The Complete CFO Handbook From Accounting to Accountability Frank J. Fabozzi Pamela Peterson Drake ralPh s. Polimeni John Wiley & Sons, Inc. Copyright © 2008 by John Wiley & sons, inc. all rights reserved. Published by John Wiley & sons, inc., hoboken, new Jersey. Published simultaneously in Canada. Wiley bicentennial logo: richard J. 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Fabozzi, Pamela P. Peterson Drake, ralph s. Polimeni. p. cm. includes index. isbn 978-0-470-09926-1 (cloth) 1. Chief inancial oficers—handbooks, manuals, etc. 2. Corporations—United states—Finance—handbooks, manuals, etc. i. Peterson Drake, Pamela, 1954- ii. Polimeni, ralph s. iii. title. hG4027.35.F33 2007 658.15’1--dc22 2007018191 Printed in the United states of america. 10 9 8 7 6 5 4 3 2 1 FJF to my wife, Donna, and my children, karly, Patricia, and Francesco PPD to my husband, randy RSP to my inspiration, maxine elko Contents Preface xv About the Authors xix CHAPTER 1 The Changing Role of the CFO: From Accounting to Accountable 1 soX act of 2002 and the CFo 2 expanded responsibilities of the CFo 6 our agenda 14 PART ONE Funding 15 CHAPTER 2 Capital Structure Decisions 17 Debt versus equity 18 Concept of leverage 21 Capital structure and Financial leverage 25 Financial leverage and risk 29 Capital structure and taxes 31 Capital structure and Financial Distress 37 Cost of Capital 41 agency relationship 43 optimal Capital structure: theory and Practice 47 a Capital structure Prescription 51 bottom line 52 appendix: Capital structure theory—the modigliani-miller theory and beyond 53 CHAPTER 3 Types of Debt Financing 63 General Features of Debt obligations 64 vii viii CONTENTS term loans 65 syndicated bank loans 69 notes and bonds 71 short-term Financing 86 off-balance-sheet Financing 93 bottom line 95 CHAPTER 4 Equity Funding 99 Common stock 100 Preferred stock 115 bottom line 121 CHAPTER 5 Structured Financing: Asset Securitization and Structured Notes 123 asset securitization 124 structured notes 139 bottom line 149 PART TWO Strategy, Taxes, and Risk Management 151 CHAPTER 6 Strategy and Financial Planning 153 strategy and Value 155 Financial Planning and budgeting 158 importance of Financial Planning 158 budgeting Process 160 sales Forecasting 161 seasonal Considerations 163 budgeting 165 Pro Forma Financial statements 172 long-term Financial Planning 179 Financial modeling 179 Performance evaluation 183 strategy and Value Creation 191 bottom line 195 Contents ix CHAPTER 7 Basics of Corporate Taxes and Tax Risk Management 197 tax management 199 tax risk 200 U.s. tax law and taxation of Corporations 205 state and local taxes 218 non-U.s. taxes 218 bottom line 224 CHAPTER 8 Corporate Risk Management 227 risk Deined 228 enterprise risk management 230 managing risks 235 risk transfer 237 bottom line 255 PART THREE Performance Evaluation 259 CHAPTER 9 Financial Ratio Analysis 261 ratios and their Classiication 262 return-on-investment ratios 264 liquidity 271 Proitability ratios 279 activity ratios 282 Financial leverage ratios 284 Common-size analysis 289 Using Financial ratio analysis 290 illustration: Pizer, inc., 1990–2005 292 bottom line 307 x CONTENTS CHAPTER 10 Cash Flow Analysis 309 Dificulties with measuring Cash Flow 309 Cash Flows and the statement of Cash Flows 311 Free Cash Flow 316 Calculating Free Cash Flow 318 net Free Cash Flow 320 Usefulness of Cash Flows in Financial analysis 322 bottom line 327 CHAPTER 11 Decentralized Operations and Responsibility Accounting 329 organization structures and Concepts 330 examples of types of organization structure and resposibility reporting 331 Decentralization Problems 337 responsibility accounting 338 Controllable Costs 345 Costs of service Departments 346 executive incentive Compensation Plans and Dysfunctional Decision making 347 bottom line 351 CHAPTER 12 Responsibility Center Performance Evaluation 353 basis for Comparison 354 Cost Center Performance evaluation 356 Proit Center Performance evaluation 364 Proit Center Decision making 372 investment Center Performance evaluation 373 bottom line 394 appendix: Gross Proit analysis 394 CHAPTER 13 Transfer Pricing 405 transfer Pricing methods 407 Dual transfer Pricing system 418 international transfer Pricing 419 bottom line 424 Contents xi PART FOUR Asset Management 427 CHAPTER 14 Capital Budgeting and Cash Flow Analysis 429 the investment Problem 430 Capital budgeting 432 Cash Flow from investments 437 bottom line 454 appendix 14.a: expected Cash Flows from the Disposition of an asset 455 appendix 14.b: expansion of the Williams 5 & 10 457 CHAPTER 15 Capital Budgeting Techniques 463 evaluation techniques 464 net Present Value 466 Proitability index 471 internal rate of return 472 modiied internal rate of return 477 Payback Period 480 Discounted Payback Period 482 issues in Capital budgeting 483 Comparing techniques 486 Capital budgeting techniques in Practice 489 Conlicts with responsibility Center Performance evaluation measures 490 Capital budgeting and the Justiication of new technology 491 bottom line 495 CHAPTER 16 Capital Budgeting and Risk 497 Project risk 498 measurement of Project risk 500 measuring a Project’s market risk 505 incorporating risk in the Capital budgeting Decision 514 real options 518 Certainty equivalents 525 assessment of Project risk in Practice 526 bottom line 528 xii CONTENTS CHAPTER 17 Leasing 531 how leasing Works 532 types of equipment leases 533 Full-Payout leases versus operating leases 535 reasons for leasing 536 types of lessors 541 lease brokers and Financial advisers 541 lease Programs 542 Financial reporting of lease transactions by lessees 543 leveraged lease Fundamentals 546 Federal income tax requirements for true lease transactions 556 synthetic leases 558 Valuing a lease: the lease or borrow-to-buy Decision 560 bottom line 574 CHAPTER 18 Managing Short-Term Assets 579 Cash management 581 marketable securities 589 receivables management 591 inventory management 601 bottom line 607 PART FIVE Cost and Managerial Accounting 609 CHAPTER 19 Classifying Costs 611 elements of a Product 612 relationship to Production 615 relationship to Volume 616 ability to trace 622 Department Where incurred 623 Functional areas 624 Period Charge in income 625 relationship to Planning, Controlling, and Decision making 626 techniques for new Product Cost estimation 629 bottom line 633