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Financial management principles and applications 10th

  1. 1. PE~RSONLow PRICE EDITION ~ Education
  2. 2. BR tE,F~e.O,N TEN TS Preface xvii P.ART 1: THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT CHAPTER 1 An Introduction to Financial Management 3 CH~PTER 2 Und,brstanding Financial Statements, Taxes, and Cash Flows 31 CHAPTER 3I-- Evaluating a Firms Financial Performance 71 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107 PART 2: VALUATION OF FINANCIAL ASSETS CHAPTER 5 The Value of Money 137 CHAPTER 6 Risk and Rates of Return 181 CHAPTER 7 Valuation and Characteristics of Bonds 22 3 CHAPTER 8 Stock Valuation 255 PART 3: INVESTMENT IN LONG-TERM ASSETS CHAPTER 9 Capital Budgeting Decision Criteria 289 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 CHAPTER 11 Capital Budgeting and Risk Analysis 371 CHAPTER 12 Cost of Capital 405 CHAPTER 13 Managing for Shareholder Value 435 vii
  3. 3. viii BRIEF CONTENTS , PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER 14 Raising Capital in the Financial Markets 469 CHAPTER 15 Analysis and Impact of Leverage 505 CHAPTER 16 Planning the Firms Financing Mix 551 CHAPTER 17 Dividend Policy and Internal Financing 605 PART 5: WORKING-CAPITAL MANAGEMENT AND SPECIAL TOPICS IN FINANCE CHAPTER 18 Working-Capital Management and Short-Term Financing 645 CHAPTER 19 Cash and Marketable Securities Management 673 CHAPTER 20 Accounts Receivable and Inventory Management 705 PART 6: SPECIAL TOPICS IN FINANCE CHAPTER 21 Risk Management 739 CHAPTER 22 International Business Finance 773 CHAPTER 23 Corporate Restructuring: Combinations and Divestitures* 23-1 CHAPTER 24 Term Loans and Leases* 24-1 Appendixes A-I Glossary G-l Indexes I-I *Chapters 23 and 24 can be found at www.prenhall.comlkeown
  4. 4. CONTENT:S Preface XVii PART 1: THE SCOPE AND ENVIRONMENT . - ­ OFFINANCIAL MANAGEMENT - -- - -- CHAPTER 1 An Introduction to Financial Management 3 What Is Finance? 4 Goal of the Firm 4 Legal Forms of Business Organization 7 Ten Principles That Form the Basics of Financial Management 12 PRINCIPLE 1: The Risk-Return Trade-Off-We wont take on additional risk unless we expect to be compensated with additional return 13 PRINCIPLE 2: The Time Value of Money-A dollar received today is worth more than a dollar received in the future 14 PRINCIPLE 3: Cash-Not Profits-Is King 14 PRINCIPLE 4: Incremental Cash Flows-Its only what changes that counts 15 ----- PRINCIPLE 5: The Curse of Competitive Markets-Why its hard to find exceptionally profitable projects 15 PRINCIPLE 6: Efficient Capital Markets-The markets are quick and the prices are right 16 PRINCIPLE 7: The Agency Problems-Managers wont work for owners unless its in their best interest 17 PRiNCIPLE 8: Taxes Bias Business Decisions 18 PRINCIPLE 9: All Risk Is Not Equal-Some risk can be diversified away, and some cannot 18 PRINCIPLE 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance 20 Overview of the Text 22 Finance and the Multinational Firm: The New Role 24 How Financial Managers Use This Material 25 Summary 25--/ CHAPTER 2 Understanding Financial Statements, Taxes, and Cash Flows 31 The Income Statement: Measuring a Companys Profits 32 The Balance Sheet: Measuring a Firms Book Value 34 Computing a Companys Taxes 41 Measuring Free Cash Flows 44 Financial Statements and International Finance 49 How Financial Managers Use This Material 50 Summary 50 Appendix 2A: Measuring Cash Flows: An Accounting Perspective 66 ix
  5. 5. x CONTENTS JCHAPTER 3 Evaluating a Firms Financial Performance 71 Financial Ratio Analysis 72 The DuPont Analysis: An Integrative Approach to Ratio Analysis 85 How Financial Managers Use This Material 89 Summary 89 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107 Financial Forecasting 108 Limitations of the Percent of Sales Forecast Method 113 The Sustainable Rate of Growth 115 Financial Planning and Budgeting 117 How Financial Managers Use This Material 120 Summary 120 PART 2: VALUATION OF FINANCIAL ASSETS .,j CHAPTER 5 The Time Value of Money 137 Compound Interest and Future Value 138 Compound Interest with Nonannual Periods 146 Present Value 147 Annuities-A Level Stream 150 Annuities Due 157 Present Value of Complex Stream 160 Perpetuities and Infinite Annuities 163 Making Interest Rates Comparable 163 The Multinational Firm: The Time Value of Money 164 How Financial Managers Use This Material 165 Summary 165 ,/ CHAPTER 6 Risk and Rates of Return 181 Rates of Return in the Financial Markets 182 The Effects of Inflation on Rates of Return and the Fisher Effect 184 The Term Structure of Interest Rates 185 Expected Return 187 Risk 188 Risk and Diversification 192 Measuring Market Risk 196 Measuring a Portfolios Beta 201 The Investors Required Rate of Return 203 How Financial Managers Use This Material 207 Summary 208
  6. 6. CONTENTS xi j CHAPTER 7 Valuation and Characteristics of Bonds 223 Types of Bonds 224 Terminology and Characteristics of Bonds 22 7 Definitions of Value 231 Determinants of Value 232 Valuation: The Basic Process 234 Bond Valuation 235 The Bondholders Expected Rate of Return (Yield to Maturity) 238 Bond Valuation: Five Important Relationships 240 How Financial Managers Use This Material 246 Summary 246 / CHAPTER 8 Stock Valuation 255 Features and Types of Preferred Stock 256 Valuing Preferred Stock 259 Characteristics of Common Stock 261 Valuing Common Stock 267 Stockholders Expected Rate of Return 272 How Financial Managers Use This Material 275 Summary 275 Appendix 8A: The Relationship between Value and Earnings 283 PAR T 3: I N VE S T MEN TIN LON G - T E R MAS SET S CHAPTER 9 Capital-Budgeting Decision Criteria 289 Finding Profitable Projects 290 Payback Period 292 Net Present Value 295 Profitability Index (Benefit/Cost Ratio) 298 Internal Rate of Return 299 Ethics in Capital Budgeting 312 A Glance at Actual Capital-Budgeting Practices 313 How Financial Managers Use This Material 314 Summary 315 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 Guidelines for Capital Budgeting 328 An Overview of the Calculations of a Projects Free Cash Flows 332 Complications in Capital Budgeting: Capital Rationing and Mutually Exclusive Projects 344I~
  7. 7. xii CONTENTS The Multinational Firm: International Complications in Calculating Expected Free Cash Flows 353 How Financial Managers Use This Material 353 Summary 354 CHAPTER 11 Capital Budgeting and Risk Analysis 371 Risk and the Investment Decision 372 Methods for Incorporating Riskinto Capital Budgeting 376 Other Approaches to Evaluating Risk in Capital Budgeting 383 The Multinational Firm: Capital Budgeting and Risk 389 How Financial Managers Use This Material 390 Summary 390 CHAPTER 12 Cost of Capital 405 The Cost of Capital: Key Definitions and Concepts 406 Determining Individual Costs of Capital 407 The Weighted Average Cost of Capital 414 Cost of Capital in Practice: Briggs & Stratton 417 Calculating Divisional Costs of Capital: PepsiCo, Inc. 419 Using a Firms Cost of Capital to Evaluate New Capital Investments 420 How Financial Managers Use This Material 424 Summary 424 CHAPTER 13 Managing for Shareholder Value 435 Who Are the Top Creators of Shareholder Value? 437 Business Valuation-The Key to Creating Shareholder Value 438 Value Drivers 443 Economic Value Added (EVA)® 445 Paying for Performance 448 How Financial Managers Use This Material 456 Summary 457 PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER 14 Raising Capital in the Financial Markets 469 The Financial Manager, Internal and External Funds, and Flexibility 472 The Mix of Corporate Securities Sold in the Capital Market 474 Why Financial Markets Exist 475 Financing of Business: The Movement of Funds Through the Economy 478 Components of the U.S. Financial Market System 481 The Investment Banker 489 More on Private Placements: The Debt Side 493
  8. 8. CONTENTS xiiiFlotation Costs 494Regulation 495The Multinational Firm: Efficient Financial Markets and Intercountry Risk 499How Financial Managers Use This Material 500?ummary 501CHAPTER 15Analysis and Impact of Leverage 505Business and Financial Risk 506Break-Even Analysis 509Operating Leverage 519Financial Leverage 524Combination of Operating and Financial Leverage 527The Multinational Firm: Business Risk and Global Sales 531How Financial Managers Use This Material 532Summary 533CHAPTER 16Planning the Firms Financing Mix 551Key Terms and Getting Started 552A Glance at Capital Structure Theory 553Basic Tools of Capital Structure Management 568The Multinational Firm: Beware of Currency Risk 580How Financial Managers Use This Material 581Summary 587CHAPTER 17Dividend Policy and Internal Financing 605Dividend Payment Versus Profit Retention 607Does Dividend Policy Affect Stock Price? 608The Dividend Decision in Practice 621Dividend Payment Procedures 625Stock Dividends and Stock Splits 625Stock Repurchases 628The Multinational Firm: The Case of Low Dividend Payments-So Where Do WeInvest? 631How Financial Managers Use This Material 633Summary 633 PART 5: WORKING-CAPITAL MANAGEMENT AND S P E C I A L TOP I C SIN FIN A N C.ECHAPTER 18Working-Capital Management and Short-Term Financing 645Managing Current Assets and Liabilities 646Financing Working Capital with Current Liabilities 647 j
  9. 9. xiv CONTENTS Appropriate Level of Working Capital 648 Hedging Principles 648 Cash Conversion Cycle 651 Estimation of the Cost of Short-Term Credit 653 Sources of Short-Term Credit 654 Multinational Working-Capital Management 661 How Finance Managers Use This Material 662 Summary 662 CHAPTER 19 Cash and Marketable Securities Management 673 What are Liquid Assets? 674 Why a Company Holds Cash 674 Cash-Management Objectives and Decisions 676 Collection and Disbursement Procedures 678 Composition of Marketable Securities Portfolio 684 The Multinational Firm: The Use of Cash and Marketable Securities 691 How Financial Managers Use This Material 691 Summary 691 CHAPTER 20 Accounts Receivable and Inventory Management 705 Accounts Receivable Management 706 Inventory Management 716 TQM and Inventory-Purchasing Management: The New Supplier Relationships 724 How Financial Managers Use This Material 727 Summary 728 ". ./ CHAPTER 21 Risk Management 739 Futures 740 Options 746 Currency Swaps 757 The Multinational Firm and Risk Management 758 How Financial Managers Use This Material 759 Summary 759 CHAPTER 22 International Business Finance 773 The Globalization of Product and Financial Markets 774 Exchange Rates 775 Interest-Rate Parity Theory 785 Purchasing-Power Parity 785 Exposure to Exchange Rate Risk 787 Multinational Working-Capital Management 791
  10. 10. CONTENTS xvInternational Financing and Capital-Structure Decisions 793Direct Foreign Investment 794How Financial Managers Use This Material 796Swnmary 796.1~ CHAPTER 23~ Corporate Restructuring: Combinations and Divestitures 23-1Why Mergers Might Create Wealth 23-3Determination of a Firms Value 23-6Divestitures 23-14How Financial Managers Use This Material 23-17Summary 23-19 ~ CHAPTER 24 - , Term Loans and Leases 24-1Term Loans 24-3Loan Payment Calculation 24-5Leases 24-7The Economics of Leasing Versus Purchasing 24-16How Financial Managers Use This Material 24-20Summary 24-20Appendixes A-IGlossary G-lIndexes I-I*Chapters 23 and 24 can be found at www.prenhall.comlkeown
  12. 12. CHAPTER 1 An Introd uction to Financial ManagementIn 1985, Harley-Davidson teetered only hours away from bank­ a successful stock offering, and Spring 2003, Harleys stockruptcy as one of Harleys largest lenders, Citicorp Industrial price rose approximately 125-fold. How did Harley-Davidson, aCredit, was considering bailing out on its loan. Since its begin­ company whose name grown men and women have tattooedning in 1903, the company survived two world wars, the Great on their arms and elsewhere, a company that conjures upDepression, and competition from countless competitors, but images of burly bad boys and Easy Rider hippies in black leatherby the early 1980s, Harley had become known for questionable jackets riding down the road, pull off one of the biggest busi­reliability and leaving oil stains on peoples driveways. It looked ness turnarounds of all time? Harley made good decisions.for a while like the future was set, and Harley wouldnt be Thats what were going to look at in this book. Well look atthere. It looked like the future of motorcycles in America would what it takes to turn Harley or any other company around.feature only Japanese names like Honda, Yamaha, Kawasaki, Well look at how a company goes about making decisions toand Suzuki. But none of that happened, and today Harley­ introduce new product lines. For example, in 2003, Harley­Davidson stands, as President Reagan once proclaimed, as "an Davidson introduced the Buell Lightning Low XB95, a low-cost,American success story." For a company in todays world, sur­ lightweight bike with a lower seat height aimed at bringingviving one scare is not enough-Today the business world shorter riders into the sport. How did it make this decision?involves a continuous series of challenges. As for Harley, it was Well also follow Harley-Davidson throughout this book, exam­a major accomplishment to make it through the 1980s, allow­ ining how its experience fits in with the topics we are examin­ing it to face another challenge in the 1990s: a market that ing. In doing so, we will see that there are countless interac­looked like it might disappear within a few years. How did tions among finance, marketing, management, and accounting.Harley do against what looked like a shrinking market? It Because finance deals with decision making, it takes on impor­increased its motorcycle shipments from just over 60,000 in tance, regardless of your major. Moreover, the tools, techniques,1990 to over 260,000 in 2002 with expected sales in 2003 of and understanding you will gain from finance will not only helparound 290,000! How have the shareholders done? Between you in your business career, but will also help you make edu­1986, when Harley-Davidson returned to public ownership with cated personal investment decisionsin the future. ~ CHAPTER PREVIEW ~ In this chapter, we will lay a foundation for the entire decisions. Then, we will describe the golden thread book. We will explain what finance is, and then we that ties everything together: the 10 basic principles will explain the key goal that guides financial deci­ of finance. Finally, we will look at the importance of sion making: maximization of shareholder wealth. looking beyond our geographic boundaries. We will examine the legal environment of financial 3
  13. 13. 4 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Objective ~ WHAT IS FINANCE? Financial management is concerned with the maintenance and creation of economic value or wealth. Consequently, this course focuses on decision making with an eye toward creating wealth. As such, we will deal with financial decisions such as when to introduce a new product, when to invest in new assets, when to replace existing assets, when to bor­ row from banks, when to issue stocks or bonds, when to extend credit to a customer, and how much cash to maintain. To illustrate, consider two firms, Merck and General Motors (GM). At the end of 2003, the total market value of Merck, a large pharmaceutical company, was $103 billion. Over the life of the business, Mercks investors had invested about $30 billion in the busi­ ness. In other words, management created $73 billion in additional wealth for the share­ holders. GM, on the other hand, was valued at $30 billion at the end of 2003; but over the years, GMs investors had actually invested $85 billion-a loss in value of $55 billion. Therefore, Merck created wealth for its shareholders, while GM lost shareholder wealth. In introducing decision-making techniques,we will emphasize the logic behind those techniques, thereby ensuring that we do not lose sight of the concepts when dealing with the calculations. To the first-time student of finance, this may sound a bit overwhelming. However, as we will see, the techniques and tools introduced in this text are all motivated by 10 underlying principles or axioms that will guide us through the decision-making process. Objective ~ GOAL OF THE FIRM We believe that the preferable goal of the firm should be maximization of shareholder wealth, by which we mean maximization of the price of the existing common stock. Not only will this goal be in the best interest of the shareholders, but it will also provide the most benefits to society. This will come about as scarce resources are directed to their most productive use by businesses competing to create wealth. To better understand this goal, we will first discuss profit maximization as a possible goal for the firm. Then we will compare it to maximization of shareholder wealth to see why, in financial management, the latter is the more appropriate goal for the firm. PROFIT MAXIMIZATION In microeconomics courses, profit maximization is frequently given as the goal of the firm. Profit maximization stresses the efficient use of capital resources, but it is not spe­ cific with respect to the time frame over which profits are to be measured. Do we maxi­ mize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating research and devel­ opment expenditures and cutting down on routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base financial decisions ona goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the.real world. In microeconomics, profit maximization functions largely as a theoretical goal, with economists using it to prove how firms behave rationally to increase profit. Unfortunately, it ignores many real-world complexities that financial managers must address in their deci­ sions. In the more applied discipline of financial management, firms must deal every day with two major factors not considered by the goal of profit maximization: uncertainty and timing. Microeconomics courses ignore uncertainty and risk to present theory more easily. Projects and investment alternatives are compared by examining their expected values or
  14. 14. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 5 weighted average profits. Whether one project is riskier than another does not enter into these calculations; economists do discuss risk, but only tangentially.! In reality, projects differ a great deal with respect to risk characteristics, and to disregard these differences in the practice of financial management can result in incorrect decisions. As we will discover later in this chapter, there is a very definite relationship between risk and expected return-that is, investors demand a higher expected return for taking on added risk-and to ignore this relationship would lead to improper decisions. Another problem with the goal of profit maximization is that it ignores the timing of the projects returns. If this goal is only concerned with this years profits, we know it inappropriately ignores profit in future years. If we interpret it to maximize the average of future profits, it is also incorrect. Inasmuch as investment opportunities are available for money in hand, we are not indifferent to the timing of the returns. Given equivalent cash flows from profits, we want those cash flows sooner rather than later. Thus the real-world factors of uncertainty and timing force us to look beyond a simple goal of profit maxi­ mization as a decision criterion. Finally, and possibly most important, accounting profits fail to recognize one of the most important costs of doing business. When we calculate accounting profits, we con­ sider interest expense as a cost of borrowing money, but we ignore the cost of the funds provided by the firms shareholders (owners). If a company could earn 8 percent on a new investment, that would surely increase the firms profits. However, what if the firms shareholders could earn 12 percent with that same money in another investment of simi­ lar risk? Should the companys managers accept the investment because it will increase the firms profits? Not if they want to act in the best interest of the firms owners (share­ holders). Now look at what happened with Burlington Northern. Burlington Northern is a perfect example of erroneous thinking. In 1980, Richard Bressler was appointed as Chief Executive Officer (CEO) of the company. Bressler, unlike his predecessor, was not a "railroad man." He was an "outsider" who was hired for the express purpose of improving the value of the shareholders stock. The reason for the change was that Burlington Northern had been earning about 4 percent on the share­ holders equity, when Certificates of Deposit (CDs) with no risk were paying 6 percent. Management was certainly increasing the firms profits, but they were destroying share­ holder wealth by investing in railroad lines that were not even earning a rate of return equal to that paid on government securities. We will turn now to an examination of a more robust goal for the firm: maximization of shareholder wealth. -~ MAXIMIZATION OF SHAREHOLDER WEALTH In formulating the goal of maximization of shareholder wealth, we are doing nothing more than modifying the goal of profit maximization to deal with the complexities of the operating environment. We have chosen maximization of shareholder wealth-that is, maximization of the market value of the existing shareholders common stock-because the effects of all financial decisions are thereby included. Investors react to poor invest­ ment or dividend decisions by causing the total value of the firms stock to fall, ano they react to good decisions by pushing up the price of the stock. In effect, under this goal, good decisions are those that create wealth for the shareholder. Obviously, there are some serious practical problems in implementing this goal and in using changes in the firms stock to evaluate financial decisions. We know the price of a firms stock fluctuates, often for no apparent r(ason. However, over the long run, price equals value. We will keep this long-run balancing in mind and focus on the effect that I See, for example, Robert S. Pindyck and Daniel Rubenfield, MiC7OecQlwlIIics, 2d ed. (New York: MacmiUan, !992), 244--46. I: }...J........­
  15. 15. 6 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT FINANCE - ..... . < ~~.. ,.. ~ • , ~ ~.-I": ~ ... ­ -4#. ETHICS ~ ~". k -~ - c- C . S Y "" - ~;r., I - ~ • . .. . _ , THE ENRON LESSONS On December 2, 2001 the Enron Corporation (Houston, everything (more than $48 billion), and there was not nearly . TX) declared bankruptcy. Enrons failure shocked the busi­ the public outcry over this bankruptcy. ness community because of the size and prominence of the finn. Perhaps most telling is the fact that Enron Corp. had Failure of the Public Reporting Process been named the most innovative company in America by What weve learned about the deep seeded problems at F01tune Magazine for six srraight years, with the most recent Enron after the firms failure has led many investors to ques­ award being made in January 2001. The Enron failure dom­ tion the adequateness of public reporting. For example, inated the financial press for months thereafter and also where were the analysts and credit rating agencies, since no resulted in a series of high profile congressional hearings. early warning was sounded? Where were the firms auditors Throughout this book we will be presenting the lessons and why were they not reporting what appear in hindsight to learned from Enron in a series of boxes, but first, here is an be a blatant disregard for standard reporting practice to the assessment of why there was so much public concern over board of directors auditor committee? Speaking of which, the event. where was the firms board of directors and why were they In a capitalistic economy firms are formed by enrre­ not questioning some of Enrons related party rransactions? preneurs-some grow to be large, publicly traded firms It would appear that an important source of the public like Enron, and many of them eventually fail. So why is outcry associated with the failure of Enron comes from the the failure of Enron so important? After all, failure is just fact that this failure provides a clear warning as to just what evidence of the Darwinian survival of the fittest principle can happen. Investor confidence in the system of public at work, right? However, the Enron situation seems to be reporting has been shaken. If the most innovative company different. Lets consider some of the reasons why the in America for six straight years and the darling of Wall Enron case might be special and see if they can explain Srreet can be this close to bankruptcy and no one seems to the public rancor over the firms failure. notice, what about less notable firms? This Was the Largest Bankruptcy Ever" Political Influence, Fraud, and Scandal True, Enrons bankruptcy is the largest such bankruptcy ever Even the National Enquirer devoted its cover story to with a total of $63 billion in equity value vaporized in a Enron. b Add the prospect of criminal wrongdoing by 12-month period. But this loss of shareholder value is far Enrons executives to the fact that Enron was a major con­ from the largest such loss of value ever. Consider the fact tributor to both political parties (although its ties to the that the following list of firms have lost more than twice the Republican party are better known) and you have the stuff of shareholder value that Enron lost: AOL Time Warner, which good soap opera plots are made. Cisco, EMC, Intel, JDS Uniphase, Lucent, Microsoft, Nortel, Sun Microsystems, and Worldcom. In fact, the value "From "More Reasons ro Get Riled Up," Geoffrey Colvin, Fortllne (3/4/02). of Ciscos equity fell a mind boggling $423 billion compared © 2002 Time, Inc. All Rights Reserved. to Enrons meager $63 billion. But since Enron lost every­ bKevin Lynch, Michael Hanrahan, and David Wrighr, "Enron: The Untold thing, thats different, right? Global Crossings also lost Srory," The NlTtirmal Enqllirer (February 26,2002). our decision should have on the stock price if everything else were held constant. The market price Of the firms stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk. As we follow this goal throughout our discussions, we must keep in mind that the shareholders are the legal owners of the firm. See the Finance Matters box, "Ethics: The Enron Lessons." CONCEPT CHECK 1. What are the problems with the goal of profit maximization? ! 2. What is the goal of the firm? I - -
  16. 16. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 7 LEGAL FORMS OF BUSINESS ORGANIZATtON Objective -.!JIn the chapters ahead, we will focus on financial decisions for corporations. Although thecorporation is not the only legal form of business available, it is the most logical choicefor a firm that is large or growing. It is also the dominant business form in terms of salesin this country. In this section, we will explain why this is so. This will in turn allow us tosimplify the remainder of the text, as we will assume that the proper tax code to follow isthe corporate tax code, rather than examine different tax codes for different legal forms ofbusinesses. Keep in mind that our primary purpose is to develop an understanding of thelogic of financial decision making. Taxes will become important only when they affect ourdecisions, and our discussion of the choice of the legal form of the business is directed atunderstanding why we will limit our discussion of taxes to the corporate form. Legal forms of business organization are diverse and numerous. However, there arethree categories: the sole proprietorship, the partnership, and the corporation. Tounderstand the basic differences between each form, we need to define each form andunderstand its advantages and disadvantages. As we will see, as the firm grows, theadvantages of the corporation begin to dominate. As a result, most large firms take onthe corporate form.SOLE PROPRIETORSHIPThe sole proprietorship is a business owned by a single individual. The owner main- Sole proprietorshiptains title to the assets and is personally responsible, generally without limitation, for the t:- business owned by a singleliabilities incurred. The proprietor is entitled to the profits from the business but must indiVIdual.also absorb any losses. This form of business is initiated by the mere act of beginning the (I:---;Tl e +~, 1::"-~:" o D, ;business operations. Typically, no legal requirement must be met in starting the opera- .,c. - ,_ • ­ . ,~,tion, particularly if the proprietor is conducting the business in his or her own name. If a s. -n~ ,_ ~l ""special name is used, an assumed-name certificate should be filed, requiring a small regis- • ,_ - r­tration fee. Termination occurs on the owners death or by the owners choice. Briefly u:, "t.;)]I .Ii J ;"1stated, the sole proprietorship is, for all practical purposes, the absence of any formal!ega!business structure.PARTNERSHIPThe primary difference between a partnership and a sole proprietorship is that the part­ Partnershipnership has more than one owner. A partnership is an association of two or more persons An association of two or morecoming together as co-owners for the purpose of operating a business for profit. individuals joining together as co-owners to operate a businessPartnerships fall into two types: (1) general partnerships and (2) limited partnerships. for profit.GENE RAL PA RTNERSHIP In a general partnership, each partner is fully responsiblefor the liabilities incurred by the parmership. Thus, any parmers faulty conduct evenhaving the appearance of relating to the firms business renders the remaining partnersliable as well. The relationship among parmers is dictated entirely by the partnershipagreement, which may be an oral commitJnent or a formal document.LIMITED PARTNERSHIP AND LIMITED LIABILITY COMPANY Inadditiontothe general partnership, in which all partners are jointly liable without limitation, manystates provide for a limited partnership. The state statutes permit one or more of the part­ners to have limited liability, restricted to the amount of capital invested in the partner­ship. Several conditions must be met to qualify as a limited parmer. First, at least onegeneral partner must remain in the association for whom the privilege of limited liabilitydoes not apply. Second, the names of the limited partners may not appear in the name of j
  17. 17. 8 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT the firm. Third, the limited partners may not participate in the management of the busi­ ness. If one of these restrictions is violated, all partners forfeit their right to limited liabil­ ity. In essence, the intent of the statutes creating the limited partnership is to provide lim­ ited liability for a person whose interest in the partnership is purely as an investor. That individual may not assume a management function within the organization.Limited liability company A limited liability company (LLC) is a cross between a partnership and a corpora­(LLC) tion. It retains limited liability for its owners, but is run and taxed like a partnership. BothAn organizational form that is a states and the IRS have rules for what qualifies as an LLC, but the bottom line is that itcross between a partnershipand a corporation. must not look too much like a corporation or it will be taxed as one. CORPORATIONCorporation The corporation has been a significant factor in the economic development of theAn entity that legally functions United States. As early as 1819, ChiefJustice John Marshall set forth the legal definitionseparate and apart from its of a corporation as "an artificial being, invisible, intangible, and existing only in the con­owners. templation of law."2 This entity legally functions separate and apart from its owners. As such, the corporation can individually sue and be sued, and purchase, sell, or own prop­ erty; and its personnel are subject to criminal punishment for crimes. However, despite this legal separation, the corporation is composed of owners who dictate its direction and policies. The owners elect a board of directors, whose members in turn select individuals to serve as corporate officers, including president, vice president, secretary, and treasurer. Ownership is reflected in common stock certificates, designating the number of shares owned by its holder. The number of shares owned relative to the total number of shares outstanding determines the stockholders proportionate ownership in the business. Because the shares are transferable, ownership in a corporation may be changed by a shareholder simply remitting the shares to a new shareholder. The investors liability is confined to the amount of the investment in the company, thereby preventing creditors from confiscating stockholders personal assets in settlement of unresolved claims. This is an extremely important advantage of a corporation. After all, would you be willing to invest in General Electric if you would be liable in the event that one of their airplane engines malfunctions and people die in a crash? Finally, the life of a corporation is not dependent on the status of the investors. The death or withdrawal of an investor does not affect the continuity of the corporation. The management continues to run the corpora­ tion when stock is sold or when it is passed on through inheritance. See the Finance Matters box, "Ethics: The Enron Lessons." COMPARISON OF ORGANIZATIONAL FORMS Owners of new businesses have some important decisions to make in choosing an organi­ zational form. Whereas each business form seems to have some advantages over the oth­ ers, we will see that, as the firm grows and needs access to the capital markets to raise funds, the advantages of the corporation begin to dominate. Large and growing firms choose the corporate form for one re~son: ease in raising capital. Because of the limited liability, the ease of transferring ownership through the sale of common shares, and the flexibility in dividing the shares, the corporation is the ideal business entity in terms of attracting new capital. In contrast, the unlimited liabili: ties of the sole proprietorship and the general partnership are deterrents to raising equity capital. Between the extremes, the limited partnership does provide limited liability for limited partners, which has a tendency to attract wealthy investors. However, the imprac­ 1 Tbe Trustees ofDmtmrJUtb College v. Woodward, 4 Wheaton 636 (1819).
  18. 18. CHAPTER AN INTRODUCTION TO FINANCIAL MANAGEMENT 9 THE ENRON LESSONS The bankruptcy and failure of the Enron Corporation on lead to a type of managerial short-sightedness or myopia December 2, 2001 shook the investment community to that focuses managerial attention on "hyping" the firms its very core and resulted in congressional hearings that potential to investors in an effort to reach higher market val- could lead to new regulations with far reaching implica- uations of the firms stock. tions. Enrons failure provides a sober warning to From the shareholders perspective one might ask what is employees and investors and a valuable set of lessons for wrong with achieving a higher stock price? The problem is students of business. The lessons we offer below reach far that this can lead to a situation where investor expectations beyond corporate finance and touch on fundamental become detached from what is feasible for the firm. principles that have always been true, but that are some- Ultimately, when investors realize that the valuation of the times forgotten. firms shares is unwarranted, there is a day of reckoning that can bring catastrophic consequences as it did with Enron. Lesson: Maximizing Share Value Is Not Always Thus, maximizing share value where the firms underlying the BeSt Thing to Do fundamentals do not support such valuations is dangerous If there is a disconnect between current market prices and business. In fact, it is not clear which is worse, having an the intrinsic worth of a firm then attempts to manipulate over- or an undervalued stock price. share value may appear to be possible over the short run. The problems associated with ma.naging for shareholder Under these circumstances problems can arise if firms use value in a capital market that is less than omniscient (per- equity-based compensation based on performance bench- fectly efficient) is largely uncharted territOly for financial marks using stock price or returns. These circumstances can economists.ticality of having a large number of partners and the restricted marketability of an inter-est in a partnership prevent this form of organization from competing effectively with thecorporation. Therefore, when developing our decision models, we will assume that weare dealing with the corporate form. The taxes incorporated in these models will dealonly with the corporate tax codes. Because our goal is to develop an understanding of themanagement, measurement, and creation of wealth, and not to become tax experts, in thefollowing chapter we will only focus on those characteristics of the corporate tax codethat will affect our financial decisions.THE ROLE OF THE FINANCIAL MANAGERIN A CORPORATIONAlthough a firm can assume many different organizational structures, Figure 1-1 presentsa typical representation of how the finance area fits into a corporation. The VicePresident for Finance, also called the Chief Financial OffIcer (CFO), serves under thecorporations Chief Executive Officer (CEO) and is responsible for overseeing financialplanning, corporate strategic planning, and controlling the firms cash flow. Typically, aTreasurer and Controller serve under the CFO. In a smaller firm, the same person mayfill both roles, with just one office handling all the du.ties. The Treasurer generally han-dles the firms financial activities, including cash and credit management, making capitalexpenditure decisions, raising funds, financial planning, and managing any foreign cur-rency received by the firm. The Controller is responsible for managing the firmsaccounting duties, including producing financial swtements, cost accounting, payingtaxes, and gathering and monitoring the data necessary to oversee the firms financialwell-being. In this class, we focus on the duties generally associated with the Treasurerand on how investment decisions are made.
  19. 19. 10 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT FIGURE 1-1 How the Finance Area Fits into a Corporation Board of Directors Chief Executive Officer (CEO) ::=J Vice President- Vice President-Finance Vice President- Marketing or Production and Operations ChiefFinanciaI Officer (CFO) Duties: Oversee financial planning Corporate strategic planning Control corporate cash flow Treasurer Controller Duties: Duties: Cash management Taxes Credit management Financial statements Capital expenditures Cost accounting Raising capital Data processing Financial planning Management of foreign currencies CONCEPT CHECK 1. What are the primary differences among a sole proprietorship, a partnership, and a corporation? 2. Explain why large and growing firms tend to choose the corporate I form. 3. What are the duties of the Corporate Treasurer? Of the Corporate Controller? I - - - -"- -" - -- THE CORPORATION AND THE FINANCIAL MARKETS: THE INTERACTION Without question, the ease of raising capital is the major reason for the popularity of the corporate form. While we will look at the process of raising capital in some detail in Chapter 14, lets spend a moment looking at the flow of capital through the financial mar- kets among the corporation, individuals, and the government. Figure 1-2 examines these flows. (1) Initially, the corporation raises funds in the finan- cial markets by selling securities. The corporation receives cash in return for securities- stocks and debt. (2) The corporation then invests this cash in return-generating assets- new projects for example-and (3) the cash flow from those assets is then either reinvested
  20. 20. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 11 FIGURE 1-2 The Corporation and the Financial Markets: The Interaction1. Initially, the corporation raises funds in the financial markets by selling securities-stocks and bonds; 2. Thecorporation then invests this cash in return-generating assets-new project; 3. The cash flow from those assets is eitherreinvested in the corporation, given back to the investors, or paid to the government in the form of taxes. 1. Primary Markets Corporation Cash Investors Secondaty markets o Securities 2. Corporation Cash reinvested invests in the corporation in return- Securities traded generating 3. among investors assets Cash flow from Cash distributed operations back to investors Taxes (rl)vernmentin the corporation; given back to the investors in the form of dividends or interest pay-ments, or used to repurchase stock, which should cause the stock price to rise; or given tothe government in the form of tax payments. One distinction that is important to understand is the difference between primaryand secondary markets. Again, we will reexamine raising capital and the differencebetween primary and secondary markets in some detail in Chapter 14. To begin with, asecurities market is simply a place where you can buy or sell securities. These markets cantake the form of anything from an actual building on Wall Street in New York City to anelectronic hookup among security dealers all over the world. Securities markets aredivided into primary and secondary markets. Lets take a look at what these terms mean. A primary market is a market in which new, as opposed to previously issued, securi- Primary marketties are traded. This is the only time that the issuing firm actually receives money for it~ A market in which new, as opposed to previously issued,stock. For example, if Nike issues a new batch of stock, this issue would be considered a securities are traded.primary market transaction. In this case, Nike would issue new shares of stock and receive Initial public offering (lPO)money from investors. Actually, there are two different types of {)fferings in the primary The first time the companysmarkets: initial public offerings and seasoned new issues or primary offerings. An initial stock is sold to the public.public offering (IPO) is the first time the companys stock is sold to the general public, Seasoned new issuewhereas a seasoned new issue refers to stock offerings by companies that already have Stock offerings by companiescommon stock traded in the secondary market. Once the newly issued stock is in the pub- that already have commonlics hands, it then begins trading in the secondary market. Securities that have previ- stock traded.ously been issued and bought are traded in the secondary market. For example, if you Secondary marketbought 100 shares of stock in an IPO and then wanted to resell them, you would be The market in which stock previously issued by the firmreselling them in the secondary markets. The proceeds from the sale of a share of IBM trades.stock in the secondary market go to the previous owner of the stock, not to IBM. That isbecause the only time IBM ever receives money from the sale of one of its securities is inthe primary markets.
  21. 21. 12 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT AN INTERVIEW WITH JEFF BlEUSTEIN. HARlEY-DAVIDSONS CEO Jeff Bleustein is the Chief Executive Officer at Harley- much-needed capital to support our operations while we Davidson Company, Inc. In our interview with Mr. Bleustein, paid on the firms large amounts of debt. he highlighted a number of milestones that he believes have • In 1983, we established our Harley Owners Group greatly influenced the companys success over the past two (HOG) to encourage our customers to use their bikes decades. Much of what he had to say related directly to the and stay illYolved with the company. At the end of 2000, main topics of this book. Specifically, he talked about the we had nearly 600,000 members. We also began a pro- companys strategies in the areas of investment decisions, gram of carefully managing the licensing of the Harley- working-capital management, financing decisions, marketing Davidson name. strategies, and global expansion. He also emphasized the • In the 1980s, we began a program to empower our importance of the people who implement these decisions. He employees. We needed to let everyone in the organization insists that there is more to business than crunching the num- know what was expected of him or her, which led us to the bers; it is people that make the difference. Mr. Bleusteins development of our corporate vision and statement ofval- remarks can be summarized as follows: ues! I strongly believe that the only sustainable corporate advantage a company can have is its people. • In 1981, the management of Harley-Davidson bought • In 1994, we began fostering a partnership with our the company from its parent company, ANIF, in a lever- unions to enable them to participate fully in the business. aged buyout. The extremely high level of debt incurred Today our two unions participate fully with the firms to finance the purchase placed the company in a very frail management in a wide range of decision making, includ- financial condition. The downturn in the economy, com- ing the firms strategies. bined with the debt load, created a powerful incentive to • Ve also initiated our circle organization, which involves improve operations to conserve cash. To add to the prob- the use of a team structure at our vice president level of lems, the firms principal lender, Citibank, announced in management to make the decisions. As a result, we elim- 1985 that it wanted out of its creditor position for the inated a whole layer from top management. firm. Last-minute refinancing was arranged on • Beginning in the 19905, we entered into a serious effort to December 31, 1985 to save the company from bank- globalize the company. We established a management team ruptcy. Then, within a few short months the companys in Europe, and over time we acquired our independent dis- financial picture had improved to the point where we tributors in major market~, such as the BenelufX, and Italy. were able to take the company public in an initial public offering. All of these decisions have significant financial implications • During the past two decades, the company has made sig- that are tied to our study of finance. Specifically, they reflect nificant capital investments in new product lines, such as financing choices, investment decisions, and working- the Evolution engine, the Softail motorcycle, and most capital management. So, we invite you to join us in our study recently, the Twin Cam 88 engine, one of our current of finance and, in the process, learn about a company that engine designs. Also, in 1998 we invested in new manu- has accomplished in real terms what few others have been facturing facilities in Kansas City, Missouri, and able to eLl. Menominee Falls, ·Wisconsin. • To improve the films management of its working capital, Harley-D;lvidson Motor Company: mission statement is, ""Ve fulfill we introduced the use of just-in-time inventory conu·ol. dreams through the experiences of motorcycling by providing to motorcy- clists and the general public an expanding line of motorcycles, branded We called our program MAN, which stands for Materials products and services in selected market segments. The firms value state- As Needed. This program allowed us to remove $51 mil- ment is exprcssed as, Tell the tmth, be fair, keep your promises, respect the lion from our work-in-process inventory and provided individual, and encourage intellectual curiosity. Objective --.!J TEN PRINCIPLES THAT FORM THE BASICS OF FINANCIAL MANAGEMENT We will now look at the finance fow1dations that lie behind the decisions made by finan- cial managers. To the first-time student of finance, the subject matter may seem like a col- lection of unrelated decision rules. This could not be further from the truth. In fact, our
  22. 22. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 13decision rules, and the logic that underlies them, spring from 10 simple principles that donot require knowledge of finance to understand. However, while it is not necessary to under-standfinance in order to understand these priluiples, it is necessary to understand these principlesin order to understand finance. Keep in mind that although these principles may at firstappear simple or even trivial, they will provide the driving force behind all that follows.These principles will weave together concepts and techniques presented in this text,thereby allowing us to focus on the logic underlying the practice of financial manage-ment. In order to make the learning process easier for you as a student, we will keepreturning to these principles throughout the book in the form of "Back to the Principles"boxes-tying the material together and letting you son the "forest from the trees." PRINCIPLE The Risk-Return Trade-Oft-We wont take on additional risk unless we expect to be compensated with additional returnAt some point, we have all saved some money. Why have we done this? The answer issimple: to expand our future conswnption opportunities-for example, save for a house,a car, or retirement. We are able to invest those savings and earn a return on our dollarsbecause some people would rather forgo future consumption opportunities to consumemore now-maybe theyre borrowing money to open a new business or a company isborrowing money to build a new plant. Assuming there are a lot of different people thatwould like to use our savings, how do we decide where to put our money? First, investors demand a minimum return for delaying conswnption that must begreater than the anticipated rate of inflation. If they didnt receive enough to compensatefor anticipated inflation, investors would purchase whatever goods they desired ahead oftime or invest in assets that were subject to inflation and earn the rate of inflation onthose assets. There isnt much incentive to postpone conswnption if your savings aregoing to decline in terms of purchasing power. Investment alternatives have different amounts of risk and expected returns.Investors sometimes choose to put their money in risky investments because theseinvestments offer higher expected returns. The more risk an investment has, the higherwill be its expected return. This relationship between risk and expected return is shownin Figure 1-3. FIGURE 1-3 The Risk-Return Relationship E a ~ -g t Expected return :<II for taking on } added riskExpected return { for delaying consumption LI _ Risk
  23. 23. 14 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns from investing will be, but we cant peer into the future and see what those rerurns are actually going to be. If investors could see into the future, no one would have invested money in the software maker Citrix, whose stock dropped 46 percent on June 13, 2000. Citrixs stock dropped when it announced that unexpected problems in its sales channels would cause second-quarter profits to be about half what Wall Street expected. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest convinces some investors to take on the added risk of purchasing a General Motors bond. This risk-return relationship will be a key concept as we value stocks, bonds, and proposed new projects throughout this text. We will also spend some time determining how to measure risk. Interestingly, much of the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 1-3 and how to measure risk. Both the graph and the risk-return relationship it depicts will reappear often in this text. PRINCIPLE 2 The Time Value of Money-A dollar received today is worth more than a dollar received in the future A fundamental concept in finance is that money has a time value associated with it: A dol- lar received today is worth more than a dollar received a year from now. Because we can earn interest on money received today, it is better to receive money earlier rather than later. In your economics courses, this concept of the time value of money is referred to as the opporrunity cost of passing up the earning potential of a dollar today. In this text, we focus on the creation and measurement of wealth. To measure wealth or value, we will use the concept of the time value of money to bring the future benefits and costs of a project back to the present. Then, if the benefits outweigh the costs, the project creates wealth and should be accepted; if the costs outweigh the benefits, the pro- ject does not create wealth and should be rejected. Without recognizing the existence of the time value of money, it is impossible to evaluate projects with future benefits and costs in a meaningful way. To bring future benefits and costs of a project back to the present, we must assume a specific opportunity cost of money, or interest rate. Exactly what interest rate to use is determined by Principle 1: The Risk-Return Trade-Off, which states investors demand higher returns for taking on more risky projects. Thus, when we determine the present value of future benefits and costs, we take into account that investors demand a higher return for taking on added risk. ---., PRINC I PLE 3 Cash-Not Profits-Is King In measuring wealth or value, we will use cash flows, not accounting profits, as our mea- surement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits, that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand. As a result, a firms cash flows and accounting profits may not be the same. For example, a capital expense, such as the purchase of new equipment or a building, is depreciated over sev- eral years, wjth the annual depreciation subtracted from profits. However, the cash flow, or actual dollars, associated with this expense generally occurs immediately. Therefore
  24. 24. CHAPTER"l AN INTRODUCTION TO FINANCIAL MANAGEMENT 15cash inflows and outflows involve the actual receiving and payout of money-when themoney hits or leaves your hands. As a result, cash flows correctly reflect the timing of thebenefits and costs. PRINCIPLE 4 Incremental Cash Flows-its only what changes that countsIn 2000, Post, the maker of Cocoa Pebbles and Fruity Pebbles, introduced Cinna CrunchPebbles, "Cinnamon sweet taste that goes crunch." There is no doubt that Cinna CrunchPebbles competed directly with Posts other cereals and, in particular, its Pebbles prod-ucts. Certainly some of the sales dollars that ended up with Cinna Crunch Pebbles wouldhave been spent on other Pebbles and Post products if Cinna Crunch Pebbles had notbeen available. Although Post was targeting younger consumers with this sweetenedcereal, there is no question that Post sales bit into-actually cannibalized-sales fromPebbles and other Post lines. Realistically, theres only so much cereal anyone can eat.The difference between revenues Post generated after introducing Cinna Crunch Pebblesversus simply maintaining its existing line of cereals is the incremental cash flows. Thisdifference reflects the true impact of the decision. In making business decisions, we are concerned with the results of those decisions:What happens if we say yes versus what happens if we say no? Principle 3 states that weshould use cash flows to measure the benefits that accrue from taking on a new project.We are now fine tuning our evaluation process so that we only consider incremental cashflows. The incremental cash flow is the difference between the cash flows if the project istaken on versus what they will be if the project is not taken on. What is important is that we think incrementally. Our guiding rule in decidingwhether a cash flow is incremental is to look at the company with and without the newproduct. In fact, we will take this incremental concept beyond cash flows and look at allconsequences from all decisions on an incremental basis. PRINCIPLE 5 The Curse of Competitive Markets-Why its hard to find exceptionally profitable projectsOur job as financial managers is to create wealth. Therefore, we will look closely at themechanics of valuation and decision making. We will focus on estimating cash flows,determining what the investment earns, and valuing assets and new projects. But it will beeasy to get caught up in the mechanics of valuation and lose sight of the process of creat-ing wealth. Why is it so hard to find projects and investments that are exceptionally prof-itable? Where do profitable projects come from? The answers to these questions tell us alot about how competitive markets operate and where to look for profitable projects. In reality, it is much easier evaluating profitable projects than finding them. If anindustry is generating large profits, new entrants are usually attracted. The additionalcompetition and added capacity can result in profits being driven down to the requiredrate of return. Conversely, if an industry is returning profits below the required rate ofreturn, then some participants in the market drop out, reducing capacity and competi-tion. In turn, prices are driven back up. This is precisely what happened in the VCR videorental market in the mid-1980s. This market developed suddenly with the opportunityfor extremely large profits. Because there were no barriers to entry, the market quicklywas flooded with new entries. By 1987, the competition and price cutting produced lossesfor many firms in the industry, forcing them to flee the market. As the competition less-ened with firms moving out of the video rental industry, profits again rose to the pointwhere the required rate of return could be earned on invested capital.
  25. 25. 16 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can we find good projects-that is, projects that return more than their expected rate of return given their risk level (remember Principle 1). Although competition makes them difficult to find, we have to invest in mar- kets that are not perfectly competitive. The two most common ways of making markets less competitive are to differentiate the product in some key way or to achieve a cost advantage over competitors. Product differentiation insulates a product from competition, thereby allowing a company to charge a premium price. If products are differentiated, consumer choice is no longer made by price alone. For example, many people are willing to pay a prernium for Starbucks coffee. They simply want Starbucks and price is not important. In the pharma- ceutical industry, patents create competitive barriers. Schering-Ploughs Claritin, an allergy relief medicine, and Hoffman-La Roches Valium, a tranquilizer, are protected from direct competition by patents. Service and quality are also used to differentiate products. For example, Levis has long prided itself on the quality of its jeans. As a result, it has been able to maintain its market share. Similarly, much of Toyota and Hondas brand loyalty is based on quality Service can also create product differentiation, as shown by McDonalds fast service, cleanliness, and consistency of product that brings customers back. Whether product differentiation occurs because of advertising, patents, service, or quality, the more the product is differentiated from competing products, the less compe- tition it will face and the greater the possibility of large profits. Econornies of scale and the ability to produce at a cost below competition can effec- tively deter new entrants to the market and thereby reduce competition. Wal-Mart is one such case. For Wal-Mart, the fixed costs are largely independent of the stores size. For example, inventory costs, advertising expenses, and managerial salaries are essentially the same regardless of annual sales. Therefore, the more sales that can be built up, the lower the per-sale dollar cost of inventory, advertising, and management. Restocking from warehouses also becomes more efficient as delivery trucks can be used to full potential. Regardless of how the cost advantage is created-by econornies of scale, proprietary technology, or monopolistic control of raw materials-the cost advantage deters new market entrants while allowing production at below industry cost. This cost advantage has the potential of creating large profits. The key to locating profitable investment projects is to first understand how and where they exist in competitive markets. Then the corporate philosophy must be aimed at creating or taking advantage of some imperfection in these markets, either through product differentiation or creation of a cost advantage, rather than looking to new mar- kets or industries that appear to provide large profits. Any perfectly competitive indus- try that looks too good to be true wont be for long. It is necessary to understand this to know where to look for good projects and to accurately measure the projects cash flows. We can do this better if we recognize how wealth is created and how difficult it is to create it. PRINCIPLE 6 Efficient Capital Markets-The markets are quick and the prices are right Our goal as financial managers is the maximization of shareholder wealth. How do weEfficient market measure shareholder wealth? It is the value of the shares that the shareholders hold. ToA market in which the values ofall assets and securities at any understand what causes stocks to change in price, as well as how securities such as bondsinstant in time fully reflect all and stocks are valued or priced in the financial markets, it is necessary to have an under-available public information. standing of the concept of efficient markets.
  26. 26. CHAPTER t AN INTRODUCTION TO FINANCIAL MANAGEMENT 17 / Whether a market is efficient or not has to do with the speed with which informationis impounded into security prices. An efficient market is characterized by a large numberof profit-driven individuals who act independently. In addition, new information regard-ing securities arrives in the market in a random manner. Given this setting, investorsadjust to new information immediately and buy and sell the security until they feel themarket price correctly reflects the new information. Under the efficient market hypothe-sis, information is reflected in security prices with such speed that there are no opportu-nities for investors to profit from publicly available information. Investors competing forprofits ensure that security prices appropriately reflect the expected earnings and risksinvolved and thus the true value of the firm. What are the implications of efficient markets for us? First, the price is right. Stockprices reflect all publicly available information regarding the value of the company. Thismeans we can implement our goal of maximization of shareholder wealth by focusing onthe effect each decision should have on the stock price if everything else were held con-stant. That is, over time good decisions will result in higher stock prices and bad ones,lower stock prices. Second, earnings manipulations through accounting changes will notresult in price changes. Stock splits and other changes in accounting methods that do notaffect cash flows are not reflected in prices. Market prices reflect expected cash flowsavailable to shareholders. Thus, our preoccupation with cash flows to measure the timingof the benefits is justified. As we will see, it is indeed reassuring that prices reflect value. It allows us to look atprices and see value reflected in them. While it may make investing a bit less exciting, itmakes corporate finance much less uncertain. PRINCIPLE The Agency Problem-Managers wont work for owners unless its in their best interestAlthough the goal of the firm is the maximization of shareholder wealth, in reality, theagency problem may interfere with the implementation of tllis goal. The agency prob- Agency problemlem results from the separation of management and the ownership of the firm. For exam- Problem resulting fromple, a large firm may be nm by professional managers who have little or no ownership in conflicts of interest between the manager (the stockholdersthe firm. Because of this separation of the decision makers and owners, managers may agent) and the stockholders.make decisions that are not in line with the goal of maximization of shareholder wealth.They may approach work less energetically and attempt to benefit themselves in terms ofsalary and perquisites at the expense of shareholders. To begin with, an agent is someone who is given the authority to act on behalf ofanother, referred to as the principal. In the corporate setting, the shareholders are theprincipals, because they are the actual owners of the firm.The board of directors, theCEO, the corporate executives, and all others with decision-making power are agents ofthe shareholders. Unfortunately, the board of directors, the CEO, and the other corpo-rate executives dont always do whats in the best interest of the shareholders. Instead,.they act many times in their own best interest. Not only might tlley benefit themselves interms of salary and perquisites, but they might also avoid any projects that have risk asso-ciated with them-even if theyre great projects witll huge potential returns and a smallchance of failure. Why is this so? Because if tlle project doesnt turn out, these agents ofthe shareholders may lose their jobs. The costs associated with the agency problem are difficult to measure, but occasionallywe see the problems effeCt in the marketplace. For example, if the market feels manage-ment of a firm is damaging shareholder wealth, we might see a positive reaction in stockprice to the removal of that management. In 1989, on the day following the death ofJohnDorrance, Jr., chairman of Campbell Soup, Campbells stock price rose about 15 percent.
  27. 27. 18 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT Some investors felt that Campbells relatively small growth in earnings might be improved with the departure of Dorrance. There was also speculation that Dorrance was the major obstacle to a possible positive reorganization. If the management of the firm works for the owners, who are the shareholders, why doesnt the management get fired if it doesnt act in the shareholders best interest? In the- ory, the shareholders pick the corporate board of directors and the board of directors in turn picks the management. Unfortunately, in reality the system frequently works the other way around. Management selects the board of director nominees and then distrib- utes the ballots. In effect, shareholders are offered a slate of nominees selected by the management. The end result is management effectively selects the directors, who then may have more allegiance to managers than to shareholders. This in turn sets up the potential for agency problems with the board of directors not monitoring managers on behalf of the shareholders as they should. We will spend considerable time monitoring managers and trying to align their inter- ests with shareholders. Managers can be monitored by auditing financial statements and managers compensation packages. The interests of managers and shareholders can be aligned by establishing management stock options, bonuses, and perquisites that are directly tied to how closely their decisions coincide with the interest of shareholders. The agency problem will persist unless an incentive structure is set up that aligns the interests of managers and shareholders. In other words, whats good for shareholders must also be good for managers. If that is not the case, managers will make decisions in their best interests rather than maximizing shareholder wealth. PRINCIPLE 8 Taxes Bias Business Decisions Hardly any decision is made by the financial manager without considering the impact of taxes. When we introduced Principle 4, we said that only incremental cash flows should be considered in the evaluation process. More specifically, the cash flows we will consider will be after-tax incremental cash flows to the firm as a whole. When we evaluate new projects, we will see income taxes playing a significant role. When the company is analyzing the possible acquisition of a plant or equipment, the returns from the investment should be measured on an after-tax basis. Otherwise, the com- pany will not truly be evaluating the true incremental cash flows generated by the project. The government also realizes taxes can bias business decisions and uses taxes to encourage spending in certain ways. If the government wanted to encourage spending on research and development projects it might offer an investment tax credit for such invest- ments. This would have the effect of reducing taxes on research and development projects, which would in turn increase the after-tax cash flows from those projects. The increased cash flow would turn some otherwise unprofitable research and development projects into profitable projects. In effect, the government can use taxes as a tool to direct business investment to research and development projects, to the inner cities, and to pro- jects that create jobs. PRINCIPLE 9 All Risk Is Not Equal-Some risk can be diversified away, and some cannot Much of finance centers around Principle 1: The Risk-Retunt Trade-Off. But before we can fully use Principle 1, we must decide how to measure risk. As we will see, risk is difficult to measure. Principle 9 introduces you to the process of diversification and demonstrates how ityan reduce risk. We will also provide you with an understanding of how diversification makes it difficult to measure a projects or an assets risk.
  28. 28. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 19 You are probably already familiar with the concept of diversification. There is an oldsaying, "dont put all of your eggs in one basket." Diversification allows good and badevents or observations to cancel each other out, thereby reducing total variability withoutaffecting expected return. To see how diversification complicates the measurement of risk, let us look at the dif-ficulty Louisiana Gas has in determining the level of risk associated with a new naturalgas well drilling project. Each year, Louisiana Gas might drill several hundred wells, witheach well having only a 1 in 10 chance of success. If the well produces, the profits arequite large, but if it comes up dry, the investment is lost. Thus, with a 90 percent chanceof losing everything, we would view the project as being extremely risky. However, ifLouisiana Gas each year drills 2,000 wells, all with a 10 percent, independent chance ofsuccess, then they would typically have 200 successful wells. Moreover, a bad year mayresult in only 190 successful wells, and a good year may result in 210 successful wells. Ifwe look at all the wells together, the extreme good and bad results tend to cancel eachother out and the well drilling projects taken together do not appear to have much risk orvariability of possible outcome. The amount of risk in a gas well project depends upon our perspective. Looking atthe well standing alone, it looks like a lot; however, if we consider the risk that each wellcontributes to the overall firm risk, it is quite small. This is because much of the risk asso-ciated with each individual well is diversified away within the firm. The point is: We cantlook at a project in isolation. Later, we will see that some of this risk can be further diver-sified away within the shareholders portfolio. Perhaps the easiest way to understand the concept of diversification is to look at itgraphically. Consider what happens when we combine two projects, as depicted in Figure1-4. In this case, the cash flows from these projects move in opposite directions, and whenthey are combined, the variability of their combination is totally eliminated. Notice thatthe return has not changed-each individual projects and their combinations returnaverages 10 percent. In this case, the extreme good and bad observations cancel eachother out. The degree to which the total risk is reduced is a function of how the two setsof cash flows or returns move together. As we will see for most projects and assets, some risk can be eliminated throughdiversification, whereas some risk cannot. This will become an important distinction laterin our studies. For now, we should realize that the process ofdiversification can reduce risk, andas a result, measuring a projects or an assets risk is very difficult. A projects risk changesdepending on whether you measure it standing alone or together with other projects thecompany may taktion. See the Finance Matters box, "Ethics: The Enron Lessons." FIGURE 1-4 Reducing Risk Through Diversification 20 Asset A---.e:, ~ E 10E~ Asset B o Time