AN INTRODUCTION TO ACCOUNTING and MANAGERIAL FINANCE A Merger of Equals This page intentionally left blank AN INTRODUCTION TO ACCOUNTING and MANAGERIAL FINANCE A Merger of Equals Harold Bierman, Jr. Cornell University, USA World Scientific N E W J E R S E Y • LONDON • SINGAPORE • BEIJING • SHANGHAI • H O N G K O N G • TAIPEI • CHENNAI Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Bierman, Harold. An introduction to accounting and managerial finance : a merger of equals / by Harold Bierman. p. cm. Includes index. ISBN-13: 978-981-4273-82-4 (hardcover) ISBN-10: 981-4273-82-1 (hardcover) 1. Corporations--Accounting. 2. Corporations--Finance. I. Title. 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Wanda - An Intro to Accounting.pmd 1 3/8/2010, 6:19 PM November 6, 2009 13:43 spi-b811 9in x 6in b811-fm Preface Introductory accounting and finance have traditionally been taught as two separate courses, even though the importance of a basic knowledge of finance in learning accounting and a knowledge of accounting in learning finance have been widely acknowledged. One important historical reason for having two separate courses was that, in the past, few professors could teach both courses well. This lack of competent instructors has disappeared, and there are now many professors who can well integrate the basic elements of accounting and finance. Accounting is an ever-evolving art. Understanding accounting is necessary to understand financial reporting by business organizations and the uses of financial reports by decision makers, both internal managers and financial analysts. The structure of accounting is an important educational tool. The basic logic of the debit-credit process is elegant and logically consistent. The use of debits and credits emphasizes the relationships between accounts and simplifies the explana- tion of a wide range of financial transactions. This book is also an introduction to corporate financial management, build- ing on the basic capital budgeting framework and the time value of money. The objective is to stress the theoretical formulations that are most useful in making managerial financial decisions. A working knowledge of the time value of money is essential to having a complete liberal education. The terms net present value, internal rate of return, and capital asset pricing model are today widely used by managers.A few years ago, the persons in important managerial positions might have said that they made the firm’s big decisions on the basis of their experience, judgment, and intuition. Now, top managers insist more and more on having financial information properly analyzed before they exercise their judgments. Many of the financial models are simplifications of the real world. If they were to be applied without thought, it is likely that some of the models would lead to undesirable decisions. However, if used correctly, such models will give insights into the weaknesses of other, more simplified and erroneous decision-making tech- niques. This book emphasizes that the correct application of financial techniques v November 6, 2009 13:43 spi-b811 9in x 6in b811-fm vi An Introduction to Accounting and Managerial Finance in business situations improves the likelihood of making good decisions. However, exact answers and correct decisions are not always guaranteed in a complex and uncertain world. This book is based on a number of fundamental principles. First, the time value of money is used as the basic foundation for a large amount of the analysis. Second, decisions are approached on an after-tax basis. Third, we have avoided relatively complex models that are more appropriate for a more advanced finance course. Fourth, we emphasize decision making. We emphasize the models and methods of analysis that are most useful and practical rather than discussing theory for theory’s sake. Finally, once the reader understands the basic concepts and methods, we think it is important to introduce various real-world constraints and complexities. I acknowledge the invaluable contributions of my co-authors on other writing projects, Sy Smidt, Jerry Hass, and Bob Swieringa. While these friends and col- leagues cannot be held responsible for any mistakes (misstatements), they did help contribute significantly to my understanding of the topics covered in this book. Harold Bierman, Jr. Cornell University November 6, 2009 13:43 spi-b811 9in x 6in b811-fm Contents Preface v Chapter 1. Finance, Accounting and Corporate Objectives 1 Chapter 2. The Time Value of Money 13 Chapter 3. An Introduction to Financial Reporting 29 Chapter 4. Capital Budgeting 57 Chapter 5. The Income Statement 85 Chapter 6. Comparing the Use of Cash Flows and Incomes 101 Chapter 7. Depreciation Expense 111 Chapter 8. Long-Term Liabilities 137 Chapter 9. Stockholders’ Equity 151 Chapter 10. Distributions to Shareholders 167 Chapter 11. Capital Structure: Weighted Average Cost of Capital (WACC) 193 Chapter 12. Buy versus Lease 223 Chapter 13. Preferred Stock 247 vii November 6, 2009 13:43 spi-b811 9in x 6in b811-fm viii An Introduction to Accounting and Managerial Finance Chapter 14. Managerial Performance 259 Chapter 15. Mergers and Acquisitions: Consolidations 289 Chapter 16. Convertible Bonds 323 Chapter 17. Inventories 343 Chapter 18. The Cash Flow Statement 363 Appendices 377 About the Author 385 Index 387 November 6, 2009 13:43 spi-b811 9in x 6in b811-ch01 Chapter 1 Finance, Accounting and Corporate Objectives Corporate Objectives The motivation for buying the common stock of a corporation is the expectation of making a larger risk-adjusted return than can be earned elsewhere. The managers of a corporation have the responsibility of administering the affairs of the firm in a manner consistent with the expectation of returning the investors’ original capital plus the required return on their capital. The common stockholders are the residual owners, and they earn a return only after the investors in the more senior securities (debt and preferred stock) have received their contractual claims. We will assume that the objective of the firm is to maximize its common stockholders’ wealth position. Stockholders invest in a corporation with the expectation of making a net gain on their investment consistent with the investment’s risk. The managers and the board of directors of a corporation have the responsibility of administering the affairs of the firm in a manner consistent with the interests of the stockholders. Thus, one of management’s primary goals should be the maximization of stockholders’ wealth. Although corporations might have other objectives (such as fulfilling their social responsibilities or treating their workers fairly), we will focus our attention on the more narrow corporate goal of stockholder wealth maximization. But even this narrow definition is apt to give rise to misunderstanding and conflict. It is very likely that situations will arise where one group of stockholders will prefer one financial decision while another group of stockholders will prefer another decision. For example, imagine a situation where a business undertakes an investment that is deemed to be desirable by management, but the immediate effect of the investment will be to depress earnings and the common stock price today. In the future, the market may realize that the investment is desirable, and at that 1 November 6, 2009 13:43 spi-b811 9in x 6in b811-ch01 2 An Introduction to Accounting and Managerial Finance time the stock price will reflect the enhanced value. But the stockholders expecting to sell their stock in the near future would prefer that the investment be rejected, while stockholders holding for the long run would prefer that the investment be undertaken. A statement such as “profit maximization” does not adequately describe the appropriate objective of the firm, since profits are conventionally computed and do not effectively reflect the cost of the stockholders’ capital that is tied up in the investment. Total sales or share of product market are also inadequate normative descriptions of corporate goals, although these goals may also lead to maximization of the shareholders’ wealth position by their positive effect on profits. Since the managers of a corporation are acting on behalf of the stockholders, there is a fiduciary relationship between the managers (and the board of direc- tors) and the stockholders. The stockholders, the suppliers of the risk capital, have entrusted a part of their wealth position to the firm’s management. Thus, the success of the firm and the appropriateness of management’s decisions must be evaluated in terms of how well this fiduciary responsibility has been met. The accounting reports measure (at their best) how well management is meeting this goal. Managerial Finance The study of managerial finance is concerned with the financial decisions of a firm (as distinct from the study of the structure of markets for obtaining capital). We break the firm’s decisions down into three basic types: 1. Investment decisions or, more generally, the allocation of funds among different types of assets or activities.