1). Governance Environment

 

Corporate Governance is a group of rules and
practices which companies is directed and controlled. One of the main reasons
for Corporate Governance is for accountability and to ensure long term success.
The board of directors who represent the interests of the company shareholders
are responsible for the governance within the company. Textron adopted its Governance
Guidelines and Policies in 1996. Textron follows many corporate governance
practices such as director independence. When it comes to director independence,
10 of Textron’s directors are independent with the CEO being their only
management director. Textron’s three principal Board committees are each
composed entirely of independent directors (Governance). The names of the
Textron Board committees are Audit Committee, Nominating and Corporate
Governance Committee and Organization and Compensation Committee (Proxy, 16). The
Nominating and Corporate Governance Committee has responsibility for corporate
governance matters. They also have the independent directors meet without
management present on many occasions throughout the year.

Independent directors annually designate a
director from among the Committee chairs to serve as Lead Director (Proxy, 16).
Textron also implemented some internal controls because the Lead Director is
assigned clearly defined and expansive duties. The Lead Director, among other
functions, presides at all meetings of the Board at which the Chairman is not
present and all meeting between the independent Directors. The Lead Director
also serves as liaison between the CEO and independent Directors. All directors
must stand for election annually (Proxy,16). The non-employee directors conduct
an annual performance evaluation of the CEO. The Board and the committees
perform annual self-evaluations and may not stand for reelection after their
75th birthday (Proxy, 16).

Textron also has a group of external auditors
from Ernst and Young, LLP that review and confirm financial statements to make
sure there aren’t mistakes or misrepresentation in the Annual Reports as well
as the reports for the SEC.

           

 

2). Agency Conflicts

 

Agency Conflicts are when interests of agents
and principals do not align with each other. The agent is a person who has the
implied or actual authority to act on the behalf of the other. The owners whom
the agents represent are the principles. There are many consequences of agency
conflicts, a company’s reputation will diminish and the cost of capital will be
higher. All these consequences make it hard for a company to do business.

Textron has strict guidelines when it comes to agency
conflicts and ethics. The Board expects its Directors and other employees to
act ethically at all times and to adhere to the Textron Business Conduct
Guidelines (Governance, 4). Directors are expected to avoid any action,
position or interest that conflicts with an interest of Textron or that gives
the appearance of a conflict. If any actual or potential conflict of interest
arises for a director, the director must inform the Chairman, the CEO and the
chair of the Nominating and Corporate Governance Committee (Governance, 4). If
a significant conflict exists and cannot be resolved, the director should
resign. Directors will recuse themselves from discussions or decisions
affecting their personal, business or professional interests. Potential agency
conflicts would be a senior manager approves a certain project that goes
against the opinions or interests of the Board of Directors. Another example, similar
to the Microstrategy case would be a manager altering financials to make the
company value look higher than it should. Though audits and internal controls,
agency conflicts can be avoided.

Textron makes sure that the Nominating and
Corporate Governance Committee as well as the audit committee are working to
make sure that any director within the company remains independent to any
company or affiliates that Textron conducts business with (Governance,
16).  Textron has Director Independent
Standards that each director must adhere to or subject for review due to lack
of independence (Governance, 16).

 

3.) Auditors

 

            Having both internal and
independent auditors are very crucial to companies and their financial success.
It is very important if you are a publicly owned company. The SEC requires all
public corporations to file financial statements and make them available to the
public. The 10-K reports contain audited financial statements submitted
annually to the SEC for the distribution to the public. The 10-Q reports
contain unaudited financial statements submitted quarterly, also for public
distribution. Companies hire independent auditors for their financial
statements and their internal control of independent internal verification.
Companies have to make sure their financial statements are reported correctly
because it can drastically affect their value to investors and their reputation
throughout the world. External auditors have to assess a company’s financial
statements and publicly agree that the financial information is correct and
reliable. External auditors help prevent companies into going to litigation or
having internal company problems. It also causes employees for work on the
financial information to be more diligent because they will be held accountable
for potential mistakes that were seen by external auditors.

            Textron
has an internal committee that works with the company independent auditors.
After the independent auditors have reviewed the financial statements, they
meet with the committee with and without management to discuss the results,
their evaluations of the company internal controls and overall financial
reporting (Proxy, 18). Textron chose Ernst & Young, LLP to be the company’s
independent auditor for 2017. Textron has many guidelines and by-laws to make
sure that any independent auditor remains independent. Even though there aren’t
any independence issues occurring with Textron, an example of an independence
issue would be someone who is at Ernst & Young that has a major financial
interest in Textron. Another example would be someone at Ernst & Young is
related in some capacity to someone who is on the Board or a committee of
Textron.

           

4.) Internal Controls

 

            Internal
Controls are the processes that a company uses to make sure that are compliant
with laws and regulations. By using internal controls, a company can become more
efficient and efficient as the controls are designed to streamline the process
for corporate governance and mitigation of agency conflicts. There are six
principles of control activities. The principles are establishment of
responsibility, segregation of duties, documentation procedures, physical,
mechanical, and electronic controls, independent internal verification and
human resource controls. With establishment of responsibility, control is most
effective when one person is responsible for a given task. Different
individuals should be responsible for related activities; best practice is to
always have segregation of duties. Companies should always have documentation
procedures because documents provide evidence that transactions and events have
occurred. With having important documents, you should have some sort of physical,
mechanical and electronic control to help safeguard assets and enhance the
accuracy and reliability of the accounting records. Companies also should have
independent personnel that are responsible for verifying the information.
Companies should bond employees who handle cash, rotate employees’ duties and
require employees to take vacations; conduct through background checks.

                Textron’s management is responsible
for establishing and maintaining adequate internal control (10-K). Their
internal control structure is designed to provide reasonable assurance that
assets are safeguarded and that transactions are properly executed and
recorded. Textron’s management performs an evaluation of their internal controls
annually (10-K).  Back in 2007, the SEC
had filed Foreign Corrupt Practice and Internal Control charges against Textron
(SEC). One of their subsidiaries was receiving kickback payments in connection
with its sale of humanitarian goods to under the U.N. (SEC). They had to
forfeit over $2.7 million dollars as well as pay about $2 million dollars in
fines (SEC). This is a great example of what happens when internal controls and
external auditing is not used or not used effectively.

 

 

5.) Industry

 

                Textron conducts business in many different
industries but their biggest industry is the global commercial aircraft manufacturing industry (Longo). This
industry produces complete civilian aircrafts, including aerospace engines,
equipment and parts. Textron also works with aerospace products, aircraft
conversions and complete aircraft or propulsion systems as well. (Longo)

The industry has grown over the last five years. Increased air travel in
emerging markets, combined with the need to replace aging aircraft has
significantly increased demand for industry products over the past five years
(Longo). The industry was able to expand and the industry revenue increased at
an annualized rate of 3.8% to $369.7 billion (Longo). The next five years are
projected to have growth as well. The industry revenue is forecasted to grow at
a more moderate annualized rate of 2.4% to $416.2 billion (Longo).

Emerging markets and aircraft replacements drove the industry’s strong
performance over the past five years. Rapid growth in emerging markets gave
more consumers the means to take vacations and travel by air (Longo). As the
global economy grows, the need for travel becomes more important which is great
for the industry. Even though most of the industry is in Europe and North
America, some of the fastest-growing sources of industry demand are in those emerging
markets (Longo). Airlines have also purchased more aircrafts to improve
operational efficiencies. With companies like Textron who have been investing
in more fuel efficient aircrafts, major commercial airlines have been high
demand for those kinds of aircrafts. This is due to the world price of crude
oil being extremely volatile (Longo). Another big risk to the industry besides
the price of oil is the disposable income of consumers based on the economy.  The consumer can be a business or a person who
wants to go on vacation but if they don’t have the income, it will be hard to
travel. When disposable income increases, consumers are more likely to spend money
on tourism and travel (Longo).

 

 

6.) Beta

 

            Beta is
the measure of nondiversifiable risk. Nondiversifiable risk is the portion of a
portfolio’s total risk that cannot be eliminated by diversifying. Factors
shared to a greater or lesser degree by most assets in the market, such as
inflation and interest rate risk, cause nondiversifiable risk. The stock market
has a beta of 1, Betas higher than 1 indicate more nondiversifiable risk than
the market. Betas lower than 1 indicates less risk than the market. Risk-free
portfolios have betas of 0. Companies in low-risk, stable industries like
public utilities will typically have low beta values because returns of their
stock tend to be relatively stable. Companies who deal with more volatile
products or services will tend to have higher beta values.

            I
calculated Textron’s beta based on monthly returns to 0.18. What I did was go
to Yahoo Finance and got the monthly ending prices for the last year for both
Textron and the S&P 500. After receiving those prices, I calculated the
monthly returns for both. Then I divided the monthly asset returns of Textron
by the monthly returns of the S&P 500 and got 0.177359 which by rounding up
gives you a beta of 0.18. I have the spreadsheet that in the appendix. Based on
this data, there is minimal market risk for investing Textron. This shows that
investing Textron would be a safe decision.

 

 

7.) CAPM

 

            The capital asset pricing model (CAPM)
is a financial model that can be used to calculate the appropriate required
payment of return of an investment project, given its degree of risk as
measured by beta. There are three components of the CAPM, the risk-free rate of
return, the market risk premium and the project’s beta. The beta in the CAPM
reflects only the nondiversifiable risk of an asset, not its diversifiable
risk. Diversifiable risk is irrelevant because the diversity of each investor’s
portfolio essentially eliminates that risk. The return in a particular security
that is measured by the CAPM and beta relates to the degree of nondiversifiable
risk in the security.

            The
calculation for the CAPM is the risk-free rate of return plus the difference
between the expected market rate of return and the risk free rate of return
times the beta.  We have the beta of 0.18.
Since the beta was based on monthly returns for one year, I chose the risk-free
rate based on a one year Treasury constant maturity series of 1.65%. Based on
CNNMoney, the market rate of return for the S&P 500 Index is 18.43%. That
means the calculated for the CAPM will be: Cost of Capital/Equity = 1.65% +
(18.43% – 1.65%) * .18. That equation gives us the required rate of return of
equity of 4.5%.

 

 

8.) Capital
Budgeting

 

            Net present value of a capital budgeting
initiative is the dollar amount of the change in the value of the firm as a
result of undertaking the initiative. If an initiative has a NPV of zero, it
means that the company wouldn’t lose money if the new initiative is started. A
positive NPV means that the company could gain money if the initiative is
started. A negative NPV means the firm’s value will lose money the new initiative
is started. The internal rate of return is the estimated rate of return for a
potential initiative based on the initiative’s incremental cash flows. The
internal rate of return is similar to net present value as it considers all
cash flows for an initiative and adjusts for the time value of money but it is
expressed as a percentage compared to NPV which is a monetary figure.

            Shown in
the excel spreadsheet in the appendix, I created a scenario where Textron would
invest in a 6-year initiative. Projected cash flows for the next years would be
$10,000, $12,000, $14,000, $16,000, $18,000 and $20,000. The company cost of
capital would be estimated at 6.75%. After calculating the NPV, the present
value would be $70,227. I also calculated the internal rate of return based on
the projected cash flows and periods which ended up being a return -0.10%.
Since the internal rate of return is significantly less than the cost of
capital is equal, the initiative would lose the company money and should not be
started.

 

9.) Peer

 

            A
company that is very similar to Textron is Bombardier, Inc. Bombardier is also
in the aircraft industry. While Textron is headquartered in Providence, Rhode
Island, Bombardier is headquartered in Montreal, Canada. I am not currently
aware of any major issues facing the company right now. Like Textron,
Bombardier has potential to grow with the globalization and the constant need
for travel.

 

 

10.) Financial
Statements

 

            The
balance sheet is the financial statement that shows a company’s assets,
liabilities and equity at a given point in time. The balance sheet gives
investors information on liquidity and solvency. It also shows equity of a
company compared to the company debt. On the balance sheet, the company’s
assets are listed in order of their liquidity. The company’s liabilities are
listed by what is due earliest. When it comes to the equity section, it
contains the common stock, capital in excess of par and retained earnings.
Another important part of the balance sheet is that Assets equal the
liabilities and stockholders’ equity. The income statement is a financial
statement that presents the revenues, expenses and income of a business over a specific
time period. Revenues represent gross income of the company during the period
of time. Expenses represent the cost of providing goods and services during a
given period of time. Net income is the remainder after expenses have been
subtracted from the revenues. The statement of cash flows is the financial statement
that shows how cash is flowing in and out of the company over a given period of
time. The statement of cash flows shows cash flows in a company’s operating,
investing and financing activities. It also shows the overall net increase or
decrease within the company.

            Accountants
and investors look at these financial statements to learn about a certain
company and how they operate. There are many times that companies might look
great but when you look at their financial statements, a company can be losing
money at a rapid rate. Investors look at these statements because it shows the
potential value in a company. If it looks like the company has growing value
then investors will be willing to invest in the company. Financial statements
also reflect the reputation of the company and how they conduct business. It
helps measure profitability, liquidity, debt and asset activity as well.

 

 

 

12.) Financial
Analysis – Liquidity and Solvency Risk

 

            Liquidity means how quickly you
can turn assets into cash. Solvency is the ability to fulfill debt obligations.
You want to perform a liquidity analysis because you want to measure the
ability of a firm to meet its short-term obligation. If a company can’t pay off
debts, it can lead to major problems for the company such as bankruptcy.
Solvency analysis helps you determine whether the company can meet its
long-term obligations.

When it comes to liquidity
analysis, you can use financial ratios such as a company’s current ratio or the
quick ratio. The current ratio is current assets over current liabilities. For Textron,
the current ratio is $7,053/$3,893 which equals 1.81. That means that Textron
has $1.81 of current assets for every dollar of current liabilities. The quick
ratio is the current asset minus inventory over current liabilities. The quick
ratio is ($7,053 – $4,464)/$3893, which ends up being .66. When measuring
solvency, financial ratio is use is debt to total assets or debt to equity
ratio. Debt to total assets is total liabilities over total assets: $9,784/$15,358
= 63%. The debt to equity is: total debt/shareholder’s equity which equals
1.76.

 

 

13.) Financial
Analysis – Profitability

 

            Profitability is the ability to
generate profit and earning persistence is the ability to have income year to
year. Profitability is important when it comes to a company’s evaluation. When
thinking about investing, you do not have a company that isn’t capable of generating
profit. If the company is in the introductory state of the life state of the
cycle, the company might not always be profitable at the time but you can
project their future profitability. Companies that are in later stages in the
life cycle and are not generating profits are losing money and failing as a
company. That is something that investors do not want to spend their time on so
they calculated profitability ratios to help with their analysis. Profitability
ratios measure how much company revenue is eaten up by expenses, how much a
company earns relative to sales generated, and the amount earned relative to
the value of the firm’s assets and equity. Stockholders have a special interest
in the profitability ratios because profit ultimately leads to cash flow, a
primary source of value for a firm. There are five profitability ratios that
help determine a company’s ability to generate profit: gross profit margin,
operating profit margin, net profit margin, return on assets and return on
equity. The following are calculations for Textron and their profitability. The
gross profit margin is gross profit/sales: $2,477/$13,788 which equals 18%. The
operating profit margin is the EBIT/sales: $1050/$13,788 which is 7.6%. The net
profit margin is net income/sales which is 7%. Return of assets is net
income/total assets which is 6.2% and the return of equity is 17%. The
calculation for return of equity is net income/stockholders’ equity.

            Earnings
persistence is important as well for evaluating a company. Price to earnings
ratio is a good ratio is to use for earnings persistence. It helps measures the
market’s perception of the future earning power of a company, reflected in the
stock share price. The P/E ratio is market price per share/earning per share.
The equation is $54.57/$3.55 which is 15. This means that $54.57 is 15 times
the level of its 2016 earnings per share and it will take 15 years to accumulate
net profits of $54.57 per share. That is the amount an investor would pay today
to buy this stock.