The AMA Handbook of Financial Risk Management This page intentionally left blank The AMA Handbook of Financial Risk Management John J. Hampton American Management Association New York * Atlanta * Brussels * Chicago * Mexico City * San Francisco Shanghai * Tokyo * Toronto * Washington, D.C. Bulk discounts available. For details visit: www.amacombooks.org/go/specialsales Or contact special sales: Phone: 800-250-5308 Email: [email protected] View all the AMACOM titles at: www.amacombooks.org This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Library of Congress Cataloging-in-Publication Data Hampton, John J., 1942- The AMA handbook of financial risk management / John J. Hampton. p. cm. Includes index. ISBN-13: 978-0-8144-1744-7 ISBN-10: 0-8144-1744-2 1. Financial risk management. 2. Risk management. I. Title. II. Title: Handbook of financial risk management. HD61.H314 2011 658.15’5—dc22 2010048291 © 2011 John J. Hampton. All rights reserved. Printed in the United States of America. This publication may not be reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019 About AMA American Management Association (www.amanet.org) is a world leader in talent develop- ment, advancing the skills of individuals to drive business success. Our mission is to sup- port the goals of individuals and organizations through a complete range of products and services, including classroom and virtual seminars, webcasts, webinars, podcasts, confer- ences, corporate and government solutions, business books and research. AMA’s approach to improving performance combines experiential learning—learning through doing—with opportunities for ongoing professional growth at every step of one’s career journey. Printing number 10 9 8 7 6 5 4 3 2 1 To the MBA and MS in Accountancy candidates and the high-quality graduate business instructors at Saint Peter’s College This page intentionally left blank Contents Preface xi Introduction xv Part 1. Introduction to Financial Risk 1 Chapter 1. Categorizing Financial Risks 3 The Enterprise Risk Management Framework 3 Risk Categories 5 Financial Risk Management 14 Conclusion 16 Part 2. Accounting, Cash Flow, and Budget Exposures 17 Chapter 2. Risks from Financial Accounting 19 Overview of Accounting 19 Accounting Principles 19 Categories of Accounts 21 Trial Balance 24 Financial Statements 25 Conclusion 28 Chapter 2 Appendixes 28 Chapter 3. Managing Operating Cash Flows 33 The Cash Flow Statement 33 Cash Flow Exposures 37 Conclusion 40 Chapter 3 Appendixes 40 Chapter 4. Operating Budgets 53 Nature of Budgeting 53 Forecasting Revenues 54 Life-Cycle Stages in Budgeting 57 Risks in Revenue Forecasting 60 Expense Allocations 63 Accounting Budgets 66 Cash Budgeting 67 Details of Budgeting 70 Conclusion 72 Chapter 4 Appendixes 73 vii American Management Association www.amanet.org viii Contents Part 3. Analyzing Operating Risks 85 Chapter 5. Profit Planning 87 Planning 87 Breakeven Analysis 89 Profit-Volume Analysis 92 Marginal Analysis 93 Future Earnings per Share 95 Conclusion 99 Chapter 5 Appendixes 99 Chapter 6. Leverage 111 Return on Investment Leverage 111 Operating Leverage 116 Financial Leverage 118 Weaknesses of Profit Planning 121 Conclusion 121 Chapter 6 Appendixes 122 Chapter 7. Financial Analysis 129 Ratio Analysis 129 Liquidity Ratios 132 Profitability Ratios 136 Other Ratios 138 Determining Financial Norms 142 Conclusion 142 Chapter 7 Appendixes 143 Part 4. Relationship of Risk and Return 149 Chapter 8. Time Value of Money 151 Short-Term Financing 151 Intermediate-Term Financing 155 The Amortization Schedule 157 Conclusion 161 Chapter 8 Appendixes 162 Chapter 9. Risk and Required Return 171 Nature of Risk 171 Capital Asset Theory 178 Risk and Required Return 181 Financial and Operational Risks 183 Conclusion 186 Chapter 9 Appendixes 186 Part 5. Nature of a Capital Investment Decision 193 Chapter 10. Capital Budgeting Cash Flows 195 Foundation of Capital Budgeting 196 Cash Flows 201 Conclusion 207 Chapter 10 Appendix 208 American Management Association www.amanet.org Contents ix Chapter 11. Capital Budgeting Returns 211 Payback Method 211 Present Value Techniques 212 Internal Rate of Return Method 213 Net Present Value (NPV) Method 215 Midyear Discount Factors for Cash Flows 217 Conclusion 221 Chapter 11 Appendixes 221 Part 6. Factors That Affect the Value of a Firm 233 Chapter 12. Valuation of Common Stock 235 Common Stock and Equity Markets 235 Valuation Concepts 237 Value of Common Stock 240 Comparative Approaches to Valuation 244 Conclusion 245 Chapter 12 Appendixes 245 Chapter 13. Capital Structure of the Firm 253 Capital Structure 253 Weighted Average Cost of Capital (WACC) 254 Required Return at the Margin 257 Contribution of Miller and Modigliani 260 Optimal Capital Structure 263 Conclusion 266 Chapter 13 Appendixes 266 Chapter 14. Valuation of Business Combinations 271 Business Combinations 271 Pyramiding 273 Takeover Strategies 276 Conclusion 280 Chapter 14 Appendixes 280 Index 293 American Management Association www.amanet.org