital is translated at the exchange rate when the funds were raised.

• Revenues and expenses are translated at the average exchange rate for the current

period.

• The translation adjustment is included in other comprehensive income.

Temporal (Remeasurement) Translation Method

This method is applied in those cases where the local foreign currency is not the functional

currency of the subsidiary. The functional currency is defined as "the currency of the

primary economic environment in which the entity operates; normally, that is the currency

of the environment in which the entity generates and spends cash." Moreover, as noted

above, "A currency in a highly inf lationary environment is not considered stable enough to

serve as a functional currency and the more stable currency of the reporting parent is to be

used instead."

• All monetary assets and liabilities are remeasured at current exchange rates.

• All nonmonetary assets, liabilities, and equity balances are remeasured at historical

exchange rates.

• Revenues and expenses are remeasured at average exchange rates for the period.

However, cost of sales and depreciation are remeasured at the same rates used to

remeasure the related inventory and fixed assets, respectively.

• The remeasurement gain or loss is included in realized net income.

378 Planning and Forecasting

historical exchange rates. These procedures are followed when translation (remeasurement)

follows the temporal method.

Translation under the all-current method and remeasurement under the

temporal method are illustrated next.

The All-Current Translation Method Illustrated

Following the guidance in Exhibit 12.14, the all-current translation method is

illustrated using the data below:

1. Foreign Sub is formed on January 1, 2002 with an initial funding from a

stock issue that raised FC1,000 (FC = Foreign current units).

2. Selected exchange rates for 2002:

Direct Exchange Rates

At January 1, 2002 $0.58

Average for 2002 0.62

At December 31, 2002 0.66

The above rates indicate the amount of U.S. currency required to

equal (buy) a single unit of the foreign currency. The increase in the rate

across the year means that the dollar has lost value and that the foreign

currency has appreciated.

3. The trial balance of Foreign Sub, both in FC and in U.S. dollars and

translated following the all-current rule, is given in Exhibit 12.15. Those

accounts that would have debit balances, assets and expenses, are

EXHIBIT 12.15 Trial Balance in FC and translated US$ at

December 31, 2002.

Accounts FC Exchange Rates U.S.$

Cash $ 200 $0.66 $ 132

Accounts receivable 100 0.66 66

Inventory 300 0.66 198

Property and equipment 2,000 0.66 1,320

Cost of sales 600 0.62 372

SG&A expense 100 0.62 62

Tax provision 120 0.62 74

Totals $3,420 $2,224

Accounts payable $ 400 0.66 $ 264

Notes payable 1,020 0.66 673

Common stock 1,000 0.58 580

Retained earnings 0 0

Translation adjustment 0 87

Sales 1,000 0.62 620

Totals $3,420 $2,224

Global Finance 379

grouped first, and those with credit balances, liabilities, equities, and revenues,

are grouped second.

The totals of the two groupings of account balances must be equal,

that is, in balance. Notice that this is only achieved in the U.S. dollar trial

balance through introduction of a translation adjustment account, with a

balance just sufficient to establish this equality. Without the addition of

the $87 translation adjustment account balance, the total of the translated

assets and expenses, $2,224, exceeds the total of the translated liabilities,

shareholders' equity and sales accounts by $87. This translation

adjustment can also be directly calculated as shown next:

Beginning net assets (assets minus liabilities) FC1,000

times change in exchange rate from 1/1/02 to

12/31/02 (0.66 0.58) 0.08 $80

Net income FC180

times difference between end of year and

average exchange rates (0.66 0.62) 0.04 7

Translation adjustment $87

The $80 component represents the growth in the beginning net assets due

to appreciation in the value of Sub's foreign currency. The $7 component is the

additional net assets due to the translation of the income statement balances at

the average rate for the year of $0.62 and balance sheet amounts at the end of

year rate of $0.66. There is no retained earnings balance in the above trial balance

because 2002 is the first year of operation and the net income for the year

is added to retained earnings through a later process of closing the books.

The translated balance sheet and income statements are presented in

Exhibits 12.16 and 12.17. They can be constructed from the translated data

above. The translation of the FC data is presented again in these statements

simply to reinforce the nature of the translation process.

EXHIBIT 12.16 Translated income statement, year

ending December 31, 2002.

Income Statement FC Exchange Rates U.S.$

Sales $1,000 $0.62 $620

Less cost of sales 600 0.62 372

Gross margin 400 248

Less SG&A 100 0.62 62

Pretax profit 300 186

Less tax provision 120 0.62 74

Net income $ 180 $112

Other comprehensive income 87

Comprehensive income $199

380 Planning and Forecasting

In the absence of dividends, the retained earnings in the balance sheet

are simply the net income for the year. The translation adjustment of $87 is included

in consolidated shareholders' equity as accumulated other comprehensive

income. The net assets of Foreign Sub are in a currency that appreciated

across the year. This growth in net assets is captured in the process of translation

and represented, again, by the translation adjustment balance. It is common

for the translation adjustment in this case to be referred to as a translation

gain. It resulted because the U.S. parent has a net investment (assets minus liabilities)

in a country whose currency appreciated against the U.S. dollar.

If, instead, the FC had depreciated, then the translation adjustment

would represent a negative balance in the initial accumulated other comprehensive

income for 2002. Also, in this circumstance it is common to see the

translation adjustment referred to as a translation loss. With the translation

completed, the above statements in Exhibit 12.16 and 12.17 would now be

ready for consolidation with those of the U.S. parent.30

The Remeasurement of Statements (Temporal

Translation) Illustrated

This illustration of the remeasurement of the statements of a foreign subsidiary

uses the same data as used in the illustration of the all-current translation

method.31 However, some additional information is required:

1. Property and equipment were acquired when the exchange rate was

$0.58.

2. Depreciation on this property and equipment of FC60 was included in

SG&A expense.

EXHIBIT 12.17 Translated balance sheet, December 31,

2002.

Balance Sheet FC Exchange Rates U.S.$

Cash $ 200 $0.66 $ 132

Accounts receivable 100 0.66 66

Inventory 300 0.66 198

Property and equipment 2,000 0.66 1,320

Total assets $2,600 $1,716

Accounts payable $ 400 0.66 $ 264

Notes payable 1,020 0.66 673

Common stock 1,000 0.58 580

Accumulated OCI* 87

Retained earnings 180 112

Total liabilities and equity $2,600 $1,716

* OCI = Other comprehensive income.

Global Finance 381

3. The ending inventory was acquired at the average exchange rate of $0.62,

and cost of sales is also made up of goods that were acquired when the exchange

rate averaged $0.62.

The previous trial balance is remeasured into the U.S. dollar as shown in

Exhibit 12.18. The income statement and balance sheet, prepared with the remeasured

trial balance data, are presented in Exhibits 12.19 and 12.20.32

Notice how application of the remeasurement method sharply changes

comprehensive income. Comprehensive income was $199 with translation

under the all-current method but only $27 with the temporal method of remeasurement.

This difference of $85 is explained as follows:

All-current method comprehensive income $199

Reduction in depreciation under temporal method:

FC60 (.62 .58) 2*

Translation gain under the all-current method $(87)

Deduct remeasurement loss under temporal method 87

(174)

Temporal method net income $ 27

*Depreciation was translated at $0.62 as part of SG&A under the all-current method.

However, because the fixed assets, which give rise to the depreciation expense, are translated

at their historical exchange rate of $0.58, the depreciation component of SG&A is

reduced by $2 with remeasurement under the temporal method.

EXHIBIT 12.18 Remeasured trial balance, December 31,

2002.

Accounts FC Exchange Rates U.S.$

Cash $ 200 $0.66 $ 132

Accounts receivable 100 0.66 66

Inventory 300 0.62 186

Property and equipment 2,000 0.58 1,160

Cost of sales 600 0.62 372

SG&A expense 40 0.62 25

Depreciation 60 0.58 35

Tax provision 120 0.62 74

Remeasurement loss 87

Totals $3,420 $2,137

Accounts payable $ 400 0.66 $ 264

Notes payable 1,020 0.66 673

Common stock 1,000 0.58 580

Retained earnings 0 0

Sales 1,000 0.62 620

Totals $3,420 $2,137

382 Planning and Forecasting

The explanation for the remeasurement loss of $87 is that balance-sheet

exposure changed from net asset under the all-current method to net a liability

position under the temporal (remeasurement) method. Asset exposure in an

appreciating foreign currency results in a gain. However, liability exposure in

the same circumstance results in a loss. In the all-current example, all assets

and liabilities are translated using the current rate. Asset exposure existed

under the all-current method because assets exceeded liabilities. As a result,

the appreciation of the foreign currency resulted in a growth (gain) in net assets.

This gain of $87 was reported as other comprehensive income.

Under the temporal method of remeasurement, balance sheet exposure

is the net of monetary assets and liabilities. These balance sheet accounts are

EXHIBIT 12.19 Remeasured income statement, year

ended December 31, 2002.

Accounts FC Exchange Rates U.S.$

Sales $1,000 $0.62 $620

Less Cost of sales 600 0.62 372

Gross margin 400 248

Less: SG&A 40 0.62 25

Depreciation 60 0.58 35

Remeasurement loss (Exhibit 12.18) 87

Pretax profit 300 101

Less: tax provision 120 0.62 74

Net income $ 180 $ 27

Other comprehensive income —

Comprehensive income $ 27

EXHIBIT 12.20 Remeasured balance sheet, December 31,

2002.

Balance sheet FC Exchange Rates U.S.$

Cash $ 200 $0.66 $ 132

Accounts receivable 100 0.66 66

Inventory 300 0.62 186

Property and equipment 2,000 0.58 1,160

Total assets $2,600 $1,544

Accounts payable$ $ 400 0.66 $ 264

Notes payable 1,020 0.66 673

Common stock 1,000 0.58 580

Retained earnings 180 (income statement) 27

Total liabilities and equity $2,600 $1,544

Global Finance 383

remeasured at the ever-changing current rate. However, none of the other nonmonetary

balance-sheet accounts creates exposure because their dollar value is

frozen at fixed, historical exchange rates.

In the above example, monetary liabilities (accounts payable of FC400

plus notes payable of FC1,020) are well in excess of monetary assets (cash of

FC200 plus accounts receivable of FC100) and net liability exposure results.

Appreciation of the foreign currency increased the dollar valuation of this net

liability exposure and produced a remeasurement loss of $87. This remeasurement

loss is included in computing conventional net income, and not in other

comprehensive income as is the case under the all-current translation method.

Beyond these separately reported income statement effects of translation

gains and losses, the translated financial statements are affected in some other

less obvious ways. These are discussed next.

Other Effects of Statement Translation

and Remeasurement

The most noticeable effects of the statement translation and remeasurement

are (1) the translation adjustment that is part of other comprehensive income

under all-current translation and (2) the remeasurement gain or loss that is included

in realized net income with statement remeasurement under the temporal

method.

Statement Relationships under Translation

versus Remeasurement

Significant differences in earnings resulted in the above example with translation

under the all-current method versus remeasurement under the temporal

method. These results are due to (1) differences in currency exposure under

the two methods and (2) differences in the location of translation-related gains

and losses in the financial statements under the two methods. Translation adjustments

go to other comprehensive income under all-current translation, but

remeasurement gains and losses are included in net income with remeasurement

under the temporal method.

Key statement relationships are affected by translation versus remeasurement.

For example, both the current ratio (ratio of current assets to current

liabilities) and the debt to equity ratios differ between the two methods. It is

also common for gross margins to differ between the two methods. However,

the simple nature of this constructed example results in the same gross margins

under each translation/remeasurement method. These measures are presented

in Exhibit 12.21.

Noticeable in Exhibit 12.21 is the fact that the values of each of the measures

from the foreign-currency statements are preserved with translation

under the all-current method. However, both the working capital and debt to

equity measures differ from these values in the case of remeasurement under

384 Planning and Forecasting

the temporal method. The working capital ratio differs because inventory is

translated at a rate of only $0.62 under remeasurement, but at $0.65 with

translation under the all-current method. The debt-to-equity ratio is higher

with the remeasured statements because of the remeasurement loss under the

temporal method, but a translation gain under the all-current method. Preserving

the relationships of the foreign-currency statements in the translated

statements is seen to be a desirable feature of translation under the all-current

method.

Effects of Exchange Rate Changes not Captured by

Translation and Remeasurement

It is common for firms to comment on the effects of exchange-rate changes on

key financial statement items. In particular, the effects of exchange-rate

changes on the growth or decline in sales are frequently commented upon in

Management's Discussion and Analysis (MD&A).

The processes of translation and remeasurement summarize the joint effects

of currency exposure and exchange rate changes in a single summary statistic.

However, there are other effects associated with changing exchange rates

that are not set out separately in any financial statement. For example, assume

that the physical volume of sales and local-currency sales prices are unchanged

for a foreign subsidiary. If the currency of the country in which the subsidiary

is located depreciates in value, then the translated amount of sales revenue will

decline. If the product being sold is manufactured in the foreign country, then

there should also be a partially offsetting decline in cost of sales.33

The disclosures in Exhibit 12.22 attempt to identify the effect of changing

exchange rates on sales and profits. Galey & Lord's disclosure identifies a common

concern about the dollar appreciating in value: it makes U.S. goods more expensive

in the export market. This point is echoed by Illinois Tool Works and its

disclosure that its operating revenues were reduced each of the last three years

because of the strengthening of the U.S. dollar. Revenue reductions associated

with a strengthened dollar normally come from a combination of (1) foreign sales

EXHIBIT 12.21 Key statement relationships under translation versus

remeasurement.

In the FC

Measurement Statements Translation Remeasurement

Working capital ratioa 1.50/1 1.50/1 1.45/1

Gross margin 40% 40% 40%

Debt to equityb .86/1 .86/1 1.11/1

a Only the accounts payable are included in current liabilities.

b Debt includes only the notes payable. Equity under the all-current method includes accumulated

other comprehensive income.

Global Finance 385

simply translating into fewer dollars as well as (2) declines in the volume of foreign

sales due to the weakening of the foreign currency.

The Philip Morris disclosures highlight the value of diversification in foreign

sales by currency. Whereas revenues and profits were reduced by the depreciation

of Western European and Latin American currencies, the Japanese

yen appreciated and offset, but not fully, these negative effects. Notice that

Philip Morris identifies the net effect of the appreciation and depreciation of

foreign currencies on both revenues and income.

Praxair provides sufficient detail to reconcile its actual percentage

growth or decline in sales to the results in the absence of changes in exchange

rates. Notice that Praxair's sales declined by 4% in 1999, and that the decline

was largely explained by currency depreciation in South America. However, explaining

the behavior of sales in 1998 is more involved. The information disclosed

by Praxair for 1998 is summarized here:

EXHIBIT 12.22 Exchange rate effects on sales and profit growth.

Galey & Lord Inc. (1999)

In addition to the direct effects of changes in exchange rates, which are a changed dollar

value of the resulting sales and related expenses, changes in exchange rates also affect the

volume of sales or the foreign currency sales price as competitors products become more or

less attractive.

Illinois Tool Works Inc. (1999)

The strengthening of the U.S. dollar against foreign currencies in 1999, 1998 and 1997

resulted in decreased operating revenues of $59 million in 1999, $122 million in 1998 and

$166 million in 1997 and decreased net income by approximately 1 cent per diluted share in

1999 and 4 cents per diluted share in 1998 and 1997.

Philip Morris Companies Inc. (1999)

Currency movements decreased operating revenues by $782 million ($517 million, after

excluding excise taxes) and operating companies income by $46 million during 1999. Declines

in operating revenues and operating companies income arising from the strength of the U.S.

dollar against Western European and Latin American currencies were partially mitigated by

currency favorabilities recorded against the Japanese yen and other Asian currencies.

Praxair Inc. (1999)

The sales decrease of 4% in 1999 as compared to 1998 was due primarily to unfavorable

currency translation effects in South America. Excluding the impact of currency, sales grew

by 2%.

The productivity improvements and currency translation impacts resulted in an $18 million

decrease in selling, general, and administrative expenses despite the increase due to

acquisitions.

Sales for 1998 were f lat when compared to 1997, primarily because sales volume growth of

4% and price increases of 2% were offset by negative currency translation effects.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

386 Planning and Forecasting

Disclosed sales growth 0%

Breakdown of Sales-Change Components

Volume +5%

Price changes +2%

Currency depreciation 7%

Sales growth 0%

The Praxair zero change in sales revenue in 1998 could be interpreted in

a manner that is too negative. After all, in the face of the zero growth in actual

dollar sales revenue, Praxair was able to increase prices and still improve sales

volume by 5%. Disclosure of quantitative details on the effects of the three elements,

volume, price and currency makes it possible to develop a much better

understanding of Praxair's 1998 business performance.

In the case of positive revenue growth, increases from volume or price

adjustments should be preferred to growth resulting from favorable exchangerate

movements. Revenue growth driven by changes in exchange rates may

prove to be only temporary. Sustained revenue growth, in the absence of volume

growth and/or price increases, would require ongoing strengthening of

foreign currencies—not a very likely prospect.

The effects of changes in exchange rates on sales and profits can be controlled

to some extent by management. As with most foreign-currency exposure,

management can elect to control or hedge this risk through operational

arrangements and currency derivatives. Much discussion of these matters has

already been provided. However, the focus of the next section is on the management

of currency risks associated with foreign subsidiaries.

MANAGING THE CURRENCY RISK OF

FOREIGN SUBSIDIARIES

It is a common view that translation-related currency risk associated with the

statements of foreign subsidiaries is quite different from currency risk associated

with foreign-currency transactions. Transactional exposure has the clear

potential to expand or contract the cash f lows associated with foreign-currency

asset and liability balances. If a U.S. firm holds a Japanese yen account receivable

and the yen falls in value, then there is a loss of cash inflow. If a Japanese

firm has an account payable in the U.S. dollar and the yen strengthens, then a

smaller cash outf low is required to discharge this liability.

There are no identifiable cash inf lows or outf lows in the case of translation

gains or losses that result from either statement translation or remeasurement.

A study of both U.S. and U.K. multinationals found that "it was generally

agreed that translation exposure management was a lesser concern" (less than

transaction exposure management).34 The Wharton survey results on hedging

(Exhibit 12.10) found the management of the volatility of cash f lows as the

major objective of hedging. However, it is very common for disclosures of

transaction-related currency hedging to cite the goal of protecting cash f lows.

Global Finance 387

The reduced level of currency risk-management in the case of translation

exposure is explained largely by the absence of direct cash flow and earnings

risk. There is a somewhat greater effort to manage remeasurement-related risk

because, unlike under the all-current method, remeasurement gains and losses

are included in net income. Some companies do hedge translation exposure

even though the translation adjustments are only included in other comprehensive

income, with this element generally going straight to shareholders' equity.

However, the absence of an impact on earnings under all-current translation

makes it less likely that this exposure will be hedged.

Prior to the issuance of SFAS No. 52, Foreign Currency Translation,

SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions

and Foreign Financial Statements, required all firms to use the temporal

method and to include all translation gains and losses in the computation of net

income.35 As a result, one would expect the hedging of translation exposure to

have declined after the issuance of Statement No. 52. Under SFAS No. 52,

most translation is by the current-rate method and translation adjustments are

omitted from conventional net income. Available evidence supports this view.

For example, Houston and Mueller note: "In particular, firms that must no

longer include all translation gains or losses arising from their foreign operations

in their income statements are more likely to have stopped or reduced

hedging translation exposure."36

To gain some insight into translation hedging practices, disclosures of

translation-hedging policies by a number of firms are presented in Exhibit 12.23.

The examples in Exhibit 12.23 are selective and do not represent the relative frequency

with which translation exposure is hedged. Rather, the disclosures are

simply designed to present some of the matters that appear to inf luence decisions

on the hedging of translation exposure.

Notice that AGCO does not hedge its translation exposure. However, it

attempts to achieve what could be called a natural hedge by the device of financing

its foreign operations with local borrowings. Increasing local-currency

borrowings reduces the net investment in the subsidiary—assets minus liabilities—

and with it translation exposure. This example suggests a potential for misinterpretation

of company statements about their translation hedging. AGCO

apparently means that it does not use currency derivatives to hedge translation

exposure. However, it does attempt to reduce exposure by other means.

Becton Coulter indicates occasional hedging of translation exposure.

Note the reference to the hedge of the market (exchange rate) risk of a subsidiary's

net-asset position. Again, in the case of translation with the allcurrent

method, exposure is approximated by a subsidiary's net-asset position,

that is, assets minus liabilities. Becton Coulter must be making reference to

subsidiaries translated using the all-current method because it indicates that

any gains or losses on hedges of translation exposure are included in accumulated

other comprehensive income. This is also the location of the translation

gains and losses that result from the all-current translation method. The gains

and losses on the hedges of this translation exposure are included in other comprehensive

income and offset, respectively, translation losses and gains.

388 Planning and Forecasting

The Becton Dickenson statement is the clearest statement of the case for

not hedging translation exposure. The key elements of the Becton Dickenson

position are that: (1) translation adjustments are included in shareholders' equity;

(2) translation adjustments do not affect conventional net income; and

(3) translation adjustments do not affect cash flow.

The DaimlerChyrsler reference to the net assets of subsidiaries located

abroad not being included in the management of currencies means that they

are not hedged. The Quaker Oats Company does do some hedging of net investments

in foreign subsidiaries. Both Henry Schein and Titan International

emphasize the long-term nature of the investments in foreign subsidiaries in

explaining the decision not to hedge this exposure.

EXHIBIT 12.23 Hedging of translation exposure: Selected company

policies.

Company Hedging Policy

AGCO Corporation (1999) The Company's translation exposure resulting from

translating the financial statements of foreign subsidiaries

into U.S. dollars is not hedged. When practical, this

translation impact is reduced by financing local operations

with local borrowings.

Becton Coulter Inc. (1999) We occasionally use foreign currency contracts to hedge the

market risk of a subsidiary's net asset position. Market value

gains and losses on foreign currency contracts used to hedge

the market risk of a subsidiary's net asset position are

recognized in "Accumulated Other Comprehensive Income"

as translation gains and losses.

Becton, Dickenson & The Company does not generally hedge these translation

Company (1999) exposures since such amounts are recorded as cumulative

currency translation adjustments, a separate component of

shareholders' equity, and do not affect earnings or current

cash f lows.

DaimlerChyrsler AG (1999) The net assets of the Group which are invested abroad in

subsidiaries and affiliated companies are not included in the

management of currencies.

The Quaker Oats Company The Company uses foreign currency forward and option

(1999) contracts and currency swap agreements to manage foreign

currency rate risk related to certain cash f lows from foreign

entities and net investments in foreign subsidiaries.

Henry Schein Inc. (1998) The Company considers its investments in foreign operations

to be both long-term and strategic. As a result, the Company

does not hedge the long-term translation exposure in its

balance sheet.

Titan International (1999) The Company views its investments in foreign subsidiaries as

long-term commitments and does not hedge foreign currency

transaction or translation exposures.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

Global Finance 389

There is some hedging of translation, but the hedging of translation exposure

is clearly less common than the hedging of transaction exposure. Hedging

practice, based upon cited surveys and our own study of hundreds of company

reports, suggests the following ordering of management demand for hedging,

from high to low:

1. To protect cash flow and earnings, both level and stability.

2. To protect earnings, both level and stability.

3. To protect shareholders' equity, both level and stability.

In continuing to observe hedging motivated by both two and three above,

it is important to consider the significance of earnings and equity amounts

without regard to the issue of cash f lows. For example, there is a tremendous

current focus on whether or not earnings meet the consensus forecasts of Wall

Street. The penalty for missing the forecast, sometimes by pennies, can be dramatic

reductions in share value. Of the two translation methods, only the temporal

(remeasurement) method includes the remeasurement gains or losses in

the computation of net income. There is no evidence that a failure to meet the

Wall Street consensus will be forgiven if it results from unhedged remeasurement

exposure.

Management compensation is often based, directly or indirectly, upon reported

earnings. This provides an incentive for management to hedge in order

to avoid earnings reductions from remeasurement losses.

Finally, it is common for debt and credit agreements to include financial

covenants that require the maintenance of minimum amounts of shareholders'

equity or minimum ratios of debt to equity. Unhedged translation exposure,

under either the all-current or temporal (remeasurement) methods, may reduce

shareholders' equity and cause these covenants to be violated.

Differences in hedging practices are explained in part by different attitudes

towards bearing currency risk as well as the cost and capacity to hedge

exposures in different countries. In addition, firms will differ in their capacity

to minimize currency exposure through various operational, organizational and

business arrangements.

As a final topic in this coverage of currency risk and hedging, an overview

of the current requirements in the accounting for currency derivatives

is provided.

ACCOUNTING FOR HEDGES:

CURRENT GAAP REQUIREMENTS

Important changes in the accounting for currency derivatives were introduced

with the issuance of SFAS No. 133, Accounting for Derivative Instruments and

Hedging.37 Initial required application of the standard begins with the first fiscal

quarter of the first fiscal year beginning after June 15, 2000.

One of the most important requirements of the new standard is that all

derivative instruments must be recognized on the balance sheet and carried

390 Planning and Forecasting

at their fair values. Whether or not these changes in fair value go immediately

into the computation of net income will depend upon (1) whether or

not the derivative is used for hedging purposes and (2) the nature of the

hedge applications.

The accounting for changes in the fair value of a foreign-currency derivative

depend upon its intended use. Possibilities include (1) the hedging of

exposure to changes in the fair value of a recognized asset, liability or an unrecognized

firm commitment, (2) the hedging of exposure to variable cash

f lows of a forecasted transaction, and (3) the hedging of a net investment in a

foreign operation. These three hedging applications are referred to as fair

value, cash flow and net-investment hedges, respectively.

Changes in the fair values of currency derivatives will either be reported

in the income statement as these changes take place or they will initially be reported

in other comprehensive income (OCI). The gains and losses that are initially

included in OCI will subsequently be included in the income statement

when the hedged transaction affects net income.

Fair Value Hedges

A firm purchase commitment in a foreign currency is an example of a transaction

that could be a fair-value hedge candidate. Normally, there is no initial

recording on the books of the firm commitment. However, there is currency

risk and subsequent increases and decreases in the value of the foreign currency

give rise to losses and gains, respectively. To illustrate how a hedge

would be accounted for in this case, assume a purchase commitment made for

100 million yen when the yen rate was $0.008976. By the end of the accounting

period the yen has appreciated to $0.009000. This increase in the yen of

$0.000024 ($0.009000 $0.008976) creates a loss on the purchase commitment

of $2,400 ($0.000024 × 100 million yen). Also assume that the firm had

entered into a forward contract to buy 100 million yen as a hedge of the firm

commitment. We will assume that the forward contract (the currency derivative)

also increased in value by $2,400.

Under SFAS No. 133, the $2,400 increase in the cost of the purchase

commitment would be recorded as a loss on the commitment. In addition, the

forward contract would also be marked to market value, creating an offsetting

gain of $2,400. Each of these items would be reported in the income statement

where they will offset each other.

The special feature of the above accounting (i.e., hedge accounting), is

the recognition of the loss on the purchase commitment. Prior to SFAS No.

133, it would have been common not to recognize the loss on the purchase

commitment, but to recognize and defer the gain on the forward contract.

Then the loss on the purchase commitment would not be recognized until the

purchase was made. At this time, the deferred gain on the currency derivative

would be deducted from the cost of the purchase. SFAS No. 133 basically

eliminates this type of gain or loss deferral on financial derivatives.

Global Finance 391

Many of the hedging examples disclosed in Exhibits 12.5 and 12.8 involved

balances that were already recorded on the balance sheet of the

hedging firms. The use of hedges in these cases requires no special hedge accounting.

For example, consider the case of a one million pound sterling account

receivable recorded when the sterling rate was $1.50. By the end of the

year, but before the pound receivable was collected, the pound depreciated to

$1.45. Assume that the U.S. firm hedged the full amount of the pound sterling

account receivable by entering a forward contract to sell the one million

pounds at the expected collection date.

Under current GAAP, the pound receivable must be revalued to the new

rate of $1.45, and a foreign currency transaction loss of $50,000 would be recognized.

Moreover, the currency derivative would be marked to its new market

value, which is assumed to be $50,000, a perfect hedge.38 This activity is summarized

below:

£ Account Receivable

Initial value of £1,000,000 at $1.50 equals $1,500,000

Value at year-end: £1,000,000 at $1.45 equals 1,450,000

Foreign-currency transaction loss 50,000

Currency Derivative

End-of-period value of the currency derivative $ 50,000

Initial value of the forward contract 0

Gain on the currency derivative (50,000)

Net effect on earnings $ 0

No special hedge accounting is required in the above case to cause the loss on

the receivable and the gain on the currency derivative to offset each other in

the income statement.

Cash Flow Hedges

Hedges of forecasted transactions, cash f low hedges, are distinguished from

hedges of firm commitments, which are classified as fair value hedges. As an

example, a forecasted transaction might involve the future receipt of royalty

payments in a foreign currency. There is currency exposure here because a decline

in the value of the foreign currency will reduce the dollar value of the

royalty, a cash flow, when it is received. A hedge of this exposure could be

achieved by selling a futures contract, investing in a put option, or selling the

foreign currency through a forward contract.

In order to illustrate hedge accounting for a cash-flow hedge, assume

that a firm forecasts the receipt of one million German marks (DM) from royalties.

A currency derivative is acquired to hedge all of this exposure. At the

date that the derivative contract is entered into, the DM rate is $0.45. At the

end of the accounting period, but before the royalties are received, the DM

depreciates to $0.43. The value of the derivative contract increases by

$20,000. SFAS No. 133 requires that a gain from the increase in the fair value

392 Planning and Forecasting

of a derivative contract be recognized as it occurs. However, GAAP does not

permit recognition of the loss from the decline in the dollar value of the forecasted

DM cash flow.

Recognition of the $20,000 gain on the currency derivative as part of

earnings would present a problem. There would be no offsetting loss in the income

statement from the decline of the dollar value in the DM royalties.

Hedge accounting deals with this problem by providing that the $20,000 gain

on the derivative be included in other comprehensive income and not net income.

Then, when the DM royalties are received, the $20,000 gain is reclassified

out of accumulated other comprehensive income and in to net income.

To illustrate the above fully, assume that the one million DM of royalties

are received, and that the value of the DM has not changed in value from

its previous year-end rate of $0.43. The hedge accounting is summarized in Exhibit

12.24.

Notice that the total income recognized in the income statement in the

period in which the royalty is received is $450,000. This is equal to the original

value of the expected royalty cash flow. However, the $450,000 is made up of

only $430,000 in royalty value and the remainder is the product of the cash

flow hedge.

Hedges of Net Investments in Foreign Operations

Earlier discussion of statement translation revealed far less hedging of translation

as opposed to transaction exposure. Most translation of the net investments

in foreign operations, typically foreign subsidiaries, employs the all-current

method. Under this translation procedure, all translation adjustments (translation

gains and losses) are recorded in other comprehensive income. These translation

adjustments are only included in the computation of net income if all or a

significant portion of the foreign operation is sold or otherwise disposed of.

Some firms do hedge their translation exposure. Consistent with the translation

adjustments being included in other comprehensive income, offsetting

gains and losses on currency derivatives used to hedge translation exposure are

EXHIBIT 12.24 Hedge accounting for expected cash f low.

Period of Receipt

Initial Period of Royalties

Included in net income

Gain on currency derivative 0 $ 20,000

Royalty cash inf low 0 430,000

$450,000

Included in other comprehensive income:

Gain on currency derivative $20,000 $ (20,000)

Global Finance 393

also recorded in other comprehensive income (see Becton Coulter Inc. in Exhibit

12.23 for an example of this treatment).

The review of current accounting requirements has not explored a number

of technical points related to hedging. These matters go beyond the goals

of this chapter. However, many of these items are included in more technical

and comprehensive treatments of hedging and derivative instruments.39

U.S. AND INTERNATIONAL GAAP DIFFERENCES

A variety of new financial, accounting, tax, and managerial issues faced

Fashionhouse when it acquired a Danish subsidiary. The issues of statement

translation and currency risk-management were discussed above. Recall

that the requirement to consolidate the Danish subsidiary into the dollarbased

statements of Fashionhouse, the parent, requires translation. In addition,

to the extent that Danish accounting practices differ from those in the

U.S., adjustments must be made so that the subsidiary's statements conform

to U.S. GAAP.

International GAAP Differences and the IASC

A review of the statements of companies located in different countries will

reveal cases of both agreement and disagreement between foreign and U.S.

GAAP. In order to address the high level of international disagreement found

in accounting practices, the International Accounting Standards Committee

(IASC) was formed in 1973. The IASC, which was comprised initially of representatives

from the leading professional accounting bodies of Australia,

Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom,

Ireland, and the United States, began working toward the harmonization

of accounting standards internationally. Today, the IASC represents

accounting bodies from over 70 countries. Each member body has agreed to

work towards the compliance of accounting standards in their home countries

with the standards issued by the IASC. In fact, a number of countries, such

as India, Kuwait, Malaysia, Singapore, and Zimbabwe, either adopt IASC

standards as their own generally accepted accounting principles or place

heavy reliance on them in developing their own accounting standards.

To date, 39 international accounting standards and several exposure

drafts have been issued. The IASC has also issued a document that both

identifies major differences in international accounting practices and categorizes

them in terms of their being, (1) the required or preferred treatment,

(2) the allowed alternative treatment, or (3) the treatment eliminated.40 The

immediate goal of the proposal is to eliminate most of the choices in accounting

treatment now available in standards issued by the IASC. The IASC enumerated

the expected benefits of this harmonization in financial reporting as

follows:41

394 Planning and Forecasting

1. Improve the quality of financial reporting.

2. Make easier the comparison of the financial position, performance and

changes in financial position of enterprises in different countries.

3. Reduce the costs borne by multinational enterprises that presently have

to comply with different national standards.

4. Facilitate the mutual recognition of prospectuses for multinational securities

offerings.

A subsequent statement has reported responses to this initial document

and outlined plans for implementation of some of the initial proposals and additional

study for others.42 The major approach to implementation of the IASC

proposals is to incorporate those proposals on which agreement has been

reached into revised International Accounting Standards.

Examples of some of the accounting treatments that would be eliminated

under the IASC proposals follow:

1. Completed contract method for the recognition of revenue on construction

contracts.

2. Deferral of exchange gains and losses on long-term monetary items.

3. Translation of statements of subsidiaries operating in hyperinf lationary

economies, without first applying price-level adjustments.

4. Use of the closing (end of period) exchange rate to translate income statement

balances.

5. Maintenance of investment properties on the books without depreciation

6. Immediate deduction of goodwill against shareholders' equity.

Examples of U.S. and international GAAP differences are provided in the

next section along with an illustration of how international firms mitigate the

impact of differences for U.S. statement users.43

U.S. and International GAAP Differences

In spite of the harmonizing efforts of the IASC, there remain numerous differences

between the GAAP applied in countries around the world. A sampling

of some areas of current or previous differences between U.S. GAAP and

GAAP in selected other countries is provided in Exhibit 12.25.

As GAAP in different countries are constantly changing, as well as the

specific methods selected by firms within countries, some of the GAAP differences

in Exhibit 12.25 may no longer be current. However, they remain illustrative

of areas in which major GAAP differences are found between U.S.

GAAP and those employed in other countries. Fortunately, in the United States

the Securities and Exchange Commission requires that listed foreign firms

provide disclosures of differences between the GAAP on which their statements

are prepared and U.S. GAAP.

Global Finance 395

SEC Requirements for Disclosing the Effects

of GAAP Differences

With the continuing globalization of financial markets, international firms

have become more sensitive to the analytical burdens that result from differences

between foreign and domestic GAAP. Further, the U.S. Securities

and Exchange Commission requires that some foreign firms file reports that

EXHIBIT 12.25 Examples of U.S. and international GAAP differences.

Accounting Policy Country/Company GAAP Difference

Software costs England /Reuters Holdings Reuters expenses all software costs;

a portion of such cost would

normally be capitalized under U.S.

GAAP.

Tax accounting Malaysia /United Malacca Deferred taxes are not booked if

Rubber Estates temporary differences are deferred

indefinitely; deferred taxes are

booked on all temporary differences

under U.S. GAAP.

Investments Australia/BHP Limited Equity accounting is not applied to

investments in excess of 20% of

voting shares; U.S. GAAP generally

requires application of the equity

method.

Property Hong Kong/Hong Kong Tangible fixed assets and property

Telecommunications may be restated on the basis of

appraised values; upward revaluations

are not permitted under U.S. GAAP.

Sale/leaseback gains Netherlands/PolyGram Gains on sale/leaseback transactions

are recognized in the year of sale;

such gains are normally deferred and

amortized into future earnings under

U.S. GAAP.

Construction interest Sweden/Pharmacia Interest related to the construction of

assets is expensed; U.S. GAAP requires

capitalization and amortization.

Foreign exchange gains England /British Airways Foreign exchange gains and losses are

and losses (on loans to deducted from or added to the cost of

acquire aircraft) aircraft; included in income as

incurred under U.S. GAAP.

Unrealized foreign Germany/Continental Losses are deducted from income but

exchange gains and Aktiengesellschaft gains are not recorded; U.S. GAAP

losses recognizes both in earnings.

396 Planning and Forecasting

include schedules reconciling earnings under U.S. and foreign GAAP (the 20-F

Report). An example of such disclosure is provided below from the 20-F report

of the Portuguese firm, Electricidade de Portugal SA (EP). As is required, EP

provides a reconciliation of Portuguese to U.S. GAAP for both net income (Exhibit

12.26) and shareholders' equity (Exhibit 12.27). A selection of the principal

differences between U.S. and Portuguese GAAP underlying these

statements are discussed below:

1. EP writes up the value of its fixed assets. It in turn records depreciation

on these revalued amounts. This causes depreciation in the Portuguese-

GAAP statements to be greater than it would be under U.S. GAAP, where

such revaluations are not permitted. This higher depreciation caused the

EP earnings to be reduced below their level under U.S. GAAP. This explains

the addition to net income made for "depreciation of revaluation of

fixed assets" in the Exhibit 12.26 reconciliation of Portuguese GAAP to

U.S. GAAP net income. Also notice that the cumulative effect of this

GAAP difference results in a reduction in Portuguese GAAP shareholders'

EXHIBIT 12.26 Reconciliation of net income under Portuguese GAAP

to income under U.S. GAAP: Electricidade de Portugal ,

year ended December 31, 1998 (in thousands except

for per-share amounts and shares outstanding).

Escudos U.S.$

Net income as reported under Portuguese GAAP 104,808,918 539,307

U.S. GAAP adjustments increase (decrease) due to:

a. Depreciation of revaluation of fixed assets 48,045,972 247,226

b. Capitalized overheads (949,690) (4,887)

c. Depreciation of exchange differences 5,121,052 26,351

d. Deferred costs (1,537,691) (7,912)

e. Hydrological correction adjustments — —

f. Distribution to management and employees (3,845,532) (19,788)

g. Pension and other post-retirement benefits — —

h. Self-insurance — —

i. Employee termination benefits 19,969,334 102,755

j. Accounts receivable—municipalities (10,429,115) (53,664)

k. Power purchase agreements (343,236) (1,766)

m. Income taxes (19,642,655) (101,074)

Net adjustments 36,388,439 187,241

Approximate net income in accordance with U.S. GAAP 141,197,357 726,548

Net income per share 235 1.21

Number of shares outstanding 600,000,000 600,000,000

SOURCE: Electricidade de Portugal SA, annual report, December 1998. Information obtained from Disclosure

Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC

(Bethesda, MD: Disclosure Inc., June 2000).

Global Finance 397

equity in the Exhibit 12.27 reconciliation of shareholders' equity. Writing

up its fixed assets increased EP's shareholders' equity.

2. EP capitalized a portion of general and administrative overhead that

would not be permitted under U.S. GAAP. This called for a reduction in

both Portuguese GAAP net income and in shareholders' equity. These adjustments

follow the same pattern as those required by the revaluation of

fixed assets.

3. EP capitalized and amortized foreign exchange gains and losses. Under

U.S. GAAP, the capitalization of these items is not permitted. EP's disclosures

indicate that this practice is not followed for new exchange gains

and losses after 1995. The adjustment in Exhibit 12.26 required an addition

to Portuguese GAAP income of $26,351,000. This is the amount by

which Portuguese GAAP earnings were understated in 1998. The adjustment

of $422,925,000 in Exhibit 12.27 represents the remaining cumulative

overstatement of shareholders equity that resulted from the

capitalization of net foreign exchange losses under Portuguese GAAP.

EXHIBIT 12.27 Reconciliation of shareholders' equity under Portuguese

GAAP to income under U.S. GAAP: Electricidade de

Portugal, year ended December 31, 1998 (in thousands).

Escudos U.S. $

Shareholders' equity as reported under Portuguese GAAP 1,228,414,979 6,320,958

U.S. GAAP adjustments increase (decrease) due to:

a. Revaluation of fixed assets (476,437,696) (2,451,568)

b. Overheads capitalized (139,891,196) (719,287)

c. Exchange differences capitalized (82,191,222) (422,925)

d. Deferred costs (4,906,140) (25,245)

e. Hydrological correction account 77,688,063 399,213

f. Distribution to management and employees (3,736,760) (19,228)

g. Pension and other post-retirement benefits 21,868,807 112,529

h. Self-insurance — —

i. Employee termination benefits 25,844,334 132,985

j. Accounts receivable—municipalities (10,429,115) (53,664)

k. Power purchase agreements 2,317,186 11,923

l. Investments 12,659,000 65,139

m. Income taxes 183,082,286 942,072

Net adjustments (394,132,453) (2,028,056)

Approximate shareholders' equity in accordance with

U.S. GAAP 834,282,526 4,292,902

SOURCE: Electricidade de Portugal SA, annual report, December 1998. Information obtained from Disclosure

Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC

(Bethesda, MD: Disclosure Inc., June 2000).

398 Planning and Forecasting

4. Among costs deferred by EP were research and development. These costs

must be expensed as incurred under U.S. GAAP.

5. The line item for "Pension and other post-retirement benefits" highlights

the current consistency between Portuguese and U.S. GAAP in recognizing

the associated expense. However, the adjustment in Exhibit 12.27,

shareholders' equity reconciliation, reveals a continuing difference in the

recognition of the associated benefit liability. EP had recognized a larger

liability, and charged this amount against shareholders' equity, than

would be required under U.S. GAAP. This explains the increase in shareholders'

equity in Exhibit 12.27.

6. Prior to 1995, EP reduced income in recording an accrual for selfinsurance

that was not permitted under U.S. GAAP.

7. Termination benefits were accrued by EP in 1997 that would not have

been accrued in that year under U.S. GAAP. The necessary adjustments

are a $102,755,000 increase in Portuguese GAAP net income and a

$132,985,000 increase in shareholders equity.

8. EP's policy of recognizing bad debts on accounts receivable results in

their being recorded at a later point in time than would be true under U.S.

GAAP.

9. EP records income taxes based upon the amount of taxes currently

payable as determined by government tax regulations. U.S. GAAP requires

that income taxes be recorded on the basis of earnings reported in

the shareholder income statement as opposed to earnings in the income

tax return. This results in an overstatement of the Portuguese-GAAP net

income for 1998 and a cumulative understatement of shareholders' equity

at the end of 1998.44

The differences between Portuguese GAAP net income and shareholders'

equity are fairly substantial, but differences between foreign and U.S. GAAP

in other countries may be far greater. EP's 1998 net income would have been

about 35% higher under U.S. GAAP. However, shareholders' equity would have

been about 32% lower.

This difference between the effects on net income and shareholders' equity

result from the overstatement of assets (overstates depreciation and understates

current earnings) and understated liabilities (understates expenses

and overstates earnings). For a single year, an asset overstatement may understate

net income because a portion of the asset overstatement is amortized as

an additional expense in the income statement. Shareholders' equity remains

overstated because asset net overstatements remain on the balance sheet.

Domestic users of foreign financial statements need to be aware of the

differences in financial reporting practices, and also have some information

on the effect of these differences on such key financial statistics as earningsper-

share and shareholders' equity. For example, security analysts use ratios of

market price to earnings-per-share (the price/earnings or P/E ratio) as one way

Global Finance 399

to judge whether a stock might be either over or undervalued. Electricidade

de Portugal's P/E ratio is higher under Portuguese GAAP because its earnings

per share are lower than they would be under U.S. GAAP. Under Portuguese

GAAP Electricidade de Portugal would appear to be more conservatively valued

than under U.S. GAAP. Similarly, bankers use the relationship of total debt

to stockholders' equity to judge the capacity of firms to handle service and

repay their borrowed funds. By this statistic, Electricidade de Portugal will appear

to be less highly leveraged because its stockholders' equity is much higher

under Portuguese GAAP.

The differences between U.S. and Portuguese GAAP, revealed in Exhibits

12.26 and 12.27, are multiplied if one adds to the types of companies

and numbers of countries. As the markets for securities become more global,

some claim that there is the absence of a level playing field because of these

GAAP differences. If the efforts of the International Accounting Standards

Committee (IASC) are fruitful, then the playing field should become much

more level in the future. However, in the meantime there remains a great deal

of international diversity in GAAP.

GAAP Differences and the Level Playing Field

Some argue that international competitiveness can be impaired if earnings and

financial position under local GAAP appear weaker than they would under the

GAAP of major competitor countries. That is, the playing field will not be

level. As an example, concern has been expressed about international GAAP

differences that deal with acquisition (of other companies) accounting. A typical

acquisition will include the payment of a premium, in some cases involving

billions of dollars, for what is collectively termed goodwill. This amount consists

of the difference between the purchase price and the current value of the

net assets acquired, as in the following example:

Purchase price $1,000

Current fair value of net assets acquired (Assets Liabilities) 700

Goodwill $ 300

It has been a common practice in some countries to deduct immediately

the goodwill recorded in an acquisition from shareholders' equity. (This is one

of the practices that the IASC hopes to see eliminated under its harmonization

project discussed earlier.) U.S. GAAP has for several decades required that

goodwill be amortized through the income statement. This causes the postacquisition

earnings of a U.S. firm to appear weaker than a comparable firm in

a country that permits the immediate write-off of goodwill.

If a foreign firm, located in a country where the immediate write-off of

goodwill is permitted, and a U.S. firm were both bidding for the same company,

the foreign firm would forecast a stronger post-acquisition earnings picture.

This results because the foreign firm would deduct the goodwill

400 Planning and Forecasting

immediately, whereas the U.S. firm would take the charge through its future

income statements.45

It could be argued that the profit differences that result from the disparity

in accounting for goodwill are purely cosmetic, and that they should not

cause a U.S. bidder to be at a disadvantage in the acquisitions market. That is,

the impact of the acquisition on the bidder's future cash f low should be the

central issue. Differences in accounting policy should not have a direct impact

on future cash flow. However, it is well to remember that, cash f low aside, the

reported numbers take on a significance in their own right to the extent they

are (1) a factor in determining managerial compensation or (2) are used by

lenders to monitor compliance with debt agreements.

The U.S. GAAP requirements for goodwill accounting appear to be on

the verge of major changes in 2001. The requirement to amortize goodwill

would be eliminated in favor of a policy that would require goodwill write-offs

only in cases where the goodwill is considered to be impaired:

From the date of issuance, all goodwill would be accounted for using an impairment

approach. Under that approach, goodwill would be reviewed for impairment,

that is written down and expensed against earnings, only in the

periods in which the recorded value of goodwill is more than its fair value.46

Some countries may criticize this change in goodwill accounting as contributing

to international GAAP diversity. The change will also be seen as roughing

up and not smoothing out the playing field.

The issue of international competitiveness was also raised with respect

to the FASB statement on postretirement benefits accounting, SFAS No. 106,

Employers' Accounting for Postretirement Benefits Other Than Pensions.47 The

Statement requires companies to apply accrual accounting to what are termed

other postretirement benefits, mainly health and life insurance. When proposed,

there was fierce lobbying against issuing the statement. Some excerpts

from a statement to the FASB by the then Chief Financial Officer of Chrysler

Corporation make the key points:48

This higher cost recognition will depress reported profitability, and thereby ultimately

discourage capital formation in job-creating enterprises in the U.S.

There will be a powerful incentive to move our employment base to Canada,

Europe and Third World countries.

Foreign based companies will not be forced to adopt your new rules—all

other things being equal, a European or Japanese company will report a billion

dollars more profit doing the same business as Chrysler. In that environment,

we will simply be unable to compete fairly for investor capital. Ultimately, I believe

you will have added to the trend of foreign ownership of our U.S. industrial

base.

One can only hope for the success of the IASC program to increase international

harmony in reporting practices, if the arguments concerning the anticompetitive

potential of diversity in international GAAP are meritorious.

Global Finance 401

EVALUATING THE PERFORMANCE OF FOREIGN

SUBSIDIARIES AND THEIR MANAGEMENT

With the acquisition of its Danish subsidiary, Fashionhouse is faced with the

need to report and evaluate the performance of the subsidiary as an economic

entity, as well as the performance of the subsidiary's management. The discussion

here will focus only on those differences that result from the foreign character

of the subsidiary. Aside from this, performance evaluation should be

fundamentally the same as for a domestic firm. The fact that, after the translation

process, financial statements are available in both the domestic currency

(krone in the case of Fashionhouse) and the U.S. dollar is an important difference.

Should performance of the subsidiary and its management be judged on

the basis of the krone or dollars results? Moreover, the earnings performance

of the Fashionhouse subsidiary will be affected each year by (1) the movement

of the krone against the dollar and (2) prices set (a transfer price) on the goods

sold to Fashionhouse in the United States.

Impact of Exchange Rate Movements on

Performance Evaluation

A number of years ago, an issue arose concerning the incentive compensation

of the manager of a Netherlands subsidiary of a major U.S. heavy equipment

manufacturer. A strong profit performance was produced in the European currency,

but the translated results were a loss (note: translation followed the temporal

and not the all current method). After lengthy consideration by senior

management, a decision was made that no incentive compensation was to be

awarded. Management held that failure of the Netherlands subsidiary to earn a

profit in dollars resulted in its making no contribution to the parent, whose

goal was to maximize the dollar earnings of the consolidated entity. The manager

of the Netherlands subsidiary was not pleased.

A central precept of performance evaluation is that managers should only

be held responsible for results that incorporate variables over which they exercise

some reasonable control. Depending upon the circumstances, this might

mean that in judging the performance of a department foreman, the quantity

of material used is considered controllable but not its price. For performance

evaluation purposes, the material used would be priced at some prearranged

standard and not its actual cost. On the other hand, the vice president of manufacturing

might well be held responsible for actual material cost on the basis

that he or she has been assigned responsibility for the price of material used,

as well as its quantity.

Applied to evaluating the performance of the management of foreign subsidiary,

the concept of a controllable performance indicator would call for

either (1) using the profit results from the foreign-currency statements or

(2) using the translated dollar earnings, after adjustments designed to remove

402 Planning and Forecasting

the effects of changes in the value of the dollar, that is, the price of the dollar.

As (1) involves no unique adjustments related to foreign subsidiary status, only

(2) will be considered further.

Consider the income statements in Exhibit 12.28 in foreign currency (FC)

and the U.S. dollar. Assume that in the following year, domestic results are as

given in Exhibit 12.28 and that the foreign currency has depreciated to an average

rate of $0.50 for the year (recall that income statement amounts are

translated at the average rate under the all-current method). The new translation

would now be as outlined in Exhibit 12.29.

Net income in year two, in the foreign currency, increased by 65% over

Year 1 (from FC180 to FC 297). However, the income improvement on a translated

dollar basis was less than half this amount, only 32% ($112 to $148). The

impact of the change in exchange rates needs to be removed if the translated

income statement is to be used to evaluate performance of the subsidiary's

management—on the assumption that management has no control over exchange

rates. Net income can be adjusted as follows:

Year 2 net income in the foreign currency FC297

Translate at year 1 exchange rate × 0.62

Year 2 net income at constant exchange rate $184

EXHIBIT 12.28 Year 1 income statement (in foreign

currency and dollars).

FC Exchange Rates U.S.

Sales 1,000 $0.62 $620

Less cost of sales 600 0.62 372

Gross margin 400 248

Less SG&A 100 0.62 62

Pretax profit 300 186

Less tax provision 120 0.62 74

Net income 180 $112

EXHIBIT 12.29 Year 2 income statement (in foreign

currency and dollars).

FC Exchange Rates U.S.

Sales 1,200 $0.50 $600

Less cost of sales 660 0.50 330

Gross margin 540 270

Less SG&A 115 0.50 58

Pretax profit 425 212

Less tax provision 128 0.50 64

Net income 297 $148

Global Finance 403

The previous adjustment holds constant the value of the foreign currency

in measuring net income for purposes of performance evaluation. In judging

the subsidiary itself as an economic unit, translation at the depreciated value of

the foreign currency may still be appropriate. The dollar value of the net income

produced is indeed lower because of the currency depreciation in the

subsidiary's country.49

An alternative approach that is sometimes used is to evaluate the performance

of management is to use budgeted foreign exchange rates. This is similar

to the above in that it holds the exchange rate constant. However, the

constant rate is a budgeted exchange rate and not simply the rate from the previous

year.

There is ample evidence in U.S. annual reports of adjustments to control

for the impact of foreign-exchange changes on performance. It is standard for

the Management's Discussion and Analysis of Operations section, an SEC requirement,

to include commentary on the impact of exchange rate changes on

revenues, though far less frequently on earnings. However, Philip Morris does

identify the effect of exchange-rate changes on both revenues and the income

of operating companies. Three recent examples follow:

Johnson & Johnson Inc. (1999)

Sales by international companies were $12.09 billion in 1999, $11.15 billion in

1998 and $10.93 billion in 1997. This represents an increase of 8.4% in 1999,

1.9% in 1998 and 1.5% in 1997. Excluding the impact of foreign currency f luctuations

over the past three years, international company sales increased 12.4%

in 1999, 7.1% in 1998 and 9.6% in 1997.

Philip Morris Companies Inc. (1999)

Currency movements decreased operating revenues by $782 million ($517 million,

after excluding excise taxes) and operating companies income by $46 million

during 1999.

Praxair Inc. (1999)

The sales decrease of 4% in 1999 as compared to 1998 is due primarily to unfavorable

currency translation effects in South America. Excluding the impact of

currency, sales grew 2%.

Changes in exchange rates present a clear challenge in evaluating the performance

of both the economic units, such as the foreign subsidiaries, as well as

the management of these organizations. The emphasis on foreign operations is

on results in the domestic and not the foreign currency. This can create obvious

problems in the evaluation of the management of foreign subsidiaries because

their results in the foreign currency may improve or decline while their performance

expressed in the domestic (parent's) currency declines or improves.

If foreign entity managers have little control over their results in the parent's

currency, then judging their performance in that currency presents clear

problems. Performance evaluation in the domestic versus the foreign currency

should require that unit management have currency risk management as part

404 Planning and Forecasting

of their responsibilities. At least in the case of transactional exposure, Black &

Decker managers have in the past had this as part of their duties. However,

this would still leave open the effect of translation exposure on results and performance

evaluation. As Black & Decker reports:

Foreign currency transaction and commitment exposures generally are the responsibility

of the Corporation's individual operating units to manage as an

integral part of their business. Management responds to foreign exchange movements

through many alternative means, such as pricing actions, changes in cost

structure, and changes in hedging strategies.50

The goal of the above discussion is to highlight how the evaluation of foreign

subsidiaries and their management represents a special challenge because

of the ways in which exchange rate movements can affect measures of financial

performance. Another factor that also affects such performance evaluation

is the issue of transfer pricing. These are the prices charged when goods are

transferred between related foreign and domestic firms. The issue of transfer

pricing is discussed next.

Transfer Pricing and the Multinational Firm

The prices at which goods or services are transferred between related entities,

such as parents and subsidiaries and divisions of the same firm, are referred to

as transfer prices. Transfer prices could be a major factor in determining the

profits of the Fashionhouse Danish subsidiary because much of its product is

shipped to its U.S. parent. As in the previous case, the discussion here will focus

on the dimensions of transfer pricing that are inf luenced by the foreign status of

the subsidiary. The general topic of transfer pricing has been hotly debated over

many years. The setting of transfer prices, to both encourage optimal decisionmaking

and to facilitate performance evaluation, is not yet a settled matter.

Transfer prices are generally based upon cost, cost plus some markup, or

some approximation of market. Firms with international operations typically

disclose their method of pricing transfers of goods and services among different

taxing jurisdictions—typically countries. Some recent examples of transfer

pricing policies are presented in Exhibit 12.30.

The levels at which transfer prices are set is inf luenced by a wide range of

sometimes conf licting objectives. These include maximizing worldwide profits

after taxes, maintaining f lexibility in the repatriation of profits, encouraging

optimal decision making by profit center management, providing profit data

that are reliable indicators of managerial performance and entity profitability,

building market share, and maintaining competitiveness in foreign markets.51

There is some variation in the transfer pricing policies used by U.S. firms,

with the key distinction being market value versus cost-based transfer prices.

Moreover, these policies can have a major impact on measures of financial performance

of the foreign subsidiary. They become another factor, in addition to

changing exchange rates, that must be considered in evaluating financial performance

of a foreign subsidiary and its management.

Global Finance 405

Taxes and Transfer Pricing

A major issue surrounding transfer prices in the international arena is their effect

upon the total tax burden of parent firms. The levels of income taxes and

tariffs vary considerably across countries. Corporate income tax rates range

from the middle teens up to 50% in some countries. This presents the possibility

that transfer prices may be set in part to minimize a firm's worldwide tax

bill. Establishing the reasonableness of international transfer prices is the principal

defense against a charge of transfer price manipulation.

Ignoring other factors bearing on the setting of transfer prices, assume

that the objective is to minimize worldwide income taxes. Assume that the income

tax rate of the parent is 40% and that of the foreign subsidiary is 30%.

Further, the parent is the manufacturer and transfers are made to the foreign

subsidiary. The total cost of the product is $100 per unit and it can be sold by

the foreign subsidiary at insignificant additional cost for an amount equal to

$150. Therefore, the total worldwide pretax profit to be recognized is $50.

While the parent would not have unlimited f lexibility in setting the transfer

price, tax minimization would call for recognizing as much of the profit as

possible in the earnings of the subsidiary. This is because the subsidiary's tax

rate is only 30% while the parents is 40%. Tax minimization is accomplished by

setting a relatively low transfer price as illustrated in Exhibit 12.31.

EXHIBIT 12.30 Alternative transfer-pricing policies.

Company Transfer-Pricing Policy

Arch Chemicals Inc. (1999) Prevailing market prices

Transfers between geographic areas are priced generally at

prevailing market prices.

Conoco Inc. (1999) Estimated market values

Transfers between segments are on the basis of estimated

market values.

Dow Chemical Company Cost and market-based prices

(1999) Transfers between operating segments are generally valued at

cost. Transfers of products to the Agricultural Products

segment from the other segments, however, are generally

valued at market-based prices.

Pall Corporation (2000) Cost plus a markup on cost

Transfers between geographic areas are generally priced on

the basis of a markup of manufacturing costs to achieve an

appropriate sharing of profit between the parties.

Tenneco Inc. (1998) Market value

Products are transferred between segments and geographic

areas on a basis intended to ref lect as nearly as possible the

market value of the products.

SOURCES: Companies' annual reports. The year following each company name designates

the annual report from which each example is drawn.

406 Planning and Forecasting

The tax authorities of countries are well aware that multinationals have

strong incentives to shift profits into low-rate counties. Recent years have seen

governments increasingly willing to challenge tax computations that they believe

are based upon the use of unreasonable transfer prices. Therefore, the example

above simply shows how total tax payments can be influenced by

alternative transfer prices. The degree of f lexibility shown above may or may

not be available.

Notice, in the above example that no change in policy would result if the

foreign country also had an ad valorem tariff. Worldwide taxes would still be

minimized by a low transfer price because this would also minimize the tariff.

However, circumstances would differ if the parent's income tax rate were less

than that of the subsidiary. Setting a high transfer price would cause more of

the profit to be taxed at the lower income tax rate of the parent. But, this benefit

is offset to some extent by the higher tariff in the subsidiary's country. The

analysis would need to be extended to include tariffs in the total taxes to be

minimized.

Other Influences on Transfer Pricing Policy

and Potential Conf licts

Factors other than tax minimization also bear on the establishment of transfer

prices. An effort to build market share or to respond to severe price competition

might call for low transfer prices. However, this could be in conf lict with

a tax minimization objective if income tax rates in the country receiving the

transferred goods (transferee country) were higher than the income tax rates of

the country from which the transfer was made (transferor country).

Transfer pricing policy may sometimes be employed to circumvent restrictions

on the repatriation of profits by charging high transfer prices. This

effectively involves taking out profits in the form of payments for the goods

EXHIBIT 12.31 International transfer pricing and tax

minimization.

Low Transfer Price High Transfer Price

Parent revenue $110 $140

Cost 100 100

Pretax profit 10 40

Income tax (40%) 4 $ 4 16 $16

Subsidiary revenue 150 150

Cost (transfer price) 110 140

Pretax profit 40 10

Income tax (30%) 12 12 3 3

Worldwide tax $16 $19

Composite tax rate 32% 38%

Global Finance 407

shipped. There are, of course, some potential offsetting disadvantages from

this practice:

1. Charging higher transfer prices will increase ad valorem tariffs.

2. Charging higher transfer prices will lower profits of the transferee firm

and potentially present problems in evaluating the profit performance of

the unit and its management.

3. Charging higher transfer prices might impair the competitive position of

the transferee firm.

4. Charging higher transfer prices lowers profits of the transferee firm and

could reduce its apparent financial strength in the eyes of lenders and

other users of its financial statements.

This enumeration of factors bearing on the setting of transfer prices is not

exhaustive. However, it should be sufficient to highlight the inherent complexity

of setting transfer prices. This complexity is magnified as the global reach

of multinational firms extends into a greater numbers of countries with wide

variations in taxes, competitive conditions, business practices, types of governmental

control, variability in exchange rates, and rates of inf lation. This last

factor, rates of inf lation, is discussed next in terms of its impact on measuring

the financial performance of domestic firms as well as foreign subsidiaries.

IMPLICATIONS OF INFLATION FOR

FINANCIAL PERFORMANCE

As Fashionhouse continued its evolution as a global firm, it considered locating

manufacturing capacity in countries with low labor costs. However, in many

cases high rates of inf lation were linked to low labor costs. Judging performance

in highly inf lationary environments presents special problems. At some

point, financial statements prepared from unadjusted (historical) cost data lose

their ability to provide reasonable indicators of either the financial performance

or status of firms. Several different approaches have been developed to

adjust historical cost financial statements. The principal methods can be classified

as involving either (1) general price level or (2) current cost adjustments.

These two methods are illustrated below and contrasted with historical-cost

statements as the baseline. To provide some useful background, current management

commentary on the impact of inf lation on financial performance

is presented.

Management Commentary on the Impact of and

Response to Inf lation

Management's Discussion and Analysis, a section of the annual report required

by the SEC, often includes commentary on the implications of inf lation for financial

performance. This commentary provides useful insight into management's

408 Planning and Forecasting

assessment of inf lation's effects, as well as any company circumstances or actions

taken which mitigate the negative effects of inf lation. A series of these

comments are presented in Exhibit 12.32.

The examples in Exhibit 12.32 are representative of over 100 such disclosures

that were examined. A recurrent theme is that inf lation has been low in

EXHIBIT 12.32 Management commentary on the effects of inf lation.

Low inf lation and cost recovery contracts: Air T Inc. (2000)

The Company believes that due to the current low levels of inf lation the impact of inf lation

and changing prices on its revenues and net earnings will not have a material effect on its

manufacturing operations, or on its air cargo business. This is because the major cost

components of its operations, consisting principally of fuel, crew and certain maintenance

costs are reimbursed, without markup, under current contract terms.

Inf lation and fixed-price contracts may create problems: American Pacific

Corporation (1999)

Inf lation may have an effect on gross profit in the future as certain of the Company's

agreements with AP and sodium azide customers require fixed prices, although certain such

agreements contain escalation features that should somewhat mitigate the risks associated

with inf lation.

Inf lation leaves assets undervalued, but depreciation understated: Hartmarx

Corporation (1999)

Considering the impact of inf lation, the current value of net assets would be higher than

the Company's $189 million book value after ref lecting the Company's use of the LIFO

inventory method and increases in the value of properties since acquisition. Earnings would

be lower than reported, assuming higher depreciation expense without a corresponding

reduction in taxes.

Cost reduction programs, productivity improvements, and periodic price

increases maintain profit margins: Johnson & Johnson Inc. (1999)

Inf lation rates, even though moderate in many parts of the world during 1999, continue to

have an effect on worldwide economies and, consequently, on the way companies operate. In

the face of increasing costs, the Company strives to maintain its profit margins through cost

reduction programs, productivity improvements and periodic price increases.

Inf lation impact affected by ability to pass on cost increases to customers: Pegasus

Systems Inc. (1999)

Substantial increases in cost and expenses could have a significant impact on results of

operations to the extent such increases are not passed along to customers.

Pricing strategy and efficiency improvements offset inf lation: Polaroid

Corporation (1999)

Inf lation continues to be a factor in many countries in which the Company does business.

The Company's pricing strategy and continuing efficiency improvements have offset to a

considerable degree inf lation and normal cost increases. The overall inf lationary impact on

the Company's earnings has not been material.

Inf lation increases borrowing costs: Silgan Holdings Inc. (1999)

Historically, inf lation has not had a material effect on the Company, other than to increase

its cost of borrowing. In general, the Company has been able to increase the sales prices of

its products to ref lect any increases in the prices of raw materials.

SOURCES: Companies' annual reports. The year following each company name designates the annual report

from which each example is drawn.

Global Finance 409

recent years and, therefore, inf lation has not been a significant issue. However,

other firms with substantial international activity point out that inf lation remains

a significant issue in a number of countries where they are located or in

which they do business.

The disclosed measures taken to mitigate the effects of inf lation were

very consistent and included:

• Selective price increases.

• Productivity improvements.

• Cost-containment efforts.

• Cost reimbursement.

• Price escalation agreements.

Some of the disclosures indicated protection from inflationary cost increases

because of the presence of fixed-price contracts and escalation features

in business agreements. Concern is frequently expressed about the

ability to pass on the effects of inf lationary cost increases in the form of higher

product prices. Some protection from cost inf lation of commodities is often

achieved through the use of the same types of hedging vehicles employed to

avoid cost increases created by exchange rate movements. For example, airlines

and public transit systems routinely hedge the cost of fuel in order to avoid the

erosion of profits from increases in petroleum prices.

A traditional concern, highlighted by the Hartmarx commentary in Exhibit

12.32, is the overstatement of profits in periods of significant inf lation.

The LIFO inventory method has traditionally been viewed as a method that

reduces such profit overstatements. LIFO ensures that cost of sales approximates

replacement cost. Profit overstatement is also avoided in cases where

most depreciable assets are relatively new. In this circumstance depreciation is

closer to replacement cost than if depreciation were based principally on the

lower costs of older assets. The use of accelerated depreciation, especially for

income tax purposes, is also seen to offset some of the potential profit overstatement

associated with inf lation.

The revision of traditional cost-based statements to ref lect the effects of

either general inf lation or specific cost increases is a more comprehensive approach

to assessing the effects of inf lation upon measures of financial performance.

The approach is illustrated next.

Adjusting Financial Statements for the

Effects of Inf lation

The use of LIFO and the reliance upon relatively new depreciable assets or accelerated

depreciation to cause expenses to approximate current (replacement)

costs is only a partial adjustment for the impact of inf lation. Historically, the

comprehensive restatement of results for the effects of general as well as specific

price increases has been emphasized. In fact, in 1979 the FASB issued a

410 Planning and Forecasting

statement that called for the disclosure of supplemental information on pricelevel

adjusted earnings.52 A subsequent statement, issued in 1986, held that

these price-level adjusted disclosures, while still recommended, would no

longer be required.53 There was opposition by the business community to the

requirements of SFAS No. 33, and efforts to demonstrate that the new disclosures

were either used or useful were not successful. While principally of historical

interest in this period of very modest inf lation, some of the disclosures

required by SFAS No. 33 are discussed and presented.54

SFAS No. 33, Price-Level Adjusted Disclosures

Beginning in 1979, certain large U.S. firms were required to provide supplemental

information on the effect of inf lation on financial performance. The disclosures

included new information on earnings computed on both a constant-dollar

and a current-cost basis. The constant-dollar method retains historical cost as

the basis of financial measurement. However, it does make selected restatements

so that all financial statement balances are presented in units of the same

purchasing power, that is, expressed in the same price index. The current-cost

method replaces historical cost balances with current (replacement) costs as the

basis for financial statement measurement. Exhibit 12.33 provides an example

of disclosures of price-level adjusted results under the requirements of SFAS

No. 33.55

A very different message about profitability is conveyed by the adjusted

information in Exhibit 12.33. A significant level of historical-cost profits is almost

eliminated when current-cost adjustments are applied, and profit turns

into loss under the constant-dollar alternative. The purchasing power of the resources

invested in producing the 1980 results, as represented by the constantdollar

amount of expenses, exceeded Tiger's constant-dollar revenues. Closer

EXHIBIT 12.33 Income statements adjusted for changing prices: Tiger

International Inc., December 31, 1980 (in thousands).

Historical Current Constant

Financials Cost Dollar

Revenues $1,562,270 $1,562,270 $1,562,270

Cost and Expenses

Cost of operations 1,104,672 1,108,673 1,109,324

Selling, general, and administrative 139,462 139,462 139,462

Depreciation and amortization 118,332 151,924 171,096

Interest, net 140,929 140,929 140,929

Income tax provision 16,500 16,500 16,500

1,519,895 1,557,488 1,577,311

Net income (loss) $ 42,375 $ 4,782 $ (15,041)

SOURCE: Tiger International Inc., annual report, December 1980, 39.

Global Finance 411

study of these data is necessary to understand the reasons behind these quite

different messages.

The revenues in each of the three income statements are measured in the

average price level for the year based upon the Consumer Price Index for All

Urban Consumers. Tiger's revenues are earned fairly evenly across the year,

and therefore, the revenues in the historical-cost income statement are already

expressed in average prices for the year. Accordingly, the same revenue amount

can be used in both the constant-dollar and current-cost statements. The same

applies to the amounts for selling, general and administrative; interest, net; and

the income tax provision.

Modest adjustments were made to cost of operations to convert them to

constant dollars and current costs, respectively. The constant-dollar adjustment

requires multiplying the historical cost of operations by a ratio of price

indices. The index in the numerator is average price index for the current year,

and in the denominator, is the value of the index at the date closest to the date

on which the expense was incurred. To illustrate, assume that a $1,000 expense

was recorded on January 1, 2002, when the price index was 100; the average

price index for 2002 was 110. Adjustment to constant dollars is:

The same methodology is applied in adjusting historical cost of operations to

current-cost amounts. The difference is that specific indices of replacement

cost, or alternative measures of replacement cost, are used in place of a general

price index.

Tiger reported that increases in inventory costs, included in cost of operations,

accounted for the adjustments to historical cost of operations. In general,

adjustments to the historical cost of sales will be small if the LIFO

inventory valuation method is used; the LIFO cost flow ensures that cost of

sales already approximates current costs. Adjustments will generally be greater

where the FIFO or average cost methods are in use.

Impact of Differences in General and

Specific Price Index Movements

The major Tiger cost adjustments were to depreciation and amortization. Depreciation

and amortization represent the conversion to expense of asset balances.

In many cases these balances were recorded years earlier when the price

indices were far lower. Notice that the percentage increase in the current-cost

and constant-dollar depreciation and amortization over the historical-cost

amount is 28% and 45%, respectively. Tiger's disclosures explain the reason for

the differences: "Depreciation expense is greater when adjusted for general inf

lation than when adjusted for changes in specific prices. The difference ref

lects the Consumer Price Index (general inf lation) rising faster than the

$1, 000 $ ,

110

100

× 1 100

 

 

=

412 Planning and Forecasting

increase of costs over the last several years of the type of property, plant and

equipment used in the Company's various businesses."56

Impact of Monetary Balances on Adjusted Results

In addition to the above two inf lation-adjusted income presentations, Tiger

provided additional income data because it did not feel that the required disclosures,

adjusting mainly depreciation and cost of sales, were adequate. These

adjustments, in Exhibit 12.34, expand upon the information in Exhibit 12.33.

The final adjusted net incomes above tell a totally different story from the

initial display in Exhibit 12.33. Both measures of adjusted profits are sharply

higher than the unadjusted historical-cost results. The new income element results

from the impact of changes in the general price level on the purchasing

power of monetary assets and liabilities. Tiger explains the impact of price

changes on monetary balances as follows:

A monetary asset represents money or a claim to receive money without reference

to future changes in prices. Similarly, a monetary liability represents an

obligation to pay a sum of money that is fixed or determinable without reference

to changes in future prices. Holding a monetary asset during periods of inf

lation results in a decline in the value of the asset since the dollar loses

purchasing power when it is held. Conversely, holders of monetary liabilities

benefit during inf lationary periods because less purchasing power is required

to satisfy future obligations when they can be paid with less valuable dollars.57

Under the above reasoning, Tiger earned an unrealized purchasingpower

gain because its monetary liabilities exceeded its monetary assets.

This gain represents the reduction in the purchasing power that Tiger would

need to expend to discharge its net monetary-liability position. The impact of

both inf lation and def lation on purchasing-power gains, under conditions of

both monetary assets exceeding monetary liabilities (net asset exposure) and

EXHIBIT 12.34 Earnings adjusted for purchasing power gains from

monetary position: Tiger International Inc., (in

thousands).

Historical Current Constant

Financials Cost Dollar

Net income $42,375 $ 4,782 $(15,041)

Decrease in depreciation and interest expense

from the decline in the purchasing power of the

net liabilities — 82,195 82,195

Net income adjusted for the decrease in

depreciation and interest expense $42,375 $86,977 $(67,154

SOURCE: Tiger International Inc., annual report, December 1980, 39.

Global Finance 413

monetary liabilities exceeding monetary assets (net liability exposure), are

summarized in Exhibit 12.35.

Tiger treated the purchasing power gain as an adjustment to depreciation

and interest expense based upon the following reasoning: "Because Tiger finances

substantially all of its fixed assets with long-term debt, it effectively

hedges against the impact of inf lation on depreciation and interest expense."

Tiger's liability exposure serves as a hedge because it produces a gain under inf

lationary conditions, to offset increases in the cost of asset replacement and

interest expense, which go hand in hand with inf lation.58

The price-level adjusted reporting illustrated above proved to be a very

controversial requirement. It proved difficult to document that the price-level

adjusted data were used by either creditors or investors, or that they aided

analysis and decision making in any significant way. In 1986, SFAS No. 89: Financial

Reporting and Changing Prices was issued, which eliminated mandatory

disclosure of price-level adjusted data.59 The Statement did encourage

continued disclosure on a voluntary basis. U.S. firms have, however, not responded

to this encouragement and the price-level adjusted disclosures have

not been continued.

U.S. GOVERNMENT RESTRICTIONS ON BUSINESS

PRACTICES ASSOCIATED WITH FOREIGN

SUBSIDIARIES AND GOVERNMENT60

The last issue raised in the opening Fashionhouse scenario dealt with U.S. governmental

restrictions on business practices associated with overseas operations.

Recall that in reviewing the possible relocation of manufacturing to a

high inf lation/low labor-cost country, Fashionhouse management became

aware of potential ethical and legal issues.

Over the years the U.S. government became concerned with the practices

sometimes followed by U.S. firms doing business overseas. Of special concern

were payments to foreign governmental officials made to obtain business. From

hearings over a number of years, which focused on such incidents, a recurring

theme emerged: Even though such payments did take place, key members of

management were often unaware that the payments were being made.

EXHIBIT 12.35 Purchasing power gains and

losses and net monetary position.

Net Monetary Position

Price Movement Asset Liability

Inf lation Loss Gain

Def lation Gain Loss

414 Planning and Forecasting

The U.S. Congress addressed the issue of controlling what they saw to be

improper activities, by passing the Foreign Corrupt Practices Act of 1977. The

key features of this law were:

1. The prohibition of bribery of foreign governmental or political officials

in order to promote business.

2. The requirement that firms (a) keep accurate and detailed records of the

company financial activities and (b) maintain a system of internal accounting

controls sufficient to provide reasonable assurance that transactions

are properly authorized, recorded, and accounted for.

The above requirements are incorporated as amendments to Section 13(b)

of the Securities Exchange Act of 1934, and apply to all publicly held companies.

The record-keeping and internal control features of the Act were a response to

claims that companies had been unaware of bribery payments, because their internal

control systems had failed to detect or prevent them.

In a report addressed to the SEC, the National Commission on Fraudulent

Financial Reporting, made the following recommendation:

All public companies should be required by SEC rule to include in their annual

reports to stockholders management reports signed by the chief executive officer

EXHIBIT 12.36 Report of management: Delta Air Lines Inc., year ended

June 30, 2000.

The integrity and objectivity of the information presented in this Annual Report are the

responsibility of Delta management. The financial statements contained in this report have

been audited by Arthur Andersen LLP, independent public accountants, whose report

appears below.

Delta maintains a system of internal financial controls that are independently assessed on

an ongoing basis through a program of internal audits. These controls include the selection

and training of Delta's managers, organizational arrangements that provide a division of

responsibilities, and communication programs explaining our policies and standards. We

believe that this system provides reasonable assurance that transactions are executed in

accordance with management's authorization; that transactions are appropriately recorded

to permit preparation of financial statements that, in all material respects, are presented in

conformity with accounting principles generally accepted in the United States; and that

assets are properly accounted for and safeguarded against loss from unauthorized use.

The Board of Directors pursues its responsibilities for these financial statements through

its Audit Committee, which consists solely of directors who are neither officers nor employees

of Delta. The Audit Committee meets periodically with the independent public accountants,

the internal auditors and representatives of management to discuss internal control,

accounting, auditing and financial reporting matters.

M. Michele Burns Leo F. Mullin

Executive Vice President and Chairman and

Chief Financial Officer Chief Executive Officer

SOURCE: Delta Air Lines Inc., annual report, June 2000, 53.

Global Finance 415

and the chief accounting officer and/or the chief financial officer. The management

report should acknowledge management's responsibilities for the financial

statements and internal control, discuss how these responsibilities were

fulfilled, and provide management's assessment of the effectiveness of the

company's internal controls.61

While the SEC has not adopted the Commission's recommendation, many

companies have elected to provide voluntarily a report of management's responsibilities.

While the precise title of the report may vary, representative

titles include, Report of Management Responsibility for Financial Statements

and Internal Control and Financial Reporting Responsibility. Although the precise

language of the report differs from company to company, Exhibit 12.36 provides

a representative example from the 2000 annual report of Delta Air Lines.

The precise meaning of the provisions of the Foreign Corrupt Practices

Act continues to evolve. However, in considering expansion into a country,

where improper payments have a long and durable tradition, Fashionhouse

must pay special attention to the existence and requirements of the Act.

SUMMARY

The evolution of Fashionhouse from a purely domestic firm to a truly global

entity continues to confront it with new and increasingly complex problems of

accounting, finance, and management. This chapter has followed Fashionhouse

through this evolution and attempted to help the reader become aware of the

problems faced and how they might be addressed. The range of issues addressed

is broad and can become quite complex. It has not been possible, nor

would it have been appropriate in a chapter such as this, to deal with all aspects

of every issue raised. The reader should consult the books and articles

cited throughout the chapter and in the list of "additional readings" for additional

background.

The following are some key points for the reader to consider:

• International business and international operations raise challenges that

transcend those of a strictly domestic operation.

• Exposure to potentially adverse movements of foreign-currency exchange

rates is a key challenge for firms that engage in international business.

This currency risk can arise from both transactional and translational

exposure.

• Both transactional and translational currency risk can be managed or

hedged to some extent by relying on aspects of a firm's own operations.

This is normally referred to as employing natural hedges.

• Beyond the use of natural hedges, it is common for firms to use a variety

of foreign-currency derivatives. Forward contracts and currency options

are currently the most popular.

416 Planning and Forecasting

• Most hedging activity centers around efforts to protect cash flows and

earnings from the volatility that would be produced by the combination of

unhedged currency exposure and f luctuations in exchange rates. Translation

exposure, which does not pose the same threat to cash flows and

earnings, is hedged far less frequently than transaction exposure.

• Note all of the effects of changes in exchange rates are ref lected in transaction

and translation gains and losses. The strength of the U.S. dollar in

recent years has both reduced the dollar value of foreign sales as well as

the competitiveness of U.S. products.

• The emergence of the Euro has the potential to reduce both the cost and

complexity of hedging because many European currencies are replaced

by a single currency, the Euro. However, some companies express concern

about possible adverse competitive effects associated with the pricing

transparency that results from a common currency.

• Substantial differences continue to exist between GAAP in the U.S. and

that in other countries. However, the International Accounting Standards

Committee (IASC) continues its efforts to create more harmony in GAAP

across the world. These GAAP differences create substantial challenges

when analyzing the financial performance of foreign firms.

• The evaluation of the performance of foreign subsidiaries and their management

can be affected by exchange-rate changes. A common response is

to remove the effects of exchange rate changes from key performance indicators.

Another approach is to evaluate performance using budgeted exchange

rates. The extent to which the responsibility for hedging currency

exposure is delegated to management of these entities should affect decisions

about how to deal with the effects of exchange-rate changes. Removing

the effects of exchange rate changes is consistent with an absence

of responsibility for the hedging of currency risk.

• Recent changes in the accounting for derivative instruments and hedging

activities call for the recording of all foreign-currency derivatives at their

fair values. In some cases, gains and losses from the revaluation of currency

derivatives will initially be included in other comprehensive income.

However, these gains and losses will subsequently be included in

net income when the related hedged transaction is included in earnings.

The deferral of foreign-currency gains and losses on the balance sheet is

no longer permitted.

• Transfer pricing policies between U.S. parents and their foreign subsidiaries

create challenges in terms of both performance evaluation and

worldwide tax minimization.

• Modest levels of inf lation in the U.S. in recent years has meant that increases

in the general price level have not been a major management

issue. However, inf lation continues to present issues for global firms because

of substantial inf lation in some of their foreign markets.

Global Finance 417

• The international expansion of business activities can create potential

problems because of different business and cultural norms. Practices that

may be common in some countries may be in direct conf lict with U.S.

law. Firms should be certain that they are familiar with and in compliance

with the provisions of the Foreign Corrupt Practices Act of 1977.

FOR ADDITIONAL READING

Beaver, W., and W. Landsman, Incremental Information Content of Statement 33

Disclosures (Stamford, CT: FASB, 1983).

Choi, F., ed., Handbook of International Accounting (New York: John Wiley, 1991).

Comiskey, E., and C. Mulford, Guide to Financial Reporting and Analysis (New

York: John Wiley, 2000).

Epstein, B., and A. Mirza, Interpretation and Application of International Accounting

Standards 2001 (New York: John Wiley, 1997).

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (Norwalk,

CT: FASB, June, 1998).

Financial Accounting Standards Board, The IASC-U.S. Comparison Project: A Report

on the Similarities and Differences between IASC Standards and U.S.

GAAP (Norwalk, CT: FASB, November, 1996).

, Financial Reporting in North America—Highlights of a Joint Study (Norwalk,

CT: FASB, December, 1994).

Frishkoff, P., Financial Reporting and Changing Prices: A Review of Empirical Research

(Stamford, CT: FASB, 1982).

Goodwin, J., S. Goldberg, and C. Tritschler, "Understanding Foreign Currency Derivative

Measurements as FASB Moves Toward Fair Value Reporting," The

Journal of Corporate Accounting and Finance, 7, (spring 1996): 75–84.

Goldberg, S., and J. Godwin, "Foreign Corrupt Practices Act: Some Pitfalls and

How to Avoid Them," The Journal of Corporate Accounting and Finance , 7,

(winter 1995–1996): 35–43.

Haskins, M., K. Ferris, and T. Selling, International Financial Reporting and Analysis

(Chicago: Richard D. Irwin, 1996).

Kim, H., Fundamental Analysis Worldwide (New York: John Wiley, 1996).

Mulford, C., and E. Comiskey, Financial Warnings (New York: John Wiley, 1996).

Radebaugh, L., and S. Gray, International Accounting for Multinational Enterprises,

3rd ed. (New York: John Wiley, 1993).

Shapiro, A., Multinational Financial Management, 5th ed. (Upper Saddle River, NJ:

Prentice-Hall, 1996).

ANNUAL REPORTS REFERENCED IN THE CHAPTER

Adobe Systems Inc. (1999)

AGCO Corporation (1999)

418 Planning and Forecasting

Air Canada (1999)

Air T Inc. (2000)

American Pacific Corporation (1999)

Analog Devices Inc. (1999)

Arch Chemicals Inc. (1999)

Armstrong World Industries Inc. (1999)

Arvin Industries Inc. (1999)

Baldwin Technology Company (1999)

Baltek Corporation (1999)

Baxter International Inc. (1999)

Beckman Coulter Inc. (1999)

Becton, Dickenson & Company (1999)

Black and Decker Inc. (1995)

Blyth Industries Inc. (2000)

California First Bank (1987)

Compaq Computer Corporation (1999)

Conoco Inc. (1999)

DaimlerChrysler AG (1999)

Delta Air Lines Inc. (2000)

Dow Chemical Company (1999)

E.I. DuPont de Nemours & Company (1999)

Electricidade de Portugal SA (1998)

Federal Express Inc. (1989)

Galey & Lord Inc. (1999)

Hartmarx Corporation (1999)

H.J. Heinz Co. (1999)

Henry Schein Inc. (1998)

Illinois Tool Works Inc. (1999)

Interface Inc. (1999)

JLG Industries Inc. (2000)

Johnson & Johnson, Inc. (1999)

Olin Corporation (1999)

Pall Corporation (2000)

Pegasus Systems Inc. (1999)

Philip Morris Companies Inc. (1999)

Polaroid Corporation (1999)

Praxair Inc. (1999)

Quaker Oats Company (1999)

Silgan Holdings Inc. (1999)

Global Finance 419

Storage Technology Corporation (1999)

Telef lex Inc. (1999)

Tenneco Inc. (1999)

Tiger International Inc. (1980)

Titan International Inc. (1999)

UAL Inc. (1999)

Vishay Intertechnology Inc. (1999)

Western Digital Corporation (2000)

York International Corporation (1999)

NOTES

1. Western Digital Corporation, annual report, June 2000, 25–26.

2. Baltek Corporation, annual report on Form 10-K to the Securities and Exchange

Commission, December 1999, 3.

3. It is unlikely that either side of the transaction would be indifferent to this

matter. Insisting upon being invoiced by a foreign supplier in your own currency

means that the supplier must bear the currency risk. The supplier will have a foreigncurrency

receivable. It is reasonable to expect the foreign supplier to attempt to be

compensated for bearing this currency risk by charging a higher price for its product.

4. A U.S. electronics company recently attempted to eliminate currency risk by

having its Japanese supplier invoice them in the U.S. dollar. The Japanese supplier

agreed to do this and introduced a new schedule of prices in dollars. The U.S. company

deemed the increases to be so high that they decided to continue to be invoiced

in the Japanese yen and to manage the associated exchange risk.

5. Each of the actual case examples discussed in this section are treated in more

detail, including income tax and cash-f low issues, in E. Comiskey and C. Mulford,

"Risks of Foreign Currency Transactions: A Guide for Loan Officers," Commercial

Lending Review (summer 1990), pp. 44–60.

6. Air Canada, annual report, December 1999 (emphasis added). Information

obtained from Disclosure, Inc., Compact D/SEC: Corporation Information on Public

Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000).

7. On January 1, 1999, 11 of the 15 member countries of the European Union

adopted the Euro as their common legal currency and established fixed conversion

rates between their sovereign currencies and the Euro.

8. Holding foreign currency cash, that is, an asset balance, would be consistent

with the need to offset existing liability exposure in these foreign currencies. Alternatively,

borrowing in foreign currencies to produce a hedge implies existing asset exposure

in these foreign currencies.

9. California First Bank, annual report, December 1987, 20.

10. Federal Express Inc., annual report, December 1989, 35.

11. The accounting treatment to insure that the offsetting gains and losses are

included in the income statements at the same time was described by Federal

420 Planning and Forecasting

Express. It reported that "Exchange-rate gains and losses on the term loan are deferred

and amortized over the remaining life of the loan as an adjustment to the related

hedge (service) revenue." Federal Express Inc., annual report, December

1989, 36.

12. This example is discussed in "FX Translation—Lyle Shipping's Losses," Accountancy,

110 (December 1984): 50. Lyle has an economic hedge of its dollar

exposure.

13. See P. Maloney, "Managing Currency Exposure: The Case of Western Mining,"

Journal of Applied Corporate Finance, 2 (winter 1990): 29–34, for an analysis of

the effectiveness of this natural hedge during the eighties.

14. Survey data support this view. See G. Bodnar, G. Hayt, and R. Marston, "The

Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms," Financial Management,

25 (winter 1996): 113–133.

15. Spot and forward exchange rates normally differ. These rate differences are

determined primarily by differences in interest rates in the respective countries of

the domestic and foreign currency.

16. Beckman Coulter Inc., annual report, December 1999, 47.

17. An option that is acquired when the spot value for the currency and the

strike price in the option contract are equal is said to have no intrinsic value. However,

such contracts routinely have positive values. The value of an at-the-money

option contract is normally referred to as time value.

18. A currency option is similar to f light insurance. The option contract (insurance)

only pays off if the plane crashes and the policyholder is injured or dies. That

is, there is a gain only if the unfavorable event takes place. However, if the plane does

not crash, the favorable outcome, the policyholder is simply out the amount of the insurance

(option) premium.

19. Analog Devices Inc., annual report, December 1999. Information obtained

from Disclosure Inc.

20. JLG Industries Inc., annual report, July 2000, 23.

21. Titan International Inc., annual report, December 1999. Information obtained

from Disclosure Inc.

22. To be technically correct, a gain or loss from the translation of the statements

of a foreign subsidiary does affect other comprehensive income. However, it does not

affect net income, which continues to be the number which both company management

and other users of financial statements emphasize.

23. E.I. DuPont de Nemours & Company, annual report, December 1999, 37.

24. Ibid., 37.

25. However, this hedging by Quaker Oats is not aimed at protecting either earnings

or cash flow. Gains and losses from net-investment hedges, along with their offsetting

translation losses and gains, are reported in shareholders' equity.

26. Arch Chemicals Inc., annual report, December 1999, 34.

27. The equity method is usually employed when a voting stock interest of 20%

or more is held in another company. The investor company recognizes its share of the

investee company earnings or loss, without regard to whether any dividends are received.

The receipt of dividends is treated as a reduction in the carrying value of the

investment, and not as dividend income.

Global Finance 421

28. Denmark has not yet (early 2001) adopted the Euro. Its currency exposure

will be limited to the Euro to the extent that it trades mainly with Euro countries.

29. Information on Danish GAAP can be found in E. Comiskey and C. Mulford,

"Comparing Danish Accounting and Reporting Practices with International Accounting

Standards," in Advances in International Accounting, ed. Kenneth S. Most

(Greenwich, CT: JAI Press, 1991), 123–142.

30. If there were differences between generally accepted accounting principles

in the country of the foreign subsidiary and those in the U.S., then the statements

would first have be adjusted to conform to U.S. GAAP before consolidation could

take place.

31. Statement No. 52, Foreign Currency Translation, refers to this alternative procedure

as remeasurement and not translation. However, in the vast majority of cases,

the remeasurement is from the foreign currency to the U.S. dollar. Therefore, remeasurement

produces statements in the U.S. dollar that are ready to be consolidated with

the statements of their U.S. parent. Remeasurement is tantamount to translation.

32. It is simply coincidental that a translation gain of $87 resulted under the allcurrent

translation and a remeasurement loss of $87 resulted from remeasurement

under the temporal method.

33. From this example, a fairly obvious case can be made for, other things equal,

locating manufacturing in the same country where sales are made.

34. P. Collier, E. Davis, J. Coates and S. Longden, "The Management of Currency

Risk: Case Studies of US and UK Multinationals," Accounting and Business Research,

24 (summer 1990): 208.

35. SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions

and Foreign Financial Statements (Stamford, CT: FASB, October 1975).

36. C. Houston and G. Mueller, "Foreign Exchange Rate Hedging and SFAS

No. 52—Relatives or Strangers?," Accounting Horizons, 2 (December 1988): 57.

37. SFAS No. 133, Accounting for Derivative Instruments and Hedging (Norwalk,

CT: FASB, June 1998).

38. A common feature of derivatives is that they have little or no initial value.

This would not be true in the case of some option contracts where an option premium

is paid, even in the case of at or out-of-the-money options.

39. For a reference on these matters, see E. Comiskey and C. Mulford, Guide to

Financial Reporting and Analysis (New York: John Wiley, 2000), chapters 6 and 7.

40. International Accounting Standards Committee, Exposure Draft 32, Comparability

of Financial Statements (January 11, 1989).

41. Ibid., paragraph 6.

42. International Accounting Standards Committee, Statement of Intent, Comparability

of Financial Statements (July 1990).

43. For a standard-by-standard analysis of the differences between current U.S.

GAAP and IASC standards, see The IASC-U.S. Comparison Project: A Report on the

Similarities and Differences between IASC Standards and U.S. GAAP (Norwalk, CT:

FASB, November, 1996).

44. To examine the complete reconciliation disclosures of Electricidade de Portugal,

go to the SEC Web site (www.sec.gov) and search for the Electricidade filings. The

current reconciliation will be found in the most recent 20-F filing for the company.

422 Planning and Forecasting

45. A further negative for a U.S. firm has been the fact that goodwill amortization

was not deductible for tax purposes, whereas it was in some other countries. A

1993 change in the tax law, Internal Revenue Code, section 197, now makes it possible

to amortize goodwill in the tax return for qualifying acquisitions.

46. FASB, News Release, Financial Accounting Standards Board Announces Additional

Decisions Relating to the Treatment of Goodwill (Norwalk, CT: FASB, December

20, 2000).

47. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other

Than Pensions (Norwalk, CT: FASB, December 1990).

48. From a statement made by R. S. Miller Jr., executive vice president and chief

financial officer of Chrysler Corporation, to the Financial Accounting Standards

Board, Washington, DC, November 3, 1989, 3.

49. Removing the effects of exchange rate changes in cases where the subsidiary

is using the temporal (remeasurement) translation method, as opposed to the all-current

method, is a greater challenge and beyond the scope of this chapter.

50. Black and Decker Inc., annual report, December 1995, 35.

51. The following two references were of great assistance in preparing this discussion

of transfer pricing: Frederick D. S. Choi and Gerhard G. Mueller, An Introduction

to Multinational Accounting (Englewood Cliffs, NJ: Prentice-Hall, 1978),

chapter 9; and Jeffrey S. Arpan and Lee H. Radebaugh, International Accounting and

Multinational Enterprises (New York: Warren, Gorham & Lamont, 1981), chapter 10.

52. SFAS No. 33, Financial Reporting and Changing Prices (amended and partially

superseded) (Stamford, CT: FASB, September 1979).

53. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT:

FASB, December 1986).

54. Helpful in preparing this section was J. Largay and L. Livingstone, Accounting

for Changing Prices: Replacement Cost and General Price Level Adjustments

(Santa Barbara, CA: John Wiley/Hamilton, 1976). This is an excellent and comprehensive

treatment of this subject area that is recommended for readers interested in

a more expansive treatment of the subject.

55. Tiger International Inc., annual report, December 1980, 39.

56. Ibid., 39.

57. Ibid., 40.

58. Incorporating gain and losses on the net monetary position into the computation

of restated results was not part of the SFAS No. 33 requirements.

59. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT:

FASB, 1986).

60. For further background on this topic see: K. Skousen, An Introduction to the

SEC, 4th ed. (Cincinnati: South-Western, 1987), 32–35.

61. Report of the National Commission on Fraudulent Financial Reporting

(Washington, DC, 1987), 44.

423

13

FINANCIAL

MANAGEMENT

OF RISKS

Steven P. Feinstein

For better or worse, the business environment is fraught with risks. Uncertainty

is a fact of life. Profits are never certain, input and output prices change,

competitors emerge and disappear, customers' tastes constantly evolve, technological

progress creates instability, interest rates and foreign-currency values

and asset prices f luctuate. Nonetheless, managers must continue to make decisions.

Businesses must cope with risk in order to operate. Managers and firms

are often evaluated on overall performance, even though performance may be

affected by risky factors beyond their control. The goal of risk management

is to maximize the value of the firm by reducing the negative potential impact

of forces beyond the control of management.

There are essentially four basic approaches to risk management: risk

avoidance, risk retention, loss prevention and control, and risk transfer.1 Suppose

after a firm has analyzed a risky business venture and weighed both the

costs and benefits of exposure to risk, management chooses not to embark on

the project. They determine that the potential rewards are not worth the risks.

Such a strategy would be an example of risk avoidance. Risk avoidance means

choosing not to engage in a risky activity because of the risks. Choosing not to

f ly in a commercial airliner because of the risk that the plane might crash is an

example of risk avoidance.

Risk retention is another simple strategy, in which the firm chooses to engage

in the project and do nothing about the identified risks. After weighing

the costs and benefits, the firm chooses to proceed. It is the "damn the torpedoes"

approach to risk management. For many firms, risk retention is the optimal

strategy for all risks. Investors expect the company's stock to be risky, and

they do not reward managers for reducing risks. Investors cope with business

424 Planning and Forecasting

risks by diversifying their holdings within their portfolios, and so they do not

want business managers to devote resources to managing risks within the firm.

Loss prevention and control involves embarking on a risky project, yet

taking steps to reduce the likelihood and severity of any losses potentially resulting

from uncontrollable factors. In the f lying example, loss prevention and

control would be the response of the airline passenger who chooses to f ly, but

also selects the safest airline, listens to the pref light safety instructions, sits

near the emergency exit, and perhaps brings his or her own parachute. The

passenger in this example has no control over how many airplanes crash in a

given year, but he or she takes steps to make sure not to be on one of them, and

if so, to be a survivor.

Risk transfer involves shifting the negative consequences of a risky factor

to another person, firm, or party. For example, buying f light insurance shifts

some of the negative financial consequences of a crash to an insurance company

and away from the passenger's family. Should the airplane crash, the insurance

company suffers a financial loss, and the passenger's family is financially compensated.

Forcing foreign customers to pay for finished goods in your home currency

rather than in their local currency is another example of risk transfer,

whereby you transfer the risk of currency f luctuations to your customers. If the

value of the foreign currency drops, the customers must still pay you an agreed

upon number of dollars, for example, even though it costs them more to do so in

terms of their home currency.

No one risk management approach is ideal for all situations. Sometimes

risk avoidance is optimal; sometimes risk retention is the desired strategy.

Recent developments in the financial marketplace, however, have made risk

transfer much more feasible than in the past. More and more often now, especially

when financial risks are involved, it is the most desirable alternative.

In recent years there has been revolutionary change in the financial marketplace.

The very same marketplace that traditionally facilitated the transfer

of funds from investors to firms, has brought forth numerous derivative instruments

that facilitate the transfer of risk. Just as the financial marketplace has

been innovative in engineering various types of investment contracts, such as

stocks, bonds, preferred stock, and convertible bonds, the financial marketplace

now engineers risk transfer instruments, such as forwards, futures, options,

swaps, and a multitude of variants of these derivatives.

Reading stories about derivatives in the popular press might lead one to

believe that derivative instruments are dangerous and destabilizing—evil creatures

that emerged from the dark recesses of the financial marketplace. The

cover of the April 11, 1994, Time magazine introduced derivatives with the

caption "High-tech supernerds are playing dangerous games with your money."

The use of derivatives has been implicated in most of the financial calamities

of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, Askin

Capital Management, Orange County, Union Bank of Switzerland, and Long-

Term Capital Management, to name a few. In each of the cases, vast sums of

money quickly vanished, and derivatives seemed to be to blame.

Financial Management of Risks 425

WHAT WENT WRONG: CASE STUDIES

OF DERIVATIVES DEBACLES

Derivatives were not responsible for the financial calamities of the 1990s.

Greed, speculation, and probably incompetence were. But just as derivatives

facilitate risk management, they facilitate greed and accelerate the consequences

of speculation and incompetence. For example, consider the following

case histories and then draw your own conclusions.

Barings Bank

On February 26, 1995, Baring PLC, Britain's oldest merchant bank and one of

the most venerable financial institutions in the world collapsed. Did this failure

follow years of poor management and bad investments. Hardly. All of the

bank's $615 million of capital had been wiped out in less than four months, by

one employee, half way around the world from London. It seems that a Barings

derivatives trader named Nicholas Leeson, stationed in Singapore, had

taken huge positions in futures and options on Japanese stocks. Leeson's job

was supposed to be index arbitrage, meaning that he was supposed to take low

risk positions exploiting discrepancies between the prices of futures contracts

traded in both Singapore and Osaka. Leeson's job was to buy whichever contract

was cheaper and sell the one that was more dear. The difference would

be profit for Barings. When he was long in Japanese stock futures in Osaka, he

was supposed to be short in Japanese stock futures in Singapore, and vice

versa. Such positions are inherently hedged. If the Singapore futures lost

money, the Japanese futures would make money, and so little money, if any,

could be lost.

Apparently, Leeson grew impatient taking hedged positions. He began to

take unhedged bets, selling both call options and put options on Japanese

stocks. Such a strategy, consisting of written call options and written put options

is called a straddle. If the underlying stock price stays the same or does

not move much, the writer keeps all the option premium, and profits handsomely.

If, on the other hand, the underlying stock price either rises or falls

substantially, the writer is vulnerable to large losses. Leeson bet and lost. Japanese

stocks plummeted, and the straddles became a huge liability. Like a panicked

gambler, Leeson tried to win back his losses by going long in Japanese

stock futures. This position was a stark naked speculative bet. Leeson lost

again. Japanese stocks continued to fall. Leeson lost more than $1 billion, and

Barings had lost all of its capital. The bank was put into receivership.

Procter & Gamble

Procter & Gamble, the well-known manufacturer of soap and household products,

had a long history of negotiating low interest rates to finance operations.

426 Planning and Forecasting

Toward this end, Procter & Gamble entered an interest rate swap with

Bankers Trust in November of 1993. The swap agreement was far from plainvanilla.

It most certainly fit the description of an exotic derivative. The swap's

cash flows were determined by a formula that involved short-term, mediumterm,

and long-term interest rates. Essentially, the deal would allow Procter &

Gamble to reduce its financing rate by four-tenths of 1% on $200 million of

debt, if interest rates remained stable until May 1994. If, on the other hand,

interest rates spiked upward, or if the spread between 5-year and 30-year

rates narrowed, Procter & Gamble would lose money and have to pay a higher

rate on its debt.

Even in the rarefied world of derivatives, one cannot expect something

for nothing. In order to achieve a cheaper financing rate, Procter & Gamble

had to give up or sell something. In this case, implicit in the swap, they sold

interest rate insurance. The swap contained an embedded option, sold by Procter

& Gamble. If the interest rate environment remained calm, Procter &

Gamble would keep a modest premium, thereby lowering its financing costs. If

interest rates became turbulent, Procter & Gamble would have to make big

payments. Most economists in 1993 were forecasting calm. The bet seemed

safe. But it was a bet, nevertheless. This was not a hedge, this was speculation.

And they lost.

The Federal Reserve unexpectedly raised interest rates on February 4,

1994. Procter & Gamble suddenly found themselves with a $100 million loss.

Rather than lower their financing rate by four-tenths of 1%, they would have to

pay an additional 14%!

Rather than lick its wounds and retire from swaps, Procter & Gamble

went back for more—with prodding, of course, from Bankers Trust. As losses

mounted on the first deal, Procter & Gamble entered a second swap, this one

tied to German interest rates. German medium-term interest rates are remarkably

stable, and so this bet seemed even safer than the first one. Guess what

happened. Another $50 million of losses mounted before Procter & Gamble finally

liquidated its positions. Losses totaled $157 million. Procter & Gamble

sued Bankers Trust, alleging deception, mispricing, and violation of fiduciary

responsibilities. Procter & Gamble claimed that they did not fully understand

the risks of the swap agreements, nor how to calculate their value. Bankers

Trust settled with Procter & Gamble, just as they settled with Gibson Greeting

Cards, Air Products and Chemicals, and other companies that lost money in

similar swaps.

Metallgesellschaf t

Experts are still divided over what went wrong in the case of Metallgesellschaft,

one of Germany's largest industrial concerns. This much is certain:

In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16

billion, and equity capital of $50 million. By the end of the year, this industrial

giant was nearly bankrupt, having lost $1.3 billion in oil futures.

Financial Management of Risks 427

What makes the Metallgesellschaft case so intriguing, is that the company

seemed to be using derivatives for all the right reasons. An American subsidiary

of Metallgesellschaft, MG Refining and Marketing (MGRM) had embarked

on an ingenious marketing plan. The subsidiary was in the business of

selling gasoline and heating oil to distributors and retailers. To promote sales,

the company offered contracts that would lock in prices for a period of 10

years. A variety of different contract types was offered, and the contracts had

various provisions, deferments, and contingencies built in, but the important

feature was a long-term price cap. The contracts were essentially forwards.

The forward contracts were very popular and MGRM was quite successful at

selling them.

MGRM understood that the forward contracts subjected the company to

oil price risk. MGRM now had a short position in oil. If oil prices rose, the

company would experience losses, as it would have to buy oil at higher prices

and sell it at the lower contracted prices to the customers. To offset this risk,

MGRM went long in exchange-traded oil futures. The long position in futures

should have hedged the short position in forwards. Unfortunately, things did

not work out so nicely.

Oil prices fell in 1993. As oil prices fell, Metallgesellschaft lost money on

its long futures, and had to make cash payments as the futures were marked to

market. The forwards, however, provided little immediate cash, and their appreciation

in value would not be fully realized until they matured in 10 years.

Thus, Metallgesellschaft was caught in a cash crunch. Some economists argue

that if Metallgesellschaft had held on to its positions and continued to make

margin payments the strategy would have worked eventually. But time ran out.

The parent company took control over the subsidiary and liquidated its positions,

thereby realizing a loss of $1.3 billion.

Other economists argue that Metallgesellschaft was not an innocent victim

of unforeseeable circumstances. They argue that MGRM had designed the

entire marketing and hedging strategy, just so they could profit by speculating

that historical patterns in oil prices would persist. Traditionally, oil futures

prices are lower than spot prices, so the general trend in oil futures prices is

upward as they near expiration. MGRM's hedging plan was to repeatedly buy

short-term oil futures, holding them until just before expiration, at which point

they would roll over into new short-term futures. If the historical pattern had

repeated itself, MGRM would have profited many times from the rollover

strategy. It has been alleged that the futures was the planned source of profits,

while the forward contracts with customers was the hedge against oil prices

dropping.

Regardless of MGRM management's intent, the case teaches at least

two lessons. First, it is important to consider cash flow and timing when constructing

a hedge position. Second, when a hedge is working effectively, it

will appear to be losing money when the position it is designed to offset is

showing profits. Accounting for hedges should not be independent of the position

being hedged.

428 Planning and Forecasting

Askin Capital Management

Between February and April 1994, David Askin lost all $600 million that he

managed on behalf of the investors in his Granite Hedge Funds. Imagine the

surprise of the investors. Not only had they earned over 22% the previous year,

but the fund was invested in mortgage-backed securities—instruments guaranteed

by the U.S. government not to default. The lesson from the Askin experience,

is that in the age of derivatives, investments with innocuous names might

not be as safe and secure as they sound.

The particular type of mortgage-backed securities that Askin purchased

were collateralized mortgage obligations (CMOs), which are bonds whose

cash f lows to investors are determined by a formula. The formula is a function

of mortgage interest rates and also of the prepayment behavior of home buyers.

Since the cash flow to CMOs is a function of some other economic variable,

interest rates in this case, these instruments are categorized as

derivatives. Some CMOs rise in value as interest rates rise, others fall. Askin's

CMOs were very sensitive to interest rates. Askin's portfolio rose in value as

interest rates fell in 1993. When interest rates began to rise again in February

1994, his portfolio suffered. Interest rate increases alone, however, were not

the sole cause of Askin's losses. As interest rates rose and CMO prices fell,

CMO investors everywhere got scared and sold. CMO prices were doubly battered

as the demand dried up. It was a classic panic. Prices fell far more than

the theoretical pricing models predicted. Eventually, calm returned to the

market, investors trickled back, and prices rebounded. But it was too late for

Askin. He had bought on margin, and his creditors had liquidated his fund at

the market's bottom.

Orange County, California

Robert Citron, treasurer of Orange County, California, in 1994, fell into the

same trap that snared Procter & Gamble and David Askin. He speculated that

interest rates would remain low. The best economic forecasts at the time supported

this outlook. Derivatives allowed speculators to bet on the most likely

scenario. Small bets provided modest returns. Big bets promised sizable returns.

What these speculators did was akin to selling earthquake insurance in

New York City. The likelihood of an earthquake there is very small, so insurers

would almost certainly get to keep the modest premiums without having to pay

out any claims. If an earthquake did hit New York, however, the losses to the

insurers would be enormous.

Citron bet and lost. The earthquake that toppled his portfolio was the unexpected

interest rate hikes beginning in February 1994. Citron had borrowed

against the bonds Orange County owned, and he invested the proceeds in derivative

bonds called inverse-f loaters, whose cash f low formulas made them extra

sensitive to interest rate increases. Citron lost about $2 billion of the $7.7 billion

he managed, and Orange County filed for bankruptcy in December 1994.

Financial Management of Risks 429

Union Bank of Switzerland

What happened at Union Bank of Switzerland (UBS) in 1997 would be funny

if it weren't so sad. Imagine a bakery that sells cakes and cookies for less than

the cost of the ingredients. Business would no doubt be brisk, but eventually

the bakers would discover that they were not turning a profit. This is essentially

what happened to UBS. UBS manufactured and sold derivatives to corporate

customers. Unfortunately, there was an error in their pricing model,

and they were selling the derivatives for too low a price. By the time they

found the mistake, they had managed to lose over $200 million. Swiss banking

officials concluded that losses sustained by the Global Equity Derivatives

Business arm of UBS amounted to 625 million Swiss francs (about $428 million),

but these losses stemmed not only from the pricing model error, but also

from unlucky trading, an unexpected change in British tax laws, and market

volatility. Some speculate that these losses forced the merger of UBS with

Swiss Bank Corporation, a merger that was arranged exactly when the derivatives

losses were discovered.

Long-Term Capital Management

The most surprising of the derivatives debacles is also one of the most recent.

It is the saga of Long-Term Capital Management (LTCM). LTCM was a company

founded by John Meriwether, and joined by Myron Scholes and Robert

Merton. Meriwether had a reputation for being one of the savviest traders on

Wall Street. Scholes and Merton are Nobel prize laureates, famous for inventing

the Black-Scholes option pricing model.2 Unlike the folks at Procter &

Gamble, these individuals cannot plead ignorance. They were without a doubt

among the smartest players in the financial marketplace. Paradoxically, it may

have been their intellectual superiority that did them in. Their overconfidence

engendered a false sense of security that seduced investors, lenders, and the

portfolio managers themselves into taking enormous positions. The story of

LTCM is a classic Greek tragedy set on modern Wall Street.

LTCM was organized as a "hedge fund." A hedge fund is a limited partnership,

that in exchange for limiting the number and type of investors who can

buy in, is not required to register with the Securities and Exchange Commission,

and is not bound by the same regulations and reporting standards imposed

on traditional mutual funds. Investors must be rich. A hedge fund can accept

investments from no more than 500 investors who each have net worth of at

least $5 million, or no more than 99 investors if they each have net worth of

at least $1 million. A hedge fund is essentially a private investment club, unfettered

by the rules designed to protect the general public.

Ironically, hedge funds are generally unhedged. Most hedge funds speculate,

aiming to capture profits by taking risks. LTCM was a little different,

and for them the moniker "hedge fund" appeared to fit. Capitalizing on their

brainpower, LTCM sought to exploit market inefficiencies. That is, with an

430 Planning and Forecasting

understanding of what the prices of various financial instruments should be,

LTCM would identify instruments that were priced too high or too low. Once

such an opportunity was identified, they would buy or sell accordingly, hedging

long positions with matching shorts. As the prices in the financial marketplace

trended toward the fair equilibrium dictated by the financial models,

the prices of the assets held long would rise, and the prices of the instruments

sold short would fall, thereby delivering to LTCM a handsome profit.

LTCM's deals were generally not naked speculation, but hedged exploitation

of arbitrage opportunities. With price risk thought to be hedged out, LTCM

and their investors felt comfortable borrowing heavily to lever up the impact

of the trades on profits. The creditors, banks and brokerages mostly, happily

obliged.

LTCM opened its doors in 1994, with an initial equity investment of $150

million from the founding partners, and an investment pool of $1.25 billion in

client accounts. Success was immediate and pronounced. They thrived in the

tumultuous market of the mid-1990s. Apparently, as some of the institutions

described above lost fortunes during this period, it was LTCM that managed to

be on the receiving end. The fund booked a 28% return in 1994, a whopping

59% in 1995, followed by another 57% return in 1996. Word of this success

spread, and new investors were clamoring to get into LTCM.3

LTCM could be picky when it came to choosing investors. This was not a

fund for your typical dentist or millionaire next door. Former students of mine

who have gone on to jobs at some of the world's largest banks and investment

companies have confided to me that their firms subcontracted sizable portions

of their portfolios to LTCM. By the end of 1995, bolstered by reinvested profits

and by newly invested funds, LTCM managed $3.6 billion of invested funds.

However, the portfolio was levered 28 to 1. For every $1 a client invested, the

fund was able to borrow $28 from banks and brokerage houses. Consequently,

LTCM managed positions worth over $100 billion. Moreover, because of the

natural leverage inherent in the derivatives they bought, these positions were

comparable to investments of a much larger magnitude, estimated to be in the

$650 billion range.

By 1997, however, when the fund's capital base peaked at $7 billion,

managers realized that profitable arbitrage opportunities were growing scarce.

The easy pickings of the early days were over. The partners began to intentionally

shrink the fund by returning money to investors, essentially forcing them

out. Performance was sound in 1997, a 25% return, but with the payout of capital,

the fund's capital base fell to $4.7 billion.

Things unraveled disastrously in 1998. Each of LTCM's major investment

strategies failed. Based on sophisticated models and historical data,

LTCM gambled that (1) stock market volatility would stay the same or fall,

(2) swap spreads—a variable used to determine who pays whom how much in

interest rate swaps, would narrow, (3) the spread of the interest rate on

medium-term bonds over long-term bonds would f latten out, (4) the credit

Financial Management of Risks 431

spread—the interest rate differential between risky bonds and high-grade

bonds, would narrow, and (5) calm would return to the financial markets of

Russia and other emerging markets. However, in each case the opposite happened.

Equity volatility increased. Swap spreads widened. The yield curve retained

its hump. Credit spreads grew. Emerging markets deteriorated.

Though LTCM had spread its bets over a wide variety of positions, they

seemed to gain no diversification benefit. Everything went wrong at once. Recent

research has shown that diversification does not protect speculative positions

when markets behave erratically. Markets tend to go awry in tandem.

In August 1998 alone, the fund suffered losses of $1.9 billion. Losses for

the year so far were 52%. Fund managers were confident that their strategies

were sound, and that time would both prove them right and reward their prescience.

But time is not a friend to a levered fund losing money. Banks and brokerages

itched for their loans back. How ironic, Long-Term Capital Management

faced a short-term liquidity crunch.

Leverage amplified LTCM's remaining $2.28 billion of equity into managed

assets of $125 billion. If the market continued to move against them,

LTCM would be wiped out in short order, and that is essentially what happened.

On September 10, LTCM lost $145 million. The next day, they lost $120

million. The following three trading days brought losses of $55 million, $87

million, and $122 million, respectively. On one day alone, Monday, September

21, 1998, LTCM lost $553 million. By now traders at other firms could guess

what LTCM's positions were, and by anticipating what LTCM would have to

eventually sell, they could gauge which securities were good bets to short. This

selling pressure added to LTCM's losses and woes.

At this point, in September 1998, any of several banks could bankrupt

LTCM by calling in its loans. The Federal Reserve, which is the central bank of

the United States, and is responsible for guarantying the stability of the American

banking system, monitored the predicament. Though LTCM's equity was

shrinking precipitously, on account of their borrowed funds and the inherent

leverage of their derivatives positions, the notional principal of their positions

was about $1.4 trillion. To put this quantity into perspective, the gross national

product of the United States was about $8.8 trillion in 1998. Total bank assets

in the United States stood at $4.3 trillion. It was feared that if LTCM went

bankrupt, they would probably default on their derivative positions, triggering

a domino effect of defaults and bankruptcies throughout the world's financial

markets. It was decided, that LTCM was too big too fail.

The Federal Reserve orchestrated a plan for LTCM's creditors to buy the

company's portfolio. Each of 14 banks ponied up money in exchange for a slice

of the portfolio. The $3.65 billion paid by the bank syndicate for the portfolio

was clearly greater than the value of the portfolio by then, but this infusion of

capital prevented defaults that would have cost the banks much more. The

money was used to pay off debts and shore up the trading accounts so that existing

positions would perform without default. Very little was left over for the

432 Planning and Forecasting

original partners who were required to run the fund until it was ultimately liquidated

in 1999. The bottom line is that LTCM had lost $4.5 billion since the

start of 1998. These losses included the personal fortunes amassed so quickly

by the founding partners, which totaled $1.9 billion at one point but were completely

wiped out by the end.

Moral of the Story

The lesson from these case studies should now be obvious. Risk management is

not the art of picking good bets. Bets no matter how good are speculation.

Speculation increases risk, and subjects corporations, investors, and even municipalities

to potential losses. Derivatives are powerful tools to shed risk, but

they can also be used to take on risk. The root causes of the debacles described

in these cases are greed, speculation, and in some cases incompetence, not derivatives.

But just as derivatives facilitate risk management, they facilitate

greed and speculation. Anything that can be done with derivatives, can be

done slower the old fashioned way with positions in traditional financial instruments.

Speculators have always managed to lose large sums. With the aid of derivatives

they now can lose larger sums faster.

Superior intellect and sophistication cannot protect the speculator. As the

Long-Term Capital Management story illustrates, when you are smarter than

the market, you can go broke waiting for the market to wise up.

Government regulation is not the answer either. The benefits of regulation

must be weighed against the costs. Derivatives, properly used, are too important

in the modern financial marketplace to be severely restricted. Abuse

by a few does not warrant constraints on all users. A better solution to prevent

repetition of the past debacles is full information disclosure by firms, portfolio

managers, and municipalities. Investors and citizens should demand to know

how derivatives are being used when their money is at stake. Better information

and oversight is the most promising approach to prevent misuse of derivatives

while retaining the benefits.

Derivatives can be dangerous, but they can also be tremendously useful.

Dynamite is an appropriate analogy. Misused, it is destructive; handled with

care, it is a powerful and constructive tool.

Derivatives are tools that facilitate the transfer of risk. Interest rate derivatives

enable managers to shed business exposure to interest rate f luctuations,

for example. But when one party sheds risk, another party necessarily

must take on that very exposure. And therein lies the danger of derivatives.

The same instrument that serves as a hedge to one firm, might be a destabilizing

speculative instrument to another. Without a proper understanding of derivatives,

a manager who intends to reduce risk, might inadvertently increase

it. This chapter aims to provide the reader with a basic understanding of derivatives

so that they can be used appropriately to manage financial risks. This understanding

should help the reader avoid the common pitfalls that have proved

disastrous to less informed managers.

Financial Management of Risks 433

SIZE OF THE DERIVATIVE MARKET

AND WIDESPREAD USE

A derivative is a financial instrument whose value or contingent cash f lows depend

on the value of some other underlying asset. For example, the value of a

stock option depends on the value of the underlying stock. Derivatives as a

class comprise forwards, futures, options, and swaps. Numerous hybrid instruments,

combining the features of these basic building blocks have also been

engineered. The first thing the interested manager must understand about derivatives

is that the business in these instruments is now huge, and their use is

pervasive. Since the initiation of trading in the first stock index futures contract

in December of 1982—the Standard & Poor's 500 futures contract—the

daily volume of stock index futures has grown so that it now rivals the daily

volume in all trading on the New York Stock Exchange. (Volume of futures is

measured in terms of notional principal, which is a measure of exposure.) On

just one typical day in the 1990s, Tuesday, January 21, 1996, the notional volume

of the Standard & Poor's 500 futures contract was just shy of $40 billion.

The volume on the NYSE that same day was approximately $23 billion. On that

day, therefore, just one specific futures contract was greater than the entire

Big Board stock market in terms of trading volume. More recently, however,

the tables have turned, and the New York Stock Exchange daily trading volume

once again regularly beats that of the S&P 500 futures contract. Still the magnitudes

are comparable, and futures trading is firmly established as a significant

segment of financial market activity.

Similarly, the swaps market has revolutionized banking and finance. The

notional principal of outstanding swaps today, is greater than the sum total of

all assets in banks worldwide. The Bank for International Settlements reports

that the sum total of all assets in banks around the world was approximately

$12 trillion in June 2000. At that same time, according to the same source, the

notional principal of outstanding swaps was over $50 trillion. Measured this

way, the swaps business is now bigger than traditional banking.

The volume of the derivatives market ref lects how widespread derivatives

use has become in business. Almost all major corporations now use them

in one form or another. Some use derivatives to hedge commodity price risks.

Some use them to speculate on price movements. Some firms reduce their exposures

to volatile interest rates and foreign exchange. Other firms take on

exposures via derivatives in order to potentially increase profits. Some firms

use derivatives to secure cheaper financing. Many corporations use derivatives

to reduce the transaction costs associated with managing a pension fund, borrowing

money, or budgeting cash. Some firms implement derivative strategies

to reduce their tax burdens. Many companies offer stock options, a derivative,

as employee compensation. Some investment funds enhance returns by replacing

traditional portfolios with what are called synthetic portfolios—portfolios

composed in part of derivatives. Some investment funds buy derivatives that

act as insurance contracts, protecting portfolio value. Since their emergence in

434 Planning and Forecasting

the early 1980s, derivatives have touched every aspect of corporate finance,

banking, the investments industry, and arguably business in general.

THE INSTRUMENTS

The major derivative instruments are forwards, futures, options, and swaps.

Also available today are hybrid instruments, exotics, and structured or engineered

instruments. The hybrids, exotics, and engineered instruments are contracts

that combine features of the basic building blocks: the options, futures,

forwards, and swaps. Consequently, familiarity with the basic building blocks

goes a long way toward understanding the whole melange of derivative instruments

available today. We will begin with forwards.

Forwards

Imagine the following nearly idyllic scenario. It is late summer. You are a wheat

farmer in Kansas. The hard work of sowing and tending your acreage is about to

pay off. You expect a bumper crop this year, and the harvest is just a few weeks

away. The weather is expected to remain favorable. The crops have been

sprayed to protect them from pests. In fact, you may even have purchased crop

insurance to protect against crop damage.

Still, you cannot relax. One major uncertainty is keeping you awake at

night. You figure that if you are expecting a bumper crop, the likelihood that

your neighbors are also expecting a bumper crop is high. If the market is

f looded with wheat, prices will plummet. If prices drop, you will receive little

revenue for your harvest, and perhaps you will show a loss for the year. A worse

case scenario might be that prices fall so low, that you cannot make the mortgage

payments on your land or the machinery you bought. You very well might

lose the farm—and through no fault of your own. You farmed well, but if prices

fall, you will fail nevertheless.

Meanwhile, at the same time, another group of businesspeople is feeling

similar anxiety. A baked goods company has recently built a new cookie bakery.

The company identified its market niche as a provider of inexpensive,

mass produced, medium quality cookies. The project analysis that led to the

go-ahead for the new bakery assumed that wheat prices would stay fixed at

their current levels. If wheat prices should rise, it is altogether possible that

the firm will not be able to sell its cookies for a profit. The new bakery will

appear to be a failure.

In these scenarios, both the farmers and the bakers are exposed to wheat

price risk. The farmers worry that wheat prices will fall. The bakers worry that

prices will rise. A forward contract is the obvious solution for both parties.

The farmers and bakers can negotiate a deferred wheat transaction. The

farmers will deliver wheat to the bakers, one month from now, for a price currently

agreed upon. Such a contract for a deferred transaction is a forward

Financial Management of Risks 435

contract. A forward contract specifies an underlying asset to be delivered, a

price to be paid, and the date of delivery. The specified transaction price is

called the forward price. The party that will be selling wheat (the farmer) is

known as the "short" party; the party that will be buying wheat (the baker)

is known as the "long" party. In the jargon of the derivatives market, the long

party is said to "buy" the forward, and the short party "sells" the forward.

Note, however, that when the deal is initially struck, no money changes hands

and no one has yet bought or sold anything. The "buyer" and "seller" have

agreed to a deferred transaction.

Notice that the wheat forward reduces risk for both the farmers and the

bakers. In this transaction, both parties are hedgers—that is, they are using

the forward to reduce risk. Forward contracts are "over-the-counter" instruments,

meaning that they are negotiated between two parties and customtailored,

rather than traded on exchanges.

Suppose after one month, when the forward expires and the wheat is delivered,

the current, or spot, price of wheat has risen dramatically. The farmer may

have some regret that he entered into the contract. Had he not sold forward, he

would have been able to receive more for his wheat by selling on the spot market.

He may feel like a loser. The bakers, on the other hand, will feel like winners.

By contracting forward they insulated themselves from the rising wheat

price. When spot prices rise, the long party wins while the short party loses. A

little ref lection, however, will convince the farmer that although he lost some

money relative to what he could have gotten on the spot market, going short in

the forward was indeed a worthwhile strategy. He had piece of mind over the

one month. He was guaranteed a fair price, and he did not have to fear losing the

farm. Though there was an opportunity loss, he benefited by shedding risk. The

farmer probably never regrets that he has never collected on his life insurance

either. He similarly should not regret that the forward contract represents an opportunity

loss. He would be well advised to go short again next year.

The wheat forward contract can be used by speculators as well as

hedgers. An agent who anticipates a rise in wheat prices can profit from that

foresight by going long in the forward contract. By going long in the contract,

the speculator agrees to buy wheat at the fixed forward price. Upon expiration

of the contract, the speculator takes delivery of the wheat, pays the forward

price, and then sells the wheat on the spot market for the higher spot price.

The profit is the difference between the spot and forward prices. Of course, if

the speculator's forecast is wrong, and the wheat price falls, the speculator

would suffer losses equal to the difference between the forward and spot

price. For example, suppose the initial spot price is $3 per bushel, and the forward

price is $3.50 per bushel. If the spot price upon expiration is $4.50 per

bushel, the long speculator would earn a profit of $1 per bushel. The profit is

the terminal spot of $4.50 minus the $3.50 initial forward price. If, alternatively,

the terminal spot price is $3.25, the speculator would lose 25 cents per

bushel—that is, $3.25 minus $3.50. Notice that the $3 initial spot price is irrelevant

in both cases.

436 Planning and Forecasting

Speculators play important roles in the derivatives markets. For one,

speculators provide liquidity. If farmers wish to short forward contracts but

there are no bakers around who want to go long, speculators will step in and

offer to take the long side when the forward price is bid down low enough.

Similarly, they will take the short side when the forward price is bid up high

enough. Speculators also bring information to the marketplace. The existence

of derivatives contracts and the promise of speculative profits make it worthwhile

for speculators to devote resources to forecasting weather conditions,

crop yields, and other factors that impact prices. Their forecasts are made

known to the public as they buy or sell futures and forwards.

Futures

Futures contracts are closely related to forward contracts. Like forwards,

futures are contracts that spell out deferred transactions. The long party

commits to buying some underlying asset, and the short party commits to

sell. The differences between futures and forwards are mainly technical and

logistical. Forward contracts are custom-tailored, over-the-counter agreements,

struck between two parties via negotiation. Futures, alternatively, are

standardized contracts that are traded on exchanges, between parties who

probably do not know each other. The exact quantity, quality, and delivery

location can be negotiated in a forward contract, but in a futures contract

the terms are dictated by the exchange. Because of their standardization and

how they are traded, futures are very liquid, and their associated transaction

costs are very low.

Another feature differentiating futures from forwards is the process of

marking-to-market. All day and every day, futures traders meet in trading pits

at the exchanges and cry out orders to buy and sell futures on behalf of clients.

The forces of supply and demand determine whether futures prices rise or fall.

Marking-to-market is the process by which at the end of each day, losers pay

winners an amount equal to the movement of the futures price that day. For example,

if the wheat futures price at Monday's close is $4.00 per bushel, and the

price rises to $4.10 by the close on Tuesday, the short party must pay the long

party 10 cents per bushel after trading ends on Tuesday. If the price had fallen

10 cents, then long would pay short 10 cents per bushel. Both long and short

parties have trading accounts at the exchange clearinghouse, and the transfer

of funds is automatic. The purpose of marking-to-market is to reduce the

chance of default by a party who has lost substantially on a futures position.

When futures are marked-to-market, the greatest possible loss due to a default

would be an amount equal to one day's price movement.

Futures are marked-to-market every day. When the contract expires, the

last marking-to-market is based on the spot price. For example, suppose two

days prior to expiration the futures price is $4.10 per bushel. On the second to

last day the futures price has risen to $4.30. Short pays long 20 cents per

bushel. Suppose at the end of the next day, the last day of trading, the spot

Financial Management of Risks 437

price is recorded at $4.55. The last mark-to-market payment is from short to

long for 25 cents per bushel, equal to the difference between the spot price

upon expiration and the previous day's futures price.

Upon expiration, the futures contract might stipulate that the short party

now deliver to the long party the specified quantity of wheat. The long party

must now pay the short party the spot price for this wheat. Yes, the spot price,

not the original futures price! The difference between the terminal spot price

and the original futures price has already been paid via marking-to-market. A

numerical example will make the mechanics of futures clearer, and show how

similar futures are to forwards.

Suppose with five days remaining until expiration, the wheat futures

price is $4.00 per bushel. A baker "buys" a futures contract in order to lock in a

purchase price of $4.00. Suppose the futures prices on the next four days are

$4.10, $3.90, $4.00, and $4.25. The spot price on the fifth day, the expiration

day, is $4.30. Given those price movements, short pays the long baker 10 cents

the first day. The long baker pays short 20 cents on the second day. On the

third day, short pays long 10 cents, followed by a payment from short to long of

25 cents on the fourth day, and a payment from short to long of 5 cents on the

last day. On net, over those five days, short has paid long 30 cents. When long

now pays the spot price of $4.30 to short for delivery of the wheat, long indeed

is paying $4.00 per bushel, net of the 30 cents profit on the futures contract.

Recall that $4.00 was the original futures price. Thus, the futures contract did

effectively lock in a fixed purchase price for the wheat.

A contract that stipulates a spot transaction in which the underlying commodity

is actually delivered at expiration, is called a "physical delivery" contract.

Many futures contracts do not stipulate such a final spot transaction with

actual delivery of the underlying asset. After the last marking-to-market, the

game is over. No assets are delivered. Contracts that stipulate no terminal spot

transaction are called "cash settled." It should make little difference to traders

whether a contract is cash settled or physical delivery. A cash settled contract

can be turned into a physical delivery deal simply by choosing to make a spot

transaction at the end. Likewise, a physical delivery contract can be turned

into a cash settled deal by either making an offsetting spot transaction at the

end, or by exiting the futures contract just before it expires.

Examples of the Use of Forwards and

Futures in Risk Management

A wide variety of underlying assets is covered by futures and forwards contracts

these days. For example, exchange-traded futures contracts are available

on stocks, bonds, interest rates, foreign currencies, oil, gasoline, grains, livestock,

metals, cocoa, coffee, sugar, and even orange juice. Consequently, these

instruments are versatile risk management tools in a wide variety of situations.

The most actively traded futures, however, are those that cover financial risks.

Consider the following examples.

438 Planning and Forecasting

A Foreign Currency Hedge

Suppose an American electronics manufacturer has just delivered a large shipment

of finished products to a customer in France. The French buyer has

agreed to pay 1 million French francs in exactly 30 days. The manufacturer is

worried that the French franc may be devalued relative to the American dollar

during that interval. If the franc is devalued, the dollar value of the promised

payment will fall and the American manufacturer will suffer losses. The American

manufacturer can shed this foreign currency exposure by going short in a

franc forward contract or a franc future. The contract will specify a quantity

of francs to be exchanged for dollars, at a fixed exchange rate, 30 days in the

future. The contract locks in the terms at which the deferred franc revenue

can be converted to dollars. No matter what happens to the franc-dollar exchange

rate, the American manufacturer now knows exactly how many dollars

he will receive.

A Short-Term Interest Rate Hedge

Suppose a manufacturer of automotive parts has just delivered a shipment of

finished products to a client. Business has been growing, and the company

has approved plans to expand capacity next year. The manufacturer expects

to receive payment from the customer in 60 days, but will need to use those

funds for the planned capital expenditure 90 days after that. The plan is to

invest the revenue in three-month Treasury bills as soon as the revenue is received.

Interest rates are currently high. Managers worry that by the time

the receivables are collected from the customer, however, interest rates will

fall, resulting in less interest earned on the invested funds. The company can

hedge against this risk by buying a Treasury bill futures contract, which essentially

locks in the price and yield of Treasury bills to be purchased 60

days hence.

Longer-Term Interest Rate Hedge

A manufacturer of speed boats notices that when interest rates rise, sales fall,

and the value of the firm's stock gets battered. The correlation is easy to understand.

Customers buy boats on credit, and so when rates rise, the boats effectively

become more expensive to buy. In order to insulate the company's

fortunes from the vicissitudes of interest rates, the company could enter a contract

that pays money when rates rise. A short position in a Treasury bond

futures contract would pay off when rates rise and could thus be a desirable

hedge. Each time the futures contract expires, the company can roll over into a

new contract. The size of the position in the futures should be geared to the

f luctuation in sales resulting from changes in interest rates. The Treasury bond

hedge can reduce the volatility in the firm's net income, and the volatility of

the firm's equity value.

Financial Management of Risks 439

Synthetic Cash

A company's pension fund is invested primarily in the stocks of the Standard &

Poor's 500. The pension fund manager worries that there may be a downturn

in the stock market sometime over the next six months. She considers selling

all of the stock and investing the funds in Treasury bills. An alternate hedge

strategy that will save considerable transaction costs would be to short S&P

500 futures contracts. By establishing a short futures position, she locks in the

price at which the stocks will be sold six months hence. The fund is now insulated

from any f luctuations in stock prices. Since the fund is now essentially

risk free, it will earn the risk-free interest rate. Selling futures while holding

the underlying spot instrument is a strategy known as "synthetic cash." The

strategy essentially turns stock into cash. The fund performs as if it were invested

in Treasury bills.

Synthetic Stock

A company's pension fund is invested primarily in Treasury bills. The stock

market has been rising rapidly in recent weeks, and the pension fund manager

wishes to participate in the boom. One strategy would be to sell the T-bills and

invest the proceeds in equities. A more economical strategy would be to leave

the value parked in T-bills, and gain exposure to the stock market by going long

in stock futures. When the market rises, the futures will pay off. Should the

market fall, the fund will suffer losses. The fund will thus behave as if it were

invested in stocks. Ergo the name, "synthetic stock."

Market Timing

A manager wishes to be exposed to the stock market when he anticipates a

market rise, and be out of stocks and into T-bills when he anticipates a drop.

Buying and selling stocks to achieve this purpose is very expensive in terms of

commissions. But entering and exiting the market via futures is very cheap.

The manager should keep all his funds invested in T-bills. When he feels the

market will rise, he should go long in stock index futures, such as S&P 500 futures.

When he feels the market will drop, he should sell those futures, unwinding

the position. If alternatively he wished to assemble a diversified

portfolio such as the S&P 500 the old fashion way—a portfolio consisting of

actual stocks and no derivatives—he would have to buy each of the 500 stock

issues while selling his Treasury bills. This positioning would involve 501 separate

transactions. Turning the actual stock portfolio back into T-bills would

similarly require 501 transactions. Turning T-bills effectively into stocks via

long futures contracts, on the other hand, involves just one futures trade. Unwinding

the futures position would also be just one single trade. Market timing

is much more economically executed with futures contracts than with actual

equity trades.

440 Planning and Forecasting

A Cross-Hedge

A manufacturer of plastic water pistols wishes to hedge against increases in raw

plastic pellet prices. Unfortunately, there are no futures contracts covering

plastic prices. There is, however, a contract on oil prices, and the price of plastic

is highly correlated with the price of oil. By going long in an oil contract,

the manufacturer will be paid money when oil prices rise, which will likely

be also when plastic prices rise. Hedging an exposure with a contract tied to a

correlated underlying instrument is called a cross-hedge.

A Common Pitfall

The ease with which futures facilitate hedging sometimes coaxes managers to

occasionally take speculative positions. A photographic film manufacturer, for

example, might become experienced and comfortable hedging silver prices by

going long in silver futures. Managers at the firm might come to believe that no

one is better able to forecast silver prices than they are. A time may come when

they wholeheartedly believe that silver prices will fall. Not only might they

choose not to enter a long silver future hedge at this time, but they may choose

to go short in silver futures so as to capitalize on the falling price. If silver

prices fall they will not only benefit from a cheaper raw input, but the short silver

futures will pay off as well. The danger here is that the manufacturer has

lost sight of the fact that it is in the film manufacturing business, and not the

business of speculating on commodity prices. Although silver prices might be

expected to fall, there is always the possibility that they will rise instead. The

probability of a rise might be small, but the consequences would be catastrophic.

Not only will the firm's raw material price rise, but the firm will suffer

additionally as it loses on the futures contract. The lesson here is that firms

should stay clearly focused on what their business line is, and what role the use

of futures plays in their business. Futures use should generally be authorized

only for hedging and not for speculation. Auditing systems should be in place to

oversee that futures are used appropriately.

Futures and Forwards Summary

As the above examples illustrate, futures and forwards are useful tools for

hedging a wide variety of business and financial risks. Futures and forward

contracts essentially commit the two parties to a deferred transaction. No

money changes hands initially. As prices subsequently change, however, one

party wins at the other's expense. Futures and forwards thus enable businesses

to shed or take on exposure to changing prices. When used to offset an exposure

the firm faces naturally, futures and forwards reduce risk.

Options

Options are another breed of derivatives. They share some similarities with

futures and forwards, but they also differ in many important respects. Like

Financial Management of Risks 441

futures and forwards, option prices are a function of the value of an underlying

asset, thus they satisfy the definition of derivative. Unlike futures and forwards,

however, options are assets that must be paid for initially. Recall that no

money changes hands initially as parties enter into forwards and futures. Options,

though, are an asset that has to be bought for a price at the outset.

There are two kinds of options, call and puts. A call option is an asset that

gives the owner the right but not the obligation to buy some other underlying

asset, for a set price, on or up to a set date. For example, consider a call option

on Disney stock, that gives the owner the right to purchase one share of Disney

stock for $70 per share, on or up to next June 15. (Actually, options are usually

sold in blocks covering 100 shares. For expository purposes, however, we

will describe an option on only one single share.) The underlying asset would

be one share of Disney stock. The prespecified price, known as the "strike

price," would be $70 per share. The expiration date would be June 15. The Disney

option might cost $3 initially.

If on the expiration date, June 15, the market price of Disney stock stood

at $75, the call option owner would exercise the option, allowing him to buy a

share of Disney stock for $70. He could then turn around and sell the share for

$75 in the marketplace, realizing a terminal payoff from the option of $5. The

terminal payoff is $5, so the profit net of the $3 initial option price is $2.

Suppose, alternatively, that the market price of Disney stock on June 15

were $69. It would not be profitable to exercise the call option and thereby

purchase for $70 what is elsewhere available for $69. In such a case, the option

owner would choose not to exercise, and the call would expire worthless.

It is the right not to execute the transaction that is the major difference between

options and forwards. The long party in a forward contract must buy

the goods upon expiration whether it is advantageous to do so or not. By contrast,

a call option owner does not have to buy the underlying asset if he

chooses not to. At expiration, a call option should be exercised if and only if

the market price exceeds the strike price. When the market price is above

the strike price, the call option is said to be "in the money." When the market

price is less than the strike price, the call is "out of the money." When the

market price equals the strike price, the option is "at the money." An option

that is out of the money, or even at the money, at expiration, will expire unexercised

and worthless.

An option's payoff is defined as the maximum amount of money the option

owner would receive at expiration, if she totally liquidated her position. If

the option expires out of the money, the payoff is zero. If the option expires in

the money, the payoff is the amount of money received from exercising the call

option, and then selling the stock in the open market. For example, if the strike

price is $70 and the terminal stock price is $60, the payoff would be zero, since

the option would be out of the money and should not be exercised. If the terminal

stock price were $80, the payoff would be $10, since the option should

be exercised, allowing the owner to buy the stock for $70, and then sell that

stock for $80 in the open market. Mathematically, the payoff is the maximum

of zero or the stock price minus the strike price.

442 Planning and Forecasting

The payoff ignores the initial price that was paid for the option. Payoff

treats the initial price as a sunk cost, and measures only what the option owner

might subsequently receive. The payoff minus the initial price is known as the

option profit. The option payoff is the same for all owners of the option, regardless

of what they each initially paid for it. Profit, however, depends on

what was initially paid and therefore differs from one investor to another.

A payoff diagram is a valuable analytical device for understanding options.

A payoff diagram graphs the payoff of an option as a function of the

underlying asset's spot price at expiration. Exhibit 13.1 depicts the payoff diagram

for the Disney call option with a strike price of $70. The payoff diagram

is a picture of the option. It tells you when you will receive money and when

you will not. It helps to visualize how the contract will perform, and whether

or not the option is appropriate for any particular application.

The payoff diagram is f lat and equal to zero in the entire range where the

option is out of the money—that is, where the stock price is less than the strike

price. This means that someone who buys an option might lose his entire investment

in that option. You may pay $3 for the option, and lose 100% of that

$3 by the expiration date. On the brighter side, the payoff diagram confirms

that the most you can lose in an option is the initial premium, the $3 you paid

for it. Unlike, futures or forwards, you will never be called on to make additional

payments at a later date. Initially, you pay for the option, perhaps $3.

From then on you can only receive cash inf lows.

Note that the payoff diagram begins to rise at the point where the stock

price equals the strike price. The payoff is dollar for dollar greater than zero

for every dollar that the stock price exceeds the strike price. Thus we see that

a call option rises in value as the underlying asset rises in price. For this reason,

some people refer to call options as "bullish" instruments.

EXHIBIT 13.1 Call option payoff diagram.

0

10

5

15

20

25

30

0 10 20 30 40 50 60 70 80 90 100

Payoff (dollars)

Terminal stock price (Strike price = $70)

Financial Management of Risks 443

Hedging with a Call Option

Consider the trucking company whose rates are regulated yet costs f luctuate

with market prices. The chief raw material purchased by the company is diesel

fuel. If fuel prices rise, the trucking company will suffer losses, and may in fact

be put out of business. As we saw above, the company can guarantee a fixed

price for fuel by going long in a future or forward. Another strategy would be to

buy a diesel fuel call option contract. The strike price of the call option would

lock in the highest price that the company will have to pay for fuel. If fuel

prices should drop below the strike price, the company would be under no

obligation to exercise the option. It would simply buy fuel at the low market

price. If, however, fuel prices rise above the strike price, the company would

exercise the option and buy fuel at the relatively low strike price.

The added f lexibility of the option over the futures strategy comes at a

cost. When the company buys the call option it must pay a price or "premium."

The call option is essentially an oil price insurance contract for the firm, insuring

that fuel prices will not exceed the strike price. If fuel prices remain low,

below the strike price, the company will not collect on this insurance policy,

and the initial premiums will be lost.

Pricing Options

At this point the reader may wonder how the initial price of an option is determined.

Option pricing is no trivial exercise, and a thorough treatment of option

pricing is beyond the scope of this chapter. Some basic principles, however,

can be explained here. First, an option's "intrinsic value" prior to expiration is

equal to its payoff. That is, if an option is out of the money, its intrinsic value is

zero. If a call option is in the money, for example, if the strike price is $70 and

the current stock price is $80, then the intrinsic value equals the stock price

minus the strike price, $10.

The value of an option, however, exceeds its intrinsic value. An out-ofthe-

money option is worth more than zero, and the in-the-money option described

above is worth more than $10. This extra value is due to the fact that

the downside losses are capped off, but the upside potential is unlimited. As

long as there is still time remaining in the option's life, it is possible that an outof-

the-money option can go in-the-money. An in-the-money option can go further

in the money, and has more upside potential than downside.

A call option's value is a function of the underlying stock price, the strike

price, the amount of time remaining to expiration, the interest rate, the stock's

dividend rate, and the volatility of the underlying asset price. As the underlying

stock price rises, so will the call option's value. Holding the other variables

constant, a call option's value will be greater when there is a higher stock price,

lower strike price, longer time to expiration, higher interest rate, lower dividend

rate, and more volatility in the underlying asset. Researchers have succeeded

in formalizing an equation that prices options as a function of these

444 Planning and Forecasting

input variables. The formula is known as the Black-Scholes option pricing formula.

It is widely available on programmed computer software and in many

option theory textbooks.

A Written Call Option

In the case of life insurance or automobile insurance, when the insured party

collects another party must pay. It is a zero sum game. So it is with options. The

party that sells the option is liable for the future payoff. "Writing" an option,

and "shorting" an option are synonymous with selling an option. The payoff diagram

for a written call option position is the mirror image of the long or

bought call option position. As shown in Exhibit 13.2, the x-axis is the ref lecting

surface.

Note that once the call option writer has received the initial premium, all

subsequent cash flows will be outf lows. The best the writer can hope for is that

the call will expire out of the money. Note that the potential liability of the

written option position is unlimited. Notice as well, that the amount of money

the buyer of the option might receive at expiration is the exact amount that

writer will have to pay. Thus, when the media report that a particular company

has lost millions of dollars in options, the reader should realize that this means

some other party has made millions. The newspapers tend to focus on the

losers.

Strategies Using Written Call Options

Why would anybody wish to sell a call option if doing so subjects them to the

possibility of unlimited future liabilities? One answer is that speculators sometimes

deem the risks worthwhile in light of the expected reward. They may be

confident that the underlying asset price will not rise and the option will expire

worthless.

EXHIBIT 13.2 Payoff diagram for a written call option position.

–30

–10

–20

0

10

20

30

0 10 20 30 40 50 60 70 80 90 100

Payoff (dollars)

Terminal stock price (Strike price = $70)

Financial Management of Risks 445

Written call options can also be used to hedge in certain circumstances.

Consider oil exporting nations such as Mexico and Venezuela. When oil prices

are low they are hungry for funds, funds that are much needed for national

development projects. When oil prices are high, they have plenty of excess

revenue. A reasonable strategy would be to sell high strike price oil call options

when oil prices are low. The country thus receives premiums when

funds are most needed, and incurs a liability that only needs to be paid when

funds are most plentiful. The oil call options help to smooth the f low of funds

into the country. Abken and Feinstein (1994) elaborate on the use of written

call options in such a setting.

Warrants

Warrants are call options that are sold by the company whose stock is the underlying

asset. If Microsoft pays its executive with Microsoft call options, those options

will be called warrants. When the warrants are exercised, the total

outstanding supply of Microsoft stock will rise. Warrants are valuable, even if

they are not yet in the money. Clearly they must be worth something, otherwise

executives would not want them and would give them away! Offering warrants as

compensation to executives is not free for the firm's shareholders. Stories abound

nowadays of young Internet executives who became fabulously wealthy when

they exercised warrants paid to them as part of their employment compensation.

Put Options

The second type of option is a put. A put option is a contract that gives the

owner the right but not the obligation to sell some underlying asset for a prespecified

price, on or up to a given date. Consider a put option on Microsoft

stock. Suppose the strike price is $100 and the expiration date is December

15th. The put option owner has the right, but not the obligation to sell a share

of Microsoft stock for $100, on or up to December 15. If the market price of

Microsoft is above $100, for example $120, the put option owner would not exercise.

Why should he force someone to pay $100 for the stock? He can make

more money by selling the stock in the open market. Thus, a put option is out

of the money if the stock price is above the strike price. If the stock price is

below the strike price, however, then the put option is in the money. If the

market price of Microsoft is $80 on December 15, the owner of the put can

reap a $20 payoff. To realize this payoff, he would buy the Microsoft stock in

the marketplace for $80, and then turn around and sell it for $100 by exercising

his put option. Thus, a put option is in the money when the stock price is

below the strike price. A put option's payoff at expiration, and its intrinsic

value prior to expiration, is the strike price minus the stock price, or zero,

whichever is greater.

Exhibit 13.3 presents the payoff diagram for a put option. Should the

stock price fall to zero, the put option's payoff would be equal to the strike

446 Planning and Forecasting

price. At that point the put option owner would have the right to sell a worthless

stock for $100. From that point, the put option payoff falls one dollar for

each dollar that the stock price rises. The payoff reaches zero when the stock

price equals the strike price, and then remains at zero no matter how much

higher the stock price goes. As is the case with call options, the put option cannot

fall in value below zero. Once the put option premium is paid, the owner is

never called upon to make another payment. Any subsequent cash f low is positive.

It is altogether possible, however, for the buyer of the put option to lose

the entire premium, so one should not think that buying a put option is a safe

investment.

Notice that the put option payoff rises as the stock price falls. For this

reason, puts are thought of as "bearish" instruments—instruments that are

more profitable the more the underlying asset falls in value. Because of this

negative relationship with the underlying asset, puts can be good hedging instruments

for someone who owns the underlying asset.

Like the call option's payoff diagram, the put's payoff diagram is

kinked—that is, there is an elbow at the strike price. A kinked payoff diagram

is the hallmark of an option. If a payoff diagram has no kink, then the instrument

depicted is not an option.

The payoff diagram for a written put option position is the mirror image

of the put's payoff diagram. Such a payoff diagram is shown in Exhibit 13.4.

The possible payoff reaped by the buyer of the put option is exactly equal to

the possible outflow paid by the writer. Put options too are a zero-sum game.

Notice that whereas the writer of a call option has unlimited potential liability,

the writer of a put option has a potential liability limited to the strike price.

Furthermore, notice that a long put option payoff looks nothing like a short

call option. Similarly, notice that a long call option payoff is not the same as a

short put. Both long puts and short calls are bearish positions, just as both short

puts and long calls are bullish positions, but each of these four positions is

unique in the direction, size, and timing of cash f lows. Long calls and long puts

EXHIBIT 13.3 Put option payoff diagram.

0

40

20

60

80

100

120

0 10 20 30 40 50 60 70 80 90 100 110 120 130

Payoff (dollars)

Terminal stock price (Strike price = $100)

Financial Management of Risks 447

have to be paid for up front, and then receive a subsequent positive payoff depending

on what happens to the underlying stock. Short calls and short puts receive

all of their cash inf lows up front and then become potential liabilities.

A Protective Put Strategy

A put option can be thought of as price insurance for someone who owns the

underlying asset. For example, suppose you are a pension fund manager, and

you hold hundreds of shares of Microsoft stock. You hold the stock because you

believe the stock will rise in value. You worry, however, that the stock price

can fall, and losses will be so great that the fund will be unable to meet the

needs of the retirees. An effective hedging strategy would be to buy Microsoft

put options. You would choose the strike price to be at a level that would guarantee

the solvency of the fund. If Microsoft stock falls below the strike price of

the put options, the put options will pay off the difference between the new

lower market price and the strike price. If Microsoft stock rises, the put options

would expire out of the money. The insurance would not pay off, but you

would reap the high return of the rising stock. This strategy is known as buying

a protective put. It is essentially portfolio insurance. The strategy allows

for the upside appreciation of the portfolio, yet sets a f loor below which the

value of the portfolio cannot fall.

A protective put strategy can also be implemented by a producer who

faces the risk of his product's price falling. For example, a cattle rancher can

buy put options on cattle, thereby fixing the lowest price at which he will be

able to sell his herd.

Swaps

The third category of derivative we will examine is swaps. A swap is an agreement

between two parties to exchange cash flows over a period of time. The

EXHIBIT 13.4 Payoff diagram for a written put option position.

–110

–70

–90

–50

–30

–10

10

30

0 10 20 30 40 50 60 70 80 90 100 110 120 130

Payoff (dollars)

Terminal stock price (Strike price = $100)

448 Planning and Forecasting

size and direction of the cash f lows are determined by an agreed upon formula

spelled out in the swap agreement—a formula that is contingent on the performance

of other underlying instruments. Due to this contingency on other underlying

assets, swaps are considered derivatives.

One easy type of swap to understand is the equity swap. Suppose Back

Bay Investment Management owns a large block of Standard & Poor's 500

stocks. Suppose another firm, Capital Bank owns a large block of NASDAQ

stocks. Back Bay would like to diversify into NASDAQ stocks, and simultaneously

Capital Bank would like to diversify into S&P 500 stocks. The old fashion

way of achieving the desired objectives would be for each party to sell the

stocks they do not want, and reinvest the proceeds in the stocks they do want.

Such an approach is very expensive in terms of commissions. A much cheaper

alternative is for each party to keep their own portfolio intact, and arrange between

themselves an equity swap.

The swap agreement might dictate the following terms. For every percentage

point that the NASDAQ stock index rises over the course of the year,

Capital Bank will pay Back Bay Investment Management $1 million. Simultaneously,

for every percentage point that the S&P 500 rises over the course of

the year, Back Bay will pay Capital $1 million. Thus, if the NASDAQ index

rises 15% and the S&P 500 rises 11%, there will be a net payment of $4 million

from Capital to Back Bay. If in the following year the NASDAQ index rises

23% and the S&P 500 rises 29%, Back Bay will pay Capital $6 million on net.

The equity swap is illustrated in Exhibit 13.5.

In this equity swap, the "notional principal" is $100 million—that is, the

payments equal a base of $100 million times the indexes' respective returns.

The net effect of the swap is to essentially convert $100 million of Back Bay's

Standard & Poor's stocks into $100 million of NASDAQ stocks. Simultaneously,

$100 million of Capital Bank's NASDAQ stocks will now perform as if they

were $100 million of Standard & Poor's 500 stocks. Both sides keep their assets

parked where they were, but they swap exposures on the notional principal.

Some arithmetic will prove the point that Back Bay's portfolio will now

perform as if it were invested in NASDAQ stocks instead of S&P stocks. If

Back Bay did in fact own $100 million of NASDAQ stocks, by the end of the

first year, after the 15% rise in NASDAQ stocks, this portfolio would have

EXHIBIT 13.5 An equity swap.

Back Bay

Investment

Management

Capital Bank

Returns on $100 million of

NASDAQ stock index

Returns on $100 million of

S&P 500 stock index

Financial Management of Risks 449

grown to be worth $115 million. But Back Bay owns $100 million of S&P

stocks, and has a position in an equity swap. The $100 million of S&P stocks

grows to $111 million after the 11% S&P rise in the first year. The swap, however,

pays Back Bay $4 million at the end of the first year. Thus, at the end of

the first year, Back Bay does have $115 million in total portfolio value. Verify,

that the total value of Capital Bank's portfolio at the end of the first year will

be $111 million, just as if it had invested $100 million in S&P stocks.

Since the notional principal remains fixed at $100 million, the swap will

continue to convert $100 million of Back Bay's S&P stocks into $100 million of

NASDAQ stocks, and visa versa for Capital Bank. Total portfolio performance

in subsequent years depends on how the swap proceeds are reinvested by

each party.

Interest Rate Swaps

The most common type of swap is an interest rate swap. The typical, or "plainvanilla"

interest rate swap, is a "fixed for f loating swap," whereby cash flows

depend on the movement of variable interest rates. For example, consider two

firms Michel/Shaked Manufacturing (M) and Healing Heart Hospital (H). The

swap agreement might specify that M pay H a fixed 10% per year on a notional

principal of $100 million, and H pays to M the prime rate, as quoted in the

Wall Street Journal, times $100 million. Settlement might be once per year.

The prime rate quoted at the beginning of each year will determine the cash

flow paid at the end. Thus, if at first the prime rate is 12%, H will pay M $2

million at the end of the first year. If by the end of the first year the prime rate

has fallen to 7%, at the end of the second year M will pay H $3 million. And so

the swap continues for a specified number of years. H will benefit if rates fall;

M will benefit if rates rise. This interest rate swap is depicted in Exhibit 13.6.

Examples of Hedging Interest Rate

Exposure with a Swap

The Keating Computer Company assembles and markets computer hardware

systems. In the past several years Keating Computer has been one of the fastest

EXHIBIT 13.6 An interest rate swap.

Back Bay

Investment

Management

Capital Bank

Variable interest rate ×

$100 million

Fixed 10% interest rate ×

$100 million

450 Planning and Forecasting

growing computer hardware companies. They borrowed extensively to finance

this growth. Currently on the books is a very large long-term variable rate loan.

Also on the books is a sizable amount of short-term debt. The managers of

Keating Computer have observed that they are dangerously exposed to interest

rate risk. If rates should rise, they will have to pay more in debt service on the

variable rate loan, and they will face higher interest rates when they roll over

their short-term debt. The company is currently profitable, but they worry that

rising interest rates can wipe out that profit. Since the company is planning an

equity offering in coming years, management is very concerned about the

prospect of reporting any losses over the near term.

One solution to Keating Computer's problem would be to refinance at

fixed interest rates. The transaction costs of refinancing, however, are sizable,

and the rates currently offered on long-term debt are not favorable. Entering

an interest rate swap is a better hedging strategy. The company should enter as

the fixed rate payer, which means they would be the variable rate receiver. As

interest rates rise, the company will make money on the swap, offsetting the

higher payments they must make on their own debt. Since swaps are over-thecounter

instruments, the company can tailor the terms of the swap so that the

hedge will be in force for the exact number of years it is needed. Moreover, the

notional principal can be tailored so that the money received when rates rise is

closely matched to the new higher debt service obligations.

Another Example

Kayman Savings and Loan holds most of its assets in the form of long-term

mortgages, mortgage backed securities, and 30-year Treasury bonds. The liabilities

of Kayman Savings are mostly short-term certificates of deposits.

Kayman has also sold some short-term commercial paper of its own. Stephen

Kayman, the president of Kayman Savings, suddenly realizes that they are in

the same precarious predicament as that of many savings and loans (S&Ls) that

went bust in the 1980s. Long-term fixed income instruments are more sensitive

to interest rates than short-term instruments. When interest rates rise, both

long-term and short-term instruments fall in value, but the long-term instruments

fall much more. Consequently, if interest rates should rise, the market

value of the S&L's assets will fall farther than the market value of its liabilities.

When this happens, the S&L's equity will be wiped out. The bank will be

bankrupt. Even if government auditors do not shut down the S&L, the institution

will experience cash flow problems. The relatively low fixed interest revenue

from the long-term assets will not be enough to keep up with the rising

interest expenses of the short-term liabilities. What can Kayman do to protect

against the risk of rising interest rates?

The predicament faced by Kayman Savings is known as a "duration gap."

The duration of the assets is greater than the duration of the liabilities. As

rates rise, equity vanishes. Kayman Savings needs a hedge that will pay off

when rates rise. Entering an interest rate swap as the fixed payer can close the

Financial Management of Risks 451

duration gap. The swap will grow in value as rates rise, offsetting the equity

losses. Again, the size, timing, and other terms of the interest rate swap can be

tailored to meet the particular needs of Kayman Savings.

HOW TO CHOOSE THE APPROPRIATE HEDGE

We have now examined forwards, futures, call options, put options, and swaps.

We have observed how these instruments can be used to hedge in a wide variety

of risky scenarios. How does one choose which of these instruments to use

in a particular situation? When is a future better than a forward? When should

an option be used instead of a future? Should interest rate exposure be hedged

with bond futures or swaps? The following steps will provide some guidance.

The first task in implementing a hedge strategy is to identify the natural

exposures that the firm faces. Does the firm gain or lose when interest rates

rise? Does it gain or lose as the dollar appreciates? Is a falling wheat price good

news or bad news for the company? What about oil prices and stock prices?

How about foreign stock and bond prices? Is the company exposed, and if so,

which direction causes a loss?

Clearly the answers to these questions vary from firm to firm. The bakers

benefited from falling wheat prices while the farmers suffered. Rising interest

rates might hurt a firm that has variable rate debt, but might help a

pension fund that is about to invest in bonds. A rising dollar benefits U.S. importers

but hurts U.S. exporters. The first step in risk management is to identify

the exposures.

Once the exposures are identified, one should narrow the search for an

appropriate hedge to the set of derivatives that compensate the firm when the

adverse scenario is realized. For example, an airline that purchases jet fuel will

see higher costs when the price of oil rises. The airline should look for derivatives

that pay off when oil prices rise. Thus, the airline should consider a long

position in an oil future, or a long oil forward, or an oil call option. A bank that

suffers losses when interest rates rise should consider a short position in a bond

future or forward, bond put options, or the fixed-payer side of an interest rate

swap. An exporter that expects to receive Mexican pesos, might wish to go

short in peso futures or forwards, or buy peso puts.

The next step is to choose from among futures, forwards, options, and

swaps. This is perhaps the trickiest part of the analysis. To guide the selection,

it is helpful to categorize the risks and the instruments as either symmetric or

asymmetric. Futures, forwards, and swaps are symmetric hedging instruments,

in that they pay off money if prices move in one direction, but incur

losses if prices move in the opposite direction. Options, on the other hand, are

asymmetric hedging instruments. They pay off money if prices move in one direction,

yet result in no cash outf lows if prices should move the other way. A

symmetric risk is one in which the firm is hurt if underlying prices move one

way but benefits if prices move in the opposite direction. An asymmetric risk

452 Planning and Forecasting

is one in which the firm is hurt if prices move in one direction, but the firm

does not benefit appreciably if the price moves in the other direction. For example,

a firm that exports to Japan and receives payment in yen benefits when

the value of the yen rises, but is hurt when the yen falls in value. This foreign

exchange risk is thus symmetric. The symmetric foreign exchange risk can be

eliminated most completely with a symmetric instrument such as a future or

forward, not an option.

A portfolio manager invested in stocks also faces a symmetric risk. He

benefits if stock prices rise, and loses money if stock prices fall. The portfolio

manager, however, might wish to modify the exposure in an asymmetric way,

insuring against losses on the downside while maintaining the potential for

upside appreciation. An asymmetric instrument, a put option, would be the appropriate

hedge instrument in this case, since an asymmetric instrument converts

a symmetric risk into an asymmetric exposure.

An automobile leasing company is an example of a commercial venture

that faces an asymmetric risk. If interest rates rise, the firm's interest expenses

rise. If the firm tries to offset these higher costs by charging higher prices to

customers, the firm will lose business. However, if interest rates fall, buying an

automobile on credit becomes a more attractive substitute for leasing unless

the leasing company also lowers its prices. Thus, the leasing company suffers

when rates rise, but does not benefit when rates fall. An asymmetric hedge,

such as a bond put option would be the best choice of instrument in this case.

The bond put option will pay off when rates rise, but will not require a cash

outflow when rates fall.

The key to choosing between symmetric and asymmetric instruments is

to first identify the nature of the risk that is faced, and then choose the type of

instrument which will modify the risk appropriately. A symmetric risk can best

be eliminated with a symmetric instrument. An asymmetric risk can best be

eliminated with an asymmetric instrument. A symmetric risk can be turned

into an asymmetric exposure with an asymmetric instrument.

Finally, the last step is to choose whether the instruments should be of

the exchange-traded or over-the-counter variety. Forwards and swaps are overthe-

counter instruments; futures are exchange-traded instruments. Options are

generally exchange-traded, but they can also be bought over the counter.

Exchange-traded instruments are standardized, and are thus liquid and entail

low transaction costs. But since they are standardized, they may not perfectly

suit the risk exposure the firm wishes to hedge. Over-the-counter instruments

can be custom tailored, but they are therefore less liquid and more expensive

in terms of transaction costs. The firm must weigh the costs and benefits of

liquidity, differences in transaction costs, and custom fit. The correct choice

depends on the particular hedging situation.

A couple of examples will illustrate the process of putting all the factors

together to pick the best suited hedge. A U.S. manufacturing firm owns a production

facility in Canada. Rent and wages are paid in Canadian dollars. Consequently,

if the Canadian dollar rises in value, the wages and rent translated

Financial Management of Risks 453

into U.S. dollars would become more expensive. If the Canadian dollar falls,

the expenses in terms of U.S. dollars decline. Thus, the exposure is symmetric.

If the firm wishes to completely eliminate the exposure, a symmetric instrument

is called for, ruling out options. The firm should go long in Canadian dollar

futures or forwards, since either of these instruments will provide positive

cash flows when the Canadian dollar is rising. An exchange-traded Canadian

dollar futures contract is available. The commission on the forward is greater

than the commission on the futures, but the futures contract covers slightly

more Canadian dollars than the firm wishes to hedge, and the timing does not

exactly correspond to the timing of wage and rent payments. An over-thecounter

forward contract could be constructed so that cash f lows are synchronized

with wage and rent payments. After weighing the two alternatives, the

managers decide that the benefit from lower commissions on the futures contract

outweighs the disadvantage of the futures' slight mismatch in the hedge.

They go long in Canadian dollar futures.

The same manufacturing firm has many customers in Venezuela. If the

Venezuelan currency (the bolivar) falls in value, the U.S. dollar value of the

revenue will fall. If the Venezuelan currency rises in value, the dollar revenue

will rise. Thus, the risk is symmetric, and so the list of hedging candidates is

narrowed to futures and forwards. The firm benefits from a rise in the bolivar,

and loses when the bolivar falls. Thus, the firm should go short in bolivar futures

or forwards, so that a cash flow will be received when the bolivar falls.

No bolivar futures contracts are available on exchanges, so the firm must go

short in over-the-counter Venezuelan bolivar forwards.

A producer of copper wire purchases large amounts of copper as a raw

material. When copper prices rise, the firm must either absorb the higher expenses,

or raise the price of copper wire. Raising the price of wire, however,

causes customers to cut back on purchases, and so the firm is stuck with unsold

inventory. When copper prices fall, alternatively, competitors lower their

prices and so the firm must also lower its price in order to sell its output. Consequently,

the firm's profits suffer when copper prices rise, but profits do not

increase when copper prices fall. Management would like to increase production

capacity, but it is difficult to forecast how much the firm can sell, given recent

copper price f luctuations. With current levels of raw copper inventory,

management believes that raw copper prices can rise as much as 10% without

significantly impacting the firm's bottom line. What is the appropriate hedge?

Clearly, the firm faces an asymmetric risk. The firm is hurt when copper

prices rise, but does not benefit when the price falls. An option will best

mitigate the risk. Since the firm is hurt when copper prices rise, a call option

that pays off when copper prices rise is the best choice. Since the firm can

tolerate a 10% rise in copper prices without suffering significant losses, an

out-of-the-money copper call option that begins to pay off only when copper

prices rise more than 10% is ideal. Exchange-traded copper call options exist,

and so due to their greater liquidity and lower transaction costs, they would

be the best choice.

454 Planning and Forecasting

A cellular communications firm has sold a six-year variable rate bond,

where the interest payments are tied to the London Interbank Offered Rate

(LIBOR). When LIBOR rises, so too do the company's interest payments.

When LIBOR falls, the firm's interest payments fall. The company's interest

payments are due twice a year, on the last days of February and August. The

firm raised $160 million this way. With competition holding cellular telephone

rates down, the firm worries that an increase in interest rates can wipe out all

profits. What is the appropriate hedge instrument?

The interest rate exposure is symmetric, ruling out options. The firm

needs an instrument that will pay it money when interest rates rise. Thus, the

firm should go short in either bond futures or forwards, or the firm should be

the fixed-rate payer in an interest rate swap. Since the cash f lows that the firm

is trying to hedge do not conform to those of any exchange-traded future, the

correct choice is narrowed to the over-the-counter instruments—a forward or

a swap. The firm must hedge twelve interest rate payments, two per year for six

years. Forwards are generally constructed to provide one payment only. Swaps

are designed to hedge multiple payments over longer terms. Thus, entering a

six-year interest rate swap as the fixed payer is the ideal hedge in this situation.

SUMMARY AND FINAL RECOMMENDATIONS

This chapter has presented the basics of risk management using derivatives. By

separating an asset's value from its exposure, derivatives allow firms to exchange

exposures without exchanging the underlying assets. It is much more

economical to transfer exposures, rather than assets, and thus derivatives have

greatly facilitated risk management. Derivatives are indeed powerful risk management

tools, but in the wrong hands they can be dangerous and destructive.

It is essential that managers fully understand how much and under what conditions

derivatives will provide positive cash f lows or require cash outf lows. If it

is not absolutely clear when and how much the cash flows will be, do not enter

the contract. Managers should strive to identify the nature, magnitude, and

size of their risk exposures. They can then match those exposures with countervailing

positions in derivatives. Managers should never forget that their job

is to preserve value by reducing risk. The temptation to speculate should be

avoided. Don't be greedy.

FOR FURTHER READING

Abken, Peter, and Steven Feinstein, "Covered Call Options: A Proposal to Ease Less

Developed Country Debt," in Financial Derivatives: New Instruments and

Their Uses (Atlanta: Federal Reserve Bank of Atlanta, 1994).

Bernstein, Peter, Against the Gods: The Remarkable Story of Risk (New York: John

Wiley, 1998).

Financial Management of Risks 455

Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-Hall,

2000).

Chance, Don M., An Introduction to Derivatives (New York: Dryden Press, 1998).

Chew, Lillian, Managing Derivative Risks: The Use and Abuse of Leverage (New

York: John Wiley, 1996).

Daigler, Robert T., Financial Futures and Options Markets: Concepts and Strategies

(New York: HarperCollins, 1994).

Dunbar, Nicholas, Inventing Money: The Story of Long-Term Capital Management

and the Legends Behind It (New York: John Wiley, 2001).

Fraser, Andrew, "Top Banks Plan Bailout for Fund," Associated Press, September 24,

1998.

, "Fed Key Player in Rescue of Floundering Hedge Fund," Associated Press,

September 25, 1998.

Hull, John C., Options, Futures, and Other Derivative Securities (Upper Saddle

River, NJ: Prentice-Hall, 2000).

Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital

Management (New York: Random House, 2000).

Various authors, "Managing Risks," special report in Business Week, October 31,

1994, 86–104.

NOTES

1. Zvi Bodie and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-

Hall, 2000) deserve credit for this perspective on risk management techniques.

2. Fischer Black, who helped invent the model, passed away prior to recognition

from the Nobel committee.

3. All data referring to equity positions, assets under management, exposure,

and profits and losses in this section come from Roger Lowenstein, When Genius

Failed: The Rise and Fall of Long-Term Capital Management (New York: Random

House, 2000).

 

PART THREE

MAKING KEY

STRATEGIC DECISIONS

 

459

14 GOING PUBLIC

Stephen M. Honig

SETTING THE STAGE

It is June 2000, and recent MIT graduate John Dough and his friend, business

school graduate Mary Manager, decide to pursue a software idea that Dough

has conceptualized. Dough believes that he can design a relational database

that will more tightly store financial information and more quickly access that

information than anything now on the market.

Dough and Manager take their meager savings accounts and $20,000

of credit card advances and form Dough.com Inc., a Delaware corporation.

Dough sits down at his computer and begins to program Dough-Ware.

Mary successfully approaches five business school acquaintances; each

invests $4,000 and each is issued 4% of the company's stock.

By the spring of 2001, Dough has a working initial version of Dough-

Ware available for testing at the sites of potential clients. The company is completely

out of funds, and is without the necessary liquidity to negotiate for the

test sites, install the software, and work with prospective clients. Dough and

Manager have been networking at venture capital forums, and are able to induce

five "angel" investors, wealthy individuals with a history of investing

in emerging technology companies, to invest an aggregate of $250,000. By June

2001, each of Dough and Manager now owns 30% of their company; each of

the original five investors owns 3%; the new angel investors have received a

25% common stock interest. With this new money and with modest interim

payments from the first "beta site," or test customers, the company begins installation

and testing of its software.

460 Making Key Strategic Decisions

By June 2002 the company has refined its software into a salable product

for which Dough believes there is a significant market. However, in order to

produce, customize and install the software, and in order to broadly market,

the company needs significant new investment. All prior financing, and the

meager proceeds from the test installations, are virtually exhausted. The company

is fortunate enough to induce a venture capital investor, Vulture Partners,

to invest $1 million but there is a significant cost:

• Vulture Partners insists on receiving 50% of the equity in the form of

convertible preferred stock that will participate in the proceeds of the

sale of the company in preference to all the other stockholders, who hold

only common stock.

• Vulture Partner's preferred stock will convert into common stock upon

any public offering.

• Vulture Partners gets two board of directors seats.

• Vulture Partners insists upon a substantial increase in personnel in order

to aggressively address the market place; John Dough is given the title of

"chief scientific officer"; Mary Manager is made vice president; they hire

a chief operating officer who formerly was a senior vice president at a

large software firm, a chief financial officer from one of the big five accounting

firms, and a sales manager with experience at Mega-Soft, the

largest software development firm in the country.

The new team, properly financed, goes off to sell Dough-Ware and is fabulously

successful.

It is one year later, in the spring of 2002, and everyone involved in management,

including John Dough and Mary Manager, agrees that substantial additional

capital is needed. It looks as though the company can reach $100

million in sales next year and have a 10% market penetration, but that's going

to take an awful lot of money, something like $40 million. This money will be

necessary to further refine the product, increase the engineering capacity to

customize the product, and enter into sales efforts so as to speed market penetration.

The directors hope that a direct approach to customers will enable the

company to decrease its dependence on Big Deal Corporation, a large software

company which has marketed Dough-Ware in exchange for a substantial commission.

The directors call a board meeting for the end of June 2003 to discuss

their options.

THE THREE OPTIONS

Dough and Manager have understood from various board members that there

are three primary sources for financing company growth: raising additional

money on a private basis as in the past; raising money through an initial public

Going Public 461

offering (IPO); or merging with a strategic partner (such as Big Deal Corporation),

which might pay a high price to acquire Dough-Ware and add it to its stable

of software products offered by its existing sales force.

Dough and Manager precede the board meeting by visiting with corporate

attorney Stanley Sharp, who explains the difference between selling stock

privately and selling stock in an IPO.

Both the United States government and all of the states substantively

regulate the offer and sale of securities within their borders. The offer and

sale of securities federally is regulated by the Securities and Exchange Commission

(SEC) under authority granted by the Securities Act of 1933. Each

state also has its own similar statute, administered by various state agencies;

these state statutes collectively are referred to as "Blue Sky Laws." It is necessary

to satisfy both federal and state law in order for Dough.com Inc. to sell

shares of stock.

Whether shares of stock are sold privately or publicly, all of these laws at

a minimum require full disclosure of material information. This means that in

both private and public transactions the company typically must prepare an offering

document which explains its business, finances, and the risks of investment.

In a private offering, this booklet is often called a private placement

memorandum (PPM); in an offering to the public, this booklet is called a

"prospectus."

The big difference, Attorney Sharp continues, between public and private

sale of securities has to do with whether the transaction by which those

securities are sold is "registered" with government authorities. Registration is

the process by which the offering document is filed with and reviewed by

such authorities. In a private transaction or "private placement," there is little

or no involvement of either the federal or state governments. A private

placement generally is effected to a limited number of investors who, because

of their small number or because of their financial resources or sophistication

in making investments, do not trigger the registration requirements of federal

or state law. Attorney Sharp explains that in a $40 million private placement,

it is likely that the securities will be sold to sophisticated venture

capital investors who qualify as "accredited investors" under Regulation D of

the General Rules and Regulations of the SEC, which by its terms exempts

such sale from the federal registration requirement. Further, in many such

transactions compliance with the federal law automatically will constitute

compliance with state laws.

An IPO involves selling securities in smaller minimum investments, to a

greater number of people who need not meet any standard of sophistication or

financial resources. These people must receive a prospectus which has been reviewed

by the SEC, and in order to obtain clearance to finally utilize that

prospectus in the sale of their securities, the company will have to undergo a

"going public" process that is liable to take at least four months of management's

time and attention.

462 Making Key Strategic Decisions

THE BOARD OF DIRECTORS MEETING

The board of directors of Dough.com Inc. meets with its various advisers to

determine how to raise the necessary capital to promote the development of

Dough-Ware. Every possible solution has its advocates.

Some directors want to raise the money through a private placement of

securities from venture capital firms, believing that going public is too time

consuming, involves too much expense (upward of 10% of the proceeds typically

will be absorbed in selling commission and out-of-pocket expenses), and

that the underwriters (the investment bankers who will sell the IPO to the

public investors) will attempt to value the shares at less than their true value so

that the public investors will see the price rise upon conclusion of the offering.

An investment banker on the board suggests that the shares could be privately

placed by selling an additional 20% of the company's common stock for

$40 million, effectively valuing the company as it sits today (a "pre-money" valuation)

at $160 million.

The representative from Vulture Partners has yet another strategy. He

suggests that the company not raise the additional funds now, but push the current

version of their product out the door and work on building volume and

profitability for the next six months; then, the company can go public at a valuation

which is 30 times the company's projected pretax earnings, which would

value the company at $300 million pre-money. In conjunction with the IPO,

Vulture Partners then would sell half of its own original shares, realizing a

multimillion dollar profit while still retaining a substantial equity position.

Dough and Manager do not want to wait to raise money; they see the most

important thing as capturing market share before competitors overtake the advantage

that struggling Dough.com Inc. now enjoys. Company management

does not care whether Vulture Partners is able to sell any equity interest at this

time; they have been investors for only one year, and management does not feel

that Vulture's rush to liquidity is appropriate. But some of the other early investors,

the original group of five friends and the angel investors, also are

intrigued with the possibility of selling some of their shares.

The investment banker warns that in an IPO, it is sometimes a negative if

too many shares are sold by existing stockholders and not by the company itself;

new investors like to invest their money in the enterprise and help it grow, not

into the pockets of prior investors, and too many sales by previous investors indicate

a lack of confidence in the future.

Some of the management team wants the company acquired by Big Deal

Corporation Management, which is experienced in working with larger corporations,

sees an acquisition by a strategic acquirer as increasing the value of

their existing stock options, and believes that through their existing close contacts

with Big Deal Corporation's management they will be able to structure

attractive personal compensation packages. They point out that, whether capital

is raised publicly or privately, there is far greater risk of failure if

Dough.com Inc. goes it alone, as compared to joining forces with an existing

Going Public 463

multibillion dollar entity like Big Deal Corporation. Besides, if the key to success

is to hit the market fast with Dough-Ware, teaming up with Big Deal Corporation

is the fastest way to achieve that goal.

The investment banker says that if the desire is to sell to a strategic partner

such as Big Deal Corporation, or anyone else who can pay a high price

quickly and assist in the marketing of Dough-Ware, his investment banking

firm will be pleased to handle the proposed sale of the company and could

shop potential strategic acquirers and find the best price.

Through the afternoon, the conversation works itself toward a consensus

to effect an immediate public offering. Certainly the prospect of more rapid

ultimate profit which would result from a prompt IPO is intriguing to all:

Vulture Partners and the other prior investors; management; and John Dough

and Mary Manager as founders. All are intrigued with the advantages that

being a public entity can bring:

• Relative ease of raising additional capital for expansion in the future.

• Ability to obtain debt financing at reasonable rates (not now available due

to lack of hard asset collateral or proven cash flow).

• An ability of existing stockholders to partially cash out their investments

at a profit.

• The ability to attract employees in a highly competitive technology marketplace

by reason of public equity incentives.

• The ability to easily acquire related software companies and to make payment

for such acquisitions through the issuance of additional shares of

company stock.

Near the end of the meeting, the investment banker turns to Dough,

Manager, and the entire executive team and says that he feels compelled to

share with them some of the risks and problems, both short term and long

term, that they will encounter in going public. Effecting an IPO, and living

with the reality of being a public company thereafter, is not all a bed of roses.

For example:

• At this particularly crucial time in the marketing of the Dough-Ware product,

significant attention will be diverted from the operation of the business

into the process of going public and in preparation of the prospectus.

• The full disclosure that will be required in the prospectus will cause the

disclosure in detail of the company's business strategy and perhaps some

of its trade secrets, and will reveal the terms of its contracts with Big

Deal Corporation, and with some of its customers and suppliers.

• Any transactions between the company and its affiliates (its officers, directors,

significant stockholders, and their relatives, and companies they

own) must be disclosed.

• The cost of an IPO is significant; it is likely that investment banking firms

will be retained as underwriters and will take 7% of the gross proceeds

464 Making Key Strategic Decisions

right off the top, although this is an expense that will not be incurred unless

the offering is successful; certain other significant expenses, particularly

legal fees, accounting fees, printing fees, filing fees, and miscellaneous

out of pocket fees, must be paid even if the transaction is not successful.

Expenses in this size of proposed IPO could approximate $1 million.

• Once the company is public, it will be subject to public scrutiny, must

make periodic filings with the SEC, and will incur an overhead in dealing

with the public which does not now exist.

• There will be public pressure to achieve short-term growth on sales and

profitability so as to sustain and advance the stock price, and these pressures

will affect strategic decisions made by management which might

otherwise be based on a long-range product-driven strategy.

• Management and the directors can incur personal liability in connection

with a public offering, if it is ultimately determined that the prospectus is

materially false or misleading, causing a decline in the value of investor

shares (although certain protections from this risk can be obtained by the

company's purchase of directors and officers [D&O] insurance).

The vote is taken. With some trepidation, the board decides to attempt

a public offering, or IPO, of its shares of common stock as quickly as possible.

A "team" of two directors and three members of management is established to

pursue that result.

THE PROCESS OF GOING PUBLIC

While it is possible for the company to sell its shares directly to the public

through a variety of mechanisms including direct offerings over the Internet,

the company wants to proceed in a more traditional fashion and retain one or

more investment bankers to serve as lead or "managing" underwriters for the

public offering of its common stock. Through the contacts of the investment

banker on the board, and the contacts of Vulture Partners, the team interviews

several investment banking firms.

The entire process of going public is supervised by the managing underwriters

who will head the syndicate of other investment banking firms which

will sell the shares of common stock to the public.

An underwriter is either a distributor or sales agent for the shares, depending

upon the type of underwriting which is undertaken. A "firm" commitment

underwriting means that the underwriters agree, as a group, that if the

public offering occurs, the underwriters will themselves purchase all the

shares of stock and resell those shares to the public. Consequently, in the theoretical

event that an insufficient public market develops for the shares, the underwriters

themselves will end up owning the shares of stock as investors. As a

practical matter, it is an exceedingly rare event that the underwriters cannot

resell the shares after an IPO is effected.

Going Public 465

The other kind of underwriting is a "best efforts" underwriting. This is,

literally speaking, not an underwriting at all. The investment bankers agree, as

agents of the company, to sell such number of shares for which they can actually

find buyers. Such an underwriting may be "all or none" which means

that the underwriters must find buyers for all of the shares, or a "minimummaximum"

offering (which may close if the underwriters find purchasers for a

specified minimum number of shares). Most established underwriters only undertake

"firm" underwritings, and are entitled to receive somewhat greater

compensation under the rules of the National Association of Securities Dealers,

Inc. (which regulates underwriter compensation) in consideration of undertaking

a firm deal. The underwriters, even in a firm underwriting, are not

required to purchase the shares until the very last moment and retain certain

abilities to abort the transaction; consequently, the practical difference to the

company between these two kinds of underwritings is slight, although much

may be made of it in the marketplace.

The prospective managing underwriters all propose to do the same thing:

organize the entire process, establish a timetable, and assign tasks to the various

players; review the company's drafts of its filing with the SEC (which

consists of a "registration statement" in two parts, the longest part being the

"prospectus" which describes the company and its prospects and risks, and the

shorter part being a Part II which contains other technical information); organize

and conduct several meetings of the going public team, focused on performing

"due diligence" (an examination of the company to make sure that all

material facts are uncovered and disclosed), and on reviewing in detail the

contents of the prospectus to make sure that there is no inaccuracy or material

omission; gather other investment banking firms as part of a syndicate of underwriters

or selling group so as to achieve a broader distribution of the shares;

and find buyers for the shares.

The team considers several factors in discussions with prospective managing

underwriters:

• The value that each underwriter is willing to place on the company, and

the discount that the underwriters propose in making company shares attractive

for public purchase.

• The recent track record of the underwriter, based both on general reputation

and on that underwriter's success in closing similar transactions.

• Whether the underwriter has been able to structure prior IPOs so that

there was a sufficient "aftermarket" for the shares, preventing the price

from collapsing.

• The experience of other companies which have gone public through

that underwriter, as gathered from conversations with CEOs of those

companies.

• The degree to which the underwriter seems capable of placing some of

the shares in the hands of larger "institutional" purchasers, so as to provide

some stability in the stockholdings of the company.

466 Making Key Strategic Decisions

• The ability of the underwriter to distribute the stock on a broad enough

geographical basis that all constituencies having an interest in the company

have an opportunity to participate in the public offering.

• Whether the underwriter employs well-known securities analysts within

the company's industry, whose views are valued within the investment

community.

Finally, the team selects two investment-banking firms as managing underwriters.

A Letter of Intent, outlining the terms of the proposed public offering,

is then prepared and signed by the company. Among other matters, this

Letter of Intent will obligate the company to pay certain expenses of the underwriter,

whether or not the IPO is successful.

One of the managing underwriters takes the lead in organizing the IPO

process. First, a date is fixed for an "all hands organizational meeting." This

important meeting will be attended by the managing underwriters, the lawyers

for the underwriters, the company management, the lawyers for the company,

and the certified public accountants who will prepare the SEC-specified financial

statements. At the organizational meeting:

• It is decided that shares of voting common stock will be sold; it is expected

that Vulture Partners will convert its preferred stock into common

stock effective upon the public offering.

• All parties are assigned specific responsibilities with specific deadlines.

• A timetable for the offering is established, generally encompassing a 12-

to 16-week period from the date of the organizational meeting to a closing

of the public offering.

• The parties discuss the selection of a financial printer, and the company

later will interview and negotiate price with a printer who is experienced

in printing SEC filings and causing those filings to be effected electronically

through the SEC's electronic filing system (called EDGAR).

• The managing underwriters present a "due diligence checklist" which is a

list of numerous facts to be gathered and documents to be produced by

the company; it is the task of the underwriters to perform "due diligence"

to make sure that all facts are uncovered. The diligence process is outlined

and materials for the checklist are contained in the NASD's "Due

Diligence Examination Outline," annexed to this chapter as Appendix A.

• The participants discuss the addition of "antitakeover provisions" to the

corporate structure of the company; when a company becomes publicly

held, there is the possibility that third parties might attempt to obtain a

controlling financial interest or voting interest. The underwriters are of

the view that certain antitakeover provisions are inappropriate, as they

limit the likelihood of a legitimate takeover of the company at a high

price and therefore work against the interest of the stockholders. Management

expresses an interest in taking reasonable steps to preserve current

control. Antitakeover provisions may include: staggering the board of

directors so that all directors cannot be replaced at once; limiting

Going Public 467

the rights of stockholders to call special stockholder meetings; limiting

the rights of stockholders to amend the company's bylaws; eliminating

the right to remove directors except for cause; establishing voting mechanisms

which do not permit the purchaser of shares immediately to affect

the control of the company; and the adoption of complicated stockholder

protection plans, called "poison pills," that dilute the equity interest of

any unfriendly future significant stockholder.

• There is discussion concerning the number of shares to be offered, the

percentage of the company to be offered, the general range of share pricing,

and whether the company's shares will be listed for trading over an

exchange or quoted through the facilities of NASDAQ (National Association

of Securities Dealers' Automated Quotation System). It is decided

that approximately 10% of the shares to be sold in the IPO will belong to

Vulture Partners and other original investors in the company.

• The underwriters ask for the option to purchase from the company, for

resale to the public a short time after the closing of the IPO, an additional

number of shares of common stock. These shares, typically not in excess

of 15% of the shares sold in an IPO, are an "overallotment" to permit the

co-managing underwriters to cover short positions in the company's stock

which they may have created immediately after the IPO closing in an effort

to stabilize the stock price. These shares are sometimes referred to as

"the green shoe," named after a securities offering which allegedly first

utilized this technique.

• There is a discussion of "lockup agreements." The underwriters will require

that existing stockholders contract that for some period following

the IPO (most typically 180 days), they will not sell any shares; this prohibition

permits the underwriters to "stabilize" or create an equilibrium

in the price of the shares, and eliminates the perception that the insiders

are "bailing out." Conversely, the underwriters may be asked to include a

reasonable number of shares for sale by prior investors.

• Management asks to set up a "directed share program" by which friends

of the company, such as key suppliers and business partners, will be given

an opportunity to preferentially subscribe for shares; generally underwriters

seek to limit these programs to 5% of the total offering.

• The parties discuss the inclusion of online "e-brokers" as part of the underwriter

distribution group, in order to address the growing appetite of

online purchasers in technology-related IPOs.

The organizational meeting sets off a time of hectic effort by management,

accountants, and attorneys. Some staff is delegated to filling the due

diligence checklist. The bulk of the more visible effort is directed, however,

toward the preparation of the registration statement, which includes the

prospectus.

The company and its attorneys are charged with the task of preparing a

first draft of this registration statement. The contents of the registration statement

are rigorously specified by the forms and rules promulgated by the SEC.

468 Making Key Strategic Decisions

One of the tasks of the organizational meeting is to determine which SEC

"Form" will be utilized in going public. The SEC has promulgated two additional

forms, Form SB-1 and Form SB-2, for certain small businesses. The financial

statements for such forms are less rigorous than for Form S-1 and

require only one year of audited balance sheet and two years of audited income

statements, statements of cash f lows, and statements of stockholders' equity.

However, because of a combination of limitation on amount of capital to

be raised and value of the company at the commencement of the process, at

the organizational meeting it is determined that SEC Form S-1 must be utilized;

the accountants will be required to prepare two years of audited balance

sheets and three years of audited income statements, cash f lows, and stockholders'

equity. (Appendix B is Securities and Exchange Commission Form

S-1, the most typical registration form for an IPO.)

Although audited information is required for only three years in Form

S-1, the accountants also will have to put together the results of operations for

a five-year comparative period (if available). Since 2001 the company has received

an audit of its financial statements, but results of operations for the initial

year 2000 were prepared on a review basis only. The accountants will have

to go back and apply audit standards to this period. Since the objectives of an

audit are to obtain and evaluate evidence to corroborate management's assertions

regarding its financial statements, and to express an opinion on those

financial statements, the "review" of the operating numbers will be an insufficient

basis for the issuance of an audit opinion. But since Mary Manager was

assiduous in financial record keeping and since the certified public accountants

are familiar with the company's financial records and financial statements,

the accountants will be able to complete the audit procedure at the

same time that they are preparing the Form S-1 financial information and supporting

schedules in the format required by the SEC.

In preparing the registration statement, the company, the underwriters,

the accountants, and the attorneys are guided by specific instructions from the

SEC. The textual content of the registration statement is controlled by SEC

Regulation S-K; the accounting content is regulated by SEC Regulation S-X.

These regulations and related pronouncements contained in the General Rules

and Regulations of the SEC, may be accessed through the SEC Web site, and

are made available to companies undergoing the IPO process through a series

of publications provided without additional charge by most financial printers.

The process of drafting the prospectus is made more complicated by efforts

of the SEC to clarify communication between the company and its potential

public investors. Since October 1998, the SEC has required that the

prospectus be drafted in "plain English" pursuant to the provisions of Rule 421

of the SEC's General Rules and Regulations. The entire prospectus is to be

written in clear, concise, and understandable English using short sentences and

paragraphs, bullet lists, and descriptive headings without either technical or

legal jargon. The company will struggle to describe the technicalities of its

business in language that will be clear and understandable to an intelligent but

Going Public 469

non-technologically oriented reader. The lawyers will struggle in similar fashion

to convey technical information concerning the terms of the offering.

Special plain-English rules apply to the front and back cover pages, to the

summary contained in the front of the prospectus, and to the section of "risk

factors." Risk factors are a constant feature of IPO prospectuses, and are designed

fully to apprise the potential investor of all pitfalls that the company

might encounter and which might cause it to falter. These risk factors generally

relate to the newness and lack of financing and operating history of the company,

the experience level of management, rapid technological change for the

marketplace in which the company proposes to compete, and the superior resources

of the competition. These vital pages are the ones likely to be read most

carefully by the investing public, and must be reviewed particularly to make

sure that sentences are short, that the active voice is utilized, that concrete

everyday words are employed, and that complex information is contained in

tables or otherwise graphically depicted.

There will be several drafting meetings in the six to eight weeks between

the organizational meeting and the filing of the first draft of a registration

statement with the SEC. During these lengthy meetings, each word of the

prospectus will be reviewed and considered, some on-the-spot rewriting will

occur, and other sections will be designated for later rewrite. Much attention

will be directed to the description of the company's business, and to the

"MD&A" (management's detailed discussion and analysis of its financial operations,

liquidity, and capital requirements for the past three years, as well as for

the foreseeable future, if known). When all parties are confident that the description

is accurate, the "preliminary prospectus" will be filed as part of the

registration statement.

Contemporaneously, filings also must be made with the regulatory agencies

of each state in which the IPO will be offered; state practice varies as to

the degree of substantive review that state regulators will give to a registration

statement, and in the past the severity of state review was more stringent than

SEC review; some states involved themselves in approving or disapproving the

substance of an offering ("merit review"), while SEC review typically is restricted

to ensuring the adequacy and completeness of the description of the

company and the attendant risks of investment.

In the case of the company, a decision has been made to apply for the

immediate right to have the shares issued in the IPO quoted for trading on

NASDAQ. By law, when IPO shares will be quoted on NASDAQ or listed on

a national securities exchange, the states' right to insist on separate registration

and review is preempted.

Now everyone waits for the SEC staff to provide comments and ask questions

in a written "comment letter." It is not typical to print and distribute to

the public the first filing of the preliminary prospectus, in part because no one

is quite sure whether the SEC will have significant comments or request significant

corrections and in part because often the managing underwriters are

not ready to effect such a distribution. During the three to four weeks that it

470 Making Key Strategic Decisions

typically takes for the SEC to provide both accounting and business comments

on the prospectus, several things will be occurring:

• The company's accountants will work on updating financials, so they will

be "fresh" (i.e., within 135 days of filing) for the anticipated amendments

to the registration statement.

• The company will be careful in its public utterances and in the contents of

its Web site, to avoid the improper direct or implicit promotion of the

company's stock; during this waiting period generally the only writing

that may be utilized to actually offer company stock for sale is the

prospectus itself, and no generally ancillary writing and no inconsistent

oral presentations can be made.

• The comanaging underwriters will form a syndicate of additional underwriters

who will agree to purchase a certain number of the IPO shares.

These underwriters in turn will deal with the lowest tier of distribution,

the "selected securities dealers" whose securities customers ultimately

will be asked to purchase the shares.

• The managing underwriters will have filed with the National Association

of Securities Dealers Inc. (NASD) the following: the registration statement,

their underwriting agreement with the company, the agreement

among the underwriters themselves, and the agreement between the underwriters

and those "selected securities dealers." The NASD regulates

compensation of underwriters, and must review the offering to declare

that the consideration to be paid by the company to the underwriters is

fair and reasonable.

• The company will prepare the information necessary to permit the company's

common stock to be quoted over the NASDAQ, on completion of

the IPO.

When the SEC staff issues its comment letter, a f lurry of rewriting results

in an amended registration statement, which is combined with updated financial

statements and refiled with the SEC as promptly as possible. Typically,

this version of the prospectus is then printed in large numbers and distributed

by the underwriters to the investment community. This distributed prospectus

is typically referred to as the "red herring." Until 1996, the SEC required that

the cover of a preliminary prospectus, which was being distributed, bear in red

ink a legend which advised that the prospectus was subject to change and that

the SEC had not finally approved the offering. Under current practice, language

to similar effect is required on the front cover and on occasion may be

printed in red ink, but it need not be.

At this juncture, the underwriters together with key company management

embark on a "road show," which is a key element in the marketing of an

IPO. For a couple of weeks, the managing underwriters and management crisscross

the United States, and sometimes travel overseas, to hold brief meetings

with underwriters, brokers, securities analysts, and significant investors to

Going Public 471

present the company, discuss and answer questions concerning the prospectus,

and make the company story palpable to the people whose support is essential

to sell the offering. Management typically makes a highly orchestrated half

hour presentation, supported by a PowerPoint or similar screen presentation.

Because the company is still in the waiting period and (generally) only the

prospectus can be utilized as a written presentation of the company's

prospects, no written materials are distributed. The managing underwriters

had booked two and a half weeks of in-person meetings, mostly at breakfast

and lunch time when securities professionals and significant investors are most

available, in cities all across the United States, with a brief two-day trip to

London.

Perhaps the fastest evolving and most confused aspect of the going public

process is the road show procedures, in light of technological advances. Road

show sessions are now permitted to be accessed online with the Internet, and

the SEC and the underwriting community is grappling with the ground rules

for such access. At present, there are no general rules and regulations as to the

types of potential investors who may participant in an Internet road show, although

the trend seems to be toward opening road show participation to increasingly

less sophisticated investors. It is quite possible that this trend will

continue so as to open road shows to all interested parties, and if Internet road

shows are open to everyone, then the in-person road show seemingly could also

be fully attended. The attorneys for the underwriters have written to the SEC

and obtained specific permission to permit the Internet streaming of several of

the United States road shows to selected retail investors who are securities customers

of the underwriting syndicate, which investors will be given a password

to a Web site in order to participate. Because of the prohibition against utilizing

any writing other than the prospectus during this "cooling off " period, Internet

participants will be prohibited from downloading the PowerPoint

presentation which will be made by the company management.

Throughout this period, the underwriters gather indications of interest

for the purchase of stock. They also receive feedback as to the proposed range

of pricing, which ref lects the market value that will be placed on the company

and will be ref lected in the per share price. In dialogue with the team, and

with approval of the board of directors, just prior to final clearance from the

SEC the managing underwriters fix the per share price at which company

common stock will be sold in the IPO.

Meanwhile, the SEC staff has reviewed the amended prospectus, and has

been satisfied with the response it has received to questions it has addressed to

management and to the accountants. It has indicated that the IPO can proceed.

Pursuant to SEC practice, the underwriters may now file a final registration

statement (with fresh financials if needed), which for the first time

will contain the actual per share purchase price, the aggregate proceeds to the

company and to selling stockholders, and the specific dollar amounts for the

underwriter discount (the commission that the underwriters will receive on

the sale of the shares). This "pricing amendment" by SEC regulation will take

472 Making Key Strategic Decisions

effect in 20 days, but in practice the company requests and the SEC will grant

"acceleration," which permits the immediate offering of the stock pursuant

to the final prospectus. The prospectus is printed in large numbers for distribution

to investors, without the "red herring" legend on the front cover which

had indicated that the prospectus was subject to change. The prospectus is

now final.

At the same time that the company's registration statement under the Securities

Act of 1933 has become effective, permitting the initial sale of the

company's stock, the SEC also has permitted to become effective a filing made

by the company under the Securities Exchange Act of 1934, which statute establishes

the rules for subsequent trading of the shares on the part of the purchasers

who obtain company stock in the IPO.

It is only at this time that the company and the two managing underwriters

will sign the underwriting agreement by which the underwriters agree to

purchase the company's shares. The agreement had been filed as an exhibit

with the registration statement and had been approved by the NASD, but until

the SEC has granted its approval of the registration statement the underwriters

have not been contractually bound to purchase the shares. Even now, in the

brief period of time it will take for the underwriters to effect the going public

transaction, the underwriting agreement contains a series of "market out" provisions

which permit the underwriters, over the next few days, to decline to

move forward with the IPO in the event material and unexpected changes

occur in the financial markets.

The underwriters and the selected dealers now are entitled to accept payment

for the shares, and they sell the company's common stock to various institutional

and individual investors. Approximately one week later, a closing under

the underwriting agreement occurs. Before the underwriters will close, they

will require a series of assurances from the company and its advisers with respect

to the continuing accuracy of the contents of the registration statement.

Officers of the company will deliver certifications as to the accuracy of facts,

the attorneys for the company will give formal legal opinions with respect to

legal matters and the absence of their awareness of contrary material facts, and

the accountants will deliver a "comfort letter," which sets forth the degree of

diligence utilized by the accountants, the materials which the accountants have

reviewed, and the conclusion that nothing has come to the attention of the accountants

to indicate that the financial statements are improperly prepared or

erroneous. An example of a comfort letter approved by the American Institute of

Certified Public Accountants Inc. is attached to this chapter as Appendix C.

At the closing, the company receives $33 million from the underwriters in

exchange for its stock. Vulture Partners and certain other stockholders, who

sold their shares along with the shares issued by the company, receive $4.2 million.

The underwriters retain $2.8 million, or a 7% commission. Out of its proceeds,

the company pays many additional substantial expenses: several hundred

thousand dollars to each of its lawyers, its accountants, and its financial

printer, as well as the legal fees and expenses of the underwriters' attorneys.

Going Public 473

Dough.com Inc. now is a publicly held company with a couple of thousand

shareholders spread throughout the United States and Britain.

THE MORNING AFTER

Although the infusion of over $30 million of net capital in the company is of

major significance, the life of the company in public mode has drastically

changed. The company's executives and directors have taken on both new roles

and serious potential liabilities. The company itself has become obligated to

feed the public's earnings appetite, and the requirements of the regulatory authorities

for a continuous stream of accurate information.

As a publicly held company with shares quoted on NASDAQ and registered

under the Securities Exchange Act of 1934, both the company and its executives

have further become responsible for the filing of very specific and

complex reporting forms.

The company itself must keep the public informed by filing within 90

days of each fiscal year-end, on Form 10-K, an extensive discussion of the company's

business and financial condition. Much like a prospectus, the Form 10-K

contains a description of the business, properties, and legal proceedings involving

the company, an MD&A (management's discussion and analysis of financial

condition and results of operations) for the three prior years, three years of

audited financial statements, and a variety of other information about the company's

stock, the company's management, and (typically although not specifically

required by regulation) an ongoing and updated list of risk factors.

Less comprehensive but equally required by regulation, the company

must file within 45 days of the end of each of its fiscal quarters (except for the

year-end) a quarterly report of its financial condition on Form 10-Q, and furthermore

must file periodic reports on Form 8-K within several days after the

occurrence of significant events, such as a change of control, the acquisition or

disposition of significant assets, a change in the auditors, or a resignation of directors

because of disagreement.

The company will be required by NASDAQ to provide a written annual report

with audited financial statements to all of its stockholders. Corporate practice

will require the corporation to hold an annual meeting of its stockholders,

generally within two or three months of the release of the annual report on

Form 10-K, which will contain the financial statements for the prior year.

Now that the company's stock is widely held by a couple of thousand people

in diverse locations, it is necessary for management to seek written voting

authorization, through signature and return of a proxy card, by which stockholders

authorize designated members of management to vote the shares of

such investors for the election of directors and for any other action to be taken

at the annual meeting. Proxy regulations of the SEC will require that the company

send extensive written information (a "proxy statement") to each stockholder

in advance of the annual meeting, and in connection with management's

474 Making Key Strategic Decisions

solicitation of proxies for the voting of shares. The SEC requires filing of this

proxy statement and all related information at the same time they are sent to

stockholders; in the event significant action beyond the typical election of directors

is to be voted on at the annual meeting, the SEC requires advance filing

of proxy materials so that the SEC staff can review and comment on such

materials.

The company will have to consider whether it wishes to attempt to conduct

its annual meeting online. While substantive state law controls whether a

corporation can accept electronically sent proxies or electronically sent direct

votes, the desire on the part of companies to communicate more completely

with its stockholders will likely push the company to spend more and more

time in producing online annual meetings.

Now that the company is public, the company and its management can have

personal liability if materially incorrect information about the company falls into

the public domain. Indeed, it is the purpose of the various formal SEC filings to

make sure that accurate current information is disseminated. But often events

arise which call for public disclosure on the part of the company, and if the information

contained in such disclosure is both material and not previously contained

in an SEC filing or other public announcement, then under SEC

Regulation FD the company must make sure that contemporaneously with the

making of such private disclosure there is also a broad public dissemination.

The annual meeting presents particular problems in the control of company

information. Company officers answering questions at the annual meeting

will have to stick to a recitation of previously announced material facts; in the

event a decision is made to release previously nonpublic material information,

or if such information inadvertently is provided, SEC regulations require

prompt broad dissemination through filing of Form 8-K and through appropriate

press releases to the public. In connection with its annual meeting, management

may be briefed by attorneys and PR consultants as to how to answer

questions from the f loor concerning company operations and finances.

Indeed, separate and apart from its annual meeting, the company must

generate some specific policies on the handling of material nonpublic information.

Dough.com has already placed an ad in the newspaper for a director of investor

relations, to coordinate the need of company investors for accurate

information about the company. It is likely that this function within the company

will grow over time and indeed likely that an outside public relations firm,

experienced in the public relations and disclosure issues of public entities, will

be retained. The company should anticipate adopting a constant policy of

broadly disseminating public press releases about new products, and material

developments in the company.

Particular problems arise in connection with dealing with rumors that

may circulate in the public domain. The company may decide that it will systematically

offer "no comment" with respect to questions about certain kinds

of rumors or misinformation (whether raised at an annual meeting or at other

times). Such a policy is difficult to sustain; once adopted it must be followed

Going Public 475

rigorously, and if in the past the company had a practice of discussing such

matters, then it cannot state "no comment" in a particular case. Additionally,

rules of most Exchanges and of the NASDAQ require a company affirmatively

to correct, through its own public disclosure, materially inaccurate and misleading

rumors which circulate in the marketplace through third parties regardless

of whatever legal ground rules may exist.

The investor relations and legal advisers to the company also will now

have to pay attention to the contents of the Web site, which in the past might

have contained overly enthusiastic reports about the company, its potential

profitability and the functionality of its products. Contents of the Web site can

constitute false and misleading information upon which investors may rely to

their detriment, and financial losses incurred by investors based on erroneous

or dated Web site information can be recovered by lawsuit against the company

and its management.

In forming a public disclosure policy, the company will work closely with

legal counsel. Many of its pronouncements will contain language approved by

the Private Securities Litigation Reform Act of 1995 so as to establish a socalled

"safe harbor" for forward-looking statements. A company and its management

will be insulated from liability in connection with any statement

which later proves to be inaccurate, provided the statement is believed to be

true when made and provided it is disclosed clearly that the anticipated future

event is dependent on certain variables.

The company now must deal with the common practice of announcing

quarterly earnings, generally by a conference call with securities analysts (securities

professionals who follow the company stock and write about the stock

in research reports and publications). Although quarterly financial information

must be filed in the Form 10-Q within 45 days of the end of the first three fiscal

quarters (or included in the annual Form 10-K within 90 days of the end of

each fiscal year), it is not unusual for a company to announce its earnings by

conference call or perhaps online as soon as determined. It is also during such

earnings announcements that management is sometimes induced to speculate

as to earning trends, and such speculation must be made carefully if it is to be

protected by the "safe harbor" for forward-looking statements. The SEC is actively

involved in regulating the announcement of earnings in such a private

forum. The practice of releasing this information only to selected securities

professionals has been criticized as fundamentally unfair to the broad investing

public, and regulatory changes in this practice are likely in the near future.

Now that the company is public, management will be expected to announce

its projected sales and profits; produce results that are reasonably consistent

with its projections; adjust those projections in midquarter if it appears

that they will prove to be materially erroneous; answer questions of securities

analysts in such a way that the information which is provided is both accurate

and does not materially disclose previously unknown facts; and manage the enterprise

strategically with an eye toward quarter-to-quarter financial progress.

The morning after the IPO closing, John Dough has already learned that there

476 Making Key Strategic Decisions

will be a monthly management meeting designed to control his budget and to

narrow areas of research into the development of products with short test cycles

so as to drive forward current earnings.

John Dough and Mary Manager meet for coffee a few weeks later. Each

has sold a modest number of shares as part of the IPO. John has purchased a

small sailboat, and Mary has made a down payment on a ski house. On paper,

each is worth millions of dollars, although the remaining balance of their

shares cannot now be resold because of the lockup for 180 days, and thereafter

can be resold only pursuant to specific SEC regulations because they are "affiliates"

of an issuer of publicly traded securities.

They have to be careful what they say to reporters, investors, and securities

analysts. They even have to be careful about what they say casually in conversation

with friends and relatives, lest they inadvertently leak nonpublic

information which results in illegal insider trading profits. Someone who accidentally

"tips" or leaks material information to someone who improperly profits

from it is personally liable for that act.

Within 10 days of the IPO, Mary and John had filed with the SEC their

personal report on Form 3, disclosing the amount of company stock that each

owns of record and beneficially. Mary reminds John that these forms will have

to be updated periodically by filing other forms, Forms 4 and 5, with the SEC

whenever there is a material change in ownership. Section 16(b) of the Securities

Exchange Act of 1934 will also require John and Mary to forfeit any profit

they make in so-called "short swing trading"; the law requires automatic disgorgement

of any profit made by corporate insiders who both buy and sell securities

of their company within six calendar months as an automatic

disincentive to trading by insiders based on their possible possession of material

inside information.

If John and Mary do go to sell their shares, they will always possess much

more information than the investing public. How can they protect themselves

against a claim that they abused that information by, for example, selling just

before the price of the stock fell based on poor earnings or excessive warranty

claims? They may be able to sell their shares of stock only in prespecified time

"windows" which follow immediately and brief ly after the systematic announcement

of public information by the company, such as immediately following

the filing of SEC Form 10-K or SEC Form 10-Q. Alternately, they may

adopt a preexisting Sales Plan under SEC Rule 10b5-1, which operates like a

doomsday machine: The stockholder who wishes to trade in shares of stock of

his or her company will set up in advance a program for purchasing or selling

stock on a certain date or at a certain price, and then the brokerage firm will

effect those transactions without the insider making any specific buy or sell decisions

at the point in time that the transaction actually occurs.

Finally, John and Mary must avoid acting together in the purchase, sale or

voting of stock, or joining together with others in that regard; the mere formation

of such a "group" with respect to the stock of the company, if involving

persons owning 5% or more of the company's stock, will trigger a requirement

that such event be reported by the filing of a Form 13D with the SEC.

Going Public 477

John and Mary agree that they are richer and have the opportunity to aggressively

develop and directly market Dough-Ware, which is the reason they

started Dough.com Inc. in the first place. But they are in some ways more personally

restricted. They're sitting in the coffee shop, also agreeing that it is exciting

and gratifying to be thought of as winners in the "new economy."

Then, glancing around, they lower their voices, because they want to

make sure that no one can overhear their conversation.

FOR FURTHER READING

Arkebauer, James B., and Ron Schultz, Going Public: Everything You Need to Know to

Take Your Company Public, Including Internet Direct Public Offerings

(Chicago: Dearborn Trade, 1998).

Blowers, Stephen C., Peter H. Griffith, and Thomas L. Milan, The Ernst & Young

Guide to the IPO Value Journey (New York: John Wiley, 1999).

Bloomenthal, Harold S., and Holme Roberts & Owen, Going Public Handbook

(St. Paul, MN: West Group Securities Law Series, 2001).

Farnham, Brian, Bill Daugherty, and Jonas Steinman, Codename Bulldog: How

Iwon.com Went from the Idea to IPO (New York, John Wiley, 2000).

Harmon, Steve, Zero Gravity: Riding Venture Capital from High-Tech Start-up to

Breakout IPO (Princeton, NJ: Bloomberg Press, 1999).

Lipman, Frederick D., The Complete Going Public Handbook: Everything You

Need to Know to Turn a Private Enterprise into a Publicly Traded Company

(Roseville, CA: Prima Publishing, 2000).

Taulli, Tom, Investing in IPOs: New Paths to Profit with Initial Public Offerings

(Princeton, NJ: Bloomberg Press, 1999).

INTERNET LINKS

www.sec.gov The SEC Web site, links all SEC forms,

regulations, and filings made by companies

under EDGAR.

www.nasdaq.com/about Provides a going public summary, with

/going_public.stm discussion of fairness in underwriting

compensation. This site is maintained

by NASDAQ.

www.nyse.com and www.amex.com Descriptive listing of IPO shares on

the New York and American Stock Exchanges,

through sites maintained by

the exchanges themselves.

www.iporesources.org/ipopage.html List and link a wide variety of related

and www.emergencepub.com Web sites.

/IPO07.going.publicwebs.htm

478 Making Key Strategic Decisions

APPENDIX A

DUE DILIGENCE EXAMINATION OUTLINE

The goal of due diligence is to understand fully

the business of the issuer, to identify the risks

and problems it will face, and to assure that the

registration statement is complete and accurate.

Thoughtful analysis concerning the particular

issuer as well as the experience, knowledge and

care of the underwriters and their counsel in

this process represent the critical ingredients of

due diligence. A checklist of topics and

procedures merely serve as an aid in the due

diligence process when used in conjunction

with thoughtful analysis and the review of

applicable registration forms, rules and guides

promulgated by the SEC.

The SEC and NASD Regulation both have

acknowledged that attempts to define or

standardize the elements of the underwriters'

due diligence obligations have not been

successful. The appropriate due diligence

process will depend on the nature of the issuer,

the level of the risk involved in the offering, and

the investment banker's knowledge of and

relationship with the issuer.

Checklists of the items to be covered in a due

diligence investigation can be useful tools. It is

not possible, however, to develop a checklist that

will cover all issues or all offerings. Due diligence

is not a mechanical process. The use or absence

of use of a checklist does not indicate the quality

of due diligence. Conversely, deviation from any

checklist that is used does not taint a due

diligence review any more than the following of

a checklist validates such a review.

In view of the above, the following outline should

not be considered a definitive statement of, or a

standard recommended by, NASD Regulation

regarding the due diligence issues and procedures

that would be required or appropriate in any

particular initial public offering.

I. Before Commitment Is Made to Establish

Investment Banking Relationship with

Prospective Investment Banking Client

(the "Company")

A. Staffing the Review

1. Assign personnel who have particular

competence in the business in which

the issuer is engaged.

2. Consider retaining outside

consultants to analyze the technology

employed by the Company and others

in the Company's industry.

B. Assessing Integrity of Management

1. Inquire of appropriate parties

whether the corporation is being run

by the type of persons with whom the

investment banker would wish to be

associated.

2. Determine whether any of the

Company's officers, directors, or

principal shareholders have been

charged or convicted of any charges

involving fraud, embezzlement,

insider trading, or any other matter

concerning dishonesty.

Going Public 479

C. Review of Industry

1. Examine prospectuses, Form 10-Ks,

and annual reports prepared by other

corporations in the industry.

2. Examine research reports on major

corporations in the industry as well as

reports on the industry itself.

3. Become familiar with applicable

regulations governing the industry.

4. Study the accounting practices

followed in the industry, including

any differences in accounting practices

followed by different companies.

5. Determine financial ratios of the

industry as a whole.

6. Become acquainted with new

developments in the industry by

examining trade publications.

7. Determine the industry size and

growth rate.

8. Assess whether the industry is subject

to cyclical influences.

9. Determine whether seasonality of

demand affects the industry.

10. Determine the stage of the industry in

the industry life cycle (e.g., growth,

maturity).

11. Evaluate short-term and long-term

prospects for the industry.

II. After Commitment Is Made to Establish

Investment Banking Relationship

A. Submission of Questionnaire

to Officers and Directors

The specific information to be sought

includes:

1. Relationship to underwriters.

2. Voting arrangements.

3. Transactions with the companies.

4. Past and present occupations.

5. Record and beneficial ownership of

the stock.

6. Compensation, direct and indirect.

7. Principal shareholders.

8. Knowledge of pending or threatened

litigation.

B. Submission of Request

for Company Documents

1. Regarding legal status.

a. Charter documents (articles of incorporation

and bylaws) and all

amendments.

b. Minute books for meetings of

directors, shareholders, executive

committee, stock option committee

and the like for the past five years.

c. Copies of applications for permits to

issue stock permits, and exemption

notices.

d. Specimen stock certificates.

e. Copies of voting trust and voting

agreements.

f. Documents previously filed with the

SEC, including prospectuses, Form 10,

10-K, 9-K, 8-K, proxy statements, and

supplementary sales literature.

g. Contracts or arrangements restricting

the transferability of shares.

h. Shareholders' list indicating names,

ownership, and how shares are held.

i. Licenses to conduct business.

j. Foreign qualifications, if any.

k. All documents filed with any state

agency affecting corporate status,

including annual reports.

480 Making Key Strategic Decisions

2. Regarding the Company's business.

a. Promissory notes (except immaterial

routine notes from persons, other than

officers, directors, or 10 percent

shareholders), loan agreements, trust

deeds, indentures and all relevant

correspondence regarding same.

b. Financial statements and tax returns

for the past five years.

c. Stock option agreements, profit

sharing and pension plans, supplementary

information booklets.

d. Annual reports.

e. Advertising materials, brochures, and

other sales literature.

f. Leases and/or grant deeds.

g. Description of plants and

properties.

h. Agreements with officers, directors,

shareholders, or promoters (e.g.,

employment agreements,

indemnification agreements).

i. Documents of agreements with

affiliates (e.g., lease, purchase

agreement, license, covenant not to

compete, etc.), insiders and other

related parties, and if affiliate is other

than a natural person (e.g., trust,

estate, partnership, joint venture,

corporation) court orders, agreements,

stock book, and other documents

necessary to establish precise nature of

affiliation and terms thereof.

j. All materials contracts.

k. Copies of licenses, permits,

governmental approvals, quality

ratings, franchises, patents, copyrights,

trademark and service mark

registrations, trade secret agreements

and any opinions of counsel related

thereto.

l. Distribution or agency agreements.

m. Consignment agreements.

n. List of major customers and suppliers,

copies of their existing agreements,

and copies of correspondence for the

past year.

o. All documents relating to any

complaints, investigations, claims,

hearings, litigation, adjudications, or

proceedings by or against the

Company, including copies of the

material pleading.

p. All documents relating to issuance of

stock, including offering documents

and documents relating to reliance on

securities registration exemptions and

any related litigation action or

proceeding.

q. Business plans (past five years).

r. All written documents relating to

employment policies and practices.

s. All correspondence between the

Company and legal counsel regarding

responses to requests for auditors

information (for five years).

t. Copies of any pleading or other

documents relating to any litigation,

action, or proceeding related to any of

the Company's affiliates, officers,

directors, or beneficial owners of 10

percent or more of stock.

u. All insurance documents.

v. Affirmative action plans.

w. Any other documents that are material

to the Company.

Going Public 481

C. Review of Basic Corporate Documents

1. After gaining an understanding of the

industry, examine specific Company

documents filed with the SEC during the

past five years, including:

a. Form 10-K.

b. Form 8-K.

c. Form 10-Q.

d. Registration statements and private

offering memoranda relating to the

sale of securities and any

e. Proxy statements for:

1) Annual meetings,

2) Acquisitions, and

3) Other transactions requiring a

shareholder vote.

2. Examine document and other

communications sent to the shareholders

during the past five years, including:

a. Annual reports and quarterly reports,

with particular attention to the

president's letter, which may provide

insight into any major problems faced

by the corporation.

b. Follow-up reports on annual

meetings.

c. Shareholder letters.

3. Examine public documents on the

Company.

a. News clippings.

b. Press releases.

c. Documents on file.

d. NEXIS computer searches.

e. Recent private placement

memoranda and written rating agency

presentation.

4. Evaluate restrictive covenants.

a. Examine indentures and loan

agreements.

b. Consider the effect such covenants

might have on the Company's

operations and prospective financing.

D. Analysis of the Company and Its Industry

1. Company analysis.

a. Compare the Company's prior

business plan and financial plan with

the actual results obtained.

b. Determine the Company's principal

product lines. If the Company's

principal products are newly developed,

it may be desirable to retain an

independent consultant who can advise

on the technology, the feasibility of the

product, and its potential market.

c. Examine the demographic and

geographic markets in which the

company sells its products.

d. Compile a list of principal customers

by products.

e. Obtain samples of marketing and sales

literature used for various products.

f. Determine the mechanism for distribution

of company products or

services, i.e., wholesale and

retail distributors, personal service,

or Internet.

g. Assess the technology position of the

company.

h. Compile a list of trademarks, trade

names, and service marks and assess

the protection obtained for such marks

and names.

i. Obtain copies of permits for conduct of

business, including licenses, franchises,

concessions, and distributorship

agreements.

482 Making Key Strategic Decisions

2. Strategic analysis.

a. What are the Company's long-term

goals?

b. On what basis does the Company

measure its performance?

c. What strengths does the Company

intend to exploit to be successful in its

industry?

d. What weaknesses does the Company

have in the industry and what does it

intend to do to overcome such

weaknesses?

e. What are the current market opportunities

and how does the Company

plan to exploit such opportunities?

f. What are the risks that the Company

faces in the industry? What is the

likelihood that such risks will come to

fruition? What would be the

consequence to the Company if the

risks came to fruition?

g. What are the Company's business

strategies for success in the industry?

3. Financial analysis.

a. Compare basic financial ratios of the

Company to the industry average.

(1) Debt to equity ratios.

(2) Liquidity ratios.

(a) Current ratio (Current

assets/current liabilities).

(b) Quick ratio (Current assets

minus inventory/current

liabilities).

(c) Earnings/fixed charges.

(d) Price/earnings ratios.

(3) Asset utilization ratios.

(a) Sales turnover.

(b) Total assets turnover.

(4) Profitability ratios.

(a) Return on assets.

(b) Return on equity.

(5) Price-earnings ratios.

4. Prepare a written memorandum setting

forth questions to be asked of

management and areas to be explored in

greater depth.

E. Visits to Principal Facilities

1. If the Company is a manufacturing

concern, visit one or more of its principal

plants. Inspect the facilities to become

acquainted with the Company's products

and the manner in which they are

produced.

2. If the Company is not a manufacturing

concern, visit one or more of the

Company's offices to obtain an overview

of the Company's day-to-day operations.

3. Does it appear the facilities are being fully

utilized?

F. Meetings with Principal Officers (after

reviewing the registration statement but

before engaging in a line-by-line discussion

of the document)

1. Hold individual meetings with executive

officers responsible for significant aspects

of the Company's business.

a. Prepare a list of questions in advance to

focus the discussions.

(1) How would you assess the flexibility

of the production facilities?

(2) Do you anticipate advances in

production techniques and, if so, is

the Company prepared to make

such advances?

Going Public 483

(3) Does the Company have any

continuing obligations in connection

with sales, such as an ongoing

maintenance and repair obligation or

a requirement to finance purchases

by customers?

(4) How do you assess the quality and

quantity of resources allocated by the

Company to research and

development?

(5) What are your financial projections?

(6) Have results met past projections?

(7) How do you assess the gross profit

margin trends in your various

product lines?

(8) How do you feel about the level of

sales for each of the Company's

product lines?

(9) How do you assess labor relations?

Have there been any work stoppages

and, if so, how have you dealt with

them?

(10) What is the Company's overall

advertising and marketing plan?

(11) What is the Company's acquisition

policy? Explain the Company's recent

acquisitions, if any.

(12) For what does the Company plan to

use the proceeds of the public

offering?

(13) How would you assess the inventory

turnover?

(14) Have there been any delays in new

product introduction?

(15) Has the Company changed

accounting or legal representation

within the last five years? If so, why?

(16) Has the Company lost any major

customer, supplier or distributor

within the last five years?

If so, why?

(17) Are any of the existing shareholders

antagonistic toward the current

management of the Company? If

so, please explain.

b. During the course of the interviews,

ask the same questions of different

corporate officials to evaluate the

answers received and to obtain

different perspectives on potential

problems.

2. Hold at least one meeting with the

Company's chief executive officer (CEO).

a. Ask the CEO to review the broad

aspects of the Company's strategic and

operational goals and its plan to

achieve those goals.

b. Ask the CEO for his or her personal

assessment of the Company's strengths

and weaknesses.

(1) This interview should be as far

reaching as circumstances warrant.

(2) It is essential to listen critically to

the CEO's comments.

3. Based on the meetings, assess the

competence of the officers of the

Company.

a. Are the administrators organized and

knowledgeable?

b. Are the financial officers skilled?

c. Are the technical personnel wellqualified?

d. Is the management structure such that

it can adjust to the Company's growth

beyond the current stages of operation?

484 Making Key Strategic Decisions

G. Meetings with Company's

Accountants (Out of the Presence

of the Company's Officials)

Questions to Ask:

1. How would you assess the Company's

internal controls?

2. Are there any unusual accounting

issues in regard to the Company or the

industry?

3. Are reserves adequate?

4. How would you assess the Company's

aged-analysis of accounts receivable?

5. Do you note any unusual fluctuations

in inventory?

6. Is the Company's method of revenue

recognition in line with industry

practice and applicable accounting

principles?

7. How do you assess the Company's

segment reporting?

8. From your dealings with the

Company's accounting and financial

personnel, how would you assess their

capability?

H. Meeting with Company's Counsel

Questions to Ask:

1. How would you assess the pending

litigation and contingent liabilities of

the Company?

2. How would you assess the pending

administration and regulatory

proceedings that the Company is facing?

3. How would you assess the status of the

Company's proprietary information

and intellectual property, including any

copyrights, trademarks, service marks

and trade secrets?

I. Meetings with Other Third Parties

1. Suppliers/creditors/distributors. Does the

Company pay its bills/debts in a timely

manner?

2. Competitors and customers.

a. What is the company's reputation?

b. How would you rate management's

reputation?

c. What risks are present in the Company

and its industry?

d. How would you rate the quality of the

Company's products and services?

J. Legal Review

1. Review of basic corporate documents.

a. Articles of incorporation.

(1) Obtain copies of the articles of

incorporation, including any

restated articles and amendments.

(2) Determine whether all of these

items were certified by the Secretary

of State (by whatever name known)

of the state in which the company is

incorporated.

(3) Determine whether the purposes

clause of the articles is broad

enough under the applicable law to

include all actions previously taken

and presently being contemplated.

(4) List the dates of all amendments

and summarize changes.

(5) Were such amendments validly

authorized by the shareholders?

(6) Is the name as specified in the

Charter the same as used by the

Company?

(7) Do the powers of the Company

suggest any restrictions?

(8) Is the authorized capital sufficient?

Going Public 485

(9) Verify the description of the Company's

equity stock.

(10) Do the articles provide for preemptive

rights?

(11) Does the authorized number of

directors conform to the minutes?

(12) Do the articles provide for the accessibility

of shares?

(13) Do the articles provide for restrictions

on issuance of shares?

(14) What is the county of the principal

place of business?

(15) Do the articles provide for indemnification

of officers and directors?

b. Bylaws.

(1) Obtain copies of the bylaws, including

all amendments certified by the

corporate secretary.

(2) Review for powers of officers, roles of

committees, powers to amend, restrictions

on actions, and other governing

provisions.

c. Minutes.

(1) Obtain minutes of all meetings of

directors, committees of directors and

shareholders, including copies of any

written notices, waivers of notices, and

written consents to action without a

meeting, all for the past five years.

(2) Has the Company regularly held its

annual meeting of shareholders? If not,

explain the circumstances. If not, were

notices duly given or waivers obtained?

If notices or waivers were properly

obtained, indicate whether such waivers

were actually signed before or during

the meetings, or whether they were

executed after the meetings.

(3) Indicate whether the Company

holds regular periodic meetings of

its directors.

(4) What is the normal frequency of

such meetings?

(5) Were notices duly given or waivers

obtained with respect to these

meetings? If so, indicate whether

such waivers were actually signed

before or during the meetings, or

whether they were executed after

the meetings.

(6) If a meeting was not held, were

resolutions adopted pursuant to

proper unanimous written consent?

(7) Prepare a summary of the minutes

for review by the underwriters.

d. Meetings.

(1) Indicate the date and place for

meetings, both for directors and

shareholders, as provided in the

bylaws or articles of the

corporation.

(2) What were the actual locations of

the last three shareholders'

meetings?

(3) What were the actual locations of

the last two directors' meetings?

e. Executive committee meetings.

(1) If the Company has an executive

committee, does it hold regular

periodic meetings?

(2) If so, are minutes regularly

prepared?

(3) If such minutes are prepared, is

such preparation under the

direction or approval of the office

of general counsel?

486 Making Key Strategic Decisions

(4) If no meetings are held, are

resolutions properly adopted

pursuant to unanimous written

consent?

f. Directors' and shareholders'

meetings/minutes.

(1) How are the corporate minutes

and/or unanimous written

consents kept? If the minutes or

consents are kept looseleaf, are the

pages consecutively numbered?

(2) Are previous minutes of meetings

properly signed? Who signs the

minutes?

(3) Do all previous minutes reflect the

presence of a quorum and the

names of those in attendance?

(4) Do all previous minutes indicate

the approval of previous minutes?

(5) Do all previous minutes indicate

the time and place of the holding

of the meeting?

(6) Do all previous minutes indicate

that either waivers were properly

executed or notices properly given

for the meeting?

g. Voting trust agreements.

(1) Obtain copies of any voting

trust agreements, or

shareholders' or similar

agreement, and lists of the

shares covered.

(2) Do such agreements terminate by

virtue of the offering?

h. Minute books and stock records.

(1) Where are the minute books of the

Company physically kept?

(2) Where are the stock record books

of the Company physically kept?

(3) Who is the stock transfer agent for

the Company? (Indicate the

transfer agent's complete address.)

i. Annual reports.

(1) Obtain copies of any document

sent to shareholders, including the

Company's annual reports,

quarterly reports, following reports

on annual meetings and

shareholder letters and press

releases sent within the last three

years.

j. Proxy statements.

(1) Obtain copies of any proxy

statements of the Company for

annual meetings, acquisitions or

other transactions requiring a

shareholder vote within the last

five years.

(2) Obtain copies of the form of proxy

used for the last annual meetings.

k. Annual certified audits.

(1) Obtain copies of the annual

certified audits of the Company for

the last three years, if any, unless

contained in the annual report.

(2) Has there been any change in the

accountants?

l. Election procedures.

(1) Do election procedures for

directors, as used by the Company,

comply with all applicable laws and

regulations, including the

Company's bylaws?

(2) Have directors been unanimously

elected?

m. Concurrent director/officer status.

(1) Was any person who was both a

director and an officer present at

Going Public 487

the meeting at which his or her salary

was set?

(2) Was such person counted as part of the

quorum for such a meeting or did that

person sign a unanimous written consent

for same?

(3) If an affirmative answer is given to

either (1) or (2), does such action create

a legal problem under the applicable

law?

n. Power of board of directors.

Is it the Company's policy to get the board

of directors' approval for:

(1) Changes in reserves?

(2) Changes in surplus accounts?

(3) Declaration of dividends?

(4) Election of officers?

(5) The setting of officers' salaries and/

or bonuses?

(6) Amendments to the by-laws of the

corporations?

(7) The granting of powers of attorney?

o. Policy-making authority of the board of

directors.

(1) As a practical matter, does the

Company get the board of directors'

approval for all major policy decisions?

(2) If not, how much leeway does the board

of directors give the Company's

management in the area?

p. Indemnification.

(1) Obtain copies of any insurance policies

or other agreements, other than the

bylaws of the articles of incorporation,

which provide for the indemnification

of any officer, director, shareholder,

employee, or other agent of the

company.

(2) Is the indemnification agreement or

policy authorized by applicable

jurisdiction?

(3) Is any indemnification in the

bylaws consonant with law in the

applicable jurisdiction?

q. Rights of the various classes of stock.

(1) State the voting rights of the

various classes of stocks.

(2) Are any dividends on preferred

stock presently in arrears? If so,

indicate any additional preferences

that come into being because of the

arrearage.

(3) Indicate any potential voting right,

other than noted in Section II.J.1.b.

above, held by holders of preferred,

convertibles, debentures, bonds,

etc., that become effective on the

happening of contingent events

(such as failure to pay dividends or

make payments).

r. Dividends and other distributions

(1) Indicate the Company's dividend

record on common stock for the

past five years.

(2) Indicate any other distribution of

property to shareholders by the

Company over the past five years.

(3) Has the Company ever paid a

dividend or made another distribution

to shareholders without

meeting an earned surplus or other

test under applicable state law to

cover it? If so, explain.

s. Pension plans/profit sharing

plans/stock option plans.

488 Making Key Strategic Decisions

(1) Obtain copies of (i) all pension plans,

(ii) all profit sharing plans, and (iii)

all stock option plans.

(2) If the Company has a pension plan,

indicate the date on which there last

was a compliance with the Federal

Pension Plan Disclosure Act.

(Compliance is obtained by giving a

printed copy of the plan to the

employees covered thereby.)

t. Reports filed with governmental agencies.

(1) Review all material reports filed with

any governmental agency (state or

federal) during the last 12 months.

(2) Indicate whether the narrative in all

reports filed with any governmental

agency, as well as the Company's

annual report, is checked for accuracy

by the office of general counsel.

u. Related parties.

(1) Does the Company do business with

which any officer or director, including

spouses and other close relatives, has

an interest?

v. Insurance.

(1) Is the Company self-insured?

(2) If so, to what extent?

(3) Indicate the insurance coverage of the

Company, giving the name of the

carrier and the policy numbers of

each type of coverage.

w. License to do business.

(1) Indicate the states in which the

Company does business.

(2) Obtain copies of certificate of good

standing to determine if the

Company is properly licensed in each

state it is doing business.

(3) Is the Company licensed to

do business in any states in which it

presently is not doing business? If

so, indicate the tax consequences

for each jurisdiction.

x. Corporate opportunity doctrine

compliance.

(1) Indicate any possible violation of

the corporate opportunity doctrine

known to the Company's counsel.

y. Contingent liabilities.

(1) List all material contingent

liabilities of the Company not

otherwise set forth in this audit.

2. Documents regarding securities.

a. Stock options/stock purchases/

stock bonuses.

(1) Obtain all forms of stock option

plans, stock purchase plans, and

stock bonus plans, and all forms of

stock option agreements, or escrow

agreements that have been or may

be used under any such plan, as

well as all other documents relating

to the issuance of securities by the

Company, including other purchase

agreements, registration rights

agreements, and offering circulars.

b. Sources of capital.

(1) List each issue of stock, bonds,

debentures, options, warrants, other

convertibles, etc., indicating the

amount, the authorized amount,

and the applicable permit or registration

of each (both state and

federal), and if there is no permit

and/or registration, state the

claimed state and Federal

exemption.

Going Public 489

(2) List the states where such securities

described in Section J.2.a., above,

were issued and state the date of

blue-sky authorization. If no such

authorization, give the applicable

exemption.

(3) Indicate the date of each federal

registration, if any, and the term

for which registered.

(4) Obtain copies of any agreements

pursuant to which such securities

were issued (e.g., stock option

plans, underwriting agreements,

placement agreements, bond

indentures, etc.).

(5) Do any such agreements provide

for registration rights? If so,

describe.

(6) Obtain copies of all applications

for permits, private placement

memoranda and registration

statements.

c. Payments for stock.

(1) Do the Company's records indicate

all of its outstanding stock was

properly issued for value?

(2) Is any of the Company's stock not

fully paid? If so, explain; do statutes,

articles and by-laws permit?

d. Stock issuance/transfer restrictions.

(1) Do all issuance and transfers

comply with any rights of first

refusal, preemptive rights, or other

restrictions contained in the

articles, bylaws or other

documents, such as placement

agreements?

3. Review of material contracts.

a. Various material contracts.

(1) Obtain bank lines of credit

agreements, including any

amendments, renewal letters,

notices, default waivers, etc.

(2) Obtain other outstanding loan

agreements, guarantees, indentures,

or agreements with respect to

indebtedness.

(3) Obtain all outstanding material

leases for real and personal

property.

(4) Obtain material contracts with

suppliers and customers.

(5) Obtain any model sales contracts,

license agreements, and dealer

agreements used by the Company.

(6) Obtain agreements for loans and

any other agreements (including

consulting and employment

contracts) for officers, directors, or

employees, whether or not now

outstanding.

(7) Obtain schedule for all insurance

policies in force covering property

of the Company and any other

insurance policies, such as "key

man" policies or products liability

policies.

(8) Obtain partnership or joint venture

agreements.

(9) Obtain copies of any bonus plans,

retirement plans, pension plans,

deferred compensation plans, profit

sharing and management incentive

agreements.

b. Mortgages, notes payable, and

other liabilities.

(1) List all mortgages (including deeds

of trust) of the Company on which

490 Making Key Strategic Decisions

the anticipation is that final payment

will not be made within the 36

months of the date of this

examination.

(2) Indicate whether such mortgages

overlap any other security interest

given by the Company.

(3) List all notes and other liabilities in

excess of $5,000.

c. Reports on dividends.

(1) Does the Company make reports

(both federal and/or state) on

dividends paid to its shareholders?

(2) If so, give the date of the last such

report.

d. Corporate negotiable insurance.

(1) Indicate each institution in which the

Company has authorized its agents to

execute negotiable instruments,

showing the authorized agents, their

titles, and the limit of their authority.

(2) For each of the authorizations,

indicate the date of the corporate

resolution authorizing the signature.

e. Authority of corporate agent.

(1) Is a notice of limit of agent's

authority given to each new account

with which the Company does

business?

(2) If not, what steps are taken to ensure

that each agent of the Company does

not exceed his/her authority?

f. Business outside the United States.

(1) If the Company does any business

outside the United States, determine

whether or not any activities of the

Company might reasonably be

construed as a violation of any

statutory or regulating limitation on

doing business with specified

nations or limitation on certain

trading, such as trading in gold and

foreign exchange.

(2) What steps have been taken to

ensure that the Company does not

violate any prohibitions concerning

transactions between designated

foreign companies or concerning

transfer with respect to securities

registered in the name of

designated nationals, as well as

importation of and dealing on

certain classes of merchandise?

(3) List all corporations incorporated

in a foreign country in which the

Company owns 10 percent or more

of the capital stock, and for each

such corporation indicate (i) any

outstanding powers of attorney (ii)

any guarantees undertaken (iii) any

liabilities created, and (iv) and

contract commitments undertaken.

g. Prepaid items.

(1) List all prepaid items on the

Company's book of assets when

such prepayments exceed $100,000

and will continue in excess of this

amount for more than 12 months.

h. Bad debts.

(1) Indicate the percentage of accounts

receivable that became bad debts in

each of the last three years.

(2) Ascertain trends regarding

bad debts.

i. Security interests.

(1) What security interest, if any, is

typically used to secure open

accounts?

Going Public 491

(2) Are such security devices properly

perfected?

(3) In how many states does the Company

presently have perfected security

interest?

(4) What steps are taken to ensure

the timely filing of continuation

statements required under Article 9 of

the Uniform Commercial Code?

j. Warehousing.

(1) Does the Company, as either buyer or

seller, utilize the facilities of on-premises

warehousing for financing purposes?

(2) Does the Company, as either buyer or

seller, utilize warehouse receipts in

financing?

k. Labor contracts.

(1) List all labor contracts to which the

Company is a signer, indicating the

bargaining unit covered, the union, the

termination date, and a general

statement of the company's relationship

with the union, indicating specifically

any major problem areas.

(2) If there are material problems, obtain

copies of each labor contract.

l. Individual employment contracts.

(1) Does the Company have any individual

employees with a written employment

contract?

(2) If so, obtain copies of all forms used for

employment contracts (including forms

of contracts used for executives).

m.Minimum wage compliance.

(1) Is the Company considered to be

engaged in interstate commerce?

(2) Are any employees or employees of

subcontractors working on the

premises currently being paid less

than the applicable minimum wage

per hour? If so, what justification

can be given for a lower rate of pay?

(3) Are any employees covered by a

state minimum wage law requiring

the payment of more than the

federal minimum wage per hour? If

so, indicate with appropriate

citation the state law, the bargaining

units covered, and any other

pertinent information.

(4) Is overtime paid? If not, explain

when it is not paid.

n. Child labor.

(1) Does the Company employ any

person under eighteen years of age

on a permanent basis?

(2) What safeguards are taken to ensure

that the Company does not violate

either the federal or state "Child

Labor Act"?

o. Compliance with fair labor standards.

(1) Has any governmental agency

checked the Company within the

last three years in regard to

compliance with the fair labor

standard act or other litigation

regarding employees?

(2) If so, indicate the approximate date

and result of the investigation.

p. Compliance with antidiscrimination

statutes.

(1) Does the Company have procedures

to assure compliance with antidiscriminatory

statutes relating to age,

sex, and race; and does it keep

adequate records to demonstrate

compliance (e.g., application forms,

492 Making Key Strategic Decisions

records of employees, and work

assignments, etc.)?

(2) Does the company, in fact, have an

age limit cutoff beyond which

general hiring is not done? If so, what

is the age limit?

(3) What steps have been taken to ensure

the compliance by the Company with

federal statutes prohibiting age

discrimination in hiring?

q. Salary withholding information.

(1) Does the Company maintain an upto-

date file of Form W-4

(withholding information) for each

employee?

(2) Has the Company failed to comply

with withholding requirements?

r. Worker's compensation.

(1) Does the Company maintain the

worker compensation insurance

required by the state on each

employee?

(2) If not, explain.

s. Other. Assess compliance with state and

Federal laws related to the environment,

occupational health and safety, and

antitrust/unfair trade practice

regulations.

t. Material payments on contracts.

(1) List all contracts, presently in force,

on which the Company, directly or

indirectly, is bound, that will not be

completed within 24 months, and

each that involves payments (or

performance of services or delivery

of goods) to or by the Company of a

material account.

(2) Make a schedule of all leases for

real and personal property

requiring payment of a material

amount.

u. Contract forms and significant

provisions.

(1) Do the contract forms presently in

use by the Company meet the

requirements of the Uniform

Commercial Code?

(2) What precautions are taken to

ensure that, upon acceptance,

additional terms are not inserted by

the other party and made part of

the agreement?

(3) Obtain copies of all significant

contract forms utilized by the

Company.

(4) Are any required anti-discrimination

provisions included?

v. Current breaches of material

agreements.

(1) If any party is presently in breach of

any material agreement with the

Company, indicate:

(i) The default,

(ii) The contract penalty for the

breach, if any,

(iii) What action presently is

being taken and

(iv) What action is being

contemplated.

(2) Does the Company take action in

the event of breaches by others?

w. Sales of the Company's products.

(1) Indicate how the Company's sales

are made (i.e., through sales agents,

distributors, independent

contractors, etc.).

Going Public 493

(2) Indicate the authority each type of

selling agent possesses.

(3) If sales agents have limited authority,

what steps are taken to publish this

authority to those with whom the

agent deals?

(4) If independent contractors are used,

are they permitted to set prices? Are

they given a sales quota? Are they

truly independent contractors?

x. Identification of agents.

(1) List the titles and positions of those

who, under a reasonable interpretation

of the statutory and case law of

the jurisdiction in which they sell for

the Company, could be considered

agents of the Company.

(2) Do any such agents act through

contractual relationships?

y. Sales forms.

(1) Does the Company have sales forms

that are considered to be offers

tendered for acceptance by the

purchaser, or

(2) Does the Company have forms that

are considered offers to the Company

when executed by a purchaser? If the

latter is used, is acceptance accomplished

at the home office or by the

agent in the field?

z. Direct sales.

(1) List those jurisdictions in which

direct sales are made by the

Company.

(2) List those jurisdictions in which

direct sales are made through an

independent contractor or

distributor.

(3) List those jurisdictions in which

direct sales are made only via

communications in interstate

commerce.

aa. Trade associations.

(1) Indicate whether the Company is a

member of any trade association(s).

(2) List all such organizations with

which the Company has

any contract.

(3) Indicate the relationship between

the Company and such organizations.

(4) Indicate whether any of the organizations

above listed have been investigated

by any state or federal group,

either administrative, judicial, or

legislative, for possible anti-trust

violations during the last five years.

(5) If so, explain in detail the outcome

of the investigation and what

impact, if any, this had on the

Company.

bb. Material transactions with insiders

and affiliates.

(1) Obtain material of any material

transactions within the last five

fiscal years with any insider (i.e.,

any director, officer or substantial

owner of the Company's securities)

or any associate of, or entity

affiliated with, an insider.

4. Regulation and litigation.

a. Various items relating to regulation

litigation.

(1) Obtain all letters sent to the

Company's independent auditors in

connection with its audits for the

past five fiscal years, including

"litigation letters."

494 Making Key Strategic Decisions

(2) Obtain copies of letters from the

auditors to the Company regarding its

internal management controls.

(3) Obtain active litigation files for

material litigation, including letters

asserting claims, complaints,

answers, etc.

(4) Obtain any settlement documents for

material litigation.

(5) Obtain any decrees, orders, or

judgments of courts or governmental

agencies.

(6) Obtain information regarding any

material litigation to which the

Company is a party or in which it may

become involved.

(7) Obtain audited financial statements

(five years).

(8) Obtain recent forward-looking

budgets for the next two fiscal years

prepared on a monthly basis (if

available).

(9) Obtain recent five-year projections

(if available).

b. Pricing policies.

(1) Does the Company, in its pricing

policies, follow an industrial leader?

(2) If so, which competitor does the

Company follow as leader?

(3) If not, how are the Company's

pricing policies determined?

c. Compliance with building codes.

(1) Is the Company in compliance with

all building codes (or other similar

local governmental codes) that are

applicable to it?

(2) If not, explain.

(3) Indicate the approximate date of the

last time the Company's facilities

were checked by local governmental

authorities for possible violations

of local governmental codes, and

indicate the results of such

investigation.

(4) If any of the Company's facilities

are borderline, indicate any

remedial steps that should be

undertaken at this time.

(5) List any warnings that the

Company has received within the

past three years for the violation of

any local governmental codes.

(6) List the date and amounts of fines,

if any, paid to any local governmental

authority for violation of

local codes, other than the traffic

code, paid by the Company during

the last three years.

d. Contract defaults.

(1) Is the Company presently in

default under any contractual

arrangement?

(2) If so, explain the default and

indicate the penalties arising out of

such default.

e. Liens.

(1) List all liens presently in force

against the Company's property,

both real and personal.

(2) Have any actions been taken in

respect to any such liens?

f. Legal action.

(1) List all legal actions presently

pending or known to be

contemplated in which the

Company might have an

involvement.

Going Public 495

(2) Ascertain the identity of legal

counsel representing the Company

in such matters.

g. Assignment of patents, trademarks,

and copyrights.

(1) Obtain the form used in which

employees assign to the Company

any patent, trademark, and/or

copyright that might arise from

inventions discovered while

working for the Company, together

with a list of the employees who

have signed the contract. If a form

is not used, should it be?

(2) Does the Company have

nondisclosure agreements with

employees?

h. Surety bonds.

(1) Indicate those employees (by title

or position) who are presently

covered by a fidelity or other

surety bonds.

(2) What are the amounts of any

such bonds?

i. Charitable contributions.

(1) Indicate the number and amount

of charitable contributions made

by the Company in each of the

last two years in the following

categories: (i) religious,

(ii) educational, (iii) other.

(2) Does the Company have any policy

regarding employee charitable

contributions?

j. Lobbying activities/political campaigns

(1) Indicate whether the Company is

engaged in any lobbying activities

or political campaigns and, if so,

to what extent, and at what

financial cost.

(2) Does the Company retain any

lobbying firms?

k. Tax compliance.

(1) Does the Company file all required

tax reports?

(2) If not, explain.

(3) How long are tax records kept?

(4) Does the Company have its tax

records reviewed periodically for

compliance with tax laws?

(5) How often are the tax reports

reviewed and by whom?

(6) Does the Company utilize tax

counsel in the planning phase of

transactions?

(7) If so, is tax advice rendered by

house counsel or outside counsel?

(8) How are audits by governmental

tax authorities conducted?

l. Year 2000 compliance.

(1) Assess the affect on the company of

its compliance with the Year 2000

transition, taking into account the

costs, potential disruptions of

productivity, potential liabilities

related to company products or

services, and compliance by

suppliers.

m. Subsidiary information.

(1) Identify the Company's

subsidiaries.

(2) Where material, provide the

information above with respect to

each subsidiary of the Company.

496 Making Key Strategic Decisions

K. Review Officers' and Directors'

Questionnaire

1. Obtain from the Company's counsel

the "officers' and directors' questionnaire"

to gather information on the

Company's officers and directors,

their remuneration and employee

benefits, and material transactions

that they have had with the

Company.

2. Compare the information disclosed

in the questionnaire with the

disclosure required by the applicable

registration form, especially in regard

to:

a. Insider transactions and loans.

b. NASD Regulation affiliations.

c. Litigation.

d. Cheap stock.

e. Stock ownership.

L. Check of Order Backlogs

1. Compare oral purchase orders or

oral changes to written purchase

orders.

2. Do cancellation provisions exist in

standard purchase orders, including

any penalties for cancellation?

3. Are there indications that

outstanding offers may be "soft," or

subject to cancellation?

M. Detailed Review of Draft of

Registration Statement

1. Read the draft of the registration

statement carefully for content.

2. Read the draft of the registration

statement a second time against:

a. The items of the applicable form

(e.g., Form S-1, Form S-2, Form

S-3, Form S-18) and

b. Regulation S-K (to the extent

covered by the applicable form).

(1) Item 501-Forepart of Registration

Statement and Outside Front

Cover Page of Prospectus.

(2) Item 502-Inside Front and

Outside Back Cover Pages of

Prospectus.

(3) Item 503-Summary Information,

Risk Factors, and Ratio of

Earnings to Fixed Charges.

(4) Item 504-Use of Proceeds.

(5) Item 505-Determination of

Offering Price.

(6) Item 506-Dilution.

(7) Item 507-Selling Security

Holders.

(8) Item 508-Plan of Distribution.

(9) Item 509-Interests of Named

Experts.

(10) Item 510-Disclosure of

Commission Position on

Indemnification for Securities Act

Liabilities.

(11) Item 511-Other Expenses of

Issuance and Distribution.

(12) Item 512-Undertakings.

3. Review the registration statement on a

line-by-line basis with appropriate

individuals, including:

a. Officers of the Company responsible

for preparing the registration

statement.

Going Public 497

b. The Company's counsel.

c. Representative of the Company's

certified public accountants.

4. Based on the information elicited

through discussions with various

individuals, encourage that the

registration statement be revised in an

effort to improve upon

its disclosure.

5. After a revised draft of the registration

statement is available, see that it is

distributed to all directors and key

officials.

6. Review the Company's procedures for

collecting and evaluating comments

on the registration statement from

those persons to whom it has been

furnished.

N. Review of Other Documents

1. Review documents not previously

furnished, including those of a

confidential nature that the Company

would prefer not to be taken from its

offices, including:

a. Five-year plans.

b. Financial forecasts.

c. Budgets.

d. Periodic reports by operating units

to senior management or the board

of directors.

e. Letters of comment received by the

Company in connection with prior

registration statements.

f. At least the most recent

management letter prepared by the

accountants in connection with

their audit.

O. Review During Negotiation of Underwriting

Agreement

1. During negotiations on representations

and warranties in the underwriting

agreement, be sensitive to potential

problems that arise and may need to be

disclosed in the registration statement.

2. Review legal counsel's summary of the

Company's minutes.

III. Summary Analysis

A. Prior to effectiveness of registration

statement, prepare a memorandum

summarizing the due diligence investigation,

including the dates of any visits to principal

facilities, meetings with management, and

registration statement review sessions.

B. Have this memorandum reviewed by counsel

for the underwriters.

SOURCE: The NASDAQ Stock Market, Inc.

498 Making Key Strategic Decisions

APPENDIX B

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM S-1

REGISTRATION STATEMENT UNDER THE

SECURITIES ACT OF 1933

(Exact name of registrant as specified in its charter)

(State or other jurisdiction of incorporation or organization)

(Primary Standard Industrial Classification Code Number)

(I.R.S. Employer Identification Number)

(Address, including zip code, and telephone number, including area

code, of registrant's principal executive offices)

(Name, address, including zip code, and telephone number,

including area code, of agent for service)

(Approximate date of commencement of proposed sale to the public)

If any of the securities being registered on this Form are to be offered on a delayed

or continuous basis pursuant to Rule 415 under the Securities Act of

1933, check the following box:

If this Form is filed to register additional securities for an offering pursuant to

Rule 462(b) under the Securities Act, please check the following box and list

the Securities Act registration statement number of the earlier effective registration

statement for the same offering. .

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under

the Securities Act, check the following box and list the Securities Act registration

statement number of the earlier effective registration statement for the

same offering.

Going Public 499

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under

the Securities Act, check the following box and list the Securities Act registration

statement number of the earlier effective registration statement for the

same offering.

If delivery of the prospectus is expected to be made pursuant to Rule 434,

please check the following box.

Calculation of Registration Fee

Note: Specific details relating to the fee calculation shall be furnished in notes

to the table, including references to provisions of Rule 457 (§ 230.457 of this

chapter) relied upon, if the basis of the calculation is not otherwise evident

from the information presented in the table. If the filing fee is calculated pursuant

to Rule 457(o) under the Securities Act, only the title of the class of securities

to be registered, the proposed maximum aggregate offering price for

that class of securities, and the amount of registration fee need to appear in the

Calculation of Registration Fee table. Any difference between the dollar

amount of securities registered for such offerings and the dollar amount of securities

sold may be carried forward on a future registration statement pursuant

to Rule 429 under the Securities Act.

GENERAL INSTRUCTIONS

I. Eligibility Requirements for Use of Form S-1

This Form shall be used for the registration under the Securities Act of 1933

("Securities Act") of securities of all registrants for which no other form is authorized

or prescribed, except that this Form shall not be used for securities of

foreign governments or political subdivisions thereof.

II. Application of General Rules and Regulations

A. Attention is directed to the General Rules and Regulations under the Securities

Act, particularly those comprising Regulation C (17 CFR 230.400 to

230.494) thereunder. That Regulation contains general requirements regarding

the preparation and filing of the registration statement.

B. Attention is directed to Regulation S-K (17 CFR Part 229) for the requirements

applicable to the content of the nonfinancial statement portions of

registration statements under the Securities Act. Where this Form directs the

Title of Each

Class of

Securities to

Be Registered

Amount to Be

Registered

Proposed

Maximum

Offering Price

per Unit

Proposed

Maximum

Aggregate

Offering Price

Amount

of Registration

Fee

500 Making Key Strategic Decisions

registrant to furnish information required by Regulation S-K and the item of

Regulation S-K so provides, information need only be furnished to the extent

appropriate.

III. Exchange Offers

If any of the securities being registered are to be offered in exchange for securities

of any other issuer, the prospectus shall also include the information

which would be required by item 11 if the securities of such other issuer were

registered on this Form. There shall also be included the information concerning

such securities of such other issuer which would be called for by Item 9 if

such securities were being registered. In connection with this instruction, reference

is made to Rule 409.

IV. Roll-up Transactions

If the securities to be registered on this Form will be issued in a roll-up transaction

as defined in Item 901(c) of Regulation S-K (17 CFR 229.901(c)), attention

is directed to the requirements of Form S-4 applicable to roll-up

transactions, including, but not limited to, General Instruction I.

V. Registration of Additional Securities

With respect to the registration of additional securities for an offering pursuant

to Rule 462(b) under the Securities Act, the registrant may file a registration

statement consisting only of the following: the facing page; a statement

that the contents of the earlier registration statement, identified by file

number, are incorporated by reference; required opinions and consents; the

signature page; and any price-related information omitted from the earlier registration

statement in reliance on Rule 430A that the registrant chooses to include

in the new registration statement. The information contained in such a

Rule 462(b) registration statement shall be deemed to be a part of the earlier

registration statement as of the date of effectiveness of the Rule 462(b) registration

statement. Any opinion or consent required in the Rule 462(b) registration

statement may be incorporated by reference from the earlier registration

statement with respect to the offering, if: (i) such opinion or consent expressly

provides for such incorporation; and (ii) such opinion relates to the securities

registered pursuant to Rule 462(b). See Rule 411(c) and Rule 439(b) under the

Securities Act.

PART I—INFORMATION REQUIRED IN PROSPECTUS

Item 1. Forepart of the Registration Statement and Outside Front

Cover Page of Prospectus.

Set forth in the forepart of the registration statement and on the outside

front cover page of the prospectus the information required by Item 501 of

Regulation S-K (§ 229.501 of this chapter).

Going Public 501

Item 2. Inside Front and Outside Back Cover Pages of Prospectus.

Set forth on the inside front cover page of the prospectus or, where permitted,

on the outside back cover page, the information required by Item 502

of Regulation S-K (§ 229.502 of this chapter).

Item 3. Summary Information, Risk Factors, and Ratio of Earnings

to Fixed Charges.

Furnish the information required by Item 503 of Regulation S-K

(§ 229.503 of this chapter).

Item 4. Use of Proceeds.

Furnish the information required by Item 504 of Regulation S-K

(§ 229.504 of this chapter).

Item 5. Determination of Offering Price.

Furnish the information required by Item 505 of Regulation S-K

(§ 229.505 of this chapter).

Item 6. Dilution.

Furnish the information required by Item 506 of Regulation S-K

(§ 229.506 of this chapter).

Item 7. Selling Security Holders.

Furnish the information required by Item 507 of Regulation S-K

(§ 229.507 of this chapter).

Item 8. Plan of Distribution.

Furnish the information required by Item 508 of Regulation S-K

(§ 229.508 of this chapter).

Item 9. Description of Securities to Be Registered.

Furnish the information required by Item 202 of Regulation S-K

(§ 229.202 of this chapter).

Item 10. Interests of Named Experts and Counsel.

Furnish the information required by Item 509 of Regulation S-K

(§ 229.509 of this chapter).

Item 11. Information with Respect to the Registrant.

Furnish the following information with respect to the registrant:

(a) Information required by Item 101 of Regulation S-K (§ 229.101 of

this chapter), description of business;

(b) Information required by Item 102 of Regulation S-K (§ 229.102 of

this chapter), description of property;

(c) Information required by Item 103 of Regulation S-K (§ 229.103 of

this chapter), legal proceedings;

502 Making Key Strategic Decisions

(d) Where common equity securities are being offered, information required

by Item 201 of Regulation S-K (§ 229.201 of this chapter),

market price of and dividends on the registrant's common equity

and related stockholder matters;

(e) Financial statements meeting the requirements of Regulation S-X

(17 CFT Part 210) (Schedules required under Regulation S-X shall

be filed as "Financial Statement Schedules" pursuant to Item 15,

Exhibits and Financial Statement Schedules, of this Form), as well

as any financial information required by Rule 3-05 and Article 11 of

Regulation S-X;

(f ) Information required by Item 301 of Regulation S-K (§ 229.301 of

this chapter), selected financial data;

(g) Information required by Item 302 of Regulation S-K (§ 229.302 of

this chapter), supplementary financial information;

(h) Information required by Item 303 of Regulation S-K (§ 229.303 of

this chapter), management's discussion and analysis of financial condition

and results of operations;

(i) Information required by Item 304 of Regulation S-K (§ 229.304 of

this chapter), changes in and disagreements with accountants on accounting

and financial disclosures;

(j) Information required by Item 305 of Regulation S-K (§ 229.305 of

this chapter), quantitative and qualitative disclosures about market

risk;

(k) Information required by Item 401 of Regulation S-K (§ 229.401 of

this chapter), directors and executive officers;

(l) Information required by Item 402 of Regulation S-K (§ 229.402 of

this chapter), executive compensation;

(m) Information required by Item 403 of Regulation S-K (§ 229.403 of

this chapter), security ownership of certain beneficial owners and

management; and

(n) Information required by Item 404 of Regulation S-K (§ 229.404 of

this chapter), certain relationships and related transactions.

Item 12. Disclosure of Commission Position on Indemnification for

Securities Act Liabilities.

Furnish the information required by Item 510 of Regulation S-K

(§ 229.510 of this chapter).

PART II—INFORMATION NOT REQUIRED IN PROSPECTUS

Item 13. Other Expenses of Issuance and Distributions.

Furnish the information required by Item 511 of Regulation S-K

(§ 229.511 of this chapter).

Going Public 503

Item 14. Indemnification of Directors and Officers.

Furnish the information required by Item 702 of Regulation S-K

(§ 229.702 of this chapter).

Item 15. Recent Sales of Unregistered Securities.

Furnish the information required by Item 701 of Regulation S-K

(§ 229.701 of this chapter).

Item 16. Exhibits and Financial Statement Schedules.

(a) Subject to the rules regarding incorporation by reference, furnish

the exhibits as required by Item 601 of Regulation S-K (§ 229.601

of this chapter).

(b) Furnish the financial statement schedules required by Regulation

S-X (17 CFR Part 210) and Item 11(3) of this Form. These schedules

shall be lettered or numbered in the manner described for exhibits

in paragraph (a).

Item 17. Undertakings.

Furnish the undertakings required by Item 512 of Regulation S-K

(§ 229.512 of this chapter).

SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, the registrant

has duly caused this registration statement to be signed on its behalf by the

undersigned, thereunto duly authorized in the City of , State

of , on , 20 .

(Registrant)

By (Signature and Title)

Pursuant to the requirements of the Securities Act of 1933, this registration

statement has been signed by the following persons in the capacities and on the

dates indicated.

(Signature)

(Title)

(Date)

504 Making Key Strategic Decisions

Instructions.

1. The registration statement shall be signed by the registrant, its principal

executive officer or officers, its principal financial officer, its controller

or principal accounting officer, and by at least a majority of the board of

directors or persons performing similar functions. If the registrant is a

foreign person, the registration statement shall also be signed by its authorized

representative in the United States. Where the registrant is a

limited partnership, the registration statement shall be signed by a majority

of the board of directors of any corporate general partner signing the

registration statement.

2. The name of each person who signs the registration statement shall be

typed or printed beneath his or her signature. Any person who occupies

more than one of the specified positions shall indicate each capacity in

which he or she signs the registration statement. Attention is directed to

Rule 402 concerning manual signatures and to Item 601 of Regulation S-K

concerning signatures pursuant to powers of attorney.

Going Public 505

APPENDIX C

COMFORT LETTER

AICPA Professional Standards

(Updated as of January 1, 2000)

Copyright c 2000, American Institute of Certified Public Accountants Inc.

[Note: dating throughout, in 1900s]

1. The contents of comfort letters vary, depending on the extent of the information

in the registration statement and the wishes of the underwriter or

other requesting party. Shelf registration statements may have several closing

dates and different underwriters. Descriptions of procedures and findings

regarding interim financial statements, tables, statistics, or other

financial information that is incorporated by reference from previous 1934

Act filings may have to be repeated in several comfort letters. To avoid restating

these descriptions in each comfort letter, accountants may initially

issue the comments in a format (such as an appendix) that can be referred

to in, and attached to, subsequently issued comfort letters.

Example A: Typical Comfort Letter

2. A typical comfort letter includes—

a. A statement regarding the independence of the accountants (paragraphs

.31 and .32).

b. An opinion regarding whether the audited financial statements and financial

statement schedules included (incorporated by reference) in the

registration statement comply as to form in all material respects with

the applicable accounting requirements of the Act and related rules and

regulations adopted by the SEC (paragraphs .33 and .34).

c. Negative assurance on whether—

(1) The unaudited condensed interim financial information included

(incorporated by reference) in the registration statement (paragraph

.37) complies as to form in all material respects with the applicable

accounting requirements of the Act and the related rules

and regulations adopted by the SEC.

(2) Any material modifications should be made to the unaudited condensed

consolidated financial statements included (incorporated

by reference) in the registration statement for them to be in conformity

with generally accepted accounting principles.

d. Negative assurance on whether, during a specified period following

the date of the latest financial statements in the registration statement

and prospectus, there has been any change in capital stock, increase in

506 Making Key Strategic Decisions

long-term debt, or any decrease in other specified financial statement

items (paragraphs .45 through .53).

Example A is a letter covering all these items. Letters that cover some of

the items may be developed by omitting inapplicable portions of example A.

Example A assumes the following circumstances. The prospectus (Part I

of the registration statement) includes audited consolidated balance sheets as

of December 31, 19X5 and 19X4, and audited consolidated statements of income,

retained earnings (stockholders' equity), and cash f lows for each of the

three years in the period ended December 31, 19X5. Part I also includes an

unaudited condensed consolidated balance sheet as of March 31, 19X6, and

unaudited condensed consolidated statements of income, retained earnings

(stockholders' equity), and cash flows for the three-month periods ended

March 31, 19X6 and 19X5, reviewed in accordance with section 722 but not

previously reported on by the accountants. Part II of the registration statement

includes audited consolidated financial statement schedules for the three years

ended December 31, 19X5. The cutoff date is June 23, 19X6, and the letter is

dated June 28, 19X6. The effective date is June 28, 19X6.

Each of the comments in the letter is in response to a requirement of the

underwriting agreement. For purposes of example A, the income statement

items of the current interim period are to be compared with those of the corresponding

period of the preceding year.

June 28, 19X6

[Addressee]

Dear Sirs:

We have audited the consolidated balance sheets of The Blank Company

Inc. (the company) and subsidiaries as of December 31, 19X5 and 19X4, and the

consolidated statements of income, retained earnings (stockholders' equity),

and cash f lows for each of the three years in the period ended December 31,

19X5, and the related financial statement schedules all included in the registration

statement (no. 33-00000) on Form S-1 filed by the company under the

Securities Act of 1933 (the Act); our reports with respect thereto are also included

in that registration statement. The registration statement, as amended

on June 28, 19X6, is herein referred to as the registration statement. In connection

with the registration statement—

1. We are independent certified public accountants with respect to the

company within the meaning of the Act and the applicable rules and regulations

thereunder adopted by the SEC.

2. In our opinion [include the phrase "except as disclosed in the registration

statement," if applicable], the consolidated financial statements and

financial statement schedules audited by us and included in the registration

statement comply as to form in all material respects with the applicable

Going Public 507

accounting requirements of the Act and the related rules and regulations

adopted by the SEC.

3. We have not audited any financial statements of the company as of any

date or for any period subsequent to December 31, 19X5; although we have

conducted an audit for the year ended December 31, 19X5, the purpose (and

therefore the scope) of the audit was to enable us to express our opinion on the

consolidated financial statements as of December 31, 19X5, and for the year

then ended, but not on the financial statements for any interim period within

that year. Therefore, we are unable to and do not express any opinion on the

unaudited condensed consolidated balance sheet as of March 31, 19X6, and the

unaudited condensed consolidated statements of income, retained earnings

(stockholders' equity), and cash flows for the three-month periods ended

March 31, 19X6 and 19X5, included in the registration statement, or on the financial

position, results of operations, or cash f lows as of any date or for any

period subsequent to December 31, 19X5.

4. For purposes of this letter we have read the 19X6 minutes of meetings

of the stockholders, the board of directors, and [include other appropriate

committees, if any] of the company and its subsidiaries as set forth in the

minute books at June 23, 19X6, officials of the company having advised us that

the minutes of all such meetings through that date were set forth therein; we

have carried out other procedures to June 23, 19X6, as follows (our work did

not extend to the period from June 24, 19X6, to June 28, 19X6, inclusive):

a. With respect to the three-month periods ended March 31, 19X6

and 19X5, we have—

(1) Performed the procedures specified by the American Institute

of Certified Public Accountants for a review of interim financial information

as described in SAS No. 71, Interim Financial Information,

on the unaudited condensed consolidated balance sheet as of

March 31, 19X6, and unaudited condensed consolidated statements

of income, retained earnings (stockholders' equity), and cash flows

for the three-month periods ended March 31, 19X6 and 19X5, included

in the registration statement.

(2) Inquired of certain officials of the company who have responsibility

for financial and accounting matters whether the unaudited

condensed consolidated financial statements referred to in a(1) comply

as to form in all material respects with the applicable accounting

requirements of the Act and the related rules and regulations

adopted by the SEC.

b. With respect to the period from April 1, 19X6, to May 31, 19X6, we

have—

(1) Read the unaudited consolidated financial statements of the

company and subsidiaries for April and May of both 19X5 and 19X6

508 Making Key Strategic Decisions

furnished us by the company, officials of the company having advised

us that no such financial statements as of any date or for any

period subsequent to May 31, 19X6, were available.

(2) Inquired of certain officials of the company who have responsibility

for financial and accounting matters whether the unaudited

consolidated financial statements referred to in b(1) are stated on a

basis substantially consistent with that of the audited consolidated

financial statements included in the registration statement.

The foregoing procedures do not constitute an audit conducted in accordance

with generally accepted auditing standards. Also, they would not necessarily

reveal matters of significance with respect to the comments in the

following paragraph. Accordingly, we make no representations regarding the

sufficiency of the foregoing procedures for your purposes.

5. Nothing came to our attention as a result of the foregoing procedures,

however, that caused us to believe that—

a. (1) Any material modifications should be made to the unaudited

condensed consolidated financial statements described in 4a(1), included

in the registration statement, for them to be in conformity

with generally accepted accounting principles.

(2) The unaudited condensed consolidated financial statements described

in 4a(1) do not comply as to form in all material respects

with the applicable accounting requirements of the Act and the related

rules and regulations adopted by the SEC.

b. (1) At May 31, 19X6, there was any change in the capital stock, increase

in long-term debt, or decrease in consolidated net current assets

or stockholders' equity of the consolidated companies as

compared with amounts shown in the March 31, 19X6, unaudited

condensed consolidated balance sheet included in the registration

statement, or

(2) for the period from April 1, 19X6, to May 31, 19X6, there were

any decreases, as compared to the corresponding period in the preceding

year, in consolidated net sales or in the total or per-share

amounts of income before extraordinary items or of net income, except

in all instances for changes, increases, or decreases that the registration

statement discloses have occurred or may occur.

6. As mentioned in 4b, company officials have advised us that no consolidated

financial statements as of any date or for any period subsequent to

May 31, 19X6, are available; accordingly, the procedures carried out by us with

respect to changes in financial statement items after May 31, 19X6, have, of necessity,

been even more limited than those with respect to the periods referred

to in 4. We have inquired of certain officials of the company who have responsibility

for financial and accounting matters whether

Going Public 509

(a) at June 23, 19X6, there was any change in the capital stock, increase

in long-term debt, or any decreases in consolidated net current assets or

stockholders' equity of the consolidated companies as compared with

amounts shown on the March 31, 19X6, unaudited condensed consolidated

balance sheet included in the registration statement or

(b) for the period from April 1, 19X6, to June 23, 19X6, there were any

decreases, as compared with the corresponding period in the preceding

year, in consolidated net sales or in the total or per-share amounts

of income before extraordinary items or of net income. On the basis of

these inquiries and our reading of the minutes as described in 4, nothing

came to our attention that caused us to believe that there was any

such change, increase, or decrease, except in all instances for changes,

increases, or decreases that the registration statement discloses have

occurred or may occur.

7. This letter is solely for the information of the addressees and to assist

the underwriters in conducting and documenting their investigation of the affairs

of the company in connection with the offering of the securities covered

by the registration statement, and it is not to be used, circulated, quoted, or otherwise

referred to within or without the underwriting group for any purpose,

including but not limited to the registration, purchase, or sale of securities, nor

is it to be filed with or referred to in whole or in part in the registration statement

or any other document, except that reference may be made to it in the underwriting

agreement or in any list of closing documents pertaining to the

offering of the securities covered by the registration statement.

510

15 THE BOARD

OF DIRECTORS

Charles A. Anderson

Robert N. Anthony

This chapter describes the nature and function of the board of directors,

which has the ultimate responsibility for governing a corporation. It describes

the board's activities in normal meetings, in strategy meetings, and in special

situations, and it describes the work of three important board committees: the

compensation committee, the audit committee, and the finance committee.

We focus on large corporations whose stock is listed on a securities exchange.

These corporations must conform to regulations of the Securities and

Exchange Commission. Most of the discussion is also relevant to boards of

smaller corporations.

WHY HAVE A BOARD OF DIRECTORS?

Every corporation is required by law to have a board of directors. The board's

legal function is to govern the corporation's affairs. However, in a small corporation

in which the chief executive officer (CEO) is also the controlling shareholder,

the CEO actually governs and the board acts primarily as an adviser.

When a corporation grows to a size where it needs outside capital, it may

go public by selling shares of stock (as explained in Chapter 14), and the board

then represents the interests of these shareholders. The shareholders, who are

the owners of the corporation, have a say in the way their company is run.

They expect to receive regular, reliable reports on the company's operations.

If the company is profitable, they probably expect to receive dividends. If the

The Board of Directors 511

company has problems, the owners need to know about these problems so that

they can take any necessary remedial action.

A corporation may have many shareholders; American Telephone & Telegraph

Corporation has 2.6 million. Individual shareholders obviously can't govern

the company directly; moreover, most of them are engaged in their own

pursuits and will not give much, if any, time to governance. They elect people

to act for them. This is the board of directors.

SIZE AND COMPOSITION OF THE BOARD

The typical board has about 11 members. Some boards, especially those in

banks, are much larger. Large boards must delegate much of their work to an

executive committee for overall matters and to several committees for specific

topics.

Most board members typically are "outside directors"; that is, they are

not employees of the corporation. At one time, most board members were "inside

directors," and this is still the case in a few boards. The trend toward outside

directors results from the shareholders' recognition that the board should

have a significant degree of independence from the company's management.

The board is responsible for selecting, appraising, and compensating management.

If the board and management are the same people, the board can hardly

perform its governance role in an objective manner.

Many outside board members are CEOs or senior officers of other corporations

(but not competitors). Other outsiders are lawyers, bankers, physicians

(on health-care boards), scientists and engineers (on high-tech boards), retired

government officials, and academics. A few people are professional board

members; that is, their principal occupation is serving on boards. The number

of female and minority board members has increased substantially in recent

years. The CEO and perhaps one or two senior members of management typically

are members of the board.

Board members are compensated. Generally, they receive an annual retainer

plus a fee for meetings attended. In addition, many companies offer

some form of stock compensation and retirement benefits. According to a

Conference Board survey, the median basic annual compensation in manufacturing

companies for 1999 (not including stock components) was $35,000.

When the value of the stock component was added, compensation totaled

$46,000.

Board members are elected at the annual meeting of shareholders. The

shareholders almost always elect the slate proposed by the incumbent board;

thus, as a practical matter, the board is self-perpetuating. The process of selecting

candidates for filling board vacancies is an important board function.

Many have staggered terms; that is, one-third of the board members are

elected each year for a three-year term. This practice is intended to make it

more difficult for corporate raiders to obtain control of the company.

512 Making Key Strategic Decisions

BOARD MEMBER RESPONSIBILITIES

In the following sections, we describe the specific activities for which the

board is responsible. In this section, we describe the responsibilities of individual

board members.

Board members must not personally buy stock or sell their own stock immediately

after they learn of important developments at board meetings or

other activities. Examples of relevant developments include current estimates

of earnings, change in dividend policy, a decision to acquire another company

or to buy back stock, and changes in senior management. The Securities and

Exchange Commission and rules of the stock exchanges impose an "earnings

blackout" period of one or two days in which such trading is prohibited.

Board members and management must not disclose any of these events to

a selected group of interested parties. For example, they must not make a telephone

conference call to a selected group, send an Internet message to them, or

disclose information at a meeting of such a group. When this information is disclosed,

it must be made available at the same time to the general public. These

rules were significantly tightened in 1999 and 2000 by SEC Regulation FD.

RELATION TO THE CHIEF EXECUTIVE OFFICER

Their titles indicate that the board of directors "directs" and the chief executive

officer "executes" the board's directions, but these terms are not an accurate

description of the roles of these two parties. In the majority of companies,

the chief executive officer is also the board's chairman and is the principal architect

of policies. Executing these policies is indeed a primary responsibility.

The CEO is truly the "chief."

The board selects the CEO and, therefore, wants to give the CEO its full

support. The CEO is accountable to the board and may be terminated if the

board decides that the individual's performance was unsatisfactory.

The appropriate relationship is one of trust. The board must believe that

the CEO is completely trustworthy, provides the board with all the information

it wants and needs, withholds nothing, and doesn't slant arguments to support

a preconceived position. The CEO, in turn, must believe that he or she has

the full support of the board.

Appraising the CEO

A board's major responsibility is to appraise the CEO. If performance is below

expectations, there are two possible explanations: (1) The CEO is to blame, or

(2) extraneous inf luences are responsible. In most cases, both factors are involved,

and the directors have the extraordinarily difficult job of judging their

relative importance. If they conclude that the CEO has made an incorrect decision,

they may suggest a different course of action. More likely, however, they

The Board of Directors 513

may say nothing and mentally file the incident for future reference in evaluating

the CEO. The Business Roundtable, a group of CEOs of leading companies,

succinctly described the directors' role vis-a-vis the CEO as "challenging, yet

supportive and positive."

An important function of board meetings, conversations, and even social

occasions is to give the directors a basis for continuously appraising the CEO.

Directors usually cannot make constructive suggestions on the details of current

operations. Occasionally, they may call attention to a matter that should be

investigated. Primarily, however, they listen carefully to what the CEO says

and do their best to judge whether things are going satisfactorily and, if not,

where the responsibility lies.

The directors want the CEO to be frank and to give an accurate analysis

of the company's status and prospects; concealing bad news is one of the worst

sins a CEO can commit. Nevertheless, human nature is such that directors cannot

expect the CEO to be completely objective. Incipient problems may go

away, and making them known, even in the relative privacy of the boardroom,

may cause unnecessary alarm. Directors, therefore, are on the alert for indications

of significant problems. In many well-publicized bankruptcies of public

companies, the directors were significantly responsible; they did not identify

or act on the problem soon enough.

Louis B. Cabot, former chairman of the board of Cabot Corporation, had

a frustrating experience with the ill-fated Penn Central Corporation. He joined

the Penn Central board about a year before the company went under. From the

outset, he was disturbed by management's unwillingness to furnish the information

about performance that he felt he needed. A few months after joining

the board, he wrote the CEO a letter that contains the following succinct description

of the director's role:

I believe directors should not be the managers of a business, but they should ensure

the excellence of its management's performance. To do this, they have to

measure that performance against agreed-upon yardsticks.

The Next CEO

The board cannot tell beforehand whether a candidate will make a good CEO.

The best indicator is how well the individual performs in his or her current job.

In most instances, therefore, the board looks to senior executives with proven

track records as candidates for the CEO position. One of the most important

responsibilities that a board assigns to a CEO is to develop a succession plan

for the company's senior managers. The purpose of such a plan is to identify

potential CEO candidates, provide them with opportunities for growth, and

groom them for higher level positions. The board participates actively in this

process by meeting with the CEO (usually once a year) in a meeting devoted

largely to reviewing the senior management. Typical questions asked are: How

is a key executive performing? What is his or her potential? Who are potential

successors for the CEO, now and in the future?

514 Making Key Strategic Decisions

At one company the authors are familiar with, the chairman and CEO

held an annual meeting of the outside directors to discuss succession. He referred

to it as the "truck meeting" because he always started with the question,

"Suppose I am run over by a truck tomorrow. What will you do?" At this meeting,

two, and sometimes three, managers were identified as potential CEOs.

Individuals were added to or eliminated from the list and their relative ranking

changed. When this process works properly, an agreed upon CEO candidate is

available in an emergency, and a person who will take over from a retiring

CEO in normal succession is identified.

If boards fail to deal effectively with succession, they may be forced to go

outside the company for a new CEO. Under most circumstances, this increases

the risk that the CEO will not succeed since chances for a successful succession

are usually better when the CEO position is filled by a proven executive

from within the organization. In some cases, an organization may need a "shaking

up" and the board may elect to go outside for a CEO who can give the organization

new life.

NORMAL BOARD MEETINGS

Most boards meet eight, nine, or ten times a year. Some meet only quarterly,

and a few meet every month. The typical meeting lasts two to three hours, but

it may go considerably longer if contentious issues arise.

Premeeting Material

Prior to the meeting, board members are sent an agenda and a packet of material

on topics to be discussed. This homework usually requires several hours of

work. Directors may query the CEO, in person or by a phone call before the

meeting, on matters that require clarification.

Current Situation and Outlook

The first substantive topic on a meeting's agenda usually is a discussion of current

information about the company and its outlook. The CEO leads this discussion,

perhaps delegating part of it to another senior officer. Much of the

information is financial—that is, condensed income statements for each division

or for groups of division, corporate expenses, and key balance sheet items,

such as inventory and receivable amounts. There are three ways to present this

financial information:

1. Compare management's current estimate of performance for the whole

year with budgeted performance for the year. What is the current estimate

of how the company will perform for the whole year? This is the

most important type of information. However, it is also the most sensitive,

and many CEOs do not circulate it prior to the meeting.

The Board of Directors 515

2. Compare actual performance with budgeted performance for the current

period and for the year to date. Because the actual numbers are firm,

they provide a more objective basis for analysis than the current estimate

for the whole year.

3. Compare actual current performance with performance for the same period

last year. A carefully prepared budget incorporates changes in the

business and the economy that have occurred since the prior year, and

this is a more meaningful basis for comparison than last year's numbers.

If, however, the budgeted amounts, particularly the estimate of revenue,

are highly uncertain, the numbers for last year provide a firmer foundation

for comparison.

Variances between actual and budgeted performance are discussed. Are

unfavorable variances temporary? If not, what steps will be taken to eliminate

them, or, if they result from unforeseen outside forces, what adjustments in the

company's operations will be made?

By reviewing the company's financial performance and raising questions

or making suggestions to management, directors form judgments regarding the

company's affairs. Preparing and presenting to the board a report on the company's

performance is an important discipline for management.

Other Actions

Next, a number of proposed actions are submitted for board approval. Many

of these recommendations come to the full board from committees that have

discussed the topics in meetings held prior to the board meeting; these are

described later in this chapter. Questions may be raised about the recommendations,

but usually they are requests for clarification. Board members

rely on committee members to explore these matters thoroughly; there is not

enough time to do so in the full board meeting. Unless new information surfaces,

these recommendations typically are approved.

The board also deals with a number of routine items. These include requests

for approval of capital projects, of signature authority for various

banking connections, of exceptions to pension plans, and of certain types of

contracts. Except for large capital projects, these items are usually referred to

as "boilerplate." In most cases, they come to the board because state law, corporate

bylaws, or written policy requires board action. They are approved with

little discussion, sometimes en bloc, despite the fact that the minutes may state

for each of them, "After a full discussion, a motion to adopt the recommendation

was duly made and seconded, and the motion was approved."

Education

A division manager, assisted by senior associates, may report on the activities

of the division. This is an educational experience for the directors. (Some

516 Making Key Strategic Decisions

board meetings may be held at company plants or other facilities; this also is a

valuable educational device.)

The meeting itself and the informal activities that usually are associated

with it are also educational. Directors have an opportunity to appraise both

company officials and their own colleagues. Judgments about these individuals

may be valuable if the board is required at some time to deal with a crisis

situation.

Setting Standards

Partly through written policy statements, but primarily through their attitudes,

directors communicate to management the standards that they believe

should govern the organization's actions. There are two general types of standards;

they might be labeled economic standards and ethical standards, although

neither term is precisely correct.

With respect to economic standards, the directors communicate the overall

goals they believe the company should attain: the relative importance of

sales growth, earnings per share and return on investment, and the specific

numbers that they believe to be attainable. The board also indicates the relative

importance of short-run versus long-run performance. In the final analysis,

board members generally rely on management's recommendations, but the

enthusiasm, or lack of enthusiasm, with which they support a given recommendation

conveys an important message to management.

Ethical standards are nebulous. Written policy statements are always impeccably

virtuous, but directors' actual expectations are revealed in the way

they react to specific ethical problems. How does the company deal with its female

and minority employees? What happens to an employee who has a drinking

problem? Does the company have a policy concerning support for the

communities in which it operates? These and many other issues are loaded

with ethics, and the manner in which the board reacts to them establishes the

real policy, regardless of what is in a written statement.

It is easy to rely on counsel's answer to the question, Must we report this

unpleasant development to the Securities and Exchange Commission? The answer

depends on the legal interpretation of the regulations. It is much more difficult

for the directors to agree, and to convey to management, that certain

policies or practices, although perhaps within the letter of the law, should not be

allowed or sanctioned. Examples include environmental considerations, employment

practices in Third World countries, and involvement in political issues.

STRATEGY

A company should have a set of strategies that are well thought out and clearly

understood by all managers. Strategies include the industry in which the company

has decided to operate, its product lines within this industry, the price

The Board of Directors 517

and quality position of these products, the targeted customers and markets

(local, regional, national, international), the company's distribution channels

(direct sales, dealers, distributors), marketing policies (advertising, sales promotion),

manufacturing policies (in-house production, plant locations, outside

sourcing), financial policies (balance among borrowing, equity financing, retained

earnings), and others.

The board usually does not have the knowledge necessary to initiate a

strategy or to decide among alternative strategies. It must rely on management

to take the initiative, make the necessary analyses, and bring its recommendations

to the board. What the board can and should do is described by Kenneth

R. Andrews in The Concept of Corporate Strategy.1 He writes, as a summary,

A responsible and effective board should require of its management a unique

and durable corporate strategy, review it periodically for its validity, use it as

the reference point for all other board decisions, and share with management

the risks associated with its adoption.

While it is unrealistic to expect directors to formulate strategies, they

should satisfy themselves that management has a sound process for developing

them. The strategy is probably acceptable if:

• It is based on careful analysis by people who are in the best position to

evaluate it, rather than on an inspiration accepted without study.

• The reasoning seems sensible.

• No significant information has been omitted from the analysis.

• The results expected from the strategy are clearly set forth so that actual

accomplishment can be compared with them.

Strategy Meetings

As a basis for considering strategic plans, many companies arrange a meeting at

which directors, together with senior managers, spend one, two, or three days

discussing where the company should be headed. In order to minimize distractions

and provide an opportunity for informal discussion and ref lection, these

meetings are often held at a retreat that is distant from the corporate offices.

While company practices differ widely, it is not uncommon for meetings devoted

primarily to strategic issues to be held every year or two.

The primary purpose of a strategy meeting is for management to explain

current and planned strategies and the rationales for them. The explanations

provide useful information to the directors. The quality of the rationale for the

strategies indicates the competence of senior management and the managers of

the divisions concerned. Thus, the strategies provide additional insight about

the abilities of the CEO and the participants who may be CEO candidates.

Once adopted, a corporate strategy must be adhered to. Management

brings to the board for decision and approval many matters that may impact a

company's strategy—major capital expenditures, acquisitions, divestitures, and

518 Making Key Strategic Decisions

financing proposals. The board ensures that these proposals are consistent with

the adopted strategy. If they are not, the company can drift off course and may

get into serious trouble.

DEALING WITH MAJOR CRISES

In addition to its regular activities, a board occasionally must deal with crises.

These usually arise unexpectedly and require special board meetings. We describe

two of these: terminating the CEO and dealing with takeover attempts.

Terminating the CEO

There are times when a board must replace the CEO. Failure to act in time is

a major criticism of some boards. Although such criticism may be justified one

should recognize that it is much easier for an outside observer to criticize than

to be in the shoes of the directors who are faced with this decision.

The decision to replace a CEO is subjective and usually emotional. Sometimes

there are compelling reasons for taking action—for example, when the

CEO is becoming an alcoholic or when his or her corporate performance has

dramatically deteriorated. In most instances, however, the case is not so clear.

Earnings may not have kept pace with industry leaders because the board discouraged

management from assuming additional debt that would have enabled

the company to expand. Or perhaps the board supported a major acquisition

that did not work out. In such instances, it is not obvious that the CEO is primarily

at fault.

There are, however, several important signals that can alert a board to

question the CEO's capabilities:

Loss of confidence in the CEO. If a significant number of directors have

lost confidence in, or no longer trust, the CEO, the individual should be

replaced.

Continuing deterioration in corporate results. Earnings may be significantly

below industry norms or below the budget without an adequate explanation.

The board must act before it is too late.

Organizational instability. A CEO who consistently has problems retaining

qualified senior executives probably should be replaced.

These problems are especially serious in the many new companies springing

up in information technology industries. In these industries, change is

rapid, competition is severe, there are no track records on which to base judgment,

and stock prices may change by huge percentages in a few days, ref lecting

changes in investors' opinions about the company's outlook.

It is one thing for board members to begin to doubt the CEO's capabilities,

but it is quite another thing for them to demonstrate the courage and

The Board of Directors 519

consensus needed to take action. The CEO and the directors usually have

worked together for some time; they are good, perhaps close, friends. For the

CEO, dismissal is a catastrophic event. Taking action that will probably destroy

the career of a business associate is a difficult decision.

Replacing the CEO precipitates a crisis, not only for the board but also for

the entire organization. When it happens, the board must be prepared to announce

a successor and to deal with the problems inherent in the transfer of executive

authority. Such action puts a major burden on the outside directors.

Nevertheless, this is their responsibility to the shareholders and to the other

constituencies of the corporation.

For example, in early 2000, Jill E. Barad, CEO of Mattel Inc. the world's

largest toy manufacturer "resigned." Ms. Barad built one of Mattel's f lagship

products, the Barbie doll, from $250 million in annual sales in the mid-1980s to

$1.7 billion in 1999. In the late 1980s, Barbie's growth slowed, and Ms. Barad

turned to acquisitions. Unfortunately, several acquisitions failed to live up to

expectations. A loss of $82 million was recorded for 1999, and Mattel's stock

price dropped from a high of $45 in 1998 to a low of $11 in early 2000. The

board acted, and Ms. Barad "resigned." Apparently the board decided that

there was no suitable successor within the company. They selected Robert

Eckel, formerly CEO of Kraft Foods to be the new CEO.

The turnover of CEOs of major corporations seems to be accelerating in

the twenty-first century. Mr. William Rollinick, a Mattel board member and former

acting chairman, observed that when a chief executive stumbles, "there's

zero forgiveness. You screw up and you're dead." The investing community puts

boards under considerable pressure to act when things appear to be going wrong.

Sarah Telsik, executive director of the Council of Institutional Investors, which

represents 110 pension funds with more than $1.5 trillion in assets, believes that

underperforming CEOs were not losing their jobs fast enough.

Too fast or too slow? A board should decide what is in the long-term best

interests of the company and its stockholders. In some instances, immediate

pressures should be resisted in favor of long-term considerations. In other

cases, the board should "bite the bullet." The decision is not easy.

Unfriendly Takeover Attempts

Another crisis event is the hostile, or unfriendly, takeover attempt. Board decisions

vital to the company's future—even its continued existence—must be

made in circumstances in which emotions are high, vested interests are at

stake, and advice is often conf licting. The business press reports daily the dramatic

developments of offers and counteroffers, tactics, and strategies as each

side in the struggle seeks to gain an advantage. Boards and management spend

much time preparing offensive and defensive plans.

One of the problems in takeover situations is that the board, which represents

the shareholders, may have interests that differ from those of management.

In most successful unfriendly takeovers, the senior managers of the

520 Making Key Strategic Decisions

target company lose their jobs. A common accusation, therefore, is that management

resists takeovers in order to entrench itself, even though the deal

would result in a handsome gain for the shareholders.

In these situations, directors must exercise great care in making a decision

that is in the shareholders' interests. This is not always easy to determine.

What is the intrinsic value of the corporation? What is the real value of the

"junk bonds" being offered to the shareholders? What consideration, if any,

should the directors give to the interests of other parties—employees, communities,

suppliers, and customers?

In an unfriendly takeover attempt, the directors of the target company

must rely on legal advice since takeovers inevitably lead to lawsuits. The board

also depends on expert advice from investment banks about the value of the

company and the true value of offers to acquire it.

In practice, when a hostile takeover is initiated, the target company's

lawyers, investment bankers, accountants, and other advisers, together with

the board and management, become involved in a hectic struggle that can last

for weeks or months. It is a sixteen-hour-day, seven-day-week effort; nearly

everything else yields to the intense preoccupation with survival or striking the

best possible deal.

BOARD COMMITTEES

Much of the board's work is done in committees. They meet before board

meetings, hear reports, and prepare summaries and recommendations for full

board action. In this section, we describe the activities of the three committees—

compensation, audit, and finance—that deal with finance and accounting

matters.

COMPENSATION COMMITTEE

The board determines the compensation of the CEO and the other principal

corporate officers. In many boards, a compensation committee, composed of

outside board members, analyzes what compensation should be and makes its

recommendations to the full board.

The SEC requires that a section of the proxy statement, issued prior to

the annual meeting of shareholders, must describe the work of the compensation

committee, the decisions on compensating senior executives, reasons for

the decision, their compensation for the past three years, and comparisons with

other companies in the industry.

CEO Compensation

When the board sets the CEO's compensation, it is establishing a compensation

standard for managers throughout the company. Their compensation is integrally

The Board of Directors 521

related to the CEO's and this, therefore, is the single most important compensation

decision the board must make.

In most instances this decision is not easy. Most CEOs are ambitious and

competitive, and compensation is their report card. Since proxy statements disclose

the compensation of all CEOs of public companies, each CEO is able to

see just where he or she stands in relation to others. Virtually every CEO would

like to stand higher on that list.

Compensation committees consider three principal factors. The CEO's

compensation should: (1) be related to performance, (2) be competitive, and

(3) provide motivation. Compensation includes not only salary but also

perquisites and, in most companies, long-term incentive arrangements, such as

stock options or performance-share plans. These plans, however, are far from

perfect, and compensation committees constantly struggle to find new

arrangements or formulas in an effort to relate compensation more closely

to performance.

Performance

The CEO's compensation should be related to performance. Superior performance

should be rewarded with high compensation, while poor performance,

if it does not warrant dismissal, should at least result in decreases or minimal

increases in compensation.

There is justification for the claim that in some companies top-executive

compensation continues to climb without regard to performance. The problem

is complex. In theory, the CEO should be rewarded for increasing the shareowner's

wealth over the long term. Although this is a splendid generalization,

the criterion is hard to measure, especially on a year-to-year basis.

Competitive Range

Compensation committees look at the CEO's compensation relative to that of

competitors. They can be sure that their CEO has this information and is likely

to be unhappy if the compensation is perceived as unfair or not competitive.

There are many sources for salary information. They include proxy statements

from similar organizations and published surveys. Some consulting organizations

specialize in executive compensation; they provide data and advice

on these matters. In the end and with all of the information at hand, the committee

makes its judgment as to where in the competitive spectrum they want

the CEO's compensation to fall.

Motivation

Compensation committees ask themselves, How can we structure a compensation

package that motivates the CEO to do what the board expects? If the

company has a plan to move aggressively and take unusual risks in the near

term, with the possibility of significant long-term payoff, the committee can

522 Making Key Strategic Decisions

structure a compensation plan for the CEO that will reward that kind of behavior.

For example, the CEO might have a multiyear contract that provides assurance

of employment during the high-risk phase, as well as a long-term stock

option plan. At the other extreme, a mature company might be interested in

moderate growth but steady dividends. The compensation committee might

then structure a plan weighted heavily toward a fixed salary, reviewed annually,

with only modest incentive features.

There are many types of compensation arrangements: base salary reviewed

annually, base salary plus annual discretionary bonus, base salary

with bonus based on a formula, stock option plans, performance share plans,

and multiyear incentive plans. Benefits play an important part in CEO compensation

arrangements, especially retirement programs. Each plan has its

own motivational features, and the compensation committee attempts to

structure a plan that provides the motivation for the CEO that the board

wants to generate.

Compensation Reviews

In addition to deciding the CEO's compensation, the committee also determines

compensation for the other senior executives—that is, corporate officers

and others whose salary is above a stated level. The review process usually

takes place at a meeting that brings together the compensation committee, the

CEO, and the staff officer concerned with compensation and personnel

policies.

At this meeting the CEO describes the compensation history of, and

makes a recommendation for, each executive. Usually, a few of the recommendations

are discussed, and a few changes may be made. For the most part, however,

the committee accepts the CEO's recommendations. Nevertheless, the

review process is important. It enables the compensation committee to be sure

that the CEO is following sensible guidelines and consistent policies and is not

playing favorites. It also serves to remind the CEO that recommendations to

the committee must be justified.

Board Remuneration

The compensation committee also recommends compensation arrangements

for the board members. Obviously, this is a delicate matter because the board

is disbursing company funds (actually shareholder funds) to its members.

Directors' compensation is disclosed on the annual proxy statement. Most

companies would like to see their directors "respectably" compensated and,

while compensation usually is not the compelling reason for holding a directorship,

directors want to feel that they are being compensated on a competitive

basis. On the other hand, most directors want to feel that their compensation is

not excessive and that they will never be criticized for compensating themselves

improperly.

The Board of Directors 523

Much survey information is available on board retainer fees, board meeting

fees, and compensation for committee chairs to help reach a balanced level

of compensation.

AUDIT COMMITTEE

The audit committee is responsible for ensuring that the company's published

financial statements are presented fairly in conformance with generally accepted

accounting principles (GAAP), and that the company's internal control

system is effective. Furthermore, the audit committee deals with important

cases of alleged misconduct by employees, including violations of the company's

code of ethics. It also ratifies the selection of the company's external auditor.

All companies listed on major stock exchanges are required to have audit

committees, and most other corporations have them. The SEC requires at least

three members of the audit committee to be "financial literate or to become financial

literate within a reasonable period of time."2

Responsibility

Although the full board can delegate certain functions to the audit committee,

this delegation does not relieve individual board members of their responsibility

for governance. In its 1967 decision in the BarChris case, the federal court

emphasized this fact:3

Section 11 [of the Securities Act of 1933] imposes liability in the first instance

upon a director, no matter how new he is. . . . He is presumed to know his responsibility

when he became a director. He can escape liability only by using

that reasonable care to investigate the facts which a prudent man would employ

in the management of his own property.

Directors have directors' and officers' (D&O) insurance, but this only

partially protects them against loss from lawsuits claiming that they acted improperly.

Recent decisions suggest that courts are increasingly willing to examine

directors' decisions. For example, the shareholders of Oxford Health Care

sued the company for misleading financial statements. Oxford's stock price

thereupon fell by 50%, a $14 billion drop in market value. The company reportedly

agreed to settle the case for $2.83 billion. In the 1990s, there were

more than 100 fraud actions annually against SEC firms and many more against

smaller firms.

Audit committee members walk a tightrope. On one hand, they want to

support the CEO—the person whom the board itself selected. On the other

hand, they have a clear responsibility to uncover and act on management inadequacies.

If they do not, the entire board of directors is subject to criticism

at the very least and imprisonment at worst. Their task is neither easy

nor pleasant.

524 Making Key Strategic Decisions

Published Financial Statements

The audit committee does not conduct audits; it relies on two other groups to

do this. One is the outside auditor, a firm of certified public accountants. All

listed companies are required to have their financial statements examined by

an outside auditor, and most other corporations do so in order to satisfy the requirements

of banks and other lenders. The other group is the company's internal

audit staff, a group of employees whose head reports to a senior officer,

usually the CEO or chief financial officer (CFO).

Selection of Auditors

Ordinarily, management recommends that the current auditing firm be appointed

for another year and that its proposed audit scope and fee schedule be

adopted. After some questioning, the audit committee usually recommends approval.

The recommendation is submitted to shareholders in the annual meeting.

Occasionally, the audit committee gives more than routine consideration

to this topic.

There may be advantages to changing auditors, even when the relationship

between the audit firm and the company has been satisfactory for several

years. One advantage is that the process of requesting bids from other firms

may cause the current firm to think carefully about its proposed fees. However,

the public may perceive that a change in outside auditors indicates that

the superseded firm would not go along with a practice that the company

wanted. The SEC requires that when a new auditing firm is appointed, the reason

for making the change must be reported on its Form 8-K. Also, because a

new firm's initial task of learning about the company requires management

time, management may be reluctant to recommend a change.

Public accounting firms often perform various types of consulting engagements

for the company: developing new accounting and control systems,

analyzing proposed pension plans, and analyzing proposed acquisitions. Fees

for this work may exceed the fees for audit work. The SEC and the stock exchanges

have strict rules that prohibit a public accounting firm from conducting

an audit if it has consulting engagements with the corporation that might

affect the objectivity of the audit. Some auditing firms have responded to

these rules by setting up a separate firm to conduct these engagements.

The Audit Opinion

In its opinion letter, the public accounting firm emphasizes the fact that management,

not the auditor, is responsible for the financial statements. Almost all

companies receive a "clean opinion"; that is, the auditor states that the financial

statements "present fairly, in all material respects" the financial status and

performance of the company in accordance with GAAP. Note that this statement

says neither that the statements are 100% accurate nor whether different

The Board of Directors 525

numbers would have been more fair.4 The audit committee's task is to decide

whether the directors should concur with the outside auditor's opinion and, occasionally,

to resolve differences when auditors are unwilling to give a clean

opinion on the numbers that management proposes.

Management has some latitude in deciding the amounts to be reported,

especially the amount of earnings. Since managers are human beings, it is

reasonable to expect them to report performance in a favorable light. Examples

of this tendency, discussed next, are: (1) accelerating revenue, (2) smoothing

earnings, (3) reporting unfavorable developments, and (4) the "big bath."

Much of the discussion of these topics is complicated by differences in the

meaning of "materiality." The SEC has tried to lessen the reliance on materiality

by publishing detailed descriptions of what the term means.

Accelerating Revenue

A company may go to great lengths to count revenues actually earned in future

periods as revenues in the current period, even though this decreases the next

period's revenues. The following example illustrates:

The SEC sued two executives of Sirena Apparel Group for misleading revenue

estimates for the quarter ended March 31, 1999. They instructed employees

daily to set back the computer clock that entered the dates on invoices until a

satisfactory revenue amount was recorded. Invoices dated from April 12, 1999,

were set back.5

Not all attempts to accelerate revenue recognition are improper. There

are documented stories of managers who personally worked around the clock

at year-end, packing goods in containers for shipment. This enabled them to

count the value of the packed goods as revenue in the year that was about to

end. Counting goods that actually were shipped as revenue is legitimate.

Smoothing Earnings

There is a widespread belief (not necessarily supported by the facts) that ideal

performance is a steady growth in earnings, certainly from year to year, and

desirably from quarter to quarter. Within the latitude permitted by GAAP,

therefore, management may wish to smooth reported earnings—that is, to

move reported income from what otherwise would be a highly profitable period

to a less profitable period. The principal techniques for doing this are to

vary the adjustments for inventory amounts and bad debts, and estimated returns,

allowances, and warranties.

The audit committee, therefore, pays considerable attention to the way

these adjustments and allowances are calculated and to the resulting accounts

receivable, inventory, and accrued liability amounts. Changes in the reserve

percentages from one year to the next are suspect. The audit committee tolerates

a certain amount of smoothing, within limits. Indeed, it may not be aware

526 Making Key Strategic Decisions

that smoothing has occurred. Outside these limits, however, the committee is

obligated to make sure that the reserves and accrual calculations are reasonable.

Management may also recommend terminology that does not affect net

income but does affect income from operating activities. Examples are earnings

before marketing costs, cash earnings per share, earnings before losses on

new products, and pro forma earnings. None of these terms is permitted in

GAAP; they appear in press releases and speeches.

Reporting Unfavorable Developments

The Securities and Exchange Commission requires that its Form 8-K report be

filed promptly whenever an unusual material event that affects the financial

statements becomes known. The principal concern is with the bottom line, the

amount of reported earnings. Management, understandably, may be inclined

not to report events that might (or might not) have an unfavorable impact on

earnings. These include the probable bankruptcy of an important customer, an

important inventory shortage, a reported cash shortage that might (or might

not) turn out to be a bookkeeping error, a possibly defective product that could

lead to huge returns or to product liability suits, possible safety or environmental

violations, an allegation of misdeeds by a corporate officer, the departure

of a senior manager, or a lawsuit that might (or might not) be well founded.

It is human nature to hope that borderline situations will not actually have a

material impact on the company's earnings.

Furthermore, publicizing some of these situations may harm the company

unnecessarily. Disclosing a significant legal filing against the company is necessary,

but disclosing the amount that the company thinks it might lose in such

litigation, in a report that the plaintiff can read, would be foolish.

In any event, the audit committee should be kept fully informed about all

events that might eventually require filing a Form 8-K. One might think that

the CEO would welcome the opportunity to inform the board of these events

because this shifts the responsibility for disclosure to the board. But managers,

like most human beings, prefer not to talk about bad news if there are reasonable

grounds for waiting a while.

Occasionally, a manager may attempt to "cook the books," that is, to produce

favorable accounting results by making entries that are not in accordance

with GAAP. The audit committee must rely on the auditors (or occasionally on

a whistle-blower) to detect these situations.

The Big Bath

A new CEO may "take a big bath"; that is, the accounting department may be required

to write off or write down assets in the year he or she takes over, thereby

reducing the amount of costs that remain to be charged off in future periods.

This increases the reported earnings in the periods for which the new management

is responsible. Since the situation that led to the replacement of the former

The Board of Directors 527

manager may justify some charge-offs, and since the directors don't want to disagree

with the new chief executive officer during the honeymoon period, this

tactic is sometimes tolerated. If the inf lated earnings lead to extraordinarily

high bonuses in future years, the board may regret its failure to act.

Audit Committee Activities

In probing for the possible existence of any of the situations described above,

the audit committee takes two approaches. First, it asks probing questions of

management: Why has the receivables-reserve percentage changed? What is

the rationale for a large write-off of assets?

Then, and much more important, the committee asks similar questions of

the outside auditors. The audit committee usually meets privately with the

outside auditors and tells them, in effect, "If you have any doubts about the

numbers, or if you have reason to believe that management has withheld material

information, let us know. If you don't inform us, the facts will almost certainly

come to light later on. When they do, you will be fired."

A more polite way of probing is to ask the following: "Is there anything

more you should tell us? What were your largest areas of concern? What were

the most important matters, if any, on which you and management differed?

Did the accounting treatment of certain events differ from general practice in

the industry? If so, what was the rationale for the difference? How do you rate

the professional competence of the finance and accounting staff?"

Usually, these questions are raised orally. Because the auditors know from

past experience what to expect, they come prepared to answer them. Some

audit committees provide their questions in writing prior to the meeting.

Although cases of improper disclosure make headlines, they occur in only

a tiny fraction of 1% of listed companies. Most such incidents ref lect poorly on

the work of the board of directors and its audit committee. Increasingly, the

courts penalize such boards for their laxity. Directors are aware of the fact

that when serious misdeeds surface, the CEO often leaves the company, but

the directors must stay with the ship, enduring public criticism and the blot on

their professional reputation. Their lives will be much more pleasant in the

long run if they act promptly.

Quarterly Reports

In addition to the annual financial statements, the SEC requires companies to file

a quarterly summary of key financial data on Form 10-Q. Because the timing of

the release of this report usually does not coincide with an audit committee

meeting, most audit committees do not review it. Instead, they ask the CEO to

inform the committee chair if there is an unusual situation that affects the quarterly

numbers. The chair then decides either to permit the report to be published

as proposed or, if the topic seems sufficiently important, to have the committee

meet in a telephone conference call or an e-mail exchange to discuss it.

528 Making Key Strategic Decisions

Internal Control

In addition to its opinion on the financial statements, the outside auditing firm

writes a "management letter." This letter lists possible weaknesses in the company's

control system that have come to the auditor's attention, together with

recommendations for correcting them. (In the boilerplate preceding this list,

the auditor disclaims responsibility for a complete analysis of the system. The

listed items are only those that the firm happened to uncover.) Internal auditors

also write reports on the subject.

Audit committees follow up on these reports by asking management to

respond to the criticisms. If management disagrees with the recommended

course of action, its rationale is considered and is either accepted or rejected.

If action is required, the committee keeps the item on its agenda until it is satisfied

that the matter has been addressed.

If an especially serious problem is uncovered, the committee may engage

its public accounting firm or another firm to make a special study. If the problem

involves ethical or legal improprieties, the committee may engage an outside

law firm. As soon as material problems are identified, they must be

reported promptly to the SEC on Form 8-K.

The audit committee has a difficult problem with internal audit reports.

In the course of a year, a moderate size staff may write 100 or more reports.

Many of them are too trivial to warrant the committee's attention. (One of the

authors participated in an audit committee meeting of a multibillion dollar

company in which 15 minutes were spent discussing a recommendation to

improve the computer system that was expected to save $24,000 annually.)

Drawing a line between important reports and trivial ones is difficult, however.

A rule of thumb, such as, "Tell us about the dozen most important matters,"

may be used, but what if the thirteenth matter also warrants the

committee's attention?

In its private meeting with the head of internal audit, the audit committee

assures itself that the CEO has given the internal audit staff complete freedom

to do its work. The committee also makes it clear that the head of internal

audit has direct access to the audit committee chair if a situation that warrants

immediate board attention is uncovered. The internal auditor normally would

report the matter in question to his or her superior first, but the auditor's

primary obligation is to the audit committee. The committee, in turn, should

guarantee, as well as it can, that the internal auditor will be fully protected

against possible retaliation.

Internal Audit Organization

The audit committee also considers the adequacy of the internal audit organization.

Is it large enough? Does it have the proper level of competence? For example,

do the auditors know how to audit the latest computer systems? In many

companies, the internal audit organization is a training ground where promising

The Board of Directors 529

accountants are groomed for controllership. The audit committee may find it

useful to get acquainted with the internal audit staff, as a basis for judging

future candidates for the controller organization.

When campaigns to reduce overhead are undertaken, the internal audit

staff may be cut more than is healthy for the organization. The audit committee

questions such cuts and gets an opinion from the outside auditing firm. However,

because internal auditors do much of the verifying that otherwise would be

done by external auditors, at a much lower cost per hour, external auditors may

not have an unbiased view of the proper size of the internal audit organization.

FINANCE COMMITTEE

The board is responsible to the shareholders for monitoring the corporation's

financial health and assuring that its financial viability is maintained. The finance

committee makes recommendations on these matters. (Nevertheless, as

emphasized earlier, the full board cannot escape its ultimate responsibility for

making sound decisions on important matters.)

The committee's agenda includes analyses of proposed capital and operating

budgets and regular reviews of the company's financial performance as reported

on the income statement, and its financial condition as reported on the

balance sheet. The committee reviews the estimated financial requirements

over the next several years and looks at how these requirements will be met. It

also recommends the amount of quarterly dividends. The finance committee

(or a separate pension committee) reviews matters of the pension fund as well

as those of the fund for paying health-care and other post-employment benefits.

It reviews the policies that determine the annual contribution to these

funds and the performance of the firm or firms that invest them.

This section describes aspects of these matters that are dealt with at the

board of directors level. Reviews of performance and status are described in

Chapters 1 and 2. The budget preparation process is described in Chapter 6.

Financial policies are discussed in Chapters 9 through 13.

In some companies, the functions described here are divided among three

committees, for budget, finance, and pension, and the names may be different.

Our purpose is to describe what committees do, regardless of their titles.

Analysis of Financial Policies

Financial policies are recommended by management. Tools of analysis are increasingly

sophisticated. Using these tools to evaluate risk and return is the responsibility

of management, not the finance committee. These tools help to

quantify risk, but they are not a substitute for a definite policy on risk. An attitude

toward risk is a personal matter, and the finance committee should recognize

it as such. Each CEO has a personal attitude toward risk, and so does each

individual director.

530 Making Key Strategic Decisions

The committee's responsibility is to probe management's rationales for its

policies and thereby assure itself that management has thought them through

and that the policies are within acceptable limits.

Dividend Declaration

One financial policy specifically for the board to decide is the declaration of

dividends. Dividends are paid only if the company declares them; this declaration

usually is made quarterly.

Some companies regularly distribute a large fraction of earnings, while

others retain a large fraction (or all) within the corporation. Although generous

dividends may suit shareholders in the short run, they can deprive the corporation

of resources it needs to grow and thereby penalize shareholders in the long

run. Conversely, if a large fraction of earnings is retained, shareholders may be

deprived of the opportunity to make profitable alternative investments of

their own. Thus, the finance committee must balance the interests of the corporation

with the interests of individual shareholders.

Some boards take a simplistic approach to dividends: "Always pay out X%

of earnings," or "Increase dividends each year, no matter what." Both statements

are acceptable guidelines, but neither is more than a guide. In some

industries, a certain payout ratio is regarded as normal, and a company that departs

substantially from industry practice may lose favor with investors. Good

evidence suggests that a record of increasing dividends over time, or at least a

record of stable dividends, is well regarded by investors. By contrast, an erratic

dividend pattern is generally undesirable; it creates uncertainty for investors.

Dividend policy warrants careful analysis. The principal factors that the

board considers are:

• What are the company's financial needs? These needs depend on how fast

the company wants to grow and how capable it is of growing. Or, as is the

case with some companies, what is needed to preserve the company during

a period of adversity?

• How does the company want to finance its requirements for funds? It can

meet its needs by retaining earnings, issuing debt, issuing equity, or some

combination of these. Each source of funds has its own cost and its own

degree of risk.

• What return does the company expect to earn on shareholder equity, and

what degree of risk is it willing to assume in order to achieve this objective?

The trade-off between risk and return will determine the appropriate

type of financing and thus inf luence the extent to which earnings

should be retained or paid out in dividends.

These are complex questions. Moreover, the factors involved in arriving

at answers to them interact with one another. Consider the example of Cisco

Systems:

The Board of Directors 531

Cisco was founded in 1984 and shipped its first product in 1985. The company

grew rapidly. In 2000 it was a world leader in networking for the Internet, with

sales of $18.9 billion and net income of $2.7 billion. The following statement is

included in the company's 2000 Annual Report. "The Company has never paid

cash dividends on its common stock and has no present plans to do so." Cisco retained

all of its earnings to help finance its growth and used its stock to acquire

other companies, which it integrated into its operations.

Cisco's dividend policy is typical of high-growth technology companies

that need resources to grow but find raising equity in the financial markets expensive

because they have no financial "track record" for new ventures.

Many successful companies have quite different dividend and financing

policies from Cisco's. Many public utility companies, for example, have long,

unbroken records of stable dividends that are a relatively high percentage of

earnings, ranging from 50% to 90%. Even during the Depression in the 1930s

many of these companies maintained their regular dividends, although dividends

exceeded earnings in some periods.

The contrast between Cisco Systems and public utility companies indicates

the extent to which dividend policy depends on an individual company's

circumstances and needs. It also highlights the relationships between dividend

policy, the company's need for financing, and the methods that it selects in

order to meet its financial requirements.

Pension Funds

The finance committee considers two aspects of pension fund policy: (1) the

amount required to be added to the fund and (2) the investment of the fund.

Size of the Pension Fund

Most corporate pension plans are defined benefit plans. In deciding the size of

the fund required to make benefit payments to retirees, directors tend to rely

heavily on the opinion of an actuary. The actuary calculates the necessary size

of the fund using information about the size and demographic characteristics

of the covered employees, facts about the provisions of the plan, and assumptions

about the fund's return on investment and probable wage and salary increases

over time. (With available software, the company can make the same

calculation.)

There is no way of knowing, however, how reasonable are two key assumptions:

the future return on investment and the future wage and salary

payments on which the pensions are based. Since the actuarial calculations depend

on the accuracy of these assumptions, the calculations should not be

taken as gospel. Both of these variables are roughly related to the future rate of

inf lation, and the spread between them should remain roughly constant. That

is, when one variable changes by one percentage point, the other variable also

is likely to change by one percentage point.

532 Making Key Strategic Decisions

Pension Fund Investments

The most conservative practice is to invest the pension fund in annuities or in

bonds whose maturities match the anticipated pension payments. Such a policy

is said to "lock in" the ability to make payments. This works out satisfactorily for

employees who have already retired, but not for employees who are currently

working. If the latter group's compensation increases at a faster rate than is assumed

in the actuarial calculations, or if the plan itself is sweetened, the fixed

return will turn out to be inadequate. Under a defined benefit plan, there is no

sure way to guarantee that the cash will be available when it is needed. In any

event, with such a conservative policy, the company gives up the opportunity to

earn the usually greater return from an investment in equities.

Most companies hire one or more banks or investment firms to manage

their pension funds. Voluminous data are available on the past performance of

these managers. However, an excellent past record is no guarantee of excellent

future performance. A firm is a collection of individuals. Investment performance

is partly a function of the individuals doing the investing, and the performance

record may change when these individuals leave or lose their skills.

For many years, when it was managed by Peter Lynch, the Magellan Fund was

the most successful of all mutual funds. After Mr. Lynch left, the fund's performance

was not so huge (but was still above average). Performance is also

partly a matter of luck.

Some companies divide the pension fund among several managers, periodically

compare their performance, and replace the one with the poorest

record. This may spread the risk somewhat, but it does not guarantee optimum

performance. Luck and the individual who manages the fund continue to be

dominant factors. It is a fact that some managers are better than others. The finance

committee watches performance carefully. It is cautious about making

changes based primarily on short-run performance, but it does so promptly

when it is convinced that a better manager has been identified.

The finance committee also decides on asset allocation investment policies:

how much in equities, how much in fixed income securities, how much in

real property, how much in new ventures, how much in overseas securities, and

the maximum percentage in a single company or industry.

Companies must also provide for costs of health-care and other benefits

of employees who have not yet retired. The problems of estimating these costs

are similar to those for pension funds, but with the additional complication that

healthcare costs continue to increase at an unpredictable rate.

SUMMARY

In doing its job, the board accepts certain responsibilities. It should:

• Actively support the CEO, both within the organization and to outside

parties, as long as the individual's performance is judged to be generally

satisfactory.

The Board of Directors 533

• Discuss proposed major changes in the company's strategy and direction,

major financing proposals, and other crucial issues, usually as proposed by

the CEO.

• Formulate major policies regarding ethical or public responsibility matters,

convey to the organization its expectation that the policies will be

adhered to, and ensure that policy violations are not tolerated.

• Ensure, if feasible, that the CEO has identified a successor and is grooming

that person for the job.

• Require the CEO to explain the rationale behind operating budgets,

major capital expenditures, acquisitions, divestments, dividends, personnel

matters, and similar important plans. Accept these proposals if they

are consistent with the company's strategy and the explanation is reasonable.

Otherwise, require additional information.

• Analyze reports on the company's performance, raise questions to highlight

areas of possible concern, and suggest possible actions to improve

performance, always with the understanding that the CEO, not the

board, is responsible for performance.

• Assure that financial information furnished to shareholders and other outside

parties fairly presents the financial performance and status of the

company. Assure that internal controls are satisfactory.

• Replace the CEO promptly if the board concludes the executive's performance

is and will continue to be unsatisfactory.

• Participate actively in decisions to elect or appoint directors.

• Decide on policies relating to the compensation of senior management,

including bonuses, incentives, and perquisites. Determine the compensation

of the CEO. Review recommendations of the CEO and ratify the

compensation of other executives.

FOR FURTHER READING

American Bar Association Committee on Continuing Professional Education, Corporate

Governance Institute: ALI-ABA Course of Study Materials (Philadelphia,

PA: American Law Institute, 2000).

, Corporate Director's Guidebook (Chicago, IL: ABA, 1994).

American Law Institute-American Bar Association, Current Issues in Corporate

Governance: ALI-ABA Course of Study Materials (Philadelphia, PA: ALI-ABA,

1996).

American Society of Corporate Secretaries, Current Board Practices (New York:

ASCS, 2000).

Anderson, Charles A., and Robert N. Anthony, The New Corporate Directors (New

York: John Wiley, 1986).

Bawley, Dan, Corporate Governance and Accountability: What Role for the Regulator,

Director, and Auditor? (Westport, CT: Quorum, 1999).

534 Making Key Strategic Decisions

Berenbeim, Ronald, The Corporate Board: A Growing Role in Strategic Assessment

(New York: Conference Board, 1996).

Bureau of National Affairs, Corporate Governance Manual (Washington, DC:

Author, 1998).

Cagney, Lawrence K., Compensation Committees (Washington, DC: Bureau of National

Affairs, 1998).

Cohen, Stephen S., and Gavin Boyd, eds., Corporate Governance and Globalization:

Long Range Planning Issues (Northampton, MA: Edward Elgar, 2000).

Davies, Adrian, A Strategic Approach to Corporate Governance (Brookfield, VT:

Gower, 1999).

Donaldson, Gordon, and Jay W. Lorsch, Decision Making at the Top (New York: Basic

Books, 1983).

Ernst & Young, Compensation Committees: Fulfilling Your Responsibilities in the

1990s (New York: Ernst & Young, 1995).

Harvard Business Review on Corporate Governance (Boston: Harvard Business

School, 2000).

Investor Responsibility Research Center, Global Corporate Governance: Codes, Reports,

and Legislation (Washington, DC: Author, 1999).

Iskander, Magdi R., and Nadereh Chamlou, Corporate Governance: A Framework for

Implementation (Washington, DC: World Bank, 2000).

Keasey, Kevin, and Mike Wright, eds., Corporate Governance: Responsibilities,

Risks, and Remuneration (New York: John Wiley, 1997).

Knepper, William E., and Dan A. Bailey, Liability of Corporate Officers and Directors,

6th ed. (Charlottesville, VA: Michie, 1998).

Lorsch, Jay W., Pawns or Potentates: The Reality of America's Corporate Boards

(Boston: Harvard Business School, 1984).

Mace, Myles L., Directors: Myth and Reality, rev. ed. (Boston: Division of Research,

Harvard Business School, 1984).

Montgomery, Jason, Corporate Governance Guidelines: An Analysis of Corporate

Governance Guidelines at S&P 500 Corporations (Washington, DC: Investor

Responsibility Research Center, 2000).

National Association of Corporate Directors, The Role of the Board in Corporate

Strategy (Washington, DC: NACD, 2000).

, Report of the NACD Blue Ribbon Commission on Director Professionalism

(Washington, DC: NACD, 1996).

Oliver, Caroline, ed., The Policy Governance Fieldbook: Practical Lessons, Tips, and

Tools from the Experience of Real-Word Boards (San Francisco: Jossey-Bass, 1999).

Patterson, D. Jeanne, The Link between Corporate Governance and Performance:

Year 2000 Update (New York: Conference Board, 2000).

Stoner, James A. F., R. Edward Freeman, and Daniel R. Gilbert, Jr., Management,

6th ed. (London: Prentice-Hall International, 1995).

Vancil, Richard F., Passing the Baton: Managing the Process of CEO Succession

(Boston: Harvard Business School Press, 1987).

Varallo, Gregory V., and Daniel A. Dreisbach, Corporate Governance in the 1990s:

New Challenges and Evolving Standards (Chicago, IL: American Bar Association,

1996).

The Board of Directors 535

Ward, Ralph D., Improving Corporate Boards: The Boardroom Insider Guidebook

(New York: John Wiley, 2000).

, 21st Century Corporate Board (New York: John Wiley, 1997).

Weidenbaum, Murray L., The Evolving Corporate Board (St. Louis: Center for the

Study of American Business, Washington University, 1994).

NOTES

1. Kenneth R. Andrews, The Concept of Corporate Strategy (Homewood, IL:

Dow-Jones Irwin, 1980).

2. SEC Release 34-41982.

3. Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).

4. If the auditing firm cannot make this statement, it states that it is unable to

give any opinion. In these circumstances, the stock exchanges immediately suspend

trading in the company's stock.

5. Investors Relation Business. Press release October 9, 2000.

536

16

INFORMATION

TECHNOLOGY

AND THE FIRM

Theodore Grossman

INTRODUCTION

The personal use of information technology was discussed in an earlier chapter.

This chapter will discuss the firm's use of information technology.

Of all the chapters in this book, the two dealing with information technology

will have the shortest half-life. Because of the constant flow of new

technology, what is written about today will have changed somewhat by tomorrow.

This chapter presents a snapshot of how technology is used today in industry

finance and accounting. By the time you compare your experiences with

the contents of this chapter, some of the information will no longer be applicable.

Change means progress. Unfortunately, many companies will not have

adapted; consequently, they will have lost opportunity and threatened their

own futures.

HISTORICAL PERSPECTIVE

To understand the present and future of information technology, it is important

to understand its past. In the 1960s and 1970s, most companies' information

systems were enclosed in the "glass house." If you entered any company

that had its own computer, it was located behind a glass wall with a security

system that allowed only those with access rights to enter the facility. One

computer controlled all of a company's data processing functions. Referred to

as a host centric environment, the computer was initially used for accounting

purposes—accounts payable, accounts receivable, order entry, payroll, and

so on. In the late 1970s and 1980s, most companies purchased in-house

Information Technology and the Firm 537

computer systems and stopped outsourcing their data processing. Recognizing

the power and potential of information technology, companies directed the

use of their technology toward operations, marketing, and sales; and they created

a new executive position, Chief Information Officer (CIO), to oversee

this process.

In the 1980s, many companies gradually changed from host centric to distributed

computing. Instead of processing all of the information on one large,

mainframe computer, companies positioned minicomputers to act as processors

for departments or special applications. The minicomputers were, in many

cases, networked together to share data. Databases became distributed, with

data residing in different locations, yet accessible to all the machines in the

network.

The personal computer had the greatest impact on the organization. It

brought true distributed processing. Now everybody had their own computer,

capable of performing feats that, until then, were only available on the company's

mainframe computer. This created both opportunities and headaches

for the company, some of which will be addressed in the section on controls. As

companies entered the 1990s, these computers were networked, forging the

opportunity to share data and resources, as well as to work in cooperative

groups. In the mid-1990s, these networks were further enhanced through connection

to larger, wide area networks (WANs) and to the ultimate WAN, the

Internet. Companies are doing what was unthinkable just a couple of years ago.

They are allowing their customers and their suppliers direct connection into

their own computers. New technology is being introduced every day, and new

terms are creeping into our language (Internet, intranet, extranet, etc.). It is

from this perspective that we start by looking at computer hardware.

HARDWARE

Most of the early computers were large, mainframe computers. Usually manufactured

by IBM, they were powerful batch processing machines. Large numbers

of documents (e.g., invoices or orders) were entered into the computer

and then processed, producing various reports and special documents, such as

checks or accounts receivable statements.

Technology was an extremely unfriendly territory. In many companies,

millions of lines of software were written to run on this mainframe technology.

Generally speaking, these machines were programmed in a language called

COBOL and used an operating system that was proprietary for that hardware.

Not only was it difficult to run programs on more than one manufacturer's

computer, but, because there were slight differences in the configurations and

operating systems, it was difficult to run the same software on different computers,

even if they were produced by the same manufacturer.

In the 1980s, technology evolved from proprietary operating systems

to minicomputers with open systems. These were the first open systems,

538 Making Key Strategic Decisions

computers that functioned using the UNIX operating system. While, in the

1970s, Bell Labs actually developed UNIX as an operating system for scientific

applications, it later became an accepted standard for commercial applications.

Platform independent, the operating system and its associated applications could

run on a variety of manufacturers' computers, creating both opportunities for

users and competition within the computer industry. Users were no longer inexorably

tied to one manufacturer. UNIX became the standard as companies

moved into the 1990s. However, standards changed rapidly in the nineties, and

UNIX has lost ground due to the development of client server technology.

In the early 1990s, technologists predicted the demise of the mainframe.

IBM's stock declined sharply as the market realized that the company's chief

source of margin was headed toward extinction. However, the mainframe has

reinvented itself as a super server, and, while it has been replaced for some of

the processing load, the mainframe and IBM are still positioned to occupy

important roles in the future.

Server technology is heading toward a design in which processors are built

around multiple, smaller processors, all operating in parallel. Referred

to as symmetrical multiprocessors (SMPs), there are between two and eight

processors in a unit. SMPs are made available by a range of manufacturers and

operating systems, and they provide processor power typically not available in a

uniprocessor. Faced with the demanding environment of multiple, simultaneous

queries from databases that exceed hundreds of gigabytes, processors with massively

parallel processors, or MPPs, are being utilized more and more. MPPs

are processors that have hundreds of smaller processors within one unit. The

goal of SMPs and MPPs is to split the processing load among the processors.

In a typical factory in the 1800s, one motor usually powered all of the

machinery, to which it was connected by a series of gears, belts, and pulleys.

Today, that is no longer the case, as each machine has its own motor or, in some

cases, multiple, specialized motors. For example, the automobile's main motor

is the engine, but there are also many other motors that perform such tasks as

opening and closing windows, raising and lowering the radio antenna, and powering

the windshield wipers. Computers are the firm's motors, and like motors,

they, too, have evolved. Initially, firms used a host centric mainframe, one

large computer; today, they are using many computers to perform both specialized

and general functions.

In the early 1990s, Xerox's prestigious Palo Alto Research Center introduced

"ubiquitous computing," a model that it feels ref lects the way companies

and their employees will work in the future. In ubiquitous computing, each

worker will have available differing quantities of three different size computers:

20 to 50 Post-it note size portable computers, three or four computers the

size of a writing tablet, and one computer the size of a six-foot-by-six-foot

white board. All of the computers will work together by communicating to a

network through, in most cases, wireless connections.

The progress of chip technology has been highly predictable. In the early

1960s, Gordon Moore, the inventor of the modern CPU at Intel, developed

Information Technology and the Firm 539

Moore's Law, which predicts that the density of the components on a computer

chip will double every 18 to 24 months, thereby doubling the chip's processing

power. This hypothesis has proven to be very accurate. Exhibit 16.1

shows the growth of the various Intel CPU chips that have powered the personal

computer and many other machines. As can be seen, the PC's power has

just about doubled every 18 to 24 months.

This growth can be seen more dramatically when the graph is plotted

logarithmically, as in Exhibit 16.2.

EXHIBIT 16.1 Moore's Law—charting the power of the growth of

the PC.

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Year

MIPS (millions of instructions

per second)

0

100

200

300

400

500

600

700

800

900

1000

EXHIBIT 16.2 Moore's Law—charting the growth of the PC

(logarithmically).

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Year

MIPS (millions of instructions

per second)

0.1

1.0

10.0

100.0

1000.0

540 Making Key Strategic Decisions

SOFTWARE

Exhibit 16.3 represents the information systems paradigm. Operational control

systems, which run the company's day-to-day operations, are typically used by

the lowest level of the organization, are run on a scheduled basis, and usually

contain large volumes of input data, output reports, and information. These

systems might be accounts payable, accounts receivable, payroll, order entry,

or inventory control.

Decision support systems are generally used by middle-level managers to

supply them with information that they can use to make decisions. Usually run

on an ad hoc basis and involving small amounts of data, budgets, exception reporting,

cash-f low forecasting, accounts receivable dunning reports, "what if "

analyses, audit analysis reports, and variance analyses are examples of these

decision support systems. Many of the newer applications packages come with

facilities for managers without any programming knowledge to create their

own decision reports.

Strategic information systems are used by senior management to make decisions

on corporate strategy. For example, a retail company might use demographic

census data, along with a computerized geographical mapping system,

to evaluate the most appropriate locations at which it should open new stores. A

manufacturing company, given its demands for both skilled and unskilled

labor, might use a similar method to determine the optimal location for a

new plant.

While most older hardware has given way to newer computers, most companies

use a combination of newly acquired and older, self-developed software.

The latter was developed over a period of years, perhaps 20 or more, using

COBOL, which, until the early 1990s, was the standard programming language

in business applications. Today, many companies' mission critical systems still

EXHIBIT 16.3 Types of information systems.

Operational control

systems

Decision support

systems

Strategic

information

systems

Information Technology and the Firm 541

run on mainframe technology, using programs written in COBOL; in fact,

there are billions of lines of COBOL programming code still functional in U.S.

business.

These "legacy" systems have become a major issue for many, though, and

were the key issue behind the Y2K problem. In many instances, they have

grown like patchwork quilts, as they have been written and modified by programmers

who are no longer with their firms. More often than not, documentation

of these changes and enhancements is not available, and the guidelines

for many of these software applications no longer exist. Replacing these applications

is cost prohibitive, and the distraction to the organization caused by the

need to retrain workers would be tremendous.

Nonetheless, as a result of the Y2K problem, many of these systems were

replaced, but large volumes of them were merely patched to allow for the millennium

change. These systems will eventually have to be replaced. If history

is a lesson, many of these systems will not be replaced, though, until it is too

late. In any event, the business community should not face the singular deadline

it faced at the end of 1999.

Today, most programmers write in C++, C, or fourth-generation programming

languages. C++ is an object oriented programming language; object oriented

languages provide the programmer with a facility to create a programming

object or module that may be reused in many applications. Fourth-generation

programming languages are usually provided with sophisticated relational database

systems. These database systems provide high-level tools and programming

languages that allow programmers to create applications quickly without having

to concern themselves with the physical and logical structure of the data. Oracle,

Informix, Sybase, and Progress are some of the more popular relational

database package companies.

INTERNET TECHNOLOGY

Nothing has impacted technology and society in the past 10 years more than

the Internet. When Bill Clinton was inaugurated in January 1993, there were

50 pages on the Internet. Today, there are more than 200 billion pages. The underlying

technology behind the Internet has its roots in a project begun by the

U.S. government in the early 1970s. The network was originally developed by a

consortium of research colleges and universities and the federal government

that was looking for a way to share research data and provide a secure means of

communicating and for backing up defense facilities. The original network was

called ARPANET. ARPANET was sponsored by the Department of Defense's

Advanced Research and Planning Agency (ARPA). It was replaced in the 1980s

by the current network, which was originally not very user friendly and was

used mostly by techies. The Internet's popularity exploded with the development

of the World Wide Web and the necessary software programs that made

it much more user friendly to explore.

542 Making Key Strategic Decisions

The Internet works on a set of software standards the first of which,

TCP/IP, was developed in the 1970s. The entire theory behind the Internet

and TCP/IP, which enables computers to speak to each other over the Internet,

was to create a network that had no central controller. The Internet is unlike

a string of Christmas lights, where if one light in the series goes out the

rest of the lights stop functioning. Rather, if one computer in the network is

disabled, the rest of the network continues to perform.

Each computer in the Internet has an Internet, or IP, address. Similar to

one's postal address, it consists of a series of numbers (e.g., 155.48.178.21),

and it tells the network where to leave your e-mail, and data. When you access

an Internet site through its URL (e.g., www.babson.edu), a series of

computers on the Internet, called domain name servers (DNS), convert the

URL to an IP address. When an e-mail, message, or data is sent to someone

over the Internet, it is broken into a series of packets. These packets, similar

to postcards, contain the IP address of the sender, the IP address of the

recipient, the packet number of the message (e.g., 12 of 36), and the data

itself. These packets may travel many different routes along the Internet.

Frequently, packets belonging to the same message do not travel the same

route. The receiving computer then reassembles these packets into a complete

message.

The second standard that makes the Internet work is HTML, or Hypertext

Markup Language. This language allows data to be displayed on the

user's screen. It also allows a user to click on an Internet link and jump to a

new page on the Internet. While HTML remains the underlying programming

language for the World Wide Web, there are many more user-friendly

software packages, like FrontPage 2000, that help create HTML code. Moreover,

HTML, while powerful in its own right, is not dynamic and has its limitations.

Therefore, languages such as JavaScript, Java, and Pearl, which create

animation, perform calculations, create dynamic Web pages, and access and

update databases with information on the host's Web server, were developed

to complement HTML. Using a Web browser (e.g., Netscape Navigator or

Microsoft's Internet Explorer), the computer converts the HTML or other

programming languages into the information that the users see on their computer

monitors.

Internet technology has radically changed the manner in which corporate

information systems process their data. In the early and mid-1990s, corporate information

systems used distributed processing techniques. Using this method,

some of the processing would take place on the central computer (the server)

and the rest on the users' (the clients') computers—hence, the term clientserver

computing. Many companies implemented applications using this technology,

which ensured that processing power was utilized at both ends and that

systems were scalable. The problem with client-server processing was that different

computers (even within the IBM-compatible PC family) used different

drivers and required tweaking to make the systems work properly. Also, if the

software needed to be changed at the client end, and there were many clients

Information Technology and the Firm 543

(some companies have thousands of PC clients), maintaining the software for all

of those clients could be a nightmare. Even with specialized tools developed for

that purpose, it never quite worked perfectly.

As companies recognized the opportunity to send data over the Internet,

whether for their customers or their employees, they started to migrate all of

their applications to a browser interface. This change has required companies

to rethink where the locus of their processing will occur. Prior to the 1990s,

companies' networks were host-centric, where all of their processing was conducted

using one large mainframe. In the early 1990s, companies began using

client-server architecture. Today, with the current browser technology and the

Internet, the locus has shifted back to a host-centric environment. The difference,

though, is that the browser on the users' computers is used to display and

capture data, and the data processing actually occurs back at the central host

on a series of specialized servers, not on one large mainframe computer. The

only program users need is a standard browser, which solves the incompatibility

problem presented by distributed data processing. No specialized software

is stored on the users' computers.

Internet technology was largely responsible for many of the productivity

enhancements of the 1990s. Intel's microprocessors, Sun and Hewlett Packard's

servers, CISCO's communications hardware, and Microsoft's Windows operating

systems have all facilitated this evolution. While Windows is the predominant

client operating system, most servers operate on Windows NT or 2000,

UNIX or LINUX operating systems.

TODAY'S APPLICATION SYSTEMS

In the 1970s and 1980s, application software systems were stand-alone. There

was little sharing of data, leading to the frequent redundancy of information.

For example, in older systems, there might have been vendor data files for both

inventory and accounts payable, resulting in the possibility of multiple versions

of the truth. Each of the files may have contained address information, yet

each of the addresses may have been different for the same vendor. Today,

however, software applications are integrated across functional applications

(accounts payable, accounts receivable, marketing, sales, manufacturing, etc.).

Database systems contain only one vendor data location, which all systems utilize.

These changes in software architecture better ref lect the integration of

functions that has occurred within most companies.

Accounting systems, while used primarily for accounting data, also provide

a source of data for sales and marketing. While retail stores' point of sale

cash registers are used as a repository for cash and to account for it, they are

also the source of data for inventory, sales, and customer marketing. For example,

some major retailers ask their customers for their zip codes when point of

sale transactions are entered, and that data is shared by all of the companies'

major applications.

544 Making Key Strategic Decisions

Accounts receivable systems serve two purposes. On one hand, they allow

the company to control an important asset, their accounts receivable. Also, the

availability of credit enables customers to buy items, both commercial and retail,

that they otherwise would not be able to buy if they had to pay in cash.

Credit card companies, which make their money from the transaction fees and

the interest charges, understand this function well. Frequently, they reevaluate

the spending and credit patterns of their client base and award increased credit

limits to their customers. Their goal is to encourage their customers to buy

more, without necessarily paying off their balance any sooner than necessary.

Information systems make it possible for the companies to both control and

promote their products, which in this case are credit card transactions.

These examples of horizontally integrated systems, as well as the understanding

of the strategic and competitive uses of information technology,

demonstrate where industry is headed.

ACCOUNTING INFORMATION SYSTEMS

As mentioned earlier, computer-based accounting systems were, for most companies,

the first computerized applications. As the years progressed, these systems

have become integrated and consist of the following modules:

• Accounts Payable.

• Order Entry and Invoicing.

• Accounts Receivable.

• Purchase Order Management and Replenishment.

• Inventory Control.

• Human Resource Management.

• Payroll.

• Fixed Assets.

• General Ledger and Financial Statements.

Whereas in past years some of these modules were acquired and others were

self-developed, today most companies purchase packaged software.

In the 1980s, "shrink-wrapped" software was developed and introduced.

Lotus Corporation, along with other companies, was a pioneer, selling software

like its 1-2-3 application in shrink-wrapped packages. The software was accompanied

by sufficient documentation and available telephone support to ensure

that even companies with limited technical expertise could manage their own

destinies.

There are a host of software packages that will satisfy the needs of companies

of all sizes. Smaller companies can find software selections that run on

personal computers and networks, are integrated, and satisfy most of the companies'

requirements. Quicken and Computer Associates have offerings that

Information Technology and the Firm 545

provide most of the necessary functional modules for small and medium size

companies, respectively. The more advanced packages, like Macola and Acc-

Pac, are equipped with interfaces to bar-code scanners and scales, which, together,

track inventory and work in process and weigh packages as they are

shipped, producing not only invoices but also shipping documents for most of

the popular freight companies such as FedEx and UPS. These packages range

in price from $100 for the entire suite of accounting applications for the smallest

packages to approximately $800 per module for the larger packages, which,

of course, have more robust features. While some of the smaller packages are

available through computer stores and software retailers, the larger packages

are acquired through independent software vendors (ISV), who, for a consulting

fee, will sell, install, and service the software. The practice of using third

party ISVs began in the 1980s, when large hardware and software manufacturers

realized that they were incapable of servicing all of the smaller companies

that would be installing their products, many of whom required a lot of handholding.

Consequently, a cottage industry of distributors and value added dealers

developed, in which companies earn profits on the sale of hardware and

software and the ensuing consulting services.

Larger companies are following a trend toward large, integrated packages

from companies like SAP and Oracle. These packages integrate not only the accounting

functions but also the manufacturing, warehousing, sales, marketing,

and distribution functions. These systems are referred to as enterprise resource

planning (ERP) systems. Many of these ERP systems, available from

companies such as SAP, Oracle, and BAAN, also interface with Web applications

to enable electronic commerce transactions. SAP has spawned an entire

industry of consulting companies that assist large companies in implementing

its software, a process that may take several years to complete. As in any software

implementation, one must always factor into the timetable the process's

cost and the distraction it causes the organization. In today's lean business environment,

people have little extra time for new tasks. Implementing a major

new system or, for that matter, any system, requires a major time and effort

commitment.

INFORMATION TECHNOLOGY IN

BANKING AND FINANCE

The financial services industry is the leading industry in its use of information

technology. As shown in Exhibit 16.4, according to a survey conducted in 1999

by the Computer Sciences Corporation, this sector has spent 5.0% of its annual

revenue on IT, almost more than double that of any other industry, except the

technology driven telecommunications industry.

This graph also illustrates how integral a role real-time information plays

in the financial services industry, whether it be for accessing stock quotes or

processing bank deposits. The industry has become a transaction processing

546 Making Key Strategic Decisions

industry that is information dependent. Very little real money is ever touched.

Rather, all transactions, from stock purchases to the direct deposit of workers'

checks, are processed electronically. Information technology has paved the way

for innovations like the NASDAQ trading system, in which, unlike the New York

Stock Exchange (NYSE), all of the trades are conducted totally electronically.

NETWORKS AND COMMUNICATIONS

It is becoming increasingly common in industry to create virtual wide area networks

using multiple, interconnected local area networks. These networks also

connect the older mainframe and midrange computers that industry uses for its

older legacy systems to the client terminals on the users' desks. Exhibit 16.5 is

a model of a typical company's wide area network, and it demonstrates how all

of the older technology interconnects with the newer local area networks and

the Internet.

In the early 1990s, there were numerous, competing network operating

systems and protocols. While Novell and its NetWare software holds the largest

market share, Microsoft's Windows NT is becoming the network operating system

of choice, and, because of the Internet's overwhelming success, TCP/IP is

rapidly becoming the standard communications protocol. Remember, though,

success is very fragile in the world of information technology. Today's standard

can easily become yesterday's news. If you are always prepared for change,

then you will not be surprised by it.

EXHIBIT 16.4 Information technology budgets by industry.

Financial services

Percentage of revenue

Health care

Aerospace/defense

Manufacturing

Chemicals

Retail

Telecommunications

Consumer goods

Utilities

Oil/energy

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Information Technology and the Firm 547

Electronic Data Interchange (EDI) allows companies to communicate and

conduct electronic commerce from one computer to another. EDI is one of the

industry's growing uses for data communications, and many companies are using

it to send purchase orders to their suppliers, thereby lessening the time it takes

for purchase orders to be mailed and then entered and processed by the suppliers.

Inventories are lowered by speeding up the turnaround time of ordering

and receiving goods and materials. On the f lip side, many suppliers use EDI to

send their customers advance ship notifications (ASN), advising them of what

has been shipped so that they can prepare their warehouses for the goods and

EXHIBIT 16.5 Model of wide area network (local area network and

Internet connection using open communications

protocol, c. 1997).

Server

Minicomputer

Mainframe

Internet

(TCP/IP)

Router

Server

Minicomputer

Mainframe

Client

Client

(e.g., branch office)

Key:

= Processing capacity (e.g., the ability to run program code)

TCP/IP = Transmission Control Protocol/Internet Protocol

Local

area

network

(TCP/IP)

548 Making Key Strategic Decisions

materials. Lastly, some companies use EDI to transmit their invoices and then

to receive the subsequent payments. While industries use different versions of

EDI in different ways, their goals are always the same: minimize the processing

time and lower inventory costs and overhead expenses. An industry organization

in Washington, D.C., developed and maintains a standard format that dictates

how all transactions are sent, ensuring that all companies that wish to implement

EDI can be assured that all vendors' and customers' computers will understand

each others' transactions, without requiring any custom programming.

EDI, while still used quite extensively, has been eclipsed by electronic commerce,

which will be discussed later in this chapter.

The 1990s has also seen the advent of virtual organizations. Virtual organizations

are formed when companies join together to create products or enterprises

that they could not have created individually. In most cases,

information technology allows companies to create these partnerships and

share information as if they were one company. Using communications and

groupware products like Lotus Notes, the partners can share information with

each other about their individual progress to ensure the best possible success.

This will be discussed further in the section on IT strategy.

DATABASE

The following scenario depicts what information systems looked like prior to

the use of database management systems. Imagine a physical office in which

each person has his or her own file cabinet. The information in the file cabinets

belongs to the people whose desks are closest to them. They decide what information

will be in their file cabinets and how it will be organized. For example,

sales might refer to gross sales in one worker 's cabinet and net sales in another's.

Yet, the discrepancy would be unimportant, because there was actually

very little sharing of data.

Database management systems assume that information is a corporate

asset to be shared by all workers in the enterprise. Database technology, therefore,

allows a company to have one integrated location for the storage of all

company data. These systems create a standard vocabulary, or data dictionary,

by which all references are consistent (e.g., sales always means net sales). They

also enable each user to have her own individual view of the data as if the information

were still in the file cabinet next to her desk. Users need not concern

themselves with the physical location or physical order of the data either. Database

management systems are capable of presenting the data as necessary. In

fact, with distributed databases, the data does not even have to reside in the

same location or computer. It can be spread around the world if necessary.

Database systems are sufficiently intelligent and can find the data and process

it as if it were located directly on the user's personal computer.

Most of the software that was developed in the earlier years relied on data

structures called f lat files. While some companies utilized database technology

Information Technology and the Firm 549

to store information, those database management systems were, in many cases,

unwieldy and very expensive to both acquire and maintain. They were usually

hierarchical or network database systems that, alone, cost in excess of $200,000

and frequently required special database administrators just to constantly finetune

the system.

Today's database technology is based on a relational model, and, on a very

simplistic basis, it resembles a spreadsheet. In a relational database, there are a

series of tables or files. Similar to a spreadsheet table, each table has columns

with attributes and rows of data. The difference is that there is only one table

in a spreadsheet, whereas there can be an almost unlimited number of tables in

a database. In addition, there is a practical limit to the size of a spreadsheet,

but databases can contain thousands of columns and millions of rows of data.

In addition, databases also allow users to relate or connect tables that share

common columns of data.

Exhibit 16.6 is an example of a very simple portion of a payroll application.

There are two different tables. The employee table contains data about

each of the company's employees: name, address, marital status, number of dependents,

and so on. The pay table contains data about every time each of the

employees is paid: their gross payroll, social security taxes, federal withholding,

state tax, and so forth.

First, notice the common column between the two tables, the employee

number. This column enables the database management system to relate the

two tables. It allows the system, for example, to print a payroll journal that has

both the weekly payroll information from the pay table and to access the employees'

names from the employee table. Why not combine all the data into one

table? Not only would the employees' names, social security numbers, and

other information appear multiple times, requiring the unnecessary use of data

storage, but also multiple versions of the truth might occur. If one of the employees

should happen to change his name or address (if address were included

in the employee table), the database would show one name for part of the year

and another for the rest of the year. Redundant data creates opportunities for

data corruption; just because data is changed in one table, that same data is not

necessarily changed in all tables. Prudent systems design eliminates data field

duplications wherever possible.

DATE WAREHOUSE

Data warehousing attempts to reconcile and live with past applications software,

while still benefiting from today's newer technology. As mentioned

earlier, industry is rife with older legacy systems that are currently cost prohibitive

to replace. Most of these older systems are mission critical operational

control systems (see Exhibit 16.3) and satisfy most of the operational needs

of the company. However, they are built on technology that cannot support

the kinds of decision support tools that management requires. Many of these

550

EXHIBIT 16.6 Database example.

EMPLOYEE TABLE

Social Date of Hourly

Employee Security Marital Number of Date of Date of Date of Last or

Number First Name Initial Last Name Number Status Dependents Birth Hire Termination Pay Raise Pay-Rate Salary

1 Mary E Smith 123456789 M 4 4/1/63 7/21/91 9/1/96 8.505 H

2 Tom T Day 234567890 M 3 3/2/55 11/15/91 1/15/96 750.000 S

3 Harry F Jones 345678901 S 1 11/30/71 1/15/92 9/24/96 11/6/94 12.500 H

4 Sally D Kraft 456789012 S 0 10/5/65 3/6/92 3/5/96 14.755 H

5 Charlie Malt 567890123 S 1 6/6/80 6/2/93 6/17/96 900.000 S

6 John K Free 678901234 M 5 8/5/49 11/1/94 12/15/95 17.500 H

PAY TABLE

Number of Number of Social Federal

Employee Regular Overtime Security Medicare Withholding Check

Number Date Hours Hours Gross Payroll Tax Tax Tax Net Pay Number

1 1/7/96 40.0 4.0 391.23 24.26 5.67 101.1642534 21.52 238.62 1

2 1/7/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 2

3 1/7/96 40.0 0.0 500.00 31.00 7.25 129.29 27.50 304.96 3

4 1/7/96 40.0 4.0 678.73 42.08 9.84 175.5060034 37.33 413.97 4

5 1/7/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 5

6 1/7/96 40.0 2.5 765.63 47.47 11.10 197.9753125 42.11 466.97 6

1 1/14/96 40.0 12.0 493.29 30.58 7.15 127.5549282 27.13 300.87 7

2 1/14/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 8

3 1/14/96 40.0 8.0 650.00 40.30 9.43 168.077 35.75 396.45 9

4 1/14/96 40.0 7.9 765.05 47.43 11.09 197.8257886 42.08 466.62 10

5 1/14/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 11

6 1/14/96 40.0 0.0 700.00 43.40 10.15 181.006 38.50 426.94 12

1 1/21/96 40.0 0.0 340.20 21.09 4.93 87.968916 18.71 207.49 13

2 1/21/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 14

3 1/21/96 40.0 2.4 545.00 33.79 7.90 140.9261 29.98 332.41 15

4 1/21/96 40.0 6.7 738.49 45.79 10.71 190.9581624 40.62 450.42 16

5 1/21/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 17

6 1/21/96 40.0 5.0 831.25 51.54 12.05 214.944625 45.72 507.00 18

Information Technology and the Firm 551

systems use older file structures or obsolete database management systems and

are almost incapable of accessing and manipulating data.

As an alternative to replacing these systems, data warehousing provides a

state of the art database management system that is fed data from the older

legacy systems. However, data does get duplicated, which can potentially cause

a synchronization problem between the data in the warehouse and the data in

the older legacy systems. Consequently, IT management must put stringent

controls in place. Still, the benefits outweigh the potential problems, for the

data warehouse comes with all of the high tech tools that will enable management

to create a plethora of queries and reports. Most of the newer Decision

Support Tools and Executive Information Systems, which will be discussed

later, require a storage capability similar to the data warehouse.

CONTROLS

Because the initial software applications that were developed in the 1960s and

1970s were accounting oriented, data processing, which is what information

technology was then called, typically reported to the Chief Financial Officer,

creating a control atmosphere consistent with accounting controls. A central

group of trained data entry operators was responsible for entering and verifying

data. Access to the "glass house" was restricted, and in some cases access to

the data entry and report distribution areas was also restricted. Because everything

was self-contained, control was not a major issue.

In the late seventies and early eighties, online terminals began appearing

on users' desks, outside of the glass house, allowing them access to data. Initially,

these terminals were used for information inquiry. Yet, even this limited

function was tightly controlled by strict software access control and password

protection. While workers were getting additional capabilities, they were also

creating opportunities for lapses in control. This was just the beginning of the

Trojan horse. Eventually, data entry moved out of the glass house to the warehouse

receiving dock to be used for inventory receipts; the order entry desk to

be used for new orders; the purchasing department to be used for purchase

orders; and, in the case of retailing, on to the sales f loor for point of sale processing.

No longer were trained data-entry operators responsible for the quality

of the data; others were responsible for entering data, and it was just an

ancillary part of their job, for which they were not necessarily even trained.

The control environment was breaking down, and the introduction of the

personal computer only complicated the issue. No longer was control centralized.

While access to data could be controlled, control over the use of data and

the content of reports was lost. For example, two people could each issue a report

on sales, and the numbers could easily be different. Yet, both reports

could be accurate. How is this possible? Simple. One of the reports may have

been about gross sales and the other about net sales, or one may have been

based on data through Friday and the other on data through Saturday.

552 Making Key Strategic Decisions

When all programming was controlled by a small professional group, control

was much easier. Because today's spreadsheet programs are user friendly,

however, and software does not require programming knowledge, everybody is

his or her own programmer. Thus, it is difficult to control the consistency of

the information that is being distributed.

The problems only become more complicated. Now companies allow their

business partners, vendors, and even outsiders to access their computers, using

the Internet and EDI. Data is interchanged and moneys are exchanged electronically

often without paper backup. While technology can prevent most

unauthorized access to data, as recent history has shown, even the U.S. Defense

Department has not successfully prevented the best hackers from accessing

its computers and wreaking havoc. What was relatively simple to

control before 1990 is now a nightmare. Accountants, systems professionals,

and auditors must remain forever vigilant against both inadvertent and intentional

unauthorized use and abuse of company data.

INFORMATION TECHNOLOGY STRATEGY

How do companies decide how to invest their IT money? What projects get

funded? Which projects are of higher priority? IT strategy is not created in a

vacuum. Rather, like all of the other operational departments within a corporation,

IT must support the direction and goals of the company. The Chief Information

Officer's job is to educate the rest of senior management about IT's

ability to create opportunities for the company and help it move in directions

that make sense.

IT architecture is developed to support the IT and corporate strategy. If

additional networks, workstations, or data warehouses are required, they are

either acquired or developed.

In the late 1980s and early 1990s, Wal-Mart adopted an everyday low

pricing strategy. To accomplish this goal, Wal-Mart needed to change the manner

in which it both conducted business with its suppliers and managed the inbound

logistics, warehousing, and distribution of merchandise to its stores. It

needed to abolish warehousing as much as possible and quicken the process by

which stores ordered and received merchandise. Also, Wal-Mart needed to

eliminate any unnecessary inventory in stores and allow stores to order merchandise

only as needed. Lastly, lags in its distribution centers needed to be

prevented, enabling goods to be received from their suppliers and immediately

shipped to stores.

As a result, Wal-Mart designed a systems and technology infrastructure

that, through EDI, enables the stores to order goods, as needed, from their

suppliers. Moreover, Wal-Mart permits manufacturers to access computerized

sales information directly from its computers, which, in turn, allows them

to gauge Wal-Mart's demand and then stage production to match it. Wal-Mart

effectively shifted the burden of warehousing merchandise from its own

Information Technology and the Firm 553

warehouses to the vendors, eliminating the costs of both warehouse maintenance

and surplus inventory. The distribution centers were automated, allowing

cross docking, whereby goods being received for specific stores were

immediately sent to the shipping area designated for those stores, thus putting

an end to all time lags.

Wal-Mart now has the lowest cost of inbound logistics in its industry. Its

selling G&A is 6% below its nearest competitor, enabling it to be the most

aggressive retailer in its industry. Wal-Mart aligned its IT strategy and infrastructure

to support the company's overall strategy. IT was the agent for

change. Without the newer information technologies, none of the newer strategies

and directions could have been successful.

JUSTIFYING THE COST OF

INFORMATION TECHNOLOGY

Should companies take that giant leap of faith and invest millions of dollars in

new machines and software? Can we measure the return on a company's investment

in technology?

These are questions that, for years, have concerned professional technology

managers. Today, information technology consumes an increasing share of companies'

budgets. While we cannot live with the cost of technology, ultimately, we

cannot live without the technology. Thus, when every new version of the personal

computer chip or Windows hits the market, companies must decide

whether it is a worthwhile investment. Everyone wants the latest and greatest

technology, and they assume that, with it, workers will be more productive.

While IT is the medium for change, its costs and soft benefits are difficult

to measure. As technology gets disbursed throughout a company, it becomes

increasingly difficult to track costs. As workers become their own

administrative assistants, each company must determine whether its workers

are more or less productive when they type their own documents and prepare

their own presentations. These are many of the issues that companies are facing

now and will be in the future as they struggle with new IT investments.

INTERNET/ INTRANET/EXTRANET

The Internet, intranets, and extranets provide companies with a plethora of

opportunities to find new ways of transacting business. An alternative to some

of the older technology, an intranet, a subsystem of the Internet, was developed

in 1996 to allow employees from within a company to access data in the

company's system. A "firewall" prevents outsiders from accessing any data

that a company wishes to keep confidential. An intranet refers to those systems

that are inside the firewall. Employees have the access authority to break

through the firewall and access information, even though they might be using

554 Making Key Strategic Decisions

a computer outside of the company. Remember, the Internet is just one large

party line on which everybody is sending around data.

One manufacturing company provides an intranet facility for its employees

to learn about their health, life and disability insurance, and educational

benefits. The system allows them to sign up for these programs and, in the frequently

asked questions (FAQs) section, to inquire about some of the most

common issues specific to the programs. When online, employees can also access

and sign up for a list of in-house training courses, read an employee

newsletter, and check the current price of the company's publicly traded stock.

An extranet is a version of the intranet that allows external users to access

data inside of the firewall. For example, part of Wal-Mart's ordering and logistics

system allows its vendors and suppliers to access Wal-Mart's store sales

data directly from Wal-Mart's computer systems. If these transactions occurred

over the Internet, they would be referred to as extranet transactions.

ELECTRONIC COMMERCE

Electronic commerce is changing the entire landscape in how business is

transacted. While most consumers think just about business to consumer

(B2C) e-commerce, the greatest potential lies in business-to-business (B2B)

e-commerce. International Data Corporation estimates that B2C e-commerce

will generate $300 billion annually by 2004, but B2B e-commerce will generate

$2.2 trillion annually by 2004. Most of the focus of the investor community

during 1999 and 2000 was on the B2C space, with millions of dollars made and

lost as a result of people not understanding the business model. Most of the

money raised in venture capital was used for advertising to gain brand recognition,

whereas very little was invested in infrastructure. As a result, the B2C

landscape is littered with the corpses of failed ventures. Those that have survived

are spending money on the traditional back office functions that brick

and mortar retailers have developed over the years.

All the while, bricks-and-mortar retailers have been experimenting in

selling on the Internet and have adopted a hybrid model for doing so. Customers

are able to order over the Internet, but they can also return merchandise

to traditional stores. The Internet can also make a significant difference

when products, such as music and software, can be ordered—and delivered—

electronically.

These new opportunities create new challenges for those involved in the

operations, accounting, and finance of these virtual-marketplace companies.

The order is being not only processed electronically but also shipped automatically,

sometimes from a third party's fulfillment center. Also, the payment

is being processed electronically. The electronic payment, usually through a

third-party clearance house, must conform to various security standards in

order to protect credit card information that is transmitted over the Web. Frequently,

the company selling the goods never receives the credit card number

Information Technology and the Firm 555

of the consumer, only an authorization number from the credit card clearance

house. The tracking of the merchandise, as well as the payment, not to mention

the processes for handling customer returns and credits, will present significant

angst for the auditors and controllers of these firms.

Nonetheless, the financial services industry has embraced e-commerce

and now offers most of its products over the Internet. Online services include,

among others, the purchase of stocks and bonds, online mortgages, and life

insurance and online banking. Because they are nontangible, these products

and services lend themselves well to e-commerce. The Internet works well in

many cases, because, while it is not delivering the product itself, it is delivering

information about the product, often in levels of detail and consistency that

were never available in the physical world.

As noted earlier, the real action is and will be in B2B e-commerce. Companies

of every shape and size are realizing the opportunities for both ordering

and selling their products over the Internet. Businesses are or will be using the

Internet for both the purchasing of direct and indirect materials and MRO

(maintenance, repair, and operations). General Electric runs its own auction

site on which suppliers bid to provide GE's operating divisions with millions

of dollars of materials per day. Their private e-auction is squeezing hundreds of

millions of dollars out of purchases annually and opening their purchasing to

many new vendors. Some companies, such as W. W. Grainger, long known as a

supplier of MRO materials through its network of physical distribution centers,

have established a giant Internet presence for the sale of MRO materials

called Total MRO. They are attempting to supply any nondirect material a

company could use, including office equipment and supplies.

Other marketplaces have been created to offer products for specific industries

(vertical marketplaces) or across industries (horizontal marketplaces).

These marketplaces provide not just buying opportunities, but selling opportunities

as well. Many utilize auctions or reverse auctions. Hundreds of millions

of dollars are or will be changing hands on a daily basis, totally electronically.

As per legislation passed by the U.S. government in 2000, it is now possible to

electronically sign purchase commitments and contracts over the Internet.

Some companies are using their Internet site to process orders, create and

price custom configurations (similar to what Dell Computer is doing on its

site), track orders, and assist with customer service. Some industries are creating

their own marketplaces for the cooperative purchase of goods and services.

The most notable of these marketplaces, Covisint, is an online auto parts

exchange created by major automobile manufacturers Ford, GM, and Daimler-

Chrysler. There are multitudes of B2B marketplaces and exchanges. Some are

vertical, servicing specific industries like Metalsite.com for the steel industry,

retailexchange.com for the retail industry, or paperexchange.com for the paper

industry. Others are horizontal marketplaces, like staples.com or wwgrainger

.com. There are also some hybrid models, like Verticalnet.com, that address

multiple industries. Companies like Ariba and Commerce One provide the

necessary software that facilitates these marketplaces and exchanges.

556 Making Key Strategic Decisions

APPLICATION SERVICE PROVIDERS (ASPS)

ASPs are companies that provide hosted access to software applications like

Microsoft Office and ERP systems. In effect, a company rents the application

while the data is processed on the ASP's computer. Companies typically pay a

per-user fee along with a cost-per-storage unit and access-time unit. This cost

structure is similar to a model from the 1960s and 1970s, when computers

were very expensive and companies used service bureaus to process their data.

The difference today is that much of the data is accessed over high speed data

lines or over the Internet. The downside of using an ASP is that the user is

placing its destiny in another company's hands and is dependant on its security

and financial health. The upside is that users are not responsible for purchasing

the application, maintaining it, and having to provide the computer power to

process the data.

WEB HOSTING

While many companies host their own Web site, others prefer to contract that

job out to other companies. These companies provide the communications

lines, Web servers, data backup, and, in some cases, Web design and maintenance

services. Companies that choose to outsource their Web hosting are also

protecting their main network from security breeches. However, they are still

placing a great deal of their data on the Web hosting company's computer,

which is still subject to security hackers. Many large companies such as Earthlink,

AT&T, Qwest, along with many smaller companies, provide Web hosting

services. These companies provide speed, reliability, and cost advantages,

along with redundancy and technical service.

DECISION SUPPORT SYSTEMS/EXECUTIVE

INFORMATION SYSTEMS

A class of software that is used mostly by middle-level and senior executives to

make decisions, this software combines many of the features of traditional exception

reporting with the graphical display tools available in spreadsheets. It

allows users to make their own inquiries into large volumes of data, stored in

databases or data warehouses, and provides for drill down reporting, or "slice

and dice" analysis.

Typically, most data in a database or data warehouse is three dimensional

and looks something like a Rubic's cube. Consider a database model for a chain

of 300 retail stores. The first dimension may be the company's merchandise;

the second dimension may be its store locations; and the third dimension may

represent different points in time. An executive might examine the men's department

sales. Not satisfied with the results, she might then probe to learn

557

EXHIBIT 16.7 Example of options screen for a decision support system.

558

EXHIBIT 16.8 Example of output from a decision support system.

Information Technology and the Firm 559

what categories of items sold better than others. After finding an underperforming

category, she may check how different groups or districts of stores

performed for that category. Knowing how each store performed, she might explode

down, looking at individual items, and compare their performance to

that of a prior week or year. This process is like taking the Rubic's cube and

continually rotating the levels, looking at each of the cube's faces. Each face of

each small cube represents data for a piece of merchandise for a store for a period

of time. That is why this process is referred to as "slice and dice." You can

slice and turn the data any which way you desire. The data can also be viewed

and sorted in a tabular or graphical mode. The same theory applies whether

the database contains retailing data, stock market data, or accounting data. Exhibits

16.7 and 16.8 show examples of a decision support system's output. The

output was created by Pilot Software's executive information system.

ADVANCED TECHNOLOGY

Many new technologies are on the horizon, two of which are database mining

and intelligent agents. Both address the issue of information overload. In the

1970s, the average database was perhaps 100 megabytes (millions of bytes) in

size. In the 1980s, databases were typically 20 gigabytes (billions of bytes).

Now, databases are in the terabytes (trillions of bytes). Wal-Mart has a data

warehouse that exceeds 100 terabytes. With all that data, it is difficult for a

user to know where to look. It is not the question that the user knows to ask

that is necessarily important, but, rather, the question that the user does not

know to ask that will come back to haunt him.

These new technologies examine entire databases, scanning them for any

data that does not fit the business's model and identifying any data that the

user needs to examine further. These data mining techniques can be used successfully

in many industries. For example, auditors might use them to scan

client transaction detail to look for transactions that do not conform to company

policies, and stock analysts can use them to scan data on stock prices and

company earnings over a period of time in order to look for opportunities.

CONCLUSION

The world of business has changed dramatically in the past 10 years. What was

unimaginable then is ordinary today. Product life-cycle times have decreased

from years to months. New technology is being introduced every day. An Internet

year is equal to three or four calendar months. The manager who is comfortable

with and understands the practical implications of technology will be

one of the first to succeed. Imagination and creativity are vital. Don't be afraid

of change. Understand it, and embrace it.

560 Making Key Strategic Decisions

FOR FURTHER READING

Amor, Daniel, The E-business (R)Evolution (Upper Saddle River, NJ: Prentice-Hall,

2000).

Frenzel, Carroll, Management of Information Technology, 3rd ed. (Danvers, MA:

Boyd & Fraser, 1999).

Fried, Louis, Managing Information Technology in Turbulent Times (New York: John

Wiley, 1995).

Kanter, Jerry, Information Literacy (Wellesley, MA: Babson Press, 1996).

Kanter, Jerry, Information Technology for Business Managers (New York: McGraw-

Hill, 1998).

Kalakota, R., and M. Robinson, E-Business 2.0 (Boston: Addison-Wesley, 2000).

Nickerson, Robert, Business and Information Systems, 2nd ed. (Upper Saddle River,

NJ: Prentice-Hall, 2001).

Pearlson, Keri, Managing and Using Information Systems (New York: John Wiley,

2001).

Reynolds, George, Information Systems for Managers (St. Paul, MN: West, 1995).

Turban, E., E. McLean, and J. Wetherbe, Information Technology for Management,

2nd ed. (New York: John Wiley, 2001).

Turban, E., J. Lee, D. King, and H. M. Chung, Electronic Commerce—A Managerial

Perspective (Upper Saddle River, NJ: Prentice-Hall, 2001).

INTERESTING WEB SITES

www.ariba.com ARIBA

www.baan.com BAAN

www.commerceone.com Commerce One

www.esri.com ESRI

www.greatplains.com Great Plains Software

www.intel.com Intel

www.intuit.com INTUIT

www.macola.com Macola Software

www.microsoft.com Microsoft

www.microstrategy.com Microstrategy

www.oracle.com ORACLE

www.retailexchange.com Retail Exchange

www.sap.com SAP

www.staples.com Staples

www.sun.com Sun Microsystems

www.verticalnet.com VerticalNet

www.wwgrainger.com W. W. Grainger

561

17

PROFITABLE

GROWTH BY

ACQUISITION

Richard T. Bliss

The subject of this chapter is growth by acquisition; few other business transactions

receive more scrutiny in both the popular and academic presses. There are

several reasons for this attention. One is the sweeping nature of the deals, which

typically result in major upheaval and job losses up to the highest levels of the

organizations. A second is the sheer magnitude of the deals—the recently announced

merger between Time-Warner and AOL, worth more than $150 billion,

exceeds the annual GDP of 85% of the world's nations! Thirdly, the

products involved are known to billions around the globe. Daimler-Benz, Coca

Cola, and Louis Vuitton are just a few of the world-renowned brand names recently

involved in merger and acquisition (M&A) transactions. Finally, the personalities

and plots in M&A deals are worthy of any novelist or Hollywood

scriptwriter. The 1988 acquisition of Nabisco Foods by RJR Tobacco—at that

time the largest deal ever, at $25 billion—was the subject of a New York Times

best-seller and a popular film, both called Barbarians at the Gate. Since then,

there have been numerous other best-selling books and movies based on real

and fictional M&A deals.

In spite of this publicity and the huge amounts of money involved, it is important

to remember that M&A transactions are similar to any other corporate

investment, that is, they involve uncertainty and the fundamental tradeoff between

risk and return. To lose sight of this simple fact or to succumb to the

emotion and frenetic pace of M&A deal-making activities is a sure path to an

unsuccessful result. Our goal in this chapter is to identify the potential pitfalls

you may face and to create a road map for a successful corporate M&A strategy.

562 Making Key Strategic Decisions

We review the historical evidence and discuss some of the characteristics of

both unsuccessful and successful deals. The importance of value creation is

highlighted, and we present simple analytical tools that can be used to evaluate

the potential of any merger or acquisition. Practical aspects of initiating and

structuring M&A transactions are presented and the issues critical to the successful

implementation of a new acquisition are brief ly described. It is important

to understand that there are many legal and financial intricacies involved

in most M&A transactions. Our objective here is not to explain each of these in

detail, since there are professional accountants, lawyers, and consultants available

for that. Instead, we hope to provide valuable and concise information for

busy financial managers so that they can design and implement an effective

M&A strategy.

DEFINITIONS AND BACKGROUND

Before examining the historical evidence on acquisitions, we need to define

some terminology. An acquisition is one form of a takeover, which is loosely defined

as the transfer of control of a firm from one group of shareholders to another.

In this context, control comes with the ability to elect a majority of the

board of directors. The firm seeking control is called the bidder and the one

that surrenders control the target. Other forms of takeovers include proxy contests

and going private, but the focus of this chapter is takeover via acquisition.

As we can see, acquisitions may occur in several ways. In a merger, the

target is absorbed by the bidder and the target's original shareholders receive

shares of the bidder. In a consolidation, the firms involved become parts of an

entirely new firm, with the bidder usually retaining control of the new entity.

All original shareholders hold shares in the new firm after the deal. The two

transactions have different implications for shareholders, as the following examples

make clear.

Example 1 There has recently been a wave of takeover activity in the

stuffed animal industry. Griffin's Giraffes Inc. (GGI) has agreed to merge

Takeover

Acquisition

Proxy contest

Going private

Merger or consolidation

Stock acquisition

Asset acquisition

Profitable Growth by Acquisition 563

with Hayley's Hippos Inc. (HHI). GGI offers one of its shares for three shares

of HHI. When the transaction is completed, HHI shares will no longer exist.

The original HHI stockholders own GGI shares equal in number to one-third

of their original HHI holdings. GGI's original shareholders are unaffected by

the transaction, except to have their ownership stake diluted by the newly issued

shares.

Example 2 Kristen's Kangaroos Inc. (KKI) wishes to take over the operations

of Michael's Manatees Inc. (MMI) and Brandon's Baboons Inc. (BBI). Rather

than giving its shares to the owners of MMI and BBI, KKI decides to establish

a new firm, Safari Ventures Inc. (SVI). After this consolidation, shareholders of

the three original companies (KKI, MMI, and BBI) will hold shares in the new

firm (SVI), with KKI having the controlling interest. The three original firms

cease to exist.

Another method of acquisition involves the direct purchase of shares,

either with cash, shares of the acquirer, or some combination of the two. These

stock acquisitions may be negotiated with the mangers of the target firm or by

appealing directly to its shareholders, often via a newspaper advertisement.

The latter transaction is called a tender offer, which typically occur after negotiations

with the target firm's management have failed. Finally, an acquisition

can be effected by the purchase of the target's assets. Asset acquisitions are

sometimes done to escape the liabilities (real or contingent) of the target firm

or to avoid having to negotiate with minority shareholders. The downside is

that the legal process of transferring assets may be expensive.

Acquisitions can be categorized based on the level of economic activity

involved according to the following:

Horizontal: The target and bidder in a horizontal merger are involved in

the same type of business activity and industry. These mergers typically

result in market consolidation, that is, more market share for the combined

firm. Because of this, they are subject to extra antitrust scrutiny.

The pending acquisition of USAir by United Airlines is an example of a

horizontal merger (see p. 564). Because the combined entity would be the

world's largest airline and have a dominant market share in the United

States, the Justice Department has demanded that certain assets and

routes be divested before approval for the deal will be granted.

Vertical: A vertical merger involves firms that are at different levels of

the supply chain in the same industry. For example, stand-alone Internet

service provider/portal AOL functions primarily as a distribution channel.

Its pending merger with Time Warner will allow AOL to move up the

home entertainment industry supply chain and control content in the

form of Time Warner's music and video libraries.

Conglomerate: In a conglomerate merger, the target and bidder firms are

not related. These were popular in the 1960s and seventies but are rare

564 Making Key Strategic Decisions

today. An auto manufacturer acquiring an ice cream producer would be

an example.

Armed with a basic understanding of the types of acquisitions and how

they occur, we now turn our attention to the track record of M&A transactions.

Be forewarned that it is spotty at best and that many practitioners, analysts, and

academics believe that the odds are stacked against acquirers. We do not say this

to dissuade anyone from pursuing an acquisition strategy, but rather to highlight

the fact that without careful planning, there is little chance of success.

THE TRACK RECORD OF MERGERS AND ACQUISITIONS

There has been tremendous growth in the number and dollar value of M&A

transactions over the last two decades (see Exhibit 17.1). In 1998, the total annual

value of completed transactions exceeded one trillion dollars for the first

time in history. The number of deals fell in 1999, but larger deals resulted in a

total deal value of almost $1.5 trillion. Exhibit 17.2 lists the largest deal for

each of the years between 1990 and 2000.

While the data in Exhibits 17.1 and 17.2 focus on large transactions, the

growth trend for all M&A deals is similar. And in 1999, for the first time in

history, there were more deals done abroad than in the United States. By any

SOURCE: The Wall Street Journal, December 20, 2000.

Profitable Growth by Acquisition 565

measure, the 1990s was an increasingly acquisitive decade around the world.

This explosion in deal making might lead one to assume that mergers and acquisitions

are an easy way for corporate managers to create value for their

shareholders. To assess this, we now examine the empirical evidence on mergers

and acquisitions. Let's begin with the wealth of academic studies that analyze

M&A performance.1

M&A activity has been the focus of volumes of academic research over

the last 40 years. The evidence is mixed, but we can draw several clear conclusions

from the data. We break our discussion into two pieces: short-term

EXHIBIT 17.1 M&A activity, 1981–1999.a

aData is for deals valued at at least $5 million and involving one U.S. company.

SOURCE: Mergers & Acquisitions, September 2000.

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

Year

Number of deals

Value (billions)

Number of deals (left axis)

Total value (right axis)

0

2,000

4,000

6,000

8,000

10,000

12,000

0

200

400

600

800

1,000

1,200

1,400

1,600

EXHIBIT 17.2 A decade of megadeals.

Price

Year Bidder Target (billions)

1990 Time Inc. Warner Communications $ 12.6

1991 AT&T Corp. NCR Corp. 7.5

1992 BankAmerica Corp. Security Pacific Corp. 4.2

1993 Merck & Co. Medco Containment Services 6.2

1994 AT&T Corp. McCaw Cellular Inc. 18.9

1995 AirTouch Communications US West Inc. 13.5

1996 Walt Disney Co. Capital Cities/ABC Inc. 18.9

1997 Bell Atlantic Corp. NYNEX Corp. 21.3

1998 Travelers Group Inc. Citicorp 72.6

1999 Exxon Corp. Mobil Corp. 78.9

2000 America Online Inc. Time Warner Inc. 156.0

SOURCE: Mergers & Acquisitions, September 2000.

566 Making Key Strategic Decisions

and long-term M&A performance. The short-term is a narrow window, typically

three to five days, around the merger announcement. Long-term studies

examine postmerger performance two to five years after the transaction is

completed.

We can offer three unambiguous conclusions about the short-term financial

impact of M&A transactions:

1. Shareholders of the target firms do very well, with average premiums between

30% and 40%.

2. Returns to bidders have fallen over time as the market for corporate control

becomes more competitive; recent evidence finds bidder returns indistinguishable

from zero or even slightly negative.

3. The combined return of the target and the bidder, that is, the measure of

overall value creation, was slightly positive.

However, these results are highly variable depending on the specific samples

and time periods analyzed. The findings on the long-term performance of

mergers and acquisitions are not any more consistent or encouraging. Agrawal

et al. report "shareholders of acquiring firms experience a wealth loss of about

10% over the five years following the merger completion."2 Other studies' conclusions

range from underperformance to findings of no abnormal postmerger

performance. The strongest conclusions offered by Weston et al. are that, "It is

likely, therefore, that value is created by M&As," and that, "Some mergers

perform well, others do not."3 So much for the brilliance of the academy! This

level of confidence hardly seems to justify the frenetic pace of merger activity

chronicled in Exhibits 17.1 and 17.2.

If the academic literature seems ambivalent about judging the financial

wisdom of M&A decisions, the popular business press shows no such hesitancy.

In a 1995 special report, Business Week carefully analyzed 150 recent deals

valued at $500 million or more and reported "about half destroyed shareholder

wealth" and "another third contributed only marginally to it." The article's last

paragraph makes it clear that this is not a benign finding and places the blame

squarely on corporate CEOs.

All this indicates that many large-company CEOs are making multibilliondollar

decisions about the future of their companies, employees, and shareholders

in part by the seat of their pants. When things go wrong, as the

evidence demonstrates that they often do, these decisions create unnecessary

tumult, losses, and heartache. While there clearly is a role for thoughtful and

well-conceived mergers in American business, all too many don't meet that

description.

Moreover, in merging and acquiring mindlessly and f lamboyantly, dealmakers

may be eroding the nation's growth prospects and global competitiveness.

Dollars that are wasted needlessly on mergers that don't work might

better be spent on research and new-product development. And in view of the

growing number of corporate divorces, it's clear that the best strategy for most

would-be marriage partners is never to march to the altar at all.4

Profitable Growth by Acquisition 567

A 1996 survey of 150 companies by the Economist Intelligence Unit in London

found that 70% of all acquisitions failed to meet the expectations of the initiator.

Coopers and Lybrand studied the postmerger performance of 125 companies

and reported that 66% were financially unsuccessful.

We now turn our attention to several specific M&A transactions. While

unscientific, this approach is more informative and certainly more interesting

than reviewing academic research. We purposely focus on failed deals in an attempt

to learn where the acquirers went wrong. In the next section, we examine

the acquisition strategy and policies of Cisco Systems, the acquirer ranked

No. 1 in a recent survey of corporate M&A practices.

As you read about these dismal transactions, can you speculate on the reasons

for failure? On their faces, they seemed like strategically sound transactions.

While one might question AT&T's push into personal computers, the

other two deals were simple horizontal mergers, that is, an extension of the existing

business into new product lines or geographic markets. In hindsight,

each deal failed for different reasons, but there are some common issues. The

lessons learned are critical for all managers considering growth by acquisition.

We now examine these colossal failures in more detail.

Analysts believe that the merger between AT&T and NCR failed due to

managerial hubris, overpayment, and a poor understanding of NCR's products

and markets. A clash between the two firms' cultures proved to be the final

nail in the coffin. In 1990 AT&T's research division, Bell Labs, was one of the

worlds premier laboratories. With seven Nobel prizes and countless patents to

its name, it was where the transistor and the UNIX operating system had been

invented. AT&T's executives mistakenly believed that this research prowess

Disaster Deal No. 1

Between 1985 and 1990, AT&T's computer operations lost approximately $2

billion. The huge conglomerate seemed unable to compete effectively against

the likes of Compaq, Hewlett Packard and Sun Microsystems. They decided to

buy rather than build and settled on NCR, a profitable, Ohio-based personal

computer (PC) manufacturer with 1990 revenues of $6 billion. NCR did not

want to be purchased and this was made clear in a letter from CEO Chuck

Exley to AT&T CEO Robert Allen: "We simply will not place in jeopardy the

important values we are creating at NCR in order to bail out AT&T's failed

strategy." OUCH! However, after a bitter takeover fight—and an increase of

$1.4 billion in the offer price (raising the premium paid to more than

100%!)—AT&T acquired NCR in September 1991 for $7.5 billion.

Aftermath: In 1996, after operating losses exceeding $2 billion and a $2.4 billion

write-off, AT&T spun-off NCR in a transaction valued at about $4 billion,

approximately half of what it had paid to acquire NCR less than five years

before.

568 Making Key Strategic Decisions

and $20 billion of annual long-distance telephone revenues, along with the

NCR acquisition, would guarantee the company's success in the PC business.

They were confident enough to increase their original offer price by $1.4 billion.

The problem was that by this time, PCs had become a commodity and

were being assembled at low-cost around the world using off-the-shelf components.

Unlike the microprocessor and software innovations of Intel and Microsoft,

AT&T's research skills held little profit potential for the PC business.

AT&T hoped to use NCR's global operations to expand their core telecom

business. But NCR's strengths were in developed countries, whereas the

fastest-growing markets for communications equipment were in developing

third-world regions. And in many companies, the computer and telephone systems

were procured and managed separately. Thus, the anticipated synergies

never materialized.

Finally, the two companies had very different cultures. NCR was tightly

controlled from the top while AT&T was less hierarchical and more politically

correct. When AT&T executive Jerre Stead took over at NCR in 1993, he

billed himself as the "head coach," passed out T-shirts, and told all of the employees

they were "empowered." This did not go over well in the conservative

environment at NCR, and by 1994, only 5 of 33 top NCR managers remained

with the company.

Disaster Deal No. 2

Throughout 1994, Quaker Oats Co. was rumored to be a takeover target. It was

relatively small ($6 billion in revenue) and its diverse product lines could be

easily broken up and sold piecemeal. In November, Quaker announced an

agreement to buy iced-tea and fruit-drink maker Snapple Beverage Corp. for

$1.7 billion, or $14 per share. CEO William Smithburg dismissed the 10%

drop in Quaker 's stock price, arguing "We think the healthy, good-for-you

beverage categories are going to continue to grow." The hope was that Quaker

could replicate the success of its national-brand exercise drink Gatorade,

which held an extraordinary 88% market share.

Snapple, which had 27% of the ready-to-drink tea segment was distributed

mainly through smaller retail outlets and relied on offbeat advertising

and a "natural" image to drive sales. Only about 20% of sales were from supermarkets

where Quaker 's strength could be used to expand sales of Snapple's

drinks.

Aftermath: In April 1997, Quaker announced it would sell Snapple for

$300 million to Triarc Cos. Quaker takes a $1.4 billion write-off and the sale

price is less than 20% of what Quaker paid for Snapple less than three years

earlier. Analysts estimated the company also incurred cash losses of approximately

$100 million over the same period. Ending a 30-year career with the

company, CEO Smithburg "retires" two weeks later at age 58.

Profitable Growth by Acquisition 569

What doomed the Quaker-Snapple deal? One factor was haste. Quaker

was so worried about becoming a takeover target in the rapidly consolidating

food industry that it ignored evidence of slowing growth and decreasing profitability

at Snapple. The market's concern was ref lected in Quaker's stock price

drop of 10% on the acquisition announcement. In spite of this, Quaker's managers

proceeded, pushing the deal through on the promise that Snapple would

be the beverage industry's next Gatorade. This claim unfortunately ignored the

realities on the ground: Snapple had onerous contracts with its bottlers, fading

marketing programs, and a distribution system that could not support a national

brand. There was also a major difference between Snapple's quirky, offbeat

corporate culture and the more structured environment at Quaker.

Most importantly, Quaker failed to account for the possible entrance of

Coca Cola and Pepsi into the ready-to-drink tea segment—and there were few

barriers to entry—which ultimately increased competition and killed margins.

Disaster Deal No. 3

The 1998 $130 billion megamerger between German luxury carmaker Daimler-

Benz and the #3 U.S. automobile company, Chrysler Corporation, was universally

hailed as a strategic coup for the two firms. An official at a rival firm

simply said "This looks like a brilliant move on Mercedes-Benz's part."* The

stock market agreed as the two companies' shares rose by a combined $8.6 billion

at the announcement. A 6.4% increase in Daimler-Benz's share price accounted

for $3.7 billion of this total. The source of this value creation was

simple: There was very little overlap in the two companies' product lines or geographic

strengths. "The issue that excites the market is the global reach," said

Stephen Reitman, European auto analyst for Merrill Lynch in London.* Daimler

had less than 1% market share in the U.S., and Chrysler 's market share in

Europe was equally miniscule. There would also be numerous cost-saving opportunities

in design, procurement, and manufacturing.

The deal was billed as a true partnership, and the new firm would keep

operational headquarters in both Stuttgart and Detroit and have "co-CEOs"

for three years after the merger. In addition, each firm would elect half of the

directors.

Aftermath: By the end of 2000, the new DaimlerChrysler 's share price

had fallen more than 60% from its post merger high. Its market capitalization

of $39 billion was 20% less than Daimler-Benz's alone before the merger! All

of Chrysler 's top U.S. executives had quit or been fired, and the company's

third-quarter loss was an astounding $512 million. As if all of this weren't bad

enough, DaimlerChrysler 's third-largest shareholder, Kirk Kekorian, was suing

the company for $9 billion, alleging fraud when they announced the 1998 deal

as a "merger of equals."

* "Auto Bond: Chrysler Approves Deal With Daimler-Benz," The Wall Street Journal,

May 7, 1998.

570 Making Key Strategic Decisions

In this case, Quaker's management was guilty of two mistakes: failure to analyze

Snapple's products, markets, and competition correctly and overconfidence

in their ability to deal with the problems. Either way, their lapses cost

Quaker's shareholders billions.

Although the jury is still out on the Daimler-Chrysler merger, analysts already

have assigned at least some of the blame. There were culture issues from

the start, and it quickly became apparent that co-CEOs were not the way to

manage a $130 billion global giant. Chrysler CEO Robert Eaton left quietly at

the beginning of 2000 and there were other departures of high-level American

executives. Morale suffered as employees in the U.S. realized that the "merger

of equals" was taking on a distinctive German f lavor and in November 2000,

the last remaining Chrysler executive, U.S. president James Holden, was fired.

Rather than deal with these issues head-on, Daimler CEO Jergen

Schremp took a hands-off approach as Chrysler's operations slowly spiraled

downward. The company lost several top designers, delaying new product introductions

and leaving Chrysler with an aging line of cars at a time when its

competitors were firing on all cylinders. The delay in merging operations

meant cost savings were smaller than anticipated as were the benefits from

sharing technology. Finally, analysts suggested that Daimler paid top dollar for

Chrysler at a time when the automobile industry in the U.S. was riding a wave

of unprecedented economic prosperity. As car sales began to sag at the end of

2000, all three U.S. manufacturers were facing excess capacity and offering

huge incentives to move vehicles. This was not the ideal environment for

quickly restructuring Chrysler's troubled operations and Daimler was facing a

35% drop in projected operating profit between 1998 and 2001.

Conclusions: These three case studies highlight some of the difficulties

firms face in achieving profitable growth through acquisitions. Managerial

hubris and a competitive market make it easy to overestimate the merger 's

benefits and therefore overpay. A deal that makes sense strategically can still

be a financial failure if the price paid for the target is too high. This is especially

a problem when economic conditions are good and high stock prices

make it easy to justify almost any valuation if the bidder 's managers and directors

really want to do a deal. Shrewd managers can sell deals that make little

strategic sense to unsuspecting shareholders and then ignore signals from the

market that the deal is not a good one.

The previous examples make it clear that it is easy to overstate the benefits

that will come after the transaction is completed. Whatever their source,

these benefits are elusive, expensive to find and implement, and subject to attack

by competitors and economic conditions. Managers considering an acquisition

should be conservative in their estimates of benefits and generous in the

amount of time budgeted to achieve these benefits. The best way to accurately

estimate the benefits of the merger is to have a thorough understanding of the

target's products, markets, and competition. This takes time and can only come

from careful due diligence, which must be conducted using a disciplined

Profitable Growth by Acquisition 571

approach that fights the tendency for managers to become emotionally attached

to a deal. In spite of the time pressures inherent in any merger transaction,

this is truly a situation where "haste makes waste."

A common factor in each of these transactions—and one often overlooked

by managers and researchers in finance and accounting—is culture. Two types

of culture can come into play in an acquisition. One is corporate or industry

culture and the second is national culture, which is a factor in cross-border

deals. If the target is in a different industry than the bidder, a careful analysis

of the cultural differences between them is essential. Culture is especially

critical in industries where the main assets being acquired are expertise or intellectual

capital. Failure to successfully merge cultures in such industries can

be particularly problematic because key employees will depart for better working

conditions. The attempted 1998 merger between Computer Associates

(CA) and Computer Science Corporation (CSC) ultimately failed when CA realized

that their mishandling of the negotiations and their insensitivity to the

culture at CSC would cause many of CSC's consultants to quit the merged

company. We will discuss the keys to successful implementation of mergers

later in the chapter. In the next section we examine the acquisition strategy of

Cisco Systems Inc. We do this to make it clear that there are ways to increase

your chances of success when planning and implementing an M&A strategy.

ANATOMY OF A SUCCESSFUL ACQUIRER:

THE CASE OF CISCO SYSTEMS INC.

Cisco Systems Inc., the Silicon Valley-based networking giant, is one of the

world's most successful corporations. Revenues for the fiscal year ending July

2000 were up an incredible 55% to $18.9 billion, while net income grew to $3.9

billion, resulting in a healthy 21% net profit margin. Even more impressive was

its 10th consecutive quarter of accelerating sales growth, culminating in a 61%

sales increase for the last quarter. At $356 billion, Cisco's market capitalization

trailed only General Electric Company. What is behind such phenomenal results?

Beginning in 1993, Cisco has acquired 51 companies, 21 of them in the

12-month period ending March of 2000. Not every one of these deals has been

a winner, and certainly some elements of Cisco's strategy are unique to the

high-technology industry. However, in a recent survey of corporate M&A policies

Cisco was ranked number 1 in the world, and there are lessons for any potential

acquirer in its practices.5

We will focus on two aspects of Cisco's acquisition strategy: the competitive

and economic forces behind it and how new acquisitions are merged into

the corporate fold. The strategic imperative behind Cisco's acquisition spree is

simple. Each year the company gets 30% to 50% of its revenue from products

that it did not sell 12 months before. Technological change means that Cisco

cannot internally develop all of the products its customers need. They have

two choices; to limit their offerings or to buy the products and technology they

572 Making Key Strategic Decisions

can't or choose not to develop. In this case, the strategy is driven by their customer's

demands and by the realities of the industry. Once CEO John Chambers

and Cisco's board made rapid growth a priority, an effective M&A plan

was the only way to accomplish this goal. To minimize risk, Cisco often begins

with a small investment to get a better look at a potential acquisition and to assess

it products, customers, and culture. Finally, Cisco often looks for private

and pre-IPO companies to avoid lengthy negotiations and publicity.

Cisco's 1999 acquisition of fiber-optic equipment maker Cerent Corporation

is a good example of this strategy. Cisco purchased a 9% stake in Cerent in

1998 as a hedge against what analysts viewed as Cisco's lack of fiber-optic expertise.

Through this small investment, Cisco CEO John Chambers got to

know Cerent's top executive, Carl Russo. He quickly realized that they had

both come up through the high-tech ranks as equipment salesmen and had

built their companies around highly motivated and aggressive sales teams. Cerent's

266 employees included a 100-member sales team that had assembled a

rapidly growing customer base. Cerent also favored sparse offices—a Cisco

trademark—and Mr. Russo managed the company from an eight-foot square

cubicle. All of these factors gave Cisco important insights into Cerent's

strengths and corporate culture.

When Mr. Chambers felt comfortable that Cerent could successfully become

part of Cisco, he personally negotiated the $7 billion purchase price for

the remaining 91% stake with Mr. Russo. The discussions took a total of two

and a half hours over three days. When the deal was announced on August 25,

1999, the second—and arguably the most important—phase of Cisco's acquisition

strategy kicked in. Over the years, including an occasional failure, Cisco

had developed a finely tuned implementation plan for new acquisitions. The

plan has three main pieces:

1. Don't forget the customer.

2. Salespeople are critical.

3. The small things garner loyalty.

There is often a customer backlash to merger announcements because

customers' perception of products and brands may have changed. In the recent

spate of pharmaceutical industry mergers, only those firms that avoided pairing

up experienced substantial sales growth. As part of the external environment,

customers are easy to ignore in the short term when the tendency is to

focus on the internal aspects of the implementation. This is a big mistake. To

allay customer fears, in the weeks after Cerent was acquired, Mr. Russo and his

top sales executive attended the annual Cisco sales convention meeting and

Mr. Chambers joined sales calls to several of Cerent's main customers.

This lesson did not come cheaply. When Cisco acquired StrataCom in

1996, it immediately reduced the commission schedule of StrataCom's sales

force and reassigned several key accounts to Cisco salespeople. Within a few

months, a third of StrataCom's sales team had quit, sales fell drastically, and

Cisco had to scramble to retain customers. In the Cerent implementation, the

Profitable Growth by Acquisition 573

sales forces of the two companies remained independent and Cerent's salespeople

received pay increases of 15% to 20% to bring them in line with Cisco's

compensation practices. As a result, there was little turnover and sales grew.

Cisco executives realized early on that the strategic rationale for an acquisition

and their grand plans for the future meant little to the target's midand

low-level employees. They had more basic concerns like job retention and

changes in their day-to-day activities. Cisco had also learned that quickly winning

over these employees—and keeping them focused on their jobs—was critical

to a successful implementation. This process begins weeks before the deal

is done, as the Cisco transition team works to map each employee at the target

into a Cisco job. As each Cerent employee left the meeting where the acquisition

was announced, they were given an information packet on Cisco, telephone

and e-mail contacts for Cisco executives, and a chart comparing the

vacation, medical, and retirement benefits of the two companies. There were

follow-up sessions over the next several days to answer any lingering questions.

Cisco also agreed to honor several aspects of Cerent's personnel policies that

were more generous than their own, such as providing more-generous expense

allowances and permitting previously promised sabbaticals to be taken. Cisco

understood that these are relatively small items in the larger context of a successful

and timely transition.

When the merger was actually completed, Cerent employees had new IDs

and business cards within days. By the following week, the e-mail and voicemail

systems had been converted to Cisco's standards and all of Cerent's computer

systems were updated. By the end of September, one month after the

acquisition announcement, the new employee mapping had been implemented.

Most employees kept their original jobs and bosses; about 30 were reassigned

because they had positions that overlapped directly with Cisco workers. Overall,

there was little turnover.

This example highlights some of the factors important to developing and

implementing a successful acquisition strategy. However, all companies are not

like Cisco, and what works for them may not guarantee you a winning acquisition

plan. Cisco is fortunate to be in a rapidly growing industry in continuous

need of new technologies and products. It also has the benefit of a high stock

market valuation, which makes its shares valuable currency for making acquisitions.

At the same time, the keys to successful implementation discussed previously—

that is, concern for the customer, taking care of salespeople, and

understanding what creates employee loyalty—are universal and must be part

of any acquisition strategy. In the next section we look more closely at the question

of value creation in M&A decisions.

CREATING VALUE IN MERGERS

AND ACQUISITIONS

We have already presented the dubious historical evidence on the financial

performance of mergers and acquisitions. This record makes it clear that a

574 Making Key Strategic Decisions

significant number destroy shareholder value, some spectacularly. In this section,

we more closely examine the issue of value creation, focusing on its

sources in mergers and acquisitions. We begin the discussion with an assumption

that the objective of managers in initiating these transactions is to increase

the wealth of the bidder's shareholders. We will ignore the reality that managers

may have personal agendas and ulterior motives for pursuing mergers and

acquisitions, even those harmful to their shareholders. A discussion of these issues

is beyond the scope of this chapter.6

To be very clear, recall the source of all value for holders of corporate equity.

Stock prices are a function of two things: expected future cash f lows and

the risk of those f lows. These cash flows may come as dividends, share price

increases, or some combination of the two, but the important thing to understand

is that changes in share prices simply ref lect the market's expectations

about future cash flows or their risk—nothing more and nothing less. If investors

believe a company's cash f lows in the future will be smaller or riskier,

ceteris paribus, the share price will decline. If the expectation is for larger or

less risky cash f lows, the share price goes up. Thus, when we talk about M&A

decisions creating value, there can only be two sources of that value: more cash

f low or less risk. Our discussion focuses primarily on the former.

Consider two independent firms, A and B, with respective values VA and

VB. Assume that the managers of firm A feel that the acquisition of firm B, that

is, the creation of a merged firm AB, would create value. That is, they believe

VAB > VA + VB. The difference between the two sides of this equation, VAB (VA

+ VB), is the incremental value created by the acquisition, sometimes called the

synergy. That is,

Clearly, positive synergy would be a prerequisite to going forward with the acquisition.

In practice, things are a bit more complicated for two reasons: the

costs of an acquisition and the target premium. The acquisition process carries

significant direct costs for lawyers, consultants, and accountants. There is also

the indirect cost caused by the distraction of the bidder's executives from their

day-to-day operation of the existing business. Finally, the data presented in the

section on mergers and acquisitions shows that target shareholders in acquisitions

typically receive a 30% to 40% premium over market price. Some transactions

have smaller premiums, but in almost all cases, the acquirer pays a

price above the pre-acquisition market value. All of these costs can be factored

into the evaluation as follows:

Example 3 Midland Motorcycles Inc. is considering the acquisition of Scotus

Scooters. Midland's current market capitalization is $10 million, while Scotus

has a market capitalization of $2 million. The executives at Midland feel the

combined firm would be worth $14 million due to synergies. Current takeover

premiums average 35% and the total cost of the acquisition is estimated at $1.5

million. Should Midland proceed with the deal?

Net advantage of merging = V Merger costs Premium (2) AB A B [ (V + V )]− −

Synergy (1) AB A B = V (V + V )

Profitable Growth by Acquisition 575

The deal would destroy $200,000 of value. Note that this is in spite of the fact

that there are $2 million of positive synergies created by the acquisition. The

reality is that this synergy is more than offset by the costs of the transaction

and the premium paid for the target, a typical problem in acquisitions. For example,

consider Coca-Cola's recent interest in Quaker Oats, which Coke CEO

Douglas Daft felt "fit perfectly into Coke's strategy of boosting growth by increasing

its share of non-carbonated drinks."7 Even Coke's directors felt that

the strategic rationale behind the transaction was sound. But the deal was

ultimately rejected because of the price. Warren Buffett, a major Coca-Cola

shareholder, said "Giving up 10% of the Coca-Cola Company was just too much

for what we would get."8

Note that the bracketed term in equation 2 is just the synergy as defined

in equation 1. Where does this synergy or incremental value originate? From

above, we know that value can only come from two places—increased cash

f lows or reduced risk. In this case, the synergy can be computed as follows:

where ร„CFt is the incremental cash f low in period t, and r is the appropriate

risk-adjusted discount rate. The total synergy is just the present value of all future

incremental cash flows. Equation 3 makes it clear that changes in future

cash f lows or their risk are at the root of any M&A synergies. Before considering

how a merger might impact cash f lows, recall how they are computed:

With this in mind, we can look more closely at potential sources of incremental

cash flows—and therefore, value—in acquisitions. We focus on the following

three areas:

1. Incremental revenue.

2. Cost reductions.

3. Tax savings.

Incremental Revenue More revenue for the combined firm can come from

marketing gains, strategic benefits, or market power. Increased revenue

through marketing gains result from improvements in advertising, distribution

or product offerings. For example, when Citicorp and Travelers Inc. announced

their merger in 1998, incremental revenue was a key factor:

Incremental Revenues

Incremental Costs

Incremental Taxes

Incremental Investment in New Working Capital

Incremental Investment in Fixed Assets

= Incremental Cash Flow

Synergy = (3)

( + ) =

ร“ ร„CF

r

t

t t 1 0

Net advantage of merging =[14 ($10 + $2)]$1.5 (35%× $2) = −$0.2 million

576 Making Key Strategic Decisions

"Finally, there is the central justification of the deal: cross-selling each other 's

products, mainly to retail customers. Over the next two years, Citigroup ought

to be able to generate $600 million more in earnings because of cross-selling."9

After acquiring Miller Brewing Company in 1970, Philip Morris used its marketing

and advertising strength to move Miller from the number 7 to the number

2 U.S. beer maker by 1977.

Some acquisitions provide strategic benefits that act as insurance against

or options on future changes in the competitive environment. As genetic research

has advanced, pharmaceutical firms have used acquisitions to ensure

they participate in the commercial potential offered by this new technology.

The 1998 acquisition of SmithKline Beecham PLC by Glaxo Wellcome PLC

was motivated by Glaxo's fear of missing out on this revolution in the industry.

SmithKline had entered the genetic research field in 1993 by investing $125

million in Human Genome Sciences, a Rockville, Maryland, biotechnology

company created to commercialize new gene-hunting techniques.

Finally, the acquisition of a competitor may increase market share and

allow the merged firm to charge higher prices. By itself, this motive is not valid

justification for initiating a merger, and any deal done solely to garner monopolistic

power would be challenged by global regulators on antitrust grounds.

However, market power may be a by-product of a merger done for other reasons.

American Airline's potential bid for USAir, while launched primarily to

thwart a similar attempt by its competition, would also have implications for

market power in the industry.

American is particularly worried about the prospect of USAir falling into

United's hands. Nabbing the carrier for itself would give American coveted

slots at Chicago's O'Hare, New York's LaGuardia, and Washington's National

Airport.10

Cost Reductions Improved efficiency from cost savings is one of the most

often cited reasons for mergers. This is especially true in the banking industry,

as the recent merger between J.P. Morgan and Chase Manhattan makes clear.

The key to executing the merger, say analysts, will be how quickly Chase can

trim its expenses. It plans to save $500 million through job cuts, $500 million by

consolidating the processing systems of the two institutions and $500 million

by selling off excess real estate. In London, for example, the two banks have 21

buildings, and they won't need all of them.11

In total, there is an estimated $1.5 billion of annual savings. The link between

this and value creation is easy for investors to understand and the benefits from

cost reductions are relatively easy to quantify. These benefits can come from

economies of scale, vertical integration, complementary resources, and the

elimination of inefficient management.

Economies of scale result when a certain percentage increase in output

results in a smaller increase in total costs, resulting in reduced average cost. It

Profitable Growth by Acquisition 577

doesn't matter whether this increased output is generated internally or acquired

externally. When the firm grows to its "optimal" size, average costs are

minimized and no further benefits are possible. There are many potential

sources of economies of scale in acquisitions, the most common being the ability

to spread fixed overhead, such as corporate headquarters expenses, executive

salaries, and the operating costs of central computing systems, over

additional output.

Vertical integration acquisitions can reduce costs by removing supplier

volatility, by reducing inventory costs, or by gaining control of a distribution

network. Such benefits can come in any industry and for firms of all sizes.

Waste Systems International, a regional trash hauler in the United States, acquired

41 collection and disposal operations between October 1996 and July

1999 with the goal of enhancing profitability.

The business model is fairly straightforward. Waste Systems aims to own the

garbage trucks that pick up the trash at curbside, the transfer stations that consolidate

the trash, and the landfills where it's ultimately buried. Such vertical

integration is seen as crucial for success in the waste business. Owning landfill

space gives a trash company control over its single biggest cost, disposal fees,

and, equally important, produces substantial economies of scale.12

One firm may acquire another to better utilize its existing resources. A chain

of ski retailers might combine with golf or tennis equipment stores to better

utilize warehouse and store space. These types of transactions are typical in

industries with seasonal or very volatile revenue and earnings patterns.

Personnel reductions are often used to reduce costs after an acquisition.

The savings can come from two sources, one being the elimination of redundancies

and the second the replacement of inefficient managers. When firms combine,

there may be overlapping functions, such as payroll, accounts payable, and

information systems. By moving some or all of the acquired firm's functions to

the bidder, significant cost savings may be possible. In the second case, the target

firm managers may actually be making decisions that limit or destroy firm

value. By acquiring the firm and replacing them with managers who will take

value-maximizing actions, or at least cease the ones that destroy value, the bidder

can effect positive changes.

The U.S. oil industry in the late 1970s provides an excellent example of

this. Excess production, structural changes in the industry, and macroeconomic

factors resulted in declining oil prices and high interest rates. Exploration

and development costs were higher than selling prices and companies

were losing money on each barrel of oil they discovered, extracted, and refined.

The industry needed to downsize, but most oil company executives were

unwilling to take such action and as a result, continued to destroy shareholder

value. T. Boone Pickens of Mesa Petroleum was one of the few industry participants

who not only understood these trends, but was also willing to act. By acquiring

several other oil companies and reducing their exploration spending,

Pickens created significant wealth for his and the target's shareholders.13

578 Making Key Strategic Decisions

Tax Savings Corporations in the U.S. pay billions each year in corporate income

taxes. M&A activity may create tax savings that would not be possible absent

the transaction. While acquisitions made solely to reduce taxes would be

disallowed, substantial value may result from tax savings in deals initiated for

valid business purposes. We consider the following three ways that tax incentives

may motivate acquisition activity:

1. Unused operating losses.

2. Excess debt capacity.

3. Disposition of excess cash.

Operating losses can reduce taxes paid, provided that the firm has operating

profits in the same period to offset. If this is not the case, the operating losses

can be used to claim refunds for taxes paid in the three previous years or carried

forward for 15 years. In all cases, the tax savings are worth less than if

they were earned today due to the time value of money.

Example 4 Consider two firms, A and B, and two possible states of the economy,

boom and bust with the following outcomes:

Firm A Firm B

Boom Bust Boom Bust

Taxable income $1,000 $(500) $(500) $1,000

Taxes (at 40%) (400) 0 0 (400)

Net income $ 600 $(500) $(500) $ 600

Notice that for each possible outcome, the firms together pay $400 of

taxes. In this case, operating losses do not reduce taxes for the individual firms.

Now consider the impact of an acquisition of firm B by firm A.

Firm A/B

Boom Bust

Taxable income $500 $500

Taxes (at 40%) (200) (200)

Net income $300 $300

The taxes paid have fallen by 50% to $200 under either scenario. This is

incremental cash f low that must be considered when assessing the acquisition's

impact on value creation. This calculation must be done with two caveats.

Firstly, only cash f lows over and above what the independent firms would ultimately

save in taxes should be included and secondly, the tax savings cannot be

the main purpose of the acquisition.

Interest payments on corporate debt are tax deductible and can generate

significant tax savings. Basic capital structure theory predicts that firms will

issue debt until its additional tax benefits are offset by the increased likelihood

Profitable Growth by Acquisition 579

of financial distress. Because most acquisitions provide some degree of diversification,

that is, they reduce the variability of profits for the merged firms,

they can also reduce the probability of financial distress. This diversification

effect is illustrated in the previous example, where the postmerger net income

is constant. The result is a higher debt-to-equity ratio, more interest payments,

lower taxes, and value creation.

Many firms are in the enviable position of generating substantial operating

cash f lows and over time, large cash surpluses. At the end of 1999, for example,

Microsoft and Intel held a combined $29 billion in cash and short-term

investments. Firms can distribute these funds to shareholders via a dividend or

through a stock repurchase. However, both of these options have tax consequences.

Dividends create substantial tax liabilities for many shareholders and

a stock repurchase, while generating lower taxes due to capital gains provisions

cannot be executed solely to avoid tax payments. A third option is to use the excess

cash to acquire another company. This strategy would solve the surplus

funds "problem" and carry tax benefits as no tax is paid on dividends paid from

the acquired to the acquiring firms. Again, the acquisition must have a business

rationale beyond just saving taxes.

The following example summarizes the sources of value discussed in

this section and illustrates how we might assess value creation in a potential

acquisition.

Example 5 MC Enterprises Inc. manufactures and markets value-priced digital

speakers and headphones. The firm has excellent engineering and design

staffs and has won numerous awards from High Fidelity magazine for its most

recent wireless bookshelf speakers. MC wants to enter the market for personal

computer (PC) speakers, but does not want to develop its own line of new products

from scratch. MC has three million outstanding shares trading at $30/share.

Digerati Inc. is a small manufacturer of high-end speakers for PCs, best

known for the technical sophistication of its products. However, the firm has

not been well managed financially and has had recent production problems,

leading to a string of quarterly losses. The stock recently hit a three-year low of

$6.25 per share with two million outstanding shares.

MC's executives feel that Digerati is an attractive acquisition candidate

that would provide them with quick access to the PC market. They believe an

acquisition would generate incremental after-tax cash f low from three sources.

1. Revenue enhancement: MC believes that Digerati's technical expertise

will allow it to expand their current product line to include high-end

speakers for home theater equipment. They estimate these products

could generate incremental annual cash flow of $1.25 million. Because

this is a risky undertaking, the appropriate discount rate is 20%.

2. Operating efficiencies: MC is currently operating at full capacity with

significant overtime. Digerati has unused production capacity and could

easily adapt their equipment to produce MC's products. The estimated

580 Making Key Strategic Decisions

annual cash f low savings would be $1.5 million. MC's financial analysts

are reasonably certain these results can be achieved and suggest a 15%

discount rate.

3. Tax savings: MC can use Digerati's recent operating losses to reduce its

tax liability. Their tax accountant estimates $750,000 per year in cash savings

for each of the next four years. Because these values are easy to estimate

and relatively safe cash f lows, they are discounted at 10%. The

values of MC and Digerati premerger are computed as follows:

Number of

Company Shares Price/Share Market Value

MC Enterprises 3,000,000 $30.00 $90 million

Digerati Inc. 2,000,000 6.25 12.5 million

Assume that MC pays a 50% premium to acquire Digerati and that the

costs of the acquisition total $3 million. What is the expected impact of the

transaction on MC's share price?

Solution: We first compute the total value created by each of the incremental

cash f lows:

Annual Cash Discount

Source Flow Rate Value

Revenue enhancement $1.25 million 20% $ 6.25 million

Operating efficiencies 1.5 million 15 10.0 million

Tax savings $750,000 10 2.38 million

Total Value = $18.63 million

The total value created by the acquisition is $18.63 million. A 50% premium

would give $6.25 million of this incremental value to Digerati's shareholders.

After $3 million of acquisition costs, $9.38 million remains for MC's

three million shareholders. Thus, each share should increase by $3.13 ($9.38

million divided by the 3 million shares outstanding) to $33.13.

Note that the solution to Example 5 assumes the market knows about and

accepts the value creation estimates described. Investors will often discount

management's estimates of value creation, believing them to be overly optimistic

or doubting the timetable for their realization. In practice, estimating

the synergistic cash flows and the appropriate discount rates is the analyst's

most difficult task.

Summary The sole motivation for initiating a merger or acquisition should

be increased wealth for the acquirer's shareholders. We know from the empirical

evidence presented in section III that many transactions fail to meet

this simple requirement. The main point of this section is that value can only

come from one source—incremental future cash f lows or reduced risk. If we

can estimate these parameters in the future, we can measure the acquisition's

Profitable Growth by Acquisition 581

synergy, or potential for value creation. For the deal to benefit the acquirer's

shareholders, management must do two things. The first is to pay a premium

that is less than the potential synergy. Many acquisitions that make strategic

sense and generate positive synergies fail financially simply because the bidder

overpays for the target. The second task for the acquirer's management is

to implement the steps needed after the transaction is completed to realize

the deal's potential for value creation. This is a major challenge and is

discussed further in section VII. In the next section we brief ly present some

of the key issues managers should consider when initiating and structuring

acquisitions.

SOME PRACTICAL CONSIDERATIONS

In this section, we brief ly discuss the following issues you may encounter in developing

and executing a successful M&A strategy:

• Identifying candidates.

• Cash versus stock deals.

• Pooling versus purchase accounting.

• Tax considerations.

• Antitrust concerns.

• Cross-border deals.

This is not meant to be a comprehensive presentation of these topics. Rather,

the important aspects of each are described with the focus on how they can inf

luence cash f lows and synergy. The goal is to make sure that you are at least

aware of how each item might affect your strategy and the potential for value

creation.

Identifying and Screening Candidates

Bidders must first identify an industry or market segment they will target. This

process should be part of a larger strategic plan for the company. The next step

is to develop a screening process to rank the potential acquisitions in the industry

and to eliminate those that do not meet the requirements. This first screen

is typically done based on size, geographic area, and product mix. Each of the

target's product lines should be assessed to see how they relate to (a) the bidder's

existing target market, (b) markets that might be of interest to the bidder,

and (c) markets that are of no interest to the bidder. Keep in mind that

undesirable product lines may be sold.

It is also important to evaluate the current ownership and corporate governance

structure of the target. If public, how dispersed is share ownership

and who are the majority stockholders? What types of takeover defenses are in

582 Making Key Strategic Decisions

place and have there been previous acquisition attempts? If so, how have they

fared? For a private company, there should be some attempt to discern how

likely the owners are to sell. Information about the recent performance of the

firm or the financial health of the owners may provide some insight.

The original list of potential acquisitions can be shortened considerably

by using these criteria. The companies on this shortened list should be first analyzed

assuming they would remain as a stand-alone business after the acquisition.

This analysis should go beyond just financial performance and might

include the following criteria:14

Other popular tools for this analysis include SWOT (strengths, weaknesses,

opportunities, and threats) analysis, the Porter's Five Forces model,

and gap analysis. Once this process is completed, the potential synergies of

the deal should be assessed using the approach presented in the previous section.

The result will be a list of potential acquisitions ranked by both their potential

as stand-alone companies and the synergies that would result from a

combination.

Cash versus Stock Deals

The choice of using cash or shares of stock to finance an acquisition is an important

one. In making it, the following factors should be considered:

1. Risk-sharing: In a cash deal, the target firm shareholders take the money

and have no continued interest in the firm. If the acquirer is able to create

significant value after the merger, these gains will go only to its shareholders.

In a stock deal, the target shareholders retain ownership in the new

firm and therefore share in the risk of the transaction. Stock deals with

Microsoft or Cisco in the 1990s made many target-firm shareholders

wealthy as the share prices of these two firms soared. Chrysler Corporation

Future Performance Forecast

Growth prospects

Future margin

Future cash flows

Potential risk areas

Key Strengths/Weaknesses

Products and brands

Technology

Assets

Management

Distribution

Industry Position

Cost structure versus competition

Position in supply chain

Financial Performance

Profit growth

Profit margins

Cash flow

Leverage

Asset turnover

Return on equity

Business Performance

Market share

Product development

Geographic coverage

Research and assets

Employees

Profitable Growth by Acquisition 583

stockholders on the other hand, have seen the postmerger value of the

Daimler-Benz shares they received fall by 60%.

2. Overvaluation: An increase in the acquirer's stock price, especially for

technology firms, may leave its shares overvalued historically and even in

the opinion of management. In this case, the acquirer can get more value

using shares for the acquisition rather than cash. However, investors may

anticipate this and view the stock acquisition as a signal that the acquirer's

shares are overpriced.

3. Taxes: In a cash deal, the target firm's shareholders will owe capital gains

taxes on the proceeds. By exchanging shares, the transaction is tax-free (at

least until the target firm stockholders choose to sell their newly acquired

shares of the bidder). Taxes may be an important consideration in deals

where the target is private or has a few large shareholders, as Example 6

makes clear.

Often firms will make offers using a combination of stock and cash. In a study

of large mergers between 1992 and 1998, only 22% of the deals were cash-only.

Stock only (60%) and combination cash and stock (18%) accounted for the vast

majority of the deals.15 This contrasts with the 1980s when many deals were

cash offers financed by the issuance of junk bonds. The acquirer's financial advisor

or investment banker can help sort through these factors to maximize the

gains to shareholders.

Example 6 Sarni Inc. began operations 10 years ago as an excavating company.

Jack Sarni, the principal and sole shareholder, purchased equipment (a

truck and bulldozer) at that time for $40,000. The equipment had a six-year

useful life and has been depreciated to a book value of zero. However, the machinery

has been well maintained and because of inf lation, has a current market

value of $90,000. The business has no other assets and no debt.

Pave-Rite Inc. makes an offer to acquire Sarni for $90,000. If the deal is

a cash deal, Jack Sarni will immediately owe tax on $50,000, the difference between

the $90,000 he receives and his initial investment of $40,000. If he instead

accepts shares of Pave-Rite Inc. worth $90,000 in a tax-free acquisition,

there is no immediate tax liability. He will only owe tax if and when he sells the

Pave-Rite shares. Of course in this latter case, Sarni assumes the risk that

Pave-Rite's shares may fall in value.

Purchase versus Pooling Accounting

The purchase method requires the acquiring corporation to allocate the purchase

price to the assets and liabilities it acquires. All identifiable assets and

liabilities are assigned a value equal to their fair market value at the date of acquisition.

The difference between the sum of these fair market values and the

purchase price paid is called goodwill. Goodwill appears on the acquirer's

books as an intangible asset and is amortized, or written off as a noncash

584 Making Key Strategic Decisions

expense for book purposes over a period of not more than 40 years. The amortization

of purchased goodwill is deductible for tax purposes and is taken over

15 years.

Under the pooling of interests method, the assets of the two firms are

combined, or pooled, at their historic book values. There is no revaluation of

assets to ref lect market value and there is no creation of goodwill. Because of

this, there is no reduction in net income due to goodwill amortization. This

method requires that the acquired firm's shareholders maintain an equity

stake in the surviving company and is therefore used primarily in acquisitions

for stock.

Weston and Johnson report that 52% of the 364 acquisitions they analyzed

used pooling and 48% used purchase accounting.16 To illustrate the difference

between the two methods of accounting for an acquisition, we offer a simple

example.

Example 7 Consider the following predeal balance sheets for B.B. Lean Inc.

and Dead End Inc., both clothing retailers:

B.B. Lean Inc. ($ millions) Dead End Inc. ($ millions)

Cash $ 6 Equity $28 Cash $ 3 Equity $12

Land 22 Land 0

Building 0 Building 9

Total $28 $28 Total $12 $12

Now assume that B.B. Lean offers to purchase Dead End for $18 million

worth of its stock and elects to use the purchase method of accounting. Assume

further that Dead End's building has appreciated and has a current market

value of $12 million. B.B. Lean's balance sheet after the deal appears as

follows:

B.B. Lean Inc. ($ millions)

Purchase Method

Cash $ 9 Equity $46

Land 22

Building 12

Goodwill 3

Total $46 $46

Note that the acquired building has been written up to ref lect its market

value of $12 million and that the difference between the acquisition price ($18

million) and the market value of the assets acquired ($15 million) is booked as

goodwill. Lean's equity has increased by the $18 million of new shares it issued

to pay for the deal.

Now assume that the same transaction occurs, this time using the pooling

method.

Profitable Growth by Acquisition 585

B.B. Lean Inc. ($ millions)

Pooling Method

Cash $ 9 Equity $40

Land 22

Building 9

Goodwill 0

Total $40 $40

Under the pooling method, there is no goodwill and the acquired assets

are put on B.B. Lean's balance sheet at their book value.

Entire volumes have been written on the accounting treatment of acquisitions

and this is a very complex and dynamic issue. In fact, as this chapter is

being written, accounting-rule makers in the United States were proposing to

eliminate the pooling of interests method of accounting for acquisitions. Because

of this, it is important to get timely, expert advice on these issues from

competent professionals.

Tax Issues

Taxes were discussed brief ly in the paragraph comparing cash and stock deals.

In a tax-free transaction, the acquired assets are maintained at their historical

levels and target firm shareholders don't pay taxes until they sell the shares received

in the transaction. To qualify as a tax-free deal, there must be a valid

business purpose for the acquisition and the bidder must continue to operate

the acquired business. In a taxable transaction, the assets and liabilities acquired

are marked up to ref lect current market values and target firm shareholders

are liable for capital gains taxes on the shares they sell.

In most cases, selling shareholders would prefer a tax-free deal. In the

study by Weston and Johnson (1999), 65% of the transactions were nontaxable.

However, there are situations where a taxable transaction may be preferred. If

the target has few shareholders with other tax losses, their gain on the deal can

be used to offset these losses. A taxable deal might also be optimal if the tax

savings from the additional depreciation and amortization outweigh the capital

gains taxes. In this case, the savings could be split between the target and bidder

shareholders (at the expense of the government). Again, it is important to

get current, expert advice from knowledgeable tax accountants when structuring

any transaction.

Antitrust Concerns

Regulators around the world routinely review M&A transactions and have the

power to disallow deals if they feel they are anti-competitive or will give the

merged firm too much market power. More likely than an outright rejection

are provisions that require the deal's participants to modify their strategic

586 Making Key Strategic Decisions

plan or to divest certain assets. These concessions can have important implications

for margins and ultimately cash flow and shareholder value. For example,

in approving the recent megamerger between AOL and Time Warner, the U.S.

Federal Trade Commission (FTC) imposed strict provisions on the new company

with respect to network access by competing internet service providers.

The goal of this is to increase competition, which will ultimately reduce

AOL/Time Warner's margins and future cash f lows.

The basis for antitrust laws in the U.S. is found in the Sherman Act of

1890, the Clayton Act of 1914, and the Hart-Scott-Rodino Act of 1976. Regulators

assess market share concentration within the context of the economics of

the industry. Factors such as ease of entry for competitors and the potential for

collusion on pricing and production levels are also considered. In the end, antitrust

enforcement is an inexact science that can have a major impact on M&A

activity. When assessing potential acquisition candidates, the potential for regulatory

challenges—and an estimate of the valuation impact of likely remedies—

must be considered in the screening and ranking process.

Cross-Border Deals

In 1999, for the first time in history, there were more acquisitions of foreign

companies (10,413) than U.S. companies (7,243). The U.S. deals were larger

on average, totaling $1.2 trillion versus $980 billion for the foreign transactions.

17 By any measure, the level of international M&A activity is increasing

as the globalization of product and financial markets continues. All of the issues

discussed in this chapter apply to cross-border deals, in some cases with

significant added complexities, which are discussed brief ly next.

Each country has its own legal, accounting, and economic systems. This

means that tax and antitrust rules may vary greatly from U.S. standards. While

there is a move to standardized financial reporting via generally accepted accounting

principles (GAAP) or international accounting standards (IAS), there

is still great variability in the frequency and reliability of accounting data

around the world. The problem is that developing nations, which offer some of

the best acquisition opportunities, have the most problems.

Doing M&A transactions across borders brings additional risks that have

not been previously discussed. These include currency exchange risk, political

risk, and the additional risk of national cultural differences. If a company is

going to execute an effective international M&A strategy, all of these must be

identified and quantified, because they can have a significant impact on synergies

and the implementation timetable. It is critical for a bidder to get capable

financial and legal advisors in each country it is considering acquisitions.

SUCCESSFUL POSTMERGER IMPLEMENTATION

The section on mergers and acquisitions makes it clear that most acquisitions

fail to meet the expectations of corporate managers and shareholders. This

Profitable Growth by Acquisition 587

dismal record is attributable to various causes, including ill-conceived acquisition

strategies, poor target selection, overpayment, and failed implementation.

In a study of 45 Forbes 500 firms, Smolowitz and Hillyer ask senior executives

to rate a list of reasons for the poor performance record of acquisitions.18 The

following were the five most frequently ranked factors:

1. Cultural incompatibility.

2. Clashing management styles and egos.

3. Inability to implement change.

4. Poor forecasting.

5. Excessive optimism with regard to synergy.

The last two are premerger problems, but the first three occur in the postmerger

transition process. Deloitte & Touche Consulting estimates that 60% of

mergers fail largely because of integration approach. Managers must understand

that the acquisition closing dinner marks the end of one stage of the

transaction and the beginning of the process that will determine the deal's ultimate

success or failure. In this section, we brief ly discuss the following key

components of a successful implementation plan:

• Expect chaos and a loss of productivity.

• Create a detailed plan before the deal closes.

• First, keep your executives happy.

• Speed and communication are essential.

• Focus managerial resources on the sources of synergy.

• Culture, culture, culture.

The process of merging two firms creates havoc at every level of the organization.

The moment the first rumors of a possible acquisition begin, an air

of uncertainty and anxiety permeates the company. The first casualty in this

environment is productivity, which grinds to a halt as the gossip network takes

over. While the executives debate grand, strategic issues, the employees are

concerned with more basic issues and need to know several key things about

their new employers, their compensation and their careers before productivity

will resume. Managers must understand that this "me first" attitude is human

nature and must be addressed—especially in transactions where the most important

assets are people.

The first step in any postmerger implementation must be a detailed

plan. We saw how Cisco "maps" the future of every employee in a soon-to-beacquired

firm. For those continuing on, their new position and duties within

Cisco are clearly defined from the beginning. The employees that will be relocated

or terminated are also identified and a separate plan for handling

them is created. Relocation and severance packages must be generous to signal

retained workers that their new employer is ethical and fair. The second

reason for a detailed plan is that it allows transition costs to be accurately estimated.

The costs to reconfigure, relocate, retrain, and sever employees

588 Making Key Strategic Decisions

must be budgeted as they can have a significant impact on postmerger cash

f lows.

The detailed plan must start at the highest levels of the organization. If

executives from the two firms are going to lead the transition, they must be

confident of their future roles and comfortable with their compensation plans.

In the Daimler-Benz-Chrysler deal, there was a good deal of animosity between

executives as the German managers watched their American counterparts

walk away with multimillion-dollar payoffs from their Chrysler stock

options while simultaneously receiving equity in the newly merged firm. A fair

incentive system must be in place at the corporation's executive suite before

any implementation plan begins.

Once the key managers have been identified, retained, and given the

proper incentives, they must carry the vision of the merger to the rest of the

organization. To combat the productivity problems discussed above, managers

have two critical weapons, speed and communication. Remember that the

enemy from the employee's perspective is uncertainty, and absent timely information

from above, they will usually assume the worst. Executives must move

quickly to convey the vision for the merged entity and to assure key employees

of their role in executing this vision.

While all employees should be part of this process, those that deal with

the firms' customers should receive special attention. We saw how Cisco moves

quickly to retain key salespeople and reassure important customers that the

merger will only improve product offerings and services. In contrast, the 1997

merger between Franklin Planner and Covey Systems failed to heed this advice.

Combining sales forces was seen as a key source of synergy, but the company

was unsuccessful in merging the two compensation programs.

Divisions were especially strong within the company's 1,700-person sales force,

which marketed its seminars and training sessions. Former Covey salespeople

got higher bonuses than Franklin staffers. Covey employees also kept their free

medical coverage, while Franklin's had to pay part of their premiums.19

This situation created such sniping by sales reps on both sides that productivity

plunged.

The implementation plan must focus management resources on those areas

at the root of the deal's synergies. If value is going to be created, it will only be

by executing on those aspects of the deal that were the original rationale for

merging. Without a plan, it is too easy for managers to get bogged down in details

of the implementation that have little marginal impact on shareholder

wealth. In the failed AT&T-NCR merger, the hoped-for technological synergies

between telecommunications and computers never materialized as managers

worried more about creating a team environment.

In many cases, the disappointing performance of mergers can be traced

to a failure to account for cultural differences between organizations. These

differences can be based in corporate culture or national culture in the case of

cross-border deals. In many transactions, both corporate and national cultural

Profitable Growth by Acquisition 589

differences are present. Because they are difficult to measure and to some extent

intangible, cultural differences are often ignored in the pre-acquisition

due diligence. This is unfortunate since they can ultimately be the most costly

aspect of the implementation process. In mergers where the firms have similar

cultures, the rapid combination of the two organizations can actually be easier.

However, where there are large cultural differences, executives should consider

keeping the entities separate for some time period. This allows each to

operate comfortably within its own culture while at the same time learning to

appreciate the strengths and weaknesses of the cultural differences between

the organizations. Such an arrangement may delay the realization of certain

synergies but, in the end, is the most rationale plan. The key is that culture can

have a huge impact on value (both positive and negative), and therefore needs

to be part of the planning process from the very beginning—even before any

acquisition offer is made.

To ensure success, the postmerger implementation process must be carefully

planned and executed. Even when this is done, there will undoubtedly be

surprises and unanticipated problems. However, a well-thought-out plan should

minimize their negative impact. The most important parts of the plan are

speed and communication, which are critical weapons in the fight against successful

implementation's main enemies—uncertainty, anxiety, and an inevitable

drop in productivity. A plan conceived and implemented swiftly by

the firms' executives, with their full and active leadership, improves the

chances for a successful transition. As always, we urge acquirers to seek the advice

of knowledgeable experts on the implementation process.

SUMMARY AND CONCLUSIONS

Mergers and acquisitions are a popular way for firms to grow, and as economic

globalization continues, there is every reason to believe their size and frequency

will increase. However, it is not that case that profitable growth by acquisition

is easy. The empirical data presented in this chapter makes it clear

that corporate combinations have historically failed to meet the operational

and financial expectations of the acquiring firm's managers and shareholders.

While target firm shareholders typically earn 30% to 40% premiums, M&A

transactions do not create value on average for the acquirer's stockholders.

This information should make it clear that a carefully designed acquisition

strategy, realistic estimates of the potential synergies, and an efficient implementation

plan are critical if the historical odds are to be overcome.

Managers must understand that the only source of incremental value in

corporate mergers and acquisitions is incremental future cash f lows or reduced

risk. These cash f lows can come from increased revenues, reduced costs, or tax

savings. The sum of the potential value created from these incremental cash

f lows is called synergy. For a deal to be successful financially the premium

paid and the costs of the transaction must be less than the deal's total synergy.

590 Making Key Strategic Decisions

Only then will the bidder's shareholders see their wealth increase. This sounds

simple, but in a competitive market for corporate control, there must be a relatively

unique relationship between the bidder and the target that other firms

cannot easily match. The market must perceive the target as worth more as

part of your firm than alone or with some other firm.

There are many practical details that potentially impact the creation of

value in M&A transactions. These include the choice of payment (cash vs.

stock), the accounting method (purchase or pooling), tax considerations, and

antitrust concerns. Each of these may affect future cash flows and synergies

and therefore must be part of the premerger due diligence process. We describe

brief ly how each factor can impact value creation, but refer potential

bidders to investment bankers, professional accountants, tax experts, and attorneys

for the most timely and customized advice.

The final and most important part of the process is the postmerger implementation

plan. Managers often focus on completing the transaction, which is

unfortunate, since the transition to a single organization is where the keys to

value creation lie. A detailed implementation plan must be developed before

the transaction closes and communicated quickly and effectively to employees

by the firm's new leadership. The plan must focus on the roots of synergy in

the deal to ensure the successful creation of the anticipated shareholder value.

In deals where there are major cultural differences, special attention must be

paid to smoothly integrating these differences. Failure to do so can doom an

otherwise sound transaction.

In the end, profitable growth by acquisition is possible but difficult. The

market for corporate control is competitive and it is easy for bidders to overestimate

potential synergies and therefore overpay for acquisitions. To avoid this,

managers must develop and stick to an acquisition plan that makes strategic

and financial sense. Only then can they hope to overcome history, human

nature, and the odds against successfully creating shareholder value through

mergers and acquisitions. Our hope is that this chapter provides the basic information

needed to embark on such a course.

FOR FURTHER READING

Morosini, Piero, Managing Cultural Differences (New York: Elsevier, 1997). A comprehensive

discussion of culture's role in mergers and other corporate alliances.

The focus is on cross-border deals, but the strategies for effective implementation

can be used by all.

Sirower, Mark L., The Synergy Trap: How Companies Lose the Acquisition Game

(New York: Free Press, 1997). Focuses on assessing the potential for synergies

and value creation in mergers.

Vlasic, Bill, and Bradley A. Stertz, Taken for a Ride: How Daimler-Benz Drove Off with

Chrysler (New York: HarperCollins, 2000). A fascinating behind-the-scenes look

Profitable Growth by Acquisition 591

at the Daimler-Benz-Chrysler deal. Clearly shows the roles of culture, human

nature, and managerial hubris in M&A transactions.

Weston, J. Fred, Kwang S. Chung, and Juan A. Siu, Takeovers, Restructuring, and

Corporate Governance (Upper Saddle River, NJ: Prentice-Hall, 1998). An excellent

reference for developing and implementing an effective M&A strategy.

INTERNET LINKS

www.cnnfn.cnn.com/news/deals Up-to-date stories on deals, all free

information

www.stern.nyu.edu/adamodar Academic site with numerous

quantitative examples and spreadsheets

that can be used to value potential

synergies

www.mergerstat.com Comprehensive source of M&A data;

some good free information

www.webmergers.com Good reports on M&A activity of

internet companies

NOTES

1. For a concise summary of and more detail on empirical tests of M&A performance

see chapter 7 of J. Fred Weston, Kwang S. Chung, and Juan A. Siu, Takeovers,

Restructuring, and Corporate Governance (Upper Saddle River, NJ: Prentice-Hall,

1998).

2. Anup Agrawal, Jeffrey F. Jaffe, and Gershon N. Mandelker, "The Post-

Merger Performance of Acquiring Firsms: A Re-examination of an Anomaly," Journal

of Finance 47 (September 1992): 1605–1621.

3. Weston, Chung, and Siu, 133, 140.

4. Business Week, October 30, 1995.

5. Merger & Acquisition Integration Excellence (Chapel Hill, NC: Best Practices,

2000).

6. For a more thorough discussion of this topic, see Weston, Chung, and Siu,

chapter 5.

7. The Wall Street Journal, November 30, 2000, B4.

8. Ibid.

9. Business Week, April 20, 1998, 37.

10. Business Week, October 16, 1995, 38.

11. The Wall Street Journal, September 21, 2000, C22.

12. The Wall Street Journal/New England, July 28, 1999, NE3.

13. See Harvard Business School case #285053, Gulf Oil Corp—Takeover, for a

complete discussion of this value creation.

592 Making Key Strategic Decisions

14. Adapted from Brian Coyle, Mergers and Acquisitions (Chicago: Glenlake,

2000), 32.

15. J. Fred Weston and Brian Johnson, "What It Takes for a Deal to Win Stock

Market Approval," Mergers and Acquisition 34, no. 2 (September/October 1999): 45.

16. Weston and Johnson, 45.

17. "M&A Time Line," Mergers & Acquisitions, 35(8) (September 2000): 30.

18. Ira Smolowitz and Clayton Hillyer, Working Paper, 1996, Bureau of Business

Research, American International College, Springfield, MA.

19. Business Week, November 8, 1999, 125.

593

18 BUSINESS

VALUATION

Michael A. Crain

It has been said that determining the value of an investment in a closely held

business is similar to analyzing securities of public companies. The theories are

similar and not overly complex on the surface. There are even Web sites that

proclaim to be able to value a private business. But like so many things in the

business world, the devil is in the details. The valuation of a closely held business

depends on many variables. While the theories of valuation are not overly

complicated, the accuracy of the valuation result is only as good as the variables

that go into it. The valuation of closely held businesses is often complicated

because of the limitations of the underlying information and the way

private businesses are operated. Unlike public companies, private businesses

often do not have complete and accurate information available. Dollar for dollar,

the time to accurately value most profitable private companies is out of

proportion to the analysis of public-company securities. This is illustrated in

the following case study that demonstrates the financial theories of business

valuation and the level of information needed for an accurate result.

For the past 20 years, Bob has owned and operated a manufacturing business

that has grown significantly since its inception. Bob is approaching 60 years of

age and his children do not appear capable of taking over the company. He is

contemplating the future of the business at a time when he would like to slow

down. One of his options is selling his business. Bob's company, ACME Manufacturing

Inc. is a manufacturer of certain types of adhesives and sealants and

has revenues of approximately $50 million. It has six manufacturing locations

throughout the country. Bob owns 100% of the company's common stock. He

does not know what the company is worth, nor does he know how its value

594 Making Key Strategic Decisions

would be determined. Bob asked his certified public accountant (CPA) about

valuing the business. The CPA tells him that it would be most appropriate to

engage someone who specializes in business valuations. After interviewing several

candidates, Bob hires Victoria to appraise his business. The valuation date

is December 31, 2000, and the standard of value is fair market value. Victoria

explains the appraisal process and the scope of her work.

THREE APPROACHES TO VALUE

Victoria tells Bob that the value of a business is determined by considering

three approaches.

1. Income approach.

2. Market approach.

3. Asset (or cost) approach.

The income approach is a general way of determining the value using a

method to convert anticipated financial benefits, such as cash f lows, into a

present single amount. This approach is based on the concept that the value of

something is its expected future benefits expressed in present value dollars. (A

simple example of present value is that a dollar received a year from now is

worth less than a dollar today.)

The market approach is a general way of determining a value comparing

the asset to similar assets that have been sold. For example, real estate appraisals

using the market approach rely on the sales prices of comparable properties.

In business valuation, it is sometimes possible to locate similar businesses

that have sold and are appropriate to use as guidelines in the appraisal.

The asset approach is a general way of determining the value based on the

individual values of the assets of that business less its liabilities. The company's

balance sheet serves as a starting point for this approach. The proper application

requires that all of the business's assets be identified. Often, the balance

sheet prepared in accordance with general accepted accounting principals

does not include assets that have been created within the company such as

goodwill and other intangible assets. Once all the company assets and liabilities

have been identified, each one is valued separately.

DIFFERENT TYPES OF BUYERS

Victoria explains to Bob that buyers have different motives for acquiring businesses

and they may be willing to pay different prices for the same business.

Most buyer motives can be grouped into these categories:

Financial buyers. These buyers are primarily motivated by getting an appropriate

rate of return on their investment. Financial buyers generally

have a much broader range of investment alternatives than other types of

Business Valuation 595

buyers. Also, financial buyers often have an exit strategy to sell their investment

at some time in the future. They usually pay fair market value

(defined next).

Strategic/investment buyers. These buyers probably already know the

company or already operate in its industry. Therefore, the number of

strategic buyers for a particular business is typically more limited than

the market of financial buyers. A strategic buyer is usually looking at integrating

its operations with the purchased business. Most of these buyers

will pay a price that ref lects certain synergies that are not readily available

to financial buyers. This price is called investment value, which is

different than fair market value.

The smallest of businesses, sometimes called "mom and pop businesses,"

often have two other groups of buyers—lifestyle buyers and buyers of employment.

A lifestyle buyer is looking to acquire a business that gives him or her a

desired lifestyle (e.g., a motel in the mountains). Another group of buyers of

small businesses is primarily motivated to provide employment for the buyer

and/or the family.

Among strategic and financial buyers, strategic buyers will usually pay a

higher price because of the anticipated synergies between the two businesses.

After explaining the different types of buyers to Bob, Victoria discusses

how it applies to ACME. Obviously, Bob would like to obtain the highest price

possible if he sold his business. However, Victoria has no way to foresee who

that buyer may be or that buyer's strategic motives for buying ACME. Therefore,

she is going to determine what a financial buyer would likely pay—the

company's "fair market value." Practically, determining the fair market value

will assist Bob in establishing a target minimum price to accept when selling

ACME. If Bob can locate a particular strategic buyer who would pay a strategic

price (or investment value), he will try to obtain a higher price.

Bob asks Victoria to explain fair market value and how it differs from investment

value. She tells him that fair market value is defined as "the price, expressed

in terms of cash equivalents, at which property would change hands

between a hypothetical willing and able buyer and a hypothetical willing and

able seller, acting at arm's length in an open and unrestricted market, when

neither is under compulsion to buy or sell and when both have reasonable

knowledge of the relevant facts."1 Fair market value contemplates what the

"market" will pay. Investment value is the price a specific investor would pay

based on individual requirements and expectations. It frequently ref lects a

higher price for the unique synergies between the buyer and company.

AN OVERVIEW OF THE BUSINESS

VALUATION PROCESS

Victoria explains to Bob that a complete business appraisal is both a quantitative

and qualitative process involving a risk and investment return analysis. A

596 Making Key Strategic Decisions

complete valuation is more than simply analyzing the historic financial statements

of the business and then making future projections. Valuations that give

the most accurate results consider qualitative matters such as technology

changes, the company's competition, and its customers. In addition, other areas

that are considered are macro-environment issues such as the industry and the

national and local economic factors that affect the particular business. A complete

business valuation will consider the following areas:

• Analysis of the company.

• Industry analysis.

• Economic analysis.

• Analysis of the company's financial statements.

• Application of the appropriate valuation methodologies.

• Application of any appropriate valuation discounts or premiums.

A large part of valuing a business is the assessment of the investment risk

of buying and owning the business. A buyer of the business assumes the risk

that he or she will actually receive the anticipated economic benefits. Of

course, there is no guarantee of actually receiving the projected income. A

fundamental concept in business valuation is the risk-reward relationship in

making any kind of investment. Rational individuals and companies make investment

decisions regularly by comparing the risk of an investment to the

anticipated rewards. For example, a certificate of deposit from a bank that is

guaranteed from default may have a rate of return (interest) of 5%. This investment

has little or no risk. Investments in large public company (large-cap)

stocks have traditionally returned an average of 10% to 12% per year over the

long term. Small public company (small-cap) stocks have average historical

rates of return in the 15% to 20% range over the long term. These three types

of investments illustrate the risk-reward relationship investors have in making

decisions. Buying large-cap stocks instead of a certificate of deposit carries

more risk and, thus, the market rewards the investor with a higher rate of return.

Small-cap stocks over the long term have been more risky than large

company stocks and have rewarded investors even more with higher returns.

Simplistically, the valuation of a closely held business considers the risk of an

investment in the company and compares it to alternative forms of investments.

Victoria further explains that valuation concepts are founded in several

economic principles. The first is the principle of alternatives that states that

each person has alternatives to completing a particular transaction. In the preceding

example, the individual has the alternatives of investing funds in a bank

certificate of deposit, large-cap stocks, or small-cap stocks. Investing in a business

is yet another alternative. The second economic principle in valuation is

the principle of substitution. This states that the value of something tends to

be determined by the cost of acquiring an equally desirable substitute. For example,

if a new restaurant offers steak on its menu, it will likely have a price

similar to other restaurants selling steak (all things being equal). The first

Business Valuation 597

restaurant will probably not sell very many steaks if the price is double what

the customer could buy at another restaurant. Likewise, a potential purchaser

of a business is not likely to pay significantly more than the price he or she can

purchase a similar business.

In business valuation, we must remember that buyers/investors have many

places to invest their money and they will generally not pay significantly more

for a business than the price of comparable investments. Thus, a business valuation

will generally benchmark the profitable private company against alternative

investments. This involves an analysis of the risk of those investments as

well as those of the business being valued.

INDUSTRY ANALYSIS

ACME operates in the adhesive and sealant industry. The U.S. government's

Standard Industrial Classification (SIC) is number 2891. Victoria researches this

industry and finds that the segment consists of approximately 1,100 U.S. establishments

primarily engaged in manufacturing industrial and household adhesives,

glues, caulking compounds, sealants, and linoleum, tile, and rubber

cements. The annual sales in this industry segment are $16.9 billion, and the industry

employs roughly 36,000 people. Also, the industry has grown at an average

annual compound rate of 6.7% over the past 10 years. Victoria finds that this

industry segment is a large growing global segment. However, the U.S. portion is

highly fragmented and a significant majority of the industry participants are

small and regional companies. It is expected that the industry will consolidate as

companies seek to enhance operating efficiencies and new product development,

sales and marketing, distribution, production, and administrative overhead.

Victoria concludes that the industry outlook is positive in revenue and

earnings expectations but moderated by the level of competition from numerous,

smaller companies selling similar products.

THE FUNDAMENTAL POSITION OF THE COMPANY

During Victoria's management interview, she discovers that Bob founded

ACME 20 years ago. The company's history has been one of relative success. It

started in a small garage and grew by expanding the number of products and

its customer base. Over the years, ACME acquired new facilities, not only in its

hometown but in other cities as well. The company's growth was primarily

funded by reinvesting its profits and with long-term financing when purchasing

real estate. During the past five years, ACME's sales increased from $34 million

to $50 million. ACME currently expects to expand its manufacturing capacity

by adding equipment to the existing locations.

Victoria's investigation into ACME's competitors reveals competition

from numerous companies, many of which are small, privately held businesses.

598 Making Key Strategic Decisions

She also finds that ACME's customers are retail distributors of its products

and the company does not have any significant customer concentration.

Generally, relationships with customers have been long term.

The company currently has numerous products in the adhesives and

sealants area. ACME has several trademarks and several products that are well

recognized as well as ACME's name. Victoria determines through her research

that the risk of product obsolescence or replacements by new products is a

minimal risk to ACME.

ACME has conducted research and development activities and the costs

range from $250,000 to $500,000 per year over the past five years. Management

does not expect any significant product developments in the near future.

Victoria's financial analysis examines the dividend paying capacity of

ACME. Because the company is closely held, special analysis of the compensation

paid to family members and perquisites is necessary. Victoria determines

that officers' compensation, shareholder distributions, and perquisites over the

past five years have been as follows:

Officers' Compensation, Perquisites,

and Shareholder Distributions

Year $ Million

2000 $7.7

1999 5.5

1998 8.2

1997 6.3

1996 6.5

Closely held businesses are frequently operated to minimize taxable income.

Publicly held companies, in contrast, are operated to maximize earnings

for the benefit of the shareholders and public markets. A financial analysis of a

closely held company should make adjustments so that revenues and expenses

are "normalized." In this particular case, Victoria determines the amount of

economic benefits the family members took from the business and compares

that with the market compensation for others employed in similar positions.

The difference between the two amounts is actually an economic benefit or

dividend (profit) flowing to ACME's owner. Victoria's analysis strives to identify

the actual profitability of the business enterprise even though it is different

from what is reported on the income statement.

ACME has approximately 240 employees at its six locations. The three top

individuals in management are family members including Bob. Should the

company be sold, it is unlikely that the three family members would remain in

the business.

Summary of Positive and Negative

Fundamental Factors

As a result of Victoria's preceding analysis of ACME's fundamental position,

she identifies the following key positive and negative factors for the company.

Business Valuation 599

Positive

ACME has been in existence for 20 years.

ACME has a long-term history of growing sales and profits.

ACME owns several trademarks for products that are well known.

ACME has diversification in the number of its manufacturing locations.

ACME's industry outlook is moderately positive.

The demand for ACME's products is expected to continue.

Negative

ACME is highly dependent on the three family members who hold the

top management positions.

ACME's products face significant competition and are regionalized.

FINANCIAL STATEMENT ANALYSIS

An analysis of a company's historic financial statements is important (unless it

is a start-up business), as the past is usually relevant to estimating future business

operations. If a company has had high growth in recent years, that may indicate

significant growth potential in the future. If past earnings have been

volatile, this is an indication of increased financial risk for a buyer of the business.

While an analysis of the financial statements is important, the process

does not stop with looking at the company's past performance. The ultimate

goal of the quantitative analysis is estimating the future profitability of the

business since that is what a prospective buyer is looking to receive. Future

earnings may or may not be similar to the past.

Balance Sheet Analysis

Victoria prepares Exhibit 18.1 that presents ACME's historic balance sheets in

condensed form for the most recent five years. She finds that total assets grew

an average of 15% per year over the five years and a similar amount in the most

recent year. The current assets consist primarily of accounts receivable and inventory.

Fixed assets primarily consist of land, buildings, and improvements,

machinery and equipment, factory construction in progress, and transportation

equipment. As of the most recent year's end, ACME's depreciable fixed assets

were depreciated to 69% of their original costs.

The most recent year ref lects unamortized intangible assets, consisting

primarily of goodwill (that had been recorded in accordance with generally

accepted accounting principles) in connection with ACME's acquisition of a

manufacturing facility.

Current liabilities consist of accounts payable and the amounts due within

the next 12 months on promissory notes and obligations under capital leases.

ACME is moderately leveraged. During the past five years, ACME's interest

bearing debt (both current and noncurrent portions) increased from $6.6

600

EXHIBIT 18.1 ACME Manufacturing Inc.: Summary of condensed balance sheets 1996 –2000.

($million) Growth Rates

2000 1999 1998 1997 1996 1996–2000 1999–2000

Assets

Current assets $11.69 $11.56 $12.37 $ 9.43 $ 9.17 6.3% 1.1%

Fixed assets, net 13.87 10.36 9.37 7.65 6.79 19.5 33.9

Other assets 3.17 3.00 3.25 1.12 0.62 50.4 5.5

Total assets $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3%

Liabilities and Equity

Current liabilities $11.50 $ 6.41 $ 8.78 $ 4.34 $ 4.94 23.5% 79.4%

Long-term liabilities 5.83 7.26 7.78 4.85 4.96 4.1 19.7

Total liabilities 17.33 13.67 16.56 9.19 9.90 15.0 26.8%

Equity 11.39 11.25 8.42 9.01 6.69 14.2 1.3

Total liabilities and equity $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3%

Common Size

2000 1999 1998 1997 1996

Assets

Current assets 40.7% 46.4% 49.5% 51.8% 55.3%

Fixed assets, net 48.3 41.6 37.5 42.0 41.0

Other assets 11.0 12.0 13.0 6.1 3.7

Total assets 100.0% 100.0% 100.0% 100.0% 100.0%

Liabilities and Equity

Current liabilities 40.1% 25.7% 35.1% 23.9% 29.8%

Long-term liabilities 20.3 29.1 31.2 26.6 29.9

Total liabilities 60.3 54.9 66.3 50.5 59.7

Equity 39.7 45.1 33.7 49.5 40.3

Total liabilities and equity 100.0% 100.0% 100.0% 100.0% 100.0%

Business Valuation 601

million to $10.4 million. Debt consists of real estate mortgage notes, term

loans, a revolving line of credit, and obligations under capital leases.

Over the past five years, the shareholder equity increased from $6.7 million

to $11.4 million. Shareholder equity decreased slightly as a percentage of

total liabilities and equity over the past five years.

Income Statement Analysis

Victoria also prepares Exhibit 18.2 that presents ACME's historic income

statements in condensed form for the past five years. She also prepares Exhibit

18.3, which is a graph of ACME's annual revenues for the previous five years.

It graphically shows the revenue amounts from Exhibit 18.2 and more clearly

shows the revenue growth trend. The company had a compounded annual

growth rate in revenues of 11.1% during the previous five years and 3.5% for

the most recent year. ACME's revenue growth rate over the past five years was

substantially higher than the 5.6% revenue growth reported by the chemical

products industry.

Cost of goods sold as a percentage of revenues f luctuated between 66.6%

and 69.9% over the past five years. Operating expenses, exclusive of officers'

compensation, ranged from 9.8% to 11.8%. The overall trend is up.

ACME reported consistent profitability during the past five years. In

1996, income before officers' compensation and taxes was $6.5 million ($4.31 +

$2.23). For 2000, it increased to $8.7 million ($5.29 + $3.38).

Ratio Analysis

Victoria also prepares Exhibit 18.4 that presents various financial operating

ratios of ACME for the past five years. The liquidity ratios indicate the ability

of ACME to meet current obligations as they come due. The current ratio

decreased from 1.9 to 1.0 during the five-year period. Working capital also decreased

from $4.2 million to $190,000 during the same five-year period. These

indicate the company has a greater risk in being able to pay its bills.

The activity ratios indicate how effectively a company is utilizing its assets.

The average number of days in ACME's accounts receivable was similar

over the past five years at approximately 50 days. However, the average number

of days inventory remained at the plant before being sold decreased from

58 days to 47 days. The average number of days of accounts payable was similar

during the five-year period at 48 days.

The coverage ratios indicate a company's ability to pay debt service. The

number of times interest was earned, as measured by earnings before interest

and taxes (EBIT) divided by interest expense, decreased from 8 to 7 times.

The leverage ratios generally indicate a company's vulnerability to business

downturns. Highly leverage firms are more vulnerable to business downturns

than those with lower debt-to-worth positions. ACME's debt to tangible

worth increased in the past five years from 1.5 to 1.8. Fixed assets to tangible

worth increased from 1.0 to 1.5.

602

EXHIBIT 18.2 ACME Manufacturing Inc.: Summary of condensed income statements 1996 –2000.

($million) Growth Rates

2000 1999 1998 1997 1996 1996–2000 1999–2000

Revenues $50.29 $48.59 $40.85 $37.94 $33.02 11.1% 3.5%

Cost of goods sold 34.80 33.95 28.45 25.25 22.63 11.4 2.5

Gross profit 15.49 14.64 12.39 12.69 10.39 10.5 5.7

Operating expenses 5.95 5.58 4.34 3.72 3.31 15.8 6.7

Officers' compensation 3.38 2.86 3.53 3.03 2.23 11.1 18.4

Operating EBITDA 6.15 6.20 4.52 5.94 4.86 6.0 0.9

Depreciation and amortization 0.31 0.22 0.10 0.05 0.07 44.9 42.3

Operating income (EBIT) 5.84 5.99 4.42 5.89 4.79 5.1 2.5

Miscellaneous (income) (0.30) (0.25) (0.19) (0.18) (0.12) 26.1 17.1

Interest expense 0.84 0.74 0.55 0.47 0.59 9.0 12.6

Pretax income 5.29 5.49 4.06 5.60 4.31 5.3 3.6

Less: Income taxes* — — — — — N/A N/A

Net income $ 5.29 $ 5.49 $ 4.06 $ 5.60 $ 4.31 5.3% 3.6%

Common Size

2000 1999 1998 1997 1996

Revenues 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of goods sold 69.2 69.9 69.6 66.6 68.5

Gross profit 30.8 30.1 30.3 33.4 31.5

Operating expenses 11.8 11.5 10.6 9.8 10.0

Officers' compensation 6.7 5.9 8.6 8.0 6.8

Operating EBITDA 12.2 12.8 11.1 15.7 14.7

Depreciation and amortization 0.6 0.5 0.2 0.1 0.2

Operating income (EBIT) 11.6 12.3 10.8 15.5 14.5

Miscellaneous (income) 0.6 0.5 0.5 0.5 0.4

Interest expense 1.7 1.5 1.3 1.2 1.8

Pretax income 10.5 11.3 9.9 14.8 13.1

Less: Income taxes* 0.0 0.0 0.0 0.0 0.0

Net income 10.5% 11.3% 9.9% 14.8% 13.1%

* ACME is an S

corporation for tax purposes and taxable income is passed through to the shareholder. Thus, the corporation does not pay income taxes.

Business Valuation 603

The profitability ratios ref lect the returns earned by ACME and assist in

evaluating management performance. ACME has been consistently profitable

in each of the past five years. The earnings before taxes to tangible worth f luctuated

between 55% and 66%. Officers' compensation ranged from $2.2 million

to $3.6 million during the five years and was $3.4 million in the most

recent year.

EXHIBIT 18.3 ACME Manufacturing Inc.: Revenue growth 1996 –2000.

Year

Dollars (millions)

Revenues

1996 1997 1998 1999 2000

$-

10

20

30

40

50

60

EXHIBIT 18.4 ACME Manufacturing Inc.: Ratio analysis 1996 –2000.

2000 1999 1998 1997 1996

Liquidity ratios:

Current ratio 1.0 1.8 1.4 2.2 1.9

Quick ratio 0.6 1.1 0.9 1.3 1.1

Activity ratios:

Revenue/accounts receivable 7.3 7.5 7.0 7.8 7.2

Days' receivable 49.8 48.6 52.4 46.9 50.4

COS/inventory 7.8 7.6 6.4 7.2 6.3

Days' inventory 46.6 47.8 57.2 50.5 58.1

COS/payables 7.6 9.4 4.9 7.4 7.6

Days' payables 47.7 39.0 73.9 49.2 48.0

Revenue/working capital 274.2 9.4 11.4 7.5 7.8

Coverage/leverage ratios:

EBIT/interest 7.3 8.4 8.4 13.0 8.3

Fixed assets/tangible worth 1.5 1.1 1.5 0.9 1.0

Debt /tangible worth 1.8 1.5 2.6 1.0 1.5

Profitability & operating ratios:

EBT/tangible worth 55.4% 58.8% 63.4% 62.8% 65.5%

EBT/total assets 18.4% 22.1% 16.2% 30.8% 26.0%

Revenue/fixed assets 3.6 4.7 4.4 5.0 4.9

Revenue/total assets 1.8 2.0 1.6 2.1 2.0

604 Making Key Strategic Decisions

COMPARISON TO INDUSTRY AVERAGES

Victoria also compares ACME's key financial ratios to peer companies. The

main differences between ACME and other companies of similar size in the

same industry are as follows:

• ACME's liquidity is significantly less than other companies in the group.

Similar companies had a ratio of 1.6 while ACME had a current ratio of

1.0. This is likely due to ACME having a significant portion of its financing

due within twelve months as opposed to longer term financing.

• The average number of days in accounts payable for ACME is 48 days and

is significantly more than the peer group at 32 days. This is likely due to

the company taking longer to pay its expenses related to raw materials and

inventory than that of its peer group because of low working capital.

• The times interest earned measure for ACME is significantly higher than

its peer group. The company had a measure of 7.3 as compared to its

peers at 4.0. This is likely due to ACME having a higher profit margin

than its peers.

• ACME is significantly more leveraged than its peer group. Its measure of

debt to tangible worth is 1.8 as compared to its peers at 1.2. Also, the

company's measure of fixed assets to tangible worth is 1.5 as compared to

its peers at 0.5. This assessment is related to the company having a higher

level of fixed assets as compared to its tangible worth.

• ACME is more profitable than its peers. The measure of earnings before

taxes to total assets was 18%, as compared to its peers' 12%. Additionally,

ACME's earnings before taxes to tangible worth was 55% as compared to

its peers at 22%. This is due to ACME's profit margin of 11%, as compared

to its peers at 5%.

The purpose of the this part of Victoria's analysis is to assess the risk factors

of owning this business as compared to an investment in the average peer

company. As previously discussed in this chapter, investors have options of

where to place their capital and rational investors require a higher reward (in

the form of returns) for investments with higher risks.

APPRAISAL OF FAIR MARKET VALUE

Victoria tells Bob that the shares of ACME are closely held securities and there

is no ready market for their sale. The three general approaches available for the

valuation of private business interests were discussed earlier in this chapter.

Victoria considers all relevant valuation approaches and methods and ultimately

relies on two approaches to estimate the value of ACME's common

stock—a market approach and an income approach. She rejects the asset approach

because the premise of value is a going concern and the company has no

Business Valuation 605

intention to liquidate the assets. In addition, this approach does not clearly ref

lect the value of the business resulting from its earnings potential.

Debt-Free Analysis

She further explains to Bob that there are two ways to value the equity (stock)

of a private business under the income approach. The first is the direct equity

methodology. Under this approach a company's net income or cash f low is the

basis to determine the value of the company's stock. This methodology either

capitalizes net income or net cash flow, or it determines the present value of a

series of future cash f lows.

The second is the debt-free methodology (or invested capital methodology).

How much or how little a company is leveraged can have a significant impact

on the value of the company's stock. If a specific company has too little

leverage or too much leverage as compared to an ideal blend of debt and equity

capital, the direct equity methodology may result in a distorted valuation.

A company's invested capital represents all of its sources of capital to

fund the business—capital from investors (equity) and lenders (debt). When

we say the value of a "business," it often has a different meaning from the

value of the corporation's equity. This concept is illustrated below.

When we say the value of a "business" or "company," we are often referring

to the value of the overall capital (the debt and equity capital equals the

total assets). Many sales transactions are structured only to transfer the assets

of a business and it is up to the buyer to raise capital from investors and/or

lenders. (In an asset sale, the seller would be responsible for paying off the existing

debt, usually upon the receipt of the sales proceeds.) When the objective

is to value only the equity, debt is subtracted from the value of the total assets.

This is the underlying model of the debt-free methodology. First, the total assets

are valued based on the company's cash flow without regard to servicing

the debt. Second, if the equity is being valued, then the company's debt is subtracted

from the value of the assets.

The direct equity methodology determines the value of the equity by

using the net cash f low after the company services its debt, which results in a

=

Value of assets

Value of

overall capital structure

Debt

Equity

606 Making Key Strategic Decisions

lower cash flow. Then a discount rate or capitalization rate (multiple) is applied.

The result is the value of the company's equity. The direct equity and

debt-free methodologies are summarized below:

COST OF CAPITAL

Bob asks Victoria to explain the cost of capital. She says that when a business

owner or prospective buyer is raising capital, debt capital is less expensive than

equity capital. Debt capital represents those monies borrowed from a lender,

such as a bank, to fund the business. The lender expects a return on its investment

in the form of interest. From a financial prospective, interest expense on

the debt is called the cost of debt. Therefore, the business pays interest, or the

cost of debt, which is often near the prime lending rate. ACME's cost of debt

that it pays in interest is 9%. However, since ACME can take a tax deduction

for the interest expense, its actual cost of debt capital is 5.4% (9% interest cost

less 40% in reduced taxes). For every $100 ACME pays in interest expense to

the bank, its income tax obligation is lowered by $40 because interest is a business

expense that lowers taxable income. Thus, ACME's after-tax interest expense

is $60 ($100 minus $40 in reduced taxes).

In order for a business to raise equity capital (selling stock to investors), it

expects to provide the shareholders a rate of return. As previously discussed,

stocks of large public companies have had average returns of 10% to 12% per

year to the shareholders over an extended time period. Small public company

stocks have traditionally yielded 15% to 20% to shareholders. Since closely held

companies are frequently more risky than small public companies, most private

businesses must offer a rate of return to shareholders exceeding the returns of

small public stocks. Let's say that a closely held business is raising capital by

selling stock. The return a company expects to give its investors (stockholders)

in order to attract their capital is called the company's cost of equity.

Therefore, a company has a cost of debt capital and a cost of equity capital.

Combined, they are referred to as a company's cost of capital. The cost of debt is

less than the cost of equity as illustrated above. Management of a business can

Direct Equity Methodology Debt-Free Methodology

Net income or net cash f low to equity

holders (defined later)

Net cash flow to holders of total invested

capital (defined later)

Apply discount rate or capitalization

rate on a cost of equity basis (discussed

later)

Apply discount rate or capitalization

rate on a weighted average cost of

capital basis (discussed later)

Results in value of company's equity Results in value of company's invested

capital (debt and equity)

Subtract value of debt capital to arrive

at the value of the company's equity

Business Valuation 607

maximize the shareholders' returns by using a blend of debt financing (less expensive)

and equity capital (more expensive). Say that a prospective buyer of a

business must raise $10 million to acquire the company. If it raised the entire $10

million from the sale of stock, it would have to pay those shareholders a rate of return

of, say, 20%. Or, it could raise a portion of the $10 million by borrowing

from a bank at, say, an after-tax interest cost of 5%. Obviously, the cost of debt is

significantly less than the cost of equity. If management borrows $5 million from

the bank and raises another $5 million through the sale of stock, its overall cost of

capital is significantly lower than if the company raised the entire $10 million

from the sale of stock. This comparison is presented below:

Blended Capital Structure of Debt and Equity

Weighted

Average

Type of Amount Cost of Cost of

Capital ($ million) Percent Capital Capital

Debt $ 5 50% 5% (after-tax) 2.5%

Equity 5 50 20 10.0

Debt and Equity 10 100 N/A 12.5

No Debt in Capital Structure

Type of Amount Cost of

Capital ($ million) Percent Capital

Equity $10 100% 20%

The above illustrates that with the proper blending of debt and equity

capital, management can decrease its overall cost of capital from 20% to

12.5%. This has the effect of increasing the shareholders' rate of return. It also

has a positive effect on the value of the company's stock.

(This concept of different returns for different types of capital and the

respective weightings is called the band of investment methodology when used

in real estate appraisals.)

The relevance of all this to business valuation is that if a particular company

does not already have the proper blend of debt and equity capital, a

valuation may be performed and have an incorrect result unless a more sophisticated

debt-free analysis is done. The direct equity methodology does not

take into account an optimal blend of debt and equity (unless the business already

happens to have it). Consequently, the result of a valuation using the direct

equity methodology may result in an incorrect value. However, if the

business already has an appropriate blend of capital, the direct equity method

is a simpler valuation methodology and produces a correct value result. In addition,

buyers of smaller private companies do not necessarily take capital

structure into account when making purchase decisions, so a debt-free analysis

may not be necessary for these companies to determine fair market value.

Victoria's research indicates that ACME does not have the ideal capital

structure. Therefore, she concludes that a debt-free methodology is necessary to

608 Making Key Strategic Decisions

arrive at a proper value of ACME. This methodology determines the earnings

of ACME without regard to its debt service. Thus, net income on a debtfree

basis will be higher than the company's net income, which typically

includes interest expense. The resulting higher value using the debt-free

methodology is not only for equity holders but also debt holders. This combined

value of equity and debt is known as the market value of invested capital

(MVIC). Once the value of ACME's MVIC is determined, then the value of

debt capital is subtracted resulting in the value of ACME's equity. Victoria

summarizes this concept for Bob. The debt-free methodology results initially

in the combined value of equity and debt (total invested capital) of the business.

Interest bearing debt is then subtracted to determine the value of the

company's equity. This methodology is more complicated but it is frequently

necessary to obtain a correct valuation when the business's debt and equity

blend is not optimal.

ADJUSTMENTS TO EARNINGS

FOR VALUATION PURPOSES

As previously mentioned, financial statements of private companies sometimes

do not ref lect the true profitability. Victoria tells Bob that valuation adjustments

to the financial statements are sometimes necessary.

These adjustments fall into two categories. The first type of adjustment is

the elimination of unusual or nonrecurring items. These adjustments eliminate

the effect of past events that are not expected to occur again in the future,

such as a profit center that has been eliminated, legal expenses that were incurred

to defend an extraordinary lawsuit, or a nonrecurring capital gain from

the sale of an asset. A buyer of the business does not expect these items to

recur in the future and, therefore, they are eliminated. The second type of adjustment

are the economic adjustments. These include adjustments to expenses

that are not ref lected at their market values, such as the officers' compensation

being paid at an above-market amount, the company's rent expense being

paid on a shareholder-owned building at an amount different than market rent,

or the shareholder's extra perquisites being expensed by the business. In addition,

some closely held businesses fail to report all of their revenues and these

amounts should be considered in the adjustments. Any expenses related to nonoperating

assets (e.g., a ski condominium) would also be eliminated.

After the valuator identifies the adjustments, the reported earnings of

the company are modified to ref lect the economic earnings of the business on

an ongoing basis.

In the case of ACME, Victoria determines that officers' compensation actually

being paid is in excess of the amount the business would need to pay by replacing

the family members. Thus, officers' compensation expense is reduced to

the market level and earnings increased accordingly. In addition, Bob owns some

of the factory locations personally. Victoria also determines that ACME is not

Business Valuation 609

paying market rents to Bob, and she makes the corresponding adjustment to rent

expense. As ref lected in Exhibit 18.2, ACME has elected to be treated as an

S corporation for income tax purposes. Thus, ACME does not pay income taxes

since the income is reported on Bob's personal income tax return. Bob pays the

income taxes instead of the corporation. Victoria determines that the most likely

buyer of ACME would be a large corporation that would not be able to maintain

ACME's S corporation tax status. (The most likely buyer is a C corporation that

pays its own taxes.) Therefore, Victoria makes an economic adjustment to

ACME's pro forma income statement to include income tax expense. The aftertax

income is what a typical buyer expects to earn from purchasing this business.

After these adjustments are made on a pro forma income statement, the result

indicates ACME's true profitability to a typical buyer of the business.

Once Victoria determines ACME's actual earnings base, she continues

her appraisal by applying the most appropriate valuation methodologies for the

business.

INCOME APPROACH: DISCOUNTED

CASH FLOW METHOD

As previously discussed, the income approach is based on the concept that the

value of an asset today represents its perceived future benefits discounted to

present value. Victoria uses the discounted cash flow (DCF) methodology in

her valuation. This method forecasts ACME's cash f lows into the future and

discounts them to their present value. In addition, this method assumes that

ACME will be sold at some point in the future and the owner will receive the

sales proceeds at that time. The estimated future sales price, also know as the

residual value (or terminal value), is also discounted back to present value. The

sum of the present values of future cash f lows and the residual value are added

together to determine the value of ACME. This concept is summarized here:

This methodology can be applied to different forms of earnings—net income,

cash f low to equity holders, or debt-free cash flow. Many business valuators

prefer to use cash flows as the earnings base rather than net income

because it is cash f low that is available for shareholder distributions. As previously

discussed, cash flows may be determined after the inclusion of debt costs

(referred to as equity net cash f low) or on a debt-free basis (referred to as invested

capital net cash f low). The formulas for these types of cash f lows are

presented below. The use of either type of cash f low is valid when the appropriate

discount rate is applied in the DCF model.

Discounted Cash Flow Valuation Method (simplified)

Annual future cash flows, discounted to present value

Future residual value of the company, discounted to present value

Value (today)

+

=

610 Making Key Strategic Decisions

A common error in the income approach to valuation is improperly matching

the income stream and discount rate. The equity net cash flow represents

the return on investment to the equity holders. Thus, the appropriate discount

rate in the DCF model is the company's cost of equity. The invested capital net

cash f low is the rate of return to all holders of invested capital and, therefore,

the company's weighted average cost of capital should be used.

Projected Financial Statements

Management of ACME prepared a financial projection and discusses it and the

underlying assumptions with Victoria. Management's financial projections are

presented in Exhibits 18.5, 18.6, and 18.7. Key assumptions incorporated into

the projections include:

• Sales would grow 12% in 2001 and 2002, 11% in 2003 and 2004, and 10%

in 2005.

• Costs of goods sold are 69% of sales.

• Operating expenses (exclusive of officers' salaries) are 12% of sales.

• Officers' salaries (at market) are 3.1% of sales.

• The 2001 capital expenditures are $2.8 million and increase thereafter

5% per year.

• The company needs a minimum cash balance of $200,000.

Invested Capital Net Cash Flow

After-tax net income

+ Depreciation and amortication (noncash) expenses

Capital expenditures

Increases (or + decreases) in working capital requirements

+ Interest expense × (1 minus tax rate)

= Net cash f low to holders of total invested capital (debt and

equity)

Equity Net Cash Flow

After-tax net income

+ Depreciation and amortization (noncash) expenses

Capital expenditures

Increases (or + decreases) in working capital requirements

+ Increases (or decreases) in long-term debt

= Net cash f low to equity holders

Application of DCF Model

Type of Type of

Income Stream Discount Rate

Equity net cash f low Cost of equity

Invested capital net cash f low Weighted average cost of capital

Business Valuation 611

• The dividend payout ratio (the amount of cash f lows actually distributed

to shareholders; the remainder is reinvested in the company) ranges from

55% to 65% per year.

Residual Value

The DCF valuation methodology assumes the company will be sold at some

point in the future and the business owner will receive the proceeds. Victoria

assumes ACME will be sold five years in the future, on December 31, 2005.

(Five years is common among analysts for established businesses. Start-up

businesses may require financial projections for a longer period such as 10

years until the company's earnings become stable.) The value of a company at

the end of the financial forecast is the residual value. The residual value of

EXHIBIT 18.5 ACME Manufacturing Inc.: Projected income statements

2001–2005.

($million)

Pro Forma 2001 2002 2003 2004 2005

Revenue $50.29 $56.32 $63.08 $70.02 $77.72 $85.50

Cost of goods sold 34.58 38.86 43.53 48.32 53.63 58.99

Gross profit 15.70 17.46 19.56 21.71 24.09 26.50

Operating expenses 5.95 6.76 7.57 8.40 9.33 10.26

Officers' salary 1.54 1.75 1.96 2.17 2.41 2.65

Depreciation & amortization 1.00 0.88 1.01 1.14 1.28 1.43

Interest expense 0.84 1.04 1.10 1.14 1.21 1.28

Operating profit 6.37 7.03 7.92 8.85 9.87 10.88

Other expenses/(income) (0.30) (0.21) (0.21) (0.21) (0.21) (0.21)

Income before taxes 6.66 7.24 8.13 9.06 10.08 11.09

Income taxes 2.67 2.90 3.25 3.63 4.03 4.44

Adjusted net income $4.00 $4.34 $4.88 $5.44 $6.05 $6.65

Common Size

Pro Forma 2001 2002 2003 2004 2005

Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of goods sold 68.8 69.0 69.0 69.0 69.0 69.0

Gross profit 31.2 31.0 31.0 31.0 31.0 31.0

Operating expenses 11.8 12.0 12.0 12.0 12.0 12.0

Officers' salary 3.1 3.1 3.1 3.1 3.1 3.1

Depreciation & amortization 2.0 1.6 1.6 1.6 1.6 1.7

Interest expense 1.7 1.8 1.7 1.6 1.6 1.5

Operating profit 12.7 12.5 12.6 12.6 12.7 12.7

Other expenses/(income) 0.6 0.4 0.3 0.3 0.3 0.2

Income before taxes 13.2 12.9 12.9 12.9 13.0 13.0

Income taxes 5.3 5.1 5.2 5.2 5.2 5.2

Adjusted net income 8.0% 7.7% 7.7% 7.8% 7.8% 7.8%

612 Making Key Strategic Decisions

ACME is estimated based on the net cash f lows in 2005 and then increasing

them by the estimated sustainable (long-term) earnings growth rate. For the

projection's final year, items such as interest expense and depreciation need to

be stated at their stabilized ongoing amounts since the hypothetical new buyer

at December 31, 2005, is expecting to receive a stabilized annual net cash flow

using this residual value methodology. The result of this portion of the DCF

analysis is the estimated net cash f lows someone would expect ACME to earn

in 2006. The presumption is that the company will be sold at the end of 2005,

its earnings have stabilized, and a new owner can expect to receive the 2006

cash f lows.

A multiple is applied to ACME's estimated 2006 net cash f low in order to

determine the residual value at the end of 2005. The multiple is based on the

inverse of the company's weighted average cost of capital less the estimated

sustainable long-term earnings growth rate. This is called a capitalization rate

(or capitalization factor) and is illustrated:

Capitalization rate Discount rate Sustainable long-term earnings

growth rate

Price-earnings (P/E) multiple

Capitalization rate

= −

= 1

EXHIBIT 18.6 ACME Manufacturing Inc.: Projected invested capital net

cash f lows 2001–2005.

($million)

2001 2002 2003 2004 2005

Projected after-tax income $4.35 $4.88 $5.44 $6.05 $6.65

Projected interest expense 1.04 1.10 1.14 1.21 1.28

Tax shield of interest expense (0.42) (0.44) (0.45) (0.48) (0.51)

Common stock dividend adjustment (0.30) (0.26) — — —

Projected depreciation/amortization 0.88 1.01 1.14 1.29 1.43

After-tax gross cash f low to invested capital 5.55 6.28 7.26 8.06 8.86

± Increase/decrease in working capital

(excluding interest-bearing ST debt) (0.54) (0.63) (0.65) (0.72) (0.73)

± Increase/decrease in investments (2.80) (2.94) (3.09) (3.24) (3.40)

± Increase/decrease in other assets (0.13) (0.15) (0.16) (0.18) (0.20)

± Increase/decreasein other liabilities — — — — —

Cash available for financing 2.08 2.57 3.37 3.92 4.53

Preferred stock dividends — — — — —

Net cash f low 2.08 2.57 3.37 3.92 4.53

+ Beginning cash balance 0.04 0.20 0.20 0.20 0.20

Preliminary cash available 2.12 2.77 3.57 4.12 4.73

Minimum required cash balance (0.20) (0.20) (0.20) (0.20) (0.20)

Available for dividend to invested capital,

net free cash f low $1.92 $2.57 $3.37 $3.92 $4.53

Business Valuation 613

Required Discount Rate (Rate of Return)

As previously discussed, since ACME is being analyzed on a debt-free basis,

Victoria uses the weighted average cost of capital (WACC) as the discount rate.

The WACC incorporates the cost of debt and the cost of equity using market

evidence and weights them based on capital structure. Each element of the

weighted average cost of capital as it applies to ACME is discussed in the following

sections.

Cost of Equity

As discussed earlier in this chapter, an investor has many places to invest his or

her funds. A rational investor expects a higher rate of return when an investment

carries more risks. In developing ACME's rate of return on equity capital,

Victoria uses the modified capital asset pricing model (CAPM) that is

defined as:

Equity rate of return Risk-free rate Equity risk premium Beta)

Size risk premium Specific company risk premium

= + ×

+ +

(

EXHIBIT 18.7 ACME Manufacturing Inc.: Projected balance sheets

2001–2005.

Adjusted ($million)

2000 2001 2002 2003 2004 2005

Cash $ 0.04 $ 0.20 $ 0.20 $ 0.23 $ 0.24 $ 0.40

Accounts receivable 6.87 7.69 8.61 9.55 10.61 11.67

Inventory 4.45 4.98 5.58 6.19 6.88 7.56

Other current assets 0.34 0.38 0.42 0.47 0.52 0.57

Total current assets 11.69 13.24 14.81 16.44 18.24 20.20

Fixed assets 14.34 17.14 20.08 23.16 26.40 29.80

Accumulated depreciation (2.94) (3.82) (4.83) (5.97) (7.26) (8.69)

Net fixed assets 11.40 13.32 15.25 17.19 19.15 21.12

Other assets 1.33 1.47 1.61 1.77 1.95 2.15

Total assets $24.42 $28.03 $31.67 $35.41 $39.34 $43.46

Accounts payable $ 4.55 $ 5.12 $ 5.74 $ 6.37 $ 7.07 $ 7.77

Notes payable — 0.30 0.26 — — —

Current portion LTD 4.58 3.28 3.45 3.63 3.85 4.07

Other current liabilities 2.37 2.66 2.97 3.30 3.66 4.03

Total current liabilities 11.50 11.35 12.42 13.29 14.58 15.87

Long-term debt 5.83 7.65 8.04 8.46 8.98 9.49

Total liabilities 17.33 19.00 20.46 21.75 23.57 25.36

Equity 7.09 9.03 11.21 13.66 15.77 18.10

Total liabilities & equity $24.42 $28.03 $31.67 $35.41 $39.34 $43.46

614 Making Key Strategic Decisions

Investments in closely held businesses are widely considered to be longterm

rather than short-term investments. Accordingly, the risk-free rate, the

first element in the modified CAPM, is based on the 20-year U.S. Treasury

bond yield as of the valuation date. U.S. Treasuries are considered risk-free investments

and the 20-year bond is considered a long-term investment benchmark

for purposes of valuing closely held businesses. At the valuation date, the

risk-free rate is 6.4%.

Victoria explains that the second element of the modified CAPM is the

equity risk premium. The equity risk premium is the additional rate of return

investors in stocks require above a risk-free rate of return because of the

higher risks of investing in equities. Ibbotson Associates of Chicago, Illinois,

has performed annual empirical studies of the equity risk premium that investors

have received dating back to 1926. As of ACME's valuation date, the

historic equity risk premium since 1926 has been 8.1% above the risk-free

rate. Again, since investments in closely held businesses are considered long

term, the equity risk premium is also measured on a long-term basis.

The CAPM uses the sensitivity of a company (investment) as compared to

swings in the overall investment market. The risk that is common to all investment

securities that cannot be eliminated through diversification is called systematic

risk. When using CAPM, the systematic risk of a particular investment

is measured by beta. Beta is a measure of the relationship between the returns

on an individual investment and the returns of the overall market as typically

measured by an index such as the Standard & Poor's 500. For example, the

market prices of some investments have a tendency to rise and fall faster than

the overall market. The base measure of beta is 1.0. When an investment's

beta is greater than 1.0, its returns have tended to be more than the market returns.

Also, the investment's losses have tended to be greater than the market's

losses. An investment with a beta of less than 1.0 has had returns that tend to

be less than the market returns. In summary, beta measures an investment's

return volatility as compared to the overall market. If an investment has a beta

greater than 1.0, its returns are more volatile and carry more risk than the

market. If beta is less than 1.0, its returns are less volatile and carry less risk

than the market.

One way to estimate the beta of a closely held company is to use the average

beta of guideline publicly traded companies. Beta is a coefficient used by

financial analysts that adjusts the general equity risk premium to a specific investment

in the CAPM. A complete discussion of beta is beyond the scope of

this chapter but it is widely available in finance literature. The beta of publicly

traded companies is generally available from investment publications and from

empirical studies such as the one conducted by Ibbotson Associates.

Victoria's research analysis indicates the average beta of publicly traded

companies in ACME's industry is 0.99 as of the valuation date. She concludes

that this average is a reasonable estimate of ACME's beta for use in the CAPM.

Therefore, the equity risk premium for ACME is 8.0% (the general equity

risk premium of 8.1% multiplied by the beta of 0.99).

Business Valuation 615

Victoria tells Bob that the capital asset pricing model is widely used by

analysts for investment management where a specific investment's risks can be

eliminated through portfolio diversification. Business valuation theory uses

CAPM but modifies it to consider a specific company's unsystematic risks in

addition to the systematic risks. Unsystematic risk represents those risks

uniquely associated with an investment that cannot be avoided through portfolio

diversification. ACME's unsystematic risks are discussed next.

Studies have shown that investments in small companies typically have

more risk than those in large companies. Generally, small company earnings

and stock prices are more volatile than those of larger companies. Over the

long term, investors in smaller companies have received higher rates of return

than investors in the larger Standard & Poor's (S&P) 500 companies. Empirical

data from Ibbotson Associates shows that the smallest 20% of public companies

have yielded an extra 2.2% rate of return above the returns of S&P 500

companies since 1926. Therefore, Victoria adds a premium of 2.2% to ACME's

required rate of return for the risks associated with its size as compared to

S&P 500 companies.

Finally, the differences between ACME and small publicly traded companies

are considered. Victoria previously identified the quantitative and qualitative

attributes of ACME that are considered negative and positive risk

factors for the company. These were presented earlier in the chapter. After reviewing

her quantitative and qualitative analyses, she determines that ACME

is somewhat more risky than small public companies. In Victoria's judgment,

she adds a 2% specific company risk premium as an additional required rate of

return for an investor in ACME.

In summary, Victoria determines ACME's cost of equity using the modified

CAPM as shown Exhibit 18.8.

Cost of Debt

Victoria analyzes ACME's audited financial statements, including the footnotes,

and interviews management to determine the company's interest rate on

long-term financing was 9%. This was comparable to market interest rates.

Since interest paid by the company is tax deductible, the after-tax effective

EXHIBIT 18.8 ACME Manufacturing Inc.:

Cost of equity.

Risk-free rate 6.4%

Overall equity risk premium 8.1%

Multiply by Beta 0.99

ACME's equity risk premium 8.0%

Small company risk premium 2.2%

Specific company risk premium 2.0%

ACME's cost of equity 18.6%

616 Making Key Strategic Decisions

interest rate is less than 9%. Victoria determines that ACME is in the 40% income

tax bracket. Therefore, ACME's after-tax cost of debt is 5.4% as presented

in Exhibit 18.9.

Weighted Average Cost of Capital

Victoria estimates the optimal capital structure for ACME as 40% debt and

60% equity based on her analysis of the average capital structures of publicly

traded companies and then considering that ACME does not have the same access

to capital sources as public companies.

Based on this weighting between debt and equity, ACME's weighted average

cost of capital is 13.3%. The calculation is presented in Exhibit 18.10.

Discounted Cash-Flow Calculation

As previously discussed, ACME's forecasted invested capital net cash f lows for

2001 to 2005 are discounted to present value as of the December 31, 2000, valuation

date. The discount rate is ACME's weighted average cost of capital—

13.3%. In addition, the residual value of ACME in 2005 is discounted to

present value using the same rate.

Victoria prepares Exhibit 18.11 that presents the resulting value from discounting

the cash f lows for the five-year period and also discounting the residual

value. It assumes that the annual cash f lows are earned equally throughout

each year. Therefore, the present value calculation for the annual cash flows

uses the middle of each year (June 30) to determine the length of time for the

present value calculation. This is called the mid-year convention. For example,

EXHIBIT 18.9 ACME Manufacturing Inc.:

Cost of debt.

ACME's borrowing rate 9.0%

Multiply by the tax effect (1 Tax rate of 40%) 60%

ACME's cost of debt 5.4%

EXHIBIT 18.10 ACME Manufacturing Inc.:

Weighted average cost of capital.

Cost of equity (above) 18.6%

Equity weighting 60%

11.1%

Cost of debt (above) 5.4%

Debt weighting 40%

2.2%

ACME's weighted average cost of capital 13.3%

Business Valuation 617

the first forecasted year (2001) is discounted one-half year, rather than one

complete year, to the valuation date of December 31, 2000.

The residual value is based on the expected invested capital net cash flow

in the last year of the projection (2005) of $4.533 million. Victoria estimates

ACME's long-term sustainable earnings growth rate at 5% annually. Accordingly,

the cash f low for 2006 is estimated at $4.760 million ($4.533 million ×

1.05). The multiple Victoria applies for the residual year is 12. The calculation

for the multiple is presented in Exhibit 18.11. ACME's residual value at December

31, 2005, is estimated as $57.1 million.

The present values of the five years of cash f lows are added together

plus the present value of the residual value. These items represent the anticipated

future benefits to all capital holders at December 31, 2000. The sum of

the present values represents the market value of the total invested capital

(MVIC) of $42.1 million. ACME's interest bearing debt of $10.4 million is

subtracted resulting in $31.7 million for the value of ACME's common stock

EXHIBIT 18.11 ACME Manufacturing Inc.: DCF method of

valuation as of December 31, 2000.

(Exhibit 18.6)

Forecast Projected Present

Year Cash Flows WACC Value

2001 $1,921,000 13.3% $ 1,804,731

2002 2,565,000 13.3% 2,126,878

2003 3,367,000 13.3% 2,464,157

2004 3,917,000 13.3% 2,530,165

2005 4,533,000 13.3% 2,584,349

Residual value (see below) 13.3% 30,591,919

Value of invested capital 42,102,198

Less: debt capital (10,411,554)

Value of equity $31,690,644

Value of equity (rounded) $31,700,000

Residual Value at December 31, 2005

2005 Projected cash f low $4,533,000

Estimated sustainable growth rate 1.05

2006 Projected cash f low 4,759,650

Price multiple

WACC (discount rate) 13.3%

Less: Sustainable growth rate 5.0%

Capitalization rate 8.3%

Multiple (inverse of capitalization rate) 12

Residual value at December 31, 2005 $57,115,800

Present value of residual value $30,591,919

618 Making Key Strategic Decisions

as of December 31, 2000, on an as-if-freely-traded basis. Since this amount is

based on rates of return of freely traded marketable securities, Victoria will

take a valuation discount for lack of liquidity at the end of her analysis.

Because Victoria made adjustments to the 2000 pro forma income statement

(see the pro forma column in Exhibit 18.5) for discretionary items (officers'

compensation and rent expense) and income tax expense, the 2000 pro

forma earnings and resulting value of $31.7 million represents a value for a

control (rather than a minority) equity interest.

In summary, the discounted cash flow methodology determines ACME's

value today, which represents an owner's perceived future benefits discounted

to the present value. The DCF method forecasts ACME's cash f lows into the

future and discounts them to their present value. In addition, this method assumes

that the owner will sell the company at some point in the future and receive

the sale price. The estimated future sale price is also discounted back to

present value. The present values of future earnings and future sale price are

added together to determine the value of ACME.

MARKET APPROACH: PUBLICLY TRADED

GUIDELINE—COMPANIES METHOD

Bob asks Victoria to explain the market approach to determining value. She

says the market approach is a general way of determining a value by comparing

the asset to similar assets that have been sold. In business valuation, this can be

done by looking for any prior arm's-length sales of the company's stock, sales of

other companies, or prices of shares in publicly traded companies. In the latter

two instances, careful analysis of the other companies must be done to determine

if they would properly serve as guidelines under this approach. The

American Society of Appraisers describes guideline companies as those "companies

that provide a reasonable basis for comparison to the investment characteristics

of the company being valued. Ideal guideline companies are in the

same industry as the company being valued; but if there is insufficient transaction

evidence available in the same industry it may be necessary to select companies

with an underlying similarity of relevant investment characteristics

(risks) such as markets, products, growth, cyclical variability and other salient

factors." 2

In ACME's case, there have never been any prior sales of corporate stock.

In addition, Victoria is unable to find any sales of guideline companies in which

adequate information is available. However, she is able to identify five publicly

traded companies that could potentially serve as guidelines under the market

approach.

Having identified the list of potential public companies through database

searches, Victoria performs a qualitative and quantitative analyses on the companies

to determine whether they should serve as guideline companies. This

analysis results in the selection of five companies.

Business Valuation 619

Victoria's analysis looks at the public companies' balance sheets and income

statements over several years, growth rates, margins, returns on assets

and equity, and financial ratios. She also analyzes various share price multiples

of the public companies such as:

• Market value of invested capital to sales.

• Market value of invested capital to earnings before interest, taxes, depreciation,

and amortization (EBITDA).

• Market value of invested capital to earnings before interest and taxes

(EBIT).

• Market value of equity to pretax income.

• Market value of equity to net income.

• Market value of equity to cash flow.

• Market value of equity to book value.

Based on her detailed analyses of the guideline companies and comparing

them to ACME, Victoria determines that the following price multiples of the

public companies appear to be most correlated and relevant for application to

ACME: market value of invested capital to sales, market value of invested capital

to EBITDA, market value of invested capital to EBIT, and market value of

equity to pretax income.

The median price multiples for the five public companies are:

Then Victoria applies the median price multiples to ACME. See Exhibit

18.12 for her calculations. Her analysis indicates a value of ACME's equity

at December 31, 2000, of $35.2 million on an as-if-freely-traded basis.

Since Victoria made adjustments to the 2000 income statement (see the

resulting pro forma column in Exhibit 18.5) for discretionary items (officers'

compensation and rent expense), she explains that the 2000 earnings and resulting

value of $35.2 million represents a value to an owner of a control equity

interest. Thus, Victoria concludes that there is no need to add a control

premium. A control premium is an upward adjustment to the value that ref

lects the power of control as compared to the value of a noncontrol equity interest.

(However, many analysts believe that a control premium would be

necessary simply because of the use of public minority share multiples even

though the income was adjusted upward to ref lect the discretionary expenses

of a control owner. Many of these people, however, would not use the median

multiple of the public companies as Victoria did but adjust it [usually down]

Median

Price

Multiple

Market value of invested capital to sales 0.54

Market value of invested capital to EBITDA 5.80

Market value of invested capital to EBIT 7.26

Market value of equity to pre-tax income 6.72

620

EXHIBIT 18.12 ACME Manufacturing Inc.: Publicly Traded Guideline Co. method of valuation.

ACME ($million)

Median Market Value

Multiple of Pro Forma of Invested Market Value Weighted

Price Multiple Guidelines Amountsa Capital Less: Debt of Equity Weight Average

Market value of invested capital

to sales 0.54 Sales $50.29 $27.16 $10.41 $16.75 25% $ 4.19

Market value of invested capital

to EBITDA 5.80 EBITDA 8.21 47.62 10.41 37.21 25% 9.30

Market value of invested capital

to EBIT 7.26 EBIT 7.21 52.34 10.41 41.93 25% 10.48

Market value of equity to pretax

income 6.72 Pretax income 6.66 N/A N/A 44.76 25% 11.19

Value of Equity $35.16

a See Exhibit 18.5 for 2000 pro forma amounts after valuation adjustments were made.

Business Valuation 621

for fundamental differences between the selected public companies and the

private business. Thus, if these analysts first adjust the price multiple downward

as a fundamental adjustment and then apply an upward control premium,

the result may be similar to Victoria's valuation conclusion.)

However, since the $35.2 million value is based on freely traded marketable

securities, Victoria will take a valuation discount for lack of liquidity at

the end of her analysis.

RECONCILIATION OF VALUATION METHODS

The results of Victoria's valuation analysis are:

Method Value

Income approach $31.7 million

Market approach 35.2 million

Average 33.5 million

Victoria chooses to weigh each method equally resulting in an average

value of $33.5 million. This value represents 100% of the common stock of

ACME at December 31, 2000, on an as-if-freely-traded and control basis.

DISCOUNT FOR LACK OF LIQUIDITY

A freely traded basis means an investment can be sold and converted to cash

within several days. When shares of stock are sold on a public exchange, the

seller will usually receive cash within a few days making them freely traded investments.

Under the income approach, Victoria used rates of returns from

publicly traded securities. Under the market approach, she used price multiples

of publicly traded shares. Thus, the values under both of Victoria's approaches

result in as-if-freely-traded values. Because it would likely take Bob

(or any other owner of the business) several months or longer to sell ACME and

receive cash, the liquidity of an investment in ACME's shares is significantly

different than the liquidity of publicly traded shares of stock. Therefore, Victoria

takes a discount from the as-if-freely-traded value of $33.5 million for

ACME's equity.

The preceding provides the rationale for applying a discount for lack of

liquidity. However, the amount of the discount must be quantified. The closest

empirical evidence to quantify the discount comes from studies of restricted

public stock prices and studies of share prices just prior to companies' initial

public offerings. These studies indicate discounts for lack of marketability of

35% to 45% on average. Since these studies relate to minority equity positions

in the companies instead of control positions, Victoria uses a discount below

the averages of the studies. Based on her analysis and judgment, she applies a

10% lack of liquidity discount to the as-if-freely-traded $33.5 million equity

622 Making Key Strategic Decisions

value. This represents the discount an investor would require for buying shares

in ACME instead of an investment that is freely traded.

VALUATION CONCLUSION FOR ACME

Victoria concludes that the fair market value of the common stock of ACME as

of December 31, 2000, was $30,150,000 ($33.5 million less 10% discount for

lack of liquidity).

VALUING MINORITY INTERESTS

The preceding ACME case study valued 100% of the equity (stock) in the

business. Had Bob owned only, say, 25% of the common stock, Victoria would

have to apply some additional analysis to value his minority interest. With a

25% interest, Bob would no longer have the ability to control the company.

A minority interest is a business ownership of less than 50% of the voting

shares. The owner of a minority interest in most private businesses cannot control

the company. A control interest in a company has the power to direct management

and policies of a business usually through ownership of enough shares

to inf luence voting and other decisions. Intuitively, someone would rather own

a control interest in a private business (51%) instead of a minority interest

(49%) because of the power to control the company. Buyers would typically

pay a significantly different price when comparing a 51% interest to a 49%

interest. This phenomenon is called a discount for lack of control (or minority

discount).

The second area of additional analysis for Victoria would be for the typical

difficulty in selling a minority interest in a closely held business. Marketability

is the ability to quickly convert property (an investment) to cash at

minimal cost. Hypothetically, if Bob owns only 25% of ACME's stock and

someone else owns the other 75%, the number of buyers interested in buying

Bob's shares is significantly less than if he owns 100%. Since Bob actually

owns the entire company, he has several ways to sell it. For example, he can sell

the company through an investment banker or business broker. He can also

take the company public. If Bob hypothetically only owns 25% of ACME's

stock, these options are not realistically available to him. Therefore, his minority

interest is less marketable. Intuitively, investors prefer owning marketable

investments over nonmarketable ones. Therefore, buyers of minority interests

in private companies typically pay less since the shares are not marketable.

This is called a discount for lack of marketability.

In valuing a minority interest, a major consideration is the timing and

amount of the anticipated future economic benefits flowing directly to the minority

owner. This consists of the company's periodic distributions to the minority

owner and the estimated holding period for owning the equity interest

Business Valuation 623

until it is sold and the sales proceeds are received. We saw through the DCF

model that the value of the asset is the present value of the expected future

benefits. In valuing a minority interest, the emphasis shifts toward the future

benefits flowing to the minority shareholder as opposed to the business overall.

For example, if a minority owner expects not to receive any distributions from

the business for 10 years even though the business is profitable, this is significantly

different from a business that makes annual shareholder distributions of

the profits. The values in these two situations would be considerably different.

BUSINESS VALUATION STANDARDS

Professional business appraisers follow certain standards when doing business

valuations. Business valuation standards include the following:

Uniform Standards for Professional Appraisal Practice—The Appraisal

Foundation.

Standards issued by various membership organizations such as American

Society of Appraisers, Institute of Business Appraisers, and National Association

of Certified Valuation Analysts.

VALUE ENGINEERING

Just as the CEO of a public company tries to enhance the value of the shares,

management of a private company can work on increasing the value of the

business in anticipation of a future sale. Certain factors can have a significant

effect on the value of a typical closely held business. Management can focus on

these factors to potentially increase the future value of the business. Some of

the factors are obvious, while some are not. They include the following:

• Decrease expenses (increases cash f low/income).

• Increase revenues (increases cash f low/income).

• Significantly increase the earnings growth rate (may increase earnings

projections, lower capitalization rate due to growth factor).

• Eliminate the owners' personal expenses and perquisites (increases cash

f low/ income, lowers buyer risk of inaccurate financial statements).

• Report all income on the financial statements and tax return (increases

cash f low/income).

• Develop the management team for the possibility that the current

owner(s) may leave the business upon a sale (lowers buyer risk of earnings

volatility).

• Plan for the current owner-managers' continuing employment under the

new owner for a fixed period (lowers buyer risk of earnings volatility and

loss of customers, employees, and vendors).

624 Making Key Strategic Decisions

• Have annual financial statements audited or reviewed by a certified public

accountant and improve interim financial reporting (lowers buyer risk

of inaccurate financial statements).

• Develop a list of potential synergistic buyers and identify the ones with

the most to gain from an acquisition of the subject company (search for

the highest synergistic value to be paid).

• Decrease dependency on major customers and vendors (lowers buyer risk

of earnings volatility in the event of the loss of any of these customers or

vendors).

• Begin assembly of key business information for potential buyers (lowers

buyer risk of perceptions of potential earnings volatility without having

such knowledge).

• Improve any existing poor financial statistics or ratios (lowers buyer financial

risk).

Public companies report earnings and performance on a quarterly basis

and the share prices frequently react quickly. On the other hand, private company

values generally react more slowly to changes. Thus, management may

need to work on value improvement factors one to two years in advance of marketing

a business.

SUMMARY

The fair market value of a private business is essentially an estimate of the

price that a willing buyer would pay and a willing seller would accept. Buyers

have different motives for buying a business. Financial buyers are looking for a

return on their investment. Strategic buyers are usually looking to integrate

their company with the business for unique strategic reasons. Financial buyers

pay fair market value while strategic buyers usually pay a price ref lective of

the unique strategic advantages to the specific buyer. Often, strategic buyers

pay more than fair market value. Although it is possible to conduct a business

valuation that is not overly complex, the question remains whether the resulting

value is accurate. Many variables go into a valuation analysis. A business

valuation is both a quantitative and qualitative process that is focused on assessing

investment risk and investment return. It is largely an assessment of the

risks a buyer is taking in acquiring and owning the company. In addition, a valuation

attempts to project the earnings an owner of the business can expect in

the future as a return on investment.

Author's Note. This chapter is not intended to be a complete text on business

valuation. It is meant to illustrate through examples many of the fundamentals

of business valuation and their application. The proper application of valuation

theory depends on the actual facts and circumstances of the investment being

valued.

Business Valuation 625

FOR FURTHER READING

Desmond, G. and J. Marcell, Handbook of Small Business Valuation Formulas and

Rules of Thumb, 3rd ed. (Los Angeles: Valuation Press, 1993).

Pratt, S., R. Reilly, and R. Schweihs, Valuing a Business: The Analysis and Appraisal

of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000).

Pratt, S., R. Reilly, and R. Schweihs, Valuing Small Businesses and Professional Practices,

3rd ed. (New York: McGraw-Hill, 1998).

Reilly, R. and R. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill,

1998).

Smith, G. and R. Parr, Valuation of Intellectual Property and Intangible Assets (New

York: John Wiley, 2000).

Trugman, G., Understanding Business Valuation: A Practical Guide to Valuing Smallto

Medium-Sized Businesses (New York: AICPA, 1998).

, Handbook of Business Valuation, 2nd ed. T. West and J. Jones, Eds. (New

York: John Wiley, 1999).

, Stocks, Bonds, Bills, and Inf lation Yearbook Valuation Edition (Chicago:

Ibbotson Associates, published annually).

INTERNET LINKS

www.aicpa.org American Institute of Certified Public

Accountants

www.appraisers.org American Society of Appraisers

www.appraisalfoundation.org Appraisal Foundation

www.gofcg.org Financial Consulting Group

www.ibbotson.com Ibbotson Associates

www.instbusapp.org Institute of Business Appraisers

www.nacva.com National Association of Certified

Valuation Analysts

NOTES

1. International Glossary of Business Valuation Terms, jointly published by the

American Institute of Certified Public Accountants, American Society of Appraisers,

Canadian Institute of Chartered Business Valuators, National Association of Certified

Valuation Analysts, and Institute of Business Appraisers. Further terminology

from this jointly published international glossary is included in glossary at the end of

this book.

2. American Society of Appraisers, Statement on Business Valuation Standards 1.

626

Glossary

Accounting exposure: Increases or decreases in assets and liabilities resulting from

exchange rate movements, which may not be associated with either current or

prospective cash inf lows or outf lows. Accounting exposure is distinguished from

economic exposure where cash inf lows and outf lows are expected to be associated

with exchange rate movements.

Accrual accounting: An accounting method that recognizes revenues as they are

earned and expenses as they are incurred. The timing of revenue and expense

recognition is not tied to the timing of the inf low and outf low of cash. Accrual accounting

is seen as essential in order to develop reliable measures of periodic financial

performance.

Acquisition: The purchase—not necessarily for cash—of a controlling interest in a

firm.

Activity-based costing: A process of identifying the different activities that generate

costs.

Adapter: Typically, a small circuit board inside a computer that lets the computer

work with hardware external to the computer. Examples: A network adapter allows a

computer to be hooked into a network; a display adapter allows a computer to drive

(display text, graphics) a computer monitor.

AICPA: The American Institute of Certified Public Accountants. This is the national

professional association of certified public accountants (CPAs).

All-current method: A method of translating foreign-currency financial statements

whereby all assets and liabilities are translated at the current (balance sheet

date) exchange rate, contributed capital accounts are translated at historical exchange

rates (rates in existence when the account balances first arose), and all revenues

and expenses are translated at the average exchange rate in existence during

the reporting period. Translation adjustments resulting from fluctuating exchange

rates are accumulated and reported with accumulated other comprehensive income

in shareholders' equity.

Amortization: the periodic, noncash charge used to reduce an intangible asset.

Application Service Providers (ASP): Companies that rent out applications and

process data for other companies, similar to service bureaus in the 1960s and 1970s.

Glossary 627

Asset (asset-based) approach: A general way of determining a value indication of

a business, business ownership interest, or security by using one or more methods

based on the value of the assets of that business net of liabilities.

Asset acquisition: an acquisition executed by purchasing the assets of the target

firm.

Asymmetric risk: An exposure that results in profits or losses only if the underlying

price or economic variable moves in one direction.

At-the-money: The condition of a call or put option when the strike price equals

the stock price. Some economists define at-the-money as being the case when the

stock price equals the present value of the strike price.

B2C e-commerce: The sale of goods and services between a company and a consumer

over the Internet.

Balanced scorecard: A comprehensive set of performance measures intended to

capture a more balanced picture of management's success in achieving goals than can

be captured by financial measures only.

Bearish: Pessimistic. Anticipating a decrease in an asset value.

Best efforts underwriting: An agency arrangement by which underwriters agree

to use best efforts to sell all, or a certain minimum number of, shares of a public

offering.

Beta: A measure of systematic risk of a security; the tendency of a security's returns

to correlate with swings in the broad market.

Bidder: The firm that initiates a merger or acquisition; the bidder usually retains

control of the surviving firm.

Bit: The smallest gradation of data stored in a computer. Technically, a bit is either

a 1 or a 0. Computers use groups of bits, called bytes, to represent character data.

Blue-sky laws: State laws regulating securities that provide for licensing

brokers/dealers and registering new securities issuances.

Budget: A comprehensive, quantitative plan for utilizing the resources of an entity

for some specified period of time—showing planned revenues, expenses, and resulting

earnings—together with a planned balance sheet and cash f low statement. If budgets

adjust for volume they are called f lexible; otherwise, they are static.

Budget entity: Any accounting entity, such as a firm, division, department, or

project, for which a budget is prepared.

Budget performance report: An internal accounting report that shows the difference

between actual results and expected performance planned in a budget.

Budget review process: The process of evaluating budget proposals and arriving

at the master budget.

Budget variance: The difference between the budgeted data and actual results.

Bullish: Optimistic. Anticipating an increase in an asset value.

Business valuation: The act or process of determining the value of a business enterprise

or ownership interest therein.

Byte: Typically, eight bits in a computer, which as a unit, represent one character of

data. A computer diskette can store 1,400,000 bytes of data, or 1,400,000 characters

of data. This represents about 500 pages of single-spaced text.

628 Glossary

C+, C++: Programming languages used in the 1990s to program many personal computer

and UNIX based applications.

Call option: An asset which gives the owner the right but not the obligation to purchase

some other asset for a set price on or up to a specified date.

Capital asset pricing model (CAPM): A model in which the cost of capital for any

security or portfolio of securities equals a risk-free rate plus a risk premium that is

proportionate to the systematic risk of the security or portfolio.

Capital loss carryover: The excess of capital losses over capital gains that may not

be deducted currently but may be carried forward and set off against future capital

gains.

Capital structure: The composition of the invested capital of a business enterprise;

the mix of debt and equity financing.

Capitalization: The conversion of a single period stream of benefits into value.

Capitalization factor: Any multiple or divisor used to convert anticipated benefits

into value.

Capitalization rate: Any divisor (usually expressed as a percentage) used to convert

anticipated benefits into value.

Cash flow: Cash that is generated over a period of time by an asset, group of assets,

or business enterprise. It may be used in a general sense to encompass various levels

of specifically defined cash flows. When the term is used, it should be supplemented

by a qualifier (e.g., "discretionary" or "operating") and a definition of exactly what it

means in the given valuation context.

Cash settled: A future contract that does not require delivery of the underlying

asset upon expiration. Instead of actual delivery, the contract is marked to market, so

that one party is compensated in cash by the other for the change in the underlying

asset price.

CD: A compact disk, which stores roughly 700,000,000 bytes (700 megabytes) of

data in digital format. CDs used in computers and in stereos are identical. A music

CD has the capacity to store roughly one hour of sound.

Changes in accounting estimates: Estimates are essential to the implementation

of accrual accounting. A typical example would the estimates of useful lives and salvage

values that are necessary in computing depreciation. Changes in either useful

lives or salvage values would represent changes in accounting estimates.

Changes in accounting principles: A change in the accounting treatment applied

to a particular area of accounting. The most common examples would be discretionary

changes in inventory and depreciation accounting. A firm might change

from the LIFO to the FIFO inventory method or from the accelerated to straightline

method of computing depreciation. Most accounting changes are not discretionary

but rather are the result of the mandatory adoption of new accounting

standards.

Charges: Commonly used in accounting in referring to expenses and losses.

COBOL: A programming language used prior to the early 1990s to program most

business applications.

Comfort letter: Communication from the independent auditor to the underwriter,

at the time of registration of securities, which includes information about the auditor

's role, auditor 's independence, compliance of the financial statements with the

Glossary 629

Securities Act of 1933, and any changes in the financial statements subsequent to information

included in the Registration Statement.

Comprehensive income: An expanded measure of income that includes items of

other comprehensive income in addition to traditional realized net income.

Conglomerate merger: a combination of firms in unrelated industries.

Consolidation: A merger in which an entirely new firm is created.

Constant-dollar method: A method of inf lation accounting whereby accounts,

which are measured according to historical cost accounting principles, are restated

into units of the same purchasing power using the same general price index.

Control: The power to direct the management and policies of a business enterprise.

Control premium: An amount (expressed in either dollar or percentage form) by

which the pro rata value of a controlling interest exceeds the pro-rata value of a noncontrolling

interest in a business enterprise, that ref lects the power of control.

Cooling-off period: That period from the filing of a Registration Statement in connection

with an IPO (or other public offering) until the effective date of the Registration

Statement, during which time the only written information that may be

provided to prospective investors is the Prospectus itself.

Core earnings: Earnings exclusive of the effects of nonrecurring items (see sustainable

earnings base). Also refers to earnings that only derive from the primary, or

core, activities of the firm.

Cost approach: A general way of estimating a value indication of an individual asset

by quantifying the amount of money that would be required to replace the future service

capability of that asset.

Cost driver: The cause of the cost of an activity.

Cost of capital: The expected rate of return (discount rate) that the market requires

in order to attract funds to a particular investment.

CPU: The Central Processing Unit of a computer. The CPU is the computer 's equivalent

to its brain: All logical operations occur in the CPU, and the CPU directs all

other hardware associated with the computer.

Credit risk: The loss potential that would result from the inability of a counterparty

to satisfy the terms of the foreign currency derivative.

CRT: A Cathode Ray Tube is very similar to the picture tube in a television set. Most

computer monitors use CRT technology, which is relatively cheap.

Currency swap: An exchange of currencies between two parties with an agreement

to re-exchange the currencies at a future date at the same rate.

Current-cost method: A method of inf lation accounting that replaces historical

cost accounting principles with current (replacement) cost as the basis for financial

statement measurement.

Data warehouse: A repository for data transactions, in a database format. This

technology is frequently used as a stop gap to replace older legacy systems in order

to allow greater access to data.

Decision support system: An application used by middle-level and senior management

to make management decisions.

Deferred tax valuation allowance: A portion of a deferred tax asset that is judged

unlikely to be realized.

630 Glossary

Derivative: An instrument whose value or contingent cash f lows are a function of

the value of some other asset or economic variable.

Derivative instrument: A financial instrument that derives its value from its relationship

to some other financial contract, currency, commodity, or index.

Discontinued operations: Operations that constitute an entire segment of the

firm's business and not, for example, simply one product line in a segment made up of

a number of related product lines. Other key characteristics include: Segments engage

in business and produce revenues and incur expenses; the operations of segments

are regularly reviewed by the chief operating officer of the enterprise; and

discrete financial information can be provided on the operations of segments.

Discount rate: A rate of return (cost of capital) used to convert a monetary sum,

payable or receivable in the future, into present value.

Duration gap: A situation in which assets are more sensitive to interest rates than

are liabilities. As interest rates rise, assets fall more than liabilities, wiping out equity.

DVD: Digital Video Disks are the direct descendents of CDs, but have the capacity

to store roughly 10 times the amount of data as does a CD. This capacity allows a

DVD to store all of the pictures and sounds that make up an entire, feature-length

movie.

Economic exposure: "Derived from the risk that currency f luctuations could affect

the dollar value of future cash f lows at the operating income level" (Dow 1995

annual report, p. 36).

Economies of scale: the decrease in the marginal cost of production as a firm's

output expands.

EDGAR: The electronic filing system by which IPOs and other filings required

under the Securities Act of 1933 and the Securities Exchange Act of 1934 are effected.

The public may access such filings through the World Wide Web.

EDI: Electronic Data Interchange. Used by businesses to transact commerce electronically.

These transactions include purchase orders, shipping notifications, invoices,

and so on.

Effective income tax rate: Total income tax provision (expense) deducted from

pretax income from continuing operations divided by pretax income from continuing

operations.

Effectiveness: The degree to which a goal is met.

Efficiency: A measure of the inputs needed to produce a given level of output in

pursuit of a goal, or the outputs produced in pursuit of a goal by a given level of

inputs.

Efficient search sequence: A pattern of searching for nonrecurring items that is

designed to maximize their discovery and minimize search time.

Electronic commerce: The transacting of business over the Internet, whether for

the purchase or sale of goods and services.

E-mail: Electronic mail is one of the most common and important computer applications,

allowing people to communicate cheaply and quickly with other computer

users almost anywhere on earth.

Encryption: Encryption is a process of encoding data to protect its confidentiality.

Typically, we encrypt data before it is transmitted from one computer to another so

that, should the data be intercepted by a third party during transmission, the data

Glossary 631

will be unintelligible to that third party. Secure Web sites use encryption to protect

confidential data that users might send them, such as credit card numbers.

Equity net cash flows: Those cash f lows available to pay out to equity holders (in

the form of dividends) after funding operations of the business enterprise, making

necessary capital investments, and ref lecting increases or decreases in debt financing.

Equity risk premium: A rate of return in addition to a risk-free rate to compensate

for investing in equity instruments because they have a higher degree of probable risk

than risk-free instruments (a component of the cost of equity capital or equity discount

rate).

ERP: An integrated software package that processes and controls all the functions of

a company, including order processing, inventory control, purchasing, invoicing, financial

systems, and customer management.

Exercise price: Same as Strike price.

Exotics: Engineered derivatives that contain unusual features, or nonstandard contingent

cash f low formulas.

Extraordinary gains and losses: Revenues or gains and expenses or losses that are

both unusual and nonrecurring.

Fair market value: The price, expressed in terms of cash equivalents, at which

property would change hands between a hypothetical willing and able buyer and a

hypothetical willing and able seller, acting at arm's length in an open and unrestricted

market, when neither is under compulsion to buy or sell and when both have

reasonable knowledge of the relevant facts.

Family limited partnership: An estate planning device which may entitle a donor

to a discount on the value of gifts while allowing the donor to maintain control over

the assets given away.

FAQ: Frequently asked questions. A file of questions that are frequently asked about

a specific product or topic that is available to users through the Internet or intranet.

FASB: See Financial Accounting Standards Board.

FIFO: A method of computing cost of sales that includes the oldest inventory costs

first in the computation of cost of sales. That is, the cost of goods purchased first

(first-in) are included first (first-out) in the computation of cost of sales.

Financial Accounting Standards Board (FASB): The principal private sector

organization with the responsibility of establishing U.S. generally accepted accounting

principles (see GAAP).

Fire wall: A hardware and software device that protects an organization's computer

systems and data from possible electronic intrusion from external sources. Computers

that are connected to the Internet would be under constant threat from hackers and

snoops without the protection of a fire wall.

Firm underwriting: An arrangement by which the underwriters agree themselves

to purchase all the shares of a public offering.

Fixed costs: Those costs that are not responsive to changes in volume over the relevant

range, but which respond to factors other than volume. Fixed costs are sometimes

known as "period costs" when they depend on time (e.g., rent, depreciation,

insurance).

Flexible budget: A budget prepared for more than one level of activity, covering

several levels within the relevant range of activity. Also called a dynamic budget.

632 Glossary

Foreign Corrupt Practices Act of 1997: The law that explicitly prohibits the

bribery of foreign governments or political officials and requires firms to keep accurate

and detailed records of company financial activities and maintain an adequate

system of internal controls.

Foreign currency transaction: Any transaction (e.g., the sale or purchase of inventory,

the lending or borrowing of money) that creates a balance-sheet account that

is denominated in foreign currency. Examples include foreign-currency denominated

receivables and loans, and foreign-currency denominated payables and long-term

debt.

Form S-1: The standard form which is to be completed by a registrant and filed

with the Securities and Exchange Commission in connection with an IPO (and with

many other public offerings).

Forms 10-K, 10-Q, 8-K: Principal periodic reports filed by most companies registered

under the Securities Acts.

Forms SB-1 and SB-2: Forms for filing an IPO or other public offering with the Securities

and Exchange Commission for certain small business issuers.

Forward: A contract in which two parties agree to a deferred transaction. One party

is obligated to deliver an underlying asset or commodity; the other party is obligated

to take delivery and pay for it. The terms of the deferred transaction are fully specified

in the forward contract.

Forward exchange contract: A privately negotiated agreement to purchase foreign

currency for future receipt or to sell foreign currency for future delivery. The

amount of foreign currency, the rate of exchange, and the future date of settlement

are established at the time the contract is made.

Forward exchange rate: Rate at which currencies are to be exchanged at future

dates.

Functional currency: The currency of the primary economic environment in

which the entity operates. Typically, this is the currency of the environment in which

it generates and expends cash. The functional currency may be the U.S. dollar and not

the local currency of the foreign country.

Futures contract: An exchange-traded instrument with a preestablished expiration

date, whose market value is linked to the relative exchange rates between two currencies.

A futures contract can be purchased (a long position), resulting in a gain if

the foreign currency appreciates and a loss if it depreciates. A contract can also be

sold (a short position), resulting in a gain if the foreign currency depreciates or a loss

if it appreciates.

GAAP: See generally accepted accounting principles.

Generally accepted accounting principles: The body of standards, rules, procedures,

and practices that guide the preparation of financial statements. For commercial

firms, the primary bodies involved with adding to or modifying existing GAAP

are the Financial Accounting Standards Board, the American Institute of Certified

Public Accountants, and the Securities and Exchange Commission.

Geographical information system: A computer application that uses a mapping

system display on a terminal or a printer. Data, such as sales data or census data, is

overlaid over the geographical information for decision-making purposes.

Glossary 633

Giga-: The prefix given to another number which means a billion. Thus, a 10 gigabyte

hard drive has the capacity to store 10 billion bytes of data.

Going private: The conversion of a public firm into a private company, usually by

either a leveraged buyout (LBO) or a management buyout (MBO).

Goodwill: As it relates to valuation, that intangible asset arising as a result of name,

reputation, customer loyalty, location, products, and similar factors not separately

identified. The excess of purchase price over fair market value of net assets acquired

under the purchase method of accounting; goodwill appears on the acquirer 's balance

sheet as an intangible asset and is amortized over a period of not more than 40

years.

Hedge: To reduce risk by taking a position that offsets some preexisting risk

exposure.

Hedging: Steps taken to protect the dollar value of a foreign-currency asset or to

hold constant the dollar burden of a foreign-currency liability, in the presence of

f luctuating exchange rates, by maintaining offsetting foreign-currency positions.

Horizontal merger: A merger of firms producing similar goods or services.

Hypertext: Hypertext is the data-connecting protocol of the Internet that allows a

document on the World Wide Web to connect with (or link to) other documents on

the Web.

Income (income-based) approach: A general way of determining a value indication

of a business, business ownership interest, security, or intangible asset using one

or more methods that convert anticipated benefits into a present single amount.

Income from continuing operations: A measure of financial performance for the

period that excludes the effects of discontinued operations, extraordinary items, and

the cumulative effect of accounting changes. All other revenues, gains, expenses, and

losses are included in the computation of income from continuing operations.

Intangible assets: Nonphysical assets (such as franchises, trademarks, patents,

copyrights, goodwill, equities, mineral rights, securities, and contracts as distinguished

from physical assets) that grant rights, privileges, and have economic benefits

for the owner.

International Accounting Standards Committee (IASC): An organization representing

accounting bodies from over 70 countries whose mission is to harmonize

accounting standards internationally.

In-the-money: An option is in-the-money when exercise would be profitable. For a

call option this is when the underlying stock price is above the strike price. For a put

option, this is when the stock price is below the strike price.

Intrinsic Value: The amount of money earned when an option is exercised, or zero,

whichever is greater. For a call option, intrinsic value is the maximum of zero or the

stock price minus the strike price. For a put option it is the maximum of zero or the

strike price minus the stock price.

Invested capital: The sum of equity and debt in a business enterprise. Debt is typically

(a) long-term liabilities or (b) the sum of short-term interest-bearing debt and

long-term liabilities.

Invested capital net cash flows: Those cash f lows available to pay out to equity

holders (in the form of dividends) and debt investors (in the form of principal and

634 Glossary

interest) after funding operations of the business enterprise and making necessary

capital investments.

Investment risk: The degree of uncertainty as to the realization of expected

returns.

Investment value: The value to a particular investor based on individual investment

requirements and expectations.

IPO: An initial public offering; such transaction is registered with the Securities and

Exchange Commission and permits a company, called a "registrant," first to offer to

the public its shares of common stock or other securities.

Irregular items of revenue, gain, expense, or loss: See nonrecurring items.

ISP: An Internet service provider is an organization that sells connectivity to the Internet.

An ISP has a permanent, high capacity connection to the Internet. Customers

of the ISP use a telephone or cable modem to connect themselves to the ISP, and,

thereby, the Internet. America OnLine is the largest ISP in the world.

Kilo-: The prefix given to another number which means a thousand. Thus, a 10 kilobyte

document contains 10,000 bytes or characters of data.

Labor variance: A measure of the change in the cost of labor, analyzed according

to wage changes and changes in labor productivity.

LAN: A local area network is a group of computers, usually within one or a few

nearby buildings, which are connected to each other to allow the sharing of data,

printers, e-mail, and other capabilities.

LCD: A liquid crystal display is a method of displaying data using a relatively f lat

panel. Many digital watches use LCDs to show time. LCD technology competes with

CRT technology in computer monitors. LCDs take up less space than CRTs, but cost

more.

Leading and lagging: A foreign-currency hedging technique that involves the

matching of cash f lows associated with foreign currency payables and receivables by

speeding up or slowing down their payment or receipt.

Legacy systems: Older systems that were developed prior to the 1990s using older

technologies. Usually mission critical systems, they are both costly and difficult to

replace.

LIBOR: The London interbank offered rate. The interest rate used in Euromoney

transactions between London banks. It is widely used as the benchmark f loating rate

in swaps.

LIFO inventory method: A method of computing cost of sales that charges the

most recent inventory costs to cost of sales. The most recent (last-in) inventory items

go into the cost of sales computation first (first-out).

LIFO liquidation: A reduction in the physical quantity of inventory by a firm using

the LIFO method. Typically, older and lower costs will be associated with the liquidated

quantities. This has the effect of reducing cost of sales and increasing earnings.

This earnings increase is treated as nonrecurring in the computation of sustainable

earnings.

LIFO reserve: The excess (typically) of the replacement cost of a LIFO inventory

over its LIFO carrying value.

Link: A connection from one World Wide Web document to another. Typically, one

navigates the Web by following a series of links.

Glossary 635

Liquidity: the ability to quickly convert property to cash or pay a liability.

Long: To enter a future or forward as the long party. Also known as "buying" the future

or forward.

Long party: The party in a forward or future contract that will take delivery of

the underlying asset and make payment, that is, the buying party. The party in a forward

or future contract that benefits from a rise in the price of the underlying

asset.

Management's Discussion and Analysis of Results of Operations and Financial

Condition (MD&A): A report required under Securities and Exchange Commission

regulations, constituting part of an S-1 for an IPO and an annual report on

Form 10-K. The discussion of operations is required to include material nonrecurring

items of revenue, gain, expense, and loss.

Mark to market: The process by which at the end of each trading day, a payment is

made from one party in a futures contract to the other, based on that day's movement

in the futures price. When the futures price rises, the short party pays the long party

the amount of the price rise. When the futures price falls, the long party pays the

short party the amount the price fell.

Market (market-based) approach: A general way of determining a value indication

of a business, business ownership interest, security, or intangible asset by using

one or more methods that compare the subject to similar businesses, business ownership

interests, securities, or intangible assets that have been sold.

Marketability: The ability to quickly convert property to cash at minimal cost.

Master budget: The total budget package of an organization, including both the

operating and financial budgets. Sometimes referred to as the profit plan.

Material items: Items of sufficient size to have the potential to inf luence decision

makers or other users of financial statements.

Material variance: A measure of the change in cost of materials used, analyzed

according to price changes and changes in material efficiency.

MD&A: See Management's Discussion and Analysis of Results of Operations

and Financial Condition.

Mega-: The prefix given to another number which means a million. Thus, a 10

megabyte file contains 10,000,00 bytes or characters of data.

Merger: The combination of two or more companies into a single entity

Minority discount: A discount for lack of control applicable to a minority interest.

Minority interest: An ownership interest less than 50% of the voting interest in a

business enterprise.

Modem: A device used to allow computers to communicate with each other over

wires not originally designed for computer communications. The most common

form of modem allows computers to communicate over regular voice telephone

wires. Cable modems allow computers to communicate using wires originally designed

for cable TVs.

Monetary assets and liabilities: Assets and liabilities that represent a fixed

number of monetary units. Monetary assets include cash and accounts receivable;

monetary liabilities include accounts and notes payable. During inf lationary

periods monetary assets (liabilities) result in purchasing power gains (losses),

respectively.

636 Glossary

Multimedia: The simultaneous use of multiple forms of media on a computer. If

you were to watch a football game on your computer that is coming to you over the

Internet, you would be simultaneously using both video and sound media.

Multistep income statement: An income statement format that includes one or

more profit subtotals such as gross profit and operating profit (also see single-step income

statement).

NASD: See National Association of Securities Dealers Inc.

NASDAQ: National Association of Securities Dealers Automated Quotation System.

An organized, electronically linked over-the-counter market for stocks. The

NASDAQ stock index comprises stocks that trade on NASDAQ. These stocks are generally

smaller, less capitalized stocks than those that compose the S&P 500.

National Association of Securities Dealers Inc: A self-regulatory organization

which regulates the business of broker/dealers, including underwriters who sell securities

to the public. In an IPO or any other public offering, the underwriters must obtain

approval of the NASD of their compensation as "fair and reasonable."

Net cash flow: A form of cash flow. When the term is used, it should be supplemented

by a qualifier (e.g., "Equity" or "Invested Capital") and a definition of exactly

what it means in the given valuation context.

Net operating loss carry-forward: Under U.S. tax law, operating losses can be

carried back and set off against profits in the previous three years. A refund of taxes

can be obtained. If the loss is greater that the profits in the three previous years, then

the loss can be carried forward for 20 years and set off against the profits of

future years. The carrying forward of a loss may produce a future tax savings. In contrast,

the carrying back of a loss produces a tax refund.

NetWare: The network operating system standard through the early and mid-1990s.

Developed by Novell.

Network: The connecting together of two or more computers, typically with the

purpose of sharing resources, such as printers, data, or an Internet connection.

Nonrecurring items: Items of revenue, gain, expense, and loss that appear in

earnings on only an infrequent or irregular basis, f luctuate significantly in terms of

amount and or sign, and are often not related to the core operational activities of

the firm.

Notional principal: The principal amount specified in a swap agreement, which

though not exchanged, serves as the benchmark to determine all cash f lows. The cash

f lows generally equal the difference between two interest rates, multiplied by the

notional principal.

Operating income: An intermediate, pretax measure of financial performance.

Only operations-related items of revenue, gain, expense, and loss are included in the

computation of operating income.

Operational control system: Systems that run the company's day-to-day

operations.

Opportunity cost: A benefit forgone as a result of pursuing an alternative action.

Option contract: The right, but not the obligation, to purchase foreign currency at

a fixed price (a call option), or the right, but not the obligation, to sell foreign currency

at a fixed price (a put option).

Glossary 637

Other comprehensive income: A set of unrealized income elements that are

added to conventional net income to arrive at comprehensive income. The key other

comprehensive income items are foreign currency translation adjustments, unrealized

gains and losses on certain securities, and adjustments related to underfunded

pension plans.

Out-of-the-money: An option is out of the money when exercise would generate a

loss. For a call option this is when the underlying stock price is below the strike price.

For a put option this is when the stock price is above the strike price.

Overhead variance: A measure of the change in the cost of overhead items, analyzed

according to price and salary changes and changes in labor productivity.

Over-the-counter: Description of contracts that are negotiated between two parties,

often with the help of an intermediary. Over-the-counter derivatives are custom-

tailored to meet the needs of the parties involved. Over-the-counter derivatives

are not traded on exchanges.

Participative budgeting: The process of preparing the budget using input from

managers who are held responsible for budget performance.

PDA: Personal Digital Assistants are small, pocket-sized computers, usually with

LCD screens, which allow users to keep their calendar, list of contacts, play games,

and, in some cases, send and receive e-mail.

Physical delivery: A future contract that stipulates actual delivery of the underlying

asset upon expiration of the contract.

"Plain English": The standards for clarity in drafting various portions of a

Prospectus, as set forth in SEC Rule 421.

Plain vanilla: The most common type of swap. It is a fixed for f loating interest rate

swap, where LIBOR is the f loating rate. The fixed rate is the current rate of the

Treasury bond with the same maturity as the swap.

Pooling method: After the acquisition, the bidder and target firm balance sheets

are combined simply by adding book values

Premise of value: An assumption regarding the most likely set of transactional

circumstances that may be applicable to the subject valuation (e.g., going concern,

liquidation).

Premium: The amount paid to the target over current market price to execute an

acquisition.

Premoney valuation: The valuation ascribed to a business enterprise prior to the

issuance of additional equity securities, for the purpose of pricing those securities to

their public or private purchasers.

Private placement: An offering of securities to a sufficiently small or to a sufficiently

sophisticated group of purchasers, such that registration of the transaction is

not required with the Securities and Exchange Commission.

Private Securities Litigation Reform Act of 1995: A U.S. statute that establishes

a safe harbor for forward-looking statements by public companies, insulating

the company and management from liability for statements that ultimately prove to

be inaccurate if they are believed to be true when made and if the contingencies on

which their accuracy depend are properly articulated.

Productivity: Output divided by input. Productivity rates measure the input required

for a unit of output. Compare the definition of efficiency.

638 Glossary

Profit plan: A company's total budget used in achieving a desired profit goal. Sometimes

the term refers only to the operating budget, and sometimes it is used synonymously

with the term master budget.

Prospectus: Part I of a Registration Statement filed by a company offering its securities

to the public, which Registration Statement is filed with and must be approved

by the Securities and Exchange Commission. The Prospectus describes the registering

company, its business and finances, and the risk factors the company faces.

Proxy: The grant by a shareholder to another party of the right to vote the stockholder

's shares of stock.

Proxy contest: An attempt to gain control of a corporation by soliciting shareholder

votes.

Purchase method: After the acquisition, the target firm's assets are put on the bidder

's balance sheet at their fair market value.

Put option: An asset that gives the owner the right but not the obligation to sell

some other asset for a set price on or up to a specified date.

RAM: Random access memory is the hardware which a computer uses for storing

programs and data that the computer is currently using. In human terms, you can

think of RAM as the memory storing part of your brain. When you are thinking about

a problem, you are using your own RAM to work through various calculations and

thoughts.

Rate of return: An amount of income (loss) and/or change in value realized or

anticipated on an investment, expressed as a percentage of that investment.

Red herring: A preliminary, nonfinal Prospectus distributed by underwriters for

the purpose of generating interest in shares of stock to be offered to the public.

Registration statement: A filing made with the SEC by a company issuing its securities

to the public, which describes the company and its financial condition. Part I

consists of the Prospectus.

Regulation FD: A Securities and Exchange Commission Regulation which among

other matters requires a company which purposely or inadvertently releases previously

unknown material information to promptly further distribute that information

to the public.

Regulation S-K: A Regulation of the Securities and Exchange Commission that sets

forth the standards for drafting the body of a Prospectus.

Regulation S-X: A Regulation of the Securities and Exchange Commission that sets

forth the standards for the preparation of financial statements to be included in documents

filed with the Securities and Exchange Commission.

Remeasurement: See temporal translation procedure.

Reporting currency: The currency in which a firm prepares its financial statements.

Residual value: The prospective value as of the end of the discrete projection

period in a discounted benefit streams model.

Restructuring charges: Expenses typically recognized in conjunction with downsizings,

reengineerings, reorganizations, and comparable activities. The expenses are

usually made up of cash costs, accruals of obligations for future expenditures, as well

as the write-down of assets.

Risk factors: That section of a Prospectus, or of a Form 10-K or other SEC filing,

which lists the operational and financial risks faced by a company.

Glossary 639

Risk-free rate: The rate of return available in the market on an investment free of

default risk.

Risk premium: A rate of return in addition to a risk-free rate to compensate the investor

for accepting risk.

Road show: A trip, generally of two or more weeks' duration, by underwriters and

company management to meet with underwriters, brokers, and investors in different

cities in order to explain a proposed public offering of securities.

Roll over: To enter a new future or forward contract to replace a contract that is

expiring.

ROM: Read-only memory are forms of data storage which cannot be written to (or

changed), but from which data can only be retrieved. A music CD (and, hence, CD

ROM) is a device from which you can play back music, but you cannot record your

own music to a CD ROM. (If you can record to a CD, the device is called a CD-R

(for recordable), not a CD ROM.)

Securities Act of 1933: The U.S. statute that permits the private placement or private

sale of securities without registration provided full and fair disclosure is made

and that requires the registration of public offerings of securities.

Securities and Exchange Commission (SEC): An agency of the U.S. government

which regulates the public issuance of securities under the Securities Act of 1933

and the conduct of trading markets and brokerage firms under the Securities Exchange

Act of 1934, so as to protect investors from fraud and misleading or inadequate

corporate and financial information.

Securities Exchange Act of 1934: The U.S. statute which established the Securities

and Exchange Commission and regulates the operation of broker/dealers. Under

this statute, companies with publicly held securities are required to make periodic

reports to the public on various forms, most typically Forms 10-K, 10-Q, and 8-K. Officers,

directors, and significant shareholders of publicly held companies are required

to report purchases and sales of securities and the formation of "groups" for the holding,

voting, purchase, or sale of publicly traded securities.

Short: To enter a future or forward as the short party. Also known as "selling" the

future or forward.

Short party: The party in a forward or future contract that will deliver the underlying

asset and receive payment (i.e., the selling party). The party in a forward or future

contract that benefits from a decline in the price of the underlying asset.

Single-step income statement: An income statement format that simply deducts

expenses and losses from revenues and gains in arriving at a single measure of income

from continuing operations.

Speculate: Attempt to profit by taking on a risk exposure.

Spot market: The market in which transactions are executed for immediate delivery

of an asset.

Spot price: The price to be paid for immediate delivery of an asset or commodity.

Spot rate: Rate at which currencies are exchanged for immediate delivery.

Standard and Poor's 500: A stock portfolio consisting of 500 large corporations.

The composition and value of the stock portfolio is tracked and reported by the Standard

and Poor 's publishing company. The S&P 500 value is widely used as a benchmark

index of overall stock market performance.

640 Glossary

Standard of value: The identification of the type of value being utilized in a specific

engagement (e.g., fair market value, fair value, investment value).

Standards: Predetermined, expected levels of efficiency or measures of desired

performance (e.g., a budget amount, a standard cost, or a nonquantitative statement

of desired performance). A standard cost is the predetermined cost of an input per

unit of output. Standards may be unchanging (basic), perfect (ideal), or currently

attainable.

Statements of Financial Accounting Standards (SFAS): Pronouncements of

the Financial Accounting Standards Board that are the central elements of generally

accepted accounting principles.

Stock acquisition: The purchase of a controlling interest in a firm by buying its

outstanding equity.

Strategic information system: An application used by senior management to create

a company's strategy.

Streaming media: Typically, refers to Internet sites that send out a continuous

flow of sound or video signal to user. An example might be www.radiotango.com,

which plays tangos 24 hours per day.

Strike price: The prespecified purchase or sale price for the underlying asset in an

option contract.

Sustainable earnings base: A revised historical earnings series from which the

effects of all nonrecurring items have been removed (see core earnings).

Sustainable earnings worksheet: A worksheet used to organize and summarize

nonrecurring items so that their effects can be removed from as-reported net income

in order to arrive at a sustainable earnings base.

Swap: An agreement between two parties to exchange cash f lows over a period of

time. Cash f lows are determined by an agreed upon formula specified in the swap

agreement—a formula that is contingent on the performance of other underlying

instruments.

Symmetric risk: An exposure that results in profits when an underlying price or

economic variable moves in one direction, and proportional losses if the variable

moves in the opposite direction.

Synergy: The incremental value generated by the combination of two or more firms.

Synthetic stock portfolio: A portfolio that consists of Treasury bills and a long

position in equity futures contracts. A properly constructed synthetic stock portfolio

behaves the same as a portfolio consisting of actual stocks.

Systematic risk: The risk that is common to all risky securities and cannot be eliminated

through diversification. When using the capital asset pricing model, systematic

risk is measured by beta.

Takeover: The transfer of corporate control from one group of shareholders to

another.

Target: A firm that is the subject of takeover or acquisition activities.

Tau: The amount of time remaining prior to an option's expiration.

Taxable transaction: An acquisition in which the target firm shareholders are immediately

subject to capital gains on their sale of shares.

Glossary 641

Tax-adjusted nonrecurring items: Pretax nonrecurring items of revenue, gain,

expense, and loss that are multiplied by one minus a representative income tax rate.

The result is the after-tax effect of each of these items on net income.

Tax-free transaction: An acquisition in which the primary consideration paid to

the target's shareholders is the acquirer 's common stock, thereby deferring capital

gains taxes until the new shares are sold.

TCP/IP: The communications standard that is used by the Internet. A protocol is

the understanding that computers have for how information will be delivered over

the communications network, which enables computers with different operating systems

to communicate with each other and to eliminate errors in data.

Temporal (remeasurement) translation procedure: A method for translating

foreign currency financial statements in which monetary assets (including assets

valued at market) and liabilities are translated at current exchange rates. Nonmonetary

assets, liabilities, and paid-in capital accounts are translated at historical exchange

rates; cost of sales and depreciation expense are translated at the rates in

existence when the related inventory or fixed assets were acquired; and revenues

and other expenses are translated at the average exchange rate in existence during

the reporting period. Translation gains and losses are reported as a component of

net income.

Transaction exposure: The potential for gains and losses as foreign-denominated

assets and liabilities (e.g., accounts receivable, accounts payable, notes payable), increase

or decrease in value with changes in exchange rates.

Transfer prices: Prices charged when goods or services are transferred either

within firms (e.g., from one division of a firm to another) or between related firms

(e.g., between a parent and its subsidiaries).

Translation exposure: Typically, the excess of foreign-currency assets over foreign

currency liabilities of foreign subsidiaries. Translation gains result from increases in

the value of the foreign currency and losses in the event of decreases.

Translation of foreign currency financial statements: The restatement of the

financial statements of a foreign entity from its local currency to the reporting currency

of its parent.

UNIX: An open operating system running on many manufacturers' computers. The

first successful nonproprietary operating system. It was developed by Bell Labs in

the 1970s.

Unsystematic risk: The portion of total risk specific to an individual security that

can be avoided through diversification.

Unwind: To close out a future or forward position.

URL: Universal Resource Locator is the Internet address for a given Web site. The

URL for the president of the United States is www.whitehouse.gov.

Valuation date: The specific point in time at which the valuator 's opinion of value

applies (also referred to as "Effective Date" or "Appraisal Date").

Variances: Measures of the difference between actual costs and standard costs.

They are favorable if costs are less than expected and unfavorable otherwise. Variances

may be analyzed by the effect of changing prices (price variances) or changing

usage (quantity or usage variances).

642 Glossary

Vertical merger: A merger in which the two firms are from different stages of the

same industry or production process (e.g., an automobile manufacturer purchases a

steelmaker).

WAN: A wide area network is a connection of two or more computers which are geographically

distant from each other. The typical purpose of a WAN is to send data or

communicate with distant facilities. Thus, an airline might have a WAN connecting

all of its airports world wide to allow for the quick communications of scheduling

changes between its various facilities.

Weighted average cost of capital (WACC): The cost of capital (discount rate) determined

by the weighted average, at market value, of the cost of all financing

sources in the business enterprise's capital structure.

Windows NT or 2000: Quickly becoming the network operating system standard

of the industry. Developed by Microsoft.

Write an option: Sell an option. The writer is paid the option premium up front.

The writer of a call must later sell the underlying asset if the call option owner

exercises. The writer of a put must later buy the underlying asset if the put option

owner exercises. The writer of the option is essentially liable for any future payoffs

received by the option owner. Also known as shorting the option.

643

About the Authors

Charles A. Anderson's career includes academic and business experience. He

has been a faculty member of both the Harvard Business School and the Stanford

Business School. He was the president, chief executive officer, and a

director of Walker Manufacturing Co., J.I. Case, and the Stanford Research

Institute. He has served on a number of corporate boards of directors, including

NCR Corp., Owens-Corning Fiberglas Corp., Boise-Cascade Corp., and

the Eaton Company.

Robert N. Anthony is Ross Graham Walker Professor of Management Control,

Emeritus, at Harvard Business School. He has been a director and chairman

of the audit committee of Carborundum Company and Warnaco, Inc. He

has been a director of several smaller organizations and a trustee (including

chairman of the board) of Colby College, and of Dartmouth-Hitchcock Medical

Center. He is the author or coauthor of some 20 books and 100 articles on

management subjects, especially management control; his books and articles

have been translated into 12 languages. He is a past president of the American

Accounting Association.

Richard T. Bliss has been involved in corporate financial analysis since 1987

and is currently on the finance faculty at Babson College. He teaches at the undergraduate,

MBA, and executive levels, specializing in the areas of Corporate

Financial Strategy and Entrepreneurial Finance. Prior to coming to Babson,

Dr. Bliss was on the faculty at Indiana University and he has also taught extensively

in Central and Eastern Europe, including at the Warsaw School of Economics,

Warsaw University, and the University of Ljubljana in Slovenia.

With publications in the areas of corporate finance, entrepreneurship,

and banking, Dr. Bliss has an active research agenda. His recent work on the

impact of bank mergers on CEO compensation has been cited in Fortune magazine

and numerous other business publications and will be published in the

Journal of Financial Economics.

644 About the Authors

Dr. Bliss holds a PhD in Finance from Indiana University. He also received

his MBA in Finance/Real Estate from Indiana University and graduated

with honors from Rutgers University, earning a BS degree in Engineering and a

BA degree in Economics

Edward G. Cale Jr. is a professor of information systems at Babson College in

Wellesley, Massachusetts. Dr. Cale holds a BS in electrical engineering from

Stanford University and an MBA and a DBA from the Harvard Business

School. After working for five years in the aerospace and integrated circuits industries,

Dr. Cale has spent the past 20 years in academia, teaching, conducted

research, and consulting in the management of information technology.

Eugene E. Comiskey received his PhD from Michigan State University and

his professional qualifications include both Certified Public Accountant (CPA)

and Certified Management Accountant (CMA). Professor Comiskey taught

from 1965 to 1980 at the Krannert Graduate School of Management at Purdue

University and also as a visiting faculty member during 1972 and 1973 at

the University of California, Berkeley. While at Purdue, he twice received the

Salgo Noren Foundation Award as the outstanding professor in the Graduate

Management Program. Since arriving at Georgia Tech he has six times been

recognized as Professor of the Year by the Graduate Students in Management

organization. In 1999, Professor Comisky was the recipient of the Educator of

the Year award from the Georgia Society of CPAs.

Professor Comiskey has published over 60 papers in a wide range of professional

and scholarly journals and edited books. A book, with Charles W.

Mulford, Financial Warnings (478 pages), was published in 1996 by John Wiley

& Sons and is now in its fifth printing. Another book, Guide to Financial Reporting

and Analysis (624 pages), also with Charles W. Mulford, was published

by John Wiley & Sons in 2000. A third book, The Financial Numbers Game, is

under contract with John Wiley and should be published in late 2001 or early

2002. Current research interests center on financial analysis and financial reporting

practices, financial early warnings, international financial reporting

practices, and the role of financial data in credit decisions. For over 25 years,

Professor Comiskey has worked with commercial banks, both in the United

States and in Europe and Asia, in the design and delivery of educational programs

to improve the financially oriented credit analysis skills of lenders. Since

1988, he has been a partner in Financial Training Associates, a financial training

and consulting firm that he founded with his colleague Charles W. Mulford.

Professor Comiskey served from 1978 to 1980 as Director of Research

for the American Accounting Association. He also served (1995–1996) as president

of the Financial Accounting and Reporting Section of the American

Accounting Association. The Section has a membership of over 1,500 and is

made up of scholars and practitioners who have a primary interest in matters

related to the measurement and disclosure of financial information. Professor

About the Authors 645

Comiskey served two terms on the editorial review board of the Accounting

Review—the second term was as an editorial consultant, or under current

nomenclature, an associate editor. He has also served a term on the editorial

review board of Issues in Accounting Education and is now serving a threeyear

term on the editorial board of Accounting Horizons.

Michael A. Crain, CPA/ABV, ASA, CFE, MBA, is a business appraiser and litigation

consultant practitioner in Ft. Lauderdale, Florida. He is an Accredited

Senior Appraiser in business valuation awarded by the American Society of

Appraisers and he is Accredited in Business Valuation from the American Institute

of Certified Public Accountants (AICPA). He has served on the examination

committee for the AICPA's business valuation accreditation and on other

AICPA national committees. He has been retained as an expert witness and

testified on numerous occasions. His articles have appeared in the Journal of

Accountancy, CPA-Expert, and other professional publications, and he has spoken

on numerous occasions to national audiences.

Steven P. Feinstein, PhD, CFA, is an associate professor of finance at Babson

College and a consultant with the Michel/Shaked Group in Boston. He holds a

PhD in economics from Yale University. Prior to entering academia, Dr. Feinstein

served as an economist at the Federal Reserve Bank of Atlanta. Dr. Feinstein's

primary areas of research are financial valuation and the use and pricing

of derivatives. He has presented his research at numerous academic conferences

including the annual meetings of the American Finance Association and

the Financial Management Association. His articles have appeared in Derivatives

Quarterly, the Journal of Risk, Risk Management, the Atlanta Federal Reserve

Bank Economic Review, the American Bankruptcy Institute Journal, and

the Journal of Financial Planning. Dr. Feinstein conducts professional seminars

for executives and has consulted for a wide variety of institutions. Clients

have included Bankers Trust, Cho Hung Bank of Korea, Chrysler, Honeywell,

ITT, Lehman Brothers, Nippon Life Insurance, Travelers Insurance, and numerous

law firms.

Theodore Grossman is a member of the faculty of Babson College, where he

teaches information technology and accounting. He lectures on various information

technology topics such as Web technologies, e-commerce, strategic information

systems, managing information technology, and systems analysis and

design. He also performs extensive consulting for food and nonfood retailers,

suppliers of technology products to the retail industry. He is called upon frequently

to act as an expert witness in complex litigation in matters relating to

technology and cyber law. Prior to joining Babson College, he was the founder

and CEO of a computer software company for the retail industry. He holds a

BS degree in engineering from the University of New Hampshire and an MS in

management from Northeastern University.

646 About the Authors

Robert Halsey has an MBA in finance and a PhD in accounting from the University

of Wisconsin—Madison. During his business career, he managed the

commercial lending division of a large Midwestern bank, and served as the

Chief Financial Officer of a privately held retailing and manufacturing company.

Prior to joining the faculty of Babson College, Dr. Halsey taught at the

University of Wisconsin—Madison where he received the Douglas Clarke

Memorial Teaching Award. His research interests are in the area of financial

reporting and include firm valuation, financial statement analysis, and disclosure

issues. He has published in Advances in Quantitative Analysis of Finance

and Accounting, the Journal of the American Taxation Association, and Issues

in Accounting Education.

Stephen M. Honig is senior partner with the Boston office of the national law

firm of Schnader, Harrison, Segal & Lewis, LLP. A holder of a BA from Columbia

College and an LLB from Harvard University, Mr. Honig has worked in

the private and public finance of emerging technology companies since 1966.

He was assisted in the preparation of his chapter by his partner Albert Dandridge,

formerly on the staff of the Securities and Exchange Commission, and

associate Craig Circosta, both of Schnader's Philadelphia office.

William C. Lawler is an Associate Professor of Accounting at Babson College,

Wellesley, Massachusetts, and Director of the Consortium for Executive Development

at Babson College's School of Executive Education. Dr. Lawler did

his undergraduate work at the University of Connecticut and his graduate

studies at the University of Massachusetts. His teaching and research focus on

two areas: financial footprints of business unit strategy and the impact of new

technologies on cost systems design.

Professor Lawler has authored several papers and given numerous professional

presentations. His primary focus is on aiding operational managers in understanding

the financial consequences of their decisions. He has run seminars

on this topic for such diverse groups as telecom managers in China, production

managers in the Czech Republic, and R&D managers in the United States. Dr.

Lawler consults with a number of companies, ranging from small biotechs to

Fortune 100 computer companies, concerning the design and use of cost information

systems for management decision support rather than external financial

reporting. His most recent publications in this area are chapters on Activity

Based Accounting and Profit Planning for the third edition of The Portable

MBA in Finance and Accounting.

John Leslie Livingstone earned MBA and PhD degrees from Stanford University.

He is a CPA, licensed in New York and Texas, and a CVA (certified in

business valuation). Les directs a nationwide business consulting practice,

headquartered in West Palm Beach, Florida. He has been a partner in Coopers

& Lybrand (now PricewaterhouseCoopers), an international accounting

firm, and in The MAC Group, an international management consulting firm

About the Authors 647

specializing in business strategy with offices in Boston, Chicago, Los Angeles,

New York, San Francisco, Washington, D.C., London, Paris, Munich, Rome,

Madrid, and Tokyo (since acquired by Cap Gemini/Ernst & Young). He has

consulted to major corporations and other organizations such as the U.S.

Postal Service and the SEC. He was the Arthur Young Distinguished Professor

of Accounting at Ohio State University, Fuller E. Callaway Professor of

Accounting at Georgia Institute of Technology, and Chairman of the Department

of Accounting and Law at Babson College. He has authored or coauthored

10 books, several chapters in authoritative accounting handbooks, and

many articles in professional journals.

Richard P. Mandel is an associate professor of law at Babson College, where

he teaches a variety of courses in business law and taxation on the undergraduate

and graduate school levels and has served as chairman of the Finance Division.

He is also a partner in the law firm of Bowditch and Dewey, of Worcester

and Framingham, Massachusetts, where he specializes in the representation of

growing businesses and their executives. Mr. Mandel has written a number of

articles regarding the legal issues encountered by small businesses. He holds an

AB in Government and Meteorology from Cornell University and a JD from

Harvard Law School.

Charles W. Mulford is Invesco Chair and professor of accounting in the

DuPree College of Management at Georgia Tech. Since joining the faculty in

1983, he has been recognized nine times as the Core Professor of the Year and

once as the Professor of the Year by the Graduate Students in Management. In

1999 the Graduate Students in Management voted to rename the Core Professor

of the Year Award the "Charles W. Mulford Core Professor of the Year

Award." An additional teaching award received in 2000 was the universitywide

W. Roane Beard Class of 1940 Outstanding Teacher Award.

Dr. Mulford's scholarly pursuits include the publication of numerous papers

in scholarly as well as professional accounting and finance journals. His

research interests center on the effects of accounting standards on investment

and credit decision making, earnings forecasts, the relationship between

accounting-based and market-based measures of risk and international accounting

and reporting practices. More recently, his research interests have

turned to the use of published financial reports in the prediction of financial

distress. He has coauthored a book on the subject, Financial Warnings, published

in 1996. A second book on financial analysis, Guide to Financial Reporting

and Analysis, was published in July 2000. A third book on how

accounting is used to mislead investors, The Financial Numbers Game: Identifying

Creative Accounting Practices, is scheduled for publication in 2001. All

three books were or will be published by John Wiley & Sons, New York.

In addition to his work at Georgia Tech, Professor Mulford regularly consults

with major domestic and international commercial banks on issues related

to credit decision making.

648 About the Authors

Charles Mulford has a doctorate in accounting from Florida State University

and is professionally qualified as a Certified Public Accountant (CPA) in

Florida and Georgia. Prior to joining the Georgia Tech faculty, he practiced

public accounting with the firm of Coopers & Lybrand. He was an audit senior

in the firm's Miami office.

Michael F. van Breda teaches at Southern Methodist University where he

was chair of the accounting department for a number of years. He is currently

Director of the Graduate Certificate Program in Finance and Accounting. His

courses have included cost and managerial accounting at the graduate level.

He obtained his PhD in Accounting from Stanford University and his MBA

from the University of Cape Town. He was previously on the faculty of

MIT and has held positions at the University of Cape Town, the University

of the Witwatersrand, and at University College, Oxford. He is the author of

numerous scholarly publications one of which won the Lybrand silver medal for

its contribution to managerial accounting. He is the coauthor (with Eldon S.

Hendriksen) of the fifth edition of Accounting Theory (Richard D. Irwin,

1991). In addition he has consulted to a number of major corporations.

Andrew "Zach" Zacharakis, PhD, is the Paul T. Babson Term Chair in Entrepreneurship

and an associate professor of entrepreneurship with the Arthur

M. Blank Center for Entrepreneurship at Babson College. Professor Zacharakis

received a BS (finance/marketing), University of Colorado; an MBA (finance/

international business), Indiana University; and a PhD (strategy and

entrepreneurship/cognitive psychology), University of Colorado. At Babson, he

teaches the business plan preparation course at both the MBA and undergraduate

levels. He also actively advises entrepreneurial start-ups and venture

capital firms. His primary research areas include the (1) venture capital

decision-making process and (2) entrepreneurial growth strategies. Professor

Zacharakis has articles appearing in Journal of Business Venturing, Entrepreneurship:

Theory and Practice, Journal of Small Business Management, Venture

Capital: An International Journal of Entrepreneurial Finance, Journal of

Private Equity Capital, International Trade Journal, Academy of Management

Executive, Journal of Business Strategies, Case Research Journal, as well as

Frontiers of Entrepreneurial Research. Professor Zacharakis has been interviewed

in newspapers nationwide including the Boston Globe and the Los

Angeles Times. He has also appeared on Bloomberg Small Business Report.

Professor Zacharakis's dissertation, The Venture Capital Investment Decision,

received a Certificate of Distinction from the Academy of Management and

Mr. Edgar F. Heizer recognizing outstanding research in the field of new

enterprise development. Professor Zacharakis's actively consults with entrepreneurs

and small business start-ups. His professional experience includes positions

with The Cambridge Companies (investment banking/venture capital),

IBM, and Leisure Technologies.

649

Index

Accounting:

changes in, 51–53

cross-border deals, 586

for goodwill, 399–400

government, 217–218

hedge, 389–393

information systems, 543, 544–545

international differences in, 356, 393–400

policies note, 82

standard cost accounting systems, 217–219

Accounts payable, 18, 20–21, 188

Accounts receivable, 18, 19, 187, 543

Accrued expenses (financial budget), 189

Acid test ratio, 18, 28

Acquisition, 83–84, 322–324, 561–592

antitrust concerns, 585–586

bidder, 562

cash vs. stock deals, 582–583

conglomerate merger, 563–564

consolidation, 562

cost reduction benefits, 576–577

cross-border deals, 586

definitions/background, 562–563

horizontal, 563

identifying/screening candidates, 581–582

Internet links, 591

postmerger implementation, 586–589

practical considerations, 581

proxy contests, 562

purchase vs. pooling accounting, 583–585

successful case study (Cisco Systems Inc.),

571–573

takeover, 562

taxes, 322–324, 583, 585

track record of, 564–571

value creation in, 573–581

vertical, 563

Activity-based costing (ABC), 126–148

Activity-based management (ABM), 136,

145

Activity indices, 206

Activity ratios (valuation), 601

Administrative expense budget, 186

Adobe Systems Inc., 359, 361

Advanced Micro Devices, 45

Advertising/promotion, 275–276

Advisory boards, 281–283

AGCO Corporation, 387, 388

Agent /principal, 237–238

Air Canada, 358

Air T Inc., 408

AK Steel Holding Corporation, 47, 54, 71

Alternatives, principle of, 596

Altman z score, 31–32

American Airlines, 576

American Institute of Certified Public

Accountants, 33, 35, 167

American Pacific Corporation, 408

Analog Devices Inc., 368, 369

Andrews, Kenneth R., 517

Antitrust concerns, 585–586

AOL/Time Warner, 561, 563, 586

Application service providers (ASPs), 556

Applications software, 156–164

Arch Chemicals Inc., 369, 405

Archer Daniels Midland Company (ADM),

59–61

Argosy Gaming, 43

Armco, 52–53

Armstrong World Industries Inc., 359, 361,

364

ARPANET, 541

Arvin Industries Inc., 364

Askin Capital Management, 428

650 Index

Asset(s):

current, 17–18

turnover, 30, 31

valuation approach, 594

AT&T/NCR merger attempt, 567–568, 588

Audit, 12–13

Audit committee, 523–529

Baker Hughes, 75–94

Balance sheet, 4, 6, 7, 8, 10, 15, 17, 25, 599–601,

613

Baldwin Technologies, 358, 361

Banking/finance, information technology in,

545–546

Bankruptcy predictor (ZETA), 32

Barad, Jill E., 519

Bard (C.R.) Inc., 64, 66, 67

Baxter International Inc., 373, 374

B.B. Lean Inc., 584, 585

Becton, Dickenson & Company, 388

Becton Coulter Inc., 363, 387, 388, 393

Beta, 613

Biogen, 61

Black & Decker, 404

Blyth Industries Inc., 373

Board of directors, 241–243, 281, 510–535

audit committee, 523–529

chief executive officer (CEO) and, 512–514,

518–519

compensation committee, 520–523

corporation business form and, 241–243

dealing with major crises, 518–520

finance committee, 529–532

meetings, 514–516, 517–518

member responsibilities, 512

reasons for having, 510–511

strategy, 516–518

Books "R" Us, 117, 118, 127

Break-even calculations, 107

Brooke Group Inc., 121–122

Brooktrout Technologies, 43

Brown & Williamson Tobacco Corporation,

121–122

Budget(s)/budgeting, 173–198

accounts receivable/payable, 187, 188

accrued expenses, 189

activity indices, 206

actual vs. static vs. f lexible, 193–195,

203–204, 205

administrative expense, 186

behavioral issues in, 181–182

capital expenditures, 188, 291–313

cash, 184–185, 189–190

comprehensive process (diagram), 179

control, 174, 178–181, 201–208, 219–220

cost of goods sold, 183–186

defining standards, 202

financial, 187–189

fixed cost, 215–217

forecasting and, 191–193

goal orientation, 176, 177

improper use of, 181

income statement, 186–187

labor indices, 211

legal /contractual requirements, 176

market effects, 207

master, 182–183

material indices, 210–211

overhead indices, 211–212

performance evaluation and, 176

periodic planning and, 175

price indices, 206

profit plan, 195

quantification, 175

realistic planning, 178

reasons for, 174–177

review process, 195–197

sales, 183

standards and, 202–203

statement of cash f lows, budgeted (indirect

method), 190–191

variable cost, 208–213

variance analysis/reports, 179, 180,

212–213

Buffett, Warren, 575

Buildup technique, 286, 287–288

Burn rate, 285

Business form/entity, 225–259. See also

Corporation; Limited liability company

(LLC); Limited partnership; Partnership;

Sole proprietorship

case illustrations, 225–226, 255–259

choice of, 255–259

comparison factors (five basic forms), 228,

231–244

Business plan, 260–290

getting started on, 262–263

length, 261–262

outline, 264

resources/Web sites, 289, 290

sections:

appendices, 288–289

company/product description, 271–273

competition analysis, 269–270, 271

cover, 265, 266

critical risks, 284–285

customer analysis, 269

development plan, 279–281

executive summary, 267–268

financial plan, 286–288

industry analysis, 268–269

marketing plan, 273–277

offering, 286

operations plan, 278–279

table of contents, 265–267

team, 281–283

Index 651

story model, 263–265

types of, 261–262

Buy-sell agreements, 345–347

Cabot, Louis B, 513

California First Bank, 360, 361

Capital asset pricing model (CAPM), 613–615

Capital budgeting, 188, 291–313

cost of debt financing, 303–304, 606,

615–616

decision rules, 292, 307–311

discount rate, 303–307, 613

divisional vs. firm cost of capital, 307

economic value added (EVA), 311, 312

forecasting cash f low, 297–299

leverage effects, 305–307

real options, 312

recent innovations in, 311–312

weighted average cost of capital (WACC),

304–305

Capitalization rate/factor, 612

Cash:

budget, 184–185, 189–190

deals, acquisitions (vs. stock deals), 582–583

equivalents, 18

synthetic, 439

Cash f lows:

forecasting, 292–299

nonrecurring items, 54–58, 90

statement of, 8–10, 11, 15, 54–58, 77,

190–191

Cerent Corporation, 572–573

Chambers, John, 572

Champion Enterprises, 46

Chase Manhattan, 576

Chief executive officers (CEO), 526–527

acquisitions and, 566

appraisal of, 512–513

board of directors and, 512–514

compensation, 520–522

terminating, 518–519

Cisco Systems, 530–531, 543, 566, 571–573, 582,

587, 588

Citicorp, 575

Client-server network, 164, 165

Collateralized mortgage obligations (CMOs), 428

Comfort letter, 472, 505–509

Commodities, 409

Company/product description (business plan

section), 271–273

Compaq, 373, 374

Compensation, 283, 315–317, 325–330, 520–523

Competitors. See also Industry(ies)

analysis, 269–270, 271, 274

financial ratio comparisons, 29

risks section of business plan (competitor

actions/retaliation), 284–285

Computer components, 152–155

Computing,"ubiquitous," 538

Conglomerate merger, 563–564

Conoco Inc., 405

Consolidation, 562

Control(s):

budgeting and, 174, 178–181, 201–208,

219–220

business entities/forms and, 228, 237–244

discount for lack of, 622

information technology, 551–552

interest, 622

premium, 619

Cookies, 169

Core earnings. See Sustainable earnings

Corporation:

continuity of life, 234–235

control, 238–243

directors, 241–243

formation, 229–231

liability, 245–247

officers, 243

out-of-state operation, 232

professional, 227, 233

sale of, 350–351

stockholders, 239–240

subchapter S, 227, 252–253, 318–322

taxation, 249, 250–253, 318–322

transferability of interest, 236

Cost(s):

awareness (budgeting function), 176

behavior estimation (methods of ), 116–120

benefits, mergers/acquisitions, 576

of capital, 304–305, 307, 606–608

of debt, 303–304, 606, 615–616

of equity, 606, 613–615

estimating headcount schedule, 287–288

fixed, 215–217, 218–219

of goods sold (budgets), 183–186

opportunity, 298

standard, 218–219

structure analysis, 104–106

sunk, 299

variable, 208–213, 218

Cost-volume-profit (CVP) analysis, 102–125

CVP analysis chart, 107, 108

for decision making, 109–111

high-low analysis, 118–119

in multiple product situation, 112–115

price discrimination, 111–112

regression analysis, 119–120

role of pricing, 121–123

sensitivity analysis, 113, 116

visual fit, 118–119

Coverage ratios (valuation), 601

Covey Systems, 588

Covisint, 555

CPA (certified public accountant), 12–13

Cross-border deals, 586

652 Index

Cross-hedge, 440

Crugnale, Joey, 273

Cryomedical Sciences, 45

Currency, 67– 69, 92–93, 356–375, 386–389, 438

financial reporting of foreign-currency

denominated transactions, 356–358

foreign exchange gains/losses, 92–93

futures, 368–369

hedging/risk management, 356, 358–375, 438

options, 365–368, 369

transaction/translation exposure, 67–69

Customer analysis (business plan section), 269

Customer value proposition (CVP), 129, 130

Daft, Douglas, 575

DaimlerChrysler, 388, 569, 570, 582–583, 588

Dana, 61

Database systems/software, 161, 543, 548–549,

550

Data warehousing, 549–551

Dead End Inc., 584

Death taxes, 344

Debt:

cost of, 303–304, 606, 615–616

long-term obligations, 22

ratio of, to equity, 26

Debt-free analysis (valuation), 605–606

Decision analysis, and CVP analysis, 109–111

Decision support systems/executive information

systems, 556–559

Dell Computer, 555

Delta Air Lines, 37–38, 414

Depreciation, 295

Derivatives, 361–370, 423–455

call options, 443, 444–445

case studies of debacles involving, 425, 432

Askin Capital Management, 428

Barings Bank, 425

lessons from, 432

Long-Term Capital Management (LTCM),

429–432

Metallgesellschaft, 426–427

Orange County, California, 428

Procter and Gamble, 425–426

Union Bank of Switzerland, 429

choosing appropriate hedge, 451–454

equity swaps, 448

exchange-traded vs. over-the-counter, 452

forwards, 434–436, 437–440

futures, 434, 436–440

instruments, 434–451

interest rate swaps/hedges, 438, 449–451

market timing, 439

options, 434, 440–442

put options, 445–447

risk transfer using, 423, 424, 432

size of market, 433–434

swaps, 434, 447–449

synthetic cash/stock, 439

written call option, 444–445

Desktop computers, 151

Detection Systems, 45

Development plan (business plan section),

279–281

Dibrell Brothers Inc., 68–69

Digerati Inc., 579

Directed share program, 467

Direct equity methodology, 605–606

Directors. See Board of directors

Discontinued operations, 47– 48, 49

Discounted cash f low (DCF), 300–301,

303–307, 609–618

Discounted payback period rule, 308–309

Discount for lack of control, 622

Discount rate, 303–307, 613

Distribution strategy, 275

Dividends, 26, 339–340, 530–531, 579

Doom loop, 121

Dow Chemical Company, 364, 405

Due diligence checklist /examination outline,

466, 478–498

"Dumping," 123

Dupont analysis/formula, 30, 31

Earnings, 35–101, 475, 525–526, 608–609

adjustment to, for valuation purposes,

608–609

analysis of, 35–101

annual reports referenced, 96–98

Internet links, 95–96

nonrecurring items, 35–71

"other comprehensive income," 71–72

smoothing, 525–526

sustainable (core/underlying), 72–96, 617

Eaton, Robert, 570

EBIT, 21, 26, 27

Eckel, Robert, 519

Economic value added (EVA), 311, 312

Electronic commerce, 168–169, 554–555

Electronic Data Interchange (EDI), 547, 548,

552

Electronic mail (e-mail), 165–166

Electronic Transaction Network (ETN/ W),

126–148

ABC example, 126–148

customer value proposition (CVP), 130

history, 127–130

transaction processing, 140–144

value system and strategy, 130–131

Employee stock ownership plans, 341–343

Engineered instruments, 434

Engineering studies, 213–214

Enterprise resource planning (ERP) systems, 544

Equity risk premium, 613

Escalon Medical Corporation, 54, 55, 57, 58

Estate planning, 343–347

Index 653

Estimates, changes in, 53–54

Executive compensation, and taxes, 325–335

Exotics, 434

Extraordinary items, 47–51

Fairchild Corporation, 43, 62, 69, 70

Family limited partnership, 344–345. See also

Limited partnership

Fashionhouse Furniture, 353–357, 361, 375, 401,

404, 407, 413, 415

Federal Express, 360, 361

File server, 164

Finance committee, 529–532

Financial budget, 187–189. See also Budget(s)/

budgeting

Financial Management Association, 168, 172

Financial plan (in business plan), 286–288

Financial ratios, 21–23, 28–29, 30–31, 601–603

activity ratios, 601

analysis, 601–603

combining, 30–31

coverage ratios, 601

industry composites comparison, 29

investment profitability, 25–28

leverage ratios, 601

liquidity ratios, 601

long-term solvency analysis, 21–23, 28

profitability ratios, 28, 603

sales profitability, 23–25, 28

short-term liquidity analysis, 28

Financial statements, 3–34, 286 –288, 409–410,

524, 610–611

analyzing, 16–28

assets/liabilities, current, 17–18

audit, 12–13, 524

balance sheet, 4, 6, 7, 8, 10, 15, 17, 25,

599–601, 613

in business plan, 286–288

case study, 4–13, 17

cash f low statement, 8–10, 11, 15, 54–58, 77,

190–191

compilation, 13

of foreign subsidiaries, 356, 375–386

format, 14–16

income statement, 5, 10, 11, 14, 23, 24, 25,

39–54, 56, 90, 186 –187, 410, 601, 602

inf lation effects and adjustment of, 409–410

Internet links, 33–34

points to remember about, 10–11

projected, 610–611

review, 12, 13

service levels (CPA) relating to, 12–13

uses of, 13–14

valuation and analysis of, 599–603

Financing:

sources, 460

timing/availability (critical risks section of

business plan), 285

Firewall, 553

First Aviation Services, 61–62

Forecasts/projections:

budgets and, 191–193

cash f low, 292–299

sales/marketing, 276–277

Foreign company, predatory pricing by

(dumping), 123

Foreign exchange. See Currency

Foreign subsidiaries:

evaluation of performance of, 356, 401–407

impact of exchange rate movements on

performance evaluation, 401–404

transfer pricing, 404–407

translation of financial statements of, 356,

375–386

U.S. government restrictions on business

practices, 356, 413–415

Forward contracts, 361, 434–436, 437–440

Franklin Planner, 588

Freeport-McMoRan, 46

Futures, 361, 434, 436–440

Galey & Lord, 384, 385

General Electric, 555

General partnership, 226 –227. See also

Partnership

General Utilities doctrine, 351

Gerber Scientific, 61

Gift tax, 317–318

Glaxo Wellcome PLC, 576

Global finance, 353–422

accounting policy differences, 356, 393–400

case illustration (Fashionhouse Furniture),

353–357, 361, 375, 401, 404, 407, 413,

415

companies referenced, 417–419

currency risk management, foreign

subsidiaries, 356, 386–389

financial reporting of foreign-currency

denominated transactions, 356–358

hedge accounting, 389–393

inf lation effects, 356, 407–413

performance evaluation, foreign

subsidiaries/management, 356, 401–407

risk management alternatives for foreigncurrency

denominated transactions, 356,

358–375

translation of financial statements of foreign

subsidiaries, 356, 375–386

U.S. government restrictions, 356, 413–415

Goal orientation (budgets), 176–177

Goodwill, 399–400, 583–584

Goodyear Tire and Rubber Company, 38, 63

Government accounting, 217–218

Government restrictions on business practices

associated with foreign subsidiaries and

governments, 356, 413–415

654 Index

Gross profit, 5

Guideline companies approach, 618

Handy and Harman Inc., 58–59

Hardware, 150–155, 537–539

Hartmarx Corporation, 408, 409

Headcount schedule, 287–288

Hedge(s)/hedging, 356, 358–375, 389–393. See

also Derivative(s)

accounting (current GAAP requirements),

389–393

cash f low, 391–392

choosing appropriate, 451–454

cross-hedge, 440

decision factors, 370–375

fair value, 390–391

foreign-currency, 359, 361–370, 438

interest rate, 438, 449–451

with internal offsetting balances or cash f lows,

358–361

natural, 359

of net investments in foreign operations, 392–393

risk management alternatives for foreigncurrency

denominated transactions, 356,

358–375

Heinz Company (H.J.), 43, 376, 377

Henry Schein Inc., 388

High-low analysis (method of cost behavior

estimation), 118–119

Holden, James, 570

Horizontal merger, 563

Hostile takeover attempts, 519–520

Human Genome Sciences, 576

Hybrid instruments, 434

Illinois Tool Works Inc., 384, 385

Imperial Holly, 46

Income approach (valuation), 594, 609–618

Income statement, 5, 10, 11, 14, 23, 24, 25,

39–54, 56, 90

adjusted for changing prices, 410

alternative formats, 40–42, 46

analysis, 601, 602

budgeted, 186–187

nonrecurring items, 39–54, 56, 90

spreadsheet pro forma, 158

Index arbitrage, 425

Industry(ies):

analysis, business plan section, 268–269

analysis, for valuation, 597

comparisons for valuation, 604

financial ratios, comparing composites for, 29

information technology budgets for specific,

546

Inf lation, 356, 407–413

Information technology:

accounting information systems, 544–545

accounting sites, 172

advanced technology, 559

application service providers (ASPs), 556

application software, 156 –164, 543–544

in banking and finance, 545–546

budgets for, by industry, 546

database, 161, 548–549, 550

data warehousing, 549–551

decision support systems/executive

information systems, 556–559

electronic commerce, 554–555

financial management sites, 172

firewall, 553

for the firm, 536–560

fourth generation programming languages, 541

future, 170–171

hardware, 150–155, 537–539

historical perspective, 536–537

for the individual, 149–172

information systems paradigm, 540

Internet /intranet /extranets, 541–543,

553–554

justifying cost of, 553

networks/communication, 164–170, 546–548

personal finance software, 161, 162

presentation graphics software, 160

project management software, 161–164

search engines, 171

software, 540–541

spreadsheet software, 157–160

strategy, 552–553

types of information systems, 540

useful Web sites, 171–172, 560

Web hosting, 556

word processing, 156–157

Initial public offerings (IPOs), 460–461,

473–477

Interest(s):

complete termination of, 341

control, 622

minority, 622–623

pooling of, 584

transferability of, 228, 235–237

Interest expense, 296

Interest-free loans, 328–330

Interest rate swaps/hedges, 438, 449–451

Interface Inc., 358, 359, 373

Internal audit organization, 528–529

Internal control, 528

Internal rate of return (IRR), 309–311

International Trade Commission (ITC), 123

Internet /intranet /extranets, 166 –167, 541–543,

553–554

accounting sites, 172

domain types, 167

financial management sites, 172

hypertext link, 167

vs. intranet /extranets, 553–554

privacy, 169

Index 655

search engines, 171

Web browsers, 169

vs. World Wide Web, 167–168

Internet service providers (ISPs), 166

Inventory:

adjustment, 92

disclosures, 58–59

ending (in financial budget), 187

LIFO method, 58–59, 318–319, 409–411

note, nonrecurring items, search process, 90

subchapter S, 318–319

turnover ratio, 18, 19–20

Investment(s), 25–28, 532, 596, 607, 621

Irregular items. See Nonrecurring items

(gains/losses)

Jackson Printing, 199–220

JLG Industries, 369

Johnson & Johnson Inc., 373, 403, 408

J.P. Morgan, 576

Kayman Savings and Loan, 450–451

Kaynar Technologies, 70

Keating Computer, 449–450

Kekorian, Kirk, 569

Kellogg's, 191–193

Kelly, Carol, 127–148

Labor indices, 211

Laptop computers, 151

Legacy systems, 541

Legal /contractual requirements (budgets), 176

Leverage, 27, 30, 31, 305–307, 601

Levitt, Arthur, 70

Liability, 228, 244–248

Liggett Group Inc., 121

Like-kind exchanges, 337–339

Limited liability company (LLC), 227–228

continuity of life, 235

control, 244

formation, 231

liability, 247–248

out-of-state operation, 232

pass-through entity, 318

recognition as legal entity, 233

taxation, 254–255

transferability of interest, 237

Limited partnership:

continuity of life, 235

control, 243–244

family, 344–345

formation, 231

liability, 247

out-of-state operation, 232

pass-through entity, 318

recognition as legal entity, 233

taxation, 253–254

transferability of interest, 236

Liquidity:

analyzing short-term, 16–21, 28

discount for lack of, 621–622

ratios, 601

Local area network (LAN), 164

Lockup agreements, 467

Long-Term Capital Management (LTCM),

429–432

Long-term solvency, analyzing, 21–23, 28

Loss:

passive, 320–322

risk management by prevention/control of, 423,

424

Lotus Corporation, 544

Lyle Shipping, 361

Lynch, Peter, 532

M.A. Hanna Company, 62

Management by exception, 202

Management's Discussion and Analysis (MD&A),

64–67, 80–82, 90, 469

Market approach:

publicly traded guideline-companies method,

618–621

valuation, 594

Market effects (budgetary control), 207

Marketing plan (business plan section), 273–277

advertising/promotion, 275–276

distribution strategy, 275

pricing strategy, 274–275

product /service strategy, 274

sales/marketing forecasts, 276–277

sales strategy, 276

target market strategy, 273–274

Market interest and growth potential (critical

risks section of business plan), 284

Market timing, 439

Market value, fair, 595, 604–606

Market value of invested capital (MVIC), 608

Mason Dixon Bancshares, 35–36, 65

Master budget, 182–183. See also Budget(s)/

budgeting

Material indices, 210–211

Mattel Inc., 519

MC Enterprises Inc., 579

Mergers. See Acquisition

Micron Technology, 61–62

Microsoft, 121, 582

Miller Brewing, 576

Moore's Law, 538–539

Multimedia, 154–155, 170

Nabisco Foods, 561

NASDAQ, 469, 470

Net present value (NPV), 292–312

cash f low projection/forecasting, 292–299

computing, 292–301

cost of debt financing, 303–304

656 Index

Net present value (NPV) (Continued)

decision rules other than, 307–311

discounting cash f lows, 300–301

discount rate, 303–307

divisional vs. firm cost of capital, 307

examples, 302–303

leverage effects, 305–307

taxable income and income tax, 296

time value of money, 299–301

weighted average cost of capital (WACC),

304–305

windfall profit and windfall tax, 295–296

Network(ing), 164–170, 546–548. See also

Internet /intranet /extranets

architecture, 164

browsers, 169

client-server, 164, 165

cookies, 169

electronic commerce, 168–169

electronic mail (e-mail), 165–166

file server, 164

firms and, 546–548

individuals and, 164–170

local area network (LAN), 164

operating system, 164

peer-to-peer, 164

streaming media, 170

wide area network (WAN), 165, 166

wireless modems, 164

World Wide Web, 167–168

Network adapter, 154

Nonrecurring items (gains/losses), 35–71, 90, 91

accounting changes, 51–53

changes in estimates, 53–54

in continuing operations income, 42–43

discontinued operations, 47– 48, 49

extraordinary items, 47–51

foreign exchange (transaction and translation

exposure), 67–69

identification process, 39

in income statement, 39–54, 56

in income tax note, 59–62

in notes to financial statements, 67–71

interpreting information in operating activities

section, 56–58

in inventory disclosures of LIFO firms, 58–59

located below income from continuing

operations, 46–47

in Management's Discussion and Analysis

(MD&A), 64–67

nature of, 37–39

operating income (inclusions/exclusions),

43–46

in "other income and expense" note, 62–64

quarterly and segmental financial data, 70–71

restructuring notes, 69

search process, 39, 40, 90, 91

in statement of cash f lows, 54–58

Offering, 286

Officers, 243

Olin Corporation, 369

Operating systems, 156

Operations/operating:

consolidated statements of (example), 76

expenses (critical risks section of business

plan), 285

income, 43–46

nonrecurring items, 43–46

plan, 278–279, 280

Opportunity costs, 298

Options, 361, 434, 440–442

Osmonics, 43

"Other comprehensive income," 71–72

"Other income and expense" note, 62–64, 90

Overhead, 299

Pall Corporation, 62, 359, 373, 405

Partner(s), strategic, 281

Partnership, 226–227

continuity of life, 234

control, 237–238

formation, 229

liability, 245

limited (see Limited partnership)

pass-through entity, 318

recognition as legal entity, 232–233

taxation, 250

transferability of interest, 236

Passive losses, 320–322

Pass-through entities, 319–320

Pave-Rite Inc., 583

Payback period rule, 308

Peer-to-peer network, 164

Pegasus Systems Inc., 408

Penn Central Corporation, 513

Pension funds, 531–532

Performance:

evaluation (budget function), 176

of foreign subsidiaries/management, 356,

401–413

Personal digital assistants (PDAs), 149, 151–152

Personal finance software, 161, 162

Philip Morris Companies Inc., 385, 403, 576

Phillips Petroleum, 65–66, 75

Pickens, T. Boone, 577

Pizzi, Denise, 127–148

Planning, 195

budgets and, 175, 178, 291–313 (see also

Budget(s)/budgeting; Capital budgeting)

business plan, 260–290

enterprise resource planning (ERP) systems,

544

estate, 343–347

Polaroid Corporation, 369, 373, 408

Pollo Tropical, 46

Pooling of interests method, 584

Index 657

Portuguese firm example (Electricidade de

Portugal SA), 396–399

Praxair Inc., 385–386, 403

Predatory pricing, 121–122

Presentation graphics software, 160

Price(ing):

capital asset pricing model (CAPM), 613–615

CVP (cost /volume/profit) analysis and,

121–123

discrimination, 111–112

financial statement adjustments, 410–413

indices, 206, 411–412

options, 443–444

predatory, 121–122, 123

strategy (business plan), 274–275

strike, 364

transfer (multinational firm), 404–407

variances, and budgetary control, 204

Principal /agent, 237–238

Private, going, 562

Product description, in business plan, 271–273

Productivity, measuring, 199–221

budgetary control, 201–208, 219–220

collecting standards, 213

fixed cost budgets, 215–217

government accounting, 217–218

standard cost accounting systems, 217–219

variable cost budgets, 208–213

Product /service strategy (marketing plan within

business plan), 274

Profitability:

ratios for analyzing, 23–28, 603

in relation to investment, 25–28

in relation to sales, 23–25, 28

valuation and, 603

Profit chart, 108

Profit margin, 30–31

Profit plan, 195

Project management software, 161–164

Proxy contests, 562

Proxy regulations, 473–474

Publicly traded companies, 459–509

comfort letter, 472, 505–509

directed share program, 467

due diligence checklist, 466, 478–498

guideline-companies method, 618–621

initial public offerings (IPOs), 460–461,

473–477

Internet links, 477

lockup agreements, 467

process of going public, 464–473

underwriters, 464–466

Publishing industry value system, 103

Purchase vs. pooling accounting, 583–585

Quaker Oats Company, 369, 372, 388, 568,

569–570, 575

Quarterly financial data, 70–71

Quarterly reports (Form 10-Q), 527

Quick ratio, 18, 28

Real options, 312

Registration statement, 469

Regression analysis, 119–120

Remuneration, board, 522–523

Residual value, 611–612

Restructuring notes, 69

Return on assets, 30

Return on equity, 30

Revenue acceleration, 525

Reverse triangle merger, 352

Risk, 33

avoidance, 423

choosing appropriate hedge, 451–454

competitor actions and retaliation, 284–285

critical risks section of business plan, 284–285

currency, 356, 386–389

financing timing/availability, 285

instruments, 434–451

loss prevention and control, 423, 424

management approaches (four), 423

market interest and growth potential, 284

operating expenses, 285

retention, 423–424

risk-free rate, 613

sharing, 582

systematic risk, 613

time/cost to development, 285

transfer, 423, 424 (see also Derivative(s))

unsystematic risk, 615

Risk Management Association (RMA), 33

RJR Tobacco, 561

Rock, Eric, 127–148

Roger, Dave, 126–148

Rollinick, William, 519

ROTA (return on total assets), 26

Russo, Carl, 572

Sales:

budget, 183

in business plan, 276–277

forecasts, 276–277

ratios for analyzing profitability in relation to,

23–25, 28

strategy, 276

Sarni Inc., 583

Schremp, Jergen, 570

Search engines, 168

Securities Exchange Commission (SEC), 33, 70,

468–469, 474, 475, 498–504

Segmental financial data, 70–71

Segment and related information note, 86–87

Sensitivity analysis, 113, 116

Server technology, 538

Shareholders, 189, 239–240, 511

Shaw Industries Inc., 40, 41–42

658 Index

Sherwin-Williams Company, 62–63, 64

Silgan Holdings Inc., 408

Sirena Apparel Group, 525

SmithKline Beecham PLC, 576

Snapple Beverage Corp., 568, 569–570

Social Security/FICA, 326

Software, 156 –164, 540–541

Sole proprietorship, 226

continuity of life, 234

control, 237

formation, 228–229

liability, 245

out-of-state operation, 231

recognition as legal entity, 232

taxation, 248–249

transferability of interest, 235–236

Southwest Airlines, 53–54

Spin-offs and split-ups, 347–350

Spreadsheet software, 157–160

Standard(s):

collecting, 213

cost accounting systems, 217–219

currently attainable, 203

engineering studies, 213–214

fixed costs, 218–219

government accounting, 217–218

motivation, 213–215

past data, 215

setting (by board of directors), 516

time/motion studies, 214

types of, 202–203

valuation, 623

variable costs, 218

Stead, Jerre, 568

Stock(s), 331–335

appreciation rights (SARs), 331–332

vs. cash deals (M&A), 582–583

employee plans (ESOP), 341–343

shareholders, 189, 239–240, 511

substantially disproportionate distributions,

340–341

synthetic, 439

tax issues, 331–335, 340–341

Storage Technology Corp., 376, 377

Story model, 263–265

Straddle, 425

Strategic partners, 281

Strategy, 516–518, 552–553

Streaming media, 170

Strike price, 364

Subchapter S, 227, 252–253, 318–322

Substitution, principle of, 596

Sunk costs, 299

Sustainable earnings, 72–96, 617. See also

Earnings

Swaps, 361, 433, 434, 447–449

equity, 448

interest rate, 449–451

SWOT, 178

Synthetic cash, 439

Synthetic stock, 439

Systematic risk, 613

Taglines, 263

Takeover, 562

Tax issues:

acquisition, 322–324, 578, 580, 583, 585

business decisions, 314–352

business expenses, 325–326

business forms/entities, 228, 248–255

buy-sell agreements, 345–347

case illustration, 315

complete termination of interest, 341

deferred compensation, 326–328

dividends, 26, 339–340

employee stock ownership plans, 341–343

equity sharing, 330–335

estate planning, 343–347

executive compensation, 325–330

family limited partnerships, 344–345

foreign subsidiaries, 405–406

gift tax, 317–318

income tax note (example), 78–79

individual federal income tax rates, 249

interest-free loans, 328–330

like-kind exchanges, 337–339

nonrecurring items, 59–62, 78–79, 90, 93

passive losses, 320–322

pass-through entities, 319–320

reverse triangle merger, 352

sale of corporation, 350–351

shelters, 321

spin-offs and split-ups, 347–350

stock appreciation rights (SARs), 331

stock options, 332–334

subchapter S corporation, 316–322

substantially disproportionate distributions,

340–341

taxable income and income tax, 296

three-corner exchange, 339

unreasonable compensation, 315–316

vacation home rental, 335–338

Team (business plan section), 281–283

advisory boards, 281–283

bios/roles, 281

board of directors, 281

compensation, 283

external members, 281–283

ownership, 283

strategic partners, 281

Technology. See Information technology

Telef lex Inc., 359

Telsik, Sarah, 519

Tenneco Inc., 364, 373, 405

Three-corner exchange, 339

Tiger International Inc., 410–413

Index 659

Timeline, 281, 282

Time/motion studies, 214

Time value of money (TVOM) analysis, 299–301

Time Warner/AOL, 561, 563, 586

Titan International Inc., 370–371, 388

Toys "R" Us Inc., 40, 42, 43

Transaction processing, 140–144

Transfer pricing, 404–407

Transfer of risk, 424, 432

Travelers Inc., 575

Trimark Holdings, 45

Turnover ratios, 18

UAL Inc., 364

"Ubiquitous" computing, 538

Underlying earnings. See Sustainable earnings

Underwriters, 464–466

United Airlines, 563, 576

United States government restrictions on

business practices associated with foreign

subsidiaries and governments, 356, 413–415

UNIX operating system, 538

Unsystematic risk, 615

Unusual charges, 85, 94

USAir, 563, 576

Vacation home, renting (tax impact), 335–338

Valuation of business, 593–625

adjustment to earnings for purposes of,

608–609

appraisal of fair market value, 604–606

approaches to value (asset /income/market),

594

band of investment, 607

buyers (different types of ), 594–595

comparison to industry averages, 604

control interest, 622

control premium, 619

cost of capital, 606–608

direct equity methodology, 605–606

discounted cash f low method, 609–618

discount for lack of control, 622

discount for lack of liquidity, 621–622

discount for lack of marketability, 622

fair market value, 595, 604–606

financial buyers, 594–596

financial statement analysis, 599–603

guideline companies approach, 618

industry analysis, 597

Internet links, 625

investment risk, 596

marketability, 622

market value of invested capital (MVIC), 608

minority interests, 622–623

"mom and pop" business, 595

principle of alternatives, 596

principle of substitution, 596

process overview, 595–597

publicly traded guideline-companies method,

618–621

ratio analysis, 601–603

reconciliation of methods, 621

standards, 623

strategic/investment buyers, 595

Value creation in M&A, 573–581

Value engineering, 623–624

Varco, 93–94

Variable overhead indices, 211–212

Variance analysis/reports (budgets), 179, 180,

212–213

Veeco Instruments, 43

Vertical integration, 576, 577

Vertical merger, 563

Vishay Intertechnology Inc., 364

Visual fit (method of cost behavior estimation),

118–119

Walker, James, 260

Wal-Mart, 552–553, 554, 559

Warrants, 445

Wealth, maximizing, 291–292

Weighted average cost of capital (WACC),

304–305, 616

Western Digital Corporation, 354

Wide area network (WAN), 165, 166, 537, 547

Windfall profit and windfall tax, 295–296

Wireless modems, 164

Word processing software, 156–157

World Market Watch, 34

World Wide Web, 167–168. See also

Internet /intranet /extranets

W.W. Grainger, 555

Xerox Palo Alto Research Center, 538

Y2K, 541

York International Corporation, 369

ZETA, 32

Z score, 31–32

 

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